ECONOMIC DEVELOPMENT AS SELF-DISCOVERY* Ricardo Hausmann and Dani Rodrik Revised April 2003 John F. Kennedy School of Government Harvard University 79 Kennedy Street Cambridge, MA 02138 (617) 496-3740 [email protected] John F. Kennedy School of Government Harvard University 79 Kennedy Street Cambridge, MA 02138 (617) 495-9454 [email protected] ABSTRACT In the presence of uncertainty about what a country can be good at producing, there can be great social value to discovering costs of domestic activities because such discoveries can be easily imitated. We develop a general-equilibrium framework for a small open economy to clarify the analytical and normative issues. We highlight two failures of the laissez-faire outcome: there is too little investment and entrepreneurship ex ante, and too much production diversification ex post. Optimal policy consists of counteracting these distortions: to encourage investments in the modern sector ex ante, but to rationalize production ex post. We provide some informal evidence on the building blocks of our model. * We thank the Ford and Rockefeller Foundations and the Carnegie Corporation of New York for financial support, and Zoë McLaren and Anton Dobronogov for research assistance. We also thank Bill Easterly, Murat Iyigun, Devesh Kapur, Michael Klein, Andres Rodriguez-Clare, Peter Schott, Sebastian Edwards, and participants at the NBER-IASE meeting in Monterrey, Mexico, November 15-16, 2002, for helpful comments.ECONOMIC DEVELOPMENT AS SELF-DISCOVERY Ricardo Hausmann and Dani Rodrik Introduction The theory and practice of economic development have converged in the last two decades on a remarkably simple view of growth fundamentals. Stated in its starkest form, this view is that economic growth requires two things: foreign technology and good institutions. This perspective is well grounded in the neoclassical model of economic growth, which predicts that poor countries will experience rapid convergence with advanced economies once they have access to state-of-the-art technologies and their governments respect property rights. From this perspective, failure to grow can be attributed to one or both of two pathologies. One is the “closed-economy” pathology, in which governments retard technological progress by reducing access to foreign trade and investment and imported capital equipment and intermediate goods. The other is the “corruption” pathology, in which political leaders either willfully fail to respect property rights and screw things up deliberately in order to enrich themselves and their cronies or fall into inefficient games in which sound money and fiscal solvency perish. The natural remedies for these pathologies are economic openness and improved governance. With these remedies in place, economic growth should follow naturally. In the words of a recent paper on growth: “Once a developing country government establishes the rules to a fair game and ensures their enforcement, it would be well advised to stand back and enjoy the self-generating growth” (Roll and Tallbott 2001). Reforms in the areas of governance and openness have accordingly become the cornerstones of development strategy in virtually every country during the last fifteen years.2Actual development experience presents at best an awkward fit with this conception of growth basics. We point in particular to two important types of evidence that seem to us to run counter to the consensus view. The first of these relates to the economic performance of Latin American countries during the 1990s. By the standards of the consensus view, the quality of policymaking in Latin America has been unmistakably and significantly better in the 1990s than it was two or three decades before. For example, Lora’s (2001) index of structural reform—measuring the degree to which government intervention has been reduced in trade, finance, taxation, and state ownership—shows the average for 16 Latin American countries rising steadily from around 0.34 in 1985 (out of a maximum of one), to 0.58 in 19991. Yet these economies’ response to the reforms has been extremely disappointing. Per capita income declined in these countries from an average of 22.9 percent of the US level in 1985 to 17.7 in 1999, a relative decline of 22.7 percent2. Economic growth in the 1990s has been on average much lower than in the decades before 1980, even though the region was closed to trade and had poorer institutions by most benchmarks in the earlier period. In fact, only three Latin American countries (Chile, Uruguay, Argentina) have outperformed in the 1990s their record during 1950-1980. Of these three, only Chile remains a clear success. Uruguay’s performance has hardly been exemplary, as its growth rate looks good only in relation to an even worse performance prior to 1980, and together with Argentina, it now lies in ruins. Why is growth so low in a region that has tried so hard to adopt the consensus agenda? 1 Morley, using Lora’s (1997) methodology extends the index back to the early 1970’s. He finds that the index moves from 0.34 in the early 1970’s to 0.82 by 1995. 2 Note that by 1985 Latin America was in the midst of a debt crisis which had led to a major recession. This should have made the subsequent recovery larger.3The other side of the coin, and the second strand of ill-fitting evidence, is presented by the experience of countries that have had greater success. Some of the most important among these countries—South Korea and Taiwan since the early 1960s, China since the late 1970s, and India since the early 1980s—have done extremely well under quite heterodox arrangements. All these countries have emphasized exports and none grossly violated property rights. But their strategies bear only passing similarity to today’s consensus precepts. South Korea and Taiwan retained high levels of protection for a long time, and made active use of industrial policies. When Korea was hit with the Asian financial crisis in 1997, its economy had so many institutional weaknesses by orthodox standards that many observers located the crisis’ roots in Korea’s “governance” problems. China achieved phenomenal growth rates without formally enacting private property rights—something that would have seemed impossible to many economists had the Chinese miracle not taken place. India