New Structural Economics: A Framework for Rethinking Development [with

Comments]
Author(s): Justin Yifu Lin, Anne Krueger and Dani Rodrik
Source: The World Bank Research Observer , August 2011, Vol. 26, No. 2 (August 2011),
pp. 193-229
Published by: Oxford University Press

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 New Structural Economics: A Framework
for Rethinking Development1

Justin Yifu Lin

As strategies for achieving sustainable growth in developing countries are re-examined in

light of the financial crisis, it is critical to take into account structural change and its
corollary, industrial upgrading. Economic literature has devoted a great deal of attention
to the analysis of technological innovation, but not enough to these equally important
issues. The new structural economics outlined in this paper suggests a framework to
complement previous approaches in the search for sustainable growth strategies. It takes
the following into consideration.
First, an economy's structure of factor endowments evolves from one level of develop-
ment to another. Therefore, the optimal industrial structure of a given economy will be
different at different levels of development. Each industrial structure requires correspond-
ing infrastructure (both "hard" and "soft") to facilitate its operations and transactions.
Second, each level of economic development is a point along the continuum from a
low-income agrarian economy to a high-income industrialized economy, not a dichotomy
of two economic development levels ("poor" versus "rich" or "developing" versus "indus-
trialized"). Industrial upgrading and infrastructure improvement targets in developing
countries should not necessarily draw from those that exist in high-income countries.
Third, at each given level of development, the market is the basic mechanism for effec-
tive resource allocation. However, economic development as a dynamic process requires
industrial upgrading and corresponding improvements in "hard" and "soft" infrastruc-
ture at each level. Such upgrading entails large externalities to firms' transaction costs
and returns to capital investment. Thus, in addition to an effective market mechanism,
the government should play an active role in facilitating industrial upgrading and infra-
structure improvements. JEL codes: L16, 010, 020, 021, 025, 040

The World Bank Research Observer

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doi:10.1093/wbro/lkr007 Advance Access publication July 8, 2011 26:193-221

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Several decades from now when economic historians look back on the story of
the past hundred years, it is very likely that they will be intrigued by the
mystery of diverging performances by various countries, especially during the
second half of the twentieth century. On the one hand, they will be amazed by
the rapid growth path followed by a small number of countries such as Brazil,
Chile, China, Indonesia, India, Korea, Malaysia, Mauritius, Singapore, Thailand,
and Vietnam, where the industrialization process quickly transformed their sub-
sistence, agrarian economies and lifted several hundred million people out of
poverty in the space of one generation. On the other hand, they will be
puzzled by the apparent inability of many other countries, where more than
one-sixth of humanity remained trapped in poverty. They will also notice that
with the exception of a few successful economies, there was little economic
convergence between rich and poor countries in spite of the many efforts made
by developing countries and despite the assistance of many multilateral devel-
opment agencies.
Long-term sustainable and inclusive growth is the driving force for poverty
reduction in developing countries, and for convergence with developed econom-
ies. The current global crisis, the most serious one since the Great Depression,
calls for a rethinking of economic theories. It is therefore a good time for econ-
omists to reexamine development theories as well. This paper discusses the
evolution of development thinking since the end of World War II and suggests
a framework to enable developing countries to achieve sustainable growth,
eliminate poverty, and narrow the income gap with the developed countries.
The proposed framework, called a neoclassical approach to structure and
change in the process of economic development, or new structural economics,
is based on the following ideas:

• First, an economy's structure of factor endowments evolves from one level of

development to another. Therefore, the industrial structure of a given
economy will be different at different levels of development. Each industrial
structure requires corresponding infrastructure (both tangible and intangible)
to facilitate its operations and transactions.
• Second, each level of economic development is a point along the continuum
from a low-income agrarian economy to a high-income post-industrialized
economy, not a dichotomy of two economic development levels ("poor" versus
"rich" or "developing" versus "industrialized"). Industrial upgrading and
infrastructure improvement targets in developing countries should not necess-
arily draw from those that exist in high-income countries.
• Third, at each given level of development, the market is the basic mechanism
for effective resource allocation. However, economic development as a
dynamic process entails structural changes, involving industrial upgrading

194 The World Bank Research Observer, vol. 26, no. 2 (August 2011)

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 and corresponding improvements in "hard" (tangible) and "soft" (intangible)
infrastructure at each level. Such upgrading and improvements require an
inherent coordination with large externalities to firms' transaction costs and
returns to capital investment. Thus, in addition to an effective market mech-
anism, the government should play an active role in facilitating structural
changes.

The remainder of the paper is organized as follows: the next section examines
the evolution of development thinking and offers a critical review of some of its
main schools of thought. I then outline the basic principles and conceptual fra-
mework of the new structural economics, the function of the market, and the
roles of a facilitating state. In the next section I highlight similarities and differ-
ences between old and new structural economics, and discusses some preliminary
insights on major policy issues based on this new approach.

A Short Review of Development Thinking and Experiences

The process of sustainable per capita income increase and economic growth,
characterized by continuous technological innovation and industrial upgrading,
is a modern phenomenon. From Adam Smith to the early twentieth century,
most economists believed that laissez-faire was the best vehicle for achieving sus-
tainable growth in an economy. It was assumed that in thriving economies all
decisions about resource allocation are made by economic agents interacting in
markets free of government intervention. The price system determines not only
what is produced and how but also for whom. Households and firms pursuing
their own interests would be led, "as if by an invisible hand," to do things that
are in the interests of others and of society as a whole. Although the laissez-
faire approach was challenged by Marxist economists and others, it became the
dominant intellectual framework for the study of growth in all countries and
remained so for a long time. It certainly provided many good insights on the
process of economic development but it missed the importance of the process
of continuous, fundamental technological changes and industrial upgrading,
which distinguishes modern economic growth from premodern economic
growth (Kuznets 1966).
The study of economic development proceeds in two related but separate
tracks: growth theories and development theories. While some of the key ingredi-
ents of modern growth theory such as competitive behavior, equilibrium
dynamics, the importance of physical capital and human capital, the possibility of
diminishing returns, and the impact of technological progress can be found in the
work of classical economists (Ramsey 1928; Schumpeter 1934), systematic

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modeling only started in the 1940s when some pioneers used primary factors to
build generic models based on aggregate production functions. Harrod (1939)
and Domar (1946) triggered extensive research along these lines. Following their
initial work, the Solow-Swan model sparked the first major wave of systematic
growth analysis. The objective was to understand the mechanics of growth, ident-
ify its determinants, and develop techniques of growth accounting, which would
help explain changes in the momentum and role of economic policy. That first
generation of growth researchers highlighted the centrality of capital. One impor-
tant prediction from these models was the idea of conditional convergence,
derived from the assumption of diminishing returns to capital - poor economies
with lower capital per worker (relative to their long-run or steady-state capital per
worker) will grow faster. While that assumption allowed the model to maintain its
key prediction of conditional convergence, it also seemed odd: technology, the
main determinant of long-run growth, was kept outside of the model (Lin and
Monga 2010).
A new wave of growth modeling had to come up with a convincing theory of
technological change. Endogenous growth theory, as it came to be known, main-
tained the assumption of nonrivalry because technology is indeed a very different
type of factor from capital and labor - it can be used indefinitely by others, at zero
marginal cost (Romer 1987, 1990; Aghion and Howitt 1992). But it was impor-
tant to take the next logical step and to understand better the public good charac-
terization of technology and think of it as a partially excludable nonrival good.
The new wave therefore reclassified technology not just as a public good but as a
good that is subject to a certain level of private control. However, making it a par-
tially excludable nonrival good and therefore giving it some degree of excludability
or appropriability was not sufficient to ensure that incentives for its production
and use were socially optimal. The move away from perfect competition was there-
fore necessary. It has yielded high methodological payoffs. While neoclassical
models of growth took technology and factor accumulation as exogenous,
endogenous growth models explain why technology grows over time through new
ideas and provide the microeconomic underpinnings for models of the technologi-
cal frontier.

Another important question has been to understand how technological diffu-

sion takes place across countries and generates or sustains growth - and why it
does not take root in others. Various interesting possibilities have recently been
explored in an attempt to answer that critical question (Jones 1998; Acemoglu,
Johnson, and Robinson 2001; Glaeser and Shleifer 2002). Both on the theoretical
and empirical fronts, progress has been made in our understanding of growth in
recent decades. However, growth research still faces significant methodological dif-
ficulties and challenges in identifying actionable policy levers to sustain and accel-
erate growth in specific countries.

