by L Burlamaqui · Cited by 1 — paper suggests that “convergence” and “catch-up” are, from a Schumpeterian perspective innovation processes are in effect firms trying to imitate other successful companies
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Page 1 of 20 Development Theory: Convergence, Catch – up or Leapfrogging and Finance ? Leonardo Burlamaqui 1 and Rainer Kattel 2 Abstract The paper offers four propositions for discussion. First, it argues that instead of the often – assumed convergence among nations, history shows us that divergence is a more appropriate way to conceptualize development trajectories; and that this is especially visible in the last century. Second ly , the paper suggests that convergence and – are, from a Schumpeterian perspective, theoretically inadequate concepts as they frame development narratives similarly to the Rostovian idea of a linear path towards some sort of Thirdly, we outline this Schumpe terian framework, centered on the concept of leapfrogging through innovation. T he paper concludes by point ing out that macrofinancial coherence and financial governance are essential dimensions of such alternative framework although under resear ched – for understanding development trajectories. Resumo O trabalho sugere quatro pontos para discussão . O primeiro é que divergência e não convergência tecnológica ou de trajetória s de desenvolvimento é a norma na história do desenvolvimento, e um f enômeno especialmente visível no último século . O segundo é que convergência e – são, de uma perspectiva calcada na concorrência Schumpeteriana, conceitos teoricamente inadequados para explicar as referidas trajetórias na medida em que ambos impl icam uma espécie de imposto à Em terceiro lugar, propomos de forma compacta os contornos de uma abordagem analítica centrada no conceito de leapfrogging (ultrapassagem) pela via das inovações. Por fim, o trabalho salienta a importância da Macrofinança em particular a estrutura do sistema financeiro , sua relação com os processos de financiamento e com a governança financeira como elemento tão importante , ainda que pouco pesquisado , quanto as variáveis tecnológicas nas teorias do desenvolvimento, quando se trata de explicar trajetórias bem sucedidas. Área: Crescimento, Desenvolvimento Econômico e Instituições Códigos JEL : 01, 033,038. 1 Professor of Economics at the State University of Rio de Janeiro, Brazil. 2 Professor of Innovation Policy, Tallinn University of Technology, Estonia.

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Page 2 of 20 1. Introduction Mainstream development theories differ in many ways. 3 However, they share two key assumptions, which are adopted by most policy makers and embed the of trade, knowledge and finance under the WTO treaties and its multiple descendants. The first assumption is that all economic activities (or all innovations) have inherently the same growth inducing potential and, secondly, that free trade is the best regime for enabling all countries to scale up their comparative advantages and develop. The implication of t hose assumptions is clear: In essence, under a free trade regime, eventually all countries should converge around a certain level of development, provided that they have and and in order to be able to invest. Yet, there is growing evide nce both from heterodox and (discontent) neoclassical economists that at least the convergence corollary that however long it make take, eventually all development is toward a shared equilibrium is in fact not what the data shows us. (See, e.g., Ocampo , Kregel and Griffith – Jones 2007, Reinert 2007, and Rodrik 2007). There are some well – known examples: measured in 1990 international dollars, South Korea had in 1950 almost exactly the same GDP per capita as an average African country (around 860 GK dollar s); by 2012, the difference was twelve – fold. 4 However, diverging fortunes between regions (such as Africa vs. East Asia) and within regions (such as Sweden vs. Greece) seem to be rather the norm in the international economy. This paper aims to show that, if we use a Schumpeterian approach to understand and analyze development processes, divergence , not convergence should be the expected outcome. In other words, differentiation, not homogenization, is the result of Schumpeterian competition and is in fact a n essential dimension of capitalist evolution. It is easy to translate that perspective into a Hirschmanian parlance labeling it as development as an un – balanced growth process (Hirschman 1958; Adelman 2012). In fact, the policy take away we offer is that promoting economic development requires very distinctive policy tools as well as continuous, evolutionary, institutional reforms. A key point of the paper is that the theoretical backing for this policy perspective is that successful economic development involves a leapfrogging process a straightforward dimension of Schumpeterian competition rather than a path towards of convergence or catching up. In other words, development, both successful or not, is not a continuous but rather an abrupt and conflic t – prone process. More precisely, the paper offers four propositions for discussion in this context. First, it argues that instead of the often – assumed convergence among nations, history shows us that divergence is a more appropriate way to conceptualize de velopment trajectories; and that this is especially visible in the last half a century. Second, the paper suggests that convergence and 3 The authors are grateful to Erik S. Reinert and L. Randall Wray for their comments on an earlier d raft of this paper. 4 The Conference Board and Groningen Growth and Development Centre, Total Economy Database, extracted March 2012, http://www.conference – .

