metadata: authors: 0: author: Klein,Maximilian Michael Johann
docna: 0: docna: Ways out of poverty : diffusing best
            practices and creating capabilities - perspectives on
            policies for poverty reduction
docty: Policy Research Working Paper
subtopic: Social Policy,Legal Products,Judicial System Reform,Labor Markets,Common Property Resource Development,Coastal and Marine Resources,Legal Reform,Legislation,Regulatory Regimes,Energy and Natural Resources,Inequality,Global Environment
teratopic: Poverty Reduction
abstracts: cdata!: Fundamentally, poverty reduction is
            about bringing growth processes to poor areas. Because poor
            areas can benefit from technical and organizational
            innovations made elsewhere in the world, it is possible
            today to create productive jobs faster and in greater
            quantity than ever before. The puzzle is what helps spread
            such "best practices." Saving, investment,
            education, resources, and new technology are all needed-and
            fairly easy to obtain. What is hard to obtain are the
            institutions that allow these factors of production to be
            combined and translated into productive job creation. Firms
            are the key vehicles that spread best practices and
            productive jobs to areas where poor people live. Because we
            can never be sure which firm will be successful, it is
            necessary that new firms can enter markets, that substandard
            firms are allowed to fail, and that good firms face few
            barriers to growth. This is the definition of competition,
            and competition is what selects good firms and thus drives
            the spread of best practice and productive jobs. Governments
            need to provide the framework in which capable firms can
            emerge. Yet, the right mix of state activity and how it best
            interacts with firms are not fully understood. Some
            selection mechanism, which allows for policy experiments and
            selects successful ones, is valuable for national,
            provincial, and local governments. Thus competition among
            jurisdictions and firms is an integral part of dynamic
            social systems that hold promise for creating wealth and
            ending poverty.
repnme: repnme: Ways out of poverty : diffusing best
            practices and creating capabilities - perspectives on
            policies for poverty reduction
display_title: Ways out of poverty : diffusing best
            practices and creating capabilities - perspectives on
            policies for poverty reduction
listing_relative_url: /research/2003/03/2176365/ways-out-poverty-diffusing-best-practices-creating-capabilities-perspectives-policies-poverty-reduction
topicv3: Natural Resources m1326446 1979,Personal Property Rights m1326571 1907,Poverty m1326687 695,Environment, Natural Resources and Blue
            Economy m1327391 566,Jobs m1503931 2670
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Poverty Reduction
origu: PSI
no_of_pages: 48
author_keys: 0: author_key: 1439711
model_extractions: I POLICY RESEARCH WORKING PAPER 2990

# Abstract

> Fundamentally, poverty reduction is about bringing growth processes to poor areas. Because poor areas can benefit from technical and organizational innovations made elsewhere in the world, it is possible today to create productive jobs faster and in greater quantity than ever before. The puzzle is what helps spread such "best practices." Saving, investment, education, resources, and new technology are all needed-and fairly easy to obtain. What is hard to obtain are the institutions that allow

> these factors of production to be combined and translated into productive job creation. Firms are the key vehicles that spread best practices and productive jobs to areas where poor people **live.** Because we can never be sure which firm will be successful, **it** is necessary that

new firms can enter markets, that substandard firms are allowed to fail, and that good firms face few barriers to growth. This is the definition of competition, and competition is what selects good firms and thus drives the spread of best practice and productive jobs. Governments need to provide the framework **in** which capable firms can emerge. Yet, the right mix of state activity and how it best interacts with firms are not fully understood. Some selection mechanism, which allows for policy experiments and selects successful ones, is valuable for national, provincial, and local governments. Thus competition among jurisdictions and firms is an integral part of dynamic social systems that hold promise for creating wealth and ending poverty.

