3

Theories of Development Economics

Pablo Heidrich

Workers make rubber bands from raw materials in a village at the outskirts of Mawlamyine, Myanmar. Photo by SAI AUNG MAIN/AFP via Getty Images

Learning Objectives

• To understand economic development as an aspiration for material betterment that has existed since at least the Industrial Revolution
• To learn how development economics was framed by the experiences of the Great Depression, the Second World War, and the Cold War.
• To recognize the tension in development economics between freeing market forces and assigning the state a critical role.
• To identify the different theoretical schools of development economics from the mid-20th century until today.
Introduction

This chapter introduces the major contributions of development economics using a history of ideas approach that
places various thinkers in their historical context. It pays particular attention to the ongoing debate between those
who see economic development as primarily the result of market forces and those who envision an important role
for the state as catalyst. The chapter begins by considering the political economists who reflected on the Industrial
Revolution that occurred in England in the late 18th and early 19th century, and those who saw in England’s ascent
a political and economic threat that required a different set of policy tools to catch up. The experience of the Great
Depression validated an increasing role for the state in economic policy, an approach inherited after World War II
by the newly-born field of development economics. At this point, newly independent countries and their first-world
advisors saw economic development as a process of economic, political, social, and cultural transformation and
modernization led by big investments in infrastructure, import substitution, and foreign aid. It was not until the
early 1980s, when this state-led development began to falter, that classical liberal economic recipes returned as
neoliberalism. Neoliberalism’s emphasis on market forces promoted trade and economic liberalization, financial
integration with the global economy, and a minimal welfare state. By the 2000s, the market fundamentalism of the
neoliberals had given way to a new institutionalism that emphasized the important role played by institutions in
economics, allowing for greater pragmatism in how to stimulate economic development in the Global South.
The Question of Development

Until the mid-1700s, most people around the world lived in rural areas, dedicated themselves to subsistence agricultural production, and produced
manufactured goods at an artisanal scale or in small factories. International trade existed on a comparatively limited scale, trading niche products such as
spices, precious metals, and some luxury goods.

Starting in Great Britain in the 1750s, steam engines and other mechanized and technical processes began to be applied to the production of manufactured
goods, unleashing what would later be called the Industrial Revolution. This transformation in the manner of production—whereby workers specialized in
different stages or tasks while working in larger groups and with machinery—unleashed rapid increases in the quantity of material goods that could be
produced for mass and luxury consumption. This in turn triggered a process of faster economic growth and structural transformation in the British economy,
and similar processes took place soon after in France and the Benelux countries (Belgium, the Netherlands, Luxembourg).

As more goods were produced, more became available for export, and demand grew for imported raw materials for industrial production and foodstuffs for the
growing urban populations. Agriculture was also gradually transformed in Great Britain and France at this time as communal lands and smaller farms were
absorbed into larger landholdings employing mechanization, while much of the rural populations were encouraged or forced to migrate to urban centres (see
Chapter 4).

Classical Political Economy

This dramatic transformation in parts of western Europe induced much rethinking about political and social arrangements, planting the seeds of what was later
known as political economy, through which intellectuals and academics of those times sought to understand the rules, regularities, and patterns in the
changing economy and politics of the period. Among the most renowned thinkers were Adam Smith, David Ricardo, and Karl Marx. Smith encouraged the
changes happening during the Industrial Revolution, arguing that a society of free individuals using their personal abilities to pursue their individual self-
interest—without interference from the state and following the invisible hand of the market via supply and demand—would be more productive and peaceful.
David Ricardo built on those observations by making the case that countries should specialize in the production of goods they were comparatively better at,
given available land, labour, and capital. This theory of comparative advantage promised that specialization in international trade would create benefits for
all participants that were greater than producing all goods and services domestically, without cross-border commerce.

The works of Smith and Ricardo, plus those of others that followed them, provided the intellectual foundation for today’s capitalist economy based on individual
self-interest, free market rules governing the use of labour, land and capital, and free trade among nations. Writing 70 years later than Smith and 30 years
later than Ricardo, Karl Marx took a much more critical view. He argued that market rules led to a society in which employers or owners of land and capital
accrued most of the benefits while workers (who only had their labour to sell) benefitted least. International trade and investment flows, according to Marx,
exported those same exploitative relations to other countries (see Chapter 4 for a more detailed consideration of Marx).

The study of these economic phenomena reflected the fascination and fear produced by the rapid growth in wealth, industry and military superiority of the
United Kingdom over other parts of Europe, the Americas, and East Asia. An early reaction to the classical liberal economists took the form of economic
nationalism.

An example is Friedrich List, a German political economist writing in the 1840s, who called for trade protectionism to help develop domestic industry and
scientific knowledge sufficient to catch-up and compete with other “more advanced” European nations. His ideas were partially inspired by the American
revolutionary leader, Alexander Hamilton, and List’s own observations of the United States. Hamilton, as secretary of economic affairs in the US’s first
independent administrations, had protected local industries from foreign competition and accelerated domestic technological change through government
intervention. Among non-Western countries facing threats from European imperialism, the Japanese thinker Tokuzo Fukuba also proposed maintaining
protection for domestic producers while learning how to include Western technologies and adapt local institutions to imitate European industrialization. He went
on to introduce Western economics in Japan and promote its integration with local knowledge about markets, regulations, and innovation.

20th-Century Experiences and Early Catch-up Thinking

While British industrialization and military superiority inspired protectionism in Western Europe, Japan, and North America, other parts of the world
responded by thinking about how to catch up with the more advanced economies. Of those “catch-up” theorists, Russian economic historian Alexander
Gerschenkron articulated in 1951 what is understood to be the first explicit theory of economic development. He defined the role of the state in planning to
accelerate economic growth—and to induce a structural transformation in agrarian economies that had little industry—as “jumping ahead from economic
backwardness” (Gerschenkron 1962). He argued that governments could, in a context of abundant natural resources and labour, collaborate with private
business to foment rapid industrialization with imported foreign technology. While his theory referred specifically to the plans implemented by Imperial
Germany and Czarist Russia in the 19th century, his later writings clarified that this premeditated planning to transform a country’s economy in short order
was also applicable to the newly independent countries in the Global South in the 1950s and 1960s.