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 Intellectual progress has been even slower in the particular domain of develop-
ment theories. It took a paper by Rosenstein-Rodan (1943) to bring development
issues to the forefront of the discipline. The paper suggested that the virtuous
circle of development depended essentially on the interaction between economies
of scale at the level of individual firms and the size of the market. Specifically it
assumed that modern methods of production can be made more productive than
traditional ones only if the market is large enough for their productivity edge to
compensate for the necessity of paying higher wages. But the size of the market
itself depends on the extent to which these modern techniques are adopted.
Therefore, if the modernization process can be started on a very large scale, then
the process of economic development will be self-reinforcing and self-sustaining. If
not, countries will be indefinitely trapped in poverty.
Rosenstein-Rodan's framework sparked a wave of similar ideas (Chang 1949;
Lewis 1954; Myrdal 1957; Hirschman 1958) which came to be known as the
structuralist approach to economic development. These early development the-
ories held that the market encompassed insurmountable defects and that the state
was a powerful supplementary means to accelerate the pace of economic develop-
ment (Rosenstein-Rodan 1943; Nurkse 1953; Hirschman 1958). The slump of
international trade in the Great Depression led to export pessimism in the post-
War period. In Latin America, for instance, political leaders and social elites were
influenced strongly by the deterioration in the terms of trade, the economic diffi-
culty encountered during the Great Depression in the 1930s, and the thesis devel-
oped by Prebisch (1950) and Singer (1950). They believed that the decline in the
terms of trade against the export of primary commodities was secular and led to
the transfer of income from resource-intensive developing countries to capital-
intensive developed countries. They argued that the way for a developing country
to avoid being exploited by developed countries was to develop domestic manufac-
turing industries through a process known as import substitution. Moreover, the
emergence of previous colonies or semi-colonies as newly independent states in
Asia and the Middle East, and later in Africa, was accompanied by strong nation-
alist sentiments.

The results were disappointing in many cases. In many developing countries,

well-intended government interventions failed. This was the case across Latin
American, African, and South Asian countries in the 1960s and 1970s when
import substitution and protection were essential features of the development
strategy. One of the main reasons for the failure of many former socialist and
developing countries to achieve dynamic growth in their transitional processes
was the fact that they attempted to defy the comparative advantage determined
by their endowment structures and gave priority to development of capital-inten-
sive heavy industries when capital in their economies was scarce. In order to
implement such strategies, developing-country governments had to protect

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numerous nonviable enterprises in their priority sectors (Lin 2009a; Lin and Li
2009).
By shielding unsustainable industries from import competition, developing
countries also imposed various types of other costs on their economies. Protection
typically led to: (i) an increase in the price of imports and import-substituting
goods relative to the world price and distortions in incentives, pushing the
economy to consume the wrong mix of goods from the point of view of economic
efficiency; (ii) the fragmentation of markets, as the economy produced too many
small-scale goods, which resulted again in loss of efficiency; (iii) decreased compe-
tition from foreign firms and support for the monopoly power of domestic firms
whose owners were politically well connected; and (iv) opportunities for rents and
corruption, which raised input and transaction costs (Krueger 1974; Krugman
1993).
As government-led economic development strategies based on the structuralist
teachings failed in many countries, the free market approach appeared to triumph
and influence development thinking. This trend was reinforced by a new revolu-
tion in macroeconomics. The prevailing Keynesian macroeconomics was chal-
lenged by the stagflation in the 1970s, the Latin American debt crisis, and the
collapse of the socialist planning system in the 1980s. The so-called rational
expectations revolution emerged and refuted the structuralist theoretical foun-
dation for the state's role in using fiscal and monetary policy for economic
development.
The Latin American debt crisis began in 1982 when international financial
markets realized that the collapse of the Bretton Woods system had put some
countries with unlimited access to foreign capital in a situation where they
could not pay back their loans. The crisis was precipitated by a number of inter-
related exogenous shocks that toppled the Mexican and several other Latin
American economies, which were already overburdened with a substantial
percentage of the world's outstanding debt (Cardoso and Helwege 1995). It
prompted multilateral lending institutions and bilateral lenders - especially the
United States - to call for a comprehensive set of reforms of Latin American
economies and to advocate a set of free-market policies that followed the canons
of the neoclassical paradigm, later known as the Washington Consensus
(Williamson 1990).
The Washington Consensus quickly came to be perceived as "a set of neoliberal
policies that have been imposed on hapless countries by the Washington-based
international financial institutions and have led them to crisis and
misery" (Williamson 2002). It promoted economic liberalization, priv
and the implementation of rigorous stabilization programs. The resul
policies in terms of growth and employment generation were at best con
(Easterly, Loayza, and Montiel 1997; Easterly 2001). By the end of the

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parallel to the dismissal of structuralism and the prevalence of the free market
approach, the development economics research community was witnessing
the end of an era dominated by cross-country regressions, which attempted to
identify growth determinants. That approach had been to focus on the indepen-
dent and marginal effects of a multitude of growth determinants. This led to the
linearization of complex theoretical models. Yet, the general view was that growth
determinants interact with each other. To be successful, some policy reforms must
be implemented with other reforms. There was a general perception that the
policy prescriptions stemming from such regressions did not produce tangible
results.
An alternative perspective on non-linearities was the Growth Diagnostics or
Decision Tree approach suggested by Hausmann, Rodrik, and Velasco (2005).
They recognized the central role of structural change in economic development
and argued that there are "binding constraints" on growth in each country.
These authors suggested that binding constraints can vary over time and across
countries. They concluded that identification of the binding constraint was there-
fore key in practice. This framework highlighted pragmatically the inability of gov-
ernments to reform everything and stressed the need to prioritize reforms, which
should be done through the information revealed by shadow prices. It should be
noted that the Growth Diagnostics approach is not operational unless one
assumes away reform complementarities, which is the feature of linear growth
regressions.
The divergence in growth performance between developed and developing
countries, despite predictions of convergence from mainstream economic theory,
has led to controversy. Some have concluded that the policy prescriptions, or
expectations about their effectiveness, or both were wrong. Others have observed
that growth researchers had paid limited attention to heterogeneity (the specific
characteristics of each country). The suggestion that cross-country distribution
may be multimodal (with the existence of "convergence clubs") did not settle the
debate about which new directions were needed for growth research. Instead,
many basic questions have come back on the agenda: Are development econom-
ists looking in the wrong place in their quest for the determinants of growth?
Should the focus be on institutions (institutional outcomes), instead of or in
addition to policies? And, assuming that they are not reflecting other factors, how
can good institutional outcomes be generated?
These unanswered questions were on the agenda for a long time. Starting in
the 1980s, many development economists tried to understand better the causality
of relationships and the various transmission channels through which policies,
institutional changes, or foreign aid affect growth. They were also the rationale
for an increased focus of growth research on microbehavior issues at the house-
hold and firm levels, with two goals: (i) allowing for heterogeneity in the

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economy (across and within countries); and (ii) investigating how constraints to
growth operate at the microlevel.
The growing disappointment and disillusionment with aid effectiveness also led
to the quest for rigorous impact evaluation of development projects and programs.
This has generated a new approach to development led by economists at the MIT
Poverty Lab, whose goal is "to reduce poverty by ensuring that policy is based on
scientific evidence" through the use of randomized control trials (RCT) or social
experiments. Although RCT are good tools for understanding the effectiveness of
some specific microprojects, they often do not start from a clear strategic assess-
ment of how a particular method would fit the knowledge gaps of highest priority
(Ravallion 2009). All too often, research looks for topics "under the light." The
positive outcomes for policymaking are more often the occasional by-products of
research than its objective from the outset.
Recent microempirical studies may have indeed shed light on some important
problems, such as the impact of the investment climate on firm performance or
the impact of household behavior on productivity (Rosenzweig and Wolpin 1985).
But "there is a risk the bulk of present-day research in development economics
appears to be too narrowly focused and/or of too little generalizability to help
much in the fight against poverty and to facilitate structural change and sus-
tained growth" (World Bank 2010).
The time has come to reexamine the state of development economics, to learn
from past experiences and previous knowledge, and to offer new thinking and a
new framework. Drawing lessons from past experience and from economic the-
ories, the next section presents the key principles of a new structural economics,
which is a neoclassical approach to economic structure and dynamic change in
the process of economic development.2

A Neoclassical Approach to Structure and Change

The starting point for the analysis of economic development is an economy's
endowments. Endowments are given in an economy at any specific time and are
changeable over time. Following the tradition of classical economics, economists
tend to think of a given country's endowments as consisting only of its land (or
natural resources), labor, and capital (both physical and human).3 These are in
fact factor endowments, which firms in an economy can use in production. It
should be noted that the analysis of new structural economics focuses on the
dynamics of the capital/labor ratio. This is because land is exogenously given in
any realistic discussion of a country's development and natural resources, such as
mining resources, exist underground in fixed quantity and their discovery is often
random.

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 Conceptually, it is useful to add infrastructure as one more component in an
economy's endowments. Infrastructure includes hard (or tangible) infrastructure
and soft (or intangible) infrastructure. Examples of hard infrastructure are high-
ways, port facilities, airports, telecommunication systems, electricity grids, and
other public utilities. Soft infrastructure consists of institutions, regulations, social
capital, value systems, and other social, economic arrangements. Infrastructure
affects the individual firm's transaction costs and the marginal rate of return on
investment.