This paper-a product of the Private Sector Advisory Services Department-is part of a larger effort **in** the department to study private sector development and growth processes. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Fatima Shah, room 19-334, telephone 202-458-4846, fax 202-5223480, email address fshah@worldbank.org. Policy Research Working Papers are also posted on the Web at http:// econ.worldbank.org. The author may be contacted at mklein@worldbank.org. March 2003. (39 pages)

> _The Policy Research Working Paper Senes disseminates the findings of work_ **_in_** _progress to encourage the exchange of ideas about development issues An objective of the series is to get the findings out_ **_quiickly,_** _even_ **_if_** _the presentations are less than fully polished. The papers carry the names of the authors and should_ **_be_** _cited accordingly The findings, interpretations, and conclusions expressed_ **_in this_** _paper are entirely those of the authors. They do not necessarily represent the_ **_view_** _of the World Bank,_ **_its_** _Executive Directors, or the countries they represent._

Produced by the Research Advisory Staff
# WAYS OUT OF POVERTY **DIFFUSING BEST PRACTICES AND CREATING CAPABILITIES**

### - PERSPECTIVES ON POLICIES FOR POVERTY REDUCTION -

## Michael Klein*

* Michael Klem is the director of the Pnvate Sector Advisory Services Department (PSAS) at the World Bank.
WAYS OUT OF POVERTY **DIFFUSING BEST PRACTICES AND CREATING CAPABILITIES**

## **TABLE OF CONTENTS**

|List|ofBox|es.......<br>..<br>4|
|---|---|---|
|I.|EXE|CUTIVESUMMARY<br>..|
|II.<br>|HOP|EANDANGER<br>..<br>3|
|Il.|BAS|ICWAYSTOPROMOTEPRO-POORGROWTH<br>**_.._**<br>**_5_**|
|IV.|DRIV|ERSOFGROWTHANDJOBCREATION<br>.<br>.7|
||A.|Accumulationofcapitaland ideas<br>.7|
||B.|ImpedimentsandTraps.10|
||C.|Thekeytodevelopment:Capableinstitutions.11|
||D.|Povertyreduction:Thediffusionofbestpractice and thecreationof<br>capability.16|
|V.|COR|EINSTITUTIONS:MARKETS,FIRMSANDGOVERNMENTS<br>.<br>.18|
||A.|Experimentsandroutines-freedomtoenter andtofail.19|
||B.|Competition-themechanismtoselect themost productivefirms.<br>19|
|VI.|Mar|ketfailure andthepoliticsofchange<br>..<br>26|
|REFE|RENCE|S<br>.<br>.<br>.<br>32|

# **List of Figures**

- Figure 1: Share of world population living on less than 1 US$ per day

- Figure 2: Growth achieves more than redistribution

- Figure 3: What do people think their country needs most to get ahead - more productivity or more redistribution?

Figure 4: Intelligence is scare - natural resources abundant

> Figure 5: Factor accumulation accounts for only a fraction of income differences

- Figure 6: The difference in output per worker is due to differences in total factor productivity

> Figure 7: Location of new product innovation in the United States

Figure 8: Exporters spend more on training and acquiring foreign technology

> Figure 9: Origin of innovation in the United States Figure 10: Frequencies of misconduct of workers in an Italian firm, by region of birth

Figure 11: Distribution of employment by firm size Figure 12: India - Current and potential labor productivity Figure 13: Plant turnover and market share of entrants Figure 14: Decomposition of multifactor productivity growth in manufacturing Figure 15: The effect of industrial policy on total factor productivity growth in the manufacturing sector and on aggregate growth
Figure 16: Lower levels of regulation in Sweden

# **List of Boxes**

- Box 1: The speed of wealth creation Box 2: The role of policy reforms and diffusion of good practices in the growth of the Bangladesh garnents industry

- Box 3: Property rights and poverty reduction Box 4: Markets, the state and innovation
# **I.** EXECUTIVE SUMMARY

This paper provides perspectives on what can<sup>be done to overcome obstacles to</sup> development and poverty reduction. It argues<sup>that the key to poverty reductionis creating</sup> productive jobs where poor people live, which<sup>in statistics shows up asgrowth.</sup> Fundamentally, poverty reduction is not about<sup>redistributingthe benefitsof growth-it is</sup> about bringing growth processes to poor areas.<sup>Because poor areascan benefitfrom</sup> technical and organizational innovations made<sup>elsewherein the world, it is possible today</sup> to create productive jobs faster and in greater<sup>quantity than ever before.The puzzleis</sup> what helps spread such "best practices." The<sup>paper arguesthat saving,investment,</sup> education, resources, and new technology are<sup>all needed-andfairly easy to obtain. What</sup> is hard to obtain are the institutions that allow<sup>thesefactorsof production to be combined</sup> and translated into productive job creation.