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Page 3 of 20 – are, from a Schumpeterian perspective, theoretically inadequate concepts as they frame development narrativ es similarly to the Rostovian idea of a linear path towards some sort of (the technological frontier). We call this equilibrium imposed on Third, the paper outlines this Schumpeterian framework, centered on the concept of leapfrogging through innovation, as a more promising way to address both development theory and the historical trajectories observed since the industrial revolution in Britain. Finally, the paper points out that macrofinancial coherence and Sta te – led financial governance are essential but underdeveloped dimensions of such an alternative framework for understanding development trajectories. In that regard, we submit that while finance was already a core element in analysis, a more refined elaboration of its role came with Keynes, Hyman Minsky and Jan Kregel. Keynes introduced money and financial expectations as central features of the dynamics (Keynes: 1936, Kregel: 1999). Minsky extended that view through the Street where capitalism is conceived as essentially a financial system, and prone to waves of financial fragility and economic vulnerability (Minsky: 1982, 1986). Kregel broadened theories by linking them to development as well as introducing exchange rate instability, derivatives and the international dimension to our understanding of how the financial structure of an economy is, always , a key element of its development path (Kregel: 1998, 2001a, 2001b, 2010, Kregel and Burlamaqui: 2005). The novelty here is not for but macrofinance : the way the financial system works and how it should be structured and governed to effectively foster innovation and development. We use this body of work to attempt a bridging process and propose that successful development as leapfrogging processes are coupled with financial structures and financial governance that enable particul ar countries and their technological and innovation capabilities to engage in a strategy of following as a prelude for surpassing . A core point we are making here is to suggest, following Minsky, that capitalism is essentially a financial system (which ma y deteriorate into a collection of as it did in 2008). But we are also adding the Schumpeterian dimension, by pointing out that under certain institutional and financial arrangements, not fully understood yet, it may also become an innovat ion system creating wealth and a positive sum game for the economy. This framework might help us to rethink how both domestic and international policymaking bodies should think about development processes and in particular how domestic growth and competit iveness policies could be re – shaped. Before we proceed, let us be clear about what we want to propose. In one sense, what we are arguing runs close to what Hikino and Amsden have submitted as a learning to assess late industrialization. (Cf . Hikino and Amsden 1994). However, our claim is either broader or narrower, depending on the perspective one adopts. It is broader in the sense that we are indicating that there is nothing intrinsically new about late industrialization. An appropriate ana lytical framework for analyzing development processes

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Page 4 of 20 or is what is missing. It is narrower in the sense we are not claiming to have invented this analytical framework, we are just borrowing from Schumpeter, Keynes, Minsky and Kregel and, maybe, doing at most some creative adaptation. 5 2. Converging policies, diverging trajectories Since the advent of WTO agreements in 1990s, we witness, globally, a growing homogeneity among economic policies used for development. While emulation of succe ssful policies is historically nothing new (E. Reinert 2009a, S. Reinert 2011), WTO and its descendants (e.g., bilateral agreements) assume universal rules and institutions that should be more or less precisely copied by the developing countries. All these agreements internationally regulate areas that were previously typically left to countries themselves to govern. 6 Consequently, what we witness during past 20 years is a strong convergence in formal policies from patent policies to financial regulation. (See also Karo and Kattel 2010) However, this increasing policy convergence leads, not surprisingly if looked from the perspective we are suggesting, to diverging economic fortunes. In what follows, we do not intend to give an exhaustive empirical overvie w of divergence; rather we offer only snapshots of development trajectories, but hope this extremely condensed discussion suffices to query the idea that successful development trajectories should be understood as processes of convergence and catching up a t work in the global economy. As Figure 1 shows, if we take US GDP per capita as the goal all development processes should convergence and catch up towards, we see that during the last 60 years there is no clear trend of catching up or convergence globally . Indeed, judging from this figure, one can even argue that with the onset of WTO, divergence between regions and between countries has in fact become much more pronounced. Figure 1. GDP per capita as a % of US GDP per capita, 1950 – 2010, regional simple averages, in 1990 GK$. 5 Furthermore, Sch umpeter had important predecessors (such as Marx, Sombart and Veblen, among others) and successors (such as Freeman, Rosenberg, Nelson, and Winter among others), in what follows we use Schumpeter as our departing point because in our understanding he provi des the best combination between a bird s eye view of capitalist dynamics combining economics, sociology, politics and culture with a permanent quest for theoretical and analytical deepness. 6 Many heterodox economists have discussed the impact of WTO on development; thus, e.g., Wade 2003, Gallagher 2005, Shadlen 2003 and 2005, Correa 2000, Li and Correa 2009, and Thrasher and Gallagher 2008 offer useful summaries of these discussions.