Countries at different levels of development tend to have different economic

structures due to differences in their endowments. Factor endowments for
countries at the early levels of development are typically characterized by a
tive scarcity of capital and relative abundance of labor or resources. Their
duction activities tend to be labor intensive or resource intensive (mostly
subsistence agriculture, animal husbandry, fishery, and the mining sector
usually rely on conventional, mature technologies and produce "mature," w
established products. Except for mining and plantations, their production
limited economies of scale. Their firm sizes are usually relatively small, w
market transactions often informal, limited to local markets with familiar p
The hard and soft infrastructure required for facilitating that type of produ
and market transactions are limited and relatively simple and rudimentary.
At the other extreme of the development spectrum, high-income count
display a completely different endowment structure. The relatively abund
factor in their endowments is typically capital, not natural resources or la
They tend to have comparative advantage in capital intensive industries wi
economies of scale in production. The various types of hard infrastructure (p
telecommunication, roads, port facilities, etc.) and soft infrastructure (regul
and legal frameworks, cultural value systems, etc.) that are needed must com
with the necessities of national and global markets where business transac
are long distance and large in quantity and value.
Economic development requires continuous introduction of new and bett
technology to an existing industry. Most people in low-income countries de
on agriculture for their livelihood. Improvements in agricultural technology
key to increasing farmers' income and reducing poverty. However, economic dev
opment also requires continuous diversifying and upgrading from existing in
tries to new, more capital-intensive ones. Without such a structural change,
scope for sustained increase in per capita income will be limited. Therefore,
discussion in this paper will focus mostly on issues related to industrial upgr
and diversification.

Developing countries have the advantage of backwardness in the upgrading

process and a whole spectrum of industries with different levels of capital intensity
available for them to choose. However, they must first upgrade their factor

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endowment structure, which requires their stock of capital to grow more rapidly
than the labor force (see Ju, Lin, and Wang 2009). When they move up the
industrial ladder in the process of economic development, they also increase their
scale of production - because of the indivisibility of capital equipment. Their firms
become larger and need a bigger market, which in turn necessitates correspon-
dent changes in power, transportation, financial arrangements, and other soft
infrastructure.

The process of industrial upgrading and diversification also increases the level
of risk faced by firms. As firms move closer to the global technology frontier, it
becomes increasingly difficult for them to borrow mature technology from
advanced countries. They increasingly need to invent new technologies and pro-
ducts and thus face more risk. The idiosyncratic risk of a firm has three com-
ponents based on risk sources: technological innovation, product innovation, and
managerial capacity. At the early level of development, firms tend to use mature
technologies to produce mature products for mature markets. At that level, the
main source of risk is the managerial ability of firms' owner-operators. At a
higher level of development, firms often invent new technologies to produce new
products for new markets. In addition to managerial capacity, such firms face
risks arising from the maturity of technology and markets. Therefore, while tech-
nological innovation, product innovation, and managerial capacity all contribute
to the overall level of risk associated with firms, their relative importance varies
greatly from one industry to another and from one level of economic development
to another.

With changes in the size of firms, scope of the market, and nature of risk,
along with the upgrading of the industrial structure, the requirements for infra-
structure services, both hard and soft, also change. If the infrastructure is not
improved simultaneously, the upgrading process in various industries may face
the problem of x-inefficiency, a phenomenon discussed by Leibenstein (1957).
Because the industrial structure in an economy at a specific time is endogenous
to its given relative abundance of labor, capital, and natural resources at that
time, the economy's factor endowment will change with capital accumulation or
population growth, pushing its industrial structure to deviate from the optimal
determined by its previous level.4
When firms choose to enter industries and adopt technologies that are consist-
ent with the comparative advantage determined by changes in the country's
factor endowments,5 the economy is most competitive.6 As competitive industries
and firms grow, they claim larger domestic as well as international market shares
and create the greatest possible economic surplus in the form of profits and sal-
aries. Reinvested surpluses earn the highest return possible as well, because the
industrial structure is optimal for that endowment structure. Over time, this
approach allows the economy to accumulate physical and human capital,

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upgrading the factor endowment structure as well as the industrial structure and
making domestic firms more competitive over time in more capital and skill-inten-
sive products.
Firms care about profits. For them spontaneously to enter industries and
choose technologies consistent with the economy's comparative advantage, the
price system must reflect the relative scarcity of factors in the country's endow-
ment. This only happens in an economy with competitive markets (Lin 2009a;
Lin and Chang 2009). Therefore, a competitive market should be the economy's
fundamental mechanism for resource allocation at each level of its development.
That kind of comparative advantage-following approach in economic development
may appear to be slow and frustrating in countries with major poverty challenges.
In reality, it is the fastest way to accumulate capital and upgrade the endowment
structure, and the upgrading of industrial structure can be accelerated by better
access to technology and industries already developed by and existing in more
advanced countries. At each level in their development, firms in developing
countries can acquire the technologies (and enter the industries) that are appro-
priate for their endowment structure, rather than having to reinvent the wheel
(Gerschenkron 1962; Krugman 1979). This possibility to use off-the-shelf tech-
nology and to enter into existing industries is what has allowed some of the East
Asian newly industrialized economies to sustain annual GDP growth rates of 8
and even 10 percent.
As a country climbs up the industrial and technological ladder, many other
changes take place: the technology used by its firms becomes more sophisticated,
and capital requirements increase, as well as the scale of production and the size
of markets. Market transactions increasingly take place at arm's length. A flexible
and smooth industrial and technological upgrading process therefore requires
simultaneous improvements in educational, financial, and legal institutions, and
in hard infrastructure so that firms in the newly upgraded industries can reduce
transaction costs and reach the production possibility frontier (Harrison and
Rodriguez-Clare 2010). Clearly, individual firms cannot internalize all these
changes cost effectively and spontaneous coordination among many firms to
meet these new challenges is often impossible. Change in infrastructure requires
collective action or at least coordination between the provider of infrastructure
services and industrial firms. For this reason, it falls to the government either to
introduce such changes or to coordinate them proactively.
Successful industrial upgrading in responding to change in an economy's
endowment structure requires that the pioneer firms overcome issues of limited
information regarding which new industries are the economy's latent comparative
advantages determined by the changing endowment structure. Valuable infor-
mation externalities arise from the knowledge gained by pioneer firms in both
success and failure. Therefore, in addition to playing a proactive role in the

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improvements of soft and hard infrastructures, the government in a developing
country, like that in a developed country, needs to compensate for the information
externalities generated by pioneer firms (Rodrik 2004; Lin 2009a; Lin and Monga
2011; Harrison and Rodriguez-Clare 2010)7

What is "New" About the New Structural Economics?

Like all learning ventures, economic development thinking is bound to be a con-

tinuous process of amalgamation and discovery, continuity, and reinvention. The
existing stock of knowledge has been the result of many decades of work by thin-
kers from various backgrounds and disciplines and has come to light through
several waves of theoretical and empirical research. It is therefore only natural
that the proposed new structural economics has some similarities and differences
with previous strands in the development economics literature. Its main value-
added should be assessed on the new policy insights it provides and the perti-
nence of the research agenda ahead.

Difference with Earlier Literature on Structural Change

Earlier thinking on structural change in the context of economic development is

mostly associated with Rostow (1990 [I960]) and Gerschenkron (1962). In
trying to understand how economic development occurs and what strategies can
be adopted to foster that process, the former suggested that countries can be
placed in one of five categories in terms of their level of growth: (i) traditional
societies, characterized by subsistence economy, with output not traded or even
recorded, the existence of barter, high levels of agriculture, and labor-intensive
agriculture; (ii) societies with preconditions to growth, where there is an increase
in capital use in agriculture, the development of mining industries, and some
growth in savings and investment; (iii) societies in take-off mode, with higher
levels of investment and industrialization, accumulation of savings, and a decline
in the share of the agricultural labor force; (iv) societies that drive to maturity
and where wealth generation enables further investment in value adding industry
and development - growth becomes self-sustaining, industry is diversified, and
more sophisticated technology is used; and (v) mass-consumption societies that
achieve high output levels and where the services industry dominates the
economy.
Gerschenkron questioned Rostow's proposition that all developing countries
pass through a similar series of levels and its implication that it is possible to gen-
eralize the growth trajectory of different countries. For the new structural econ-
omics, economic development from a low level to a high level is a continuous

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spectrum, not a mechanical series of five distinguished levels. Although the
change in an economy's industrial structure reflects the changes in that econo-
my's endowment structure, the development of industries in different countries
with a similar endowment structure can be achieved in different and nonlinear
ways. This is especially true with the increased globalization of markets, the rapid
development of new products, and constant technological change, as countries
can exploit opportunities that were not available in the past and specialize in
industries that are likely to vary from one economy to another.
The new structural economics also provides a framework for understanding the
endogeneity and exogeneity issues surrounding the key stylized facts of modern
growth analysis that have been outlined by the Growth Commission (2008) and
Jones and Romer (2009): an economy that follows its comparative advantage in
the development of its industries will be most competitive in domestic and world
markets. As a result, the economy will generate potentially the largest income
and surplus for savings. Capital investment will also have the largest possible
return. Consequently, households will have the highest savings propensity, result-
ing in an even faster upgrade of the country's endowment structure (Lin and
Monga 2010).