Some important institutions develop spontaneously,<sup>such asbasicmarkets and small</sup> trade, which operate even in the most desperate<sup>cornersof the world.But to createand</sup> sustain large numbers of productive jobs<sup>requiresa complexwebof institutions. The rise</sup> of modern firms and modern government, both<sup>non-market institutions thatstarted in the</sup> mid- 1 9 th century, provides the critical institutional<sup>fabricallowing factorsof production</sup> to be combined more productively. To be<sup>truly productive,firms needto play by certain</sup> rules and be able and willing to co-operate. They<sup>need to respectproperty rightsand</sup> contracts so that they have incentives to invest<sup>and cooperatewith buyersand suppliers.</sup> They also need to respect a variety of regulations<sup>that condition their propertyrights-to</sup> ensure that products and production processes<sup>fit society'sexpectationsaboutsocially</sup> and environmentally sound practices. Under<sup>such rules,which require government</sup> enforcement, small and large firms emerge<sup>symbiotically,trading and contractingwith</sup> each other.

Firms are the vehicles that spread best practices<sup>and productive jobs to areas where poor</sup> people live. But firms require certain routines<sup>to operate,and those routines may not</sup> always be effective or sustainable. Because<sup>we can never besurewhichfirm will be</sup> successful, it is necessary that new firms can<sup>enter markets, that substandardfirms are</sup> allowed to fail, and that good firms face few<sup>barriers togrowth.This is the definition of</sup> competition, and competition is what selects<sup>goodfirms andthus drives thespread of best</sup> practice and productive jobs.

The institutional fabric of societies consisting of<sup>firmns,governmentandother types of</sup> organizations needs to combine competition<sup>and cooperationunder agreed rules-a tricky</sup> task full of unavoidable tensions. Because the<sup>spreadof best practicesand more</sup> productive jobs upsets old patterns of production,<sup>it typically disruptsthe livesof some</sup> people while improving those of others and<sup>in theend raisesliving standardsbroadly.</sup> Most if not all governments try to help the process<sup>along not just by establishingthe</sup> basics of property rights and contract security<sup>but also by providingspecialsupport to</sup> small farmers and businesses or to larger ones<sup>under industrial policies that providesome</sup> protection from competition and easier access<sup>tocredit.Politically popular, such policies</sup> can be effective in overcoming interest group<sup>resistanceto reform.But theircontribution</sup>
_2_ _Ways Out of Poverty - Diffusing Best Practices and Creating Capabilities_ to productivity improvements is limited, particularly where the basics of security of property rights and contracts-and the freedom to enter and fail-are not in place.

An alternative is broader social protection schemes such as social security systems. When sensibly designed, these allow change to occur, while providing a safety net to individuals. To fund such systems productive jobs are needed first. But a basic level of security can also support greater risk-taking and thus enhance the scope for experimentation and change that bring more productive jobs in the end. Indeed, productive societies have seen a dramatic rise in the share of government activity in the economy, mostly due to the emergence of state-sponsored social protection. At the same time, countries around the world, notably Scandinavian ones, have withdrawn from interfering with the productive activity of firms that underpins wealth creation.

