The Growth Dialogue's Working Papers

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CONTENTS

No. 1 The Republic of Korea’s Infrastructure Development Okyu Kwon ……………………….…………………………......................... No. 2 Growth Economies and Policies Shahid Yusuf …………………………………………………………………. No. 3 Growth Policy and the State Philippe Aghion ……………………….…………………………...................

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Page 51

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Experiences and Some Lessons for Africa’s Developing Economies

Okyu Kwon

W O R K I N G PA P E R N O . 1

The Republic of Korea’s Infrastructure Development

Growth_Dialogue_Cover_No.1_Korea.indd 1 5/25/2011 4:25:21 PM

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Cover design: Michael Alwan

The Republic of Korea’s Infrastructure Development iii

Contents

About the Author ........................................................................................................... iv

I. Introduction ................................................................................................................... 1

II. Korea’s Experiences in Infrastructure Development ............................................. 2

III. Korea’s PPP Experiences and Impact of Financial Crisis on PPP ....................... 9

III. Some Lessons for African Emerging Economies ................................................. 17

Annex 1. Korea’s PPP Implementation Process ......................................................... 21

Annex 2. Regional Cooperation in Infrastructure Development in Northeast

Asia Region ............................................................................................................... 30

Concluding Remarks ..................................................................................................... 39

Boxes

Box 1. The Economic Planning Board (EPB) ................................................................ 4

Box 2. The Five‐Year Economic Development Plan .................................................... 4

Box 3. Energy Supply ...................................................................................................... 7

Box 3 (continued) ............................................................................................................. 8

Figures

Figure 1. Legal Framework for PPP in Korea ............................................................ 11

Figure A1.1. Implementation Procedure for BTO Project ........................................ 24

Figure A1.2. Implementation Procedure for BTL Project ......................................... 25

Figure A1.2. BTO Projects ............................................................................................. 26

Figure A1.3. BTL Projects .............................................................................................. 26

Figure A2.1. Ferry Operations ...................................................................................... 31

Figure A2.2 Zarubino Port ............................................................................................ 31

Figure A2.3. Mongol‐China Railroad Project ............................................................. 32

Figure A2.4. Hunchun‐Makhalino Railroad .............................................................. 33

Figure A2.5. Satellite Picture of Hunchun‐Rajin Road ............................................. 34

Figure A2.6. Undersea Tunnels .................................................................................... 36

Tables

Table 1. Major Indicators of Performance, 1962–71 ..................................................... 3

Table 2. Share of Infrastructure in Gross Fixed Capital Formation .......................... 5

Table 3. Composition of Energy Sources at the Beginning of Development ........... 7

Table 4. Major Indicators of Electricity Supply ............................................................ 8

Table 5. Share of Transportation Investment in GDP ................................................. 8

Table 6. Share of PPP in Government Infrastructure Investment ........................... 11

Table 7. Foreign Participation in Projects ................................................................... 14

Table A1.1. Types of Eligible Infrastructure Activities ............................................. 22

iv Okyu Kwon

About the Author

Okyu Kwon is Visiting Professor at the Graduate School of Finance and

Accounting, KAIST, Seoul, The Republic of Korea. His previous positions

included the Deputy Prime Minister and Minister of Finance and Economy, The

Republic of Korea (2006‐2008); Chief Secretary to the President for National

Policy in June, 2006; and Senior Secretary to the President for Economic Policy in

April, 2006. Prior to taking up his current position at the Ministry, Dr. Kwon was

appointed his country’s Ambassador and Permanent Representative to the

OECD in July 2004. Dr. Kwon was also Senior Secretary to the President for

National Policy in February 2003 after he held a post of Administrator of the

Public Procurement Service in July 2002. Amongst his prominent positions, he

was Deputy Minister of Finance and Economy in April 2001; Secretary to the

President for Finance and Economy, Office of the President in July 2000; and

Alternate Executive Director of the International Monetary Fund in May 1997. In

September 1999, he joined the Ministry of Finance and Economy as Director‐

General of the Bureau of Economic Policy. Dr. Kwon has published several

books, including Strategies for the Opening of Korea’s Service Markets (The Korea

Chamber of Commerce, 1984) and The Challenges and Tasks for Korea’s Capitalism

(co‐author) (The Korea Chamber of Commerce, 1991). His forthcoming

publications include: Restructuring of the Korean Economy after Asian Financial

Crisis and Lessons from European Economies’ Experiences in Economic Development

(Three‐I Strategic Institute, Seoul, Korea).

The Republic of Korea’s Infrastructure Development 1

The Republic of Korea’s

Infrastructure Development:

Experiences and Some Lessons for

Africa’s Developing Economies

Okyu Kwon 1

I. Introduction

Infrastructure development plays a crucial role in economic growth, poverty

alleviation, and enhancing the competitiveness of developing countries.

However, many developing countries don’t have the necessary infrastructure,

and investment in infrastructure is urgently needed. According to the research

done by the Infrastructure Development Finance Company (IDFC), a private

investment company, overall infrastructure investment in developing countries

needs to be doubled from the current 2–3 percent level of GDP to at least 5.5

percent per annum.2 The problem is particularly acute in Africa’s developing

economies, which continue to lag far behind in areas such as telecommunication,

electricity, roads, and sanitation.3 As a result, potential growth as well as delivery

of basic welfare services has been substantially limited.

1 This paper was prepared for the forum “Regional Infrastructure for Africaʹs Transformation and

Growth” (June 7, 2011, Lisbon, Protugal). 2 According to estimation of IDFC, in 2008 1 billion people were without access to roads, 1.2 billion

without safe drinking water, 2.3 billion without reliable energy, 2.4 billion without sanitation, and 4

million without modern communication. (Source: M.K. Sinha, “Challenges in Infrastructure

Development in Emerging Markets,” IIA Seminar on Investing in Infrastructure Assets, 10–12 June

2008, Singapore.) 3 The following are the OECD’s estimates:

Africa East Asia Eastern Europe

South America

Middle East and North

Africa South Asia

Teledensity* 62 357 438 416 237 61

Electricity (%)** 24 88 99 89 92 43

Roads (%)*** 34 95 77 54 51 65

Sanitation (%)** 36 49 82 74 75 35

* Fixed line and mobile subscribers per 1,000 people. **% of population with access to electricity or improved sanitation. ***% of rural population living within 2 kilometers of all season road. Source: Promoting Pro-Poor Growth, OECD, 2007.

2 Okyu Kwon

The purpose of this paper is to introduce the Republic of Korea’s experiences

in infrastructure development, which had successfully supported economic

development. Lessons learned from Korea’s experiences during the second half of

the twentieth century can be shared with currently developing economies of Africa.

The paper is organized as follows. Section II discusses Korea’s experiences in

infrastructure development in the 1960s, the 1970s‐80s, and the 1990s and

thereafter. Section III focuses on public private partnerships (PPPs) with a

discussion of how PPPs were successfully adopted in Korea. The section also

touches upon the impact of the recent global financial crisis on PPPs. The paper

concludes with some lessons for African developing countries.

II. Korea’s Experiences in Infrastructure Development

The Korean economy has performed remarkably well over the past 50 years. It

has grown from a war‐devastated, subsistence‐level economy to an advanced

industrial economy. Korea has the world’s thirteenth largest GDP and is the

seventh largest exporter in terms of value. It is the largest producer of many

high‐tech products such as semiconductors, LCDs, and mobile phones and has

an average per capita GDP of more than US$20,000. Korea also has shown its

economic strength by overcoming the recent global financial crisis ahead of other

advanced countries.

Korea’s infrastructure development has played a key role in terms of fast

growth and alleviation of poverty. Development has progressed through distinct

stages. First, in the 1960s, the top priority was to meet the most urgent

infrastructure needs, particularly in the transportation and energy sectors.

Second, during the 1970s and 1980s, under the medium‐ to long‐term

development framework, preemptive and sufficient supply of infrastructure was

available. Third, during the 1990s and thereafter, PPPs were widely adopted to

complement limited government budgets for infrastructure investment.

1. Characteristics of Infrastructure Development in the 1960s <h2>

In the early 1960s, Korea had a typical poor agrarian economy with most of the

industrial facilities of the colonial legacy devastated by the Korean War. Per

capita GDP stayed at around US$60–80 and a vicious circle connecting low

investment to low production, to low income, and again to low investment

prevailed. More than 40 percent of the government revenues were concessionary

aid from a few donor countries.

In 1962, the military government started the First Five‐Year Economic

Development Plan (1962–67) based on the following principles: First, market

mechanisms and economic principles were well respected, but for key industries

substantial government intervention was to be allowed through the planning

process. Second, considering the narrowness of the domestic market and the


paucity of domestic natural resources, an outward‐oriented development

strategy was adopted by fostering export industries that utilized labor, the only

abundant resource. Third, foreign capital inducement was encouraged to cover

capital shortages.4

Major indicators of economic performance for the First and Second Five‐

Year Development Plans were remarkably good as is shown in Table 1.

Table 1. Major Indicators of Performance, 1962–71

1961 1971 1962–71 average

growth rate

GNP growth rate (%, 1975 constant price) 5.6 9.4 8.7 Per capita GNP (US$) 82 278 13.0 Investment ratio (%) 13.2 31.5 — Domestic savings ratio (%) 3.9 14.2 — Commodity export (US$ million) 41 1,132 39.3 Commodity import (US$ million) 316 2,178 21.3

Source: Handbook of Korean Economy, Economic Planning Board, 1980.

Key characteristics of infrastructure development of this era are as described below.

First, infrastructure investment was made in advance under the framework

of the overall economic development plan. The First Five‐Year Development

Plan, enacted in 1962–66, was aimed at enhancing independent growth away

from depending on foreign aid and enlarging the base for industrialization. In

terms of infrastructure, investment was focused on the security of energy supply

including electricity, construction of industrial sites, and building transportation

capacity in order to ensure that infrastructure shortages would not cause

bottlenecks on the path to economic growth. The success of Five‐Year

Development Plans in Korea was mainly the result of efforts and hard work of a

government ministry called the Economic planning Board (EPB). The role of the

EPB and main tenets of the Five‐Year Plans are described in Box 1 and Box 2.

4 Foreign capital played an important role to maintain Korea’s relatively high investment ratio.

During the early stage of development, the investment ratio stayed at around 15 percent of GDP, half

of which was financed by foreign capital. In the late 1960s the investment ratio jumped to around 25

percent, and around 40 percent of investment was financed by foreign capital since domestic savings

began to pick up as income had grown. In the 1970s, the investment ratio once again jumped to

around 30 percent of GDP and foreign capital accounted for around 25 percent of the investment in

the early 1970s. As domestic savings grew, the role of foreign capital diminished from the late

1980s, as the balance of payment position turned to surplus, capital inflow changed to outflow.

1961 1962–66 average

1967–71average

1972–76average

1977–81average

1982–86average

1987–91 average

Investment ratio (%) 13.2 16.3 26.3 28.6 29.4 29.4 31.7

Domestic savings ratio (%) 2.9 8.0 15.6 20.3 24.8 28.6 36.9

Foreign savings ratio (%) 8.6 8.6 10.1 6.8 3.8 0.7 -5.9

Note: Numbers are on the current price basis. Source: Handbook of Korean Economy, EPB, 1980 and Major Statistics of Korean Economy, EPB, 1992.

4 Okyu Kwon

Box 1. The Economic Planning Board (EPB)

The EPB was established in July 1961 and merged with the Ministry of Finance to form the Ministry of Finance and Economy in December 1994. The main function of the EPB was to pursue a systemic economic development plan with a long-term goal, which had the utmost importance especially at the beginning of development. To this end, the head of the EPB took the position of the Deputy Prime Minister (DPM) as well as the chair of Economic Ministers Meeting. He had full power in coordinating economic policies, mobilizing financial resources including budget and foreign capital (which was one of the scarcest resources), and hosting a monthly economic conference and reporting to the President. This meant that the DPM could effectively coordinate economic policies and support development plans by taking a strong hold on financial resources. Without any clients or vested interest group, the EPB maintained its unrivaled position as a leading, neutral, and professional organization in economic policy making. The success story of the EPB was also indebted to continuous overseas training opportunities given to its staff using almost 10 percent of foreign loans rendered to the Korean government during the development era.

Box 2. The Five-Year Economic Development Plan

Korea’s First Five-Year Development Plan (1962–66) started in 1962 and the Sixth (1992–96) was the last, finished in 1996. The government-led industrialization was possible mainly thanks to high-caliber government officials inherited from the traditional Confucian culture, strong financial and tax incentives, ample supply of skilled manpower, and government-funded R&D activities. The target-oriented Five-Year Plans worked well in Korea, but a more important tenet of the plan was to conduct policy-planning exercises that anticipated the future policy environment. During the planning procedure, the relevant government officials, government think tanks, the private sector including business federations and research organizations, and even journalists and academia experts joined together seriously thinking about the future. Through this process, the participants had opportunities to consider advanced country models as benchmarks and prepare for the necessary changes. To materialize five-year plan goals and targets, every year the EPB formulated the annual economic management plan reflecting changes in the environment. In the late 1990s as private sector capabilities grew, five-year planning was replaced by longer-term spatial planning that has continued to this day.

Second, the symbolic importance of large‐scale infrastructure projects to

stimulate people’s desire and will to develop cannot be overemphasized. In case

of Korea, it was the Kyungbu Expressway, the first cross‐country expressway of

428 kilometers connecting Seoul, the capitol city, and Busan, the largest seaport

on the Korean peninsula. It was initiated by late President Park, who was much

impressed by German autobahns. Naysayers among the experts doubted the

economic feasibility of the project, citing expectations of low traffic on the route.

However, President Park followed his own expectations of a much bigger

increase. He also saw that the new expressway would symbolize the country’s

strong will to develop, and would shorten the travel time between cities and

rural areas, an essential factor of modernization. This project demanded a

tremendous amount of money, equivalent to more than 4 percent of the total

annual government budget. The president himself drew detailed routes through

aerial surveys in helicopters. With the president driving the project, the biggest

project till then in Korean history was completed in just two and a half years,

from February 1, 1968 to July 7, 1970. Of course, supply created demand so that

the capacity of the road was saturated rapidly. After that, a series of expressway

construction projects followed, eventually forming a nationwide network that

included the Kyungin Expressway (constructed March 1967–December 1968), the


Honam Expressway (constructed April 1970–November 1972), and the

Yungdong Expressway (constructed March 1971–October 1975). Thanks to these

efforts, the first round of expressway networks was finished and dispersion of

industrial site development was further promoted.

Third, sufficient investment on infrastructure could be realized thanks to

successful financing. The portion of infrastructure investment in gross fixed

capital formation during 1962–71 was more than 30 percent (Table 2). For

financing, a Special Account was introduced for infrastructure investment.

Revenues in that account came from a petroleum tax, tolls, government road

bonds, and borrowings from international financial organizations such as the

World Bank and Asian Development Bank. Commercial loans were also actively

utilized. Of course, all these efforts could not have brought sufficient investment

on infrastructure without the government’s healthy operation of public finances.

Table 2. Share of Infrastructure in Gross Fixed Capital Formation (KRW billion in 1970 constant price)

1962 1965 1968 1971

Gross fixed capital formation (A) 133.9 195.3 498.3 680.6

Electricity, water, sanitation 14.0 11.4 55.1 60.0

Transportation, storage, telecom 30.9 37.1 131.2 177.8

Sub-total (B) 44.9 48.5 186.3 237.8

B/A (%) 33.5 24.8 37.4 34.9

Source: The Korean Economy: Six Decades of Growth and Development, Korea Development Institute (KDI), 2010.

Fourth, efficient infrastructure construction was possible thanks to well‐

established institutions and an effective legal framework. Traditionally

infrastructure was provided by government‐controlled monopolies in many

countries and because of that, infrastructure investment faced many weaknesses

such as high costs and poor performance of infrastructure investments,

bureaucratic decision making leading to delays in infrastructure construction,

underpricing of services due to political interests, opaque legal frameworks that

led to collusion and corruption, and so on. In the case of Korea, however, well‐

established institutions and an effective legal framework allowed the country to

avoid such common pitfalls. The public corporation in Korea, as a monopoly

supplier of infrastructure, could attract high‐quality manpower by offering

adequate compensation and job security. A legal framework, particularly the

bidding system, also could prevent collusion and corruption to some extent.5

5 For example, in international open bidding when foreign loans were used, a very strict rule‐

compliance was required from feasibility study to execution drawing to construction supervision,

which helped prevent collusion and corruption. In addition, as famous foreign engineering

companies were invited, domestic companies could learn from them through joint participation,

which provided stimulus and a momentum for development of domestic construction industry.

6 Okyu Kwon

Characteristics of Infrastructure Development in the 1970s and 1980s

After the successful completion of the First and Second Five‐Year Economic

Development Plans, priority was given in the 1970s and the 1980s to

manufacturing facility expansion and infrastructure construction to support it.

The dominant goal of the Economic Development Plan, i.e. an outward‐oriented

industrialization, was maintained. Also, after experiencing oil shocks, energy

security issue became top priorities. Characteristics of infrastructure investment

of this era were as follows.

First, the infrastructure investment plan was formulated under a longer‐

term and more comprehensive framework. The First (1972–81) and Second

(1982–91) Ten‐Year Long‐Term Comprehensive National Land Development

Plans provided that framework. According to the vision of national land set forth

in the Plan, dispersion of industrial sites, construction of utility network including

energy, and comprehensive transportation network connecting roads, railways,

harbors, and airports should be determined with the same long‐term strategy.

In the case of roads, the nationwide expressway network was expanded,

followed by the construction of national roads (a lower‐class road below

expressways that the central government constructs and maintains) to link

industrial sites, ports, and big cities. The goal was to address potential traffic

increases; enlargement and pavement of roadways were also emphasized. For

financing purposes, a Road Construction Special Account was introduced and

for its revenue, a Special Excise Tax on Petroleum was levied as an object tax.

Development in regions that had lagged behind could now be substantially

promoted thanks to the nationwide expressway network, which made possible

dispersion and connection of industrial sites as well as improved mobility of

people. In addition, deep‐rooted regional conflicts between the southeast and

southwest parts of the peninsula were moderated thanks to these dispersion and

connection functions of the new roads.

In the case of railways, in order to expand transportation capacity, railway

electrification projects continued, and the metropolitan subway system was built

in the Seoul area in 1974 as well as in five other big cities: Busan, Daegu, Incheon,

Gwangju, and Daejeon.

Second, after experiencing the first and second oil shocks, securing a stable

energy supply became a top priority. To cope with such circumstances, a

comprehensive approach was undertaken as described in Box 3.

Third, development of the construction industry by actively participating in

overseas construction could bring in higher levels of technology, and, as a result,

greatly contribute to efficient domestic infrastructure development and to the

successful adoption of PPP in later stages. Korean construction companies had a

comparative advantage due to their abundant supply of high‐quality skilled

workers, strong work discipline, and relatively low wages. Wages were at least

by 10 percent less than those of competitors, and therefore, in 1982 alone, overseas

construction orders exceeded US$13 billion. Korean construction companies were


then able to learn advanced construction technology, construction management

skills, financial know‐how, etc. from their advanced foreign partners, which

contributed to more efficient domestic infrastructure development.

Box 3. Energy Supply

From the beginning of economic development, the energy issue has had top priority because Korea’s energy endowment was extremely poor. As is seen in the Table 3, per capita energy consumption in 1961 was a meager 0.38 thousand tonnes of oil equivalent (TOE), and more than 50 percent of that was from wood charcoal. During the First Five-Year Plan period, the Korea Electric Power Corporation (KEPCO) and Korea Coal Corporation, both government corporations, played a key role in securing energy supply by maximizing development of domestic energy sources such as coal mining and hydroelectric generation.

Table 3. Composition of Energy Sources at the Beginning of Development (Unit: Thou. TOE, %)

1956 1961 1966 1971

Total Consumption 8,756 (100) 9,711 (100) 13,057 (100) 20,868 (100)

Coal 1,634 (18.7) 3,103 (32.0) 6,029 (46.2) 5,872 (28.1)

Petroleum 518 (5.9) 809 (8.3) 2,167 (16.6) 10,559 (50.6)

Hydro power 129 (1.5) 163 (1.7) 246 (1.9) 330 (1.6)

Wooden charcoal 6,473 (73.9) 5,636 (58.0) 4,611 (35.3) 4,101 (19.7)

Per capita consumption … 0.38 0.44 0.64

Note: Shares of composition are in the parenthesis. Source: Korea Energy Resource Institute, Annual Yearbook of Energy, 1984.

From the Second Five-Year Economic Development Plan, the government started to foster heavy and chemical industries, which demanded high energy intensity. Although during 1967–68 there were occasional shortages in power generation capacity due to rapidly increasing demand, the government put the highest priority on power supply security. By allocating more funds from the budget and foreign loans, the government successfully promoted an ambitious plan to secure power supply. As a result, by 1971, power generation capacity had increased to 2.63 million kilowatts, which was less than 4 percent of generating capacity in 2010, but seven times more capacity than in 1961. Most of the increase in electricity supply was from new thermal power generation plants due to exhaustion of hydro generation potential. In addition, since energy security was closely related to independence from global major petroleum companies, many Korean conglomerates, such as LG, Lotte, Hyundai, Ssangyong, and Hanhwa, made joint ventures with global petroleum companies as well as with suppliers in the Middle East to construct refinery plants.

After experiencing the first oil crisis, the government established the Ministry of Power and Resources in 1978, and formulated the Long-Term Power Resource Development Plan. According to the plan, energy supply structure was to be changed away from the highly petroleum dependent system toward a more diversified system. Since then, liquefied natural gas (LNG) and flaming coal have been actively imported and utilized. Particularly, the government began to build nuclear power plants to meet rapidly increasing electricity demand. In 1978, the first nuclear power plant was put in commercial operation and a total of six units were constructed during the 1970s. Of course, at the beginning, Korean companies did not have any experience in constructing or operating nuclear power plants, and advanced country contractors constructed plants on a turnkey basis.

Soon, however, many Korean companies, which jointly participated in construction of nuclear power plants, accumulated relevant experiences and technologies. Later, KEPCO established its own Korean standard model and Korean companies fully localized construction technology including turbines and plant operational know-how. Currently, 28 nuclear power plants are being operated in Korea, which is the fourth highest number in the world after the United States, France, and Japan.

(Box continues on next page)

8 Okyu Kwon

Box 3 (continued)

In 2009, Korea won a US$4 billion bid to construct and operate four units of nuclear power plants for the United Arab Emirates by Korean standard model. In Korea, a stable electricity supply was possible during most of the development era thanks to continuous construction of nuclear power plants, and the share of nuclear power is now around 43 percent of the total supply of electricity.

In terms of financing, the government established the Petroleum Business Fund, the revenue of which came from surcharging on petroleum. Although high oil prices eventually subsided, by maintaining high domestic oil prices, the government could secure a substantial amount of money to invest in the construction of nuclear power plants. KEPCO also successfully issued global bonds with the government’s repayment guarantees and secured enough funds to expand power supply capacity. The government’s high energy price policy for KEPCO to cover investment costs also helped KEPCO make a continuous timely expansion of power supply capacity.

Table 4. Major Indicators of Electricity Supply

1980 1985 1990 1995 1998

Generation capacity (MW) 10,375 17,640 24,056 35,356 47,983

Generation quantity (GWh) 40,078 62,667 118,461 203,546 237,197

Supply buffer ratio (%) 40.1 31.3 8.3 7.0 14.9

Shutdown min. per household 891 523 295 39.2 21.2

Source: KEPCO, Korea Electricity Statistics, 1999.

Characteristics of Infrastructure Development in the 1990s and Thereafter

During the 1980s, infrastructure investment lagged behind the pace of

development. Therefore distribution costs and congestion costs increased

substantially, resulting in a deterioration of national competitiveness. The share

of infrastructure investment in GDP in 1990 was 2.28 percent, which was

considered very low compared to the 1970s. As a result, distribution costs as a

percentage of GDP were estimated to be 15.4 percent in 1993, and private

companies’ average distribution costs compared to sales value to be 17 percent.6

Congestion costs were also estimated to be 6 percent of GDP. All this contributed

to the deterioration of industrial competitiveness. Therefore, the government put

a higher priority on expenditure for infrastructure investment and began actively

utilizing private capital through PPP. Characteristics of infrastructure

development of this era were as follows.

First, in order to save distribution costs, the government substantially

increased investment on transportation (Table 5).

Table 5. Share of Transportation Investment in GDP

1990 1993 1996

Transportation investment/GDP (%) 2.28 4.30 4.33

Source: The Korean Economy: Six Decades of Growth and Development, KDI, 2010.

6 These numbers were considered to be extremely high compared to that of the United States and

Japan, estimated at 7 percent and 11 percent respectively (The Korean Economy: Six Decades of Growth

and Development, KDI, 2010.)