Gerschenkron understood this process of economic development and change to be led by the production of capital or industrial goods and the provision of
physical infrastructure (such as railroads and electricity) rather than by the production of consumer goods or improvements in agricultural output. He also
argued that such rapid, top-down approaches to industrialization and development employed ideologies of nationalism and authoritarianism to mobilize and
discipline domestic capitalists and the population in service of the economic plan.

Another 20th-century experience that influenced early ideas on economic development was the Great Depression, a massive economic slowdown that affected
the United States starting in 1929 and expanded to Europe, its colonial empires, and Latin America through the early 1930s. John Maynard Keynes, an English
economist, is widely credited with having proposed the new economic policies that contributed to resolving it. He argued that supply and demand did not
automatically balance in market economies and, most important, that private investors could not be relied upon to make the right investment decisions to help
a society achieve its full economic potential. Together with other economists of his time, such as Roy Harrod and Evsey Domar, he argued that national
economies should be guided by state actions in order to attain sustained rates of growth. This growth could achieve and maintain the full employment of labour
and satisfy the consumption needs of the population. In other words, government regulatory interventions and spending in a market economy was legitimized
for goals not only of economic transformation and industrialization but also for maintaining economic stability and providing full employment. This approach to
managing the economy was known as Keynesianism or Keynesian economics and was highly influential among developing countries and their elites.

The experience of the Second World War—when for six years most of the global economy was refocused on arms production and the support of large-scale
armies—dramatically accentuated these beliefs about the centrality of the state to economic growth. Victors and defeated nations alike were convinced that
markets could in fact be suspended or drastically curtailed by government actions for the common good, be that military mobilization, food rationing, or
industrial and agricultural production. Most economists and other policy-makers who worked on global development issues from the 1940s through the 1970s
had their formative years in that context. For them, Keynesian ideas about states guiding economies had been proven, both during the war and during the
reconstruction of western Europe and Japan afterwards.

The relevance of these ideas to the developing world—particularly of jumping stages of development by accelerating growth and modifying economies, using
forces other than the market (namely, the state)—was exemplified in the work of economists such as Walt W. Rostow in the 1950s. He had a different public in
mind: elites in the United States who were preoccupied with the direction and alignment that newly independent countries in the Global South were taking
during the Cold War. Rostow proposed that US aid to developing countries could help them to move rapidly through the stages of economic development
while keeping them in the capitalist/Western sphere of influence. Even though such ideas were taken as a clear and optimistic blueprint for US aid diplomacy,
they in fact implied less optimism than Gerschenkron’s message—suggesting that catching up to the industrialized West could not be done without Western
support and foreign aid. In other words, a convergence of global living standards between the developing and the industrialized world could not happen solely
by state intervention, international trade and domestic investments but instead required international cooperation.

PH O TO 3 . 1 Economist and adviser Walt W. Rostow (left) meets with US president Lyndon B. Johnson at the White House, Washington, DC. Tango
Images/Alamy Stock Photo

IMPORTANT CONCEPTS
Box 3.1 Rostow’s Stages of Growth and Development
Walt W. Rostow, an American economist and adviser to US governments, postulated that economic development as done in Western industrialized
countries could be replicated in the developing world by applying a five-stage model. His theory was followed by Western governments that provided foreign
aid and policy advice for economic development throughout the post–World War II era. It was also representative of a set of approaches to development
known as modernization theory.
The initial stage of development was described as traditional in which developing-country societies were assumed to be mostly agricultural, focused on
subsistence, and employing their economic surpluses for military or religious goals rather than for economic improvement.
The second stage, named transition, subverted the previous one through the development of internal and external markets that allowed the sale of
agricultural surpluses and the import of new goods, often with foreign technology. This process altered traditional culture and shook up the pre-existing
political order by creating social interests in favour of increasing production and accumulating wealth for secular and civil purposes. The push toward more
productive economic specialization in incipient manufacturing, and interest in the diversification of economic and trading opportunities created the conditions
for the third stage.
The third stage, or take-off, was crucial because this was the moment when developing countries started switching to large-scale agriculture and industry,
thus causing rapid urbanization and social change. The pressures of urbanization and industrialization demanded significant investments in basic services
such as electrification, roads and seaports and drastic improvements in education systems. For Rostow, these all were areas where Western aid and advice
could and should be employed.
The fourth stage, called the drive to maturity, saw these tendencies deepen. In economic terms, countries would become more diversified and less
reliant on imports to cover necessities. Much of this depended on local firms making investments to increase the volume and quality of their production, and
adapting or creating their own technologies.
The last stage, called the mass consumption society, was the stage already attained by industrialized Western economies. At this stage, economies
were completely industrialized, and their productive capacity was enough to satisfy the consumption needs of citizens, including financing imports with
exports of goods and services.
Almost none of the developing countries of the 1950s and 1960s have yet attained this last stage, with the exception of some East Asian countries, which
did so mostly thanks to their own recipes, as explained later in this chapter. While Rostow’s stages of growth are rarely invoked in development policy
analysis today, this model and the accompanying political modernization theory have remained as an influential undercurrent for Western policy-making
toward the Global South.
Politics and Economics of International Development Policy

The end of the Second World War inaugurated a protracted confrontation between the capitalist Western powers and the
socialist Soviet Union and China known as the Cold War. Early tensions coincided with the collapse of the formal colonial empires,
as most developing nations achieved independence in Africa, the Caribbean, the Middle East, and Asia (see Chapter 2). This
coincidence of events framed the politics of international cooperation and development in the Global South.