The right mix of state activity and how it best interacts with firms are not fully understood. Partial reforms can work. But they can also fail. Some selection mechanism, which allows for experiments and selects successful ones, is also valuable for national, provincial, and local governments. This competition among jurisdictions and firms is an integral part of dynamic social systems that hold promise for creating wealth and ending poverty.
_3_ _Ways Out of Povertv - Diffusing Best Practices_<sup>_and Creating Capabilities_</sup>

# **II. HOPE AND ANGER**

_"First, I would like to have work of any kind." - An 18-year old man, Ecuador_

**The challenge.** The quotation is from<sup>"Voices of the Poor,"a World Bank survey</sup> capturing the perspectives of poor people<sup>around the world.'Poor people know what they</sup> need to escape poverty. Finding a decent<sup>job or establishing a small business is the key.2</sup>

But not any job or any business will lead<sup>out of poverty.If it weresimply a matter of</sup> creating jobs, having the state employ everyone<sup>would do the trick. This has been tried</sup> before in most parts of the world, notably<sup>in communist regimes.The key to poverty</sup> reduction is to create productive jobs and<sup>thuswealth, not just to compileodd jobs</sup> allowing people to scrape by. The basic<sup>sentiment comes froma man from Pakistan:"the</sup> rich have one permanent job; the poor are<sup>richin many jobs."3Neededespeciallyare jobs</sup> and productivity improvements where poor<sup>peoplelive, mostly in rural areas and the</sup> peripheries of cities.

**Hope.** The 20th century gave more hope<sup>that poverty could be eliminated than any other</sup> episode in human history. Average income<sup>per person,adjusted for inflation, increasedat</sup> least five times over the century, despite<sup>unprecedentedpopulationgrowthfrom about1.8</sup> billion to more than 6 billion.<sup>4</sup> At century's<sup>end, morepeople livedabove the basic</sup> poverty line of $1 dollar a day than even<sup>a decade before.5And when taking a definition</sup> of poverty broader than just income, human<sup>developmentin very poor countries,even in</sup> Mozambique, has advanced beyond that<sup>in Italy in thelate</sup> 19<sup>thcentury.6For thefirst time</sup> in history it appears that increases in income<sup>may notlead to a Malthusianincrease in</sup> population. Worldwide fertility rates peaked<sup>in the1960s, andpopulation growth has</sup> since started to slow.<sup>7</sup>

**Anger.** And yet, the absolute number of poor<sup>peoplehas not fallen,even though their</sup> share in total population continues to<sup>decline.Advancesare heavily concentrated in Asia,</sup> particularly China and India. In Africa, however,<sup>poverty rates increasedover the last</sup> three decades. In Eastern Europe and<sup>theformer SovietUnion they increasedduring the</sup> decade prior to the fall of communism<sup>andfaster still thereafter.Nor have two decades of</sup> reform in Latin America prevented poverty<sup>rates fromrising(figure1).Whetherall</sup> things considered global inequality has risen<sup>or declined duringthe last threedecadesof</sup>

'Narayan et al., 2000.

**2** Detailed studies making use of household<sup>survey dataconfirm this.The smglemost importantfactorsfor</sup> escaping from poverty are changing labor<sup>earningsand changes in ermploymentstatus.See, forexample,</sup> Fields et al. (2000).

> 3 Narayan et al., 2000.

4 de long, 2000. S Pfeffermann, 2000. **6** Crafts, 2000. 7 Umted Nations, 2001.
_4_ _Ways Out of Povert& - Diffusina Best Practices and Creating_<sup>_Capabilities_</sup> the 20th century remains hotly disputed.<sup>8</sup> In any case,<sup>roughly 1.2billion people still live</sup> on less that $1 a day, and 2.8 billion on less then<sup>$2 a day.9</sup>

**Figure 1: Shares of world population living on less**<sup>**than$1 a day**</sup>

<!-- Start of picture text --> 0.450 -<br>> 0.400 -<br>0.350-<br>6 0.300 -<br>; 0.250 -<br>_ 0200<br>0.150<br>0<br>X, 0100<br>0050<br>0.000<br>1970 1980 1990 1998<br>- World - Asia<br>&- China -x-- Asia rinus China<br>- - Latin Anerica + Europe & Central Asia<br>i Africa<br><!-- End of picture text --> Source: Sala-i-Martn (2002). Data for Europe & Central Asia are<sup>from</sup> World Bank (2000a).

