Inclusive Growth, Full Employment, and Structural Change

Implications and Policies for Developing Asia

Wimbledon Publishing Company

Contents

What Is Inclusive Growth?

We need to make growth more inclusive — to expand access to opportunities so that all can participate, regardless of their individual circumstances.

— Haruhiko Kuroda, ADB's President (2008)

During the last few years, terms such as "harmonious society" in the People's Republic of China (PRC), "sufficient economy" in Thailand, and similar terms in other countries across Asia, have made their way into the discourse of policy makers. The message in all cases is similar: development is more than growth. The Commission on Growth and Development (2008) in its Growth Report also echoes the same sentiment. The Government of India, for example, boasts to have fostered "inclusive growth." By this it means that the budget has increased allocations to school meals or rural road-building. The high-growth policies implemented across the region since the 1960s were successful and led to increases in per capita income and dramatic reductions in poverty, contributing to closing the gap with the developed world. But today a feeling has spread that policies and objectives need to be revised as citizens across Asia demand more than growth. Inequality, productive and decent employment, the environment, health, and climate change are becoming increasingly important in the agendas of policy makers. Institutions such as the World Bank and the Asian Development Bank also acknowledge the issue and argue that growth and globalization have to be inclusive.

What is inclusive growth? Although the term has not been formally defined, Ali and Zhuang (2007, 10) claim that a consensus is emerging as to what it means: "growth with equal opportunities." In a related paper, Ali and Son (2007, 1–2) further argue that inclusive growth is "growth that not only creates new economic opportunities but also one that ensures equal access to the opportunities created for all segments of society. Growth is inclusive when it allows all members of a society to participate in, and contribute to, the growth process on an equal basis regardless of their individual circumstances" (Box 1.1 and Table 1.1 on the PRC).

In this book, I discuss the implications of inclusive growth for policy making in developing Asia. If the term inclusive growth is a useful concept, how should it be interpreted in developing policies? What sort of policies should be implemented to achieve it? What are the constraints and tradeoffs? And finally, can it be achieved? The central argument of the book is that in order to achieve inclusive growth, governments must commit efforts and resources to the pursuit of full employment. The most significant way for a person to participate in society as a valuable member is through a productive and decent job. Moreover, maintaining the economy as close as possible to full employment will lower the need to dedicate resources to set up safety net expenditures. In the final analysis, full employment is the most direct way to improve the long-run well-being of all the people in the country. The questions into which the book is divided discuss different aspects of the link between inclusive growth and full employment and, in so doing, offer a menu of policies that will have to be tailored to each country's circumstances (some proposals may not even apply to some Asian countries). All this implies that governments must set objectives and policies aimed at achieving inclusive growth (Stiglitz 1998). As modern economic theory and historical experience show, markets are the best way to organize the production of goods and services, but in some instances they fail to produce efficient outcomes (e.g., as a result of the existence of public goods, externalities, imperfect information, technology). But of all the market failures, none is perhaps more important for its social consequences than the failure of an economy to utilize its resources fully, especially employment. This is a key tenet of this book.

Does this mean that growth is not important? No, certainly not. Growth is fundamental for developing countries. One of the main themes of this book is the relationship between growth and structural change. This is how I understand the story of the successful developing Asian countries. Understanding the dynamics of structural change is essential for comprehending the difficulties in achieving full employment. However, the elasticity of employment with respect to output in many parts of Asia is not particularly high, and in some cases it has even decreased (Felipe and Hasan 2006, chapters 3 and 4). What does this mean? To cite Felipe and Hasan (2006, 113) in discussing the PRC's employment elasticity: "In the 1980s, it took a 3% growth rate of output to induce a 1% increase in employment. By the 1990s, however, it took more than twice as much growth — about 7.8%, to achieve the same result." In the same vein, the United Nations Conference on Trade and Development (UNCTAD) has also recently claimed that although "most developing economies have seen strong growth in employment or even succeeded in stabilizing or slightly reducing unemployment rates ... open unemployment in developing countries is much less responsive to high growth rates than it is in developed countries. ... The main reason for the low impact of growth on open unemployment in many developing countries and emerging market economies could be the huge reserves of labour that enter the formal economy only after a longer phase of rising demand for labour and increasing wages. As some emerging countries — including [the People's Republic of] China — show, the process of integrating such reserves of labour into more formal labour markets may take many years of fast growth" (2007, II). This is of utmost importance because, as Figure 1.1 shows, the labor forces of many Asian countries will increase significantly in the next two decades.