The policy goals of the Western world were therefore to promote their own model of economic development, and the
strengthening of economic and political linkages with their own bloc. Ideologically, the starting point for those new relationships
was based on colonial relationships. European powers (and the United States, to a lesser extent) had maintained expansive
colonial empires through much of the Global South, and their understanding of those now-independent nations was grounded in
the experience of having been their colonial masters. Consequently, societies in the South and their new governments were still
seen in the West as being “traditional,” requiring guidance and assistance from developed nations to improve themselves (Desai
2017). Taken together, the set of theoretical approaches that envisioned poor and traditional nations transforming into modern
copies of Western nations was known as modernization theories. These theories had sociological (Durkheim, Weber, Parsons),
economic (Rostow), and political (Huntington) variants.

The social theories chosen to support such views were based on the intellectual foundations of Émile Durkheim and Max Weber,
who envisioned societies as value systems in which individuals followed a common set of beliefs, practices, and norms. With the
Industrial Revolution, those value systems had changed as individuals took increasingly differentiated roles because of the
growing specialization provoked by industrialization and urbanization. Such growing differentiation, argued Weber, could remain
compatible with the maintenance of a social order and a common identity as long as rules were respected by everyone equally
and administered impartially by a state working for the common good (Peet and Hartwick 2015). The American sociologist
Talcott Parsons further elaborated by arguing that non-Western societies could only become industrialized if their values and
identities were transformed away from traditional and “pre-modern” attitudes toward those congruent with Western cultural
and social norms.

Parsons was borrowing from biological notions of evolution to argue that the West was more evolved than the rest of the world,
particularly those newly independent (previously colonized) countries that were in the throes of development. Those were
societies where collectivist identity and emotionally driven (i.e., “non-rational”) behaviour hindered the development of
individual entrepreneurship, innovations, and, therefore, technological and economic changes. As a consequence of such thinking,
Western aid aimed to build close relationships with key figures in developing societies in order to first alter their social values,
and then usher in change to economic and political structures.

In that context, the economist Rostow was typical of other social scientists of his time, assuming that developing countries were
not initially interested in technological improvements, or scientific thinking and methods. As a result, Western governments had
to help developing countries out of their traditional stage by offering foreign aid and bank loans (to accelerate the South’s
consumption of Northern technology, consumer goods and modern tastes), increasing trade, and encouraging foreign investment
(to strengthen linkages with the developed North). Foreign aid would, therefore, facilitate industrialization and take-off.

In parallel to such economic transformation, Western theorists expected to see a political evolution from “traditional”
authoritarianism to democracy, especially as populations became more formally educated, urbanized, and able to defend their
rights. Authoritarian elites, composed of landowners and religious or military leaders with feudalistic values, were also expected
to migrate to democratic postures once they realized the need for larger domestic markets, stable rules, and independent justice
systems to achieve the later stages of development (Jahn 2013). If they were not willing to do that, “modernizing” leaders were
to be promoted by the West through aid, diplomatic pressures, and even coup d’états.

Samuel Huntington, a political scientist and adviser to United States governments in the 1970s, argued that hopes for a linear
movement toward democracy were in fact naive. He posited that the very process of rapid economic growth, with the
consequent undermining of traditional forms of power and authority, could instead lead to fragile states with limited legitimacy
(Huntington 1969). In short, economic development could lead to political instability, yet a lack of economic development could
also lead to dissatisfaction or revolts.

TAB LE 3 . 1 Theories of Economic Development

Theory / Emergence Thinkers Discipline / The Problem The Solution

Theme Tradition
Classical late 1700s, Smith, Ricardo, Mill classical liberalism low productivity labour specialization,
Political early 1800s mechanization, free trade
Economy
 Theory / Emergence Thinkers Discipline / The Problem The Solution
Theme Tradition
Nationalist 1800s List, Hamilton, nationalism unfair competition, trade protectionism, state-guided
Economics Fukuba catch up to leading industrialization
powers

Keynesianism 1930s– Keynes, regulatory crises of capitalism state-led investments to expand

1950s Gerschenkron, capitalism demand and drive growth
Harrod, Domar
Development 1940s– Lewis, Rosenstein- Keynesian low-level urbanization, industrialization,
Economics 1970s Rodan, Rostow, economics equilibrium, low controls on trade and investments
Hirschman productivity
Modernization late 1950s Almond, Huntington, Weberian / traditional society absorption of Western values and
Theory * Parsons Parsonian sociology institutions, democratization
Import 1950s to Prebish, Singer, Keynesianism, asymmetric trade trade protectionism,
Substitution 1980s Nurske nationalism relations industrialization, space for debt and
Industrialization foreign investment
Neoliberalism 1970s– Bauer, Lal, Krueger neoclassical the role of the state, free markets, financial deregulation,
present liberalism, political dirigisme globalized markets
conservatism
Developmental 1970– Chang, Liu, Kojima, Listian too weak domestic state regulations to guide market
States present Amsden mercantilism, markets competition, export promotion,
nationalism protectionism
Institutionalism 1990s– Acemoglu and institutionalism incompatible policy pragmatism, endogenous
present Robinson, North, institutions for local learning, gradual adaptation to
Ostrom, Rodrik conditions globalization

* Modernization is not an economic theory but was used amply by Western policy-makers since the 1950s to frame their economic policy advice
to developing countries.
Source: Author’s elaboration based on Desai 2017 , p.50.

In this regard, the advice from political scientists and sociologists to Western governments giving aid and support to developing
countries was contradictory. On the one hand, they were to encourage political change toward democratization. But on the other
hand, they had to strengthen the capacity of states to keep order and accelerate economic progress across the necessary stages
of development (Engerman et al. 2003). Much of the US, Canadian, and western European political and military aid during the
Cold War years from the 1950s to the 1980s was thus informed by this very contradictory logic: willingness to support market-
friendly and modernizing authoritarian governments while often admonishing them to provide political rights and move toward
democracy (Unger 2018).

The New Discipline of Development Economics

New ideas about how the developing world could rapidly become industrialized were found in the detailed programs and ideas
promoted by economists in the “new” discipline of development economics that emerged in the late 1940s and lasted until
the early 1960s. One of the most influential of these ideas was the theory of the “big push” advocated by Paul Rosenstein-
Rodan, who argued for concentrating development efforts in specific industrialization projects to be selected based on the
strength of their ripple effects in the rest of the economy, measured by number of jobs and new businesses created. An example
of big push thinking would be the National Industrialization Plans and Targets in Brazil during the late 1950s, which demanded
the creation of heavy industries such as steel plants, the output of which would later be used in the production of other goods,
such as rail cars and train tracks, ships, and heavy trucks.