However, due to political pressure, infrastructure investment was somewhat

skewed toward some roads and airports, which led to delays in construction of

other urgent infrastructure projects and brought about inefficiencies since those

less urgent projects only handled small amounts of traffic.

Second, facing government budget constraints, PPP was introduced in 1994

and thereafter widely used. Success factors of PPP in Korea are as follows; (i)

various government supports such as financial support, risk sharing structures,

credit guarantee schemes, and tax incentives were provided; (ii) the Public and

Private Infrastructure Investment Management Center (or PIMAC) was

established to provide professional services throughout the PPP procedure

including feasibility studies, value for money (VFM) tests, proposal evaluations,

and support for negotiations; and (iii) foreign investors were successfully

invited. Details of Korea’s PPP experiences will be discussed in the next section.

III. Korea’s PPP Experiences and Impact of Financial

Crisis on PPP

Major Functions of PPP

Korea introduced Public‐Private Partnership programs with the enactment of the

Act on Promotion of Private Capital into Infrastructure Investment in 1994.7

Major functions of PPP that the Korean government expected were as follows: (i)

to be an effective alternative to tackle the financial constraints that the

government faces; (ii) to provide better and more efficient public services by

taking advantage of the private sector’s know‐how and creativity; and (iii) to

create stable and long‐term investment opportunities for private investors by

providing safe and reliable places to invest. Toward this end, the government

role in PPP projects is to plan, evaluate, approve detailed execution plans of the

concessionaire, and support implementation of the projects, while the private

partner’s role is to design, build, finance, and operate the facilities.

Evolvement of the PPP Act

Just before adoption of the PPP Act, the government introduced the Total Project

Cost Management System to control the ever‐increasing cost of infrastructure

investment by escalation clauses or changes in design. In 1994 when the PPP Act

was introduced, the government seemed to consider PPP projects based on the

existing type of business permit with strong government discretion. However,

when the Incheon Airport Expressway project, which was the first PPP project in

Korea, was undertaken, it was based on an execution agreement that defined

7 In 1994 when Korea seriously introduced PPP for the first time, Korea’s per capita GDP was

US$9,727. In 1998 when more market contract–oriented PPP was introduced, per capita GDP

deteriorated to US$7,607 due to Asian financial crisis.

10 Okyu Kwon

several important market contract–oriented components, including profitability.

Since then, every year the government has formulated the Basic Plan for PPP, but

the actual number of projects undertaken was small.8

In 1998, the Act was revised and clearly stipulated that the PPP projects were

to be undertaken on the basis of execution agreement between the relevant

ministry and concessionaire. In this agreement, the concessionaire’s

responsibility was increased and at the same time many supporting measures

were introduced such as the minimum revenue guarantee (MRG),9 request for

government’s buyout, credit guarantee expansion, etc. In particular, the Private

Infrastructure Investment Center of Korea (PICKO), a supporting agency, was

established under the Korea Land Institute, a government think tank, to

undertake feasibility studies and provide other necessary services. Thanks to

these reform measures, the PPP contracts could take on more characteristics of

market contracts and lead to an open and fair competition through public

participation procedure.

In 2003, in order to promote competition further, other market‐type

measures were allowed, including participation of financiers, the introduction of

an infrastructure fund, a proposed compensation scheme for dropout of

concessionaires, relaxation of concessionaire’s floor plan, and so forth. In 2005,

additional reform measures were undertaken: private proposals without

effective competition were not to be selected and in evaluation, and the price

factor came to take on more than 50 percent weight.

Changes of the Act after the global financial crisis are described in a later

section.

Implementation Methods of PPP Projects in Korea

In Korea, the most sought‐after PPP implementation methods were Build‐

Transfer‐Operate (or BTO) and Build‐Transfer‐Lease (or BTL). In the beginning,

PPP projects were centered on transportation infrastructure using BTO. After the

revision of the PPP Act in 2005, the PPP projects also used the BTL method to

cover social infrastructure projects such as schools, healthcare facilities, culture

and sports centers, and public rental housing. In BTO projects, the private

partner realized a reasonable return on its investment by charging a user fee,

while in BTL projects the private partner recovered its investment through

payments made by the central or local government. According to the PPP Act

and its Enforcement Decree, 46 types of facilities in 15 categories were defined as

eligible infrastructure types for PPP projects (see Annex 1.)

8 During 1995‐98, despite the government announced 45 projects amounted to 35 billion US dollars,

only 10 projects were actually undertaken. 9 MRG contributed at the beginning to vitalization of PPP by lessening the burden of the

concessionaire. However, MRG was weakened after 2003 and finally abolished in 2009 due to the

moral hazard problem created by concessionaire demand and continuously increasing fiscal

burdens.


Achievements of PPP in Korea

Private investment has been continuously increasing since the introduction of the

PPP Act and has played a key role in providing infrastructure in a timely

manner, complementing public investment. The proportion of private

investment to public investment in infrastructure increased from 3.9 percent in

1998 to 15.4 percent in 2009. By the end of 2009, 461 PPP contracts had been

awarded, of which 106 BTO and 145 BTL projects were completed to provide

services to the public.

Table 6. Share of PPP in Government Infrastructure Investment (Unit: KRW trillion, %)

1998 2003 2005 2007 2009 Sum

Private investment by PPP 0.5 1.0 3.0 6.0 9.6 70.9

BTO 0.5 1.0 2.9 3.0 3.1 51.1

BTL — — 0.1 3.0 6.5 19.8

Share in gov’t investment 3.9 5.6 16.1 17.0 19.7 —

Source: The Korean Economy: Six Decades of Growth and Development, KDI, 2010.

Success Factors of Korea’s PPP Projects

First, the PPP Act provided a very clear legal framework. According to the Act,

the Ministry of Strategy and Finance (MOSF), considered to be the most

competent government ministry, was designated as the main regulator to draw

up the Basic Plan for PPP and to direct government policy. Implementation of

procedures, rights and obligations, as well as a risk‐sharing mechanism, are

clearly defined in the Act to effectively reduce potential business risks for private

sector participants.

Figure 1. Legal Framework for PPP in Korea

Second, the supporting agency was established under government think

tanks. PICKO in the 1988 Act was initially established under the Korea Land

Institute, providing services such as feasibility studies. Later, PICKO was

expanded to become the Public and Private Infrastructure Investment

Management Center (PIMAC) by the 2003 Act under the Korea Development

Institute (KDI) in order to provide a wide range of professional support for PPP

projects and to conduct research on PPP policies as the demand for professional

services increased and as experiences were accumulated. PIMAC consists of

experts from various fields including economics, finance, accounting, law,

12 Okyu Kwon

engineering, urban planning, and more, and is providing various professional

services throughout the entire PPP procurement process such as carrying out

feasibility studies and VFM tests,10 formulating the Request for Proposal (RFP),

evaluating proposals, and supporting negotiations. PIMAC also offers training

programs for government officials, and explores cooperation opportunities with

international organizations and foreign countries.

In short, thanks to PIMAC, PPP implementation conditions are thoroughly

considered, while transparency can be enhanced with a competitive bidding

process for the selection of private partners.

Third, the government has rendered strong support to stimulate investment

in PPP projects. There are two types of support to the private sector: financial

support and risk‐sharing measures. Six measures that can be considered as

financial supports and/or risk‐sharing supports are being provided:

(i) Support for land acquisition by concessionaires. Concessionaires are

granted land acquisition rights as well as the right to use national and

state or public land free of charge. Concessionaires can entrust the

relevant government authority with the execution of land purchase,

compensation of loss, resettlement of local residents, and other related

administrative tasks.

(ii) Financial support. In order to maintain an appropriate user fee level,

the government covers 100 percent of land acquisition costs for any

projects, and construction subsidies to the concessionaire, if

necessary.11

(iii) Risk sharing. When PPP projects are terminated for unavoidable

reasons during construction or operation, the government takes over

management and operation rights of the facility, and offers a certain

amount in termination payment to the concessionaire.12 The

concessionaire could request a government buyout of the project if

termination of construction or operation of facility was due to

unavoidable incidents including force majeure. However, some of the

measures, adopted to invite more foreign capital right after the Asian

financial crisis, were all abolished to avoid moral hazard. Measures

abolished included foreign exchange rate risk sharing and the

minimum revenue guarantee. Excessive incentives to attract capital,

10 A feasibility study evaluates and determines whether or not to pursue a project, while a

VFM test determines whether it is more beneficial to pursue it as a PPP project rather

than a government‐funded project. 11 For road projects, the subsidy is given up to 30 percent of the total investment. For railway

projects, it’s given up to 50 percent of the total investment. For ports, it’s given up to 30 percent of

the total investment. 12 The government guarantees redemption of the minimum costs of the projects which are the

private investment capital plus investment return ratio that is comparable to the interest on

government bonds.


when combined with inaccurate prospects for interest rates, exchange

rates, or demand, may result in a substantial future fiscal burden, the

opposite of a PPP’s intended purpose.

(iv) Credit guarantee. Credit guarantee schemes can be given by the Korea

Infrastructure Credit Guarantee Fund (KICGF) according to the PPP

Act to provide credit guarantees for concessionaires who obtain bank

loans from financial institutions or issue infrastructure bonds for PPP

projects. The maximum guarantee limit is KRW 300 billion, with

guarantee fees being determined within the range of 0.3–1.3 percent,

depending on the degree of the project risk and the company’s credit

standing. The guarantee for subordinate debt is up to 20 percent of

the total guaranteed amount.

(v) Tax benefits. Various tax benefits are granted for PPP projects

including the following:

A zero percent value‐added tax is assessed for construction

services of revertible infrastructure facilities.

Acquisition and registration taxes for BTO projects are exempt.

A separate tax rate of 14 percent is applied to income generated

from the interest on infrastructure bonds with maturity of 15 years

or longer.

A separate tax rate is applied to dividends from infrastructure

fund investment. (The 5 percent tax rate is applied to investments

below KRW 300 million, and the 14 percent to investments above

KRW 300 million. The dividends from the SPC are tax‐exempted if

more than 90 percent of their profits are distributed as dividends.)

Fourth, success in inviting foreign investors is also an important factor.

Foreign investors are treated the same as domestic investors and further entitled

to additional benefits including tax credits and financial support. Additional

support for foreign investors is provided as follows:

When foreigners invest more than US$10 million to build PPP facilities in

a Foreign Investment Area, tax breaks are granted in the areas of corporate

tax, income tax, acquisition tax, registration tax, and property tax.

When foreign exchange losses arise from loans in foreign currency for

construction due to fluctuation in the foreign exchange rate, the

government can offer subsidies or long‐term loans.

For projects in which foreign investments account for a significant

portion of the total investment, each foreign investor’s position is

respected to the fullest extent with respect to language and provisions

for conflict resolution in the concession agreement.

Table 7 shows the extent of some foreign participation in projects.

14 Okyu Kwon

Table 7. Foreign Participation in Projects

Instrument Projects

Equity Busan New Pore Phase 1 (25%), Incheon Bridge (23%), Yongin LRT (26%), Busan New Port Phase 2, 3 (18.5), Daejeon Riverside Expressway (67%), Songdo-Mansu Sewage Treatment Facility (80%), Busan Aquarium (100%)

Debt Busan New Port Phase 1 (43%), Daejeon Riverside Expressway (83%), Daegu-Busan Expressway (10%), Seoul Beltway (11%), Busan Aquarium (100%)

Lastly, since the recent financial crisis, Korea’s PPP projects have been

allowed to use flexible financing conditions. For example, for the financial

security of the project, private partners need to maintain a minimum required

equity ratio. Thus, during the construction period, project companies are

required to maintain an equity ratio of at least 20 percent for a BTO project, or 5

percent or more for a BTL project. However, when the investment ratio of

financial investors is above 50 percent of the total equity, the minimum required

equity ratio during construction could be lowered from 20 percent to 15 percent.

The concessionaire is also allowed to refinance according to changes in the

macroeconomic environment, project risk, and so forth. Refinancing gain is

shared between the concessionaire and the government to benefit both parties.

The refinancing gain can be used to lower the user fee so that facility users can

also benefit from refinancing. Financing through the Infrastructure Fund is also

encouraged to diversify investor profile.13

Impact of Recent Financial Crisis on PPP

Global PPP trend after the financial crisis

The global financial crisis that began in 2008 has made financing for PPP projects

more difficult to secure. Both existing and planned PPP projects have been

affected through various channels, such as availability and cost of credit, lower

growth, and unforeseen exchange rate movements. Depending on the

contractual arrangement between the public and private parties, changed

distribution of risks can shift the cost burden between parties, weakening the

attractiveness of PPP projects. As a result, some planned PPP projects have been

delayed, restructured, and to a lesser extent, cancelled. Transport and energy

have been the worst affected sectors so far, while middle‐income countries have

been the most affected, especially in the Eastern Europe and Central Asia region

where the domestic capital market was dominated by severely hit western

financial institutions. In comparison to these regions, East Asia, Sub‐Saharan

Africa, and the Middle East and North Africa returned to a stable position in PPP

13 The Infrastructure Fund is an indirect investment facility that collects funds from investors to

lend and invest in PPP projects, while also distributing profits to multiple investors. Regulations on

asset management and financing have been eased to promote the use of the Infrastructure Fund.

Investments through the Infrastructure Fund increased from KRW 80 billion in 1999 to KRW 3.3

trillion in 2008, with a total of 10 funds being managed at present.


investments after a short period of stagnation. Latin America and South Asia

were the least affected and even attracted higher investments. In most of the

region, recovery has been driven by large PPP projects, where there was enough

liquidity in domestic financial markets and government assumed more risk

sharing.14

Government responses

Most countries, with their objectives to support their PPP programs, are revising

their basic risk assignment framework and financing role. The tendency appears

to be for the government to assume either a larger share of the risks or assume

risk that otherwise would not have assumed. For example, more governments

are taking the following measures:

reviewing their PPP framework including strengthening of PPP laws and

units to provide solutions in an equal and timely manner;

allowing a minimum revenue guarantee either in an absolute level or an

annual basis and increasing the level;

facilitating bank lending or even providing it through government

financial institutions or infrastructure investment fund;

providing broader guarantees covering a broad reach of contract terms;

and

providing upfront government payments to facilitate private sector

financing.

Korea’s policy responses

In the case of Korea, the impact of the financial crisis on PPP was also substantial

at the beginning by decreasing PPP project profitability, leading to a sharp

decline in the number of new PPP projects as well as failures of pipeline project

financing closure. Facing these difficulties, the government implemented the PPP

Revitalization Plan twice, in February and August, 2009; the main objective was

to provide liquidity and mitigate the risks. The February measures included the

following:

providing a special loan program in collaboration with Korea

Development Bank, i.e. a one‐year bridge loan to be redeemed upon

formal financial closure with a guarantee by the Korea Infrastructure

Guarantee Fund;

increasing the guarantee limit per project from KRW 200 billion to KRW

300 billion, and for subordinate debt guarantees, from 4.5 percent to 20

percent of the total amount guaranteed;

lowering the ratio of required equity to total project costs by 5 to 10

percent;

14 Luis Guash, “PPPs: Impact and Responses to the Crisis and Moving Forward,” (ASEM PPP

Conference, Seoul Korea, October 2009).

16 Okyu Kwon

shortening resettlement period for the base bond rate from five to two

years, in order to reduce the risk of interest rate fluctuation; and

introducing a new compensation standard for the gap between the base

bond rate and interest rate for loans by allowing sharing of the upside

and compensation of the downside.15

Thanks to the February 2009 measures, BTL was substantially revived, but

BTO needed additional measures. Therefore, the August 2009 measures were

implemented as follows:

encouraging supplementary projects to improve profitability;

increasing the coverage for compensation on termination for

unavoidable reasons from up to 55 percent to 85 percent of the

investment cost; and

developing a risk‐sharing system for the government to undertake more

risks by compensating the raw cost of projects.

Additional measures in the August plan to improve financing conditions

included the following:

revitalizing infrastructure bonds by expanding the scope of eligible

institutions for bond issuance and securing guarantee support from

Korea Infrastructure Credit Guarantee Fund; and

establishing the Public Infrastructure Fund in which both public and

private institutions may participate with greater tax incentives for

investors.

However, as mentioned above, the government does not intend to adopt

extreme supportive measures such as a general buyout right, foreign exchange

rate risk sharing, and minimum revenue guarantee.

Having recorded a fast recovery from the global financial crisis ahead of

other advanced countries, and thanks to appropriate policy adjustments made in

a timely manner, Korea has shown a very positive rebound of PPP projects.

15 For risk‐sharing, the government set up a new standard called the risk‐sharing revenue. This is

the amount of operation revenue that guarantees the investment return ratio that is comparable to

the government bond’s rate of return. If actual operation revenue falls short of the risk‐sharing

revenue, then the private sector’s internal rate of return (IRR) is less than government bond’s rate

of return, which is not satisfactory to the concessionaire. So, in this case, the government will pay

the amount of shortfall to the concessionaire. Vice versa, if actual operation revenue exceeds the

risk‐sharing revenue, government subsidies will be redeemed on the basis of the realized

payments.

On the part of private sector, they also should share the risk. So, if actual operation revenue is

less than 50 percent of the risk‐sharing revenue, the government assumes it as private sector’s

delinquency and therefore does not provide subsidy for the amount of shortfall. All in all, the

concessionaire must also try to keep up the revenue level above 50 percent of the risk‐sharing

revenue.


III. Some Lessons for African Emerging Economies

Considering Korea’s successful implementation experiences in infrastructure

development, some lessons can be drawn for current African developing

economies suffering from shortages in infrastructure.

First, efficient infrastructure development requires that the government

formulate a concrete vision for the future of the nation, which can be laid out in a

high‐quality, medium‐term comprehensive economic or land development plan.

Since infrastructure is closely related to current and future industry placement,

urbanization, and daily lives of the general public, and since it takes considerable

time to arrange infrastructure investment, a comprehensive and medium‐term

approach is essential.

Unfortunately, many African countries lack planning and implementation

capacity, and institutional infrastructure is frequently inhospitable to business.

Under these circumstances, it would be useful to establish a strong planning

organization, or strengthen an existing one. An example is the Economic

Planning Board of Korea in the development era, which had full power in

economic policy coordination and a strong hold on domestic and foreign finance.

In addition, it is also important to provide continuous training opportunities for

staff of that organization. In this regard, Korea’s knowledge sharing program

could draw upon the country’s own experiences to provide planning exercises, a

roadmap for a national agenda, guidelines for institution building, and on‐the‐

job training for staff of planning organizations. Another institution that helped

Korea’s fast transformation was KDI, a government think tank established in

1971. The researchers at KDI were recruited with a good compensation and

included PhD degree holders educated in developed countries like the United

States, United Kingdom, Germany, France, and Japan. Once a strong planning

organization and a supporting think tank are set up, a high‐quality medium‐ to

long‐term infrastructure development plan can be formulated in a close

consultation with international financial organizations.

Second, a leading role of infrastructure development for economic growth as

well as poverty alleviation should be emphasized. In order for infrastructure not

to be a bottleneck for economic development, preemptive, sufficient, and steady

infrastructure investment is necessary. If infrastructure is neglected at any stage

of development, future social costs such as deterioration of competitiveness, loss

of opportunities for more equitable development by region, or congestion cost

would be tremendous. To this purpose, as the private sector does not have

enough capacity to get involved yet in many African countries, the government

should take initiatives and a top‐down approach is essential. Capital should be

attracted from developed countries, and foreign companies should be

18 Okyu Kwon

encouraged to jointly work with local companies.16 Through these efforts, the

local private sector could accumulate relevant experiences and technologies. In

order to avoid collusion and corruption, a transparent bidding procedure as well

as strict construction supervision is essential.

Third, in the case that infrastructure is still provided mainly by government‐

controlled monopolies, it is desirable to adopt a wide use of PPP. This surely

provides a useful solution to many problems that the public sector has faced

such as inefficiency and low capital availability. For the government,

infrastructure services are essentially monopolistic in nature and, therefore,

outright privatization may not be a good public policy option since efficiency

versus equity issues arise. In addition, as budget constraints are being intensified

in many countries, PPP, with government supervision, could provide

competition, efficiency, and capital. In the case of Korea, PPP started to be

utilized when Korea reached the middle‐income level, not because PPP is

relevant to income level, but because the country came to know PPP at that time.

Therefore, it seems that current African countries need not to wait until they

reach middle‐income levels of development; regardless of income level, there

should always be a possibility to use PPP. If domestic companies do not have the

capacity to supply infrastructure development, then foreign suppliers can

become development partners and domestic partners can learn from joint

participation as many Korean companies did in the past.

In Asia as a whole, regardless of income level or market maturity, PPP is

widely used. This also indicates that there is potential for African countries to

adopt PPP once better environments for PPP are provided.17

Fourth, for vitalization of PPP, it is essential to establish a strong framework

to coordinate the interests of different stakeholders involved in PPP. The

government is interested in ensuring the growth of infrastructure and

formulating effective public policy while the private sector is interested in

maximizing the return on their investment. PPP regulators are interested in

ensuring transparency and balancing interests of different stakeholders while

consumers seek to realize their value for money. Considering the diverse

16 In cases where infrastructure construction is funded by foreign aid and carried out by the donor

country’s workers, it is necessary for domestic companies to join together with local workers.

Without a joint participation of local companies and workers, the effects of foreign aid will be

limited in fostering domestic construction companies and skilled workers. 17 According to the UK subsidiary of RREEF, the real estate division for the asset management

activities of Deutsche Bank AG., attractiveness of infrastructure investment depends on population,

market size, GDP growth rate, interest rate, country risk, legal framework, and maturity of market.

In this regard, India and China, as medium‐matured markets, are the key infrastructure investment

destination in terms of power generation, electricity distribution, water, ports, airports, road, and

railways. For high‐matured market like Korea and Taiwan, China, power, water, ports, airports,

road, and railways have potential to attract PPP. For other high‐matured markets like Singapore,

power, ports, and road have potential. For low‐matured market like Vietnam, power, ports, road,

and railways have potential. (Peter Hobbes, “The Opportunities and Challenges Associated with

Investing in Asian Infrastructure,” IIA Seminar paper, 10‐12 June 2008, Singapore).


interests of different stakeholders, a good framework for coordination should be

established. The framework should include the following elements:

The role of policy makers should be given to the most competent

government organization, like the Ministry of Strategy and Finance in

Korea, in order to formulate transparent, predictable, and streamlined

policies. All the important aspects of PPP, such as planning, financing,

and implementation should be handled by this organization, which will

help minimize regulatory risks.

The regulatory framework should be clearly stipulated by law as in

Korea’s Act of Private Participation in Infrastructure of 1998, a revised

version of the original 1994 Law, and Presidential Decrees under the Act.

A transparent and efficient PPP process should be put in place, which

may need an independent and professional regulator like Korea’s

PIMAC providing professional services throughout the PPP process to

ensure transparency and efficiency. However, it is noteworthy that the

regulatory capacity of PIMAC had to be developed from modest

beginnings. At an initial stage, PICKO could only provide limited

services like feasibility study. As experience accumulated and capacity

was developed, PIMAC expanded to provide a wide range of

professional services.

A reasonable level of incentives is necessary to attract domestic and

foreign private investors by securing an appropriate rate of returns. Note

that the private sector also faces challenges in pursuing PPP such as high

up‐front costs, late returns on investment, multi‐faceted risks and

uncertainties, and limited access to financial markets. Therefore, the

government may need to find innovative ways to resolve financial

bottlenecks and to achieve optimal risk allocation and mitigation

between the parties, if necessary. Given Korea’s positive outcomes, the

six government support schemes—support for land acquisition, credit

guarantee, termination payment, risk‐sharing structure, tax benefit, and

construction subsidy—seem to be well designed.

However, overly protective incentives, such as a minimum revenue

guarantee, an unconditional government’s buyout scheme, or foreign exchange

rate risk sharing, are not desirable since they may cause moral hazard and may

increase future fiscal burden when combined with inaccurate predictions of

interest rates, exchange rates, or demand. This would be the opposite of the

intended result of PPP.

Soft infrastructure also needs to be developed in terms of legal, accounting,

taxation, capital markets, banking, etc. to provide a stable environment for PPP

development. This also cannot be completed overnight, and therefore continuous

efforts are necessary to upgrade the relevant framework.

20 Okyu Kwon

Fifth, investment of foreign capital, including loans from international

financial organizations, needs to be encouraged. It not only complements

domestic capital shortages for infrastructure development but also provides a

momentum to adopt international standards in infrastructure development, from

bidding to construction management to supervision, which are essential

elements for efficient infrastructure investment. Domestic companies will have

opportunities to learn from their foreign partners by joint participation.

