Part 1 of this post here.

The debate Joe Studwell has advanced in How Asia Works (see Sam Roggeveen's three-part interview here) is, in fact, not that novel.

Studwell is not alone in advocating industrial policy: Justin Lin, former World Bank chief economist, makes the same argument in his recent HW Arndt lecture. But even when industry policy succeeds in creating a super-efficient manufacturing sector, Japan reminds us that this doesn't necessarily translate into economy-wide efficiency. In Studwell's strategy, this industrialisation has to be combined with discipline derived from exporting to world markets.

Indonesia (along with just about every success story in Asian development) applied a more economy-wide global discipline: a very competitive exchange rate. The result was a stunning increase in exports and imports (imports provide efficiency-enhancing competition, just as exports do). International trade doubled to around 60% of GDP in the 25 years up to the 1997 crisis.

Indonesia's comparative advantage complicates the story: if a country has natural resources it would be silly not to export them, but this makes it harder for non-extractive industries to find a place in exporting (the 'Dutch disease'). Yet Indonesia's manufacturing exports (mainly textiles and electronics) made up half of exports by the time of the 1997 crisis. Competitiveness was maintained by a tightly managed exchange rate, whatever the IMF was advocating about floating.

Of course this didn't fully meet Studwell's criterion of industry policy being the vehicle for transformational technological transfer, as much of this industrial development took the form of joint ventures using foreign technology.

Nevertheless, Indonesia benefitted hugely from the 'learning by doing' externalities which came with manufacturing (though Indonesia didn't learn how to design a car engine, and even Habibie didn't plan to make his own aircraft engines). And the benefits of foreign investment weren't restricted to manufacturing: finance, hotel management, domestic airlines, telecommunications and lots more were upgraded by global exposure.

What about finance, which Studwell sees as the gate-keeper and driver of the manufacturing revolution and the third part of his three-step development formula (parts one and two discussed in my previous post)? Indonesia under Sukarno had directed cheap finance into favoured industries, disastrously. It continued in the early years of the Soeharto period, nearly as disastrously (Studwell reports the salutary experience with development bank Bapindo). It was this bitter experience, rather than doctrinal adherence to free market principles, that took Indonesia away from dirigist finance.

Studwell correctly identifies the open capital account as a fatal weakness in the 1997 crisis. Indonesia was as successful as Korea in ignoring many aspects of the IMF's free-market doctrine, but with capital flows, the Fund got its way. Other outside pressure also mattered: global capital markets expanded dramatically in the 1990s, and even Korea was not able to withstand this torrent of eager foreign money.

Indonesia accelerated growth from a pace which lagged behind population growth during the Soekarno years to average 7% during Soeharto's three decades (see Table 1). Vigorously promoted birth control reduced population growth. Indonesia went from the Malthusian basket-case portrayed in The Year of Living Dangerously to the burgeoning middle-class economy of today, with all its pluses and minuses.

Income today would be perhaps 50% higher had it not been for the disaster of the 1997-8 crisis. Of course most of the blame must rest with the Indonesians themselves; it's their country. But the Fund totally misunderstood what was happening and wouldn't listen to those who knew better. By the time Korea got into trouble, the Fund had learned from some of its earlier mistakes in Thailand and Indonesia: the support package has to be big enough to restore confidence, and capital outflow controls were needed to contain foreign debt pressures.

Without a contemporaneous political crisis, Korea bounced back quickly. In Indonesia, income per head didn't return to the pre-crisis level for five years. More importantly for the longer term, the entrepreneurial class was destroyed by bankruptcy, manufacturing moved overseas and the finance system was devastated.

Even so, Indonesia is growing at a steady 6% (which doubles income every twelve years). Not so bad for a former basket case still fettered by corruption and mal-administration.

It seems that reasonably competent macro policy is enough to get a good, if not stellar, performance. Can it avoid the middle-income trap? Some people in Indonesia (including at least one presidential candidate) will be attracted to the Studwell interventionist strategy. But without a high level of micro-economic competence, this will be a dead end.

Of course Indonesia could do better: steady 8% annual growth seems entirely feasible, even with the debilitating institutional shortcomings. But it will be achieved by keeping comparative advantage front-and-centre. And, above all, by recognising the limits which politics, history and weak administration place on activist policies.

Photo by Picasa user Abu Katada.