Similarities and Differences with Old Structural Economics

In terms of similarities, the "new" and the "old" structural economics are both
founded on structural differences between developed and developing countries
and acknowledge the active role of the state in facilitating the movement of the
economy from a lower level of development to a higher one. However, there are
profound differences between these two approaches regarding their targets and
the modalities of state intervention. The old structural economics advocates devel-
opment policies that go against an economy's comparative advantage and advise
governments in developing countries to develop advanced capital-intensive indus-
tries through direct administrative measures and price distortions. By contrast,
the new structural economics stresses the central role of the market in resource
allocation and advises the state to play a facilitating role to assist firms in the
process of industrial upgrading by addressing externality and coordination issues.
The differences between the two frameworks derive from their dissimilar views
on the sources of structural rigidities: old structural economics assumes that the
market failures that make the development of advanced capital-intensive indus-
tries difficult in developing countries are exogenously determined by structural
rigidities due to the existence of monopolies, labor's perverse response to price
signals, and/or the immobility of factors. By contrast, the new structural econ-
omics posits that the failure to develop advanced capital-intensive industries in
developing countries is endogenously determined by their endowments. The

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relative scarcity in their capital endowment and/or the low level of soft and hard
infrastructure in developing countries make the reallocations from the existing
industries to the advanced capital-intensive industries unprofitable for the firms in
a competitive market.
Old structural economics assumes a dual and restrictive view of the world, with
a binary classification of only two possible categories of countries: "low-income,
periphery countries" versus "high-income, core countries." As a result, it views
the differences in the industrial structure between developed and developing
countries as expressing a dichotomy. Contrary to that vision, the new structural
economics considers these differences as the reflection of a whole spectrum that
includes many different levels of development. The new structural economics also
rejects dependency theories. In an increasingly globalized world, it sees opportu-
nities for developing countries to counter negative historical trends by diversifying
their economy and building industries that are consistent with their comparative
advantage so as to accelerate growth and achieve convergence by exploiting the
advantage of backwardness in an open, globalized world.
Another major difference between the new and the old structural economics is
the rationale for using key instruments of economic management. Old structural
economics sees systematic government intervention in economic activities as the
essential ingredient in the modernization objective. Among the key instruments
used to move from "developing" countries to "industrialized" countries are gener-
alized protectionism (such as government-imposed tariffs on imports to protect
infant industries), rigid exchange-rate policies, financial repression, and the cre-
ation of state-owned enterprises in most sectors.
By contrast, the new structural economics recognizes that import substitution
is a natural phenomenon for a developing country climbing the industrial ladder
in its development process, provided that it is consistent with the shift in com-
parative advantage that results from changes in its endowment structure. But it
rejects conventional import-substitution strategies that rely on the use of fiscal
policy or other distortions in low-income, labor or resource-abundant economies
to develop high cost, advanced capital-intensive industries, which are not consist-
ent with the country's comparative advantage. It also stresses the idea that the
industrial upgrading process in a developing country should be consistent with
the change in the country's comparative advantage that reflects the accumulation
of human and physical capital and the change in its factor endowment struc-
ture - this ensures the viability of firms in new industries. The new structural
economics concludes that the role of the state in industrial diversification and
upgrading should be limited to the provision of information about the new indu
tries, the coordination of related investments across different firms in the same
industries, the compensation of information externalities for pioneer firms, and
the nurturing of new industries through incubation and encouragement of

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foreign direct investment (Lin 2009a; Lin and Chang 2009; Lin and Monga
2011). The state also needs to assume effectively its leadership role in the
improvement of hard and soft infrastructure in order to reduce transaction costs
on individual firms and so facilitate the economy's industrial development
process.

New Structural Economics: Some Policy Insights

The ultimate goal of development thinking is to provide policy advice that facili-
tates the quest for sustainable and inclusive economic and social progress in poor
countries. Although specific policy measures to be derived from the new struc-
tural economics approach will require further research and depend very much on
country context and circumstances, in this section I will make some conjectures
about a few preliminary insights on various topics.

Fiscal Policy. Until Britain's very high unemployment of the 1920s and the Great
Depression, economists generally held that the appropriate stance for fiscal policy
was for governments to maintain balanced budgets. The severity of the early
twentieth-century crises gave rise to the Keynesian idea of counter-cyclicality,
which suggested that governments should use tax and expenditure policies to
offset business cycles in the economy. By contrast, neoclassical economics offers
doubts about the implicit assumption behind the Keynesian model of a multiplier
greater than one8 and its implication that governments are able to do something
that the private sector has been unable to do: mobilize idle resources in the
economy (unemployed labor and capital) at almost zero social cost, that is, with
no corresponding decline in other parts of GDP (consumption, investment, and
net exports). Instead, they warn against the possibility of the so-called Ricardian
equivalence trap and point to the fact that households tend to adjust their behav-
ior for consumption or saving on the basis of expectations about the future. They
suggest that expansionary fiscal policy (stimulus packages) is perceived as
immediate spending or tax cuts that will need to be repaid in the future. They
conclude that the multiplier could be less than 1 in situations where the GDP is
given and an increase in government spending does not lead to an equal rise in
other parts of GDP The neoclassical paradigm even suggests the possibility of
some rare instances where multipliers are negative, pointing to situations where
fiscal contractions become expansionary (Francesco and Pagano 1991).
From the viewpoint of new structural economics, the effects of fiscal policy
may be different in developed and developing countries due to the differences in
opportunities of using counter-cyclical expenditure for making productivity-
enhanced investments. Physical infrastructure in general is a binding constraint
for growth in developing countries and governments need to play a critical role in

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providing essential infrastructure to facilitate economic development. In such con-
texts, recessions are typically good times for making infrastructure investments,
for three main reasons. First, such investments boost short-term demand and
promote long-term growth.9 Second, their investment cost is lower than in
normal times. And third, the Ricardian equivalence trap can be avoided because
the increase in future growth rates and fiscal revenues can compensate for the
cost of these investments (Lin 2009b).
If a developing country government follows the new structural economics
approach of facilitating the development of industries according to the country's
comparative advantage, its economy will be competitive and the fiscal position and
the external account are likely to be sound, thanks to the likelihood of strong
growth, good trade performance, and the lack of nonviable firms that the govern-
ment has to subsidize. Under this scenario, the country will face fewer homegrown
economic crises. If the economy is hit by external shocks such as the recent global
crisis, the government will be in a good position to implement a counter-cyclical
fiscal stimulus and invest in infrastructure and social projects. Such public invest-
ments can enhance the economy's growth potential, reduce transaction costs on
the private sector, increase the rate of return on private investment, and generate
enough tax revenues in the future to liquidate the initial costs.
In addition to its different stance on fiscal stimulus, the new structural econ-
omics approach also offers a different strategy for managing natural resource
wealth. In resource-abundant countries, it would recommend that an appropriate
share of revenues from commodities be used to invest in human capital, infra-
structure, social capital, and compensation for first movers in new nonresource
sectors so as to facilitate the structural transformation. To accomplish this with
the greatest effect, these resources should finance investment opportunities that
remove binding constraints on industrial diversification and upgrading, especially
in the infrastructure and education sectors. Microeconomic analyses show that
even when factory floor costs are comparable, inefficiencies in infrastructure can
make it impossible for poor countries to compete on international markets.
Freight and insurance costs in African countries are 250 percent of the global
average,10 with road freight delays two to three times as long as in Asia. Lacking
financial resources and the appropriate policy frameworks, many of these
countries are often unable to sustain much needed investment and maintenance
expenditures. In such contexts, the effective fiscal strategy would not be to keep
natural resource revenues in sovereign funds and invest in foreign equity markets
or projects but, rather, to use a substantial portion of the revenues for financing
domestic or regional projects that facilitate economic development and structural
change - i.e. projects that stimulate the development of new manufacturing
industries, diversify the economy, provide jobs, and offer the potential of continu-
ous upgrading.11

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Monetary Policy. Old structural economics suggested that monetary policy should
be under government control (not independent central banks) and directed at
influencing interest rates and even sector credit allocation. But it also acknowl-
edged that many other factors that influence the investment demand-schedule in
developing countries are too powerful for monetary policy alone to achieve suffi-
cient levels of investment, channel resources in strategic sectors, and combat
unemployment.
Building on lessons from the rational expectations revolution, neoclassical
economists doubted the idea that monetary policy could be used to support indus-
trial development. It recommended that its main goal be price stability, and advo-
cated the use of short-term interest rates by independent central banks to
maintain the general level of prices (or to control money supply growth), and not
to stimulate economic activity and trigger inflation.
The new structural economics envisions the possibility of using interest rate
policy in developing countries as a counter-cyclical tool and as an instrument
to encourage infrastructure and industrial upgrading investments during reces-
sions - measures that may contribute to productivity growth in the future.
Monetary policy is often ineffective for stimulating investment and consumption
in recessions and excess capacity situations in developed countries, especially
when nominal interest rates hit the zero bound in a context of limited profit-
able investment opportunities, pessimistic expectations, high unemployment
rates, low confidence about the future, and the likelihood of liquidity traps. It
should be noted, however, that developing countries are less likely to encounter
such liquidity traps. Even when faced with excess capacity in existing domestic
industries, their scope for industrial upgrading and diversification is large.
Their firms have incentives to undertake productivity-enhancing, industrial-
upgrading investments during recessions if interest rates are sufficiently low.
Furthermore, they tend to have many infrastructure bottlenecks. Lowering
interest rates in such contexts would also encourage investments in
infrastructure.
The objective of monetary policy should be much broader than traditionally
conceived under neoclassical economics - in economic slumps, it should aim at
encouraging investment that removes bottlenecks on growth. In practical terms,
this implies not just that interest rates should be lowered in the slump, as would
be the case in most circumstances under a standard Taylor rule. It also implies
that monetary authorities should resort to temporary interest rate subsidies, flex-
ible credit allocation rules, or similar time-bound devices, targeting infrastructure
through development banks that are identified as binding constraints, preferably
in specific geographic locations where the payoff is the largest and where political
economy constraints can be more easily managed.

