Justin Yifu Lin: The Basics of New Structural Economics

Former Chief Economist and Senior VP of World Bank says development theory goes astray when it mistakes structural difference for mere backwardness.

This article is a comprehensive introduction to new structural economics, as articulated by its proposer, Justin Yifu Lin, former Senior Vice President and Chief Economist of the World Bank (2008-2012).

At the core of new structural economics is the argument that developing countries are structurally distinct economies, with different factor endowments, different comparative advantages, and therefore different paths to industrial upgrading. Their failures stem not from an absence of the industries or institutions found in rich countries, but from policies that ignore the production structure they actually possess.

Developing countries should start with sectors aligned with their current comparative advantage, use those sectors to build savings, capital, and productive capacity, and then upgrade gradually into more sophisticated industries. Technology can be upgraded through latecomer learning, finance should fit the needs of the real economy, capital flows should be opened selectively rather than indiscriminately, and the government should act actively and pragmatically in support of structural transformation

Justin Yifu Lin, Dean of the Institute of New Structural Economics, Honorary Dean of the National School of Development (NSD), and Dean of the Institute of South-South Cooperation and Development at Peking University, delivered the lecture at 太学 TAIXUE, a TED-style lecture series of the New Economist, an online Chinese media outlet, and the first installment of the NSD’s public lecture series.

The compiled lecture transcript was published on the New Economist’s WeChat blog on 6 January 2026.

林毅夫: 新结构经济学的基本点

Justin Yifu Lin: The Basics of New Structural Economics

Hello everyone, I’d like to take this opportunity to introduce new structural economics to you all. Proposed as the third generation of development economics, new structural economics emphasises that countries at different stages of development exhibit structural differences, and these differences are not arbitrary but endogenous. By introducing this perspective, it represents a paradigm shift in the understanding of mainstream neoclassical economics.

Why did I propose the new structural economics?

I would like to take this opportunity to begin with a basic question: if development economics already exists, why is there a need for a new development economics, that is, the new structural economics that I advocated? What is its core meaning?

Theory is meant to help people understand the world and change it. The question, then, is whether the new structural economics that I have proposed can do a better job in helping people understand the world and transform it. Can it explain why, in the past, most developing countries failed, while only a few succeeded? Can it explain why mainstream economics today requires a structural revolution?

Let me conclude with one simple point: Why is it necessary to reflect on development economics?

As everybody knows, the purpose of any theory, whether in the natural sciences or in the social sciences, is to help people understand the world, explain the social and economic phenomena they observe, and, on the basis of that understanding, make sound decisions to transform the world more effectively.

If a theory cannot help people understand reality, then it needs to be re-examined. The same is true if a theory appears persuasive, yet fails when put into practice. In such a case, reflection becomes necessary. Through reflection, existing theories can be improved, and new theories can be developed.

The dilemma of first-generation development economics

Development economics emerged after the Second World War, when most developing countries had freed themselves from colonial or semi-colonial status and began, under their own national leadership, to pursue industrialisation and modernisation in the hope of catching up with the developed countries. To assist these developing countries, a new subdiscipline, development economics, emerged within mainstream economics.

In fact, development economics only emerged as a modern branch of economics after the 1940s. The earliest version of this field is now generally referred to as structuralism. The reasoning at the time appeared quite persuasive: if developing countries wanted to catch up with the developed countries, they needed to reach similarly high income levels; if they wanted to achieve similarly high income levels, they also needed to achieve similarly high levels of productivity.

Why, then, were developed countries more productive? They possessed modern, large-scale technology, advanced capital, and capital-intensive modern industries. By contrast, developing countries remained dominated by traditional agriculture and simple processing industries, both of which were associated with low productivity.

Following this logic, if developing countries wanted to catch up in terms of productivity, they had to develop modern, large-scale, advanced manufacturing industries. But at that time, it was widely believed that this could not be achieved through market forces alone. Advanced, capital-intensive manufacturing requires large-scale investment. Large-scale investment, in turn, requires capital, and capital comes from savings. Yet the finding at the time was that households in developing countries were unwilling to save and tended instead to consume what they earned.

From the perspective of modern economics, a higher interest rate should increase the incentive to save, because price signals are supposed to guide behaviour. But what was observed at the time was that, even when interest rates were raised in developing countries, ordinary households still did not save much. The conclusion, therefore, was that people in those countries did not respond to market prices due to traditional culture and customary ways of life. Such constraints were seen as structural obstacles. That is why this approach came to be known as structuralism.

If the market could not mobilise resources, increase savings, accumulate capital, and support investment in modern manufacturing, then some other mechanism had to do so. At precisely that moment, Keynesian economics was rising in macroeconomics and emphasising the role of government. The government, therefore, was expected to step in directly to mobilise resources, allocate resources, and promote the development of modern, advanced industries. The diagnosis appeared clear, and the prescription also appeared clear.

After the Second World War, this kind of policy was widely adopted, not only in socialist countries, but also in non-socialist developing countries, such as those in Latin America, South Asia, and Africa, to promote national industrialisation and modernisation. Before government intervention, modern products in developing countries were generally imported. Machinery, equipment, and industrial goods all came from abroad. Now the goal was to invest in and produce them domestically. That is why it was called the import substitution strategy.

Under the guidance of this first generation of development economics, namely structuralism, developing countries, by relying on government mobilisation of resources, generally experienced rapid, investment-driven growth for five years, or even ten years. But it was then found that, once these modern manufacturing industries had been established, their efficiency was very low.

There is an English term for this: “white elephant”. Like a white elephant, these industries looked very large, but were slow-moving and highly inefficient. Because efficiency was so low, and because the population in developing countries continued to grow, the demand for employment also kept rising. As a result, this import substitution strategy led to slow economic growth, failed to create sufficient employment, and generated many social and economic problems.

Developing countries eventually found that, under the guidance of the first generation of development economics, namely structuralism, they not only failed to catch up with the developed countries, but, because of various crises and social problems, the gap with the developed countries actually became larger and larger. So, in terms of understanding the world, structuralism seemed very powerful. But when policies based on structuralism were actually put into practice, the result was that the gap with the developed countries widened rather than narrowed. Under such circumstances, reflection became necessary.

Second-generation development economics and the lost two decades

By the 1980s, China had begun reform and opening up. In fact, at that time, both socialist countries and developing countries were undertaking reforms and reflecting on the import substitution strategy and the heavy-industry-first strategy that had been guided by structuralism.

The reflection of the 1970s and 1980s focused on a basic question: after gaining political independence and beginning to pursue national industrialisation and modernisation, why did developing countries experience such low efficiency, and why did the gap between them and the developed countries continue to widen? The view at the time was that these developing countries did not have the kind of well-developed market institutions found in the developed countries. These included prices determined by the market, resource allocation guided by market prices, a government whose role was mainly to maintain market order, and private property rights.

After the Second World War, under the import substitution strategy, these developing countries relied on direct government mobilisation and allocation of resources. As a result, prices were basically not determined by the market, and resources were not allocated by the market, but by the government. In the process of allocating resources, state-owned enterprises were often used to promote development. So the view at the time was that the developed countries had done well because prices were determined by the market, industry was based on private ownership, incentives were stronger, and resource allocation was more efficient. This was the view of neoliberalism, which emerged in the 1970s and became highly influential throughout the 1980s. It is also the view of new institutional economics, which remains highly influential even today.

According to neoliberalism, or new institutional economics, developing countries had performed poorly because there was too much market distortion and too much government intervention. This gave rise to what later became known as the Washington Consensus. According to this view, if developing countries wanted to achieve good economic performance, they had to establish modern and advanced institutions like those of the developed countries. The most basic requirements of such institutions were marketisation, with prices determined by the market, and privatisation, with clearly defined property rights. The responsibility of the government, then, was to maintain budget balance, preserve macroeconomic stability, and promote liberalisation. This was the view of the Washington Consensus.

From this theoretical perspective, the explanation for why developing countries had performed poorly also seemed very powerful. Government intervention in market prices led to the misallocation of resources. And, on the surface, developing countries at that time did indeed appear to suffer from misallocation of resources: the industries the government wanted to develop were inefficient, while industries that were competitive and efficient failed to grow. Government intervention also gave rise to rent-seeking, and state-owned enterprises were generally inefficient. These explanations were highly persuasive. As a result, after the 1980s, the Washington Consensus took shape, and the transformation of developing countries came to be guided by international development institutions. Many people found this highly convincing.