Beyond specific large-scale industrial projects, Rosenstein-Rodan also postulated that large infrastructure investments such
as seaports, road bridges, and energy generation plants were essential for developing countries because they could enable
additional economic activities and facilitate getting more products to market. The construction and operation of these projects
would also transfer significant skills in building, planning, and project management to developing countries (Rosenstein-Rodan
1944). Given their very high costs and requirements for technical knowledge, these projects typically needed to be funded
through foreign aid, thus establishing another powerful argument and agenda for official development assistance.

The idea that big projects in strategic industries and large infrastructure investments would trigger economic modernization in
underdeveloped economies was also endorsed by Albert Hirschman, a leading economist and prominent adviser to the World
Bank. Hirschman, however, underlined a different gain from injections of foreign technology and capital, namely, creating
linkages with the rest of the economy. The concept of linkages emphasizes that a given strategic industry can stimulate the
development of other industries, including some local industries that provide inputs (backward linkages) and other industries
that process outputs (forward linkages) for these new projects. Thus backward and forward linkages could jumpstart multiple
sectors of an underdeveloped economy into higher productivity (Hirschman 1958). It is important to note here that such
linkages would develop only if state policies obliged the utilization of locally made inputs and local processing of outputs before
exporting.

Those departures in development economics from traditional notions of laissez-faire economics were quite common in the 1940s
to 1960s, since many economists of this period did not accord international trade a significant role in strategies for development.
Their recent experience had been formed by the Great Depression, with its fall in international trade flows, the Second World
War, when international trade had pretty much stopped, and the early postwar period, when trade remained heavily regulated
in both the North and the South.

Furthermore, economists such as Ragnar Nurske observed that much of the growth of imports in developing countries consisted
of luxury and superfluous consumption, which he viewed as wasteful. Nurske advocated instead for increased taxation of
commodity exporters and the wealthy to finance state-led industrial projects that would diversify the economy, substitute for
imports of manufactured goods, and repress demand for luxury items (Bass 2009). Such thinking dovetailed with Rosenstein-
Rodan arguments for “big push” projects, Hirschman’s ideas of “linkages,” and Rostow’s stage sequencing of growth.

Arthur Lewis, a Caribbean economist, contributed another critical link by pointing out that industrialization could be promoted in
developing countries by encouraging labour to move from rural areas, where they worked in subsistence farming or plantations,
to urban areas to work in industry, without raising wages. That argument, named the theory of surplus labour, implied that
industrialization could achieve large profits in its early stages, which could later be reinvested in technology adaptation or
endogenous innovations, making economic development a self-sustaining project (Lewis 1954).
PH O TO 3 . 2 Arthur Lewis was the first Black person to receive a Nobel Prize in a category other than peace when he was
jointly awarded the Nobel Memorial Prize in Economic Science with Theodore W. Schultz in 1979. Keystone Press/Alamy Stock Photo

The most significant argument against focusing on international trade as a path for development came from the work of two
economists, Hans Singer and Raul Prebisch, who researched trade relations between developing and developed countries. They
observed that developing countries usually exported agricultural and mineral commodities to the rich countries while importing
manufactured goods from them. With such pattern of exchange, developing countries could only face a future of declining
national income. This was due to three main factors: income elasticity of demand, declining terms of trade, and
income volatility (Toye and Toye 2003)
Income elasticity of demand refers to the supposition that as gross domestic product (gdp) per capita grows, the amount
people dedicate to buying agricultural goods, oil, and minerals decreases as a percentage of their total expenditure even if it
grows in absolute terms. In other words, as incomes rise, people allocate a growing share of their money to buying manufactured
goods and services, the value of which depends on the knowledge or technology applied to them. For example, as people grow
wealthier, they do not consume a proportionally larger amount of basic coffee beans but instead prefer to spend more in
sophisticated coffee preparations. Thus, producers of unprocessed coffee beans in the developing world would not benefit as
much as those roasting and serving coffee with increasingly sophisticated elements added to it in your corner hipster café. The
policy lesson for countries exporting coffee beans is that their specialization in unprocessed coffee beans is unlikely to translate
into increasing incomes proportional to the growing incomes of their developed trading partners. Thus, specialization in
commodities is a way to fall behind in the world economy unless countries find a way to add value to those exports.

A related concept is the declining terms of trade, which means that developing countries exporting simple commodities and
seeking to industrialize would need to import growing and costlier manufactured goods and technologies, which rise in value
faster than commodities. The term “declining” implies that the prices of commodity exports fall over time in comparison to the
prices of manufactured imports. Even if increasing quantities of exports fetched more national income, the faster-growing costs
of imports would result in not having enough money to support that demand. As the global demand for commodities does not
grow as quickly as the demand for manufactures, if developing countries tried to produce and export more of them, global prices
for those commodities would fall, leaving them in the same situation as before.

That combination of income elasticity (a declining share of incomes dedicated to buying commodities) and the declining terms of
trade leads to income volatility for exports. This means that commodity exports suffer from highly variable prices that rise
or fall significantly on a yearly basis, making it very difficult for developing countries to plan infrastructure projects, social
services, or industrialization. If budgets and expenses are stable over time but income from exports is unpredictable,
governments face unexpected surpluses or deficits. Deficits often lead to economic crises, known as balance of payments crises,
and a pattern of economic growth that has frequent reversals or interruptions. That was called a stop-and-go pattern, and it
afflicted many developing countries in the postwar period.
Disenchantment with Keynesianism and Neoliberalism

The postwar optimism that newly independent countries in the developing world would eventually industrialize
and thus achieve, if not convergence with the developed world, at least much higher standards of living, peaked in
the early 1960s. By the early 1970s, economic growth and more important, economic development as a structural
transformation from commodity to manufacturing-based economies had only partially been realized. Latin
America and parts of East Asia had substantially increased their income per capita and begun economic
transformations, but South Asia and most of Africa were saddled with lower levels of income and failing processes
of economic modernization (Jomo and Reinert 2005). Income convergence between the Global South and the
industrialized North had not happened. In fact, that income gap had grown from 300 per cent to more than 600
per cent between 1950 and 1972 (Cypher 2014).