Worldwide, the average income per person is about $6,000<sup>a year,no more than that for</sup> the United States in 1900, then the richest country in<sup>the world.The world has thus</sup> shown that it can produce enough for everyone to lead<sup>a better life.But many people</sup> have not benefited. And so, the century that has<sup>given rise to unprecedentedhope hasalso</sup> given rise to anger that many people are left out. Precisely<sup>becausewe can now imaginea</sup> world without poverty, we can be angry about the slow<sup>progress.In the wordsof Nobel</sup> laureate Joseph Stiglitz: "The experience of the past<sup>fifty years has demonstratedthat</sup> development is possible, but not inevitable."'<sup>0</sup>

> **"** Milanovic, 1999; Ravallion, 2000; Sala-i-Martin,<sup>2002.</sup>

> **9** World Bank, 2002a. 'O **Stiglitz, 1998a.**
_5_ _Ways Out of Poverty - Diffising_<sup>_Best Practices and Creating Capabilities_</sup>

# **III.** BASIC WAYS TO PROMOTE<sup>PRO-POORGROWTH</sup>

**Alternatives to market economies.**<sup>So what can be donefor poor people to benefit from</sup> wealth creation? Today there<sup>are feweralternativeapproachestoeconomicsystems than</sup> at any time since Karl Marx wrote<sup>the Communist Manifesto in1848.Somestill hopefor</sup> non-market solutions, but they<sup>arestruggling,as exemplified in a recentspeech by Joao</sup> Amaral, a reformist member of<sup>the Portuguese CommunistParty: "Weare notsocial</sup> democrats or market-friendly<sup>socialists.Communismmeans replacing capitalismwith</sup> something better, even if we<sup>do not yet knowexactly what that will be."'Maybeat some</sup> future date a completely different<sup>economicsystem willemerge.For now we have to</sup> make some kind of system making<sup>use of markets.</sup>

**Redistribution of income.** The<sup>question becomeswhat pro-poor policiesmean in market</sup> economies. Some focus on redistributing<sup>incomes.For example,a guaranteed basic</sup> income for all was recently proposed<sup>by the BasicIncomeEuropean Network."2The</sup> massive redistribution required<sup>for sucha plan on a global scale would requirethat</sup> economic growth is adequate<sup>to fundit.Inaddition,it requireswillingnessof rich</sup> countries to fund the plan. Yet,<sup>the official development aid of all nations amounts toless</sup> than $0.15 for each person living<sup>on less than$1a day, and most of that has to be repaid.</sup> Compare that with the Republic<sup>of Korea, whichtook about10 yearsto generatemore</sup> income for its citizens from<sup>the manufacturing sector alonethan allof the world's</sup> development aid together (figure<sup>2).</sup>

**Figure 2: Growth achieves more**<sup>**thanredistribution**</sup>

<!-- Start of picture text --> 250.0<br>9 200.0<br>B 1500<br>1000<br>50.0<br>o 00-<br>1960 1965 1970 1975 1980 1985 1990 1995 2000<br>-Korea, M anufacturing Value Added<br>-Official Net Resource Flows to Dev Countrles<br>-Total Grants to Dev Countnes, Excl Tech Coop<br><!-- End of picture text --> Source: World Bank WDI Database.

**Creating productive employment.**<sup>Even doubling the world's official aid and</sup> transforming all loans into grants<sup>would notachievesustained economicgrowth in</sup> countries and areas where poor<sup>peoplelive. The hope for poor people lies in productivity</sup>

**t'** Wise, 2002. **12** Williams, 2002.
_6_ _Ways Out of Poverty - Diflfismng Best Practices and Creating Capabilities_ growth, not in redistribution. Opinion polls in Latin America show that the poorer people are, the more they place their hopes on productivity growth than on redistribution (figure 3).

