Is there a role for governments in emerging countries to accelerate economic development by intervening in product and factor markets? Indeed, many successful emerging economies engage in aggressive development and industrial policies, and in particular in policies with a pronounced pro-business tilt. Widespread examples of such policies include suppression or subsidisation of factor prices – such as wage suppression and subsidised input prices.1 In addition, these countries actively utilise production and export subsidies, and provide subsidised credit to particular sectors or firms. Successful countries also often pursue export-ledgrowth strategies that encompass a number of ‘popular’ policies such as promotion of comparative advantage sectors, competitive exchange rate devaluations, and infant industry protection. Such policies have even been embraced by the World Bank and received support in academic circles – the 2008 World Bank’s Growth Commission report argues that export promotion policies may be beneficial, at least as long as they are only temporary; similarly, Lin (2012) argues in favour of comparative advantage policies, and Rodrik (2008) in favour of exchange rate devaluations.
From a neoclassical perspective, such policies are, of course, unambiguously detrimental.2 But matters are different in a frictional environment. In our recent work, we show that when production is carried out by financially constrained entrepreneurs, many of the development policies used in practice are in fact beneficial in the early stages of economic development (Itskhoki and Moll 2018). Specifically, we show that optimal development policies involve interventions in both product and factor markets, and have a distinct pro-business tilt in the early transition, when the industrial sector is undercapitalised. Later on in the transition, the optimal policy interventions change their tack and become pro-labour, taxing the business sector in favour of greater redistribution. Failing to reverse the tilt of the policies can largely wipe out the welfare benefits of the interventions, suggesting an important caveat for practical implementation.
The stage-dependence of the optimal policies provides an efficiency rationale for the different market institutions adopted by emerging Asian and developed European countries, without relying on differences in preferences or political systems.3 In practice, of course, many of the policies are frequently adopted for reasons other than fostering development – for example, due to political, ideological, or rent-seeking considerations (e.g. Harrison and Rodríguez-Clare 2010). Yet, our analysis suggests that successful growth episodes may have occurred not despite but, at least in part, due to the adoption of such policies.
Our analysis relies on a standard growth model with financial frictions, in which heterogeneous producers face borrowing constraints that result in capital misallocation. Such models have become a workhorse in the macro-development literature and are frequently used to study the relationship between financial development and aggregate productivity (see, for example, the handbook chapter by Banerjee and Duflo 2005). We study the dynamic optimal policies in such an environment and their implications for a country’s development trajectory.
Under laissez faire, financial constraints and the ensuing capital misallocation result in depressed productivity and output. We show that the government can intervene to accelerate the transition and increase welfare of allindividuals in such an environment. Early on in the transition, pro-business policies shift resources towards entrepreneurs resulting in higher profits and faster wealth accumulation. This in turn relaxes borrowing constraints in the future, leading to higher labour productivity and wages for workers. In other words, the planner finds it optimal to hurt workers in the short run with longer work hours and lower pay, so as to reward them with higher wages and shorter work hours in the medium and long run. Perhaps surprisingly, we show that such pro-business development policies are optimal even when the planner puts zero weight on the welfare of entrepreneurs, when the workers are finitely lived and face borrowing constraints, and when the planner is present-biased in favour of current generations.
The inefficiency of the laissez fair eequilibrium emerges from the market’s failure to allocate capital to its most productive use and to equalise the productivity of capital across individuals. In particular, financially constrained entrepreneurs have a high rate of return on capital, but cannot invest and expand production because they lack collateral to secure additional borrowing. The policy interventions aim to alleviate this inefficiency. In principle, the inefficiency could be resolved with large lump-sum transfers to individual entrepreneurs. But this is likely an infeasible or unrealistic policy for a variety of reasons. In the more realistic case where such lump-sum transfers are not available, the government should instead use all available policy tools at its disposal, including labour, credit, and production subsidises, in order to shift resources towards constrained productive entrepreneurs.
An alternative way of thinking about the inefficiency of the laissez faire outcome is a dynamic pecuniary externality (Greenwald and Stiglitz 1986) – workers do not internalise the fact that working more leads to faster wealth accumulation by entrepreneurs and higher wages in the future. The planner corrects this using a Pigouvian subsidy. This pecuniary externality mechanism is similar to a learning-by-doing externality, whereby working more today increases future productivity (e.g. Krugman 1987). As a result, some of our policy implications have a lot in common with those that emerge in learning-by-doing economies, however, for quite different microeconomic reasons.