IMPORTANT CONCEPTS
Box 3.2 Import Substitution Industrialization
Countries seeking to accelerate economic growth have always found it necessary to industrialize from a
starting point based on the export of agricultural or mineral commodities, and the import of manufactured
goods. The strategy for industrialization, originally advocated by 18th- and 19th-century nationalists such as the
American Alexander Hamilton, the German Friedrich List, and others, was to substitute for imports. Import
substitution industrialization (isi) required trade protection of new “infant industries” by using tariffs or taxes on
cheaper or higher-quality imported manufactures, access to easy financing, and copying foreign technologies.
By discriminating against or limiting foreign imports, it was thought that governments could create the space for
domestic industry to blossom. The United States, Germany, Japan, and several other European countries had
already used this strategy successfully during the 19th and early 20th centuries, according to economic
historians such as Ha-Joon Chang.
Latin American countries turned to isi later, during the mid-20th century, mostly as an accidental result of the
collapse of world trade in the wake of the world wars and the Great Depression. During those crises, the
manufactured imports usually consumed by Latin Americans were simply unavailable or unaffordable, and
nascent domestic industries started to develop in response. Once in place, those local capitalists and their
supportive governments sought to maintain their advantages over foreign imports, by enlisting the arguments
proposed by Prebisch and Singer (on the declining terms of trade for commodity exporters) in favour of setting
up protective tariff barriers.
The premise of isi was that by protecting infant industries, they could grow shielded from foreign
competition, earning great profits in local markets that would be later invested in new industries and
technologies, gradually creating a more industrialized economy with higher value-added than one based on
unprocessed commodities. The United Nations Economic Commission for Latin America and the Caribbean
(eclac), founded in 1948 and headed by Raúl Prebisch, publicized that vision, arguing that the structure of the
world economy left developing countries in that region no option but to resort to industrialization with
protectionism.
The argument, however, did not preclude a role for foreign capital as direct investors and contributors of
foreign technology and expertise. As a result, many US and European corporations set up car and electronics
factories behind trade barriers in the larger Latin American countries. Thus, isi contained some contradictory
elements in practice, but the overall direction was to move toward producing more complex and expensive
manufactured goods for domestic markets in developing economies.
Since Latin American countries had for the most part rather small domestic markets, due to high levels of
income inequality, the strategy of isi industrialization financed by domestically generated profits quickly ran its
course. Moreover, it was impossible to export these goods to other markets because they were generally of
low quality due to the lack of competition in the home market. By the 1970s many Latin American nations like
Mexico and Brazil had racked up large foreign debts trying to finance their industrial development by import
substitution. Once those debts became unpayable in the early 1980s, isi could no longer be financed, and was
further undermined by IMF and World Bank loan conditionalities, which required tariff reductions and economic
deregulation. Those policy changes eliminated much of the protection domestic and locally-producing foreign
 firms had enjoyed in the isi era, and resulted in significant de-industrialization (see Chapters 10 and 15).
In many regards, Latin American isi drew on Rostow’s stages and had connections with other Keynesian
notions of big push investments and economic linkages. However, it was distinct in its profound distrust of
international trade as a possible harbinger of economic growth. Without going as far as Celso Furtado and
Henrique Cardoso, who articulated a notion of “associated” dependent development (see Chapter 4), it simply
had no faith in external sources of development, such as trade or international cooperation. In the end, the
neoliberal policy changes attached to emergency loans in the 1980s and 1990s proved isi’s undoing.

Thus, the promise of state-led capitalism, exemplified by the development economists discussed above, appeared
to have failed partially or completely in the developing world. The underperformance of this model was
demonstrated in the growing frequency of economic crises and stalled development. This, in turn, induced growing
levels of political violence in Latin America, the Middle East, and sub-Saharan Africa, where numerous countries
underwent a series of coup d’états with cycles of populist regimes and military repression supported by foreign
powers. Another significant indicator of the failure of state-led capitalism was the advance of Soviet socialist
alternatives in Africa, Southeast Asia, and the Caribbean. There were growing problems in the Western economies
in those years as well. Growth since the end of World War II had been rapid through the 1950s and 1960s, but by
the early 1970s, the double whammy of fiscal and trade deficits sent many of the Western economies into a series
of recessions. The immediate source was the growing fiscal deficits in the United States caused by vast military
expenditures resulting from the Cold War and the growth of the welfare state, without adequate expansion in the
level of taxation needed to finance both. However, other broader causes also affected North America and western
Europe, such as decreasing rates of technological innovation as well as growing industrial competition from Japan
and, to a lesser extent, from other East Asian developing nations such as South Korea and Taiwan.

Return to Classical Economics: Neoliberalism

In response to these challenges, a previously marginalized part of the economics profession, which had long
disagreed with the Keynesian synthesis of vigorous state intervention in markets and comprehensive welfare
services, irrupted forcefully into the policy debates of the mid-1970s. These economists called for a return to the
laissez faire liberalism of the early 19th century, shrinking state intervention in the economy, and a retrenchment
(reduction in size) of the welfare state. The principal tenets of that critique were anchored in the pioneering
writings of Friedrich Hayek in the 1940s and 1950s and further elaborated by Milton Friedman, who became the
leading voice of what was known as the Chicago School of economists, in the 1960s and 1970s. These neo-classical
thinkers basically argued that true sources of economic growth were to be found in individual initiative guided
by market-determined prices that naturally balanced demand and supply for all goods and services, and which
informed appropriate investment decisions (Cypher 2014). State intervention was viewed as distorting markets.
Therefore, regulations had to be dismantled (their role as guide for investment opportunities eliminated) and all
controls on flows of trade, finance, and people removed. In sum, the whole Keynesian approach to economics that
had reigned since the 1930s was rejected. In political terms, these economists, initially called monetarists and later
neoliberals, were closely aligned with conservative governments that came to power during the 1980s in the
United States with Ronald Reagan, in the United Kingdom with Margaret Thatcher, as well as in other developed
countries such as Canada, France, and Germany soon afterwards. Neoliberal reforms were quickly applied in the
United States and the United Kingdom, but less so in other parts of Europe.1