<!-- Start of picture text --> Figure 3: What do people think their country needs most to get ahead-more<br>productivity or more redistribution?<br>80<br>Honduras<br>75-<br>70- Nicaragua<br>70 NEl Salvador<br>4 65<br>Bolivia<br>Cs , 60 X CsaRc<br>Guatemala o<br>Ž55 - Cdombia<br>50- Paraguy \Unga<br>X 45- + o 8razil Argentina<br>40- Venezuela<br>R 2 = 0 51 ,Panama 0Chile<br>35 -<br>0 5,000 10,000 15,000<br>1998 GDP per capita (PPP$)<br>Note: The vertical aids represents the percentage of people in the opinion poll who chose<br>productivity growth over redistribution.<br>Source: Graham, in Fields and Pfeffemnann (2002).<br><!-- End of picture text --> Most debates about pro-poor growth today center on means to provide opportunity to poor people by improving their health and education,'<sup>3</sup> by providing them access to credit,'<sup>4</sup> by connecting them to the global market,'<sup>5</sup> by helping to create risk insurance schemes, and by creating jobs through stimulating overall growth in poor countries and regions. **_16_** Required is deeper understanding of what such interventions can accomplish and how to implement them effectively. But the basics are clear. Growth processes need to spread to areas where poor people live or where they can migrate.

> **3** World Bank, 2002b.

> 4 Morduch, 1999; Robinson, 2001.

> _15_ See World Bank, 2002b for examples of how information and communications technology is being used around the world to connect producers in low-income or remote areas directly to buyers and to provide them with access to market and business-related information. **6** Stern, 2001.
_Ways Out of Poverty - Diffising Best Practices_<sup>_and Creating Capabilities_</sup>

# **IV. DRIVERS OF GROWTH AND JOB**<sup>**CREATION**</sup>

_"There is a tendency to see development_<sup>_as the_</sup> _accumulation of something necessary._<sup>_For a while it was_</sup> _infrastructure... human capital.... It_<sup>_has been other things_</sup> _as well. There's obviously truth in_<sup>_those paradigms, but in_</sup> _a deeper sense, societies that succeed_<sup>_in developing are_</sup> _societies where the fairly common individual_<sup>_pursuit of_</sup> _selfish objectives lead to benign social_<sup>_outcomes because of_</sup> _checks and balances in governments,_<sup>_because of enforced_</sup> _private property rights, because of_<sup>_incentives for creativity_</sup> _and entrepreneurship. "_ Lawrence Summers

## **A. Accumulation of capital and ideas**

To understand pro-poor growth, one<sup>needsto understandgrowth. Clearly,growth</sup> requires the accumulation of various<sup>typesof capital-financial,physical, natural,and</sup> human. Most important, the accumulated<sup>technicaland organizational innovationsof</sup> humankind can, in principle, enable<sup>poor countriesto catch up fairly fast with richer</sup> ones. But simply making resources<sup>and innovationsavailabledoes not lead to growth.17</sup>

**Finance.** Poor countries in Sub-Saharan<sup>Africa received capital transfersin the form of</sup> development aid averaging some<sup>10 percentof GDPa yearover the1990s, a very high</sup> level of inflows relative to the size of<sup>theeconomies.But thisdid not translateinto</sup> sustained growth. Instead, Africa became<sup>the regionof the world with the highest</sup> incidence of capital flight.'<sup>8</sup> Estimates<sup>reveal that almost 40 percent of private wealthis</sup> held outside the region.<sup>19</sup>

**Investment.** Nor do high investment<sup>rates translate automatically into highgrowth. Most</sup> dramatic here are the former communist<sup>countries, whereinvestmentrates of 30or even</sup> 40 percent of GDP were amnong<sup>the highestin the world.But they implodedin a</sup> spectacular way. Hong Kong and<sup>Singaporehad similar growthper person, but Hong</sup> Kong did it with significantly lower<sup>investmentlevels.20The UnitedStates still achieves</sup> strong growth with investment rates<sup>just below 20 percentof GDP.</sup>

**Natural resources.** Natural resources,<sup>fuels,and otheragricultural andnonagricultural</sup> commodities remain critical for economies<sup>everywhere.But over the20th centurythe</sup> price of non-fuel commodities fell by<sup>four-fifthsin real terms,while per capita income</sup> grew five-fold (figure 4). Fuel prices<sup>havealsodeclined slightly as they werebuoyed by</sup>

> 7 Easterly and Levine,2001; Temnple,<sup>1999.</sup> World Bank, 2000b.