Lastly, many developing economies may face political pressure in the

decision‐making process for infrastructure investment, just like Korea did in the

1980s. To avoid political pressure, a transparent and professional decision‐

making process is necessary. For example, the PPP Act clearly stipulates a strict

compliance to the law. Furthermore, all projects should be subject to neutral and

a professional organization’s study results such as PIMAC in Korea. A two‐step

feasibility study (including a preliminary feasibility study and reassessment of

feasibility study), a VFM test, and reassessment of demand forecast are all

necessary to contribute to commercial decision making based on economic

principles. Vigorous surveillance by civic groups to alleviate political pressure

also could be a great help.


Annex 1. Korea’s PPP Implementation Process

Institutional Framework

Ministry of Strategy and Finance. The Ministry of Strategy and Finance (MOSF) is

responsible for directing and coordinating major economic policies and

formulating fiscal policies including budget formulation, treasury management,

and the tax system. As the central body in charge of national PPP programs,

major roles of the ministry include the development of PPP policies and the

establishment of comprehensive investment plans. MOSF is responsible for

administering the PPP Act and its Enforcement Decree, as well as the Basic Plan

for the PPP. It also chairs the PPP Review Committee, which deliberates on

matters concerning the establishment of major PPP policies and makes key

decisions about the implementation of large‐scale PPP projects.

Procuring Ministries. Procuring ministries are responsible for establishing and

coordinating sector‐specific PPP investment plans and policies. They also

implement and monitor PPP projects.

Public and Private Infrastructure Investment Management Center (PIMAC). PIMAC

was established under the PPP Act in order to provide comprehensive and

professional support for the implementation of PPP projects. Its main duties are

as follows:

support the government in developing PPP policies and guidelines;

provide technical assistance throughout the procurement process of PPP

projects including VFM tests, formulation of request for proposals

(RFPs), evaluation of project proposals, and negotiations with potential

concessionaires;

organize capacity‐building programs and provide support for foreign

investors through investment consultation; and

promote international cooperation for knowledge sharing.

PIMAC, which is also in charge of the ex ante evaluation of public

investment projects, contributes to enhancing efficiency and transparency in

national infrastructure planning through comprehensive and systematic

management of both public and PPP investment for infrastructure.

Korea Infrastructure Credit Guarantee Fund (KICGF). KICGF is a public fund

established under the PPP Act in order to guarantee the credit of a concessionaire

that intends to obtain loans from financial institutions for PPP projects. It is

managed by the Korea Credit Guarantee Fund (KODIT) and funded by MOSF.

22 Okyu Kwon

Comparison of BTO and BTL

In BTO projects, the private partner realizes a reasonable return on its investment

by charging a user fee, while in BTL projects the private partner recovers its

investment through payments made by the central or local government.

Types of PPP

According to the PPP Act and its Enforcement Decree, 46 types of facilities in 15

categories are defined as eligible infrastructure types for PPP projects (Table

A1.1).

Table A1.1. Types of Eligible Infrastructure Activities


Implementation Process of BTO and BTL

Proposal

Both the government and a private company can initiate a PPP project.

1. Solicited projects: The government finds a potential PPP project and then

seeks concessionaires. Competent authorities develop a potential project after

considering related plans and demands for the facility. They then weigh the

procurement options in order to determine whether the PPP procurement is

more efficient than the conventional procurement.

Major points to consider before making decisions on a PPP project are as

follows:

Is the facility qualified for a PPP project prescribed in the PPP Act and

the Enforcement Decree?

Is the project a high priority for medium‐ and long‐term infrastructure

investment plans?

Does it offer more timely benefits than a conventional government‐

procured project that has budget constraints?

Will operational efficiency and services improve by taking advantage of

creativity and know‐how from the private sector?

Will it be profitable considering the level of user fees and subsidies (for

BTO projects)?

An appropriate implementation method (BTO, BTL, etc.) is selected with

regard to the nature of the project, profitability, and other related factors.

BTL projects can only be implemented as solicited projects.

2. Unsolicited project: The private sector can propose a PPP project that is in

high demand but has been delayed due to government budget constraints. After

considering factors such as demand, profitability, project structure, construction

and operating plans, and funding, the private partner creates a project plan and

submits the proposal to the competent authority. The private sector may propose

profitable and creative ancillary/supplementary projects related to the main PPP

project.

The competent authority reviews and evaluates the contents and value for

money of the private proposal.

24 Okyu Kwon

Procedure

1. BTO projects: After conducting a VFM test to evaluate its potential as a PPP

project, competent authorities announce Request for Proposals (RFPs) and

evaluate proposals for selection. RFPs include the project plan and

implementation terms and conditions, such as the project outline, total project

cost, operational profit, construction and operation plans, and government

supports. Figure A1.1 shows the BTO implementation procedure.

Figure A1.1. Implementation Procedure for BTO Project

2. BTL projects: A BTL project is initiated by the competent authority, reviewed

by the Ministry of Strategy and Finance to decide on an aggregate investment

ceiling for BTL projects, and then approved by the National Assembly. The

investment ceiling for BTL projects is the aggregate BTL investment cost for the

fiscal year. An amount detailing the total limit of all BTL projects as well as the

limits for each facility type is submitted to the National Assembly along with the

budget plan. Figure A1.2 shows the BTL implementation procedure.


Figure A1.2. Implementation Procedure for BTL Project

26 Okyu Kwon

Performance of Korean PPPs

BTO projects are centered on transportation services including roads, railways,

and seaports (Figure A1.3).

Road projects account for more than half of all investment, and

environmental facilities top the list for the highest number of projects (while

having the least cost per project).

Figure A1.3. BTO Projects

BTL projects, which first began in 2005, have been actively pursued

especially in building and reconstructing old educational facilities like

elementary and middle schools, vocational colleges, and university dormitories

(Figure A1.4). Furthermore, BTL projects are making a great contribution to

expanding and improving sewage systems and military residences, as well as to

building new railways.

Figure A1.4. BTL Projects


Project Case Studies

BTO Projects

1. Incheon International Airport Expressway

Incheon International Airport Expressway was the first BTO road project carried

out under the 1994 PPP Act. It originally started as a government‐financed

project but was turned into a BTO project later on to help ease the fiscal burden.

Its early completion has played a significant role in the successful operation of

Incheon International Airport. Since its completion in 2000, the project has

undergone a refinancing process and now all equity holders are financial

institutions.

Total project cost: KRW 1,334 billion

Length: 40.2 kilometers, 8 lanes

Competent authority: Ministry of Land, Transport, and Maritime Affairs

Construction period: 1995~2000

Operation period: 30 years

Capital structure: Equity/Debt/Subsidies = 25%/59%/16%

Major shareholders: MKIF (Macquarie Korea Investment Finance, 24.1

percent) and other 10 financiers mostly life insurance companies of

Korea

2. Incheon Bridge

Incheon Bridge is a cable‐stayed bridge with the world’s fifth longest main span,

and the first PPP project in Korea led by AMEC, a UK company. The private

sector implemented the construction of 12.34 kilometers section of the bridge,

while the government took charge of 9.04 kilometers section, which includes the

access road. The bridge connects the Second and Third Kyungin Expressways

and Seohaean Expressway, thereby reducing the travel time to and from Incheon

International Airport and south of Seoul by more than 40 minutes.


Capital structure: Equity/Debt/Subsidies = 10%/41%/48%

Length: 12.3 kilometers, 6 lanes (21.4 kilometers including access road)




Major shareholder: AMEC and 7 Korean construction companies

3. Busan New Port Phase 1

The project aims to expand and improve Busan’s dilapidated ports, establishing

a logistics hub port for Northeast Asia. Nine of the 30 berths have been allocated

as BTO projects, with the first six of them completed in 2006 and 2007. In

addition to Korean contractors and financial institutions, DP World of the UAE, a

28 Okyu Kwon

global port developer and operator, holds a 29.6 percent equity stake to

participate in its operation.


Capital structure: Equity/Debt/Subsidies = 20% /55%/25%

Work scope: 9 berths (50,000 tons), 3.2 kilometers




Major Shareholders: DP World (29.6%), Samsung Construction (23.9%),

Korea Container Terminal Authority (9.6%), four Korean construction

companies and others (36.9%)

BTL Projects

1. The Chungju Military Apartment Housing Project

The Chungju Military Apartment Housing project was the first BTL project

carried out in Korea. The modernization of military residential facilities had been

delayed due to insufficient budgets, but was implemented at a rapid pace with

the introduction of the BTL method. A total of 200 families moved into the 12

apartment buildings, with more than 95 percent of residents expressing

satisfaction with the facilities in a survey.

Total project cost: KRW 18.6 billion

Work scope: 200 households and convenience facilities

Competent authority: Ministry of Defense



2. Ulsan National Institute of Science and Technology

Ulsan National Institute of Science and Technology is the first campus ever built

entirely by the BTL method utilizing a state‐of‐the‐art, environmental‐friendly,

and digitized design. The project company is not only responsible for facility

maintenance, management, cleaning and security, but also operates and manages

the school’s dormitories, gymnasiums, shops, and parking lots.

Total project cost: approximately KRW 250 billion

Work scope: site 1,028,200 square meters, total floor area 153,691 square

meters

Competent authority: Ministry of Education, Science and Technology

Construction period: 2007~2010 (1st phase: 2007–February 2009)


3. Anhwa High School

Anhwa High School is one of Korea’s leading BTL school projects. In 2007 it was

the recipient of an award in recognition of its excellent facilities from the Minister

of Education and Human Resource Development. There are currently more than


1,000 students enrolled at the school, which opened in 2007 with state‐of‐the‐art

facilities and equipment, and is now under the management of the project

company.

Total project cost: approximately KRW 962 million

Work scope: site 13,264 square meters, 5 stories above ground

Competent authority: Gyeonggi Province Office of Education



30 Okyu Kwon

Annex 2. Regional Cooperation in Infrastructure

Development in Northeast Asia Region

In the Northeast Asia region, there are many cooperative movements in

infrastructure development. This annex discusses three initiatives in which

Korea has been involved: (1) Great Tumen Initiative (GTI), (2) Northeast Asia

Undersea Connection Initiative, and (3) Infrastructure Cooperation Projects

between the Republic of Korea and the Democratic People’s Republic of Korea.

Great Tumen Initiative (GTI)

GTI is an intergovernmental consultative body in which Korea, China, the

Russian Federation, and Mongolia are participating for regional cooperation. It

started originally in 1992 as TRDP (Tumen River Development Program) under

the auspices of the United Nations Development Programme (UNDP). Later in

September 2005, TRDP strengthened its implementation system and changed its

name as GTI by enlarging coverage of the region and installing a common fund.

At the beginning, the Democratic People’s Republic of Korea also joined, but

withdrew in 2009 in resistance to international sanctions following its second

nuclear test. Important decisions at GTI are made by the Consultative

Commission, which consists of member countries’ representatives at the vice

minister level.

GTI has contributed to the formation of a regular consultation table for

regional cooperative issues in the East Asia region, including the exchange of

views and information on infrastructure investment. After the Ninth

Consultative Commission Meeting at Vladivostok in 2007, 12 projects were

identified for promotion in the transportation, energy, tourism, trade, and

environment sectors. Currently, however, financial resources to undertake big

projects are not available. Therefore, basic research work is ongoing, such as

transportation system and environmental effects evaluation. The current status

of the projects is discussed below.

1. North East Asia (NEA) Ferry Project

A shipping company, NEA Ferry, was established as a joint company comprising

the Republic of Korea (Gangwon Province, Sokcho City, Bumhan Shipping),

China (Hunchun City), Japan (Niigata City, North East Ferry), and Russia

(Primoravtotrans). A test operation was made from July to September, 2009, but

NEA gave up the business due to low demand for both passenger and freight,

high visa fees from Russia, cumbersome entry procedures, and inconvenience at

border checkpoints in Russia and China. Instead, the Sokcho‐Zarubino line by

Korea’s Dongchun Shipping and Donghae‐Vladivostok line by DBS Cruise are in

normal operation (Figure A2.1). Discussion is going on to make NEA Ferry’s


business more competitive compared to other transportation means by lifting

cumbersome entry procedure and decreasing relevant costs.

Figure A2.1. Ferry Operations

* Dot Lines: currently stopped.

*Red Lines: in normal operation

2. Zarubino Port Modernization Project

Zarubino Port has strategic importance due to its location at the contact point of

three country borders: the Democratic People’s Republic of Korea, China, and

Russia. The port is also very important for Mongolia and Manchuria to secure a

transportation route to proceed to East Sea (Figure A2.2). In 2004, the Zarubino

Port Authority announced a modernization plan, and an agreement was made in

May 2008 between the Zarubino Port operator and a Russian railway company to

invest more than US$100 million. In 2009, because the Russian railway company

abrogated the agreement, GTI Secretariat contacted potential investors from the

Republic of Korea and Germany. However, the chance of additional investment

seems small because of the recent global financial crisis and a substantial

decrease of freight due to Russia’s tariff increases.

Figure A2.2 Zarubino Port

32 Okyu Kwon

3. Mongol‐China Railroad Project

In November 2007, China, Mongolia, and Japan agreed to construct a railroad of

443 kilometers named the Orient Grand Passage connecting Choibalsan of

Mongolia and Arxan of Inner Mongolia, China (Figure A2.3). A feasibility study

is nearing completion. Japan’s motivation is related to importation of exploited

mineral resources in East Mongolia such as coal, but there are still constraints to

the use harbors of the Democratic People’s Republic of Korea and Russia on East

Sea basin. Therefore, it is not easy to invite private capital for the project.

In early 2010, China and Mongolia agreed to build Sino‐Mongolia railroad

by 2020, but due to low marketability, implementation of the project is also in a

difficult situation for financing.

It is expected to take more time to solicit potential investors by securing

marketability since development of mineral resources in Choibalsan region is

now at an exploration stage.

Figure A2.3. Mongol-China Railroad Project

4. Reopening of Hunchun‐Makhalino Railroad

In February 2000, the Hunchun‐Makhalino Railroad opened to provide the

shortest route to transport freights of Jilin Province to Russia’s East Sea harbors

(Figure A2.4). However, in September 2004, travel on the route was closed

stopped due to legal disputes between two railway companies of Russia. The

companies were running a branch line and TSR connection, respectively, without

a business agreement. The companies brought the case to the court and it will

take some time to fully settle. In 2008, at a working‐level meeting between China


and Russia, both countries agreed to build Makhlino station by 2010 and help to

expedite resolution of disputes between the two Russian companies by signing a

business agreement promptly.

Figure A2.4. Hunchun-Makhalino Railroad

Notes: The gray dotted line is run by JSC Golden Link, a private railway company, from the Sino-Russia border to the Far East TSR branch. JSC Russian Railways owns the remaining portion as well as Makhlino station.

5. Utilization of Roads and Harbors of China at the Borders of China and the

Democratic People’s Republic of Korea

In 2008, the Democratic People’s Republic of Korea and China signed the

Agreement on Motor Vehicle Transportation to jointly use roads and harbors on

borders of the Democratic People’s Republic of Korea and China. the However,

because the Democratic People’s Republic of Korea withdrew from GTI in 2009,

this project became difficult to promote under the GTI framework. Instead, when

Wen Jiabao, the Chinese premier, visited Pyongyang in October 2009, both

governments agreed to give development rights of Rajin harbor to Qangli Group

of China in return for construction of Hunchun‐Rajin road costing 3 billion yuan.

China wanted to use this road transport mineral resources produced in Jilin and

Heilungkiang provinces through Rajin and Chungjin harbors of the Democratic

People’s Republic of Korea to the southern part of China. Haihua Group of China

also acquired exclusive right to develop Chungjin harbor in return for $US10

million for repairing Tumen‐Chungjin railroad. Premier Wen Jiabao also

34 Okyu Kwon

promised to construct a new Yalu River bridge and Sinuiju‐Pyongyang express

highway.

Basically, infrastructure cooperation projects the Democratic People’s

Republic of Korea and China were being promoted by local provinces of China.

However, actual investments have not undertaken much because of poor

demand forecast and high construction cost due to rough terrain. For example, in

case of Rajin harbor, mass transportation would not be possible because large

cranes could not be installed due to weak ground conditions of docks. In

addition, electricity shortages and nonexistence of a distribution base mean it

will take a long time to fully develop the harbor. In terms of freight forecast,

rough mountainous road conditions between Hunchun and Rajin will limit

operation of heavy duty trucks even though the roads are expanded and paved

(see Figure A2.5)

Figure A2.5. Satellite Picture of Hunchun-Rajin Road

Other GTI Projects under Promotion

There are seven other projects in five sectors under the framework of GTI, which

are as follows:

1. In the transportation sector, the Comprehensive Infrastructure

Development Research Project is underway. This is to analyze bottlenecks

in expanding physical interchange in GTI region and to suggest ways to

overcome those bottlenecks on the basis of cost/benefit analysis.

2. In energy sector, two projects are being undertaken.

The GTI Energy Capacity Development Project: This is to minimize

technical and institutional barriers that interfere with energy trade, to

construct institutional structures for strengthening energy

cooperation, and to provide training programs for bureaucrats of less

developed countries.

The Construction of Energy DB in Northeast Asia Region and

Publication of Statistics: This is to collect and provide basic data for

energy cooperation in the region.


3. In the tourism sector, the Construction of Tourism Capacity Project is

ongoing. This is to study standardization of the issuance of tourism visas,

to produce tourist guidebooks, and to develop diversified Mt. Baekdu

tourism.

4. In the trade sector, the Training Program for Trade Facilitation is

ongoing. This is to provide training programs for bureaucrats to advance

customs clearance procedures.

5. In the Environmental sector, two projects are ongoing.

The Cross‐Border Environment Effects Analysis and Standardization

of Environmental Standard: This is to evaluate environmental effects

on the Tumen River border region and to standardize environmental

standard in the Northeast Asia region.

The Feasibility Study on the Tumen River Water Resource Protection:

This is to construct multilateral cooperation framework for

environmental protection of the Tumen River region.

Northeast Asia Undersea Connection Initiative

Motivation

The twenty‐first century is often referred to as the Era of Asia. Particularly, three

countries in Northeast Asia, the Republic of Korea, China, and Japan, are at the

center of global attention and make up one of the most dynamic regions of the

world. It is estimated that as of 2010, the three countries account for one‐fourth of

the world’s population, and for one‐fourth of the world’s economy with China

ranking 2nd, Japan 3rd, and Korea 13th in terms of GDP. Some economic forecasts

indicate that the three economies may even account for one‐third of the global

economy in less than next two decades. While China has continued to see fast

growth of around 9 percent per annum since 1990s, the division of labor in

Northeast Asia centered on Japan is also facing a new phase. Major cities in the

region are competing with each other to dominate finance, distribution, and

other knowledge‐based services; therefore among these cities competitive as well

as cooperative relations will be intensified. Considering rapidly increasing

demand for transportation of passengers and freight in the region, it is an

appropriate time to review the diversified comprehensive transportation

network connecting China, Japan, and the Korean peninsula.

In this regard, the Korean government is considering building undersea

tunnels with China and Japan, as a key component of an envisioned integrated

Northeast Asia transportation network. The Ministry of Land, Transportation,

and Maritime Affairs of Korea commissioned the state‐sponsored Korea

Transport Institute in 2009 to review the technical and economical feasibility of

the projects. The results will be available soon. According to the proposal, three

undersea tunnels for high‐speed trains and automobiles are currently being

36 Okyu Kwon

considered; the Mokpo‐Jeju (167 kilometers) section, Incheon‐Weihai (341

kilometers) section, and Busan‐Fukuoka (222.6 kilometers) section (Figure A2.6).

Figure A2.6. Undersea Tunnels

Such projects were also mentioned in a plan prepared by the Korea’s

Ministry of Land, Transportation, and Maritime Affairs to expand the country’s

bullet train network by 2020, due to the increasing importance of so‐called mega‐

regions in the global economy. If three high‐speed trains—Korea’s KTX, China’s

Hexiehao, and Japan’s Shinkansen—are connected to each other to form a

Northeast Asia high‐speed train network, economic integration of the region

could be accelerated. However, two major obstacles remain. The first is that the

undersea tunnel projects should take at least 10–15 years to launch because such

a project needs agreement with neighboring countries. (Discussions between

local governments of the three countries have already started.) The other obstacle

is the enormous cost of the projects. Each tunnel is likely to cost up to US$80

billion, which should be shared by relevant parties. Despite these obstacles, the

undersea tunnels will be needed to handle future demands, and therefore they

should be carried out as mid‐ to long‐term projects.


Undersea Tunnel Connecting the Republic of Korea and China

Considering uncertainty regarding the Democratic People’s Republic of Korea

and the need to directly connect highly populated areas of the Republic Korea

and China, it was proposed by Kyunggi Province to build an undersea tunnel

connecting 374 kilometers between Weihai, China and Pyongtaek, the Republic

of Korea. Currently China’s share in Korea’s export destination recorded around

25 percent and Korea’s share in China’s export destination 18 percent as of 2009.

Within a decade, GDP size of China and the Republic of Korea is expected to be

No. 1 and No. 10 respectively in the global economy. If the undersea tunnel is

built, a high‐speed train will take 1 hour and 15 minutes from Seoul to Weihai, 4

hours to Beijing, and 5 hours to Shanghi, which will be competitive compared to

travelling by air.

Undersea Tunnel Connecting the Republic of Korea and Japan

Compared to the recently evolved Korea‐China Undersea tunnel project, this

project idea was conceived long ago during the Japanese occupation at the turn

of the twentieth century. Studies on the tunnel have been initiated mostly by

private sector organizations such as the Korea‐Japan Tunnel Project Association

in Busan and the Japan‐Korea Tunnel Research Institute in Tokyo, both of which

are nonprofit organizations. Now, government support seems to be gaining pace,

particularly in light of the role the tunnel is expected to play in accelerating

travel and business exchanges. At the Summit meeting held in April 2008, the

leaders of Korea and Japan agreed to undertake a joint study to prepare for

vision of a new era of cooperation between their countries, which includes this

undersea tunnel project.

According to the study, if constructed, the Korea‐Japan undersea tunnel

would be 235 kilometers in length, linking Busan to Geoje Island to Japan’s

Tsushima Island to Ikido and then to Kyushu. This tunnel would be four times

longer than the 50 kilometer Channel Tunnel linking England and France and the

53.9 kilometer Seikan Tunnel in northern Japan. That means it would be the

longest undersea tunnel in the world.

The tunnel will stimulate business, ease tensions, and promote political

stability in East Asia. For example, Busan and its sister city Fukuoka could

promote various projects to create a common economic zone.

However, the project also faces many hurdles before it can become a reality.

Engineering and cost concerns are major hindrances. Construction costs are

projected at around US$60–80 billion and the project would take 7 to 10 years to

construct.

38 Okyu Kwon

Infrastructure Cooperation Projects between the Republic of Korea and the Democratic People’s Republic of Korea

Road and Railroad Connection Projects

Two projects across the DMZ to connect the Republic of Korea and the

Democratic People’s Republic of Korea were completed based on the Basic

Agreement on Motor Vehicle and Train Operation between South and North

effective as of August 1, 2005. One project is on the western part of Korean

peninsula to connect 27.3 kilometers of railroad between Munsan and Gaesung

and 12.1 kilometers of road between Tongil Bridge and Gaesung Industrial Site,

both of which are to support factories in Gaesung Industrial Site. The other

project is on the East Sea coast to connect 25.5 kilometers of railroad and 24.2

kilometers of road, both of which are to support tourists visiting Diamond

Mountain. All the costs were borne by the Republic of Korea, except labor cost

for the construction in of the part in the Democratic People’s Republic of Korea.

The future of infrastructure cooperation projects across the DMZ is so dim

because the military of the Democratic People’s Republic of Korea is strongly

resist to developing any infrastructure behind their back at DMZ. In addition, the

infrastructure of the North is so rugged that it will require tremendous amounts

of money to modernize. Uncertainty is preventing investment the Republic of

Korea, since any additional investment in the North may become a hostage in

case tension increases with the South. A very cautious approach is inevitable. As

a result, despite the 2008 Korea‐Russia Summit meeting, which agreed to

cooperate on railroad connections between the Korean peninsula and TKR and

TSR, nothing has been achieved up to now.

Gaesung Industrial Site Construction

Plans have been made to develop 6.6 million square meters at Gaesung. The first

phase of construction—3.3 million square meters—was completed in 2007.

Currently, more than 200 firms from the Democratic People’s Republic of Korea

are operating their businesses and total investment has reached US$0.9 billion.

The number of Northern workers at the site is around 45 thousand. However,

this project also faces difficulties in future expansion due to recent, increasing

uncertainties.