For the developing world, the consequences of this change in economic thinking were enormous. In terms of
North–South relations, the incipient dialogue that had begun in the late 1960s with the New International
Economic Order (nieo) conferences that aimed to facilitate improved trade and financial conditions for developing
countries was aborted, replaced by a confrontational rhetoric that developing countries were solely responsible for
their own problems (Lanoszka 2018). In terms of financial and technical assistance for development provided via
international financial organizations (the World Bank, regional development banks, and, in the case of balance of
payment crises, by the International Monetary Fund), the conditions to qualify for such loans were quickly
adapted to the neoliberals’ preferred menu of policy positions including privatizations, economic and trade
deregulation, and financial liberalization (Peet and Hartwick, 2015).
The rationale behind the turn toward what became known later as the neoliberal school in development
economics came from its trenchant critique of established practice during the postwar years: that development
would happen through a combination of state actions and foreign aid to modernize a subsistence economy into an
industrialized one. Development economists disappointed with the meagre results of that plan, such as Peter
Bauer, argued that foreign aid for such state-led programs had actually distorted incentives for economic actors.
For example, local farmers would have used their own initiative to produce what markets demanded if they been
allowed to operate without government interference via price controls. Instead, foreign aid and loans had only
increased indebtedness, produced infrastructure that was not truly needed, and created inefficient industries that
could only survive foreign competition thanks to protectionism (Cypher 2014). The result, for Bauer and other
critics, was the evident increase of poverty in many developing countries during the 1980s instead of economic
growth. Ian Little, another influential economist at Oxford University (UK), focused similar criticisms on the
perverse role of trade protectionism and state controls on finance, which he blamed for distortions in local
prices, low investments, and the consequent underperformance of agriculture in much of the developing world
(Little 1982). His views were indeed very influential, since he trained many students, such as a future minister of
finance and prime minister of India, Manmohan Singh, who later led radical neoliberal reforms in India in the
1990s and 2000s (Cypher 2014).

Therefore, the central policy critique of neoliberalism was that states could not be trusted to lead economic growth
because government bureaucrats had incomplete understanding or knowledge of how economies operated, made
poor choices, and wasted resources in the wrong investments. Furthermore, such state overreach into trade and
financial controls impeded markets from operating freely, which could have created the correct incentives for
production and investment. Keynesian development economics had ignored the basic rules of market economics:
prices and individual decision-making are necessary for the most efficient outcomes (Engerman et al. 2003).
Indian economist Deepak Lal, another neoliberal advocate, added that Northern economists had mistakenly
thought that markets did not exist or function properly in the South, making it necessary for foreign aid donors and
states to teach people there how to create growth and development. Lal argued that markets operated similarly
everywhere and that development economists’ past attempts at state-led growth (which he called a “dirigiste
dogma”) were an unsound combination of colonial thinking and war-economy experiences from World War II
applied to the wrong patient (Lal 1994). Instead, he called for reducing foreign aid, pushing for states to free
markets as much as possible, and opening developing countries’ economies to global trade and investment flows.

A final, and perhaps most lethal, criticism of development economics from the neoliberal perspective was provided
by Anne Krueger. She argued that state intervention in the economy and manipulation of markets led to “rent-
seeking,” whereby those benefitting from the intervention became proponents of it for self-interested reasons,
even if everyone knew these policies were not having a positive effect in the economy. A good example is how
import tariffs to protect nascent industries in developing countries from cheaper and better-quality imports can be
eventually dysfunctional. Once the tariffs were in place and protecting local firms from foreign competition,
industrialists and their workers knew they depended on that protection to survive, so they would lobby
governments for the maintenance of the policy, instead of investing in being a better business. Government
bureaucrats or politicians, knowing they had the power to create such opportunities for rents (unearned profits),
often sold such benefits in exchange for bribes or favours, thus unleashing a game of corruption that
simultaneously weakened economies, impeded markets from operating normally, and further distorted incentives
for those sectors where rents could be sought (Krueger 1993). In other words, Krueger demonstrated that
development economists had been naive in assigning so much power and relevance to state actors in economic
growth without seeing how state intervention itself could distort or limit economic development.

This criticism was tremendously effective, making Krueger very influential in the policy field of economic
development. She later served as chief economist at the World Bank for most of the 1980s and as deputy director
(vice-president) of the International Monetary Fund in the 2000s. By the early 1990s, the new laissez faire
framework of economic policy advice had entirely displaced the earlier interventionist paradigm in those
institutions and other regional development banks. The British economist John Williamson, seeking to summarize
the state-of-the-art thinking on best practices for economic development, put together a document describing the
“Washington Consensus.” This decalogue listed what developing countries needed to do in order to succeed in
terms of growth and development: balance government budgets; keep inflation as low as possible; privatize state
enterprises, assets, and public services; deregulate all aspects of the economy such as contracting, labour, finance
and banking; and liberalize international trade. If governments were to have any role at all, it was just in promoting
the inflow of foreign investment, protecting property rights, and providing basic education and public health
(Williamson 2009).