As a result, the transformation of developing countries in the 1980s, the 1990s, and even after 2000 was basically carried out in accordance with the then-dominant second generation of development economics, namely neoliberalism and new institutional economics. But now it seems that, although these theories sounded very persuasive in explaining the problems of developing countries, the developing countries that followed them generally experienced economic collapse or stagnation, repeated crises, and poor performance, whether in the transition of the socialist countries in the Soviet Union and Eastern Europe, or in the countries of Latin America and Africa.

Moreover, during the 1980s and 1990s, that is, during the twenty years dominated by second-generation development economics and neoliberalism, the average growth rate of these countries was actually lower than it had been in the 1960s and 1970s under structuralism, while the frequency of crises was higher. For this reason, some economists have described the 1980s and 1990s, the twenty years dominated by second-generation development economics, or neoliberalism, as the lost two decades for developing countries. From the end of the Second World War until today, the vast majority of countries have remained trapped either in the poverty trap or in the middle-income trap.

Why did the four Asian tigers succeed?

However, there were also a small number of developing economies that achieved very rapid growth during this period, narrowed the gap with the developed countries, and even caught up with them. The vast majority of these economies were in East Asia, especially the four Asian tigers, with which everyone is very familiar.

The four Asian tigers began to grow rapidly after the 1950s. Researchers found that these successful East Asian economies did not follow the structuralist development economics of the 1950s, 1960s, and 1970s. According to structuralist development economics, if a country wanted to catch up with the developed countries, it should develop modern manufacturing industries as advanced as those in the developed countries. But the four Asian tigers started instead from traditional, labour-intensive, small-scale manufacturing.

At that time, the prevailing view was that the productivity of modern manufacturing in the developed countries was so high that it was impossible to catch up by starting industrialisation from traditional, backward, and small-scale manufacturing. This was regarded as the wrong path. Moreover, the mainstream approach at the time was import substitution, whereas the development of this traditional, labour-intensive, small-scale manufacturing in the four Asian tigers was export-oriented rather than import-substituting. So, from the perspective of the mainstream theory of the time, this too was considered wrong. But these economies nevertheless achieved stable and rapid development, became emerging industrialised economies, narrowed the gap with the developed countries, and even caught up with them.

In the 1980s, when all socialist countries were undergoing transition, the prevailing view was that government-led economies under planned systems and import substitution strategies were inferior to market economies. If they were to move towards a market economy, then the institutional arrangements required for a modern market economy should be established all at once. This was shock therapy, also known as the Washington Consensus.

At that time, Vietnam, Cambodia, and the African island country of Mauritius shifted from their earlier import-substituting, government-led development model to a market-oriented model, that is, a market-guided development model. Mauritius began this transition seven years earlier than China. But during their transition, these countries did not follow the mainstream theory of the time by putting in place, in one step, all the institutional arrangements required for a market economy, namely marketisation, privatisation, macroeconomic stabilisation, and liberalisation. What they generally adopted was a gradual, dual-track approach: government intervention was retained, while market-based resource allocation was also allowed to expand. In other words, both the government and the market were present.

In the 1980s and 1990s, this approach was believed to produce even worse results than those under a government-led planned economy. The view at the time was that, if both the market and the government allocated resources at the same time, there would be two different prices: a lower government-set price and a higher market price. This would create rent-seeking and corruption, and would make resource allocation even worse than before. So the conclusion was that, since a government-led planned economy was inferior to a market economy, any successful transition to a market economy required all the institutions of the market to be put in place at one time.

If, as in China at the time, a policy of “old rules for old stakeholders, new rules for new entities” was adopted, so that both the government and the market were allocating resources at the same time, this was then regarded as an economic arrangement even worse than a planned economy or a government-led economy. But looking back now, after more than thirty or forty years, it turns out that among the developing countries in transition, those that were able to maintain stability and rapid growth were precisely the countries whose transition policies had been regarded at the time as wrong.

These successful developing economies share one common characteristic. On the one hand, they are market economies, such as the four Asian tigers, or, in China’s case, economies that moved from a government-led system towards a market economy. So the market does seem to be very important. But these countries and economies also share another feature: the role of government has been very large. If the market is important, that seems to resemble what second-generation development economics, namely neoliberalism, emphasised. But if the government also plays a very important role, that seems somewhat closer to first-generation development economics, namely structuralism, which also emphasised the role of government. So these economies contain traces of both structuralism and neoliberalism. But they are neither structuralist policies nor neoliberal policies.

As mentioned earlier, theory is meant to help people understand the world. But if one looks at the record from the perspective of understanding the world, then the countries that followed the policy recommendations derived from mainstream theory were, by and large, not successful. Theory is also meant to help people change the world. But what has been found is that the countries that followed the highly persuasive mainstream theories generally failed, while the countries that succeeded were, from the standpoint of those same mainstream theories, pursuing the wrong policies. Under such circumstances, reflection becomes necessary. What is the logic behind success in developing countries, whether in development or in transition? That is why I proposed new structural economics.

Returning to Adam Smith’s method

When I first proposed new structural economics, I emphasised that there should be a return to Adam Smith. But when I speak of returning to Adam Smith, what I mean is different from what people usually mean today when they talk about returning to Adam Smith.

Usually, when people speak of returning to Adam Smith, they mean returning to the conclusions set out in The Wealth of Nations: that there is an invisible hand in the market, that the market should allocate resources, that the division of labour is important, and that a constitutional system should be established to support that division of labour. These are the conclusions found in Adam Smith’s The Wealth of Nations.

But when I speak of returning to Adam Smith, I do not mean returning to those conclusions. What I mean is returning to the way Adam Smith arrived at those conclusions.

As is well known, Adam Smith wrote The Wealth of Nations after studying why Britain, and some other European countries in the seventeenth and eighteenth centuries, developed more rapidly than other countries and regions in the world. He asked why they developed so quickly, what lay behind that development, and what the underlying reasons were. It was based on that research that he arrived at those views. So what is being emphasised here is Adam Smith’s method.

In fact, Adam Smith’s research methodology is encapsulated in the title of The Wealth of Nations itself. The full title is An Inquiry into the Nature and Causes of the Wealth of Nations. Based on his study of those European countries that developed rapidly in the seventeenth and eighteenth centuries, he examined the nature of their wealth growth, its causes, and its determining factors. It was from that research that he arrived at such views as the importance of the invisible hand, the importance of the division of labour, and the importance of a constitutional system.

In my view, a body of thought should, as the old saying goes, teach people how to fish rather than simply give them fish, because conditions differ. In fact, the development of modern economics after Adam Smith, and the emergence of new theories, have for the most part followed Adam Smith’s method rather than simply extending his theory. They did not merely add to his theoretical framework, nor simply apply his conclusions. What was truly carried forward was Adam Smith’s method of studying problems: examining their essence and identifying their underlying determinants.

When I proposed new structural economics, I was doing the same thing. The focus was on returning to the essence of the problem and its fundamental determinants, rather than proceeding from the theory of a particular person or the doctrine of a particular school.

The essence of modern economic growth lies in structural transformation

For developing countries, the central concern is, of course, how to develop the economy and how to catch up with the developed countries. It is also well known that, before the Industrial Revolution in the eighteenth century, the world was, in today’s terms, flat, because almost all societies were still in the stage of an agrarian economy.

People back then were largely trapped in poverty, or what may be called the Malthusian trap. Since economic life depended on agriculture, living standards were low, and life expectancy at birth was only about thirty-five years. If society remained stable and the population increased, famine would follow, and then war. Famine and war would reduce the population, per capita cultivated land would increase, output would rise, and then the population would increase again. That is the Malthusian trap.

It was only after the Industrial Revolution in the eighteenth century that rapid growth began to emerge, first in Britain, and later in other countries in Western Europe. According to the research of economic historians, before the eighteenth century, the average annual growth rate of those economies was only about 0.05 per cent. At that rate, it would take roughly 1,400 years for per capita GDP to double. After the Industrial Revolution, however, industrialisation and modernisation began to take shape, and the growth rate of per capita GDP increased twentyfold, from 0.05 per cent to 1 per cent. Then, from the eighteenth century to the middle of the nineteenth century and beyond, with the First Industrial Revolution followed by the Second and then the Third, per capita GDP growth in those early industrialising countries rose further to 2 per cent. The time needed for per capita GDP to double, therefore, fell from 1,400 years to 70 years, and then to 35 years. This is what modern growth means.

Modern growth may be described as a product of the Industrial Revolution. It first appeared in the countries of Western Europe, and later in their settler colonies. Other countries in the world did not keep pace with this trend, and as a result, the gap between them and the early industrialising countries became larger and larger. That is the phenomenon that can be observed.

Generally speaking, the shift from pre-modern to modern growth was reflected, after the Industrial Revolution, in the emergence of those leading countries where technology continued to innovate, industries continued to upgrade, and productivity continued to rise. As productivity increased, infrastructure and the various institutional arrangements also improved accordingly. In essence, therefore, modern economic growth is a process in which structural transformation brings about rising productivity and continuously rising income levels.