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Page 5 of 20 Source: The Conference Board and Groningen Growth and Development Centre, Total Economy Database, extracted March 2012, http://www.conference – ; calculations by the authors. Indeed, we see impressive success stories such as Japan, South Korea, Taiwan and Singapore, that have not only caught up with Western Europe and US but, in the process, changed both the technological and business organization f rontiers, leapfrogged best practices and completely left behind Latin America and what used to be called Soviet Union. In particular the latter region, Eastern Europe and former Soviet republics, experienced massive changes in 1990s and fell rap idly behind East Asian economies that were substantially less developed and poorer only a few decades earlier. As Guerrieri argued already in 1998 less than a decade after the fall of the Berlin Wall , the East Asian economies surpassed Eastern E urope in many industries, not only in traditional product groups, but also in more technologically sophisticated and this is particularly so in – intensive (science based) (1998, 20) While Eastern European share in world trade grew fr om 0.73% in 1980 to 0.95% in 1995, East share grew in the same period from 3.80% to 10.83%. (Guerrieri 1998, 29) This trend is particularly pronounced for science – based industries: Eastern share grew from 0.29% to 0.39% in the period from 1 980 to 1995; East share grew from 4.83% to staggering 17.82%. (1998, 38) One can argue that the transition of Soviet Union was particularly badly managed process were looting and theft were the norm. Furthermore, if we look at Eastern European count ries, such as Hungary, early transition success story with high levels of FDI and high technology exports, we still see a surprisingly similar picture. Figure 2 depicts South and highly diverging fortunes during 25 years since 1980. While South GDP per capita more than quadrupled during this period, Hungary rapidly deindustrializes and her GDP per capita barely raises above the 1980 level by 2005. Figure 2. East Asia (Korea) vs Eastern Europe (Hungary): GDP per person employed, ind ex (1980 = 100) (left axis) and industry value added as % of GDP (right axis ). – 10,00 20,00 30,00 40,00 50,00 60,00 70,00 80,00 1950 1953 1956 1959 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 Africa Europe Latin America China South Korea Former USSR

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Page 6 of 20 Source: World Bank WDI Online database. Today, China is doing on steroids precisely the same as South Korea and other Asian tigers did during the previous decades. If we take, for instance, the development paths followed by Russia and China since the late 1980s, it is clear that there is no convergence whatsoever, but accumulating divergence. As Nee states: in 1990 gross domestic product (GDP) was 60 percent that of Russia, by the end of the decade the numbers had been reversed. While Russia saw an unprecedented increase in poverty, China saw an unprecedented (2007, 6) According to the World Bank (2004), transformative economic growth in China resu lted in a population of 170 million moving out of absolute poverty, accounting for more than 75 percent of poverty reduction in the developing world from 1990 to 2000. explosive economic growth has shown to have self – sustaining momentum. By 2040, T he Economist (16 September 2006, 10) predicts China will emerge as the largest economy in the world. Not surprisingly, international economic institutions now view China as the latest entry in the pantheon of successful developmental trajectories, along wi th South Korea, Taiwan and Japan. A comparison of Asia and Latin America leads us to similar results: no convergence or catching up, but another case of continuous divergence. In a recently published book on the subject, Kevin Gallagher and Roberto 25, 30, 35, 40, 45, 50, 70, 120, 170, 220, 270, 320, 370, 420, 470, Hungary GDP per person employed, index (1980 = 100) Korea GDP per person employed, index (1980 = 100) Hungary industry value added % of GDP Korea industry value added % of GDP

