In recent decades, failure to sustain economic progress has been blamed on a supposed middle-income country (MIC) trap. Such blaming obscures as much as it supposedly explains.
The ‘middle-income trap’ fable began as a World Bank story about why upper MICs in Latin America failed to become high-income countries (HICs) after pursuing policies required or prescribed by the Bretton Woods institutions.
Bretton Woods’ Frankenstein
The 1944 Bretton Woods rules-based international monetary system ended in August 1971 when President Richard Nixon unilaterally repudiated US obligations. This happened after the US Treasury had borrowed heavily from the rest of the world from the 1960s.
The US government’s ‘exorbitant privilege’ of ‘spending well beyond its means’ has continued despite the resulting international monetary ‘non-system’. Continuing acceptance of the US dollar, or ‘greenback’, as the virtual world currency has enabled its Treasury to borrow internationally at low cost.
This has enabled the US to maintain massive trade and current account deficits, and a military presence in much of the world, despite its huge, but still growing fiscal and trade deficits. The US exorbitant privilege seems to have been sustained by its ‘soft power’ and unassailable military superiority.
Facing ‘stagflation’ – economic stagnation with inflation – US Fed chair Paul Volcker raised interest rates sharply from 1980. This soon killed US inflation, but also Roosevelt’s ‘New Deal’ legacy from the 1930s.
With inflation high, real interest rates seemed low despite high nominal interest rates in the developing world. With growth high in the global South in the 1970s, borrowing to sustain investments, even from abroad, remained attractive.
But US interest rate hikes soon triggered fiscal and sovereign debt crises in many countries: Poland in 1981 was followed by various Latin American, African and other developing economies.
Washington Consensus
Facing rising interest rates, many governments could no longer service accumulated debt, let alone borrow to invest more. Instead, they had to pursue contractionary monetary and fiscal policies domestically, causing economic stagnation.
With Margaret Thatcher and Ronald Reagan demanding such macroeconomic policies, the Washington-based Bretton Woods institutions soon prescribed them, ending the post-Second World War Keynesian ‘Golden Age’.
The International Monetary Fund (IMF) demanded contractionary stabilisation policies to qualify for short-term credit facilities. World Bank structural adjustment programmes (SAPs) typically required economic liberalisation and privatisation for longer-term financing.
The Bank also advocated more export-orientation and foreign investment. When paid by Japan’s government, the Bank celebrated its post-war industrial boom as a ‘miracle’, a new model for emulation. But this soon ended with its demise due to the US-demanded overvalued yen and its ill-advised financial ‘Big Bang’.
Latin American conundrum
Latin American and other vulnerable economies lost over a decade from the 1980s while African economies lost a quarter century. Low-interest official Japanese credit initially mainly went to Southeast Asia, while South Asia took on less foreign debt.
Stabilisation and SAP conditionalities undermined Latin America’s modest industrialisation, which also prevented the region from recovering strongly until the new century. But their economies had not been sufficiently liberalised for ‘neoliberals’ despite turning more to foreign trade and investment from the 1980s.
Prosperous economies became more protectionist, especially after the 2008 global financial crisis. But developing countries were told to open up even more despite shrinking export markets.
But with globalisation over, even East Asia can no longer rely on export growth. Also, it is difficult to turn away from export-oriented production, especially as earlier trade deal commitments cannot be unilaterally repudiated.
In many prosperous economies, workers captured some of their productivity gains. But the oft-heard claim that productivity increases lag behind wage rises usually serves employers. In most ‘labour-surplus’ developing countries, wages remain low.
As in South America early this century, progressive redistribution has often accelerated, rather than subverted growth. Common claims that such redistribution is bad for growth must be critically reconsidered. After all, progressive redistribution sustained growth in post-war Europe.
Breaking out of the trap
The ‘middle-income trap’ argument claims MICs cannot sustain rapid economic progress. Supposed reasons vary with policy and ideological biases, as ostensible structural, cultural, political, behavioural or governance causes typically reflect such prejudices.
Recent narratives have proclaimed the need to ‘graduate’ from secondary to tertiary economic activities. Modern services growth is supposedly needed to sustain progress to become HICs.
Another popular argument has been that progressive redistribution has subverted growth. But it is now uncontroversial that progressive redistribution was crucial for sustaining growth in post-war Europe.
Discretionary state powers have undoubtedly been abused for political patronage and self-aggrandisement. Clientelism plagues many societies, undermining needed state interventions. But we should not throw the baby out with the bathwater.
History suggests the best way to overcome the ‘middle income trap’ would be to implement appropriate investment and technology policies. Selective policies are needed to promote growth, not only of manufacturing, but also of high-end services, as well as safe, nutritious and affordable food supplies.
But all this is not going to happen spontaneously. Reforms need to be deliberately elaborated and sequenced through various interventions as part of well-designed, coherent and sustained initiatives.
Jomo Kwame Sundaram is a prominent Malaysian economist. He is senior adviser at the Khazanah Research Institute, visiting fellow at the Initiative for Policy Dialogue, Columbia University, and adjunct professor at the International Islamic University.