It is this phenomenon that I wanted to understand. Guided by the basic Marxist principle that material conditions are primary, and using the methods of neoclassical economics, that is, modern economics, I sought to study the essence of modern economic growth and its determining factors. In other words, the question was how, since the eighteenth century, the economic structure associated with rapid economic development has evolved, what determines those changes, and what effects they produce. This is precisely in line with Adam Smith’s method of studying the essence of a phenomenon and its determining factors.

The naming and core hypotheses of new structural economics

According to the naming convention of modern economics, since my main research concerns structure, the determinants of structural change, and its impact, it should, in principle, be called structural economics. In modern economics, the study of agriculture is called agricultural economics, and the study of finance is called financial economics. So if the subject of study is structure and structural change, it should be called structural economics. But because the first generation of development economics was structuralism, and I wanted to distinguish this framework from structuralism, I called it new structural economics.

As mentioned earlier, new institutional economics is now very influential. Last year’s Nobel Prize winner was a new institutional economist. Why is it called new institutional economics? In fact, as early as the 1960s, Douglass North, who later received the Nobel Prize, began to use the methods of modern economics to study institutions and institutional change. Logically, it should have been called institutional economics. But because there had already been an earlier institutional school in the United States in the late nineteenth and early twentieth centuries that used a different method, the term new institutional economics was adopted in order to distinguish it from the earlier institutional school. In this sense, the “new” in new structural economics has something in common with the “new” in new institutional economics. In both cases, it is used to distinguish it from an earlier school that had a similar name. That is why it is called new structural economics.

What is the main theoretical content of new structural economics? Put simply, new structural economics holds that, at any given point in time, what determines the productivity level of an economy is the industries that exist in that economy at that time and the technologies used by those industries.

The industries and the technologies they use may be called the production structure. At each point in time, the production structure is determined by the factor endowment of the economy and its structure, and it can change over time. Different production structures represent different industries and technologies, and these differ in their scale characteristics, risk characteristics, and transaction characteristics in the market. They therefore require corresponding infrastructure and institutional arrangements. Since the production structure determines the level of productivity, while the quality of infrastructure and institutional arrangements determines transaction costs, productivity is, in fact, embedded in the production structure. Only when transaction costs are sufficiently low can that productivity be released. This is a basic core hypothesis.

What is the logic behind this hypothesis? At any point in time, every economy has factors of production such as capital, labour, and land. The importance of these factors lies in the fact that they are material and that they are the smallest constituent elements of all social and economic activities. Whatever the activity may be, it must be supported by these elements.

At any given point in time, the factor endowment of a country or a society, namely its capital, labour, and land, is in effect the total budget available to that economy at that moment. This is because all activities require land, labour, and capital, and the amount of land, labour, and capital available determines the range of production activities, or of social activities, that can be undertaken. Moreover, in countries at different levels of development, the relative scarcity of capital, labour, and land differs. And that relative scarcity determines the relative prices of those factors. The composition of the same production activity in terms of capital, labour, and land may be the same, but in countries at different levels of development and different factor endowments, because relative factor prices differ, the relative cost of the same production activity will also differ.

Understanding the importance of these relative prices is crucial because factor endowments and their relative scarcity determine the composition of social production activities through their effect on relative prices. If a production activity requires a great deal of land and relatively little capital, then the cost of carrying out that activity will be lower in a country with abundant land and relatively scarce capital. Conversely, if a production activity requires a great deal of capital but relatively little land and labour, then in a country where capital is abundant and therefore relatively cheap, the cost of that same activity will be lower. In other words, a country’s factor endowments and their structure determine the level of comparative advantage it has in particular production activities. It is able to achieve relatively low factor costs in those activities, and those factor costs in fact determine where that country’s potential comparative advantage lies.

Why is it called potential comparative advantage in production? Because market competition is competition in terms of total costs, and total costs are determined by both factor costs and transaction costs, while transaction costs are determined by infrastructure and institutional arrangements.

The structure of factor endowments determines in which production activities a country may have the lowest factor costs, and in that sense, it has a potential comparative advantage. But if that potential comparative advantage is to be turned into an actual comparative advantage, there must be suitable infrastructure and institutional arrangements so that total costs can be brought down.

Appropriate infrastructure and institutional arrangements are, in fact, endogenous to the production structure determined by the factor endowment structure at a given stage of development. Therefore, infrastructure and institutional arrangements must be compatible with the characteristics of the production structure determined by the factor endowment structure. Only then can total costs be minimised, and only then can potential comparative advantage be turned into actual comparative advantage. This is new structural economics.

The optimal approach to fostering firms’ viability and development

In the analysis of new structural economics, there is a very important micro-level concept called the viability of firms. What does the viability of firms mean? It means that industries develop through firms, and if the industry in which a firm operates is consistent with the comparative advantage determined by that country’s factor endowment structure, then the firm can have the lowest factor costs of production. At the same time, if the country in which that industry is located has suitable infrastructure and institutional arrangements, then transaction costs will also be the lowest. Under such conditions, the firm will have the lowest total costs. If a firm has the lowest total costs in both the domestic and international markets, then it will naturally be competitive. It will not need government protection or subsidies. As long as it is well managed, it can survive and develop. This is what is meant by viability.

Conversely, if a firm operates in an industry that goes against the comparative advantage determined by the factor endowment structure, then its production costs will be higher. Or if there is no suitable infrastructure or institutional arrangements, its transaction costs will also be higher. Under such circumstances, it will not be competitive, either in the domestic market or in the international market. It can survive only with government protection and subsidies. In that case, it is nonviable. So in the analysis of new structural economics, viability is the foundation of micro-level analysis. It is a defining and key concept.

The purpose of studying development is, of course, to raise income levels continuously. From the perspective of new structural economics, if income levels are to rise continuously, productivity must also rise continuously. And if productivity is to rise continuously, there must be continuous technological innovation and industrial upgrading, moving towards a production structure that is more capital-intensive and more advanced. Only in this way can the economy develop.

But since the production structure is endogenous to the factor endowment structure, the precondition for moving from industries with low productivity, which are labour-intensive and land-intensive, to industries that are more capital-intensive and technology-intensive, is that the factor endowment structure itself must first change. That means moving from a situation in which capital is relatively scarce to one in which capital becomes relatively abundant. Put differently, it means moving gradually, through capital accumulation, from a situation in which labour and land are relatively abundant to one in which land and labour become relatively scarce. Once such a change takes place in the factor endowment structure, the economy’s potential comparative advantage will also change, and then productivity may rise.

But if potential productivity is to be released, potential comparative advantage must be turned into actual comparative advantage. That means the infrastructure and institutional arrangements required by the production structure determined by the factor endowment structure must be continuously improved. Only then can the economy continue to develop, the structure continue to transform, productivity continue to rise, and income levels continue to increase.

From this analysis, it becomes clear how income levels can be raised. One step back, the key is to raise productivity. And to raise productivity, the factor endowment structure, the production structure, and the infrastructure and institutions must all be continuously improved. But all of this is ultimately built on the most fundamental and material basis at the micro level, namely, factor endowments. In other words, the economy must move gradually from relative capital scarcity to relative capital abundance.

How, then, can capital become relatively abundant? The best way is to choose industries and technologies according to the potential comparative advantage determined by the factor endowment and its structure at that particular point in time, and then to provide the appropriate infrastructure and institutional arrangements. If this can be done, the economy will be competitive, because its total production costs will be the lowest. It will be able to capture the largest possible share of the domestic and international markets, create the greatest possible surplus, and, in industries consistent with comparative advantage, investment will generate the highest returns to capital. The incentive to save will then also be the strongest, and the pace of capital accumulation will be the fastest. Once capital accumulates more rapidly, the speed of capital deepening in the factor endowment structure, the pace of change in comparative advantage, the speed of industrial upgrading, and the rate of economic development will all be the fastest.

The necessity of an effective market and an active government

In this process, of course, technological innovation and industrial upgrading are both necessary for the development of new productive forces. But there is an important difference between developed countries and developing countries. In developed countries, industry and technology are already at the global frontier, so they must invent new technologies and create new industries by themselves. In developing countries, however, the level of industrial technology and productivity is still relatively low.

Technological innovation means that, in the next stage of production, better technologies are used than those currently in use. For developed countries, the technologies they are using are already the most advanced, so they must rely on their own invention. But for developing countries, technology can be introduced, digested, absorbed, and then re-innovated. This is what is called the latecomer advantage. If this latecomer advantage can be used well, then the cost and risk of innovation will be lower than in developed countries, the rate of economic growth will be faster, and the gap with developed countries can be narrowed, until eventually they can catch up.