Concluding Remarks

Potential for regional cooperation in Northeast Asia is vast considering the fact

that the region’s weight in the global economy is rapidly increasing. To this

purpose, geopolitical stability should be regained first to materialize such a huge

potential.

Infrastructure development plays a crucial role in economic growth, poverty alleviation, and enhancing the competitiveness of develop-

ing countries. However, existing infrastructure in many developing countries is inadequate, and more infrastructure investment is ur-gently needed. The problem is particularly acute in Africa’s develop-ing economies, which continue to lag far behind in areas such as telecommunications, electricity, roads, and sanitation. As a result, potential growth as well as the delivery of basic services has been substantially limited.

This paper introduces the Republic of Korea’s experiences in infrastructure development, which have successfully supported economic development. Lessons learned from Korea’s experienc-es during the second half of the twentieth century can be shared with the developing economies of Africa.

Okyu Kwon is Visiting Professor, the Graduate School of Finance and Accounting, KAIST, Seoul, the Republic of Korea. Previously Dr. Kwon held the posts of the Deputy Prime Minister and Minister of Finance and Economy, the Republic of Korea.

The Growth Dialogue is a network of senior policy makers, advi-sors, and academics. The participants aim to generate a sustained stream of views and advice on policies that complements existing, established sources of opinion; to be an independent voice on eco-nomic growth; and to be a platform for policy dialogue among those entrusted with producing growth in developing and emerging mar-ket economies.

http://www.growthdialogue.org/

[email protected]

Growth_Dialogue_Cover_No.1_Korea.indd 1 5/25/2011 4:25:21 PM

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Growth Economics and Policies: A Fifty-Year Verdict and a Look Ahead iii

Contents�

About�the�Author�.............................................................................................................�v�Abstract�..........................................................................................................................�vii�1.�Industrialization�and�Growth:�The�New�Normal�....................................................�3�2.�Growth:�Supply�Push�and�Demand�Pulled�............................................................�10�3.�Policies�for�Growth:�A�Small�Pot�of�Gold�...............................................................�20�4.�Concluding�Remarks�.................................................................................................�23�References�.......................................................................................................................�24��

Growth Economics and Policies: A Fifty-Year Verdict and a Look Ahead v

About�the�Author�

Shahid�Yusuf�is�Chief�Economist,�the�Growth�Dialogue.�Dr.�Yusuf�brings�many�decades� of� economic� development� experience� to� the� Dialogue,� having� been�intensively�involved�with�the�growth�policies�of�many�of�the�most�successful�East�Asian� economies� during� key� periods� of� their� histories.� Dr.� Yusuf� has� written�extensively�on�development�issues,�with�a�special�focus�on�East�Asia�and�has�also�published�widely� in� various� academic� journals.� He� has� authored� or� edited� 24�books� on� industrial� and� urban� development,� innovation� systems,� and� tertiary�education.� His� five� most� recent� books� are:� Development� Economics� through� the�Decades�(2009);�Tiger�Economies�under�Threat�(co�authored�with�Kaoru�Nabeshima,�2009);�Two�Dragonheads:�Contrasting�Development�Paths�for�Beijing�and�Shanghai�(co�authored�with�Kaoru�Nabeshima,�2010);�Changing�the�Industrial�Geography�in�Asia:�The� Impact� of� China� and� India� (co�authored� with� Kaoru� Nabeshima,� 2010);� and�China� Urbanizes� (co�edited� with� Tony� Saich,� 2008).� Dr.� Yusuf� holds� a� PhD� in�Economics� from�Harvard� University� and� a� BA� in� Economics� from� Cambridge�University.�He�joined�the�World�Bank�in�1974�as�a�Young�Professional�and�while�at� the� Bank� spent� more� than� 35� years� tackling� issues� confronting� developing�countries.�During�his� tenure�at� the�World�Bank,�Dr.�Yusuf�was� the� team�leader�for�the�World�Bank�Japan�project�on�East�Asia’s�Future�Economy�from�2000–09.�He�was�the�Director�of�the�World�Development�Report�1999/2000:�Entering�the�21st�Century.�Prior�to�that,�he�was�Economic�Adviser�to�the�Senior�Vice�President�and�Chief� Economist� (1997–98),� Lead� Economist� for� the� East� Africa� Department�(1995–97),�and�Lead�Economist� for� the�China�and�Mongolia�Department� (1989–1993).�Dr.�Yusuf�lives�in�Washington,�DC�and�consults�with�the�World�Bank�and�with�other�organizations.��

Growth Economics and Policies: A Fifty-Year Verdict and a Look Ahead vii

Abstract�

A� scientific� and� industrial� revolution� accelerated� growth� rates� in� a� handful� of�Western� countries� starting� in� the� nineteenth� century.� By� the� early� twentieth�century,� growth� rates� had� begun� rising� in�Asian,� Latin�American,� and�Eastern�European� economies� as� well.� With� the� end� of� WWII� and� the� subsequent�decolonization,� rapid� growth� spread� to� late�starting� developing� nations.� As� a�result�of�this�history,�a�growth�ideology�has�become�firmly�entrenched.�Initially�it�was�buttressed�by�the�contest�between�capitalist�and�socialist�systems�during�the�Cold� War� era.� Since� the� 1980s,� the� quest� for� growth� has� been� reinforced� by�globalization,� by� the� “war� on� poverty”� as� championed� by� the� international�financial�institutions,�and�by�a�wealth�of�theorizing�and�empirical�research.�The�latter� effort� has� singled� out� productivity� as� the� primary� source� of� long�term�growth� and� advances� in� technology,� broadly� defined,� as� the� driver� of�productivity.�Now,�policy�makers�are�demanding�more�from�growth�than�a�mere�increase� in� GDP,� even� as� the� potential� contribution� of� industrialization� is�diminishing.�Growth�economics� is� struggling� to�expand�the� toolkit�and�enlarge�the�menu�of�practical�policy�options.�Capital�investment�embodying�advances�in�technology� remains� crucial,� albeit� difficult� to� manipulate.� Investment� in� high�quality� human� capital� promises� large� dividends� via� innovation� and� efficiency�gains,� but� raising� the� quality� of� education� and� the� volume� of� commercial�innovation�by�dint�of�policy� is�a�struggle.� Institutional�reforms�that�harness�the�full�power�of�market�forces,�tempered�by�regulation,�continue�to�offer�somewhat�elusive�hope.�Growth�economics�remains�a�vital�subdiscipline�and�the�concepts�of� sustainability,� inclusiveness,� and� greening� are� challenging� researchers.� But�with� the� refinement� of� theory� and�practice� proceeding� at� a� homeopathic� pace,�relevance�is�at�risk.�There�is�an�urgent�need�for�disruptive�innovation�to�give�new�direction�to�theorizing�and�policy.��

Growth Economics and Policies: A Fifty-Year Verdict and a Look Ahead 1

Growth�Economics�and�Policies:��A�Fifty�Year�Verdict��and�a�Look�Ahead�Shahid�Yusuf��

Our� forefathers� struggled� to�maintain� living� standards� from� one� generation� to�the�next.�Only� the�privileged�or� lucky� few�saw�their� incomes� rise� steadily�year�after�year.�Constructing�a�time�series�for�worldwide�per�capita�incomes�going�far�back� in� time� is� a� stretch.�However,�Angus�Maddison� (2008)�did�undertake� this�herculean�task�and�we�are�fortunate�to�have�his�educated�guesstimates�extending�back� to� the�dawn�of� the�Common�Era.�At� the� time�when� the�Roman� and�Han�Empires�were� in� full� flower,�per� capita�GDP�of� a�population�numbering�about�226� million� was� US$467� in� 1990� dollars.� A� thousand� years� later,� the� world’s�population� had� risen� by� a� few� tens� of�millions� (to� 267�million)� but� per� capita�incomes�were� almost� unchanged.� By� 1500,� incomes� had� crept� to� US$567� for� a�population� numbering� 378�million� and� after� another� 300� years,� with� numbers�having� more� than� doubled,� per� capita� GDP� had� inched� up� by� only� US$100.�China� and� India,� the� two� largest� economies� at� the� beginning�of� the�nineteenth�century,� had� per� capita� incomes� close� to� the� world� average� while� people� in�Western�Europe�enjoyed�incomes�of�over�US$1,200.�It�is�around�this�time�that�the�Great�Divergence� begins� to� emerge,�with� the� industrial� revolution� ushering� in�“modern� economic� growth”� in� some� West� European� countries� and� later� the�United� States.� By� the� mid�nineteenth� century,� the� tempo� of� growth� was�quickened�by�the�embrace�of�industrialization�by�Western�countries,�continuing�advances� in� scientific� knowledge� and� a� broad� spectrum� of� technologies,� and�institutional� changes.� On� the� eve� of� the� Great� War,� Western� Europe� and� its�“offshoots”� had� far� outpaced� the� rest� of� the�world�with� per� capita� incomes� of�US$3,500�and�US$5,200�respectively�as�against�US$658�in�Asia�(excluding�Japan).�The�unending�economic�growth�we�now�take�for�granted1�surfaced�in�the�latter�half�of�the�nineteenth�century�and�although�economic�progress�was�interrupted�by�cyclical�downswings,2�it�was�around�this�time�that�Europe�and�the�Americas�

��1�Classical�economics�(that�of�Smith,�Malthus,�Marx,�Mill,�and�Ricardo)�concluded�that�growth,�if�it�occurred,� would� be� temporary,� with� economies� tending� to� revert� to� a� stationary/steady� state� if�perturbed.�2�The�National�Bureau�of�Economic�Research�has�tracked�business�cycles�in�the�United�States�dating�back� to� 1854� (see� http://www.nber.org/cycles.html).�Many� downswings�were� severe� and� painful�but�they�came�to�be�viewed�as�the�inevitable� lot�of�capitalist�economic�systems.�Such�tolerance�is�much�less�in�evidence�in�the�post�WWII�period.�

�

2 Shahid Yusuf�

decisively� broke� with� the� relative� economic� stagnation� of� past� centuries� and�established�new�benchmarks.�Between�1870�and�1939,�the�United�States�and�the�United� Kingdom� averaged� unprecedented� growth� rates� of� 3.3� percent� and� 1.9�percent� respectively.� Several� European� countries� achieved� comparable� rates� of�growth� and� late� in� the� nineteenth� century,� Argentina� and� Brazil� were� also�beginning�to�catch�up.3��

Starting�in�the�early�1950s,�something�even�more�remarkable�happened.�Not�only� did� the� United� States� and� the� United� Kingdom� maintain� their� earlier�momentum,4�but�also,�within�a�decade,�economic�growth�had�emerged�as�a�key�objective� of� the� vast� majority� of� nations.� With� Germany� leading� the� way� in�Europe� and� Japan� in� East� Asia,� economies� recovering� from� the� devastation�caused�by�war�accelerated�to�growth�rates�of�5�percent�and�higher� in� the�1950s�and�these�were�joined�by�a�number�of�newly�independent�colonies�in�the�1960s.5�Very�soon,�an�extended�past�during�which�growth�was�slow�if�it�occurred�at�all�became� a� distant� memory� and� a� “new� normal”� took� root.� It� could� hardly� be�otherwise� in� the� light� of� the� vertiginous� growth� of� per� capita� incomes�worldwide:� incomes� that� had� grown� just� 18� percent� between� 1500� and� 1820�increased�by�750�percent�from�the�beginning�of�the�nineteenth�century�to�the�start�of� the� twenty�first� century.6� The� impact� of� accelerating� economic� growth� on�poverty� in� the� face� of� a� spiraling� global� population� has� been� nothing� short� of�dramatic:� between� 1981� and� 2008,� the� number� of� people� living� on� less� than�US$1.25�a�day�declined�from�1.94�billion�to�1.29�billion�and�the�decline�continued�through� 2010,� with� the� reduction� being� greatest� in� Asia� because� of� the�performance�of�the�Chinese�and�Indian�economies.7��

As� the� global� economy� recovers� from� the� financial� crisis� of� 2007–08� and�struggles�with�the�smoldering�eurozone�crisis,�two�questions�are�uppermost�for�policy�makers:�(i)�whether�and�how�industrialized�and�industrializing�countries�might�be�able�to�restore�the�robust�performance�of�the�1993–2007�period�(minus�the�bubbles),8�and�(ii)�the�contribution�that�growth�economics�could�make�to�the�

��3�Maddison�(2010).�4�In�fact,�the�mobilization�of�resources�for�the�war�effort�was�tonic�for�economies�recovering�from�lasting�effects�of�the�Great�Depression�and�subsequent,�somewhat�ill�considered,�fiscal�actions�(in�the�United�States)�to�narrow�public�sector�deficits.�5�One�of�the�earliest�accounts�of�the�recovery�of�the�European�economies�is�by�Kindelberger�(1967).��6� See� Ventura� (2005).� According� to� Zilibotti� (2007),� the� population� weighted� growth� rate� in� the�second� half� of� the� twentieth� century� alone� was� 2.9� percent� per� year.� This� growth� has� been�paralleled�by�a� lengthening� (and�an� international� convergence)�of� life�expectancy�and,�at� least� in�the� advanced� countries,� an� increase� in� the� fraction� of� individual� lifetimes� devoted� to� learning,�together�with�a�decline�in�the�fraction�devoted�to�working.��7�World�Bank�(2012).�8� This� period� is� viewed� as� a� second� golden� age� (the� 1960s� was� the� first),� even� though� it� was�punctuated� by� the� East�Asian� economic� crisis� of� 1997–98,�which� severely� imperiled� some� of� the�highest�fliers,�and�by�the�dot�com�bust�of�2000–01,�which�punctured�visions�of�a�high�growth,�low�inflation�“new�economy”�propelled�by�IT�based�innovations.�


policy� agenda.� Most� developing� and� middle�income� countries� continue� to�envisage� growth� rates� averaging� 6–8� percent.� They� are� convinced� that� the�extraordinary� performance� of� a� handful� of� countries9� during� the� past� quarter�century�can�be�replicated�by�the�many�in�the�decades�ahead.10�

The�purpose�of�this�paper�is�to�study�how�thinking�on�growth�has�evolved�since� the� 1950s11� through� the� interplay� of� international� politics,� country�level�experience,� and� theorizing� almost� exclusively� conducted� in�Western� countries.�The�paper�reflects�on�how�this�body�of�thinking�has�diffused�through�a�variety�of�channels�and�influenced�policies�in�virtually�all�developing�countries.�Finally,�the�paper� considers� whether—following� the� financial� crisis� and� the� unsettled�circumstances�in�the�first�decade�of�the�twenty�first�century—economic�research�based� on� the� experience� of� a� few� countries,� over� a� limited� period� of� time,� can�provide�relevant�and�effective�policy�guidance.��

The�paper�is�divided�into�three�parts.�Part�1�examines�the�experience�of�the�early� postwar� decades� and� the�worldwide� spread� of� a� “growth� ideology”� that�marked�a�shift�from�the�prewar�beliefs�and�experiences�of�the�majority�of�nations.�Part� 2� discusses� economic� theory� and� empirical� findings� underlying� the� new�growth� ideology� from� the� 1960s� onwards.� Part� 3� reflects� on� the� policy�prescriptions� to� be� garnered� from� growth� economics.� It� also� briefly� examines�how�thinking�on�development�is�responding�to�the�financial�crisis,�worries�about�an� income� trap� in� middle�income� countries,� notes� a� resurgent� interest� in�industrial� policies,� and� asks� questions� regarding� the� future� contribution� of�innovation�to�growth�and�its�greening.��

1.�Industrialization�and�Growth:�The�New�Normal��

Western�Europe�and�North�America�were� long� the� center�of� economic�growth.�However,�Jeffrey�Williamson�(2011)�notes�that�economic�change�was�accelerating�in� a� number� of� countries� on� the� periphery� starting� in� the� last� quarter� of� the�nineteenth� century.� Russia,� Japan,� Mexico,� Argentina,� and� Chile� all� began�building� industrial� capacity� at� a� pace� exceeding� that� of� countries� at� the� core;�industrial�growth�in�these�countries�averaged�between�4�and�6�percent�as�against�the�3.5�percent�average�of�the�United�States,�the�United�Kingdom,�and�Germany.�After� 1920,� these� early� developers� from� the� periphery� were� joined� by� several�

��9� The� Commission� on� Growth� and� Development� (2010)� identified� 13� countries� that� averaged�growth�rates�of�7�percent�or�more�per�year�between�1960�and�2002.��10�Hope�springs�eternal;�however,�Acemoglu�(2012,�p.�5)�points�out�that�the�gap�between�countries�in�the�90th�percentile�and�the�10th�percentile�as�well�as�those�in�the�75th�and�the�25th�percentile�has�widened.�The�ratio�between�the�90th�and�the�10th�percentile�was�less�than�9�early� in�the�twentieth�century�and�over�30�towards�the�end�of�the�century.�11� Seminal� papers� on� growth� by� Roy�Harrod� and� Evsey�Domar�were�written� in� 1939� and� 1946,�respectively.�These�were�in�the�Keynesian�vein�and�compared�the�stability�of�growth�paths.�

�

4 Shahid Yusuf�

Southern� European� countries� such� as� Italy� and�Greece,� by� Brazil� and�Peru,� by�Poland� and� Turkey,� and� by� colonial� Korea;� Taiwan,� China;� and� Manchuria.�Countries� enjoying� political� autonomy� followed� the� lead� of� the� pioneers� and�industrialized�faster�with�some�of�the�colonized�East�Asian�nations�close�behind.��

Starting� in� the� 1950s,� with� postwar� recovery� and� decolonization� in� full�swing,� industrialization� moved� into� higher� gear.� Williamson� (2011)� estimates�that� industrial� growth� in� the� periphery� rose� to� 7.9� percent� between� 1950� and�1975.� “Industrialization� in� the�poor�periphery�was�ubiquitous.� In� every� region,�many�others�joined�the�previous,�precocious�industrial�leaders.�In�short,�the�rate�of� industrial� catching�up� surged� in� the� post� war� quarter� century� and� it� also�spread� from� the� emerging� leaders� to� regional� followers”� (Williamson�2011,�pp.�11–12).� Many� factors� contributed� to� this� surge.� For� example,� the� transport�revolution�and�cheap�energy�lowered�costs,�which�stimulated�trade�and�helped�diffuse� industrial� production� to� the� periphery.� In� addition,� changing� terms� of�trade�favoring�manufactures�encouraged�local�production,�and�greater�readiness�to�use� tariff� and�exchange� rate�policies� to�protect�domestic�production�boosted�import�substituting� industrialization.12� Perhaps� most� significant� was� the�germination� of� a� growth� ideology� among� national� elites,� who� had� become�increasingly� aware� of� enhanced� economic� opportunities� and� eager� to� secure�material�prosperity�comparable�to�what�they�saw�in�the�West.�In�the�grip�of�this�new� fervor,� developing� countries� began� planning� for� rapid� growth.� They� took�their� cues� from� the� leading� Western� economies� and� also� drew� lessons� from�“compressed�development”13� achieved� by� the� former� Soviet�Union,� Japan,� and�China.� These� three� relatively� late�starting� countries� were� rebuilding� their�economies� with� remarkable� speed� and� reentering� an� arc� of� development�predating� WWII.� Developing� countries� could� benefit—as� Alexander�Gerschenkron� (1962)� showed—from� the� advantages� of� backwardness� by�introducing� institutional� innovations� that� could�ease�or�unlock�key� constraints.�There� were� huge� productivity� gains� to� be� realized� from� adopting� new� and�codified� agricultural� and� industrial� technologies� and� from� the� transfer� of�resources�from�the�rural�sector�to�industry�and�services�in�urban�centers.14��

The�nascent�growth�ideology�of�national�elites�was�powerfully�reinforced�by�the� ideologies� of� the� great� powers� that� defined� the� political� economy� of�international� development� throughout� the� more� than� three�decade�long� Cold�

��12�The�use�of�tariff�protection�to�promote�domestic�industrialization�mirrored�the�policies�adopted�by� the�United�States�and�Germany� in� the�nineteenth�and� the� first�half�of� the� twentieth�centuries.�Chang�(2002)�observes�that�the�United�States�was�the�most�protectionist�nation�from�the�time�of�the�Civil�War�until�the�eve�of�WWII.��13�This�is�a�term�used�by�Whitaker�and�others�(2008)�to�describe�development�in�East�Asia�bringing�out�the�role�of�the�state�and�of�links�with�global�value�chains.��14�Gerschenkron’s�ideas�are�echoed�in�Justin�Lin’s�analysis�of�the�emerging�economies—and�China�in� particular—over� the� past� 30� years� (Lin,� 2011).� See� also� Mathews� (2006)� on� the� potential�advantages�enjoyed�by�latecomers.�


War.15�Michael� Latham� (2003,� p.� 9)� observes� “though� American� visions� of� the�true� and�only�heaven�differed� from�Soviet� visions� of� the� ‘end�of� history’,� both�models� stressed� the� ability� of� enlightened� elites� to� accelerate� an� inevitable,�universal� movement� through� historical� stages� and� posited� that� technological�diffusion�would�engender�a�new�consciousness� and�a�new�society.”�Both� sides�worked� tirelessly� using� every� instrument� and� channel� they� could� mobilize� to�create,� through�the�agency�of� local� technocratic�elites,�a�new�economic�order� in�their� often�contested� spheres� of� influence.� America� and� its� allies� attempted� to�promote�modernization� and�material� prosperity�within� a� capitalist� framework,�sometimes� with� the� trappings� of� democracy,16� whereas� the� countries� of� the�communist�bloc�pursued�broadly�similar�international�policy�objectives�within�a�Leninist� framework.� And� both� sides� used� virtually� identical�means� to� achieve�desired�geopolitical� and�economic�outcomes:� foreign�aid,�power�projection�and�arm� twisting,� technical� assistance,� training�programs,� arming� of�militaries,� soft�power,�and,�not� infrequently,�proxy�wars� to�prop�up� favored�regimes�(some�of�which�persisted� for� years,�making� life� nastier� and�more� brutish� for�millions).17�Econometrically� sharpened� hindsight� shows� that� aid� in� pursuit� of� geopolitical�objectives� contributed� little� to� investment,� growth,� or� poverty� reduction.18�However,� it� cemented� alliances� with� ruling� elites19� and� trained� the� focus� on�modernization�and�development�and�through�technology�transfers�hard�as�well�as�soft,�kept�growth�at�the�center�of�policy�attention�and�the�preferred�yardstick�for�measuring�economic�progress.��

Post�war� thinking�was� influenced�by� the�efficacy�of� state�economic�control�during� WWII� and� the� embracing� of� Keynesian� policies� following� the� Great�Depression� to� help� smooth� business� cycle� fluctuations� or� at� least� reduce� their�amplitude.�These�policies� reinforced�other� trends�and�measures�contributing� to�the� acceleration� in� growth� rates.� However,� they� also� slowly� gave� rise� to� a�perception� that� the� business� cycle� had� been� largely� tamed� (some� argued� by� a�deepening� of� market� institutions� and� increasing� market/price� flexibility).� The�belief�was�that�policy�makers�had�the�tools� to�sustain�economic�activity�at�high��15�The�term�was�coined�by�George�Orwell�and�first�used�in�1947�by�Bernard�Baruch�to�describe�the�tensions� that�erupted�between� the�Soviet�Union�and� the�Western�powers�shortly�after� the�end�of�WWII.�16�America�supported�European�integration�starting�in�the�1950s�because�it�believed�that�this�would�raise�growth�rates,�strengthen�democracy,�and�neutralize�communist�influence.�17�Hironaka�(2005)�describes�some�of�these�never�ending�wars�in�postcolonial�states.�18� A� large� literature� on� the� relationship� between� aid� and� growth� comes� to� at� best� inconclusive�findings.� Aid� (including� military� assistance)� did� not� cause� growth� and� may� on� balance� have�supported� predatory� elites�who� through� their� rent� seeking� activities� were� (and� are)� a� brake� on�growth.�See�Doucouliagos�and�Paldam�(2006,�2009);�Easterly�(2006);�Roodman�(2007).�Nevertheless,�the�more�than�US$16�billion�of�aid�provided�to�the�Republic�of�Korea�by�the�United�States�and�its�allies� contributed� to� technology� transfer,� as�well� as� to� the� stabilization� and�development� of� that�country,�and�helped�ward�of�the�threat�from�the�Democratic�People’s�Republic�of�Korea.�19� In� the� process,� aid� seems� to� have� increased� inequality� in� recipient� countries.� See�Herzer� and�Nunnenkamp�(2012).�

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6 Shahid Yusuf�

levels� or,� in� other�words,� to�minimize� the� threat� of� prolonged� downturns� that�eroded� past� gains.�As� result� of� these� policies� and� beliefs,� the� role� of� the� state,�already� greatly� enlarged� during� the� course� of� the� long� war,� was� steadily�augmented,�and�the�state�acquired�the�responsibility�to�strive�after�and�maintain�rapid� growth.� The� emergence� of� a� large� and� initially� economically� successful�Communist�Bloc�(and�active�economic�proselytizing�by�the�countries�of�the�Bloc)�contributed� to� a� widespread� belief� in� the� augmented� role� of� the� state.� Fiscal�policy,�including�direct�public�sector�intervention,�was�seen�as�a�way�to�promote�private�initiative�and�industrialization.�State�guided�capitalism�received�a�strong�endorsement� from� the� performance� of� the� Republic� of� Korea;� Taiwan,� China;�Singapore;�Malaysia;�and�Thailand�and�it�provided�other�developing�economies�with�both�inspiration�and�a�proven�model�at�least�through�the�early�1990s.20�The�performance� of� the� Chinese� economy,� once� market� oriented� reforms� were�introduced� in� the� early� 1980s,� further� underscored� the� advantages� of� market�institutions�tempered�by�state�control�and�an�outward�orientation�to�harness�the�power�of�globalization.��

The�growth�expectations�that�took�root�during�the�halcyon�1960s�proved�to�be� remarkably� durable.� Europe� endured� a� long� spell� of� stagnation� during� the�1970s� and� growth�was� slow� also� in� the�United� States� through� the� early� 1980s.�Latin� America,� after� an� initial� surge,� lost� ground� starting� in� the� 1980s� and�suffered�from�“lost�decades.”�China�was�hobbled�first�by�the�havoc�caused�by�the�Great�Leap�in�1958–60�and,�after�a�short�spell�of�recovery�in�the�first�half�of�the�1960s,� by� more� than� 10� years� of� disruption� resulting� from� the� Cultural�Revolution� that� Mao� choreographed� in� 1966.� By� the� mid� 1970s,� Africa� had�entered�a�long�economic�twilight�that�persisted�for�over�two�decades,�and�India�remained�on�the�treadmill�of�the�“Hindu�growth�rate”�until�the�onset�of�reforms�in�the�early�1990s.21�Only�the�“tiger�economies”�in�East�Asia�defied�gravity�and�exploited� international� market� opportunities� to� grow� their� economies� at� high�speed�with�the�help�of�investment�in�industry�and�buoyant�exports.��

The�gloom�lifted�in�the�1990s,�arguably�because�of�four�main�developments:�(i)�accelerating�globalization�assisted�by�the� lowering�of� trade�barriers;22� (ii)� the�stripping� away� of� capital� controls� and� declining� transport� costs;� (iii)� the� tonic�effects� of� general� purpose� technologies� (GPTs)23� that� released� a� flood� of�innovations;� and� (iv)� the� spread� of� regulatory� reforms� to� weed� out� market��20�State�guided�capitalism�in�the�Republic�of�Korea�and�Taiwan,�China�was�the�subject�of�two�well�known�publications�by�Wade�(1990)�and�Amsden�(1989).�A�sampling�of�the�voluminous�literature�on�industrial�policy�is�summarized�in�Yusuf�(2011).�21� In� the� Indian�case,� the� first� steps� towards�deregulation� in� the�1980s�had�already�begun�raising�growth�rates,�but�the�release�from�the�prolonged�stagnation�took�place�in�the�1990s.�22�The�landmark�Uruguay�Round�of�trade�negotiations�was�successfully�concluded�in�1994.�23� Semiconductors� (and� microprocessors),� which� are� key� components� of� information� and�communication� technologies,� and� the� Internet� are� two� GPTs� that� have� served� as� the� drivers� of�innovation�since� the�mid�1980s.�See�Bresnahan�and�Trajtenberg�(1995);� Jorgenson,�Ho,�and�Stiroh�(2011).�


distortions� that� stifled� competition,24� caused� inefficiency,� and� promoted� rent�seeking.�The�neoliberal�argument�for�enlarging�the�role�of�markets�and�reining�in�the�activities�of� the�state25�received�a�boost� first� from�the�collapse�of� the�former�Soviet� Union� and� the� discrediting� of� the� socialist� planned� approach� to�development,� and� then,�more� convincingly,� from� the� surge� in� global� economic�activity.��

Could�the�growth�ideology�have�become�so�all�pervasive�absent�the�parallel�rise� of� growth� economics?� This� is� difficult� to� answer� because� growth� and�development�have�become�inextricably�linked�and�growth�is�widely�accepted�as�the� touchstone� of� performance.� However,� it� is� fair� to� say� that� the� rise� and�teaching�of�neoclassical�growth�economics�in�leading�Western�universities�from�the� mid�1950s� did� much� to� build� the� analytic� and� empirical� scaffolding� to�support�the�idea�that�a�steady�state�growth�path26�was�theoretically�feasible�and�was�being�demonstrated�in�practice�by�a�number�of�countries.�After�a�slow�start,�growth�modeling�exploded�in�the�1960s�as�economists�became�more�accustomed�to�using�mathematics�and�began�elaborating�the�“science�of�growth”�in�conscious�imitation� of� the�methodologies� of� the� hard� sciences.27�As� national� income�data�accumulated,�especially�on�the�United�States,�theoretical�models�were�put�to�the�test� and� the� growth� industry� was� born� providing� much�needed� intellectual�underpinnings� for� the� growth� ideology� and� a� few� conceptual� tools� for� policy�makers� wanting� to� translate� political� promises� into� tangible� economic� results.�Sections�2�and�3�of� this�paper�discuss�how�economics�accounts� for�growth,�but�before� getting� to� that� it� is� worth� listing� a� number� of� other� reasons� for� the�popularity�of�the�growth�ideology�and�why�it�has�survived�and�will�continue�to�survive�setbacks�and�disappointments.��

Growth as a Belief System The�growth�“ideology”�has�permeated�the�discourse�on�development�and�proven�compelling� for� good� and� bad� performers� alike� for� several� reasons.� First,� the�growth�rate� for� the�global�economy�between�1950�and�1999�averaged�4�percent�per�year,�well�in�excess�of�pre�1850�levels.�Moreover,�there�is�the�demonstration�effect�generated�by�highly�successful�performers,�however�small�they�might�be—and� Singapore;� Hong� Kong� SAR,� China;� Taiwan,� China;� and� the� Republic� of�

��24�This�was�a�time�when�concerns�about�state�failure�were�making�deep�inroads�into�thinking�in�the�United� States,� spurred� by� the� ideas� emanating� from� the� Chicago� School� and� the� activities� of�increasingly�influential�neoliberal�and�libertarian�think�tanks�(Backhouse�2010).�25�This�was�enshrined�in�the�“Washington�Consensus,”�first�tabled�by�John�Williamson�in�1989.�26�An�early�collection�of�essays�by�Nobel�Prize�winner�Edmund�Phelps�(1967)�offered�a�foretaste�of�the�esoterica� to�come.�Another�example� is�Chakravarty�(1969),� lavishly�praised� in�a�Foreword�by�Paul� Samuelson,� who� urged� countries� to� stay� “indefinitely� near� the� turnpike� (path)”� when�embarked�“on�a�sufficiently�long�journey”�(p.�xii)�See�also�the�work�of�Bardhan�(1970)�and�Arrow�and�Kurz�(1970).�27�The�calculus�of�variations�and�optimal�control�theory�became�a�favorite�tool�of�some�instructors�teaching�courses�in�development�economics�in�leading�American�universities.��

�

8 Shahid Yusuf�

Korea� were� small� economies� in� the� 1970s� and� 1980s.� These� resource�poor�countries�on�the�periphery�showed�that�steady�progress�from�the�lowest�rung�to�near� the� top� of� the� income� ladder� was� possible� in� as� little� as� four� decades�through� technological� catching�up� and� the� patient� building� of� human� and�physical� capital� largely� from� internal� resources.� Growth� was� achieved� not�through� the� virtuosity� of� policy� but� through� macroeconomic� and� political�stability,� successful� efforts� at� resource� mobilization,� learning� and� absorbing�technologies�from�abroad,�and�the�exploiting�of�market�opportunities�opened�up�by�globalization.�The�early�and�later�“tigers”�served�as�a�beacon�of�hope�for�the�majority� of� economies� that� have� struggled�with� low� or� negative� growth� rates.�Had� the� tigers� not�materialized,� it� is� doubtful� that� the� growth� ideology� could�have�acquired�such�a�loyal�following.�No�amount�of�modeling�can�substitute�for�7�percent�rates�of�growth�sustained�for�three�decades.�

Second,�perhaps�one�can�claim�with�little�exaggeration�(witness�the�concerns�expressed� in� the�United� States� circa� 2012)� that� in� democracies� and� autocracies�alike,�political� legitimacy�of�governments�has� come� to�hinge�on� the�delivery�of�good�economic� results�over� the�medium�term.� If� incomes�stagnate�and�become�more� unequal� or� employment� is� hard� to� come� by,� democracies� will� show�governments� the� door.� The� Arab� Spring� uprisings� have� demonstrated� that�populations� can� eventually� become� restive� even� in� tightly� policed� autocracies.�Rightly�or�wrongly,�the�notion�that�governments�must�deliver�growth�(or�steady�gains�in�welfare�that�in�time�come�to�be�widely�shared28)�has�acquired�worldwide�currency29—and�politicians�have�had�a�large�hand�in�embedding�it�more�firmly�through� the� promises� they�make� as� they� seek� office.� Rightly� or� wrongly,� it� is�becoming�conventional�wisdom�that�some�degree�of�international�convergence�of�consumption� standards� is� a� viable� objective,� given� the� relative� performance� of�developed�and�developing�countries�during�the�past�decade.30�

Third,� a� number� of� developments� over� the� past� 50� years� have� rendered�growth�more� urgent� and�made� it� harder� to� think� of� a�world�without� growth.�Population�increase�is�a�critical�concern�for�a�number�of�countries�and,�even�as�it�slows,�they�will�still�have�to�convert�a�youth�bulge�into�a�youth�dividend.�Slow�growth�will�have�enormous�economic�and�consequences�(already�apparent�in�the�Middle�East� and�South�Asia)�not� only� for� countries� saddled�with�high� rates�of�unemployment�but�also�for�others�if�mass�unemployment�leads�to�an�upsurge�in�international�migrations.�A� related� factor� is� the�promises�many�governments—

��28� Worsening� inequality� can� be� politically� corrosive� and� a� threat� to� democratic� and� capitalist�institutions.� However,� in� many� countries,� advanced� and� others,� inequality� continues� rising�inexorably.�See�the�discussion�below.��29�GDP�growth�as�measure�of�welfare�gain�is�frequently�challenged�but�has�yet�to�be�dethroned�by�an� equally� compact,� easy� to� compute,� and� compelling� indicator.� See� Stiglitz,� Sen,� and� Fitoussi�(2010).�30�Rodrik� (2011)�doubts� that� such� convergence�will� easily�materialize� except� in� the� case�of� a� few�countries.�


and� the� international� community—have� made� (and� will� continue� to� make)� to�reduce� if� not� eliminate� poverty� and�more� guardedly,� inequality.� The� evidence�suggests� that� countries� (such� as� China)� that� have� successfully� tackled� poverty�have�relied�upon�high�rates�of�growth,�which�generate�jobs,�finance�social�safety�nets,�and�enable�governments�to�provide�the�poor�with�services�that�will�equip�them�with� capabilities.31� The� commitment� to� reduce�poverty,� staunchly�backed�by�international� financial� institutions�(IFIs)�and�nongovernmental�organizations�(NGOs),� is� supported� by� vast,� international,� bureaucratic� machinery;� but� to�deliver�results,�foreign�assistance�alone�will�not�do.�Countries�saddled�with�large�poverty� burdens� must� grow.� A� return� to� nineteenth� century� rates� of� growth�would�be� intolerable.�Hence�out�of� necessity,� all�parties�must�hold� tight� to� the�growth�ideology�and�hope�for�the�best.�

Increasing� resource� and� energy� scarcities,� climate� change,� and�environmental� degradation� demand� an� urgent� greening� of� growth.� Although�debate�continues�on�the�advantages�of�early�and�precautionary�action,�the�weight�of�evidence�points�increasingly�to�net�growth�benefits�of�green�policies�and�green�technologies.32� The� evidence� also� suggests� that� 2–3� degrees� of� warming� is�becoming�unavoidable,�a�development�that�will�entail�costly�mitigating�efforts�in�the� future,� in� particular� to� increase� the� resilience� of� cities.� In� anticipation� of� a�harsher�environment,�countries�need� to�build� their� resource�bases,�because� it� is�the�wealthier�countries�that�are�far�better�able�to�weather�shocks�and�to�repair�the�damage.� These� three� developments� increase� the� pressure� on� governments� to�assign�priority� to�growth�because� there� can�be�no�doubt� that� each�will� require�large� investments� of� capital� and� advances� in� technological� capabilities—all�associated�with�success�at�growing�GDP.��

Fourth—and� there� are� other� factors� I� will� not� list—industrialized� and�industrializing�countries�are�ageing�and�faced�with�a�shrinkage�of�the�workforce�a�decade�or�two�into�the�future.�A�number�of�economies�are�weighed�down�with�large�debts�and�even� larger� contingent� liabilities,�which�will�be�difficult� to�pay�down�or�accommodate�without� fairly� robust�growth.33�Therefore,� for� fiscal�and�welfare� reason� at� the� very� least,� a� resumption� of� “adequate”� growth� rates� in�these�countries�is�vital�if�they�are�to�maintain�or�improve�on�their�current�living�standards.�Stagnating�economies�will�face�enormous�difficulties.�In�fact,�there�is�no�alternative�but�to�aim�for�the�highest�rates�of�growth�a�country�can�potentially�achieve.��

The� above� sketches� the� emergence� and� 60�year� dominance� of� the� growth�ideology.�But�while� average�growth� rates� are�handily� above� the� levels� reached�prior�to�the�mid�nineteenth�century�for�many�countries,�sustaining�growth�rates�

��31�The� capabilities� approach� is� associated�with�Amartya�Sen� (1985)� and�his� co�authors—for�example,�Martha� Nussbaum.� See� http://www.iep.utm.edu/sen�cap/;� http://plato.stanford.edu/entries/capability�approach/;�http://ndpr.nd.edu/news/26146�creating�capabilities�the�human�development�approach�2/.�32�See�Hallegatte�and�others�(2012).�33�Unless�of�course,�the�long�term�healthcare,�pension,�and�social�benefits�can�be�pared�or�revoked.�

�

10 Shahid Yusuf�

of� 7�percent�or�more�has�proven�difficult� and� this� confronts�growth�economics�with�a�severe�challenge:�to�convincingly�explain�sustained�growth�accelerations34�and�with�the�benefit�of�such�analyses�arrive�at�policy�recommendations�tailored�to�individual�country�circumstances�that�will�enable�others�to�replicate�what�thus�far�has�been� the� lot�of� a� favored� few.�Economists�have� responded� to� the� social�and�political� demand� for� policy�measures—and� the� need� to� build� professional�reputations�by�constructing�sophisticated�models�and�testing�myriad�hypotheses.�However,� as� indicated� below,� analytic� complexity� and� empirical� rigor,� while�admirable,�have�yielded�meager�results�by�way�of�policies�that�are�both�specific�to�country�needs�and�effective.�As�Arrow�(1962)�observed,�“the�math�has�taken�on�a�life�of�its�own,”�and�the�furious�productivity�of�growth�economists�has�still�to�yield�convincing�evidence�of�its�policy�relevance.��

2.�Growth:�Supply�Push�and�Demand�Pulled�

The� literature�on�growth� is� forbiddingly� large� and� the� expanding� international�army�of�researchers�guarantees�an�endless�stream�of�additions.�The�two�volumes�of�the�Handbook�of�Economic�Growth�provide�a�sense�of�the�scope�and�richness�of�the� research.35� These� were� published� in� 2005� and� much� new� material� has�appeared� since� then.� Capturing� the�many�sidedness� of� this� literature� in� a� few�pages� is� impossible.�However,�mercifully,� the�central� threads�and�stylized� facts�are�few�and�they�have�changed�little�over�time—and�there�is�nothing�to�suggest�that� the� next� 10,000� papers� will� add� or� subtract� much� from�what� we� already�know.�

Growth�can�be�viewed�from�two�angles�and�because�this�is�economics,�they�are� supply� and�demand.� In� a� contribution� to� the�debate� on� capital� theory� that�raged� between� the� two� Cambridge� schools,36� Paul� Samuelson� (1966,� p.� 444)�ringingly�announced�that�“until�the�laws�of�thermodynamics�are�repealed,�I�will�continue� to� relate� outputs� to� inputs—i.e.� to� believe� in� production� functions.”�And� factor� inputs� have� remained� the� drivers� of� growth� in� the� supply� side�version� of� growth� economics.�Demand�provides� a� complementary� perspective.�Whether� or� not� supply� materializes� is� a� function� of� demand� for� outputs.� If�demand� is� weak,� as� it� is� in� recessions,� investment� diminishes,� production�slackens,�workers� are� not� hired,� and� some�of� those� employed� are� laid� off.� The�unemployed�cut�back�their�consumption,�which�further�sours�the�expectations�of�

��34�Empirically�tracked�by�Hausmann,�Pritchett,�and�Rodrik�(2005).�35�See�Aghion�and�Durlauf�(2005).�These�are�volumes�1A�and�1B.�Volume�2�is�to�come.�36�The�controversy�swirled�around�the�aggregation�of�goods�and�services�into�a�factor�of�production�to� be� plugged� into� a� production� function� yielding� a� marginal� product� that� determines� the�distribution�of�income.�The�controversy�was�captained�by�Joan�Robinson�and�Paul�Samuelson�from�Cambridge�University,� United�Kingdom� and�Cambridge�University,� United� States,� respectively.�See�Harcourt�(1972)�and,�more�recently,�Cohen�and�Harcourt�(2003).�


investors.� In� the� absence� of� reflationary,� state�initiated� macro� policies� (as�Keynesians�advocate),�this�leads�to�a�tightening�vicious�spiral.�Economic�growth�slows� with� potentially� long�lasting� consequences.� Market� fundamentalists,�unlike�Keynesians,37�are�of�the�view�that�business�cycles�caused�by�market�forces�leave� trend� rates� of� growth� mostly� unchanged.� They� suggest� that� so� long� as�markets� are� left� to� do� their�work� (that� is,� the� state� stays� on� the� sidelines),� the�demand� side� of� growth� can� be� ignored.� But� not� all� agree� that� demand�management� is� irrelevant� from� the� standpoint� of� long�run� growth� or� that� a�“night�watchman”�state�should�be�the�twenty�first�century�ideal.��

The Reign of Capital followed by Total Factor Productivity In�the�beginning,�when�the�Harrod�Domar�model�was�the�workhorse�of�growth�economics,� only� capital� and� labor� mattered.� These� were� the� two� basic� factors�whose� entry� into� the� production� function� caused� growth,� depending� on� a�combination� determined� by� technological� relationships.� In� a� Harrod�Domar�world,�if�the�supply�of�labor�was�elastic,�then�growth�was�paced�by�the�supply�of�capital.�Countries�mobilizing�a�large�volume�of�capital�through�domestic�savings,�supplemented� by� investible� resources� from� abroad,� could� grow� faster.� This�relationship�helped�to�explain�the�performance�of�the�communist�countries�that�sacrificed�consumption�in�order�to�build�productive�capacity.�The�dominance�of�capital�lasted�until�the�middle�of�the�1950s,�when�papers�by�Trevor�Swan�(1956)�and�more�famously�by�Solow�(1956,�1957),�revolutionized�thinking�on�the�sources�of�growth.�These�papers�showed�that�as�much�as�70�percent�of�the�growth�in�the�United�States� could�not�be� traced� to� factor� inputs�but� instead�was� caused�by�a�residual,� including� technology� and� other� intangibles.38� By� singling� out�technological� change� as� a� key� factor,� Solow� (and� others� such� as�Abramovitz39)�highlighted� the� role� that� knowledge� had� come� to� play� since� the� dawn� of� the�Industrial�Revolution.�Prior�to�that,�“even�the�best�and�the�brightest�mechanics,�farmers�and�chemists—to�pick� three�examples—knew�relatively� little�about� the�fields� of� knowledge� they� sought� to� apply.� The� pre�1750�world�…�made�many�path�breaking�inventions.�But�it�was�a�world�of�engineering�without�mechanics,�iron�making�without�metallurgy,� farming�without� soil� science,�mining�without�geology,� water�power� without� hydraulics,� dye� making� without� organic�chemistry� and� medical� practice� without� microbiology� and� immunology.� Not�

��37� Sometimes� the� two� opposing� groups� are� divided� into� the� “freshwater”� school� of� market�fundamentalists� and� believers� in� real� business� cycles� (such� as� Robert� Lucas� from� Chicago� and�Thomas�Sargent,�formerly�from�Minnesota)�and�the�“saltwater”�school�of�neo��and�post�Keynesian�theory�(including�most�notably,�Paul�Krugman�and�Larry�Summers),�many�from�the�East�coast�and�some� from� the� West� coast.� See� http://seekingalpha.com/article/306991�paul�krugman�and�the�saltwater�economists�predictions.�38� Kuznets� (1966)� recognized� the� importance� of� capital� saving� innovations� and� investment� in�education�and�the�development�of�skills.��39�For�Abramovitz�(1993),�technology�accounted�for�only�a�part�of�the�coefficient�of�ignorance�or�the�residual.��

�

12 Shahid Yusuf�

enough�was�known�to�generate�sustained�growth�based�on�technological�change�(Mokyr�2005,�p.�1,119).��

Solow’s� findings� were� subsequently� validated� by� others,� and� triggered�theoretical� and� empirical� research� to� track� down� the� “quarks”� that� inhabit� the�residual—or� total� factor� productivity� (TFP)� as� it� has� come� to� be� known.40� This�quest�is�now�in�its�sixth�decade�and�although�a�multitude�of�suspects�have�been�identified,�a�theory�that�convincingly�accounts�for�the�residual/TFP,�lays�bare�its�dynamics,� and� points� unequivocally� to� effective� policies� has� proven� elusive.�Researchers� attempting� to� explain� the� differences� in� performance� among�countries� have� marshaled� scores� of� so�called� fundamental� variables� including�geography,� entrepreneurship,� financial� deepening,� religion,� ethnic�fractionalization,� and� natural� resources.41� But� after� examining� the� explanatory�robustness� of� the� leading� candidate� growth� theories,� Durlauf,� Kourtellos,� and�Tan�(2008,�p.�344)42�are�forced�to�conclude�that�there�is�a�lack�of�“strong�evidence�that� any� of� the� new� growth� theories� are� robust� direct� determinants� of� growth�when�we�account�for�model�uncertainty….�[However,]�variation�in�growth�rates�across� countries� are�more� robustly� explained� by� differences� in�macroeconomic�polices�and�unknown�heterogeneity�associated�with�regional�groupings.”�

Recent� attempts� at� estimating� TFP� for� a� large� number� of� countries� range�from�a�quarter�of�growth�to�over�two�thirds,�with�the�average�falling�somewhere�in�the�50�percent�range.43�Over�the�longer�term,�the�consensus�is�that�growth�of�GDP�and�divergences�in�per�capita�GDP�will�be�closely�tied�to�individual�country�performance�with�regard�to�productivity.�Moreover,�Solow’s�initial�intuition�that�the�explanation�for�the�residual�was�to�be�found�in�technology�grounded�in�the�accretion� of� knowledge�has� come� to� be�widely� accepted.� Technological� change�and�innovation�(some�embodied�in�new�equipment)�are�seen�as�the�mainsprings�of� productivity� growth.� Underlying� these� is� a� learning� and� innovation� system�that� produces� human� capital� and� determines� its� quality;� helps� to� absorb�technology�and�refines�it�through�incremental�innovations;�generates�ideas,�some�of�which�are�translated�into�commercial�innovations;�and�through�the�agency�of�greater�technical,�vocational,�managerial,�and�organizational�skills,�brings�about�gains� in�efficiency.�Physical� capital� is� still�very�much� in� the�picture�by�creating�productive� capacity� and� serving� as� a� vehicle� for� research� and� technology�transfer.�In�addition,�since�1995,�information�technology�(IT)�capital�has�acquired�

��40�Earlier�work�by�Denison�(1962),�Jorgenson�and�Griliches�(1967),�and�Maddison�(1987)�suggested�ways�of�decomposing�the�residual,�including�through�human�capital�inputs.�41�One�compact�source�of�cross�country�growth�analysis�is�Barro�(1997).�42�See�also�the�detailed�weighing�of�approaches�to�modeling�growth�and�econometrically�tracing�its�causes� in�Durlauf,� Johnson,�and�Temple� (2005).�Kenny�and�Williams� (2001)�also�observe� that� the�empirical�evidence�does�not�enable�one�to�select�among�competing�explanatory�factors.�43�Among�a�legion�of�TFP�enumerators,�see�Bosworth�and�Collins�(2003),�Crafts�(2010),� Jorgenson�and�Vu�(2010),�and�Allen�(2012).�


a� substantial� role,� especially� in� the� United� States� and� Europe.44� IT� is�complemented�by�technology�that�is�at�the�heart�of�what�Baumol�(2002)�describes�as� the�“capitalist�growth�machine.”�As�Parente�and�Prescott� (2000),�Comin�and�Hobijn� (2010),�Allen� (2012),� and�many� others�note,� the�main� reason�why� some�countries�are� so� far�down�on� the� income�scale�and�convergence� is� so�halting� is�because� these� economies� have� difficulty� borrowing� technologies� from� more�advanced�countries�and�tailoring�it�for�their�own�purposes.��

A� number� of� reasons� have� been� put� forward� to� explain� why� frontier�technologies� have� been� slow� to� diffuse.� Bad� institutions� that� place� limits� on�absorptive� capacity,� regulatory� constraints,� vested� interests,� and� poor�governance� must� take� some� of� the� blame.� They� have� discouraged� technology�adoption�through�their�affects�on�the�business�climate�and�entrepreneurship.�The�poor� quality� of� human� capital� and� associated� deficiencies� in� technological�capacity�has�thrown�up�additional�hurdles.�But�the�nature�of�technologies�closer�to� the� frontier� may� also� slow� diffusion.� These� technologies� tend� to� be� capital�intensive� because� they� were� developed� in� countries� where� labor� is� relatively�expensive�and�skills�are�abundant.�They�are�less�cost�effective�in�countries�where�labor� costs� are� low� relative� to� those� of� capital.� Lower�� and� middle�income�countries,�all�in�East�Asia,�that�have�managed�to�narrow�technology�gaps�in�two�or� three� decades� have� done� so� through� rapid� deepening� of� capital.� This� was�made�possible�by�intensive�resource�mobilization�and�the�provision�of�capital�at�low�rates�of�interest�to�industry�through�state�controlled�financial�channels.�This�process,�which�mimics�the�approach�adopted�by�Germany�and�Italy�during�their�catch�up� stage� in� the� late� nineteenth� century,� has� been� backstopped� by�investment�in�learning�and�innovation�systems�that�have�built�up�the�technical,�research,� and� soft� skills� to� absorb� and� effectively� utilize� advanced�methods� of�production.��

A�country�such�as�China�offers�a�good�illustration�of�how�technology�gaps�can�be�narrowed�and�productivity�raised.�China�has�invested�massively�in�state�of�the�art�production�equipment,�financed�by�equally�massive�domestic�savings�channeled� to�enterprises� through�state�owned�banks�at� state�controlled� rates�of�interest� that� substantially�depress� the�cost�of� capital.45�At� the�same� time,�China�has� successfully� enlarged� its� pool� of� skills,� thus� facilitating� absorption� of�technology�from�overseas.�This�brings�us�back�to�the�refinements�and�advances�in� growth� theory,� as� expounded� in� work� by� Paul� Romer46� that� modeled�endogenous�growth�and�explicitly�accounted�for�the�role�of�knowledge.��

��44�Jorgenson,�Ho�and�Stiroh�(2005)�note�that�a�decline�in�IT�prices�have�induced�firms�to�substitute�IT�for�non�IT�capital�and�since�1995,�Jorgenson�and�Vu�estimate�(2010)�that�IT�capital’s�contribution�worldwide�rose�from�less�than�a�quarter�to�more�than�a�third�of�the�total�contribution�of�capital.�45�Financial�repression� is�a�notable�accompaniment�of�capital�intensive�development� in�several�of�the�East�Asian�economies.��46�Romer�(1986,�1994).�

�

14 Shahid Yusuf�

From Solow to Endogenous Growth The� Solow�model,� by� clarifying� the� relationship� between� capital� accumulation�and�growth,�helped� to�partially�dislodge� the�orthodoxy� that� saw�capital� as� the�key�to�growth�and�focused�growth�augmenting�policies�exclusively�on�measures�to�raise�the�rate�of�investment.�For�example,�in�Rostow’s�analysis�(1960),�a�takeoff�into� sustained� growth� was� explicitly� a� function� of� a� prior� increase� in� capital�investment� from� 5–6� percent� to� 15� percent� or� more.47� Solow� showed� that�increasing�capital�accumulation�eventually�runs�into�diminishing�returns48�as�an�economy�shifts�from�extensive�to�intensive�growth,�but�in�avoiding�the�problem�the�model�assumed�exogenous�technological�change�that�limited�its�explanatory�power.�This�deficiency�was�remedied�by�explicitly�incorporating�(endogenizing)�knowledge� into� the� growth� model.� Endogenous� growth� theory� assumes� that�learning� by� doing49� and� investment� in� education� creates� knowledge� and�knowledge� spillovers.� Thus,� externalities� reverse� the� diminishing� returns� to�capital,� allowing� growth� to� be� sustained.� In� other� words,� the� continuous�production� of� knowledge� through� a� variety� of� avenues� staves� of� what� would�otherwise� be� an� inevitable� onset� of� diminishing� returns� that�would� negate� the�deepening� of� capital.50� It� is� arguable� whether� endogenous� growth� theory�constitutes� a� significant� advance,� however,� as� Solow� (2007,� p.� 6)� remarks,� “the�most�valuable�contribution�of�endogenous�growth�theory�has�not�been�the�theory�itself,� but� rather� the� stimulus� it� has� provided� to� thinking� about� the� actual�production�of�human�capital�and�useful�technological�knowledge.”�

The� literature� is� replete�with� an� immensity� of� small� variations� and�minor�extensions,�including�the�role�played�by�institutions�(whether�viewed�as�rules�or�as�organizations�with�specific�governance�mechanisms),51�but�the�action�revolves�

��47� Rostow’s� rules� of� thumb�were� appealing� to�American� policy�makers� because� they� distributed�countries� along� a� continuum� of� stages� and� imposed� a� semblance� of� order� on� a� complex� and� at�times�chaotic�world�situation.�This�in�turn�simplified�the�decision�rules�for�foreign�assistance�and�put�a�ceiling�on�how�much�foreign�assistance�would�be�needed�to�realize�America’s�development�objectives�for�the�international�community.�See�Haefele�(2003,�p.�87).��48� This� became� spectacularly� evident� in� the� case� of� the� former� Soviet�Union,�which�by� 1975�was�investing�38�percent�of�GDP�but�saw�its�growth�taper�through�the�1970s�to�almost�zero�in�the�1980s.�See�Allen�(2011,�p.�134).�49� The� endogenizing� of� technological� change� as� a� profit�making� activity� in� its� own� right� was�foreshadowed�by�Arrow�in�a�landmark�1962�paper�where�he�used�capital�investment�as�the�vehicle�through�which� learning/technological� change� occurs� endogenously� rather� than� being� introduced�exogenously.�See�also�Solow�(1997).�But�Solow�(2007,�p.�5)�wonders�whether�endogenizing�was�as�much�of�a�breakthrough�as�it�is�touted�to�be,�because�to�endogenize�the�growth�rate�of�a�variable�requires�a�linear�differential�equation:�“the�plausibility�of�the�model�depends�upon�the�robustness�of� that� assumption:� it� amounts� to� the� firm� assumption� that� the� growth� rate� of� output� (or� some�determinant�of�output)�is�independent�of�the�level�of�the�output�itself.”�50�Aghion�and�Howitt�(2009)�nicely�elucidate�the�workings�of�all�and�sundry�models�of�growth�and�track�the�twists�and�turns�in�the�development�of�theory.�See�also�Howitt�(2004).�51�According�to�some�researchers,�institutions�(represented�by�a�proxy�for�which�data�can�be�found)�are�the�keys�to�growth.�Institutions�such�as�property�rights�and�intellectual�property�surely�matter,�


around� capital� and� TFP� and� ways� of� parsing� TFP.� The� contribution� of� TFP�appears�to�be�rising,�according�to�a�recent�study�by�Arezki�and�Cherif�(2010)�of�94�countries�covering�the�period�1970–2000.�The�question�that�refuses�to�go�away�is� whether� all� the� fuss� over� TFP� is� increasing� the� stock� of� effective� policy�instruments� and� institutions,� and� helping� us� understand� why� growth� is� so�persistently�uneven�and�all�too�often�unresponsive�to�the�moving�of�conventional�policy� levers.� Policy� instruments� and� institutions� are� discussed� in� the� next�section.�

Introducing Demand Much� of� the� attention� of� growth� theory� has� been� on� the� supply� side,� with�demand� attracting� sporadic� attention� during� business� downturns,� as� has� been�the�case�since�2008.�Such�is�the�trajectory�of�international�growth�after�WWII�that�a�prolonged�shortfall�in�demand�was�not�perceived�as�a�significant�problem�until�recently.�This�explains�the�surprise�and�alarm52�that�greeted�both�the�severity�of�the� financial� crisis� (unexpected� by� the� legion� of� believers� in� the� efficiency� and�stability� of� Western� financial� markets� and� disinclined� to� harbor� bearish�sentiments)�and�the�Great�Recession�that� followed.�During�the�extended�period�of�calm�prior�to�2008,53�the�majority�of�macroeconomists�were�content�to�track�the�movements� of� the� economy� using� variants� of� dynamic� stochastic� general�equilibrium� (DSGE)� models� that� incorporated� consumption� smoothing� and�rational� expectations,� which� papered� over� the� differences� between� the�Keynesian54�and�new�classical�models.��

From� the� perspective� of� growth� economics,� this� neglect� of� demand�management� (including� the� demand� generated� by� net� exports)� and� the� risk� of�crises�are�hard�to�explain,�given�crises’�frequency�(though�mainly�in�developing�countries).� A� literature� going� back� several� decades� has� established� that� poor�demand� management—by� injecting� macroeconomic� volatility,55� inflationary�pressures,� or� adverse� expectations—has� been� responsible� for� depressing�investment�and�growth�in�many�countries.56�One�reason�why�the�East�Asian�tiger�

��but� how� and� how�much� they� impinge� on� TFP� is� difficult� to� determine.� As� policy� instruments,�institutional�variables�are�tricky�to�define�and�manipulate�and�the�returns�can�accrue�non�linearly�over�a�long�period�of�time.�52� And� the� initial� silence� and� the� subsequent� defensive� response� to�Queen� Elizabeth’s� question:�“Why�did�no�one�see�the�crisis�coming?”�http://www.ft.com/intl/cms/s/0/1c1d5a9e�bb29�11dd�bc6c�0000779fd18c.html#axzz1rNHjoBif.�53�Between�the�mid�1980s�and�2007,�there�was�a�relative�lull�in�financial�crises�and�defaults,�which,�according�to�Reinhart�and�Rogoff�(2008),�set�the�stage�for�the�“big�one.”�54�New�Keynesian�models�assume�(difficult�to�measure)�sticky�prices.�55� Burnside� and� Tabova� (2009)� find� that� a� country’s� average� growth� rate� is� correlated� with� its�exposure� to� risk� factors� and� the�greater� its� exposure� to� shocks,� the� lower� its� average�growth.� In�other�words,�riskier�countries�depress�domestic�investment�and�attract�less�capital�from�abroad.�56�See�Sirimaneetham�and�Temple�(2009)�for�a�reexamination�of�the�evidence�using�a�new�index�of�instability�and�for�references�to�a�large�earlier�literature.�

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16 Shahid Yusuf�

economies�performed�at�such�a�high�level�is�because,�for�the�most�part,�they�were�able�to�create�stable�macroeconomic�environments�conducive�to�investment�and�to�risk�taking.�A�second�reason�of�equal�importance�was�the�emphasis�that�East�Asian�economies�placed�on�trade�(and�foreign�direct�investment)�policies�aimed�at�maximizing� the� growth� impetus� from�exports.� Thus,� growth�was� supported�both� in� the� form� of� demand� and� through� gains� in� productivity,� technology�transfer,� and� the� encouragement� that� an� open� trading� environment� offered� to�foreign� investors.� It� was� the� relative� neglect� of� such� policies� at� the� very� time�when� globalization�was�widening� opportunities� for� growth� through� trade� that�stifled� growth� in�many� developing� economies� and� enabled� the� East� Asians� to�pluck�the�low�hanging�fruit.�

The�experience�of�Japan�also�shows�how�poor�macroeconomic�management�can� undermine� efforts� at� accumulating� knowledge� and� inducing� innovation.�Japan�is�home�to�some�of�the�most�innovative�multinational�corporations,�spends�in� excess� of� 3� percent� of� GDP� on� research� and� development� (R&D),� is� second�only�to�the�United�States� in�the�number�of�patents� it�registers�each�year,�and�is�not�short�of�science�and�technology�skills.�Nevertheless,�following�the�bursting�of�the� real� estate� bubble� in� 1989� and� the� ensuing� financial� crisis,� Japan’s� growth�slowed�to�a�crawl,�with�TFP�growing�by� just�0.6�percent�per�year�between�1990�and� 2003.57� In� other� words,� investment� in� knowledge� to� augment� science,�technology,� and� innovation� (ST&I)� activities� cannot� boost� growth� if� demand� is�persistently�weak.�Moreover,�experience�suggests�that�the�private�sector�is�quick�to�pare�R&D�spending�when�the�economy�enters�a�downturn�and�the�immediate�future�demand�for� innovation�weakens.�The�more�astute�companies�are�careful�not� to� cut� their� research� activities,� as� they� provide� the� ideas� and� products� for�future�growth,�but�the�majority�does�in�fact�take�the�axe�to�R&D.�Following�the�2007–08� financial� crisis,� companies� reacted� by� curtailing� expenditures� on�research,�as�did�some�governments�beset�with�fiscal�problems—the�result�of�past�macroeconomic�mismanagement.��

As� Keynes58� observed,� deficient� demand� tilts� the� odds� against� the�entrepreneur�and�can�stifle� innovation�and�eat� into� the�growth�of�productivity.�Amazingly,�after�so�much�research�on�macroeconomic�policy,�the�financial�crisis�and�the�problems�of� the�eurozone�have�uncovered�a�singular� lack�of�consensus�regarding� the� efficacy� of� demand� management� and� how� it� can� be� most�effectively�conducted,�once�monetary�policy�is�reduced�to�near�impotence�when��57�Jorgenson�and�Motohashi�(2005).�58�“If�effective�demand�is�deficient�…�the�individual�enterpriser�who�seeks�to�bring�these�resources�into�action�is�operating�with�the�odds�loaded�against�him.�The�game�of�hazard,�which�he�plays,�is�furnished�with�many�zeros,� so� that� the�players� as� a�whole�will� lose� if� they�have� the� energy�and�hope� to� deal� all� the� cards.�Hitherto� the� increment� of� the�world’s�wealth� has� fallen� short� of� the�aggregate� of� positive� individual� savings;� and� the� difference� has� been�made� up� by� the� losses� of�those�whose� courage� and� initiative�have�not� been� supplemented�by� exceptional� skill� or�unusual�good�fortune.�But�if�effective�demand�is�adequate,�average�skill�and�average�good�fortune�will�be�enough”�(Keynes�1936).�


interest�rates�are�at�the�zero�bound.�In�the�United�States,�for�example,�the�leading�economists� are� unable� to� agree� as� to� whether� the� multiplier� effect� of� fiscal�spending� by� the� Federal� government� is� greater� or� less� than� one.� The� reason�appears� to�be� that� the�new�classical�“freshwater”�school�never�embraced�a�role�for� fiscal�policy�as�a�stimulus.� Instead,� it�assumed�that�monetary�and�exchange�rate� polices� would� be� sufficient� and� its� members� are� virulently� opposed� to�government�intervention�of�the�sort�associated�with�fiscal�activism.�What�we�see�playing� out� on� the� macroeconomic� front� is� not� a� debating� of� policy� options�grounded�in�rigorous�empirical�analysis�but�a�contest�between�two�belief�systems�unable�to�convincingly�establish�a�position�with�reference�to�preceding�research.�Perhaps� most� disconcerting� is� that� the� debate� is� being� conducted� exclusively�among� participants� drawn� from� a� handful� of� schools� (with� strong� ideological�leanings)� in� North� America� and� Western� Europe.� Other� countries� and� other�academics� have� a� stake� in� the� outcome� of� the� debate� and� future� directions� of�macroeconomic� policies� but� their� contribution� is� barely� visible.� On� demand�management� as� on� the� supply� related� aspects� of� growth,� a� few� Western�universities�continue�to�call�the�shots�by�training�and�indoctrinating�the�majority�of�those�who�worldwide�conduct�influential�research�and�advise�policy�makers.�The�epicenter�of�growth�economics�remains�highly� localized,�and�more� than�60�years� after� the� birth� of� growth� economics,� Western� ideas,� fashions,� and�methodologies� continue� to�determine�what� is� researched,�how� it� is� researched,�and�what�gets�translated�into�policies.��

Indices of Performance In� this� context� there� remains� one� additional� substrand� of� the� demand�side�approach� that� deserves� consideration� because� it� figures� so� prominently� in� the�assessment� of� growth� prospects� and� the� making� of� policies.� This� strand�comprises� the� numerous� indices� of� competitiveness,� business� climate,�corruption,� innovation,� logistics,� and� entrepreneurship.� These� are� just� a� few�of�the� indicators� that� seek� to� gauge� a� country’s� attractiveness� for� investors,� its�potential� for� innovation,� and� its� production� competitiveness� relative� to� other�countries.59�Because�of�their�apparent�simplicity�and�due�to�intensive�marketing,�these� indicators�have� emerged�as� the�yardsticks�with�which� countries�measure�performance� and� they� provide� some� of� the� more� monitorable� policy� handles.�Macroeconomic� stability� and� demand� management� through� monetary,� fiscal,�and�exchange�rate�polices�are�the�key�determinants�of�investment,�consumption,�and� exports.� However,� some� research� confirms� that� the� “investment� climate”�(the�competitiveness�of�the�economy�as�measured�by�a�number�of�indicators)�and�innovative� capacity� (also� measured� from� several� different� angles)� affect�investment� decisions� and� innovativeness,� and� that� these� feed� through� into�growth� via� capital� accumulation� and� gains� in� productivity.� Undoubtedly,� the�

��59�See,�for�instance,�World�Bank�(2004);�WEF�(2012).��

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18 Shahid Yusuf�

various� elements� that� enter� into� these� indices�matter.�How�much� each� counts,�and�which�ones�should�be�singled�out�to�yield�the�maximum�productivity�gains,�is�unlikely�to�be�settled�because�there�are�far�too�many�indices.�Many�are�built�up�through� subjective� assessments,� and� it� is� difficult� to� say�which� combination� of�factors,�in�conjunction�with�a�host�of�other�determinants,�will�be�appropriate�for�a�specific�country.��

Inevitably,�as�with�most�things,�one�size�does�not�fit�all.�The�safe�conclusion�is� that� conventional� demand� management� dominates� all� other� types� of�management.� Insufficient� demand,� demand� volatility,� excess� demand,� and� the�distortions,� bubbles,� and� crises� they� can� cause,� are� likely� to� negatively� affect�growth�prospects.��

The� first� step� to� a� good� business� climate� and� a� competitive� economy� is�macroeconomic�stability.�Looking�at�the�fragile�state�of�many�Western�economies�following�the�official�start�of�recovery,�the�importance�of�demand�management�is�self�evident�but�not�apparently�to�a�sizable�segment�of�the�economics�profession�and�to�the�policy�makers�whose�ear�they�have.�Brad�DeLong�(2012,�p.�2)�captures�the�Keynesian�mood�well�when�he�remarks:�“For�62�years,�from�1945–2007,�with�some� sharp� but� temporary� and� regionalized� interruptions,� entrepreneurs� and�enterprises�could�bet�that�the�demand�would�be�there�if�they�created�the�supply.�This�played�a�significant�role�in�setting�the�stage�for�the�two�fastest�generations�of� global� economic� growth� the� world� has� ever� seen.� Now� the� stage� has� been�emptied.”� Clearly� Keynesians� are� on� the� defensive.� The� case� for� reflationary�fiscal�policies� to� restore�growth� is� receiving�a� frosty�political� reception�and� the�case�for�restoring�long�term�growth,�once�recovery�is�well�and�truly�launched�in�Western�countries,�is�not�being�made�in�a�manner�that�convinces�the�politician�or�the�median�voter.��

In�middle�income�countries� that�must�drive�global�growth� if� the�advanced�countries�do�not,� the�situation�is�satisfactory�in�the�short�term�but�much�less�so�over� the� longer�haul.60�Countries� such� as�Brazil,� the�Russian�Federation,� South�Africa,�India,�Malaysia,�the�Arab�Republic�of�Egypt,�Indonesia,�and�China�are�by�no�means�primed�for�sustained�growth�of�the�kind�the�high�flyers�enjoyed�in�the�1980s�and�the�1990s.�Future�growth�in�these�countries�is�vulnerable�to�a�number�of�factors,�including�dysfunctional�domestic�governance�and�political�turbulence,�low�rates�of�saving�and�investment�(in�certain�cases),�an�unwelcoming�business�climate,� major� sectoral� imbalances� and� inefficiencies,� limited� or� declining�manufacturing� capabilities,� and� weak� innovation� systems.� In� addition,� all� of�these� countries� would� be� affected� by� the� inability� of� their� Western� trading�partners� to� return� to� earlier� growth� paths,� or,� worse,� by� a� reversal� of� trade�liberalization.��

��60�Some�of�these�countries�worry�about�becoming�caught�in�a�middle�income�trap�and�being�unable�to�upgrade�industry�and�close�technology�gaps�because�of�human�and�research�capital�constraints.�


Increasing� income� inequality,� especially� in� advanced� English�speaking�countries�and�many�middle��and�low�income�ones,�including�some�in�East�Asia,�is� adding� to� the� uncertainty� regarding� future� growth� prospects.� The� Kuznets�curve� has� proven� unreliable.� Kuznets� (1955)� forecast� a� period� of� increasing�income� inequality� as� labor�migrated� from� rural� to�higher�paying�urban� jobs� in�developing�countries� (and� income�from�land�declined),� followed�by�a�return� to�greater�equality�once�societies�urbanized,�industrialized,�raised�average�levels�of�education,� and� introduced� equalizing� tax� and� transfer� programs.61� In� fact,�inequality� declined� in�Western� countries� until� about� 1980,� but� has� been� rising�since.62� In� continental� European� countries,� the� Nordic� countries,� and� Japan,�inequality� was� flat� and� is� now� increasing� slowly.� In� developing� countries,�inequality� first� declined� and� leveled� off� and� in� many� it� is� now� on� the� rise—including� in� the� East� Asian� economies,� which� demonstrated,� with� the� help� of�land� reforms� and� rapid� industrialization,63� that� countries� could� achieve� high�rates� of� income� growth� and� maintain� income� inequality.� Income� inequality� is�edging�upward� in� the�United�States,� Singapore,�China,� Japan,� some�of�Europe,�and� remains� high� in� South� America� and� Sub�Saharan� Africa.� Conventional�wisdom�would� suggest� that� growth� could� suffer� if� political� tensions� arise� and�boil� over,� affecting� policy� making� and� investor� risk� perception.� However,�research�reported�in�the�Oxford�Handbook�of�Economic�Inequality64�does�not�point�to�a�clear� relationship�running� from�inequality� to�economic�performance.�A�meta�analysis�by�de�Dominicis,�de�Groot,�and�Florax�(2006)�adds�some�valuable�detail,�which� shows� that� the� influence� of� inequality� on� growth� is� stronger� in� less�developed�countries�and�when�the�duration�of�a�spell�of�growth�is�shorter—the�long�term� impact� is� different� from� the� impact� in� the� short� run.� Although� past�experience� partially� allays� fears� regarding� growth,� recent� trends� in� inequality�and� levels� reached� are� nevertheless� disquieting� and� these� could� prove� to� be�problematic� if� growth� is�weak� because� of� the� lingering� aftermath� of� the�Great�Recession.�Inequality�could�be�become�politically�unacceptable�in�democracies�if�economic�performance�remains�sluggish,�and�could�unleash�demands�and�policy�actions�that�further�curb�growth,�at�least�over�the�medium�term.��

The� search� for� policy� recipes� to� achieve� or� restore� rapid� growth,� and� to�distribute� the� gains� more� equitably,� is� urgent,� as� countries� wrestle� with�

��61� Acemoglu� and� Robinson� (2002)� explain� the� shape� of� the� Kuznets� curve� in�Western� European�countries� as� follows:� by� increasing� inequality,� capitalist� industrialization� either� brings� about� a�change� in� the� political� regime� or� forces� the� ruling� political� elites� to� redistribute� income� in� the�interests�of�stability.��62� Goldin� and�Katz� (2009);� Atkinson,� Picketty� and� Saez� (2011);� Acemoglu� (2012).� The� increasing�equality� is� explained� by� the� spread� of� education� resulting� from� the� shifts� in� the� distribution� of�political�power,�mediated�by�democratic�institutions�and�change�in�ideological�beliefs.�63� Acemoglu� and� Robinson� (2002)� maintain� that� the� land� reforms� in� East� Asia� fundamentally�altered�the�relationship�between�growth�and�inequality.��64�Salverda,�Nolan,�and�Smeeding�(2009).�

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20 Shahid Yusuf�

unemployment,� expectations� and� contingent� liabilities.� However,� arithmetic65�suggests�that�serious�economic�and�environmental�strains�could�ensue�if�a�few�of�the� largest�countries,�such�as�China,�converged� towards� the� living�standards�of�the�West�and�the�majority�of� the�others�start� to�narrow�technology�and� income�gaps.�The� tax� that� such�growth�would� impose�on�global�public�goods,�and� the�resource� depletion� it� would� entail,� would� imperil� the� growth� project� that� has�been� the� centerpiece� of� development� for� so�many� decades.� Even� a� substantial�greening�of�growth,�were�it� to�occur�in�the�next�two�to�three�decades,�might�be�too�little�and�too�late.�Does�growth�economics�have�a�convincing�riposte�for�the�doom�mongers?� What� are� the� stylized� policy� recommendations� of� continuing�significance�that�have�come�out�of�60�years�of�research�and�its�application?�The�next�section�discusses�these�questions.�

3.�Policies�for�Growth:�A�Small�Pot�of�Gold�

Long� immersion� in� the� literature� on� growth� leaves� one� with� the� feeling� that�pearls� never� stop� pouring� in:� so� much� is� being� written� on� such� a� staggering�multitude�of�topics.�There�is�a�sense�that�a�lot�of�incremental�innovation�is�afoot�wherever�economics�is�being�taught�or�practiced—and�not�just�in�a�few�Western�hotspots.�But� then�one� stops� to� remember� the� last� 1,000�papers� read�and� the� 4�million� regressions66� scrutinized.� That� is� when� the� sense� of� moving� in� circles�becomes�apparent�and�the�impossible�task�of�summarizing�a�few�stylized�policies�begins�to�seem�manageable.��

King Capital Although�the�spotlight�might�have�shifted�to�TFP,�capital�is�the�driver�of�growth�for�most� low�� and� lower�middle�income� countries67� far� from� the� technological�frontier,� with� low� capital� labor� ratios� and� still� on� the� extensive� margin� of�development.�For�these�countries,�the�first�order�of�business�is�to�put�in�place�the�infrastructure�that�undergirds�development�and�to�build�the�productive�capacity.�Capital� investment� does� this� and� it� also� serves� as� the� avenue� through� which�technology�is�transferred�from�more�advanced�to�developing�countries.�China�is�the� foremost� exemplar� of� this� approach.� It� telescoped�decades� of� development�into� years� by� pulling� out� the� stops� on� capital� investment� and� in� the� process�transferring� technology�at�a�much� faster�pace� than�would�ordinarily�have�been�possible.�How�can�a�country�raise�investment�to�upwards�of�25�percent�of�GDP?�

��65�See�Cohen�(2012);�Sachs�(2008).�66� Only� Sala�i�Martin� (1997a,�b)� has� confessed� to� having� run� 4� million� regressions�(www.nber.org/papers/w6252.pdf),�later�reduced�to�2�million�(www.jstor.org/stable/2950909).��67� The� United� States� could� also� use� a� sizable� dose� of� capital� investment� to� restore� its� ailing�infrastructure�and�perhaps�even�partially�reverse�the�hollowing�of�its�manufacturing�activities.�In�2009,�U.S.�gross�investment�was�a�paltry�15�percent.��


Only�a� few�have�managed�this� through�a�combination�of�resource�mobilization�through� the� fiscal� system� and� public� sector� entities;� by� harnessing� publicly�owned�and�controlled�banks;� by� exerting� financial� repression,�which�depresses�interest� rates� over� long� periods;� through� state� capitalism� in� combination� with�industrial� policy� vigorously� implemented� through� fiscal� and� organizational�incentives;� and�with� the� help� of� an� exchange� rate� policy� that� undervalues� the�domestic�currency�relative�to�that�of�major�trading�partners.�This�is�a�tall�order,�beyond�the�capacity�of�most�countries,�and�some�of�the�incentives�utilized�in�the�past�are�now�disallowed�by�the�World�Trade�Organization�(WTO).�In�fact,�even�countries� that� once� achieved� high� rates� of� investment,� such� as�Malaysia,� have�fallen� far� below� earlier� levels.�Other� countries� such� as� Brazil� and� South�Africa�have�been�unable�to�approach�East�Asian�levels�in�spite�of�introducing�generous�fiscal� incentives� for� investment� and� a� deepening� of� the� financial� sector� to�mobilize�and�allocate�savings.��

Improving�the�business�climate�can�in�principle�increase�investment,�but�it�is�difficult�to�identify�countries�that�have�moved�to�a�high�growth�path�by�working�on�the�indicators�that�affect�transaction�costs.�In�the�1980s�and�a�part�of�the�1990s,�low�rates�of�saving�and�investment�in�Latin�American�and�Sub�Saharan�countries�was� blamed� on� macroeconomic� mismanagement.� However,� better� macro�management�has�increased�investment�modestly�if�at�all.�Between�1995�and�2009,�gross�investment�was�unchanged�in�Latin�America�and�rose�from�an�average�of�18� percent� to� an� average� of� 21� percent� in� Sub�Saharan� Africa.� Low� levels� of�private� investment� in� productive� capacity� and� limited� investment� in� physical�infrastructure� constrain� growth,� both� directly� and� by� dampening� the� gains� in�TFP�from�embodied�technological�progress�and�learning.��

Horizontal�and�matrix�based�approaches�(as�distinct�from�the�earlier�vertical�ones)�to�industrial�policy�that�were�pushed�aside�by�market�fundamentalism�in�the�1990s�are�back�in�favor,68�as�countries�struggle�to�raise�the�level�of�investment�and� orient� it�more� towards� the� productive� sectors� rather� than� housing� or� real�estate.�The�jury�is�still�out�on�whether�such�policies�or�others�will�make�a�tangible�difference� in� primarily� market�based� economies� operating� with� reference� to�WTO�rules.��

Human Capital the Knowledge Producer Endogenous�growth�theory�and�the�research�on�human�capital�has�brought�out�the� vital� role� of� education� and� ST&I� skills.� They� serve� both� as� drivers� of�(inclusive)� growth� in� themselves� and� as� complements� to� increasingly� more�sophisticated� capital/IT� equipment� based� on� technologies� introduced� in� the�advanced�countries.�Research�by�Hanushek�and�others69�has�demonstrated� that�the�quality�of�human�capital�(based�on�standardized�tests)�counts�for�more�than�

��68�See�Van�Reenen�(2012),�Aiginger�(2007,�2011),�and�Aiginger�and�Sieber�(2006).��69�Hanushek�and�Woessman�(2008,�2012);�Pritchett�and�Viarengo�(2008).�

�

22 Shahid Yusuf�

quantity,�especially� in� the�race� to�narrow�technological�gaps�and� to�raise� factor�productivity� by� improving� management,� soft� skills,� allocative� efficiency,� and�policy� implementation.� Learning� from� countries� that� are� high� on� the� quality�ladder� has� become� a� growth� industry� in� its� own� right,� even� as� some� of� these�countries� (for� example,� Singapore� and� Finland)� begin� to� worry� about� the�emphasis�on�rote�learning�and�on�the�inability�to�instill�sufficient�creativity�and�problem�solving�skills.�It�is�clear�from�Western�experience�that�greater�spending�on� education� does� not� by� itself� suffice,� once� it� is� over� some� threshold� of�adequacy.� Teacher� qualifications,� incentives,� status,� and� autonomy� can�make� a�difference�but� each� success� story�has� tight� and�unreplicable� cultural� correlates.�Human� capital� has� emerged� as� an� axis� of� growth� economics,� and�many�of� the�answers� countries� are� seeking� must� be� found� in� the� swampland� of� education�“science,”�itself�full�of�interesting�papers�and�dead�ends.��

Innovation Systems Human� capital� development� and� the� learning� economy� it� represents� is�inseparable�from�the�ST&I�system�that�uses�human�capital�to�generate�ideas�and�commercial� innovations� facilitated�by� legal�and�regulatory� institutions� to�move�the�TFP�needle.�The�architecture�of�innovation�systems�in�the�leading�economies�has� been� exhaustively� mapped� to� the� following� conditions:� the� role� of� the�government,� universities,� and� the� financial� system� (including� venture� capital�providers);� legal�institutions�supporting�intellectual�property�and�the�trading�of�ideas;� industrial� composition;� the� entrepreneurial� dynamics� of� the� business�community,� both� domestic� and� foreign;� and� the� contribution� of� a� competitive�market�environment.�A�series�of�OECD�reports70�elucidates�country�experiences�and� offer� policy� advice.� Lundvall� (2007)� provides� a� historical� perspective� and�Martin�(2012)�nicely�summarizes�the�state�of�the�field�and�notes�the�challenge�of�coordinating�the�actions�of�several�participants�in�the�innovation�game.�The�idea��and� innovation�generating� machine� must� function� smoothly� to� extract� the�maximum�TFP�from�capital�investment�and�the�accumulation�of�human�capital.�This� is� very�much� in� the� spirit� of� endogenous�growth� theory,� but� it� should� be�noted� that� endogenous� growth�policies� and� innovation� activities� are� not� really�separable.� They� are� carried� out�more� or� less� in� tandem,� given� the� fast�moving�nature�of� the� technological� environment.�A�universal� roadmap�exists� only� as� a�broad� sketch.�With� the�U.S.� and� Finnish� innovation� systems� showing� signs� of�strain,�two�of�the�global�icons�are�tottering�on�their�pedestals.�

Demand Management Demand�management� is� linked� to� economic� openness� and� the� role� of� trade� in�creating�opportunities�for�firms�(especially�in�small�countries).�Through�demand�management,�firms�can�realize�economies�of�scale�and�connect�with�international�value�chains.�This�creates�avenues�for�technology�transfer�and�subjects�domestic��70�See�http://www.oecd.org/document/62/0,3746,en_2649_34273_38848318_1_1_1_1,00.html.�


firms� to� competitive� pressures.� Whether� or� not� trade� enhances� productivity�through� these� channels� remains�undecided.�Bernard�and�his� co�authors71� show�that�the�firms�that�enter�export�markets�are�already�the�productive�ones.�Others�find�that�trade�does�cause�productivity�to�rise.72�As�with�macroeconomic�policy,�the�answer�seems�to�boil�down�to�a�matter�of�belief,�because�there�are�an�equal�number�of�papers�arguing�both�sides�of�the�case.�I�tend�to�go�with�the�ayes.�But�this� expression� of� belief� only� begs� the� larger� question:� How� does� a� country�become� a� successful� exporter?� If� one� takes�China� as� a�model,� then� the� answer�appears�to� lie� in�making�massive� investments�in�physical�and�human�capital� to�build� manufacturing� capability;� creating� an� innovation� system� to� enhance�absorptivity;� exploiting� foreign� direct� investment� to� increase� access� to�technology;�maximizing�fiscal,� financial,�and�exchange�incentives;�and�applying�pressure�from�the�party�organization�to�achieve�state�mandated�export�targets.��

4.�Concluding�Remarks�

The�economics�profession�has�been�hard�hit�by�the�inability�to�warn�of�the�recent�financial�crisis�and�to�contribute�coherent�policy�directions�to�aid�recovery�and�to�restore� growth.� After� a� few�months� of� soul� searching� and� the� occasional� mea�culpa,� the� response,� inevitably,� is� denial,� and� a� return� to� business� as� usual.73�Perhaps�it�cannot�be�otherwise.�For�its�part,�growth�economics�seems�resigned�to�circling� around� the� coefficient� of� ignorance� and� stirring� in�new�variables,� even�though�the�policy�value�added�from�these�efforts�is�perilously�close�to�zero.�

There� is�no�denying�the�scale�of� the�economic�research�conducted�over� the�past� half� century,� but� growth� economics� is� struggling� to� provide� detailed� and�meaningful�answers�to�policy�concerns.�If�TFP�is�indeed�the�driver�of�growth,�its�measurement� is� becoming� something� of� an� art,74� appreciated� by� practitioners�(there�are�scores�of�estimates,�no�two�alike)�but�contributing�little�to�the�content�and�precision�of�policies�for�raising�TFP.�There�is�no�consensus�on�how�growth�that� is�evenly�shared�might�be�accelerated�in�advanced�countries�and�sustained�by� middle�income� ones� fearing� the� onset� of� sclerosis.� In� the� absence� of� fresh�ideas,� the� professional� and� public� debate� mindlessly� regurgitates� well�worn�nostrums�on�investment�in�education�and�science�and�technology;�on�stimulating�innovation;� and� on� creating� an� institutionally� well�stocked,� regulation�lite,�

��71�Bernard� (2006).� Iacovone�and� Javorcik� (2012)�added�also� find� that�potential� exporters�upgrade�quality�prior�to�entering�the�export�market.�72�See�Lopez�(2005).��73� Specialization,� ideological�predispositions,�and�an�absence�of�alternative�models�makes�people�return� to� the� same� coalface.�Dislodging�neoclassical/neo�Keynesian�macroeconomics�will� require�the�mother�of�all�disruptive�theories.��74�A�survey�of�the�econometrics�of�TFP�by�Van�Beveren�(2012)�indicates�how�many�tools�and�tests�the�modeler�can�now�marshal�to�enhance�the�joys�of�estimation.��

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24 Shahid Yusuf�

market�friendly,�enabling�business�environment.�The�one�apparent�innovation�is�the�greening�of�several�of�the�latest�offerings�on�growth.��

Since�the�early�1970s,�leading�economists�have�periodically�warned�that�their�profession�would�be�marginalized�by�the�trend�towards�technical�specialization,�mathematical�modeling,�and�a� focus�on�the�testing�of�narrow�hypotheses�using�increasingly�more�abstruse�econometrics.�These�warnings�have�gone�unheeded.�As� a� consequence,� in� the� face� of� a� crying� need� for� rapid� and� effective� policy�action� on�many� fronts,� growth� economics� is� not� forthcoming� with� convincing�analysis,�plus� the�kind�of� fine�grained�policy� suggestions� informed�by�political�realities,� that� determine� whether� and� how� policies� are� implemented� and� the�nature� of� outcomes.� Policy�makers� often�have� short� time�horizons,� are� looking�for� practical� proposals,� and� must� constantly� weigh� the� political� and�distributional� implications�of�economic�policies.�Therefore,� they�have� little� time�for�recommendations�to�“strengthen�institutions,”�or�move�from�the�periphery�to�the�“core�of�the�product�space,”�or�invest�more�in�R&D,�or�improve�the�quality�of�education,� or,� most� dishearteningly,� raise� TFP.� These� are� all� suitable� grist� for�articles�and�blogs.�But�after�60�years,�growth�economics�should�be�able� to�offer�more�varied,�politically� informed,� specific,� and�operationally� relevant� fare,� and�policy� makers� and� others� who� ultimately� finance� the� uncountable� regressions�deserve�better.�Maybe�in�the�next�60�years�they�will�receive�their�due.�

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Cover design: Michael Alwan

Growth Policy and the State iii

Contents

About the Author ............................................................................................................. v

Abstract .......................................................................................................................... vii

Introduction ...................................................................................................................... 1

The Schumpeterian Growth Paradigm ......................................................................... 2

A Remark on Growth Policy and a Country’s Stage of Development ..................... 3

Growth‐Enhancing (Supply‐Side) Policy in Developed Economies ......................... 4

Investing in Growth while Reducing Public Deficits: The Strategic State ............... 5

Industrial Policy ............................................................................................................... 6

Taxation ............................................................................................................................. 7

Demand versus Supply Side .......................................................................................... 8

Macroeconomic Policy .................................................................................................... 8

Climate ............................................................................................................................... 9

The State and the Social Contract ................................................................................ 10

Democracy ...................................................................................................................... 11

Implications for the Design of a European Growth Package ................................... 11

Conclusion ...................................................................................................................... 15

References ....................................................................................................................... 15

Growth Policy and the State v

About the Author

Philippe Aghion is Robert C. Waggoner Professor of Economics at Harvard

University, Programme Director in Industrial Organization at the Centre for

Economic and Policy Research (CEPR), and Fellow at the National Bureau of

Economic Research (NBER) and the Institute for Fiscal Studies (IFS).

Professor Aghion is one of the most prolific and influential economists of his

generation. He focuses much of his attention on the relationship between

economic growth and policy, particularly innovations as a main source of

economic growth. Professor Aghion’s approach is to examine how various

factors interact with local entrepreneurs’ incentives to either innovate or to

imitate frontier technologies.

With Peter Howitt, Philippe Aghion developed the so‐called ‘Schumpeterian

paradigm’, and extended the paradigm in several directions. Much of the

resulting work is summarised in the book he co‐authored with Howitt entitled

Endogenous Growth Theory.

In the process of trying to link growth and organisations, Professor Aghion

has also contributed to the field of contract theory and corporate governance. His

work concentrates on the question of how to allocate authority and control rights

within a firm, or between entrepreneurs and investors.

In addition to his academic research, Professor Aghion has been associated

with the European Bank for Reconstruction and Development (EBRD) since 1990.

He is also managing editor of the journal The Economics of Transition, which he

launched in 1992, and is co‐editor of the Review of Economics and Statistics.

Philippe Aghion holds a PhD from Harvard University (1987). He was

elected a Fellow of the American Academy of Arts and Sciences in 2009 and of

the Economic Society in 1992. In 2001, he received the Yrjö Jahnsson Award of

the European Economic Association, which rewards a European economist

under the age of 45. He was associated with the Commission on Growth and

Development and is active in the work of the Growth Dialogue.

Growth Policy and the State vii

Abstract

The importance of investing in research and development (R&D) and knowledge

for innovation and growth is now commonly acknowledged. So is the role for

structural reforms aimed at making product and labor markets more flexible.

More controversial, however, is the role that the state should play in the growth

process. The debate on the role of the state has been revived by the financial

crisis to the extent that this crisis has turned into a public debt crisis.

One response to the public debt crisis is the neo‐conservative approach of a

minimal state. Public spending and taxes should be minimized, so that private

firms would face low interest rates and low tax rates, which in turn would

encourage them to hire and expand, thereby generating prosperity for the whole

economy. However, this approach is not working too well in the United

Kingdom, where it has been implemented. Conversely, in Scandinavian

countries, where governments remain big, innovation and productivity growth

rates remain high.

In this paper we argue for a strategic or “smart” state, rather than a reduced

state. The strategic state would target its investments to maximize growth in the

face of hard budget constraints. This departs both from the Keynesian view of a

state sustaining growth through demand‐driven policies, and from the neo‐

liberal view of a minimal state confined to its regalian functions.

Growth Policy and the State 1

Growth Policy

and the State

Philippe Aghion

Introduction

The importance of investing in research and development (R&D) and knowledge

for innovation and growth is now commonly acknowledged. So is the role for

structural reforms aimed at making product and labor markets more flexible.

More controversial however is the role that the state should play in the growth

process. The debate on the role of the state has been revived by the financial

crisis to the extent that this crisis has turned into a public debt crisis, thereby

forcing governments to make difficult choices between the need to quickly

reduce public debt and deficits on the one hand, and the need to support growth

on the other hand.

One response to the public debt crisis is the neo‐conservative approach of a

minimal state. To reduce public deficits while stimulating growth and

employment, governments should focus attention on the so‐called “regalian”

functions of the state, namely, to maintain law and order. Public spending and

taxes should be minimized, so that private firms would face low interest rates

and low tax rates, which in turn would encourage them to hire and expand,

thereby generating prosperity for the whole economy.

However, this approach is not working too well in the United Kingdom,

where it has been implemented. Conversely, in Scandinavian countries, where

governments remain big, innovation and productivity growth rates remain high.

In this paper we argue that it is not so much the size of the state that is at

stake, but rather its governance. In other words, it is not so much a reduced state

that we need to foster economic growth in our countries, but a strategic state. The

strategic state would target its investments to maximize growth in the face of

hard budget constraints. This course departs both from the Keynesian view of a

state sustaining growth through demand‐driven policies and from the neo‐liberal

view of a minimal state confined to its regalian functions.

We spell out our view of the “smart state” and apply it to European growth

policy.

2 Philippe Aghion

The Schumpeterian Growth Paradigm

A useful framework within which to think about the role of the state in the

growth process is the so‐called Schumpeterian paradigm (see Aghion and Howitt

1992, 1998). It grew out of modern industrial organization theory and put firms

and entrepreneurs at the heart of the growth process. The paradigm relies on two

main ideas.

First idea: long‐run growth relies on innovations. These can be process

innovations, namely to increase the productivity of production factors (for

example, labor or capital); product innovations (introducing new products); or

organizational innovations (to make the combination of production factors more

efficient). These innovations result from investments like R&D, firms’

investments in skills, the search for new markets, and so forth that are motivated

by the prospect of monopoly rents for successful innovators. When thinking

about the role for public intervention in the growth process, an important

consideration is that innovations generate positive knowledge spillovers (on

future research and innovation activity) that private firms do not fully

internalize. Thus private firms under laissez faire conditions tend to underinvest

in R&D, training, and other knowledge‐supporting activities. This propensity to

underinvest is reinforced by the existence of credit market imperfections that

become particularly tight in recessions. Hence an important role for the state is as

a co‐investor in the knowledge economy.

Second idea: creative destruction. Namely, new innovations tend to make old

innovations, technologies, and skills obsolete. Thus, growth involves a conflict

between the old and the new: the innovators of yesterday resist new innovations

that render their activities obsolete. This also explains why innovation‐led

growth in OECD countries is associated with a higher rate of firm and labor

turnover. And it suggests a second role for the state, namely as an insurer against

the turnover risk and to help workers move from one job to another. More

fundamentally, governments need to strike the right balance between preserving

innovation rents and at the same time not deterring future entry and innovation.

This approach offers a natural framework for thinking about growth policy.

For example, policies that have a potential effect on innovation incentives and

therefore on long‐run growth include new patent laws (like the Bayh‐Dole Act in

the United States), the introduction of a single market for goods and services in

Europe (which affects the degree of product market competition), trade

liberalization (which also affects competition), macroeconomic policy (which

affects interest rates and firms’ access to credit over the business cycle), and

education policy (which affects the cost of R&D and training).


A Remark on Growth Policy and a Country’s Stage of

Development

Innovations may be either “frontier innovations,” which push the frontier

technology forward in a particular sector, or “imitations,” which allow the firm

or sector to catch up with the existing technological frontier. The more

technologically advanced a country is, the higher the fraction of sectors that are

already close to the existing technology frontier, and therefore require frontier

innovation to develop further. On the other hand, growth in less‐advanced

countries, where most sectors lie farther behind the current frontier, will rely

more on imitation.

This dichotomy first explains why countries like China grow faster than all

OECD countries. Growth in China is driven by technological imitation, and

when one starts far below the frontier, catching up with the frontier means a big

leap forward. Second, it explains why growth policy design should not be

exactly the same in developed and less‐developed economies. In particular, an

imitative economy does not require labor and product market flexibility as much

as a country where growth relies more on frontier innovation. Also, bank finance

is well adapted to the needs of imitative firms, whereas equity financing (such as

venture capital) is better suited to the needs of an innovative firm at the frontier.

Similarly, good primary, secondary, and undergraduate education is well suited

to the needs of a catching‐up economy whereas graduate schools focusing on

research education are more indispensable in a country where growth relies

more on frontier innovations. This in turn suggests that beyond universal

growth‐enhancing policies such as good property rights protection (and more

generally the avoidance of expropriating institutions) and stabilizing

macroeconomic policy (to reduce interest rates and inflation), the design of

growth policy should be tailored to the stage of development of each individual

country or region.

This in turn offers responses to the view of Easterly (2005) that policy does

not matter for growth once controlling for institutions; to the Washington

Consensus view; and to the Growth diagnostic approach of Hausmann, Rodrik,

and Velasco (2002) whereby observed prices can help identify the binding

constraint on growth. To Easterly, an answer is that he looked at the effect of

policies independently from the countries’ stage of development. However, the

positive effects of a particular policy in some countries (for example, in more

advanced countries) may well be counteracted by its negative effects in other

countries. Instead, our approach calls for growth regression exercises where

policy is interacted with other variables such as the degree of technological or

institutional development in the country. To the advocates of the Washington

Consensus, our answer is that while macroeconomic stability and property right

protections appear to be universally growth‐enhancing factors, there are other

4 Philippe Aghion

factors to consider. When we go further and assess the growth impact of

competition policy, of various ways of designing education systems, of the

choice of exchange rate systems, or of the design of labor or credit markets,

knowing a country’s level of technological or institutional development appears

to be key. To Hausmann, Rodrik, and Velasco, our answer is that growth

regressions (particularly when also performed at more disaggregated levels, like

industry or firm levels, or at the regional level) appear to do a better job than

observed prices at encompassing possible intertemporal knowledge externalities

involved in the various types of investments.