With the arrival of the 1980s, the opportunities to apply these precepts of neoliberalism multiplied in the Global
South. Large foreign debts accumulated as a result of state-led development projects and the need to finance the
increasing costs of trade protectionism, inefficient industries, and rampant corruption weighed down many
developing countries in Latin America, Africa, and South Asia. Once these debts became unpayable, as the debt
crisis erupted in 1982, developing-country governments went to the World Bank and the IMF in search of
assistance (see Chapters 10 and 15). That assistance was conditional on the adoption of policies that reflected the
neoliberal Washington Consensus. It should be noted that despite the foreign pressure, many elites in developing
countries had also become disillusioned with Keynesian development economics and the state intervention of the
past, so they were often willing adopters of the new advice they received from the neoliberals from the
industrialized North. The crowning achievement of the neoliberal economists was the opportunity to influence the
transition of the former Soviet Union and its satellites in Europe and Central Asia into capitalist economies during
the 1990s and early 2000s.
Developmental States and Institutional Economics

Not all developing countries had poor growth records since the 1970s and 1980s—a distinct group in East Asia did extremely well during that period and
afterwards. These are known as the “Asian tigers” (South Korea, Taiwan, Hong Kong, and Singapore) to which other dynamic Southeast Asian countries such as
Malaysia, Thailand, and Indonesia were later added. Since the 1990s, China’s tremendous growth and scale might have partially eclipsed the dramatic
transformation that took place in Asia beyond its borders, but the story of the Asian tigers is one that has simultaneously defied skeptics of capitalist economic
development and neoliberal promoters of free markets for several decades already.

South Korea and Taiwan went from poverty and postwar devastation in the 1950s to very high levels of industrial development and per capita income in just 50
years by combining strong state direction of the economy with powerful private entrepreneurship, while maintaining relatively low levels of income inequality and
achieving very high indexes of human development (health, life expectancy, education, and personal freedoms). According to Wade and Amsden, much of the magic
here came from the presence of a developmental state, a bureaucracy focused on accelerating economic growth and bringing about economic transformation in
the shortest possible time. Unlike other states in the Global South, these states simultaneously maintained sufficient policy autonomy from private business
interests to discipline them (thus avoiding Krueger’s rent-seeking problem), while keeping close relationships with private firms to make sure they obtained the
capital, labour, market access, and financial support necessary to be successful (Amsden 2003). Crucially, developmental states fostered and maintained harsh
competition in domestic markets among domestic industrialists, forced them to export in order to achieve larger trade surpluses, and made them learn from
foreign companies, while they also helped domestic firms move into new technologies and markets (Wade 2003).

IMPORTANT CONCEPTS
Box 3.3 Developmental States and the Flying Geese
Japan pursued catch-up economic development in the mid-19th century to maintain its independence in the face of colonialist pressures from the West. It avidly
imported foreign technology and knowledge (engineering, scientific, and medical, etc.) and, through state actions, created a series of large business
conglomerates or zaibatsus to lead economic growth and industrialization.
Rather than borrowing from abroad, Japan exported agricultural and mining commodities to finance its own industrialization, focusing first on light
manufacturing for domestic and export markets, then moving to heavier, more expensive industries. In order to garner more natural resources and cheaper
labour, the Japanese military invaded China, Taiwan, and Korea in the 1890s and Southeast Asia in the 1940s before clashing with the US and other Western
powers during World War II, only to be ultimately defeated.
After the end of World War II, Japan’s recovery was once again led by business conglomerates, now renamed keiretsus (Toyota-Mitsuo, Mitsubishi, Hitachi-
Mizuho, etc.) and coordinated by its Ministry of Trade and Industry (miti). These firms expanded domestically and abroad while reinvesting their profits in
technological upgrading and new ventures. The state also fostered and regulated competition, secured long-term financing, and conducted business intelligence
abroad to support the keiretsus, building in that process the original developmental state.
Ever since the period of Japanese military expansionism and colonialism in the early 20th century, its bureaucracy and business leaders had promoted the
idea of an Asian Area of Co-prosperity, where other Asian nations would follow the Japanese economic model, picking up those industries in which Japan was
no longer competitive. It was named the “flying geese formation” as a metaphor for the way Asian economies would follow the “bird” ahead and leading the group
(Kojima 2000).
In the postwar period, Japanese firms constructed that flying geese formation in East Asia by investing in manufacturing plants in South Korea, Taiwan, and
later Southeast Asia to reduce costs, while passing technology and know-how to those who were prepared to absorb them there. Once firms in those countries
became more technologically capable and their labour more skilled and costly, those industries would pass to countries further down the formation. The graph
below, adapted from one presented by Saburo Okita, former minister of foreign affairs of Japan, clearly illustrates the expected relationships.
 F I G U R E 3 . 1 Structural Transformation in East Asia, 1950–1990 Note: The ASEAN-8 countries are Indonesia, Malaysia, Philippines, Singapore, Thailand, Brunei, Vietnam, and
Laos. (Today there are ten ASEA countries, which includes Myanmar and Cambodia.) Source: Author’s elaboration based on Saburo Okita, “Special Presentation: Prospects of Pacific
Economies,” Korea Development Institute. Pacific Cooperation: Issues and Opportunities (pp. 18–29). Report of the Fourth Pacific Economic Cooperation Conference, Seoul, Korea, 29 April–1
May 1985; graph is on p.1.

To successfully follow that regional model of development, Asian governments and firms have been encouraged by Japanese development aid and diplomacy to
copy its policies and institutions, with states guiding industrialization efforts and the formation of large technology firms ready to compete locally and
internationally. South Korea was a quick learner, forming its own business conglomerates or chaebols such as Samsung, Hyundai, and LG in the 1950s, while
Taiwan focused on smaller but more adaptable firms such as Foxconn since the 1970s. The model expanded in the 1980s to Indonesia, Thailand, and Malaysia,
where conglomerates have also been built often around politically connected elite families, with states again providing extensive financing, investments in
technical education, and business intelligence to support their firms domestically, in connection with other Asian firms and abroad (Jomo and Reinert, 2005).
This model of the developmental state and the flying geese has contributed to tremendous economic growth and the transformation of developing countries
into fully industrialized ones, such as South Korea and Taiwan. At the core of this process sits a highly trained bureaucracy that is at once embedded in close
relations with businesses but sufficiently autonomous to be able to guide and encourage market players toward specific industrial sectors that will absorb
abundant labour, utilize growing skills, and generate increasing profits.

