It is now part of conventional wisdom that large external balances — typified by the bilateral US-China trade relationship — played a major contributing role in the great crash. Global macroeconomic stability requires that we avoid such large current-account imbalances in the future. But a return to high growth in developing countries requires that they resume their push into tradable goods and services. In the past, this push was accommodated by the willingness of the US and a few other developed nations to run large trade deficits. This is no longer a feasible strategy for large or middle-income developing countries.
So are the requirements of global macroeconomic stability and of growth for developing countries at odds with each other? Will developing countries’ need to generate large increases in the supply of industrial products inevitably clash with the world’s intolerance of trade imbalances?
There is in fact no inherent conflict, once we understand that what matters for growth in developing countries is not the size of their trade surpluses, nor even the volume of their exports. What matters is their output of modern industrial goods (and services), which can expand without limit as long as domestic demand expands simultaneously. Maintaining an undervalued currency has the upside that it subsidizes the production of such goods; but it also has the downside that it taxes domestic consumption — which is why it generates a trade surplus. By encouraging industrial production directly, it is possible to have the upside without the downside.
There are many ways that this can be done, including reducing the cost of domestic inputs and services through targeted investments in infrastructure. Explicit industrial policies can be an even more potent instrument. The key point is that developing countries that are concerned about the competitiveness of their modern sectors can afford to allow their currencies to appreciate (in real terms) as long as they have access to alternative policies that promote industrial activities more directly.
So the good news is that developing countries can continue to grow rapidly even if world trade slows and there is reduced appetite for capital flows and trade imbalances. Their growth potential need not be severely affected as long as the implications of this new world for domestic and international policies are understood.
One such implication is that developing countries will have to substitute real industrial policies for those that operate through the exchange rate. Another is that external policy actors (for example, the WTO) will have to be more tolerant of these policies as long as the effects on trade balances are neutralized through appropriate adjustments in the real exchange rate. Greater use of industrial policies is the price to be paid for a reduction of macroeconomic imbalances.
Dani Rodrik, professor of political economy at Harvard University’s John F. Kennedy School of Government, is the first recipient of the Social Science Research Council’s Albert O. Hirschman Prize.
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