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Financial Development There is ample consensus that financial development is
essential to sustaining economic growth. There is however much less agreement
on the specific role it plays in that process. Starting with the observation that one
of the major constraints facing developing countries was limited capital accumu-
lation, old structural economics regarded the problems of the financial sector in
underdeveloped economies as resulting from widespread market failures that
could not be overcome by market forces alone.12 They recommended that govern-
ments adopt a hands-on approach in that process, mobilize savings, and allocate
credit to support the development of advanced capital-intensive industries. This
very often led to financial repression (McKinnon 1973; Shaw 1973). In some
countries, especially in Sub-Saharan Africa, the belief in soft-budget constraints
led governments to accumulate deficits in state-owned financial institutions and
created a pervasive business culture of self-repression not only for banks, but also
for private enterprises (Monga 1997). Drawing consequences from such analyses,
neoclassical economists advocated financial liberalization. They contended that
bureaucrats generally do not have the incentives or expertise to intervene effec-
tively in credit allocation and pricing, and that a well-defined system of property
rights, good contractual institutions, and competition would create the conditions
for the emergence of a sound financial system. They recommended that govern-
ment exit from bank ownership and lift restrictions on the allocation of credit and
the determination of interest rates (Caprio and Honohan 2001).
While agreeing with the need to address the deleterious effects of financial
repression, the new structural economics would emphasize the fact that those dis-
tortions are often designed to protect nonviable firms in priority sectors in devel-
oping countries. It would then stress the importance of an appropriate
sequencing of liberalization policies in domestic finance and foreign trade so as to
achieve stability and dynamic growth simultaneously during transition. The new
structural economics also posits that the optimal financial structure at a given
level of development may be determined by the prevailing industrial structure, the
average size of firms, and the usual type of risk they face, all factors that are in
turn endogenous to the economy's factor endowments at that level. Observing
that national policies frequently favor large banks and the equity market regard-
less of the structure of the economy, it would suggest that low-income countries
choose small, local banks as the backbone of their financial systems, instead of
trying to replicate the financial structure of advanced industrialized countries.
This would allow small-scale firms in agriculture, industry, and the service sector
to gain adequate financial services. As industrial upgrading takes place and the
economy relies increasingly on more capital-intensive industries, the financial
structure will change to give greater weight to large banks and sophisticated
equity markets (Lin, Sun, and Jiang 2009).

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Foreign Capital. In a world that they thought was characterized by the core-
periphery relationship, old structural economists tended to view foreign capital
mainly as a tool in the hands of industrialized countries and their multinational
firms to maintain harmful control over developing countries. They rejected the
idea that free capital movements among countries could deliver an efficient
allocation of resources and considered foreign direct investment flows to poor
countries as an instrument for foreign ownership and domination. They advo-
cated tight restrictions on virtually all forms of international financial flows.
Neoclassical economic theory argues that international capital mobility serves
several purposes: it allows countries with limited savings to attract financing for
productive domestic investment projects; it enables investors to diversify their port-
folios; it spreads investment risk more broadly; and it promotes intertemporal
trade - the trading of goods today for goods in the future (Eichengreen and others
1999). Therefore, the theory generally favors open or liberalized capital markets,
with the expectation of more efficient allocation of savings, increased possibilities
for diversification of investment risk, faster growth, and the dampening of
business cycles. It should be noted, however, that some neoclassical economists
also argue that liberalized financial markets in developing countries can be dis-
torted by incomplete information, large and volatile movements in and out of the
system, and many other problems leading to suboptimal consequences that are
damaging for general welfare.
The new structural economics approach considers foreign direct investment to
be a more favorable source of foreign capital for developing countries than other
capital flows because it is usually targeted toward industries consistent with a
country's comparative advantage. It is less prone to sudden reversals during
panics than bank loans, debt financing, and portfolio investment, and does not
generate the same acute problems of financial crises as do sharp reversals of debt
and portfolio flows. In addition, direct investment generally brings technology,
management, access to markets, and social networking, which are often lacking
in developing countries and are yet crucial for industrial upgrading. Thus, liberal-
izing inward direct investment should generally be an attractive component of a
broader development strategy. By contrast, portfolio investment that may move in
and out quickly, in a large quantity, tends to target speculative activities (mostly
in equity markets or the housing sector) and create bubbles and fluctuations. It
should not be favored.13 The new structural economics approach may also shed
new light on the puzzle raised by Lucas (1990) about the flow of capital from
capital scarce developing countries to capital abundant developed countries.
Without improvement of infrastructure and upgrading to new comparative advan-
tage industries, the accumulation of capital in a developing country may encoun-
ter diminishing returns, causing lower returns to capital in developing countries,
and justifying the subsequent outflow of capital to developed countries.

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Trade Policy. There have been various old structural economics approaches to
external trade. But one constant feature is the belief that integration into the
global economy is bound to maintain the existing world power structure, with
Western countries and their multinational corporations dominating poorer
countries and exploiting their economies. In order to break the dependency trap,
old structural economics thinkers have suggested that priority be given to import-
substitution strategies, with developing economies closed and protected until their
modern industries can compete with advanced industrialized countries in world
markets.

A radically different view was adopted by economists in the 1980s.

Observing that macroeconomic crises in developing countries almost always
have an external dimension, they considered that their immediate cause was
the lack of foreign exchange to service debts and purchase imports. They rec-
ommended trade liberalization and export promotion as a solution to generate
foreign exchange through export earnings. This was also consistent with the
view that, in the long term, outward oriented development strategies are more
effective than inward looking policies. This view was bolstered further by the
argument that such a strategy would increase demand for unskilled labor and
hence unskilled wages, as had happened in successful East Asian countries
(Kanbur 2009).
The analysis from the new structural economics would be consistent with the
view from neoclassical economics that exports and imports are endogenous to the
comparative advantage determined by a country's endowment structure (they are
essential features of the industrial upgrading process and reflect changes in com-
parative advantage). Globalization offers a way for developing countries to exploit
the advantages of backwardness and achieve a faster rate of innovation and struc-
tural transformation than is possible for countries already on the global technol-
ogy frontier. Openness is an essential channel for convergence. The new
structural economics approach recognizes, however, that many developing
countries start climbing the industrial ladder with the legacy of distortions from
old structural economics strategies of import-substitution. It would therefore
suggest a gradualist approach to trade liberalization. During transition, the state
may consider providing some temporary protection to industries that are not con-
sistent with a country's comparative advantage, while liberalizing at the same
time entry to other more competitive sectors that were controlled and repressed in
the past. The dynamic growth in the newly liberalized sectors creates the con-
ditions for reforming the old priority sectors. This pragmatic, dual-track approach
may achieve the goal of growth without losers in the transition process
(Naughton 1995; Lau, Qian, and Roland 2000; Subramanian and Roy 2003; Lin
2009a).

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Human Development Old structural economics generally said little about the role
of human development in economic growth. By contrast, neoclassical economics
has shown that the continuing growth in per capita incomes of many countries
during the nineteenth and twentieth centuries was mainly due to the expansion
of scientific and technical knowledge that raised the productivity of labor and
other inputs in production. Economic theory has demonstrated that growth is the
result of synergies between new knowledge and human capital, which is why
large increases in education and training have accompanied major advances in
technological knowledge in all countries that have achieved significant economic
growth. Education, training, and health, which are the most important invest-
ments in human capital, are considered to be the most important driving force
for economic development (Becker 1975; Jones and Romer 2009).
The new structural economics considers human capital to be one component
of a country's endowment. For economic agents, risks and uncertainty arise
during the process of industrial upgrading and technological innovation that
accompanies economic development. As various firms move up the industrial
ladder to new, higher capital-intensity industries and get closer to the global
industrial frontier, they face higher levels of risks. Human capital increases
workers' ability to cope with risk and uncertainty (Schultz 1961) but its for-
mation requires a long time. A person who loses the opportunity to receive edu-
cation at a young age may not be able to compensate for that loss at a later age.
In a dynamic growing economy, it is important to plan ahead and make human
capital investments before the economy requires the set of skills associated with
new industries and technologies. However, improvements in human capital
should be commensurable with the accumulation of physical capital and the
upgrading of industry in the economy. Otherwise, human capital will either
become a binding constraint for economic development if it is under-supplied
because of insufficient investment, or the country will have many frustrated
highly educated youths if the industrial upgrading of the economy is not progres-
sing fast enough to provide skilled jobs.
A well-designed policy on human capital development should be an integral
part of any country's overall development strategy. The new structural economics
goes beyond the neoclassical generic prescription for education and suggests that
development strategies include measures to invest in human capital that facilitate
the upgrading of industries and prepare the economy to make full use of its
resources. The key components of such strategies should follow Lucas's (2002)
suggestion to allow human capital to have both a quality and a quantity dimen-
sion. It should also include alternative policies for promoting skill formation that
are targeted to different levels of the life cycle,14 with the government and the
private sector working closely together to anticipate or respond to the skills needs
in the labor market. Singapore, one of the 13 high-growth economies15 that have

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been able to grow at more than 7 percent for periods of more than 2 5 years since
World War II, provides a successful example of human capital development as a
national strategy (Osman-Gani 2004), which goes beyond the schooling decision
and recognizes that on-the-job training is an important component of aggregate
human capital. Its human resource strategies have been continuously revised and
adjusted in conjunction with other national strategic economic policies.