How can entrepreneurs make decisions in a way that follows this economic logic? As is well known, entrepreneurs pursue profits. They do not ask whether what they are doing is consistent with comparative advantage. So the question is: how can the pursuit of profit by entrepreneurs spontaneously lead them, as new structural economics suggests, to choose industries and technologies according to the potential comparative advantage determined by the factor endowment and its structure at each point in time? This requires an institutional arrangement.

What is that institutional arrangement? It is that the relative prices of factors must accurately reflect their relative scarcity at that point in time. In other words, if capital is relatively scarce, while labour and land are relatively abundant, then capital must be relatively expensive, while land and labour must be relatively cheap. Conversely, if capital becomes relatively abundant, while labour and land become relatively scarce, then wages must rise while capital becomes relatively cheap, or land must become relatively expensive while capital remains relatively cheap.

How can such a price system be formed? Based on current knowledge, and although it is still unclear whether artificial intelligence may change this in the future, so far, the only mechanism that can provide such price signals is a sufficiently competitive market. Only when the prices of various factors are determined through market competition can those prices fully reflect the relative scarcity embodied in a country’s factor endowment structure. If such price signals exist, then in pursuing profit maximisation, entrepreneurs will generally choose industries and technologies in line with the comparative advantage determined by the factor endowment structure. That is to say, in a country where capital is relatively scarce and labour is relatively abundant, entrepreneurs seeking to maximise profits will enter industries that use more labour and less capital. Those are labour-intensive industries.

Once they enter such industries, firms will use more labour and less capital and technology. That is, they will adopt labour-intensive technologies. This is consistent with potential comparative advantage. Conversely, when capital continues to accumulate and becomes relatively abundant, while labour becomes relatively scarce, wages will continue to rise, and the price of capital will continue to fall. In that situation, entrepreneurs, in pursuit of profit maximisation, will enter industries that use more capital and less labour. Those are capital-intensive industries. Once they enter such industries, they will increasingly substitute machines for labour. That means technologies will become increasingly capital-intensive. This is also consistent with comparative advantage. For this reason, an effective market is necessary. That is why the market is so important.

But government is also very important, because the issue here is not one of static resource allocation. It is one of dynamic structural transformation. As the factor endowment structure changes, industries must upgrade, and the economic structure must change. Industries that are consistent with comparative advantage today may lose that advantage tomorrow, while new industries with potential comparative advantage will emerge.

Can these new industries with potential comparative advantage be turned into industries with actual comparative advantage? First, there must be pioneering entrepreneurs who are willing to take risks by entering new, more capital-intensive industries and adopting new, more capital-intensive technologies. This is inherently risky. They may succeed, or they may fail. If they fail, they bear all the costs of failure themselves, but in doing so, they also tell others that the industry or the technology is not suitable, so later entrants can avoid making the same mistake. They may also succeed. Once others see that they have succeeded, they follow, and many firms then enter. Once competition intensifies, the pioneering entrepreneurs no longer earn higher profits than others. So whether they succeed or fail, they provide useful information to later entrants. This is what is called an externality. But the pioneering entrepreneurs themselves bear the full cost of failure.

If pioneering entrepreneurs succeed, yet do not enjoy proportionately greater benefits than others, then they must be given some incentive and compensation. This kind of externality has to be recognised and rewarded by the government. Moreover, whether pioneering entrepreneurs succeed or not depends not only on whether their judgement is correct, but also on whether appropriate infrastructure and institutional arrangements are in place. The improvement of infrastructure and institutional arrangements requires coordination, and some of these must be provided directly by the government. In addition, there are many forms of market failure. For all these reasons, there must also be an active government, one that responds to changes in the factor endowment structure, encourages entrepreneurs to enter new industries with potential comparative advantage, and helps transform those potential comparative advantages into actual comparative advantages, so that firms can become competitive in the market.

This is why new structural economics emphasises both an effective market and an active government. The analytical framework of new structural economics can better explain the internal logic of economic development. As a third generation of development economics, it can better help people understand the world and change it.

Characteristics of successful economies and the “prescription” of new structural economics

When I went to the World Bank as Chief Economist in 2008, the World Bank released a Growth Report. For that project, the Bank invited two Nobel laureates in economics, Robert Solow and Michael Spence, to organise a commission. This commission included more than twenty senior officials who were very familiar with economics in developing countries and had also participated in national economic policymaking. China was represented at the time by Zhou Xiaochuan. The Growth Commission mainly studied 13 economies after the Second World War. Among nearly 200 developing economies, these 13 had performed exceptionally well, all achieving growth of 7 per cent or more per year for 25 years or longer.

As mentioned earlier, from the mid-nineteenth century to the present, the average annual growth rate of per capita GDP in developed countries has been about 2 per cent. If population growth of about 1 per cent is added, then over the past one hundred years or more, the average annual growth rate of developed countries has been about 3 per cent. So if a developing economy can grow at 7 per cent or more, what does that mean? It means that its growth rate is at least twice that of the developed countries, or even higher. After reform and opening up, China, in fact, grew at about three times the speed of the developed countries. If such growth can be sustained for 25 years or longer, then the gap with the developed countries can be narrowed.

It was found that these successful developing economies shared five common characteristics. First, they were basically open economies. Second, they all maintained relative macroeconomic stability. Third, they all had high savings and high investment. Fourth, they all had effective markets, either because they were market economies to begin with or because, like China, they had moved towards a market economy. Fifth, they all had active and capable governments, and in all of them the government intervened in the economy to a considerable extent.

These were the five common characteristics shared by the 13 successful economies. So after the Growth Commission’s report was released in 2008, many developing countries were very excited, because it seemed that the secret of success had finally been found. As a result, Michael Spence, the chairman of the commission, was often invited to give speeches and advise governments. But some leaders from developing countries asked Michael Spence: based on the report of the Growth Commission, how should development policy be formulated? Michael Spence’s answer was that these five characteristics were the ingredients of successful development, but not the prescription.

As everyone knows, ingredients alone cannot cure an illness if there is no prescription. The same medicinal ingredient, under one set of conditions, may be beneficial, but under another set of conditions, or in a different dosage, it may become poisonous. So if there is no prescription, the report is, in fact, of only very limited help in enabling people to understand the world and change it.

Is there, then, a prescription for success? From the perspective of new structural economics, there is. That prescription is precisely what new structural economics proposes: industries and technologies should be chosen according to the comparative advantage determined by the factor endowment structure of an economy at each point in time. That is the prescription offered by new structural economics.

If development follows comparative advantage, there are two institutional preconditions. First, there must be an effective market that can provide the correct price signals. Second, there must be an active government that can help entrepreneurs overcome market failures. These are exactly the fourth and fifth characteristics identified by the Growth Commission. The other three characteristics are, in fact, the results of development in line with comparative advantage.

If development follows comparative advantage and the economy performs well, then exports will naturally increase. Conversely, if something does not conform to comparative advantage, it will be produced less, or not produced at all, and will therefore be imported. In that sense, the economy will necessarily be open. By contrast, if development goes against comparative advantage, then production can only be pursued domestically, imports will be reduced, and limited resources will be used to support industries that do not conform to comparative advantage.

As a result, the industries that do conform to comparative advantage will not be able to develop well, and exports will also decline. So when exports are high, it may appear on the surface to be an export-oriented strategy, but in fact, it is the result of development in accordance with comparative advantage.

Moreover, if development follows comparative advantage, the industries that emerge will necessarily be competitive. In that case, endogenous crises will be fewer. Conversely, if development goes against comparative advantage, the industries that are developed will not be competitive, and many endogenous crises will arise. This is the first point.

What else does development in accordance with comparative advantage imply? It implies more exports, larger foreign exchange reserves, and healthier government fiscal revenues. Under such circumstances, when an external shock occurs, especially one like the shock in 2008, the government will have a stronger capacity to adopt counter-cyclical stabilisation measures. If endogenous crises are fewer, and if external crises can also be dealt with effectively, then the economy will naturally be relatively stable.

Conversely, if development goes against comparative advantage, then many crises are likely to arise internally. And when an external crisis occurs, because exports are fewer, foreign exchange reserves are smaller, and government fiscal revenues are also lower, the capacity to take counter-cyclical action will be weaker. The economy will therefore be more vulnerable to shocks, and there will also be less ability to intervene effectively. So macroeconomic stability is, in fact, also a result of development in accordance with comparative advantage.

