Shortages of labour, land and an ageing population mean that Sri Lanka’s opportunities for rapid catch-up growth are diminishing and institutional transformation is needed for innovation and output-led growth, a top economist has said.

The first stage of growth involves a poor country catching up with more advanced economies, using inputs like cheap labour and land, involving ‘perspiration’. 
“Once you become middle-income, especially upper-middle-income category, your growth rate inevitably slows down, this model no longer works,” Razeen Sally, Associate Professor of Lew Kwan Yew School of Public Policy in Singapore said.

“We are already seeing that in Sri Lanka. The population begins to age. You have less availability of labour - particularly cheap labour. Capital becomes more expensive. Wasting capital become more obvious, land becomes scarcer.’’

Sally was speaking at an event in Colombo on ‘Asian capitalism and what it means for Sri Lanka’, organised by Advocata Institute, a free market think tank and Echelon, a business magazine.

Inspiration vs. perspiration 

When a country exhausts catch-up growth, a second stage involving innovation, which economist Paul Krugman called ‘inspiration’ or output-led growth, was needed.
“Now you have to use your brains much more, less your sweat or brawn,” Sally said.

Output-led growth requires liberal institutions and a different type of entrepreneurial capitalism.

Economists and thinkers had defined free enterprise and capitalism in different ways.

Economist Adam Smith believed that if people had freedom to produce and consume, with secure property rights, then the market economy would flourish with increased specialisation driving efficiency. “Specialization goes deeper and if you do it across borders with freer trade, it goes wider.”

This was ‘Smithian’ growth. It was not about technology as such and describes the catch-up phase.

Friedrich List, a German, wrote his ‘National System of Political Economy’ against the economics of freedom of Smith. 

While Smith believed in free trade and removing state blockages to entrepreneurship, List advocated state support for business through protectionism and a variety of state interventions, for young and up-coming countries like Germany, to catch up with a leader like Britain.

“And that is an argument for state intervention and industrial policy, particularly to support infant industry - so-called - that has been used in countries like Japan, South Korea and Taiwan,” Sally said. “And that argument finds it echoes here in Sri Lanka.”

Marx in turn had an apocalyptic vision, that capitalism would destroy itself while Weber had an almost religious view. 

Joseph Schumpeter, an Austrian, a finance minister and banker who became a professor at Harvard University and one of the top economist theorists of the 20th century, observed another pattern.

Constant change vs. equilibrium 

In contrast to standard neo-classical economics, which is about a stable equilibrium, Schumpeter’s economic system is highly dynamic. Capitalist economies are constantly changing. Everything is being disrupted and recreated. It is disruptive innovation, which has parallels to ‘Anichcha’ in Buddhism, which means impermanence. It is about constant change, the central agent of which is the entrepreneur. 

“What Schumpeter’s entrepreneur basically does is, beg borrow or steal ideas and turn them into marketable, profitable products - goods and services,” Sally said.
“So, you take inventions and rarely is the inventor the innovator and turn them into innovations. An invention is a new idea. And an innovation is turning that into something for the mass-market, which makes profits, which generates investment, which creates jobs and livelihoods.

Most of the really big ideas of the past like gun powder, the printing press and algebra had come from China and the Middle East. 

‘‘Once you become middle-income, especially upper-middle-income category. We are already seeing that in Sri Lanka. The population begins to age. You have less availability of labour - particularly cheap labour. Capital becomes more expensive. Wasting capital become more obvious, land becomes scarcer

“But they were not innovated in China and the Middle East,” said Sally. 

“They were innovated in Europe by European entrepreneurs in the commercial revolution and subsequent agriculture-industrial revolutions that Europe had but China and the Middle East did not. That is a genuine puzzle.”

Creative destruction

Schumpeter talks about ‘perennial gales of creative destruction’, which is at the heart of his ‘capitalist economic system’. 

“So, capitalism is not about stable equilibrium but about creative destruction,” Sally said. 