Concluding Thoughts
The new structural economics approach highlights the importance of endow-
ments and differences in industrial structures at various levels of development
and the implications of distortions stemming from past, misguided, interventions
by policymakers whose belief in old structural economics led them to over-esti-
mate governments' ability to correct market failures. It also points out the fact
that policies advocated under the Washington Consensus often failed to take into
consideration the structural differences between developed and developing
countries and ignored the second-best nature of reforming various types of distor-
tions in developing countries.
The proposed new structural economics attempts to develop a general frame-
work for understanding the causality behind the observed stylized facts of sus-
tained growth. Specifically, the new structural economics proposes to: (i) develop
an analytical framework that takes into account factor and infrastructure endow-
ments, the levels of development, and the corresponding industrial, social, and
economic structures of developing countries; (ii) analyze the roles of the state and
the market at each development level and the mechanics of the transition from
one level to another; and (iii) focus on the causes of economic distortions and the
government's strategies for exit from the distortions. It is not an attempt to substi-
tute another ideologically based policy framework for those that have dominated
development thinking in past decades, yet showing little connection to the empiri-
cal realities of individual countries. Rather, it is an approach that brings attention
to the endowment structure and level of development of each country and
suggests a path toward country-based research that is rigorous, innovative, and
relevant to development policy. This framework stresses the need to understand
better the implications of structural differences at various levels of a country's
development - especially in terms of the appropriate institutions and policies, and
the constraints and incentives for the private sector in the process of structural
change.
The current state of development economics and the severe impact of the
global crisis on the economies of developing countries have generated strong
demand for a new framework for development thinking. The research agenda of

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the new structural economics should enrich research and enhance the under-
standing of the nature of economic development. This would help assist low an
middle-income countries in achieving dynamic, sustainable, and inclusive
growth, and in eliminating poverty.

Acknowledgements
Celestin Monga provided invaluable help in preparing this paper. The paper al
benefits from discussions and comments from Gary Becker, Otaviano Canuto, H
Joon Chang, Luiz Pereira Da Silva, Augusto de la Torre, Christian Delvoie, Asi
Demirgiiç-Kunt, Shantayanan Devarajan, Hinh T. Dinh, Shahrokh Fardoust, Arie
Fiszbein, Robert Fogel, Alan Gelb, Indermit S. Gill, Ann Harrison, James
Heckman, Aart Kraay, Auguste Taño Kouame, Norman V Loayza, Frank J. Lysy
Shiva S. Makki, William F. Maloney, Mustapha Kamel Nabli, Vikram Nehru
Howard Pack, Nadia Piffaretti, Claudia Paz Sepulveda, Martin Ravallion,
Mohammad Zia M. Qureshi, Sergio Schmukler, Luis Serven, and Harald Uhlig. I
am also grateful for the editor and three referees for helpful comments and
suggestions.

Notes

Justin Yifu Lin is Senior Vice President and Chief Economist of the World Bank; email address:
justinlin@worldbank.org.
1. The paper was presented as the Kuznets Lecture at the Economic Growth Center, Yale
University on March 1, 2011. The main arguments of this paper were first presented at DEC's
fourth Lead Economists Meeting and at Lin's first anniversary at the Bank on June 2, 2009. A
shorter version of the paper was presented at the conference on "Challenges and Strategies for
Promoting Economic Growth," organized by the Banco de México in Mexico City on October 19-
20, 2009, and at public lectures in Cairo University on November 5, 2009, Korean Development
Institute on November 17, 2009, OECD on December 8, 2009, UNU-WIDER on January 19, 2010,
Stockholm Institute of Transitional Economics on January 21, 2010, National University of
Management in Cambodia on September 8, 2010, Bank of Italy on April 26, 2011, and University
of Dar es Salaam on April 29, 2011.
2. I will refer to the early contributions by structuralist economists such as Prebisch (1950) and
Furtado (1964, 1970) and recent contributions by structuralist economists such as Taylor (1983,
1991, 2004) and Justman and Gurion (1991) as old structural economics.
3. The total endowments at a specific time - the economy's total budgets at that time and the
endowment structure, together with the households' preferences and firms' available production
technologies - determine the relative factor and product prices in the economy. Total budgets and
relative prices are two of the most fundamental parameters in economic analysis. Moreover, the
endowments are given at any specific time and are changeable over time. These properties make
endowments and the endowment structure the best starting point for analysis of economic

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development. Except in Heckscher-Ohlin trade theory, the economic profession has not given suffi-
cient attention to the implications of factor endowments and endowment structure.
4. The proposition that the industrial structure is endogenous to an economy's endowment struc-
ture at each level of its development has been the subject of extensive theoretical studies. For instance,
Lin and Zhang (2009) develop an endogenous growth model that combines structural change with
repeated product improvements to discuss the endogeneity of industrial structure, the appropriate
technology, and economic growth in a less developed country (LDC) in a dynamic general-equilibrium
framework. They use a two-sector model in which technological change in the traditional sector takes
the form of horizontal innovation based on expanding variety as suggested in Romer (1990) while
technological progress in the modern sector is accompanied by incessantly creating advanced capital-
intensive industry to replace backward labor-intensive industry. This requires an intentional invest-
ment of resources by profit-seeking firms or entrepreneurs (Grossman and Helpman 1994). The
model shows that: (i) the optimal industrial structure in LDCs should not be the same as that in devel-
oped countries (DCs); (ii) the appropriate technology adopted in the modern sector in LDCs ought to
be inside the technology frontier of the DCs; and (iii) a firm in an LDC that enters capital-intensive,
advanced industry (by DC standards) would be nonviable owing to the relative scarcity of capital in
the LDCs factor endowment. Ju, Lin, and Wang (2009) develop a dynamic general equilibrium model
to show that industries will endogenously upgrade toward the more capital-intensive ones as the
capital endowment becomes more abundant. The model features a continuous inverse-V-shaped
pattern of industrial evolution driven by capital accumulation: As the capital endowment reaches a
certain threshold, a new industry appears, prospers, then declines, and finally disappears. While the
industry is declining, a more capital-intensive industry appears and booms.
Capital is mobile in an open economy. It is unlikely that the mobility of capital will equalize the
capital -labor ratio in high-income, capital-abundant countries and low-income, labor-abundant
countries. This is because there are two main purposes for the capital to flow from a higher-income
country to a lower-income country. The first one is to exploit the lower-income country's comparative
advantage of abundant labor (or natural resources) so as to use the lower-income country as its
export base. For this purpose, the industry must be consistent with the recipient, lower-income coun-
try's comparative advantage determined by its factor endowment, although the technology used by
the foreign-invested firms may be somewhat more capital intensive than the indigenous firms. The
second purpose of capital flow from a higher-income country is to get access to a lower-income coun-
try's domestic markets. For this type of capital flow, the foreign-invested industries will be more capital
intensive than the indigenous firms but only the types of production activities that are consistent with
the host country's comparative advantage, for example assembly of parts into final products, will be
located in the lower-income country. Therefore, the theoretical insights derived from the assumption
that the relative abundance of capital in a country is given at any specific time will hold even with
capital mobility.
5. For nontradable goods and services, the nature of least-cost production technology will also
be endogenously determined by the endowment structure. That is, as capital becomes relatively
abundant, the technology used to produce nontradable goods and services will also become rela-
tively capital intensive, just as what happens in the tradable goods sector. For simplicity, the discus-
sion in the paper will focus on the tradable sector.
6. Porter (1990) made the term "competitive advantage" popular. According to him, a nation
will have competitive advantage in the global economy if the industries in the nation fulfill the fol-
lowing four conditions: (1) their industries intensively use the nation's abundant and relatively inex-
pensive factors of production; (2) their products have large domestic markets; (3) each industry
forms a cluster; and (4) the domestic market for each industry is competitive. The first condition in
effect means that the industries should be the economy's comparative advantage determined by the
nation's endowments. The third and the fourth conditions will hold only if the industries are con-
sistent with the nation's competitive advantage. Therefore, the four conditions can be reduced to
two independent conditions: comparative advantage and domestic market size. Of these two inde-
pendent conditions, comparative advantage is the most important because if an industry