Indeed, the expectation that labor could be released from agriculture and rapidly absorbed by industry has largely not been realized during the last 15 years. While the share of employment in agriculture has declined in much of developing Asia, labor has found new employment in the service sector (formal or informal) in relatively low-productivity occupations, mostly in trade and personal services. In other words, today, a high-growth economy does not necessarily generate the level and quality of employment that many Asian countries need. And without creation of employment, reduction of poverty will be very difficult. If growth is inclusive, it has to lead to a decrease in poverty; in particular, a faster decline in poverty should be observed for a given growth rate. The empirical evidence, however, indicates that, with the exception of East Asia, the degree of inclusiveness of Asian growth is relatively low ( Pasha 2007). This is especially true in South Asia.

A preliminary conclusion is that policy makers should, perhaps, reverse the causality between growth and employment, and start thinking that a full-employment economy has a lot of virtues, and that full employment is what will lead to high growth, rather than the other way around.

I close this first chapter with the question of whether or not we need the adjective "inclusive." Many may argue that, one way or another, growth benefits the average citizen and, therefore, this adjective is superfluous. The reality, however, is that large segments of society feel that their living standards are deteriorating vis-à-vis those of some privileged groups, so that the gap is widening. In many cases, societies are failing to transform themselves fast enough to provide sufficient productive and decent employment to the increasingly large labor forces. For these reasons and at the risk of laboring the obvious, the adjective "inclusive" plays a role, if only to alert policy makers of the nature and magnitude of the problem.

A telling example is that of the Philippines. In 2007, the country registered its highest economic growth in three decades, 7.3%. However, this growth does not appear to be benefiting the majority of Filipinos. In fact, poverty has increased. Obviously the mere quantity of economic activity, as measured by a common indicator like GDP growth, taken alone, "says virtually nothing about whether life for the common Filipino is getting better or worse. It ignores the distribution of income and makes no distinction between workers with top-paying jobs and those workers who can barely eke out a living. It ignores the fact, for instance, that the record remittances which makes economic figures so rosy have a heavy social toll in terms of broken families. The booming mining industry which the government touts? That has environmental costs, too, which should count for something when you're calculating economic balance."

What Is the Main Constraint that Developing Countries Face?

If the maximum capacity of equipment is inadequate to absorb the available labour, as will be the case in backward countries, the immediate achievement of full employment is clearly hopeless.

— Micha Kalecki (1944, 43)

The fundamental problem of most developing countries is the unemployment and underemployment of an important segment of the labor force. The cause of this problem is the shortage of capital equipment and productive capacity, the latter understood as potential production (Box 2.1). This view is very much consistent with the analyses of the classical authors and with the modern treatment in terms of growth diagnostics of Hausmann, Rodrik, and Velasco (2005). See Box 2.2.

Suppose the quantities produced of two goods x and y might be represented by point p in Figure 2.1, inside the curve. In this case, some of the available resources are clearly not fully utilized (e.g., people are unemployed). Under these circumstances, growth requires higher utilization of the country's production capacity. The country has to try to get closer to the transformation curve. This is the typical problem that most developing countries suffer from.

This does not mean that developing countries do not suffer from inadequacy of effective demand or from allocative efficiency problems. Indeed they do. The problem of markets — that, because of their small internal demand, there will be no outlet for the products of the newly built factories — may limit developing countries' growth rate. Hence, industrialization will prove impossible unless it is oriented toward external markets (even though this problem could potentially be solved if investment were sufficiently high, as this would generate demand for consumption goods). Likewise, effective demand problems can become the binding constraint on production in developing countries at a fairly advanced stage of industrialization (e.g., Malaysia, Thailand, the People's Republic of China) as they can be "balance-of-payments constrained" (McCombie and Thirlwall [1994]; also see section on Export-Led Growth and the Balance-of-Payments Constraint in chapter 16 of this book).