The third point has already been discussed earlier. If development follows comparative advantage, then the economy will be competitive, surplus will be greater, accumulation will be higher, and returns on investment will also be higher. So both the rate of return on investment and the rate of accumulation will be high. Conversely, if development does not follow comparative advantage, surplus will be small, the amount available for saving will be limited, and the return on investment will be low. As a result, the willingness to invest will also be low.

Seen in this way, the five characteristics identified by the Growth Commission can in fact be understood as follows: two of them are the institutional preconditions for development in accordance with comparative advantage, as emphasised by new structural economics, and the other three are the results of such development. In this way, the phenomenon can be explained, and it also becomes clear what the prescription is.

Reinterpreting development failures and success stories

The first generation of development economics, namely structuralism, observed that developed countries had high levels of productivity because they had modern manufacturing industries. By contrast, developing countries were still based on traditional agriculture or simple processing industries, and therefore had low productivity. In this sense, it clearly saw the structural difference. It also saw that this structural difference was associated with low productivity, and on that basis, it recommended that developing countries should build modern manufacturing industries. It found that such industries could not be developed through the market alone, and therefore concluded that there was market failure. This explanation appeared quite powerful.

But the recommendation that developing countries should develop the same kind of modern manufacturing industries as the developed countries, in fact, contained a misunderstanding. What it failed to recognise was that industrial structure is actually endogenous to the factor endowment structure. If industries and technologies are chosen according to the production structure of developed countries, then those industries and technologies are consistent with the comparative advantage of developed countries, because in those countries, capital is relatively abundant. But in developing countries, capital is relatively scarce, so those same choices are not consistent with their comparative advantage. And if they are not consistent with comparative advantage, then firms will not have viability.

In reality, developing countries at that time were unwilling to invest in such capital-intensive industries. I think there were two reasons for this. One was that their productivity level was very low, and the surplus they generated was very small. What they produced was barely enough to eat. Under such circumstances, how could savings be expected? Raising the interest rate would not help, either. What they produced was not even enough for subsistence. Survival came first.

So this was not really a market failure. Under that kind of factor endowment structure, there simply was no capacity to invest. And even if the investment was somehow forced through, the costs would be too high, and the investment would not be profitable. So on the one hand, there was no capacity to invest, and on the other hand, there was no incentive to invest. In that sense, what was described at the time as market failure was actually the result of the endowment structure. But this was misjudged, and the endogeneity of the production structure was not understood. As a result, in the industries supported by the import substitution strategy, firms did not have viability. Firms were unwilling to invest, and if they were to be induced to invest, they had to be given protection and subsidies. And even after the investment was made, their production costs remained higher than those in developed countries, so protection and subsidies also had to continue. That is why those industries, which were then called infant industries.

Under such protection and subsidies, resources were misallocated. Once these firms had been established and were operating under government protection and subsidies, they had every incentive to keep telling the government that the existing protection and subsidies were not enough, that they needed more, and that if more were not provided, they would “die”, and with them modern industry would disappear. This naturally gave rise to a great deal of rent-seeking behaviour. In order to obtain more subsidies from the government, firms would bribe officials, and corruption became widespread. So the misallocation of resources, together with rent-seeking and corruption, that could be observed in developing countries at that time were in fact the result of a catch-up strategy that disregarded the country’s material foundations.

Why did a few East Asian economies succeed while the Washington Consensus failed?

Why did a small number of East Asian developing economies succeed? Because they developed labour-intensive industries that were consistent with their comparative advantage. These labour-intensive processing industries were in line with the comparative advantage of developing countries, but not with that of developed countries. Their production costs were therefore lower than those in developed countries. And once the government, in light of the circumstances, provided them with suitable infrastructure and institutional arrangements, their total costs also became low. In that case, they were able to export to developed countries and capture markets there.

Moreover, because this pattern of development was consistent with comparative advantage, these industries were competitive. As a result, they generated more surplus, profit rates were higher, and capital accumulated more rapidly. Once capital began to accumulate quickly, these economies were able, step by step and stage by stage, to make use of the latecomer advantage. At the same time, the costs of institutional innovation, technological innovation, and industrial upgrading remained lower than in developed countries. Their rate of development was therefore faster than that of the developed countries. Gradually, they were able to change their original factor endowment structure, making it increasingly similar to that of developed countries. As that happened, their comparative advantage also became increasingly similar to that of developed countries, until eventually they were able to reach the level of developed countries. This is why East Asia succeeded.

Why, then, did the Washington Consensus fail? One of the main reasons was that it saw only the government interventions and distortions in transition economies, but did not understand that those interventions and distortions existed for a reason. Under import substitution strategies, or under the strategy of catching up through heavy industry, the industries being developed were often inconsistent with comparative advantage, and the firms in those industries were not viable. In that sense, those protectionist measures, subsidies, interventions, and distortions were endogenous. They existed to allow nonviable firms to survive and to allow industries that went against comparative advantage to be established.

If, in accordance with the Washington Consensus, all of these market distortions had simply been removed, then many of the capital-intensive industries that had already been built would not have survived. Many of them would have gone bankrupt, leading to large-scale unemployment. Moreover, among those industries, some distortions could not in fact be removed even through privatisation. For example, every country needs electricity and telecommunications, but in some cases, those sectors could not survive without protection and subsidies. Even after privatisation, they would still require protection and subsidies. There were also industries related to national defence and security. These were capital-intensive and inconsistent with comparative advantage, but without them, national defence and security could be undermined. So even if they were privatised, they would still need protection and subsidies.

And in practice, once such industries were privatised, they often had an even stronger incentive to use the fact that they were inconsistent with comparative advantage, yet burdened with policy responsibilities that the state considered necessary, as a justification for demanding protection and subsidies from the government. In that sense, the incentive for rent-seeking became even stronger.

And when asking the government for protection and subsidies, they would try to influence government officials in all kinds of ways. They might say: “Your salary is only so much, why not give me a little more protection and subsidy? If you do, I can open an account for you in Switzerland and deposit the money there in your name. You can use it after retirement, or your son can use it when he studies abroad.” As a result, corruption became even more serious.

At the same time, in sectors such as electricity and telecommunications, where economies of scale were important, privatisation often gave rise to the oligarchic monopolies seen in the transition of the Soviet Union and Eastern Europe. These monopolies, in turn, interfered with politics and reduced the efficiency of economic operation still further. This was one of the main reasons why shock therapy failed.

The second reason was that neoliberalism, that is, the Washington Consensus, held that government should be limited. Apart from education, national defence, security, the legal system, and social order, the government should not intervene in economic activity. In particular, it should not provide targeted support to any specific industry. In other words, it opposed industrial policy. But once industrial policy is rejected, the old industries may collapse, while some may continue to survive only with reduced protection and subsidies. At the same time, new industries that are in fact consistent with comparative advantage may still fail to emerge, because without government guidance, there is no one to encourage pioneering entrepreneurs, and no one to help provide the infrastructure and institutional arrangements they need. As a result, countries that adopted shock therapy generally experienced premature deindustrialisation. They deindustrialised already at the middle-income stage. Under such circumstances, economic performance was naturally worse.

Advantages of the gradual dual-track reform

Conversely, China’s gradual dual-track reform performed better. The reason is that under the gradual dual-track approach, the old rules were retained for the old stakeholders. In those capital-intensive industries, it was recognised that they were inconsistent with comparative advantage and nonviable, but at the same time, they were regarded as necessary for national development. So protection and subsidies continued, and in this way, stability was maintained.

At the same time, new industries that were consistent with comparative advantage, and that had previously been barred from entry, were now allowed to enter. Not only were they allowed to enter, but industrial parks, export processing zones, and special economic zones were also established, so that infrastructure and institutional arrangements could first be improved within a limited area. In this way, industries consistent with comparative advantage were able to turn very quickly from potential comparative advantage into actual comparative advantage. They therefore became highly competitive, and the economy was able to grow very rapidly. In this way, stability and rapid development were both maintained.

Moreover, once this part of the economy began to grow rapidly, capital accumulated quickly. As capital accumulated, the industries that had originally gone against comparative advantage gradually came to conform to comparative advantage. Once they became consistent with comparative advantage, they no longer needed protection and subsidies, because firms then had viability. The government could therefore begin to remove the original protection and subsidies. This is somewhat similar to what was proposed at the Third Plenary Session of the Eighteenth Central Committee of the Communist Party of China, namely that the market should play a decisive role in resource allocation.

By that stage, after forty years of rapid capital accumulation following reform and opening up, the heavy industries that had originally gone against comparative advantage had in fact become industries in which comparative advantage now existed. Under those circumstances, there was no longer any need to continue providing protection and subsidies. Various forms of government intervention and price distortion that had existed before could therefore be removed, and the market could then be allowed to allocate resources.