> " Collier and Gunning, 1999. **20** Young, 1992.
_Ways Out of Povertv - Diffusing Best Practices and Creating Capabilities_ _8_ OPEC during the last 30 years. So, despite massive population growth, the relative scarcity of natural resources has shrunk. Nor is possession of resources the key to growth. Botswana (diamonds) and Chile (copper) have benefited from their resource endowments, but the possession of natural resources can also be a curse.<sup>21</sup> The "curse of oil" characterizes the fact that countries endowed with high priced, large volumes of oil are not growing much or are even shrinking. Look at Nigeria, Saudi Arabia, and Venezuela.

**Figure 4: Intelligence is scarce-natural resources abundant**

<!-- Start of picture text --> sO -A4 WMd GOP p Cept. W. (R.d S t-)<br>4Co 1900 - 100 -IWeWdahWC..dt.pro r w d me)<br>300<br>200<br>150<br>100-<br>60 ~~~~~~~~~~~~~TePrice of Commnodiloes<br>0 .<br>60 - A = \ a Thae 00a<br><!-- End of picture text --> Source: The _Economist_ (Commodity Price Index); World Bank WDI Database.

**Human capital.** Even investment in education does not easily translate into superior growth.<sup>22</sup> Educational progress in Africa was much faster relative to its starting point than in East Asia, but did not bring higher growth. Educational improvements overall in the developing world in fact coincided with declining growth rates during the last 40 years. Detailed household surveys also suggest that educational levels are not critical in explaining who escapes from poverty.

**Access to resources** and **capital.** None of this is to say that finance, investment, natural resources, or education do not matter. They do, but by themselves they are not enough. And on the positive side, it has become easier to move finance into good investment opportunities. Trade barriers have been lowered, so it has become easier to acquire capital goods that embody new technologies. And the education levels needed for income growth in poor countries do not appear to be too difficult to achieve.

> **_21_** Gelb et al., 1988; Sachs and Warner, 2001. _22_ Pritchett, 1996.
_9_ _Ways Out of Poverty - Diffusing_<sup>_Best Practices and CreatinmCapabilities_</sup>

**The diffusion of ideas and**<sup>**incomegrowth.**Technicalandorganizational innovations</sup> have led to an unprecedented<sup>creationof wealth (box1).Innovations havethe nice</sup> feature that, unlike physical<sup>objects, theycan be used over and over again,if they can be</sup> communicated.<sup>2 3</sup> It is this<sup>feature of ideas that makes it possible for poor countriestoday</sup> to raise incomes much faster<sup>than has ever before beenfeasible.</sup>

## **Box** 1: The speed of wealth creation

Before the 18kh century per<sup>capitaincome grew very slowly.When they grew,populationgrowthnsked</sup> offsetting any progress, just<sup>as T. Robert Malthus arguedat the beginning of the mdustnalrevolution.In</sup> the run-up to the industrial<sup>revolutionper capita incomestartednsing. However,it took some350 years</sup> for incomes to double in pre-industrial<sup>Europe.During theindustrial revolution,the richest country,</sup> Britain, initially (1780- 1830)<sup>saw average individual incomesriseat a speed that wouldhave required</sup> 175 years to double them.<sup>Thereafter growth pickedup. Britainwas able to double per capita incomes</sup> within a span of 65 years in<sup>thelate19"hcentury.At the timeno other country couldrival this</sup> performance. However, by<sup>thesecond half of the</sup> 2<sup>0d' century,a whole rangeof countries,for example</sup> Botswana, Chile, China, Ireland,<sup>Japan, Koreaand Thailand were able togrow for sustained penodsat</sup> rates that doubled per capita<sup>incomein about10to 15years.</sup>