Allocative efficiency problems are also present in developing countries. The combination of goods and services being produced in developing countries is often not the one that maximizes the value of output at the prevailing prices. In Figure 2.2, p' is on the transformation curve. The problem is that the combination of goods and services produced may not be the optimal one, in the sense that it may not maximize the value of total output at the prevailing prices. The relative price of the two goods is shown by line ZZ. Point p is the combination of the two goods that maximizes the value of the goods at these prices. How will growth occur now? By moving from p' to p, i.e., by producing a different combination, even with constant productive capacity. Growth in this case is said to be due to improvements in allocative efficiency. This is a problem that affects mostly developed countries, and their efforts are directed toward eliminating this inefficiency, e.g., through reforms in product and factor markets. Growth, therefore, might occur, even at a constant productive capacity, by producing a different combination of goods and services (which, at the prevailing prices, would lead to a higher output).

But while these problems are pervasive in most developing countries, they are not as important as the lack of productive capacity that prevents the fuller utilization of resources. Indeed, considering the national economy as a whole, the major obstacle to the development of many poor countries in developing Asia is the shortage of productive capacity. This is obvious in policy discussions in countries like India, Pakistan, or the Philippines, where there are constant references to the "low investment" problem. This constraint prevents the elimination of unemployment and underemployment, even when an increase in demand would make the expansion of output profitable.

Developed economies, and a number of semi-industrialized economies, possess adequate capital equipment for the existing labor force. This allows them to generate high labor productivity and, consequently, a high income per capita, provided capital is fully and productively utilized. The problem in many developing countries is different. Their capital equipment, however small, may be underutilized. The problem is that even if equipment were fully utilized, it would not be capable of absorbing the available labor force, leading to low capital–labor ratios. In other words, the problem of many developing countries is the deficiency of productive capacity rather than the anomaly of its underutilization (Kalecki 1966a). Hence, most developing countries are often below full employment. Most likely, the poorer the country, the more important the problem of lack of productive capacity will be; while the more advanced the country, the more important the problem of lack of effective demand will be. From this point of view, the objective of development is to increase productive capacity, and economic development may be described as a generalized process of capital accumulation-cum-structural change.

There is a third possibility to grow in the production possibility frontier framework. This would be an outward shift in the transformation curve. Many growth theories (e.g., the neoclassical model) have concentrated on growth explanations of this type. These theories assume that the countries allocate their available resources efficiently. The problem, therefore, is how to expand the frontier. The truth is that whether productive capacity is fully utilized or not, for economic growth to be sustained over a long period, productive capacity must be expanded. This will result from a dynamic interaction between capital accumulation and technological progress.

The analysis in the previous paragraphs implies that the objective of public policy in developing countries should be to increase productive capacity to attain the full employment (defined as a situation such that no one who is ready and willing to work for an appropriate wage is without a job; chapter 3) of the labor force. Full employment must be the basic measure of a socially just economic policy. This is not an easy objective and it will be discussed in detail. But it will be very difficult (and even almost pointless) for a government that does not place this objective at the top of its agenda and that does not aim at achieving it, to set ambitious objectives for reducing inequality and poverty, and for achieving inclusive growth. What this means is that a society must achieve a "steady expansion of the economy and therewith a steady and reliable increase in the number of workers employed" (Galbraith 1996, 33). This is even more compelling in developing countries, because the ultimate cause of lack of inclusive growth is the nonexistence of adequate employment opportunities (Felipe and Hasan 2006, chapter 1). Therefore, unless governments make full employment their priority, much of their efforts to make growth inclusive will be futile.

Jesus Felipe is Principal Economist with the Central and West Asia Department of the Asian Development Bank, Manila, Philippines. His books include 'Labor Markets in Asia: Issues and Perspectives' (London, 2006).