Rodrik pessimistic on economic growth in developing countries but sees opportunities

Inclusive Economy30 Jun 2015Evert-jan Quak

Economist Dani Rodrik painted a gloomy picture during his lecture at the Overseas Development Institute (ODI) in London last week. He is ‘pessimistic’ (in his own words) because all the evidence he has gathered so far shows that growth in developing economies is running out of steam.

So far, the story about growth in developing countries, especially in the emerging economies, has been mainly positive. So what is going on? Dani Rodrik, Professor of International Political Economy at Harvard University, showed in his lecture that manufacturing will be much less the motor for economic transformation for developing countries in the near future than it has been in the past. The benefits for countries to turn to industrialization, and manufacturing in particular, are diminishing while, at the same time, the service sector is falling short as an alternative motor for economic transformation.

According to Rodrik, what developing countries need to grow is a significant increase in productivity levels across the whole economy. Manufacturing is historically the ideal way to increase productivity levels and achieve growth. For example, productivity increases, together with the mass absorption of many unskilled workers, help the transition from farming to other more diverse job opportunities. Furthermore, as manufacturing products are tradable at global level, the sector can grow without domestic demand.

However, the shape of the manufacturing curve is changing. It reaches a peak far earlier and then falls much more steeply. This applies to both the employment and output shares of manufacturing in gross domestic product (GDP), showing that developing countries are now benefiting less from output and labour absorption in the manufacturing sector.

Especially unskilled workers are facing falling employment opportunities in manufacturing. Manufacturing work needs more skills and it is skilled workers who are now finding job opportunities in new factories in Africa, Latin America and most parts of Asia.

Of course, manufactured products are still tradable but, according to Rodrik, many countries are now specializing in just one area of industrial activity and keep on going and growing within competitive global value chains. This means that, while Korea, Japan and China built large industrial complexes, countries are no longer developing their domestic manufacturing sectors.

Rodrik observed that current growth activities in developing countries are turning more and more into islands of high productivity that are doing well, without any connection to the economy as a whole, which remains quite traditional and typically has low productivity levels. This is what Rodrik calls ‘dualism’: modern activities can co-exist with traditional activities within the economy without any connection between them.

Many developing countries are focusing on the service sector to replace manufacturing. But, according to Rodrik, services are not an ideal replacement for manufacturing. High productivity and tradable services, like finance and insurance, only attract high-skilled workers and could never be the labour absorbing machine that manufacturing was. Furthermore, the bulk of the service sector is low productivity and non-tradable work, like cleaning and security services. It generates jobs, but they are not economic growth poles.

There is not a lot that can be done. Rodrik mentioned two ways in which these trends could be less devastating. First of all, by helping small businesses grow; this is related to the SME debate. Secondly, supporting modern companies could help them expand and be more inclusive. However, with both solutions, the employment-productivity trade off does not look good for the near future. Achieving greater productivity does not automatically lead to more employment, and may even reduce it. That is a stark difference from the manufacturing phase that allowed some Asian countries to grow out of poverty.

As a consequence, the majority of the labour force – even if they have worked in the formal sector before – will in the future find jobs in the informal sector, with low productivity levels and which are non-tradable. If labour moves from high productivity to low productivity, as Rodrik predicts, this will result in higher inequality and will leave only islands of modern activity in developing countries, with a far less optimistic outlook for the economy as a whole.

The debate that followed Rodrik’s lecture, initiated by ODI’s Dirk Willem te Velde and Nick Lea, Senior Economic Advisor to the Chief Economist at the UK’s Department for International Development (DFID), was interesting as many participants tried to find some optimism to contrast Rodrik’s gloomy overview. But they were mainly illustrations of the islands of modern activities that Rodrik was concerned about.

This raises the question whether development professionals are focusing too much on the good stories and best practices and ignoring the fact that such activities will never be the motors of economic transformation. And if that is the case, is that a bad or a good thing? It may be better to accept the new reality, pessimistic as it may be, and find the bright spots and opportunities within that gloomy reality to act as the building blocks for future economic growth.

The answer that Rodrik gave in his lecture was to urge for heterogeneity in development policies to find a new growth path. He also called for greater attention to be paid to the political economy, to focus on the rent-seeking elite that is not willing to take many risks, invest in productivity growth, or expand their businesses due to existing power relations. The only ‘good’ news is that the convergence between North and South will continue. Unfortunately, that it is not due to the strength of emerging economies in developing countries, but because the advanced economies will see even worse growth in the next 15 years.