216 The World Bank Research Observer, vol. 26, no. 2 (August 2011)

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corresponds to the country's comparative advantage, the industry's product will have a global
market. That is why many of the richest countries of the world are very small (Lin and Ren 2007).
7. Industries in advanced developed countries today are typically located on the global frontier
and face uncertainty as to what the next frontier industries will be. This explains why government
policy measures to support pioneer firms in such countries are usually in the form of general support
to research in universities (which has externalities to private firms' R&D), patents, preferential taxes
for capital investments, mandates, defense contracts, and government procurement. Support in the
form of preferential taxes, defense contracts, and government procurement are industry or product-
specific. Government support to basic research also needs to be prioritized for certain types of potential
industries or products because of budget constraints. However, government support to pioneer firms in
developing countries, especially low-income countries, often fails. One of the most important reasons
is the attempt by low-income countries governments to support firms in industries that are inconsist-
ent with the economy's comparative advantages (Lin 2009a; Lin and Chang 2009).
8. Barro (2009) calls active fiscal policy of the Keynesian type "the extreme demand-side view"
or the "new voodoo economics."
9. Recent research suggests that economic returns on investment projects in developing countries
averages 30-40 percent for telecommunications, more than 40 percent for electricity generation,
and more than 200 percent for roads. In Thailand, production loss due to power outages rep-
resented more than 50 percent of the total indirect costs of doing business in 2006. Firms often rely
on their own generators to supplement the unreliable public electricity supply. In Pakistan, more
than 60 percent of firms surveyed in 2002 owned a generator. The cost of maintaining a power gen-
erator is often high and burdensome, especially for small and medium-size firms, which are impor-
tant sources of employment. Yet, while these costs must be privately borne, their benefits are felt
across the economy.
10. This is percentage oí cost (UNCTAD Statistical Database).
1 1 . The exploitation of natural resources can generate a large amount of revenues but it is gen-
erally very capital intensive and provides limited job opportunities. In a recent visit to Papua New
Guinea, I observed that the Ok Tedi copper and gold mine in Tabubil generates almost 80 percent of
the country's export revenues and 40 percent of government revenues but provides only 2,000 jobs.
A proposed liquefied natural gas project will double Papua New Guinea's national income after its
completion in 2012, but the project will only provide 8,000 jobs. The majority of Papua New
Guinea's 6.5 million population still live on subsistence agriculture. The contrast between the stan-
dard of living of a few elite workers in modern mining and that of subsistence farmers is becoming a
source of social tensions. A similar observation can be made about Botswana: the failure to diversify
the economy from diamond mining and to generate employment opportunities may explain the
widening disparity and deterioration of various human and social indicators, despite the diamond
industry's great success in sustaining Botswana's growth miracle over the past 40 years.
12. Gerschenkron (1962) made a similar point, arguing that the private sector alone cannot
effectively address the problems of access to finance in weak institutional environments.
13. A sudden large inflow of portfolio capital is most likely to be invested in speculative sectors
rather than in productive sectors. The reason is twofold: a large increase in investment in existing
industries may encounter diminishing returns to capital, and the potential for quick and large
industrial upgrading is limited by human capital, as well as soft and hard infrastructure constraints.
14. Carneiro and Heckman (2003) have demonstrated the importance of both cognitive and
noncognitive skills that are formed early in life in accounting for gaps in schooling among social
groups and other dimensions of socioeconomic success. They have provided empirical evidence of a
high return to early interventions and a low return to remedial or compensatory interventions later
in life.
15. The list includes: Botswana; Brazil; China; Hong Kong SAR, China; Indonesia; Japan; Korea;
Malaysia; Malta; Oman; Singapore; Taiwan, China; and Thailand.

Lin 217

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 Comments on "New Structural
Economics" by Justin Yifu Lin

Anne Krueger

Ever since development economics became a field, there has been a search for
"the" key to development. Physical capital accumulation, human capital, indus-
trial development, institutional quality, social capital, and a variety of other
factors have been the focus at one time or another. As each became the focal
point, there was a parallel explicit or implied role of government.
If I understand Justin Lin correctly, he is saying that the "new structural econ-
omics" (NSE) accepts that earlier thought ignored comparative advantage, which
should be market determined, but that growth requires improvements in 'hard'
(tangible) and 'soft' (intangible) infrastructure at each stage. Such upgrading and
improvements require coordination and inhere with large externalities to firms'
transaction costs and returns to capital investment. Thus, in addition to an effec-
tive market mechanism, the government should play an active role in facilitating
structural change (p. 206).
He seems also to believe that growth depends almost entirely on industry
growth and believes that constant "upgrading" or moving up the value added
chain is the central challenge. He says that "the laissez-faire approach . . . missed
the importance of the process of continuous, fundamental technological changes
and industrial upgrading, which distinguishes modern economic growth from
premodern economic growth" (p. 196).
It is questionable whether such changes and upgrading must take place early
in the development process. In many countries, unskilled labor has moved to
unskilled-labor-intensive industries, with expansion of those industries' outputs
for a period during which more and more workers acquired acquaintance with
modern factory techniques, and exports of the unskilled-labor-intensive goods

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doi:10.1093/wbro/lkr010 Advance Access publication July 12, 2011 26:222-226

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increased. Only later in the development process did upgrading become a major
part of industrial growth once there had been significant absorption of rural
labor, and much of it happened in existing firms in response to rising real wages,
lower capital costs, and learning through exposure to the international market.
However, in most countries rural labor could be absorbed only as agricultural
productivity increased; Lin's NSE seems to equate growth with industrial expan-
sion, ignoring the importance of increased productivity of the large fraction of the
labor force (and of land) in rural areas. Failure to invest in agricultural research
and development and in rural health and education has been a major weakness
of many countries' development strategies. While strides have been made in redu-
cing discrimination against agriculture, the NSE as exposited by Lin would appear
to support the industrial and urban bias that has itself constituted a very large
distortion in some countries.
It will come as no surprise that I agree that the market should be used to deter-
mine comparative advantage, and that governments have responsibilities for
insuring an appropriate incentive framework and provision of infrastructure (both
hard and, as he terms it, "soft").
But there is nothing new in that. What purports to be the "new" part is the
assertion that coordination and upgrading of infrastructure should in some way
be related to particular industries. It is at this point where a question arises: most
economists would accept the view that cost-benefit analysis should be used in
the choice of infrastructure projects. If "externalities" and "coordination" are
important, are they important for specific industries or for the entire industrial
economy? If the former, how are those industries to be identified, and how would
the externalties be estimated in cost-benefit analysis? Or would they? If infra-
structure is seen to be industry-specific, it is not clear what it is. As with the poss-
ible existence of infant industries, it is one thing to believe that there are such
industries (perhaps) and quite another to identify ahead of time which they are.
And even if such industries exist and are identified, questions arise as to the
incentives that would be appropriate for the government to foster these industries.
(Would they be firm-specific treatment? Tariffs? Subsidies to firms or industries?
Each has huge problems.) And if it is more "conventional," what is new? If infra-
structure is specific to industry (or a group of industries), the same questions
must be addressed.
Some hints are given as to what Lin has in mind: "successful industrial upgrad-
ing in responding to change in an economy's endowment structure requires that
the pioneer firms overcome issues of limited information regarding which new
industries are the economy's latent comparative advantages determined by the
changing endowment structure. Valuable information externalities arise from the
knowledge gained by pioneer firms in both success and failure. Therefore, in
addition to playing a proactive role in the improvements of soft and hard

Krueger 223

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infrastructures, the government in a developing county, like that in a developed
country, needs to compensate for the information externalities generated by
pioneer firms" (p. 203).
Here, the infant industry concerns arise again. How can these externalities be
forecast? As Baldwin (1969) pointed out, there are major difficulties with this
argument, quite aside from the identification of such externalities. And firms pro-
ducing unskilled-labor-intensive goods and exporting them have usually learned
of the opportunities provided by the international market and chosen to upgrade
as their experience has increased. Learning does not seem to have been a major
issue for firms in South Korea, Taiwan, and elsewhere.
Another hint as to what Lin has in mind comes from his advocacy of coordi-
nation of infrastructure investments. According to him, "Change in infrastructure
requires collective action or at least coordination between the provider of infra-
structure services and industrial firms. For this reason, it falls to the government
neither to introduce such changes or to coordinate them proactively."(p. 203)
How this would be carried out is unclear; Lin insists that infrastructure must be
upgraded with growth as long as it is consistent with the evolving future direction
of comparative advantage, but does not elaborate on how that future direction
should be identified. Involving individual firms and industries in decisions as to
infrastructure investments would appear to offer far too much scope for individual
firms* and industries' influence over these investments.
Although it is certainly true that not everything can be done at once, focus on
selected areas for large investments at the neglect of the rest of the economy is a
highly questionable strategy. Why it would be preferable to allocate scarce capital
so that some activities have excellent infrastructure while others must manage
with seriously deficient infrastructure is not clear: without further evidence, it
would appear to be a distortion. Further, questions can also be raised as to why
"soft infrastructure," such as the "business environment" (which consists of such
things as the commercial code, the structure of taxes and subsidies, regulations,
and so on), cannot be economy wide. And the criteria by which there would be
designation of a given area, or the types of industries that would be eligible, as
the recipient of special treatment are not discussed. What the hard infrastructure
is that does not consist of items such as roads and ports, and is industry specific,
is not discussed.
But all of this hinges on the proposition that decisionmakers in the public
sector can ascertain the appropriate rate of "upgrading" and the extent of the
supposed externalities. This raises a host of issues. There is, first, the consideration
that even if one could know which activities would have comparative advantage,
that advantage often develops as small firms enter, some of which are successful
and grow larger. Any strategy of "upgrading" would inevitably favor larger, estab-
lished firms, and hence encounter the same sorts of problems as did the older

