Back in the Fast Lane The Indonesian capital bustles at night. As members N 1997-98, a financial crisis brought The per capita GDP of high-income countries three East Asian middle-income rose by about 50 percent between 1980 and of the middle- countries—Indonesia, Korea, and Thai- 2000, that of low-income countries increased income Iland—to their knees. It also affected more than 150 percent, and the income ratio Malaysia and the Philippines, which had dif- between high- and low-income countries has country club, ficulty sustaining growth. Many predicted that been halved. In contrast, average real per cap- East Asian the structural weaknesses that the crisis laid ita incomes of middle-income countries grew bare—corruption, cronyism, and nepotism— by less than 20 percent over this period, wid- nations may would condemn the region to stagnation, as ening the gap between them and high-income need to update they had in Latin America after its debt cri- countries by about 20 percent. Middle-income sis in the mid-1980s. Emerging East Asia was countries, it is argued, are squeezed between their growth expected to lose years of growth. Instead, its low-wage competitors in poor countries, which strategy growth record since 1998 has been remark- dominate mature industries, and innovators able: GDP has almost doubled, growing by in rich countries, which dominate industries more than 9 percent a year, to reach $4 trillion undergoing rapid technological change. Indermit S. Gill in current dollar terms by 2005. Despite the This line of reasoning suggests that East setback in the 1990s, growth during the past Asian middle-income countries must update and Homi Kharas 40 years has been consistent (see table). their strategies. What permits countries to Now, almost a decade later, Korea is a high- grow fast from a per capita income of $1,000 income country, and the other four are grow- to $10,000—the current challenge for most ing fast. China has joined the middle-income East Asian countries—is different and more club. Once Vietnam achieves middle-income difficult than what helped them grow from status, possibly as early as 2010, more than a per capita income of $100 to $1,000—the 95 percent of East Asians will inhabit a middle- challenge they successfully faced in the past. income country. Economic research suggests that two oppos- Should East Asia expect to continue these ing forces are at work. On the one hand, as high growth rates? The reality is that middle- countries get richer, they demand a greater vari- income countries (those with per capita ety of goods, many of which can be produced incomes of $826-$ 10,665) have grown less domestically. This creates a force toward sec- rapidly than either rich or poor countries. toral diversification. On the other hand, coun- 38 Rnance & Development March 2007 ©International Monetary Fund. Not for Redistribution tries get richer only if they specialize in what they do best. Which tendency dominates is an empirical question. Researchers have Consistent performance found that a switch to specialization happens during middle East Asia has grown rapidly despite the 1997-98 crisis. income and depends critically on the extent of economies of (per capita GDP growth, 1966-2004; percent) scale in production (see box). Region/country Growth Number of years in which the rate was What did the Asian leaders in the first wave do to success- 0-2 Above fully transit through middle-income stages of development? Negative percent 2 percent East Asia and Pacific 5.8 2 3 34 And what can today's middle-income countries in East Asia China 7.0 3 3 33 do to ensure that they do not suffer the same fate as Latin Indonesia 4.0 4 3 32 America's middle-income countries, which have struggled Thailand 4.8 3 5 31 unsuccessfully to grow into rich countries? This article Philippines 1.3 6 21 12 Malaysia 4.0 5 3 31 explores the challenges facing middle-income East Asia today. Latin America and Caribbean 1.5 10 15 14 Middle East and North Africa1 1.2 8 13 9 Recognizing economies of scale South Asia 2.6 1 12 26 In addressing these questions, policymakers in the region Sub-Saharan Africa 0.2 14 20 5 OECD 2.5 0 18 21 can learn from recent advances in thinking about economic Sources: World Bank, World Development Indicators, and Global Development growth, industrial organization, international trade, and eco- Finance central databases. nomic geography. 'Data are from 1975 to 2004. Renewed interest in economic growth since the late 1980s has been triggered by the observation that income levels across countries have not been converging in line with tradi- move from places where they are abundant to where they are tional economic theory. This theory predicted that efforts to scarce, bringing with them the latest and best products, pro- accumulate physical and human capital, improve efficiency of cesses, and technologies. production, and use the latest technologies would pay off in a But this has not happened. With few exceptions—primarily narrowing of income gaps between developed and developing East Asia's strong performers—income gaps have widened. countries. Its fundamental implication was that, in seeking the This does not mean the market has not worked at all: most highest possible returns, financial and human capital would countries have become richer and poverty has fallen. But both between and within countries, human and financial capital appear to move from places where they are scarce to How to get richer where they are abundant. This makes good sense in a world Although economic development requires constant learning of economies of scale in which factors of production tend to and adjustment, recent findings suggest that countries with cluster in cities. per capita incomes between $1,000 and $10,000 should make The main driver of economies of scale, in modern growth several major changes in their strategy. theory, is ideas. Unlike goods and factors, ideas can be used • From diversification to specialization. Countries gener- repeatedly, as well as by many people at the same time—that ally appear to diversify initially as they grow, but this trend is is, they are "nonrival." And an idea, once formed, can be used reversed after per capita incomes reach about $5,000-$8,000, as a starting point for new ideas. However, it requires effort to after which countries begin to specialize. At what stage they come up with useful ideas. And people can be prevented from reach this tipping point depends on their size and export ori- using ideas to improve products or production processes entation, but it implies that, in addition to worrying about through secrecy or enforcement of intellectual property the general investment climate, policymakers may also need rights, even if temporarily. Because of such "excludability," to develop sector-specific strategies. knowledge confers on its creators some monopoly power and • From investment to innovation. As firms in a country generates what economists call "economic rents." approach the technological frontier, regulatory policies that By bringing knowledge into formulations of economic favored investment by incumbent firms should give way growth, economists can recognize the centrality of ideas and to regulations that encourage entry of new firms and exit increasing returns, but they must also recognize that ideas do of those whose products or technologies are obsolete. This not always flourish under perfect competition. Some compe- switch has to be timed right and will be difficult to imple- tition can give firms an incentive to innovate, but too much ment because of vested interests. can reduce the value firms get from each idea and thus reduce • From basic to higher education. As countries exploit their effort to create new ideas. By the late 1980s, explana- economies of scale, skill premiums will rise rapidly and poli- cymakers must plan for an adequate supply of new graduates tions of international trade routinely discussed imperfect to mitigate the increase in income inequality. In such econo- competition to understand the rise of intra-industry trade. mies, knowledge spillovers are important and merit public By the early 1990s, growth theorists had accepted the need subsidies for higher education. to incorporate scale economies into aggregate formulations of the economy. By the mid-1990s, theorists had shown how Sources: Imbs and Wacziarg (2003), Aghion and Howitt (2005), and Romer(1994). these concepts could also be used to understand where eco- nomic activity became concentrated. Finance & Development March 2007 39 ©International Monetary Fund. Not for Redistribution Insights for middle-income countries and between cities and the countryside. The outcomes may How can modern growth economics help middle-income not be egalitarian, but policymakers should at least try to countries? At the risk of oversimplification, we classify the provide equal access to education and other social services. insights into two groups: the role of private enterprise in • Modern growth theory predicts that there will be eco- exploiting economies of scale, and the role of governments nomic rents, and how they are distributed is vital for growth. in ensuring a fair distribution of income. Both are needed to If economic rents are reinvested in public infrastructure sustain rapid growth. and social services, the foundations of economic growth The formal recognition of economies of scale, which are strengthened. If they are dissipated in ineffective cities, brings economic theory closer to the world of policymakers, social strife, or corruption, they may even slow growth. Thus, has three implications for middle-income countries: governments must tax economic rents in ways that are least • Trade can take place between all kinds of economies.