ECONOMYNEXT – Sri Lanka has to open factor markets and look for innovation led ‘inspirational’ based on output-led expansion as the ability to engage in rapid catch up growth is rapidly dimining, a top economist has said.
The first stage of growth involves a poor country catching up with more advanced economies, using inputs like cheap labour and land, or ‘perspiration’.
"Once you become middle-income, especially upper middle income categories your growth rate inevitably slows down, this model no longer works," Razeen Sally, Associate Professor of Lew Kwan Yew School of Economics said.
"We are already seeing that in Sri Lanka. The population begins to age. You have less availability of labour – particularly cheap labour. Labour becomes more expensive. Capital becomes more expensive. Wasting capital become more obvious, land becomes scarcer.
Sally was speaking at seminar in Colombo titled ‘Asian Capitalism and what it means for Sri Lanka’ organized by Advocata Institute, a free market think tank and Echelon, a business magazine.
Inspiration vs Perspiration
"And when that happens growth rates really slow down and to keep up your growth rates and improve the quality of your growth, you have to then shift to the second stage of growth, which is more about innovation, what economists call output-led growth or what (economist) Paul Krugman nicknames ‘inspiration."
"Now you have to use your brains much more, less your sweat or brawn."
Output led growth requires liberal institutions and a different type of entrepreneurial capitalism.
To boost growth, major reforms are needed in factor markets.
Thinkers, philosophers and economists have described private enterprise and capitalism in different ways.
Early economists like Adam Smith who never used the word ‘capitalism’ had a vision for a market economy based on individual freedom or ‘natural liberty’.
"So if you give people individual freedom to produce and consume, with secure property rights, then you have a flourishing market-economy, because people start to specialize," he said. "It is about the specialization and the division of labour and the productivity improvements that come from it.
"Specialization goes deeper and if you do it across borders with freer trade it goes wider."
This was ‘Smithian’ growth. Adam Smith was writing his ‘Wealth of the Nations’ in 1776, just around the time the European industrial revolution was coming, but it was not about technology as such.
Different Ideas
Friedrich List, a German wrote his ‘National System of Political Economy’ against the economics of Smith.
While Smith believed in free trade, and removing state blockages to entrepreneurship, List advocated state support for business through protectionism for young and up-coming countries like Germany, and a variety of state interventions to catch up with a leader like Britain.
"And that is an argument for state intervention and industrial policy, particularly to support infant industry – so-called – that has been used in countries like Japan, South Korea and Taiwan and that argument finds it echoes here in Sri Lanka."
Analysts say then-US Treasury Secretary Alexander Hamilton imposed small import duties on imports of steel into the US in 1791, and Donald Trump is now bringing 25 percent tariffs to protect an’infant’ that is over 200 years old.
Ideas of List and German historical economics which is based on nationalism eventually paved the way for Nazism, anlysts. say.
Karl Marx, another German, thought that capitalism would inevitably lead to its ultimate destruction leading to socialism and communism.
Max Weber, a German philosopher and political economist who wrote a book called Protestant Ethic and the Spirit of Capitalism had a vision for capitalism that was religious and sociological.
Constant Change vs Equilibrium
Joseph Schumpeter, an Austrian, a former finance minister who headed a bank, which went bankrupt became a professor at Harvard University becoming one of the top economist theorists of the 20th century.
"Schumpeter’s economic system is highly dynamic, quite in contrast to standard neo-classical economics, which is all about stable equilibrium," he said.
"In Schumpeter’s system, advanced flourishing capitalist economies are constantly changing. Everything is being disrupted. It is disruptive innovation.
"This being Sri Lanka, a majority Buddhist country, there is a relevant analogy from the heart of Bhuddism. – AnicchaAnichcha in Pali means impermanence
"It is about constant change.
The central agent of Schumpeter’s capitalism was the entrepreneur.
"What Schumpeter’s entreprenuer basically does is, beg borrow or steal ideas and turn them into marketable, profitable products – goods and services.
So you take inventions, and rarely is the inventor the innovator and turn them into innovations.
An invention is a new idea. And an innovation is turning that into something for the mass-market, which makes profits, which generates investment, which creates jobs and livelihoods.
Most of the really big ideas of the past like gun powder, the printing press and algebra had come from China and the Middle East.
"But they were not innovated in China and the Middle East, but they were innovated in Europe by European entrepreneurs in the commercial revolution and subsequent agriculture-industrial revolutions that Europe had but China and the Middle East did not. That is a genuine puzzle."
Creative Destruction
Schumpeter talks about ‘perennial gales of creative destruction’ which is at the heart of his ‘capitalist economic system.
"Creative destruction is a term that comes from Schumpeter.
"So capitalism is not about stable equilibrium, but about creative destruction," Sally said. "New entrepreneurs swarm around new ideas, inventions.
"And they turn them into innovations at crucial junctures, in the process destroying old incumbent industries.
"So a Microsoft comes along and destroying old incumbent industries for example. And Apple does the same. And in time according to Schumpeter they will be destroyed by the new entrepreneurs with new technologies, who have nimble feet who attack those big complacent, sluggish behemoths.
And this process of creative destruction – it has a destructive component and a creative component. If the system is open enough – it does not happen automatically is the very source of our business cycles of our growth and prosperity.
In other words we cannot have prospering capitalism without this kind of disruption, which can be socially very disruptive.
"This can up-end politics, society and indeed the world."
His works had an echo in the Hindu concept of trimurtiwhere Brahma was the creator, Vishnu the preserver and Shiva the destroyer, Sally said.