“New entrepreneurs swarm around new ideas, inventions. And they turn them into innovations at crucial junctures, in the process destroying old incumbent industries.”
IBM was disrupted by Microsoft and Apple, who will in turn be destroyed by different technologies from more nimble firms.  If the system is open enough, this kind of creative destruction will happen.

“In other words, we cannot have prospering capitalism without this kind of disruption, which can be socially very disruptive,” Sally said.

“This can up end politics, society and indeed the world.”

In poor Asia, there was room for catch-up growth but the opportunities dwindle as countries become richer, so they must move to the Schumpeterian growth, which means improving productivity.

Schumpeterian growth

“You want to improve the efficiency of your inputs, particularly your land, labour and capital. So, it is not the quantity or mass of them but the quality or efficiency.”
Malaysia, Thailand and China had an urgent need for innovation-led growth. The Middle Asian countries were seeing conditions similar to Japan in the 1970s and South Korea in the 1980s, when they exhausted the catch-up period. 

The Asian re-emergence of the last century was based on imitating the West, which was fine in the catch-up phase. Sally said in the first phase, it was possible to grow with weak institutions and rule of law and even corruption. But the changes needed to go forward do not happen automatically.

“You need to be open to international trade,” Sally said. 

“It is crucial. You need to improve labour markets, primary and secondary education; you need to improve hard infrastructure.

Friedrich List would argue that you also need industrial policy. The reality is that results are mixed. Asian Tiger countries have used a combination of policies from the Adam Smith and Friedrich-list textbook but not from the Schumpeterian textbook.”

Liberal institutions and complex reforms

“But when you come to that second stage, when you really need to boost your factors of production, your overall productivity and innovation, not only do you need to get your basics right, you need to improve the quality of your institutions,” Sally said.

“You need to improve the quality of your financial system including regulations, education, skills, better public administration, a more efficient judiciary and legal system, a tax system and bankruptcy procedures, going well beyond the basics.”

The World Bank’s Ease of Doing Business Index was a reflection of how good the business climate and institutions were. Only, Singapore, Hong Kong and Korea were in the global top 10. Taiwan was 15. All are part of rich Asia. For middle and poorer Asia, to join this club, their institutions must be as good but Sally said improving financial systems, legal systems and educations systems is politically difficult and complicated.

“Improving institutions depends on politics,” Sally said.

“So, I have my doubts about Asia being successful in the future as it has in the past.”  

There was a growing belief that China’s ‘Mao and Markets’ system, where a few people at the top made decisions, may allow it to overtake the West. But doubts remained whether real innovation could take place. Sally said there were questions whether people in the top would really give up the power and rents that can be earned in an autocracy.

Sally said innovation is happening in Asia, especially in the digital space. Young people in Asia are adopting digital technologies quickly. In China, a number of tech companies are emerging. The venture capital market in China for tech is now worth US $ 60 billion a year, the same as the US.

China is now promoting some state and private tech firms aggressively in a type of industrial policy. But less efficient state firms are a drag. There is also a crony private sector. Productivity growth is slowing.

Power shift

Meanwhile, the so-called Pax America, which provided a relative stable geopolitical environment, which allowed Asia to grow, is changing, Sally said. There was a possibility of a Chinese-led ‘Pax Sinica’ emerging under different rules.

The US had maintained the peace in Asia and prevented China, India and Japan from going to a major war with each other. After 9/11, the US became increasingly fixated on the problems in the Middle East. Obama was reluctant to intervene in Asia and Trump, a ‘gut isolationist’ is even less engaged.

Another possibility was a power vacuum, which could lead to a major conflict. Meanwhile, it was not a foregone conclusion that the US will continue to pull back and a Pax Sinica will come.

Sri Lanka meanwhile had not done the major reforms required and was coming increasingly under China. Sri Lanka’s current administration had initially got the basics wrong and had to go to the IMF. It was now sticking to a broad programme agreed with the IMF in getting some of the basics right.

But no major reforms had taken place in land, the banking system or education. The reform window was closing and perhaps had already closed, he said.

(Advocata Institute is an independent think tank working to promote sound public policy ideas for a freer and a more prosperous Sri Lanka)