Of course, the economy must continue to upgrade its structure, and in the course of structural upgrading, there will also be many new forms of market failure. So the government must continue to play an active role. This is why an institutional arrangement that was once regarded as the worst, and perhaps even worse than a planned economy, in fact proved to be more effective.

The implicit structure dilemma in mainstream economics

Dialectical materialism holds that matter is primary. When this principle is applied to the study of the development of human history, it becomes historical materialism. Historical materialism posits that the economic base determines the superstructure, while the superstructure in turn reacts upon the economic base. So between the economic base and the superstructure, the primary role belongs to the economic base.

The economic base is made up of the productive forces and the relations of production determined by those productive forces. Together, these constitute the economic base. But what determines the productive forces? In Marxist political economy, this question was not really explained in a systematic way. Only recently, after General Secretary Xi put forward the concept of new quality productive forces, has exploration in this area begun.

In fact, the level of productive forces is determined by the production structure of the economy. If an economy is based on traditional agriculture or simple processing industries, then its level of productive forces will be low. If it is based on capital-intensive technologies and advanced manufacturing, then its level of productive forces will be high. But when the level of productive forces is low, workers’ wages are also low, and workers remain very close to the subsistence line. Because wages are low, they can survive only if they have work; without work, they cannot survive. Capitalists, by contrast, can survive on their wealth and do not face the same survival crisis.

Under such circumstances, when workers bargain with capitalists, whether those capitalists are factory owners or landlords, workers are in a disadvantaged position. If they do not work, they cannot survive, whereas capitalists can rely on their wealth to survive. In that situation, workers’ bargaining power is weak, and capitalists are therefore more able to suppress wages and take away more of the surplus.

As the economy develops, capital becomes more abundant, and wages rise. Once wages rise, workers are also able to save. And once they have savings, they can survive for three months, half a year, or even a year without working. But capitalists, as is well known, cannot make capital appreciate if they do not employ labour in production. So at that point, the bargaining position begins to change.

Once capital becomes more abundant and wage levels are higher, workers gain more freedom. Under such conditions, the ability of capitalists to extract surplus labour becomes weaker and weaker. As a result, workers’ conditions, including their working environment, also improve.

It is well known that the production structure determines the level of productive forces, and that the level of productive forces in turn determines the relations of production. From the perspective of new structural economics, since the level of productive forces is determined by the production structure, and since the production structure is in fact determined by the factor endowment structure emphasised by new structural economics, new structural economics provides a way of bringing political economy together with modern economics to examine these traditional propositions.

The various theories of mainstream neoclassical economics are summarised from the experience of developed countries, or are designed to solve the problems of developed countries. When such theories are proposed, they basically take the structure of developed countries as an implicit structure and assume that these theories are universally applicable. What they have not recognised is that countries at different levels of development, in fact, have different structures.

Because these theories assume that their structure is universally applicable, and because that structure is in fact the structure of developed countries, they generally treat it as the only structure. Many theories of macroeconomics are based on what is called a one-sector model, with only one sector, and sometimes even only one factor within that sector, perhaps human capital. In such a theoretical model, there is no qualitative difference between developed countries and developing countries. At most, there is only a quantitative difference.

Some theories may appear to contain structure. For example, in trade theory, there may be labour-intensive industries and capital-intensive industries. But even in those models, it is assumed that the industries of developing countries and developed countries are exactly the same. The only difference is that one country has more capital and another has less, so that one produces somewhat more of the capital-intensive industry and the other somewhat less. But in reality, many industries exist in developing countries and not in developed countries, and conversely, there are many industries that exist in developed countries and not in developing countries.

So modern mainstream economics takes the structure of developed countries as its implicit structure. That implicit structure may be one-dimensional, or it may be two-dimensional. It may contain both labour-intensive industries and capital-intensive industries. But modern mainstream economics still assumes that developed countries and developing countries are fundamentally the same.

The “three-dimensional” revolution of new structural economics

New structural economics holds that countries at different stages of development have different production structures, that is, different industries and different technologies used by those industries. The infrastructure and institutional arrangements appropriate to a country must also be compatible with its production structure. In other words, at different stages of development, the structure of infrastructure and the structure of institutions will also differ. What new structural economics seeks to do, therefore, is to turn the one-dimensional and two-dimensional theories found in textbooks today, which take the structure of developed countries as their implicit structure, into a three-dimensional theory in which countries at different stages of development have different structures.

In such a three-dimensional theory, development is the process of transforming from a production structure with a low level of productivity, together with the infrastructure structure and institutional arrangements suited to it, to a production structure with a higher level of productivity, together with the infrastructure structure and institutional arrangements suited to that higher level. That is what development means.

Transformation, by contrast, means moving from a distorted structure to an undistorted structure. For example, when capital becomes abundant, the production structure should become more capital-deepening. If the production structure does not become more capital-deepening under such conditions, that too is a distortion.

Similarly, if the production structure has already undergone capital deepening in line with the factor endowment structure, but the institutional structure has not been improved in accordance with the needs of the new production structure, then institutional distortion will arise. Such distortion exists because different structural changes require different kinds of decisions, and market failures that need to be overcome are also different. So there will often be a time lag.

In addition, some distortions arise from policies that are well-intentioned but misguided. For example, under the import substitution strategy, when capital is still very scarce, capital-intensive modern manufacturing is nevertheless developed. That is a distortion because it goes against comparative advantage. And once that happens, the corresponding infrastructure and institutional arrangements will also become distorted.

Transformation means moving from a distorted structure to an undistorted one. But what is the biggest difference between transformation in new structural economics and transformation in the current mainstream approach? In the mainstream view today, transformation basically means transforming towards the structure of developed countries: industries are to become the industries of developed countries, and institutions are to become the same as those of developed countries. In new structural economics, however, transformation means transforming towards a structure that is appropriate to one’s own stage of development, including the industrial structure, the infrastructure structure, and the institutional structure. That is transformation.

Then there is the question of economic operation. Since countries at different stages of development have different structures, those structural differences mean that the economies of scale in industries, their risk characteristics, and the forms of market failure they face are also different. Economic operation is, in essence, about how to achieve economies of scale and how to solve market failure. Since economies of scale, risks, and market failures all have characteristics that correspond to a particular stage of development, economic operation will also have its own structural characteristics. Of course, there are common features in economic operation, but there will also be specific features in countries at different stages of development.

As mentioned earlier, if an economy is to develop, it must continuously foster new quality productive forces, and that in turn requires continuous innovation. But innovation does not mean the same thing for all countries. For developed countries, innovation necessarily means invention, because their industries are already at the global frontier. For developing countries, however, the situation is different. In some sectors, they may already be able to compete directly with developed countries, for example, in areas related to the fourth industrial revolution, such as artificial intelligence. But in many other sectors, they are still catching up. In those sectors, introducing, digesting, absorbing, and then re-innovating existing technologies is far less costly and far less risky than relying solely on independent invention. So although countries at different stages of development may share certain common features in economic operation, and innovation is one of them, the way innovation is pursued has its own specificity. If an industry is already at the global frontier, then innovation means invention. But if it is still behind the frontier, then the more appropriate path will often be to introduce, digest, absorb, and then re-innovate. That is where the specificity lies.

New structural economics’ new perspectives on macroeconomics

Under such circumstances, basically every subfield of modern economics can yield new insights. Let me begin with monetary theory, fiscal theory, and cycle theory in macroeconomics. For example, when macroeconomic textbooks discuss monetary theory today, they immediately introduce the idea of monetary neutrality: that in the long run, an increase in the money supply only brings inflation, and cannot bring economic growth. This is the foundation of modern monetary economics. But if one looks carefully, why is money neutral?

The reason is that its theoretical models have no structural transformation. The analysis is carried out under a given industrial structure, that is, under a given level of productivity. Since the level of productivity is taken as given, an increase in the money supply cannot raise productivity. And if productivity cannot rise, then the result of increasing the money supply can only be inflation. This is the root of the theory of monetary neutrality.

Of course, Keynesian economics is a little more nuanced. It argues that, because prices are sticky in the short run, monetary expansion may boost growth for a time. But in the long run, the conclusion is still the same. That is why it is called super-neutrality. In the long run, money is neutral, and monetary policy cannot be used to affect a country’s economic growth.

But in new structural economics, the economy is seen as a process of continuous structural transformation, in which productivity keeps rising, and the structure keeps evolving. If productivity is to keep rising, there must be continuous technological innovation and industrial upgrading. And that depends on investment, which in turn depends on the interest rate. If monetary conditions are relatively loose and interest rates are relatively low, then there will be more investment in technological innovation and industrial upgrading, and productivity will rise more quickly. Under such circumstances, money is no longer neutral. Of course, if monetary expansion proceeds at the same pace as productivity growth, then an increase in the money supply will bring growth without bringing inflation. But if the money supply grows faster than productivity, then inflation will, of course, appear. Productivity may still rise, but inflation will also be present. Even then, the rate of inflation will still be lower than the rate of monetary expansion.