Policies in a multi-sector economy
Perhaps the most policy-relevant extension of our analysis is to an environment with multiple sectors, some tradable and some non-tradable. We show that the optimal policy subsidises sectors with a latent comparative advantage and, under certain circumstances, involves a depreciated real exchange rate. Financial frictions create a wedge between the short-run and long-run (latent) comparative advantage of a country. In the short run, a country may specialise, against its technological comparative advantage, in the ‘wrong’ sectors, which have accumulated financial resources for historical or political reasons. The allocation of production factors to these sectors bids up equilibrium factor prices, reducing the scale of production and delaying wealth accumulation in sectors of latent comparative advantage. This pecuniary externality results in inefficiency when the latent sectors are financially constrained, and the optimal policy tilts the allocation of resources towards these sectors, speeding up the transition (as we illustrate in Figure 1).4
Figure 1 Optimal subsidy to a latent comparative advantage sector
Note: The figure is based on a model simulation in Itskhoki and Moll (2018). Sector 0 has a latent comparative advantage over Sector 1. An alternative interpretation is that Sector 0 has a superior technology, which is operated by a younger financially-constrained cohort of entrepreneurs. Under such circumstances, it is optimal to subsidise the allocation of inputs to Sector 0, as shown in panel a, which results in a more efficient and faster transition, as shown in panel b (solid optimal trajectories vs dashed laissez faire trajectories).
Similarly, if production is carried out by different generations of entrepreneurs, the government should favour the younger cohorts, akin to infant industry protection. In other words, unlike in a neoclassical world, financial frictions mean that the government should tax old established industries in favour of new emerging industries. The rationale is that young industries have not yet had the opportunity to accumulate sufficient net worth to escape financial constraints.
Lastly, we consider the conditions under which a government may seek to depreciate the real exchange rate as part of optimal policy. As a general rule, the government shall prefer to shift resources across sectors using more direct production or input price subsidies instead of recurring to capital controls, which affect the path of the real exchange rate. However, in the absence of these more direct policy instruments, the government should intervene dynamically, causing a temporary real exchange rate depreciation thereby favouring tradable production. Consequently, even when the goal of the government is to compress wages and shift labour towards tradable production, the implications for the real exchange rate are sensitive to the set of the available policy instruments, making it an inconvenient target for policymakers.
The presence of financial frictions opens the door for welfare-improving government interventions in product and factor markets. The optimal development policy interventions feature a pro-business tilt early on in the transition, but then change towards a more redistributive pro-labour stance as the economy accumulates financial wealth. Our normative analysis provides an efficiency rationale, but also identifies caveats, for many of the development policies actively pursued by emerging economies.
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 For example, South Korea in the 1970s imposed an official upper limit on the growth of real wages. South Korea’s Economic Planning Board directed firms to keep nominal wage growth below 80% of the sum of inflation and aggregate productivity growth, which resulted in real wage growth lagging behind productivity growth. Labour unions were also restricted. On the anecdotal side, president Park Chung Hee in his annual national address declared 1965 a “year to work,” and twelve months later, he humourlessly named 1966 a “year of harder work”. In addition, user fees for electricity, water, transportation, communications, and other services for export manufacturers were also kept under government price control; and the most successful companies were rewarded with preferential access to credit and exempted from indirect taxes on income earned from export sales. In an online appendix, we provide a detailed review of some of the development policies in seven East Asian countries that have experienced episodes of rapid growth: Japan (during 1950–70), Taiwan (1950–80), South Korea (1960–80), Malaysia (1960–90), Singapore (1960–90), Thailand (1960–90) and China (1980–present).
 For example, Cole and Ohanian (2004) take a neoclassical approach to quantify the effects of Franklin Roosevelt’s New Deal policies, which increased the monopoly power of both unions in the labour market and businesses in the product markets. They find a substantial detrimental effect from these recovery policies, which were offset only after WWII.
 Many Asian countries take a strong pro-business stance in the labour market, by halting unions and giving businesses an effective monopsony power. The governments of wealthier European countries, on the other hand, tilt the bargaining power in favour of labour by providing generous unemployment insurance and a strict regulation of hiring and firing practices. Our analysis suggests that the adoption of European pro-labour-style labour market institutions in Latin America might have become an important hindrance for the fast catch-up growth in these countries. Botero et al. (2004) document and provide a comparative analysis of labour market institutions across countries. From a historical perspective, pro-business policies were adopted by 18thcentury Britain during the period of rapid industrialisation (see Ventura and Voth 2015), and were also advocated in the US by Alexander Hamilton in his 1791Report on Manufactures.
 Of course, identifying the latent comparative advantage sectors may be a challenging task in practice, and caution is in order when implementing such policies (e.g. Stiglitz and Yusuf 2001; as well as two empirical approaches to this challenge in Hidalgo et al. 2007 and Lin 2012).