224 The World Bank Research Observer, vol. 26, no. 2 (August 2011)

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import-substitution strategy which, as Lin recognizes, failed. "Picking winners" as
industries is difficult; it cannot be firm specific or the usual problems of
corruption and cronyism arise. And yet supporting an industry or industries as
an undifferentiated entity is difficult: are textiles an industry? Or is synthetic fiber
an industry? Or is nylon an industry? And, of course, the breakdown could go
further. And as capital and skills per person accumulate, how is it to be decided
where the industrial park or export processing zone should be? And which firms
should be eligible to enter it?
Another strand of Lin's argument pertains to the role of distortions. He appears
to be saying that countries that earlier adopted import-substitution strategies have
distorted industrial structures that should affect policy. In particular, he says:
"many developing countries start climbing the industrial ladder with the legacy of
distortions from old structural strategies of import-substitution. [The new struc-
tural economics] would therefore suggest a gradualist approach to trade liberaliza-
tion. During transition, the state may consider some temporary protection to
industries that are not consistent with a country's comparative advantage, while
liberalizing at the same time entry to other more competitive sectors that were
controlled and repressed in the past" (p. 212).
Here, as elsewhere, little guidance is given as to how much protection indus-
tries would be provided with; how long that protection would last; how industries
to be protected would be chosen; and so on. But even more important, one can
imagine the political pressures for greater protection for longer periods. Protection
of some industries is disprotection of others, as is well known, so reform efforts
would clearly be dampened. Even worse, a major challenge for liberalizing
reforms is for it to be credible that the altered policies are not reversible. Lin's pre-
scription would greatly increase the challenge of creating credibility, and a slower
transition would be a longer period during which growth was slow and political
pressures opposing liberalization at all were mounting.
In all, there is much in Lin's analysis with which most would agree, but focus
on governmentally led identification of industries with "latent comparative advan-
tage" and industry-specific provision of infrastructure is not convincing. Lin calls
for much research. A first task should be to show that there are industry
(or industry-cluster) externalities, how they could be identified and measured ex
ante, and what sorts of government support would improve potential welfare and
growth prospects without generating the same sorts of rent-seeking opportunities
as import substitution policies did.
Until that research is undertaken, the NSE will, it is to be feared, be taken as a
license for governments to support specific industries (and worse yet, perhaps
even firms), in ways that may be no more conducive to growth than were the old,
failed, import-substitution policies.

Krueger 225

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Anne Krueger is Professor of International Economics in the School of Advanced International
Studies (SAIS) at Johns Hopkins University, and a Senior Fellow at the Stanford Center for
International Development

Reference

Baldwin, Robert E. 1969. "The Case against Infant Industry Protection." Journal of Political Economy
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226 The World Bank Research Observer, vol. 26, no. 2 (August 2011)

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 Comments on "New Structural
Economics" by Justin Yifu Lin

Dani Rodrik

Justin Lin wants to make structuralist economics respectable again, and I applaud
him for that. He wants to marry structuralism with neoclassical economic reason-
ing, and I applaud this idea too. So he has two cheers from me. I withhold my
third cheer so I can quibble with some of what he writes.
The central insight of structuralism is that developing countries are qualitat-
ively different from developed ones. They are not just radially shrunk versions of
rich countries. In order to understand the challenges of under-development, you
have to understand how the structure of employment and production - in par-
ticular the large gaps between the social marginal products of labor in traditional
versus modern activities - is determined and how the obstacles that block struc-
tural transformation can be overcome.
The central insight of neoclassical economics is that people respond to incen-
tives. We need to understand the incentives of, say, teachers to show up for work
and impart valuable skills to their students or of entrepreneurs to invest in new
economic activities if we are going to have useful things to say to governments
about what they ought to do. (And of course, leťs not forget that government offi-
cials must have the incentive to do the economically "correct" things too.)
If we put these two sets of ideas together, we can have a useful development
economics, one that does not dismiss the tools of contemporary economic analysis
and yet is sensitive to the specific circumstances of developing economies. This is
the kind of development economics that is appropriately nuanced in its take on
government intervention. It doesn't presume omniscience or altruism on the part
of governments. It has a healthy respect for the power and effectiveness of
markets. But it does not blithely assume that development is an automatic
process that takes care of itself as long as government stays out of the picture.

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doi:10.1093/wbro/lkr008 26:227-229

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 So as Lin rightly emphasizes, the state has a useful role to play in promoting
industrial diversification and upgrading. He lists among desirable functions the
provision of information about new industries, the coordination of investments
across firms and industries, the internalization of informational externalities, and
the incubation of new industries through the encouragement of foreign direct
investment. Policies of this kind may be unnecessary or superfluous in advanced
economies, but they are essential if poor countries are to progress.
To distinguish his brand of structuralist development economics from old-style
structuralism Lin writes that a key difference is that the old school advocated pol-
icies that go against an economy's comparative advantage. The new approach, by
contrast, "stresses the central role of the market . . . and advises the state to play a
facilitating role to assist firms in the process of industrial upgrading by addressing
externality and coordination issues." Lin argues that government policies should
"follow" comparative advantage, rather than "defy" it.
Here is where I quibble with Lin's argument. It seems to me that Lin wants to
argue both for and against comparative advantage at the same time, and I
cannot quite see how this can be done. If one believes that externality and coordi-
nation problems need to be addressed, as Lin apparently does, one must believe
that such problems are preventing firms from investing appropriately. One must
believe that markets are sending entrepreneurs the wrong signals - invest here,
not there - and that allocating resources according to comparative advantage, as
revealed by market prices, would be socially suboptimal. Comparative advantage
has practical meaning for firms only insofar as it gets reflected in prices.
So when Lin asks governments to step in to address market failures and rec-
ommends the type of policies I have listed above - the coordination of investments,
the incubation of new industries, etc. - he too is asking them to defy comparative
advantage as revealed in market prices. In this respect, there is less difference
between what the old school said and what the new school is saying.
Lin doesn't want governments to employ "conventional" import substitution
strategies to build capital-intensive industries which "are not consistent with the
country's comparative advantage." But isn't building industries that defy com-
parative advantage what Japan and South Korea did, in their time? Isn't it what
China has been doing, and quite successfully, for some time now? According to
my calculations, the export bundle of China is that of a country between three
and six times richer. If China, with its huge surplus of agricultural labor, were to
specialize in the type of products that its factor endowments recommend, would it
now be exporting the advanced products that it is?
Some people draw a distinction between static and dynamic comparative
advantage in this context, but I don't think that is the relevant distinction.
Market failures drive a wedge between market prices and social marginal valua-
tions, and distort the relative costs that signal comparative advantage. Whether
these distortions are introduced into intertemporal relative prices or today's
228 The World Bank Research Observer, vol. 26, no. 2 (August 201 1)

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relative prices is largely secondary. The policies that Lin recommends are meant
to offset such market distortions, and their intended effect is to induce firms to
make choices that defy comparative advantage.
I suspect that my difference with Lin is mainly methodological - and perhaps
even just terminological - and may have little practical import. What Lin probably
has in mind is that today's industrial policies need to have a softer touch than
that which structuralists of old tended to recommend. They must be more respect-
ful of markets and incentives; they must show greater awareness of the potential
of government failures; and they must focus specifically on market failures rather
than vague shortcomings of the private sector. I would agree with all this.
But a deeper question relates to the policy implications one draws from all this.
In principle, market failures need to be addressed with appropriately targeted pol-
icies. So if the problem is one of information spillovers, the first-best is to subsidize
the information generating process. If the problem is lack of coordination, the
first-best is for the government to bring the parties together and coordinate their
investments. In practice, though, the relevant market failures cannot be always
closely identified and the directly targeted remedies may not be available. The
practical reality is that the type of policies structuralism calls for - whether of the
traditional or the contemporary type - have to be applied in a second-best setting.
And in such a setting, nothing is all that straightforward anymore.
Presumably this is the reason why Lin recommends, for example, a gradual
approach to trade liberalization. Such an approach is, at best, a second-best
remedy to some loosely specified market failures that either cannot be precisely
identified ex ante or cannot be fully treated with first-best Pigovian interventions.
But how different is this from the old structuralist approach? Didn't most structur-
alists also view protection as a temporary expedient, to be done away with once
the requisite industrial capabilities were built?
To repeat, my differences with Justin Lin are second order, and they are
swamped by our areas of agreement. My quibbles are a bit like the internal doc-
trinal debates waged among communists - does the revolution require the intensi-
fication of the class struggle, or can that stage be skipped? - when much of the
rest of the world is on a different wavelength altogether.
As a fellow traveler, I am greatly encouraged by what Justin Lin is trying to do.
It is high time that the common sense exhibited in his approach reclaimed its
mantle in development economics.

Note

Dani Rodrik is professor of international political economy at Harvard University's John F. Kennedy
School of Government (dani_rodrik@harvard.edu).

Rodrik 229

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