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Page 8 of 20 as Ireland have enjoyed rapid growth and in fact have forged ahead of most developed countries in Europe while others such as Italy and other Southern European economies are falling behind, in particular since the single market c ame to force in Europe in mid – 1980s. Figure 3. GDP per capita of selected European countries as a % of German GDP per capita, 1950 – 2010, regional simple averages, in 1990 GK$. Source: The Conference Board and Groningen Growth and Development Centre, Tot al Economy Database, extracted March 2012, http://www.conference – ; calculations by the authors. Consequently, it is safe to assume that there are different dynamics going on among nations rather than convergence or catching up. Here, a more skeptical, and historically minded, reader might ask: even if that is true for the last three or four decades, what if we go back to the period of convergence and catch – up stori es, the Gerschenkronian 19th and early 20th centuries? The answer to that question is the same: in fact what happened in the comparative histories of industrialization in Britain, USA, Continental Europe (especially Germany) and Japan was creative destr uction and leapfrogging, not catching up or convergence: a succession of episodes of corporations, industries and countries but especially corporations and industries overtaking others and becoming leaders. Thus, for instance, by introducing new method s of production, organization, financing as well as new institutional arrangements, Germany managed around the turn to the 20th century to surpass Britain in steel, chemistry, electricity, big pharma, investment banking and corporate – based research (La ndes 1969, Watson 2011). Similarly, what Japan did, in fact, was to introduce, along with industry specific innovations, a new set of institutional innovations to foster development by means of a very coherent industrial policy (building on Germany, and t he US, as we know). As a result, Japan did not converge with the West. It leapfrogged Europe and became threatening to displace the US as number one by 1980s. Its financial bubble buried 30, 50, 70, 90, 110, 130, 150, 1950 1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 Greece Finland Ireland Italy

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Page 9 of 20 this goal at least for now but the ing the development strategy perfected by Japan, adopted later by its neighbors and now being re – invented by China, enabled it to at least for some time leapfrog and surpass technologically, rather than converge with, most of the developed world (V ogel 1979, Johnson 1982, Dore 1987, Fruin 1992, Studwell: 2013). Conceptually speaking, this is precisely what Britain, Germany, and the US had done before. Leapfrogging through powerful paradigm and/or frontier changing innovations, not convergence or ca tching up. (Perez 2002) The theoretical framework best suited to understand these processes is, we argue, Schumpeterian: Schumpeterian competition and creative destruction performed with borrowed money , embedded into the wider institutional framework and l eading to differentiation, stumbling back, sneaking up and soaring ahead. Before we show the broad contours of that framework, we must take a brief detour and critically appraise the concepts of convergence and catch – up processes. 3 . Convergence and Catch – up: Equilibrium in Development Trajectories? There are many theories that try to explain convergence and catching up. In essence, almost all economic development theories that deal with long – term economic growth, one way or the other, touch upon convergen ce. What follows is again but a snapshot of theories dealing with convergence and catch – up, and is not meant to be an exhaustive treatment. Largely, these theories can be divided into two large schools of thought: first, theories that explicitly or implici tly assume that nations will eventually convergence towards an equilibrium; second, theories that understand international economic development through stages. Convergence theories tend to assume that technology and innovation are exogenous to development and more or less freely available to all, and that countries are similar to each other but for the productive structures. Essentially, for these theories, development is a matter of copying best practice solutions and about getting the institutions right for such copying. (See also Boyer 1993) Convergence theories assume, in sum, that there is one best way of capitalism (in terms of technological, organizational, financial etc capabilities exhibited by leading firms) in any given point in time and that cou ntries will converge towards this best way and equilibrium. Policy and institutions, including international trade agreements, foster movement of all countries towards such equilibrium, or are hindrance to expected convergence. Stage theories of developme nt, 7 on the other hand, assume a variety of economies, but the same route They fall into two large categories: first, static theories that are mostly interested in how various stages of development differ from each other drawing on history (institutional underpinnings, social and political features, etc) and, second, technolo gically rooted stage theories that are mostly interested how and why countries pass from one stage to another and, importantly, may also fall back. In particular 7 Reinert 2009b is an invaluable discussion of economic stage theori es.