This alternative perspective on the developmental state has forced us to recognize that relationships between states and markets are constructed differently across
the world, and those differences matter to both the effectiveness of state leadership for economic initiatives and the rates of success of private entrepreneurs
(Unger 2018). In other words, neither have all states been as corrupt and rent-seeking as the neoliberals had assumed, nor has state intervention performed as
well as the earlier development economists had hoped for in the early postwar decades. Therefore, national or regional differences on how state–market relations
are built and nurtured are relevant.

Institutional Economics and Other New Ideas in Development

Although the emergence and diffusion of neoliberal ideas is sometimes presented as the “end of history” (Fukuyama 1993), in fact its radical posture regarding the
importance of freeing markets from state intervention was quickly contested within the mainstream of economic thought by the new institutional economics
(nie), which rose to prominence in the late 1990s. The successful economic transformation of East Asia’s Tigers in the 1980s, and later of other South East Asian
nations and China, forced Western development economists (and other social scientists) to reconsider their views regarding the role of institutions and the state in
economic development. The new institutional economics offered a theoretical justification for the global development industry’s concern with “good governance”
(see Chapter 8), and heralded a return of the interventionist state in the Global South.

The new institutional economics has parallels with an almost-forgotten school of economics named institutional economics that had long focused on the role
played by institutions that underpin basic socio-economic relationships such as trade, exchange, trust, and information gathering and dissemination. Associated
with Gunnar Myrdal (1965) and Kenneth Galbraith (1958), this line of thought argued that the cumulative experiences of crises and instability led to suboptimal
choices by private investors that in turn produced ever worse economic outcomes (Cypher 2014). Thus, governments had a role in influencing investment choices
so that they were not defensive, but instead were forward-looking and effective in accelerating economic development. Institutional economists also maintained a
critical view of individual rationality that is not reflected in the NIE, seeing individual preferences as manipulated by institutions and firms (Barnes 2017, 3–4).

The NIE is intellectually indebted to Ronald Coase’s 1937 article on the nature of the firm, which departed from the neoclassical tradition by arguing that the
existence of firms proved that market relationships were not truly frictionless as conventional economic theorizing expected (Barnes 2017, 5–6; Chapter 12).
Instead markets were characterized by numerous transaction costs, such as a lack of information about suppliers and products, contract and labour
negotiations, and costly enforcement of contracts. Firms were vehicles to reduce those frictions in markets by internalizing them within their organizational
structure (Coase 1937). Coase’s contribution was rediscovered by the Nobel Committee in 1991, as interest in the NIE began to mount. His insights had led to the
development of ideas linking institutions, including firms, to the minimization of transaction costs, found in work by Oliver Williamson, Douglass C. North and
others.

Douglass C. North, who shared the Nobel Prize in Economics (1993), is often viewed as a foundational contributor to the NIE. North viewed institutions as the rules
of game (both formal, like the law and bureaucracies; and informal, like culture and religion) that constrained human behaviour. Institutions encouraged stable and
predictable patterns of human interaction by providing key functions that affected the economic decisions of private actors. When they worked well, institutions
reduced uncertainty about others’ behaviour; reduced transaction costs, and lowered transformation costs (the cost of producing something). North also underlined
that institutions created “path dependence,” which means that once created they were resistant to change and locked-in a set of incentives for human behaviour
(North 1990, 7). In this regard, the problem of developing countries was the continued existence of institutions that discouraged productive economic activity
(North 1990, 9, 64)

Dani Rodrik agreed with North that institutions had to create the right incentives for economic actors, but he underlined that there was no one single institutional
recipe for success, which constituted an important deviation from the one-size-fits-all Washington Consensus thinking. For example, he viewed China’s
development as showing that “higher-order principles of sound economic management do not map into unique institutional arrangements. In fact, principles such
as appropriate incentives, property rights, sound money, and fiscal solvency all come institution-free” (Rodrik 2007, 29). Moreover, institutions had to be attuned
to local conditions and could not just be imported or copied from Western examples (Rodrik 2007, 55).

In an influential book, Why Nations Fail (2012), Daron Acemoglu and James Robinson built on Rodrik’s argument to show that historically generated
political institutions were crucial for the possibilities of future growth and development. They showed that the political institutions of a society influenced
whether its economic institutions were “inclusive” or “extractive.” Inclusive institutions rewarded individual initiative by protecting everybody’s (or a large
majority’s) property rights, while extractive institutions allowed an elite to live off the labour and land of others. Acemoglu and Robinson demonstrated that
extractive institutions were often established by colonial authorities in what is now the Global South, and that those contingent choices had long-term
consequences. Their analysis also accorded with Rodrik’s view that democracy was an important “meta-institution” that often influenced the quality of economic
institutions and development (see Chapter 17; Rodrik 2007, 155). In sum, these approaches suggest that the quality and appropriateness of institutions influence
the outcomes of economic development over time.

The influence of new institutional perspectives also extended to the examination of diverse informal institutions at the micro-economic level that influence how
people cooperate to solve their development problems. Elinor Ostrom, the first female recipient of the Nobel Prize in Economics (2009), is representative of this
current in new institutional economics. Her work was theoretically indebted to Mancur Olson (1965) who posited that groups of people find it difficult to self-
organize to pursue a collective good because it is in each individual’s self-interest to free-ride (to benefit from a common good without contributing to achieving it),
resulting in the undersupply of public goods. This is known as the “commons problem” and is frequently invoked to explain the failure to solve collective challenges
such as climate change (see Chapter 18). But Ostrom showed that people can create self-governing institutions to manage common resources (such as fisheries)
without the state, under certain conditions that usually include social trust within the group and having a plan to monitor and enforce the rules based on local
knowledge (Ostrom 1990). Ostrom rejected the state vs. markets duality, and was very influential in the study of developing areas, where formal institutions were
often weak and ineffective, and where regular people had to find creative solutions to their problems (Barnes 2017, 10).

The new institutional economics has profoundly reshaped contemporary understandings of economic development by underlining the relationship between
institutions (both political and economic) and developmental outcomes. Although doubts remain regarding the relative importance of institutions, as compared to
other economic factors considered in this chapter (Przeworski 2004), there can be little doubt that, for now, institutionalism in its various forms has won the
development debate (Jameson 2006).