Schumpeter was the first major economist to use the word ‘capitalism’ in his works.
Asian Economies
Asian nations were in different stages of growth and income.
Japan, Australia, New Zealand, Korea, Taiwan, Hong Kong and Singapore was rich Asia, with per capital income of US$12,000 and above was the equivalent of the ‘West’ in Asia.
Middle Asia was upper middle income economies with 4,000 dollars or above made up of China, Malaysia and Thailand, which are said to be in a ‘Middle Income Trap’.
Poor Asia was had a few very poor countries like Afghanistan, North Korea and Nepal with per capita incomes of around 1,000 US dollars or above.
There was large number of lower middle come countries between 1,000 to 4,000 US dollars, which was made of the bulk of South Asia including Sri Lanka and other countries like Indonesia, Philippines and Vietnam. Input led growth was no longer working in many countries.
Schumpeterian Growth
Schumpeterian growth involved improving productivity.
"You want to improve the efficiency of your inputs, particularly your land, labour and capital. So it is not the quantity or mass of them, but the quality or efficiency. That is Schumpeterian Growth.
In North Korea and Afghanistan, where the very basics were wrong, and there room for catch-up growth. In the richer part of poor Asia like India and Indonesia, there was still a lot of room for catch-up growth.
Malaysia, Thailand and China had an urgent need for innovation-led model of growth. Rich Asia was facing the same basic challenges as the West.
Middle Asian countries were seeing conditions similar to Japan in the 1970s and South Korea in the 1980s, when they exhausted the catch-up period.
"These changes do not happen automatically. If matters what policies you have and what institutions you have."
Macro-economic conditions had to improve with better fiscal and monetary policies. Domestic markets could not be riddled with distortions, and there had to be more competition than other developing markets.
"You need to be open to international trade, it is crucial," Sally said. "You need to improve labour markets, primary and secondary education, you need to improve hard infrastructure. Those are the basics."
"Friedrich List would argue that you also need industrial policy. There is much debate. The reality is results are mixed. Asian Tiger countries have used a combination of policies from the Adam Smith and Friedrich list textbook, but not from the Schumpeterian textbook."
In the first phase, it was possible to growth with weak institutions, corruption and weak rule of law.
Liberal Institutions
"But when you come to that second stage, when you really need to boost your factors of production, your overall productivity, boost innovation not only do you need to get your basics right, you need to improve you’re the quality of your institutions.
"You need to improve the quality of your financial system including regulations, education, skills, better public administration, a more efficient judiciary and legal system, a tax system and bankruptcy procedures, going well beyond the basics.
But these were politically difficult for many countries.
The World Bank’s Ease of Doing business index was a reflection of how good the business climate and institutions were.
Only, Singapore, Hong Kong and Korea was in the global top 10. Taiwan was 15.
Asian re-emergence was based on imitation of the West, which was fine in the catch – up phase.
Sally says innovation is happening in Asia, especially in the digital economy. Young people in Asia was adopting digital technologies fast.
In China there a number of tech companies were emerging. Rich Asia had some of the best telecom infrastructure.
The venture capital market in China for tech was now worth 60 billion US dollars a year from zero five years ago. The entire US market was about 60 billion US dollars. China was also in wind power, batteries.
China was now promoting some state and private tech firms aggressively.
But state-owned enterprises were much less efficient than private ones. There was also a crony private sector.
Productivity levels in Asia was now better that it was 10 years ago due to liberalization. But it was slowing, including in China.
Complex Reforms
Sally says improving financial systems, legal systems and educations systems is complicated.
"Improving institutions depends on politics, and some of this stuff is very political," Sally said. "So I have my doubts about Asia being successful in the future as it has in the past.
Sally says the success of countries like China has come from liberalizing product markets, where lots of competition has come. But factor markets, like in land, labour and capital, was restricted and regulated.
Malaysia had Bhumiputra policies favouring ethnic Malays. China’s banking system was under party control and there were also on land. In Sri Lanka land was restricted, financial markets were also has a strong state presence as well as labour.
One idea was that Western liberal model was necessary to become an advanced nation and catch up with the region. The other idea as ‘Mao and Markets’ style of system in China, where a few people in the top make decisions, will overtake the West.
Sally says there were questions whether people in the top will really give up the power and rents that can be earned in an autocracy.
"Can you really have innovation in a society which is engineered form the top?"
Power Shift
There was also a power shift underway.
Sally says the so called ‘Pax America’ where the US created a stable world order after the end of World War II, was changing and there was a possibility of a ‘PaxSinica’ emerging under different rules.
The US had maintained the peace in Asia and prevented China, India and Japan from going to a major war with each other.
After 911, the US became increasingly fixated on its own and the problems it had created for itself in the Middle East. Obama had led from behind was and was reluctant to intervene in Asia.
"Now we have the phenomenon of Donald Trump who is a gut isolationist," he says.
A third was a power vacuum, which could lead to a major conflict.
But it was not a foregone conclusion that the US will continue to pull back and a PaxSinica will come.
Sri Lanka meanwhile had not done the major reforms required and was coming increasingly under China.
Sri Lanka’s current administration had initially got the basics wrong and had to go to the IMF. It was now sticking to a broad program agreed with the IMF in getting some of the basics right.
But major reforms in land, the banking system or education, not much had been done.
"There is a big economic and big political challenge that has not been yet," Sally said.
The reform window was closing and perhaps had already closed.