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Page 10 of 20 within this latter group of theories, we find concepts and frameworks that help to understan d how countries tend to follow similar – economic but not necessarily end up converging towards a frontier. 8 As for catch – up, it seems to be one of those general purpose concepts given the multiple uses it allows. In a recent book, Nel son, Odagiri, Goto and and Sunami 9 provides the following definition: – up may be defined as the process in which a late – developing country narrows its gap in income (as one may specify by the word catch – and in technological capability (equally catch – vis – à – vis a leading In addition: fact has been evident since, say, the Industrial Revolution of the 18th Century and is now even more so as many industries became technology – (2011, 2 – 3). 10 One ca nnot say that this is a particularly precise definition. It is more like a reference to a multidimensional process that some countries go through and others do not. The authors acknowledge that point even before introducing the concept: be sure, some c ountries did catch – up and some even forged ahead. Some, however, actually fell (2011, 2). This imprecision seems to create a conceptual problem: is catch – up a tendency (an evident fact or a possibility (some achieve it, some do not) for late de velopers? Furthermore, catching up seems to imply convergence (narrowing the income gap) and, apparently, some kind of alignment at the technological frontier , in which case that frontier must be seen as a well defined object that moves incrementally, as in a Solow – Swan growth model. However, if some late developers actually then neither convergence nor alignment are sure to happen. Before we conclude this brief discussion, a mandatory mention to Alexander Gerschenkron is due. Gerschenkron , the doyen of economic history in the United States during the fifties and sixties, was a product of the same milieu Schumpeter has lived, and, like Schumpeter himself, influenced a whole generation of Harvard economists through his required graduate cour se in economic history (Fishlow: 2001). Although often associated with catch – up narratives, his thesis on the of (Gerschenkron: 8 Varieties of capitalism literature could be seen as a sub – form of stage theories, only in this particular framework multiple forms of capitalism are not following each other but rather co – exist as multiple best practices in parallel. 9 Who have worked extensively on the subject (Nelson in particular). 10 By narrowing the income gap , should we understood total GDP, in which case, according to the World Bank Fact Book, Brazil and China are ahead of Sweden and Switzerland, Taiwan comes in as number 24 th and Denmark as 31 st ? Or GDP per capita, in which case (also according to the WB) Qatar, Bermuda, Brunei and Kuwait would have surpassed the US, Germany and Japan comes in as 31 st and 32 nd respectively and China and Brazil are way behind the United Arab Emirates and Greece? As for technological catch – up , how do you measure it? How far are China, India and Brazil from the frontier ? How close is the UK (which produces and exports services, especially financial services)? Productivity and c hanges in productivity might be a better way to look at the dynamics of development trajectories among industries and nations , keeping in mind the nation is a very problematic unit of analysis anyway. Furthermore, narrowing the income gap is a possible re sult, not a given, but divergence, not convergence, a more likely outcome.

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Page 11 of 20 1962: chapter 1) puts him far away from stages theories a la Rostow, and brings him very close to our proposed In his 2001 review of the classic book, Fishlow provides a well – balanced perspective pointing towards that conclusion: Gerschenkron analysis is conspicuously anti – Marxian. It rejected the English Industrial Revolutio n as the normal pattern of industrial development and deprived the original accumulation of capital of its central force in determining subsequent expansion. It is likewise anti – Rostovian. There were no equivalent stages of economic growth in all participa nts. Elements of modernity and backwardness could survive side by side, and did, in a systematic fashion. Apparently, disadvantageous initial conditions of access to capital could be overcome through new institutional arrangements. Success was indicated by proportionally more rapid growth in later developers, signaled by a decisive spurt in industrial expansion (2001: p 1). We cannot delve into a comprehensive discussion of that controversial matter here but would like to suggest that his thesis, more histo rically than theoretically crafted, sides more with Schumpeterian leapfrogging processes than with the other development theories just discussed. Let us conclude this section by re – stating one of our initial points: convergence and – are rather loose ways (or concepts) to frame development narratives and more akin to the idea of a tendency towards equilibrium imposed on history. After all, what it really says is that once a nation manages to by reaching the existing, given technologica l frontier (a process that may or may not happen), it tends to or that development once achieved is self – sustaining, but maybe not even that, since nations can also ahead or fall In order to get a firmer grasp of these process es of structural change where catching – up is temporary, and just a prelude for forging ahead or falling behind , move to the Schumpeterian terrain, and to an alternative framework. 4 . Development Theory as Schumpeterian Competition : Leapfrogging by means of Innovation Economics as a scientific discipline starts with development – oriented questions, such as why some cities, like Venice, surged ahead while others, like Naples, fell behind. In that regard, Antonio 1613 highly si gnificant treatise, titled as A short treatise on the causes that make kingdoms abound in gold and silver even in the absence of mines, with particular reference to the Kingdom of Naples should be taken as a well – argued starting point. It is no coincidence that Schumpeter greatly praised Serra since he defined capitalism as a process grounded on wealth creation (of new things old things out of 1939, 228). To that matter, his, perhaps, oversimplified reflection of Sombart and Weber is telling: Schumpeter argues that it makes no sense to look for a new spirit or new rationalism in order to capitalism, it is rather the process by which capitalism incessantly moves forward innovations and their impact on

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