After reform and opening up, from 1978 to 2024, whether measured by M0, M1, or M2, China’s money supply grew by roughly 15 per cent a year. But according to mainstream monetary theory, for example, Friedman’s theory, a country’s money supply growth should be kept at about 3 per cent. In China’s case, however, the average annual increase in the money supply was much higher. Yet inflation remained very stable, averaging less than 4 per cent over more than forty years. Why? Because per capita economic growth was close to 9 per cent. Growth was very fast. Without such rapid monetary expansion, there would have been deflation, investment costs would have become too high, and growth potential could not have been realised.

So if structural transformation is taken into account, then in comparing developed countries and developing countries, Friedman’s 3 per cent monetary growth rule in fact reflects the situation of developed countries: as discussed earlier, their per capita GDP growth is about 2 per cent, that is, average productivity growth is about 2 per cent, and with population growth added, it comes to about 3 per cent.

For developing countries, if development follows comparative advantage, the rate of monetary growth can be higher than in developed countries. Of course, if monetary expansion is used first to support technological innovation and industrial upgrading, then it is in effect subsidising innovators, and it has a wealth effect. Under such circumstances, innovators in fact receive lower interest rates and are thus subsidised, so there is also a redistributive effect on wealth.

Now consider fiscal policy. The current theoretical foundation of fiscal policy is Ricardian equivalence. According to Ricardian equivalence, fiscal policy cannot influence economic growth. And if one follows that logic, one will oppose proactive fiscal policy.

Whenever this issue is discussed, many people oppose active fiscal policy. They argue, in line with Ricardo, that fiscal policy should not be used to influence economic growth. But from the perspective of new structural economics, the process of economic development is a process of structural transformation. In that process, infrastructure must be continuously improved. The improvement of infrastructure involves market failure and, therefore, must be undertaken by the government. If fiscal policy is used to support infrastructure improvement, then once infrastructure improves, technological innovation and industrial upgrading can proceed more quickly. In that case, fiscal policy will affect the rate of economic growth.

Moreover, it is actually even better to undertake infrastructure investment during an economic downturn. In a downturn, the government has the responsibility to maintain stability. According to mainstream theory today, maintaining stability basically means paying unemployment benefits. But if, during a downturn, investment is directed towards infrastructure that removes bottlenecks to economic growth, then at the same time as investment is taking place, jobs are also being created, and the need for unemployment benefits is reduced. Once that infrastructure is completed, the bottlenecks to growth are removed, the rate of growth rises, and with a higher growth rate, the government can use the increase in future tax revenue to repay the debt incurred for today’s infrastructure investment. In such a scenario, Ricardian equivalence does not hold.

The reason mainstream theory has no concept of structural transformation. It assumes that productivity is given, and it is basically concerned only with how resources can be efficiently allocated under a given level of productivity.

That is the way mainstream theory is framed today. Under such circumstances, of course, Ricardian equivalence follows. But once it is recognised that economic development is a process of structural transformation, Ricardian equivalence no longer holds, provided, of course, that government policy is made in accordance with comparative advantage.

A third major idea in mainstream macroeconomics today is real business cycle theory. In developed countries, there is technological innovation, and this technological innovation is described as endogenous growth. Such innovation carries uncertainty and appears in the form of shocks. That is the background of what macroeconomics now calls real business cycle theory.

The argument is that when a new technology suddenly appears, it creates many investment opportunities and brings economic growth. But once investment reaches saturation, investment opportunities become fewer and the rate of economic growth declines. In this way, developed-country business cycles are explained by sudden, innovative, and exogenous shocks.

But in developing countries, as the factor endowment structure accumulates and comparative advantage continuously changes, new potential comparative advantages emerge. When that happens, industries that previously had comparative advantage may lose it, and the new comparative advantages create very good investment opportunities. Many entrepreneurs will then invest, and waves of investment will appear.

A large wave of investment can bring relatively rapid economic growth. In fact, such an investment tide is endogenous to changes in the factor endowment structure. It is not like the exogenous and unpredictable shock described in real business cycle theory. In reality, cyclical fluctuations arising from changes in the factor endowment structure can be anticipated. In 2003, I wrote an article published in the Economic Research Journal entitled “Wave Phenomena and the Rebuilding of Macroeconomic Theory for Developing Countries”, which was essentially an application of this idea.

In addition, mainstream theory in developed countries argues that during an economic downturn, there may be a liquidity trap, in which monetary expansion does not lead to more investment. This has indeed happened in recent years. Monetary policy has been extremely loose, yet investment has remained weak. The main reason is that when developed countries enter a recession, their industries are already at the global frontier. Once demand falls, overcapacity appears. But the emergence of new industries is very limited, because these countries must rely on invention. Under such circumstances, existing industries suffer from excess capacity, and even when monetary conditions are loose and interest rates are very low, firms still do not invest. That is why a liquidity trap arises.

But for developing countries, although some industries may indeed have excess capacity at present, they can still be upgraded into new industries, and there remains a great deal of room for upgrading within traditional industries. Under such circumstances, the so-called liquidity trap does not arise. So the structural differences between developed countries and developing countries give rise to many different specific features in both monetary phenomena and monetary policy.

Finance, human capital, and soft budget constraints from the perspective of new structural economics

Take financial economics as another example. Finance mainly deals with financial structure and corporate finance, and another important area is asset pricing. If one looks at mainstream finance today, what it basically teaches is how to develop modern finance: large banks, stock markets, venture capital, and so on. But this kind of modern finance is mainly suited to developed countries, where industries and technologies are already at the global frontier, capital intensity is high, and risks are also high. Finance should serve the real economy.

But the characteristics of the real economy differ across countries at different stages of development. In China, for example, there are certainly advanced manufacturing sectors comparable to those in developed countries, and opportunities can be seized in the fourth industrial revolution, whether through venture capital, stock markets, or large banks. Those arrangements are suitable for such sectors. But in the “five, six, seven, eight, nine” contribution of the private economy [contributing more than 50 per cent of tax revenue, more than 60 per cent of GDP, more than 70 per cent of technological innovation, more than 80 per cent of urban employment, and more than 90 per cent of the total number of enterprises], the vast majority of agriculture and manufacturing is still traditional and small in scale. If one relies only on modern large banks, stock markets, venture capital, or corporate bonds, it is actually very difficult to provide appropriate financial services for those sectors. In reality, this traditional part of the economy consists of mature industries, mature technologies, and small-scale firms. For them, local and regional banks are more suitable providers of financial support. So the financial structure should be compatible with the characteristics of the production structure.

Then there is asset pricing. If an investment is consistent with comparative advantage, that is preferable. If it is not consistent with comparative advantage, returns will be lower and risks higher, so its asset price should also be lower. By contrast, if it is consistent with comparative advantage, risk will be relatively lower and returns relatively higher, so the asset price should also be relatively higher. This is the view of new structural economics on asset pricing.

In addition, even if an industry is consistent with comparative advantage, there are still differences. If it is an emerging industry that is consistent with comparative advantage and has large market potential, or if it is what may be called a transitional industry, that is, one that used to be consistent with comparative advantage but is now gradually losing that advantage, then even though both may still be consistent with comparative advantage, the asset pricing will be different. The asset price of the newly emerging industry will be higher, while that of the traditional industry that is on its way out will be lower.

The most obvious example is Tesla. Its market capitalisation is now more than one trillion U.S. dollars, while the combined market value of the traditional automobile companies, including General Motors, Ford, and Chrysler, is only around 150 billion U.S. dollars, less than one-seventh of Tesla’s. One belongs to an industry that is in decline, and the other to an industry that is emerging. So asset pricing is also related to the characteristics of the industry in which a firm operates. In this respect, too, new structural economics offers a new perspective.

Human capital is extremely important. But it must also be suited to the production structure. As capital intensity rises, the demand for human capital also rises, because human capital is what helps deal with uncertainty, manage risk, and adapt to new technologies through a stronger learning capacity.

Traditional industries rely on traditional technologies. That is why there used to be sayings like, “If you do not listen to your elders, you will suffer for it soon enough.” But in emerging industries, that kind of saying no longer really applies.

If a country wants to move into modern manufacturing today, where technological change is rapid and industrial upgrading is constant, then the right kind of human capital becomes essential. But this does not mean that more human capital is always better. If industrial upgrading does not keep pace, then once investment has been made in human capital, many highly educated people may still find it difficult to obtain suitable opportunities at home. Some may leave for the United States or Europe, leading to what is often called brain drain. And for the much larger number who remain at home, if they have high levels of human capital but no suitable opportunities, that can easily lead to social discontent.