Growth‐Enhancing (Supply‐Side) Policy in

Developed Economies

The above discussion suggests that supply‐side policies aimed at increasing

growth potential are appropriate in developed economies where growth is

primarily driven by frontier innovation. A first lever of growth in developed

economies is investment in the knowledge economy, particularly in in higher

education and research. Innovation‐driven growth requires the development of

high‐performing universities, particularly at the graduate school level (university

performance is measured both in terms of the volume and quality of publications

and in terms of students’ subsequent labor market success); it also requires firms

to invest more in R&D. A second lever is increasing product market competition

and labor market flexibility: the idea is that innovation‐based growth goes along

with a higher degree of firm and job turnover. This in turn results directly from

creative destruction as discussed above. Product market competition ensures that

entry by new innovators will not be deterred by incumbent firms. Whereas labor

market flexibility reduces the hiring and firing costs faced on the labor market by

new entrants, and it also helps existing firms to start new activities while closing

some old activities.

Some of these policies—for example, the enhancement of higher education

or the provision of subsidies and other inducements to R&D investment by

private firms—appear to require public support on a long‐term basis. Examples

of such policies include the excellence initiatives for universities in Germany or

France, the small business acts in the United States and other OECD countries,

and sectoral policies aimed at fostering innovation in selected sectors. Other

policies, such as the liberalization of product and labor markets, seem to require

more targeted and transitional support from governments. Examples of such

policy actions include setting up flexsecurity systems or partial employment

schemes and the transition to new labor or product market rules.


Investing in Growth while Reducing Public Deficits:

The Strategic State

A main issue facing countries in the euro area, particularly in its southern part, is

how to reconcile the need to invest in the long‐run growth levers mentioned

above with the need to reduce public debt and deficits. To address the challenge

of reconciling growth with greater budgetary discipline, governments and states

must become strategic. This first means to adopt a new approach to public

spending: in particular, they must depart from the Keynesian policies aimed at

fostering growth though indiscriminate public spending, and instead become

selective as to where public funds should be invested. They must look for all

possible areas where public spending can be reduced without damaging effects

on growth and social cohesion. A good example is potential savings on

administrative costs. Technical progress in information and communication

makes it possible to decentralize and thereby reduce the number of government

layers, for similar reasons as those that allowed large firms to reduce the number

of hierarchical layers over the past decades. Decentralization makes it also easier

to operate a high‐quality health system at lower cost, as shown by the Swedish

example.

Second, governments must focus public investments and policies on a

limited number of growth‐enhancing areas and sectors. This state support could

include investment in education, universities, and innovative small and medium

enterprises (SMEs); policy support for labor and product market flexibility; and

investment in industrial sectors with high growth potential and externalities.

Third, governments must link public financing to changes in the governance

of sectors they invest in: how can one make sure that government funds will be

appropriately used? For example, public investments in education must be

conditional upon schools taking concrete steps to improve pedagogical methods

and to provide individual support to students. Similarly, the necessary increases

in higher education investments must be conditional upon universities going for

excellence and adopting the required governance rules. For example, Aghion et

al. (2010) show that investments in higher education are more effective the more

autonomous universities are and the more competitive the overall university

system is (in particular, the more funding relies on competitive grants).

Another area where governance matters is that of sectoral investments

(“industrial policy”). Such investments must preserve if not improve competition

within the targeted sectors, and not reduce it (see Aghion et al. 2012). We discuss

this industrial policy issue in more detail in the next section.

6 Philippe Aghion

Industrial Policy

Since the early 1980s industrial policy has come under disrepute among

academics and policy advisers. In particular, it has been attacked for preventing

competition and for allowing governments to pick winners and losers—and,

consequently, for increasing the scope for capture of governments by local vested

interests.

However, three new considerations have gained importance over the recent

period, which invite rethinking the issue. First, there is increasing awareness of

climate change and of the fact that without government intervention aimed at

encouraging clean production and clean innovation, global warming will

intensify and generate all kinds of negative externalities (droughts,

deforestations, migrations, conflicts) worldwide. Second, the recent financial

crisis has revealed the extent to which laissez faire policies in several countries

(particularly in southern Europe) promoted uncontrolled development of

nontradable sectors (in particular real estate) at the expense of tradable sectors

that are more conducive to long‐term convergence and innovation. Third, China

has become prominent on the world economic stage, thanks in large part to its

constant pursuit of industrial policy.

The existence of knowledge spillovers supports a major theoretical argument

for growth‐enhancing sectoral policies. For example, firms that choose to

innovate in dirty technologies do not internalize the fact that current advances in

such technologies tend to make future innovations in dirty technologies also

more profitable. More generally, when choosing where to produce and innovate,

firms do not internalize the positive or negative externalities this might have on

other firms and sectors. A reinforcing factor is the existence of credit constraints

which may further limit or slow down the reallocation of firms towards new

(more growth‐enhancing) sectors. Now, one can argue that the existence of

market failures on its own is not sufficient to justify sectoral intervention. On the

other hand, there are activities—typically high‐tech sectors—that generate

knowledge spillovers on the rest of the economy, and where assets are highly

intangible. Such intangibility makes it more difficult for firms to borrow from

private capital markets to finance their growth. In such cases there might indeed

be a case for subsidizing entry and innovation in the corresponding sectors, and

to do so in a way that guarantees fair competition within the sector. Note that the

sectors that always come to mind are always the same four or five sectors,

including energy, biotech, information and communication technology (ICT),

and transportation.

To our knowledge, the most convincing empirical study in support of

properly designed industrial policy is by Nunn and Trefler (2009). These authors

use microdata on a set of countries to analyze whether, as suggested by the

“infant industry” argument, the growth of productivity in a country is positively

affected by tariff protections biased in favor of activities and sectors that are


“skill intensive”—that is, using highly skilled workers. They find a significant

positive correlation between productivity growth and the “skill bias” due to

tariff protection. Of course, such a correlation does not necessarily mean there is

causality between skill bias due to protection and productivity growth: the two

variables may themselves be the result of a third factor, such as the quality of

institutions in countries considered. However, Nunn and Trefler show that at

least 25 percent of the correlation corresponds to a causal effect. Overall, their

analysis suggests that adequately designed (here, skill‐intensive) targeting may

actually enhance growth, not only in the sector being subsidized but also the

country as a whole. Below we will stress the importance of sectoral policies that

are not only adequately targeted but also properly governed.1

Thus, using Chinese firm‐level panel data, Aghion et al. (2012) show that

sectoral subsidies tend to enhance total factor production (TFP), TFP growth, and

new product creation, more if they are both implemented in sectors that are

already more competitive and also distributed in each sector over a more

dispersed set of firms. In particular, sectoral investments should target sectors,

not particular firms (or “national champions”).

Taxation

Targeting investments may not be enough to square the circle of reconciling

growth investments with budgetary discipline and additional funding may have

to be found. Some countries can use the fiscal capacity they already have to raise

additional taxes to finance growth investments. Other countries may have to try

and increase their fiscal capacity (although in this case the effects on growth will

be more long term). There is a whole theoretical literature on how capital and

labor income should be optimally taxed. However, somewhat surprisingly, very

little work has been done on taxation and growth, and almost nothing in the

context of an economy where growth is driven by innovation.2 Absent growth

considerations, the traditional argument against taxing capital is that this

discourages savings and capital accumulation, and amounts to taxing

individuals twice: once when they receive their labor income, and a second time

when they collect revenues from saving their net labor income. Introducing

endogenous growth may either reinforce this result (when the flow of innovation

1An adequately targeted policy is, in principle, one that targets a particular market failure (such as

knowledge externalities and financial market imperfections). A particularly interesting case arises

in markets that suffer from imperfect competition. By subsidizing its domestic industries, a

government may give a strategic advantage to domestic firms, and allow them to gain market

shares over foreign competitors. This approach, suggested by Brander and Spencer (1985), suffers

from serious limitations, but could in principle be used to target “key” industries by looking at

their structure. See Brander and Spencer (1985) for a seminal contribution and Brander (1995) for

further insights. 2 See Aghion, Akcigit and Fernandez‐Villaverde (2012) for a first attempt.

8 Philippe Aghion

is mainly driven by the capital stock) or dampen it (when innovation is mainly

driven by market size which itself revolves around employees’ net labor income).

Excessive redistribution may deter innovation and thus growth. However, some

redistribution can help enhance competition by preventing the emergence of an

income‐based fractionalization of society with exclusion of individuals at the

bottom and the top of the wealth‐income distribution. This in turn relates to the

notion of “inclusive growth.”

Demand versus Supply Side

While governments should focus primarily on the supply side when deciding

how to target their investments in the growth process, they should not

completely disregard the demand side. Indeed, firms’ innovation incentives

depend upon the size of the market they serve. The large fraction of the market is

European—even for Germany, half of whose exports are to other EU countries.

Thus, if all EU countries were to embark on austerity policies, the resulting effect

on aggregate demand within the EU might end up deterring innovative activities

by firms across member states. This underscores the important role of automatic

stabilizers aimed at sustaining consumption demand across EU countries over

the business cycle. These stabilizers are implemented by EU countries as

countercyclical fiscal policies, and the ability to pursue such policies is enhanced

if countries can reduce their public debt. Hence also the importance of

subsidizing credit access for households wishing to purchase innovative

manufactured products: recent work by Mian (2012) shows that the tightening of

U.S. credit markets affected economic activity mainly by reducing households’

access to credit, which in turn had a negative impact on firms’ market size.

Macroeconomic Policy

Recent studies (see Aghion, Hemous, and Kharroubi, 2009; Aghion, Farhi, and

Kharroubi, 2012), performed at cross‐country and cross‐industry levels, show

that more countercyclical fiscal and monetary policies enhance growth. Fiscal

policy countercyclicality refers to countries increasing their public deficits and

debt in recessions but reducing them in upturns. Monetary policy

countercyclicality refers to central banks letting real short‐term interest rates go

down in recessions while having them increase again during upturns. Such

policies can help credit‐constrained or liquidity‐constrained firms pursue

innovative investments (such as R&D, skills development, and other training)

over the cycle in spite of credit tightening during recessions, and it also helps

maintain aggregate consumption and therefore firms’ market share over the

cycle as argued in the previous section (see Aghion and Howitt, 2009, ch. 13).


Both countercyclical fiscal and monetary policies encourage firms to invest more

in R&D and innovation. Once again, this view of the role and design of

macroeconomic policy departs both from the Keynesian approach of advocating

untargeted public spending to foster demand in recessions, and from the neo‐

liberal policy of just minimizing tax and public spending in recessions.

Climate

A laissez faire economy may tend to innovate in “the wrong direction.” This

insight is supported by Aghion et al. (2010), who explore a cross‐country, panel‐

data set of patents in the automotive industry. They distinguish between “dirty

innovations,” which affect internal combustion engines, and clean innovations,

such as those on electric cars. Then they show that the larger the stock of past

“dirty” innovations by a given entrepreneur, the “dirtier” current innovations by

the same entrepreneur. This observation, together with the fact that innovations

have been mostly dirty so far, implies that in the absence of government

intervention our economies would generate too many dirty innovations. Hence,

there is a role for government intervention to “redirect technical change”

towards clean innovations.

Delaying such directed intervention not only leads to further deterioration of

the environment. In addition, the dirty innovation machine continues to

strengthen its lead, making the dirty technologies more productive and widening

the productivity gap between dirty and clean technologies even further. This

widened gap in turn requires a longer period for clean technologies to catch up

and replace the dirty ones. As this catching‐up period is characterized by slower

growth, the cost of delaying intervention, in terms of foregone growth, will be

higher. In other words, delaying action is costly.

Not surprisingly, the shorter the delay and the higher the discount rate (that

is, the lower the value put on the future), the lower the cost will be. This is

because the gains from delaying intervention are realized at the start in the form

of higher consumption, while losses occur in the future through more

environmental degradation and lower future consumption. Moreover, because

there are basically two problems to deal with (the environmental one and the

innovation one), using two instruments proves to be better than using one. The

optimal policy involves using (i) a carbon price to deal with the environmental

externality and, at the same time, (ii) direct subsidies to clean R&D (or a profit

tax on dirty technologies) to deal with the knowledge externality.

Of course, one could always argue that a carbon price on its own could deal

with both the environmental and the knowledge externalities at the same time

(discouraging the use of dirty technologies also discourages innovation in dirty

technologies). However, relying on the carbon price alone leads to excessive

reduction in consumption in the short run. And because the two‐instrument

10 Philippe Aghion

policy reduces the short‐run cost in terms of foregone short‐run consumption, it

reinforces the case for immediate implementation, even for values of the

discount rate under which standard models would suggest delaying

implementation.

The State and the Social Contract

One of the main roles of the state is as the guarantor of the social contract—that

is, an economical and social pact on which all the citizens and their government

agree. This pact has to allow the state to control public deficits in a post‐crisis

context while maintaining social peace and avoiding strikes and social protests.

Indeed, the current economic context can be characterized by a weakening of

public finances, a tightening of credit constraints, and a need to correct global

imbalances. While government debts increased a lot during and after the crisis, it

now appears necessary to reduce public deficits while investing in growth at the

same time.

Such a reduction effort won’t be easy, and for it to be accepted by

everybody, it will have to be fairly shared in order to maintain a peaceful social

climate. This supposes that the state will choose to (i) invest in trust, (ii) promote

redistributive policies while reducing deficits, and (iii) fight against corruption.

To understand why it is necessary for the state to invest in trust, one could

remember the following statement made by the Nobel Prize Kenneth Arrow in

1972: “Virtually every commercial transaction has within itself an element of

trust, certainly any transaction conducted over a period of time. It can be

plausibly argued that much of the economic backwardness in the world can be

explained by the lack of mutual confidence.”3

This speech has given rise to a recent literature that studies the links

between trust and various economic outcomes.4 Trust appears positively

correlated with all these outcomes. Moreover, trust is also closely linked to

institutions.5 We want to underscore here the fact that trust is particularly

important for economic growth and innovation.

Closely linked to the trust question is the redistributive nature of the social

contract. Reducing public deficits involves increasing taxes and reducing public

spending in various sectors as discussed above. However, to make this pain

acceptable (and to avoid violent social movements of protestation), the effort will

have to be shared equally. Taxes will have to be increased in a fair (that is,

progressive) way and social expenditures targeted towards the poorest not cut

too much. Moreover, citizens will be more willing to accept tax increases if they

3 http://www.nobelprize.org/nobel_prizes/economics/laureates/1972/arrow‐lecture.html. 4 See, for example, Guiso et al. (2004) on financial development, Guiso et al. (2006) on

entrepreneurship, and Guiso et al. (2009) on economic exchanges. 5 See Aghion et al. (2010, 2011).


know that the fiscal resources will be used in an efficient way by the government

(hence the importance of democracy).

Consider the relevant example of Sweden. Over only four years in the 1990s,

Sweden was able to reduce its public deficit from 16 percent to less than 3

percent of GDP. This was done without reducing the level of public education

and health services provided to the Swedish population (indeed, these services

are still higher today in Sweden than in a lot of other European countries). This

success was mainly the result of Sweden’s efficient and progressive tax system.

Democracy

Our view of the state as a strategic growth investor, with priority sectors and a

concern about governance of those sectors, calls for a reexamination of how

states organize their own governance. In particular, once subsidies become

targeted to particular sectors or activities, then checks and balances on

governments become even more indispensable. First, checks and balances are

needed to make sure that the selection of sectors or activities is not driven by

interest groups activism and lobbying. Second, they are needed to make sure

than sectoral state investments that turn out to be unsuccessful will not continue

to be pursued. Third, they are needed to guarantee that state intervention does

not deter competition and entry of new firms. To this end, it is importance that

media producers and the judiciary system remain truly independent from the

government. Equally important it is to have good and well‐funded institutions to

evaluate the effects of government policies and legislations. In this respect, a

country like France still lies too far behind its counterparts in northern Europe

(see Aghion and Roulet 2011).

Free media minimize the scope for corruption as shown by recent studies.

This in turn reduces entry barriers for new businesses and increases trust in

society, both of which enhance innovation and growth in modern societies

Implications for the Design of a European Growth

Package

The above discussion suggests at least three complementary directions for a new

growth package for the EU and in particular eurozone countries: First, structural

reforms can be implemented, starting with the liberalization of product and labor

markets. Here we will argue that an important role can be played by structural

funds provided the targeting and governance of these funds is suitably modified.

Second, industrial investments can be made along the lines suggested by our

above discussion on the role and design of industrial policy. Here, a recapitalized

European Investment Bank (EIB) together with the project bonds suggested by

12 Philippe Aghion

the European Commission should play a leading role. Third, a more

countercyclical macroeconomic policy can be implemented within the eurozone,

in particular by always relying on structural (that is, corrected for cyclical

variations) measures of public debts and deficits.

1. Structural Reforms and the Role of Structural Funds

There is a broad consensus among European leaders regarding the importance of

structural reforms, in particular product and labor market liberalization and

higher education reform, to foster long‐run growth in Europe. In this section we

first assess the potential increase in growth potential from having all eurozone

countries converge fully or partly to the best standards with regard to product or

labor market liberalization, and also with regard to higher education. Then we

discuss the role that structural funds might play in encouraging such reforms.

Assessing the Growth Effects of Structural Reforms

Using the data from Aghion, Hemous, and Kharroubi (2009), we look at the

effect of structural policies using cross‐country panel regressions across 21

European countries. Our structural indicators are the following:

For higher education system: the share of population 25–64 years old

having completed tertiary education (SUP)

For the product market: an OECD index assessing product market

regulation (PMR)

For the labor market: an OECD index assessing the strictness of

employment protection (LPE).

In fact we focus on the interaction between these two rigidities, namely the

variable PMR*LPE, in the analysis of labor market and product market reforms.

We can look at the short‐ and long‐run growth effects of converging towards

the performance levels of “target countries.” The target groups include those

countries that are found to be the best performers in terms of education, product

market, and labor market regulations. In order to determine these groups, we

rank countries according to the variables SUP and PMR*LPE and we come up

with two target groups: (i) Non‐European target group: United States and Canada;

(ii) European target group: United Kingdom, Ireland, and Denmark. The

advantage of these two target groups is that they allow comparisons between

countries within the EU as well as with non‐European counterparties.

Interestingly, we found the same target groups both for the higher education and

the labor and product market regulation. We could then assess the average effect

of converging towards best practice for the eurozone (European Monetary

Union) as a whole. Our results show that converging towards the best practice in

terms of product and labor market liberalization generates a growth gain of

between 0.3 and 0.4 percent in the short run. Converging towards the best


practice in terms of higher education enrollment generates a growth gain that is

initially smaller (if we take the United Kingdom, Ireland, and Denmark as the

reference countries), but grows up to 0.6 percent by 2050. Altogether, a full

percentage point in growth can be gained through structural convergence

towards those three countries.

Rethinking the Role and Design of Structural Funds

Here we argue that structural funds can be partly reoriented towards facilitating

the implementation of structural reforms. So far, these funds have been used

mainly to finance medium‐term investment projects and to foster socioeconomic

cohesion within the EU. Moreover, these funds are allocated ex ante based on

recipient countries’ GDP relative to the EU average, population, and surface area.

We argue in favor of an alternative approach to the goals, targeting, and

governance of structural funds. On the goals of structural funds: these funds

should become transformative. In other words, they should help achieve

structural reforms in the sectors they are targeted to. In our above discussion, we

identified some main areas and sectors where structural reforms are needed:

labor markets, product markets, and education. Structural funds should aim at

facilitating changes in the functioning of these sectors in the various countries.

The allocation of funds should generally be made on an individual basis: in other

words, they should mainly target schools, employment agencies, individual

workers, but not so much countries. The funds would help finance transition

costs. The allocation of funds should be to well‐specified deliverables, such as

provision of better tutorship in education, improvements in the organization of

employment agencies, transition to portable pensions rights across two or more

countries, and setting up of diploma equivalence for service jobs. Allocation

should be also conditional upon the country or region not having put in place a

general policy that contradicts the purpose of the fund allocation.

Regarding the governance of structural funds, the allocation of funds should

be made by European agencies on the model of the European Research Council:

a bottom‐up approach with peer evaluation ex ante and ex post.

2. A New European Investment Policy

Growth also requires more European investments in growth‐enhancing

activities. Aghion, Boulanger, and Cohen (2011) survey recent studies suggesting

that sectoral aid is more likely to be growth‐enhancing if (i) it targets sectors with

higher growth potential, one measure of it being the extent to which various

industries are skill‐biased; and (ii) it targets more competitive sectors and

enhances competition within the sector.

In that research, we first compare various sectors/activities in terms of their

degree of skill‐biasness and also according to the relative importance of SMEs in

these sectors (a larger fraction of SMEs can in turn be interpreted as reflecting the

scope for increasing competition in the sector). A main finding is that the energy

14 Philippe Aghion

sector is particularly skill‐biased. Then, we look at the EIB’s investment portfolio,

and conclude that growth‐maximization considerations should lead the EIB to

invest more in the energy sector compared to the less skill‐intensive

construction/infrastructure sectors. Finally, we look in more detail at the energy

sector.

The argument for unregulated market operation seems nowadays less

convincing than it might have been in the 1980s, for a number of reasons. First,

the European single market has been associated with a reallocation of production

from the tradable to the nontradable sector, depressing growth prospects. This

may not be related to laissez faire as such but to the fact that the single market is

in fact incomplete and that other important rigidities remain on both product

and labor markets. However, it is still necessary to support adjustment in the

transition and until the single market will be truly complete. Second, climate

change will come with important negative externalities if the costs of the

transition are not at least partly supported from outside.

As we argued above, the new investment policy should not pick individual

winners, but rather should target sectors, in particular those that are more skill‐

intensive (Nunn and Trifler 2010) and/or those that are more competitive

(Aghion et al. 2012). As it turns out, within the EU skill intensity is particularly

low in the manufacturing and wholesale and retail sectors. An industrial policy

picking these sectors would be ill‐advised, for example, if not accompanied by

effective liberalizing measures. By contrast, as suggested by Nunn and Trefler

(2010), an effective industrial policy should focus on the “electricity” sector of the

International Standard Industrial Classification (ISIC) listings, mainly composed

of energy production, processing, and transport activities.

However, if we look at the composition of the EIB’s investment portfolio

within the European Union, we find that the EIB invests about twice as much in

the Transport sector as it does in the Energy sector. This suggests that EU

countries should not only increase the scope of EIB activities, both by

recapitalizing it and by using the European budget as a leveraging device

mobilize additional co‐financing, but also they should make sure that the EIB

and the EU agencies in charge of investment policy, target sectors like energy

with higher growth potential.

3. More Countercyclical Macroeconomic Policies

In previous sections we argued that more countercyclical macroeconomic

policies can help (credit constrained) firms maintain R&D and other types of

innovation‐enhancing investments over the business cycle. One implication of

this for European growth policy design is that all the debt and deficit targets

(both in the short and in the long term) should be corrected for cyclical

variations; in other words, they should always be stated in structural terms. For

example, if a country’s current growth rate is significantly below trend, then the

short‐run budgetary targets should be relaxed so as to allow this country to


maintain its growth‐enhancing investments. However, while the fiscal compact

specifies long‐term objectives that are stated in structural terms, the short‐ and

medium‐term targets agreed between the European Commission and member

states last year are in nominal terms. This inconsistency is can be damaging to

growth.

Conclusion

A successful innovation‐led economy requires a combination of policies,

including investment in the knowledge economy, liberalization of markets, and

governance reform to make the state more strategic. Although the old welfare

states are not well suited to the needs of an economy where growth is driven by

frontier innovation, the minimal state advocated by neo‐liberals may not be the

solution either. Between these two extreme solutions is what we refer to as the

strategic state. It acts primarily on the supply side of the economy and targets its

investments on the sectors or activities with higher expected growth potential. It

is a state that tries to reconcile the need to invest in growth with the need to

achieve budget balance. And it is a state that looks carefully at governance, both

of the sectors it invests in and of itself as investor. Germany or Scandinavian

countries are noteworthy signposts to the strategic state. They reacted to past

crises by implementing structural reforms, both in labor and product markets

and in the organization of the state, and they now have unemployment rates

lower than many other OECD countries and growth rates close to 3 percent.

These lessons should not be lost on us.

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