employment opportunities in these industries, under these circumstances, can surpass the losses from the bankruptcy of non-viable firms. In theory, the economy can grow dynamically soon after implementing the shock therapy, with at most a small initial loss of output and employment—another hypothetical version of ―reform without tears.‖ On the other hand, if the number of non-viable firms is too large, the output value and employment of those firms will make up too large a share of the national economy and shock therapy may be self-defeating. Economic chaos may ensue due to large-scale bankruptcies and dramatic increases in unemployment. The resulting chaos can force the hand of government into sustaining the non-viable enterprises—often resorting to ever increasing protection and subsidies for these firms—either explicitly or implicitly—and often in a more disguised way. In some cases, even if the firms are privatized, soft-budget constraint problems will continue. The subsidies to the non-viable firms post-privatization could even increase due to the private owners‘ even greater incentives to lobby for subsidies and protection (Lin and Li, 2008). In effect, this is what happened in Russia and many other countries in Eastern Europe and the former Soviet Union (Brada, 1996; Frydman et al., 1996; Lavigne, 1995; Pleskovic, 1994; Stark, 1996; Sun, 1997; World Bank, 2002). In the end, the economy can find itself in the unfortunate situation of shock without therapy (Kolodko, 2000).

In brief, the experience of a number of countries that have pursued gradualist reform strategies shows that this approach is often far superior to shock therapy. The removal of distortions is needed – whether transitioning from a predominantly government-owned system of production or from a comparative-advantage defying, but government supported, system of private enterprise. The pragmatic, two-track approach avoided some of the pitfalls of the shocktherapy that was often prescribed following the downfall of the Soviet Union.<sup>35</sup> In addition, successful transition requires the creation of new industries. The distortion removal agenda of the Washington Consensus neglected to include any positive policies to facilitate the entry of firms into these new sectors. A successful development strategy that will facilitate the structural change for successful transition can be based upon the principles outlined in the New Structural Economics (NSE) and its policy implementation via the Growth Identification and Facilitation Framework.<sup>36</sup> The NSE highlights that a country‘s economic structure is endogenous to its endowment structure; however, the government needs to play a facilitating role and this role needs to structured according to clearly defined principles.

First, for an economy to be competitive in both the domestic and international market, it should follow its comparative advantage, as determined by its endowment structure. In the early stages of development, sectors in which the economy has comparative advantage will be labor or resource intensive. Examples include light manufacturing, smallholder agriculture, fishing and mining. Only a few activities like mining are likely to be capital intensive in this early stage. In the later stages of development, the competitive sector will become increasingly capital intensive, as capital accumulates, thus changing the country‘s endowment structure. In the industrial upgrading toward more capital intensive production, infrastructure needs to be improved simultaneously to reduce the firms‘ transaction costs, and there is a clear role for government to play in this regard.

> 35 This discussion of the two track reforms draws on Lin (2009). 36 See Justin Yifu Lin (2012c).

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