In recent years, as greater emphasis has been placed on human capital, many developing countries have significantly increased investment in education. But most of them have still fallen into the middle-income trap, and new industries have not continued to emerge. As a result, people with high levels of education often find it difficult to secure suitable jobs at home, which in turn creates a great deal of social tension. So investment in education must also be aligned with changes in the production structure.

In addition, education investment has one important characteristic. People usually learn at a lower cost when they are young, and once those skills are acquired, they can be used over a long period of time. So in a rapidly developing country, educational investment should move ahead of development itself. In that way, the cost of investment in education can be lowered, while the return on that investment can be increased.

There is also the issue of the Lewis turning point and the demographic dividend. In the past, the demographic dividend was usually discussed in a two-sector model. As labour moves from agriculture to manufacturing, productivity rises continuously, and that gives rise to a growth dividend. That is the logic of the two-sector model. It is often said today that all surplus rural labour has already been transferred out, and that China therefore no longer has any demographic dividend. But that statement is not entirely accurate. Even within manufacturing, there is still a hierarchy of manufacturing industries. Some are relatively labour-intensive, and labour productivity in them is relatively low. As long as capital continues to deepen, and labour moves from lower-return manufacturing to higher-return manufacturing, that too is a demographic dividend. So once the perspective of structural transformation is introduced, many issues can be seen in a way that differs from the mainstream view.

Then there is the issue of soft budget constraints. This is a concept often discussed in transition economies. It was first introduced by the Hungarian economist János Kornai. His argument was that state-owned enterprises in socialist countries faced soft budget constraints because they were state-owned. In his view, the relationship between the enterprise and the government was like that between parent and child: if the enterprise lost money, the government had to rescue it with subsidies. That, in his view, was what a soft budget constraint meant. And if that was the problem, then the natural solution was privatisation.

But in fact, from the perspective of new structural economics, the main reason why enterprises in socialist countries, as well as in many developing countries, face soft budget constraints is that the industries in which they operate are industries that the government has chosen to prioritise, even though those industries run against comparative advantage. In that case, the firms are carrying policy burdens; they do not have viability, and the government therefore has to subsidise them.

From the perspective of new structural economics, whether an enterprise operates in an industry consistent with comparative advantage or not leads to a very different understanding of soft budget constraints, and therefore also to a very different approach to reforming state-owned enterprises. If soft budget constraints were caused simply by ownership, then privatisation would indeed be the best solution. That is why most countries influenced by neoliberalism placed so much emphasis on privatisation. But as discussed earlier in relation to transition, when the industries concerned are capital-intensive, yet at the same time regarded as necessary for the country and burdened with policy responsibilities, privatisation often does not solve the problem. In many cases, it actually makes soft budget constraints even more serious, intensifies rent-seeking and corruption, and lowers efficiency further.

So if policy burdens are to be removed and budget constraints hardened, the key is for the industry itself to become consistent with comparative advantage, and to operate in a fair and competitive environment free of policy burdens. That is the central point.

If some industries carry policy burdens because they are tied to national security, to the national economy and people’s livelihood, or to future development needs, then under such circumstances, state ownership may in fact be a suboptimal arrangement. But if that is the case, regulation must be strengthened. On the one hand, subsidies may still have to be provided. On the other hand, supervision must also be tightened. That is also why the fight against corruption must always remain ongoing.

Opening strategies, capital flows, and the resource curse from a new structural economics perspective

Is economic openness a good thing? During the era of the Washington Consensus in the 1980s, great emphasis was placed on economic openness. But in many countries, opening up led to economic collapse and then to premature deindustrialisation. As a result, many people began to oppose openness itself. But in fact, the real issue lies in how the transition is carried out and how opening up is managed, because only industries that are consistent with comparative advantage can truly survive without protection and subsidies.

If, during transition, there are industries that were originally built under the import substitution strategy and are still important for employment, national defence and security, or the functioning of the economy, then removing protection and subsidies may cause them to collapse, and economic performance will suffer. Under such circumstances, a gradual dual-track transition is reasonable. It can preserve stability, while at the same time allowing industries in which the country has comparative advantage to grow rapidly. This way, industrialisation can deepen rather than giving way to premature deindustrialisation.

Then there is international capital flow and the opening of the capital account. Originally, the capital account was regulated in every country. After the 1970s, financial liberalisation was promoted. But the result was that many developing countries experienced repeated financial crises. In fact, the frequency of financial crises in the 1980s and 1990s was higher than in the 1960s and 1970s. At that time, the idea was to remove controls, promote financial liberalisation, and encourage international capital flows. But no clear distinction was made between real capital and financial assets. If foreign direct investment enters the real sector, that is, of course, beneficial. It increases capital, brings new technologies, and opens access to international markets. All of this is helpful for developing countries. But opening the capital account to financial assets is something that must be approached with great caution, because such capital usually does not go into the real economy. It is generally speculative in nature, and it can easily surge in or rush out.

When a country’s currency is not an internationally accepted hard currency, opening the capital account too early and allowing financial assets to flow in and out freely can easily lead to large swings in capital flows, and repeated crises usually follow. That is why even institutions such as the IMF have changed their position. They now emphasise that developing countries should manage the capital account, which means that capital flows should not be allowed to move in and out completely freely.

Then there is the Lucas puzzle. Robert Lucas observed that capital is relatively scarce in developing countries and relatively abundant in developed countries. So logically, capital should flow from developed countries to developing countries. But in reality, in most developing countries, capital has tended to flow out to developed countries. This is what is known as the Lucas puzzle.

The main reason, from the perspective of new structural economics, is that many developing countries adopted import substitution strategies, with extensive government intervention and distortion, and as a result, the return on capital investment was low. Under such circumstances, foreign capital naturally cannot be attracted.

At the same time, much domestic wealth is generated through rent-seeking and corruption, and those who hold it often do not feel safe keeping it at home, so it also flows abroad. By contrast, in places such as the four Asian tigers, or the Chinese mainland after reform and opening up, development proceeded broadly in line with comparative advantage, and returns on investment were much higher. As a result, foreign capital flowed in. So whether capital flows into or out of a developing country depends, again, on whether its development strategy is consistent with comparative advantage.

So far, most of the discussion has focused on manufacturing. But agriculture and mineral resources are also very important, especially for developing countries, because the majority of their labour force is still employed in agriculture. Agricultural development can help reduce poverty. And when agriculture develops well, it can also generate surplus, provide capital accumulation, and create a market for industrial products. The development of agriculture likewise requires technological innovation, upgrading, and diversification. In analytical terms, the logic is actually much the same as in manufacturing.

Then there is the question of how resource-rich countries, or resource-rich provinces and regions, should develop. Resource abundance is certainly a comparative advantage. But in the course of development, many resource-rich countries have experienced what is called the resource curse. Why does this happen? Because natural resources lie underground, and extracting them requires government approval.

But once government approval is involved, many non-transparent dealings can arise. This easily creates opportunities to bribe officials who control approvals, and corruption then leads to the concentration of wealth in the hands of a few. As a result, inequality widens, the majority of the population does not benefit from resource development, and social and economic problems intensify. This is the resource curse.

But if resources are well managed, and if the revenues from resources enter the national fiscal system and are then used to support the development of non-resource industries, the situation can be changed. In general, at a low-income stage, resource abundance is a comparative advantage, and an abundant supply of low-cost labour is also a comparative advantage. If resource revenues are used to support the development of labour-intensive manufacturing, while also helping to improve infrastructure, education, and other necessary conditions, then resources can become a positive force for development.

So whether resources become a curse or an advantage depends, on the one hand, on how they are managed, and on the other hand, on the broader development strategy. The United States, for example, is a resource-rich country that has developed relatively successfully. One important reason is that a large share of the gains from its resources was used to support the development of non-resource industries. That is why its economy performed well.

So, in sum, new structural economics was proposed as a third generation of development economics. But once structural heterogeneity and structural endogeneity are introduced, it becomes not only a theory of development, but also a structural revolution in modern economics with implications for every subfield of economics.

Today, I have only discussed fiscal policy, monetary policy, and financial policy. But in fact, every field of modern economics is potentially open to this kind of structural rethinking, because most existing theories are still drawn from the experience of developed countries and take the structure of developed countries as their implicit structure. Yet countries at different stages of development have different structures. That is where theoretical innovation lies.

And such theoretical innovation can better help people understand the world and change it. In that sense, it helps bring knowledge and action into unity. That is why new structural economics places such strong emphasis on the unity of knowledge and action.

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