# Source: Cameron (1991); Crafts<sup>(2000).</sup>

For the first time in human<sup>historyit has becomepossiblefor largenumbersof people to</sup> escape from poverty within<sup>a life span.Today people in poorer countries can make use of</sup> new technology, new learning,<sup>and betterways of doing thingsthat were developedin</sup> more advanced economies.<sup>Theycan learnfrom organizational innovationin both firms</sup> and governments. Openness<sup>tolearnfrom other countries-or withina countryfrom</sup> centers of growth-is thus critical<sup>for rapid income growth and poverty reduction. 24</sup> The diffusion of ideas has<sup>also becomeeasier.Many more ideas are recorded, and the</sup> means of communication<sup>have becomefaster,moreefficientand more ubiquitous.Ideas</sup> might not move quite as<sup>easily asfinance these days,but onecanacquire newideas</sup> embodied in imported machines,<sup>buy technology licenses,study at home or abroad,and</sup> use the Internet. And Korea<sup>shows that acquiring new technologyand ideasfrom</sup> overseas is fairly cheap.<sup>It spent less than1.5 percentof theincreasein GDP over1973-</sup> 79 on the technology licenses<sup>that underpinnedmanufacturinggrowth.2 5</sup>

## **23** Romer, 1993.

**24** Note that the static efficiency<sup>gais from tradeliberalization cannot explain the main benefits from</sup> openness. Static gains from<sup>tradeare typically one-off benefitsin the orderof 2 percent of GDP or maybe 4</sup> to 6 percent of GDP in the<sup>presenceof product differentiationor economiesof scale.These areimportant</sup> but not nearly as important<sup>as thegainsfrom learningthat drive successfulgrowth processes.</sup> **25** See Olson, 1996. More<sup>generally, while innovatorscan earna fair deal of money,they rarely receivethe</sup> full rents from their innovation.<sup>For example,Thomas AlvaEdison receivedbut a fraction of the benefits</sup> that electric light created. Even<sup>patent protection, unlessexcessive, just affords the innovating firm on</sup> average with a normal rate of<sup>returnon thecost of invention.Patent protectionis meant to preventthat new</sup> ideas are simply made available<sup>for free so that mventorsretain an mcentiveto spend time and money to</sup> mnovate. But most of the<sup>benefitsof successfulinventionsare passedto consumersin competitive markets.</sup>
_Ways Out of Povertv - Diffusing Best Practices and Creating CapabiliIes_ _10_

# **B. Impediments and Traps**

**Types of impediments and traps.** If the provision of capital does not drive growth, if finance, capital goods and know-how are not very hard to obtain, why is it difficult for some countries to grow? One set of arguments has to do with a variety of "traps" or lasting impediments that prevent countries from growing rapidly. They may suffer from being small or landlocked or plagued by inclement climates.<sup>2 6</sup> They may suffer from ethnic strife or civil war.<sup>27</sup> They may have policy and institutional rigidities induced by vested interests.<sup>28</sup> They may suffer from cultural biases or a lack of trust, a critical part of social capital.<sup>29</sup>

**Escapees from traps and impediments.** Whatever the trap, some country has been able to escape from it. All countries that are developed today have over long periods of time emerged from "hopeless" situations. Who would have thought at the time of the thirtyyears war (1618 to 1648) that Germany would ever be an economic powerhouse?

Today many countries have escaped from their trap fairly fast by historical standards.

- Adverse climate conditions can be overcome. Tropical Singapore is a rich country, and Malaysia and Thailand have also performed well as did Venezuela over most of the 20th century until the curse of oil set in during the late 1970s. At the other end of the climate spectrum Scandinavian countries boomed during the 20th century including th~~~~~~~~~~~~~~~3isolated, inhospitable Iceland.<sup>3 0</sup>

- Remote location need not prevent development either. Landlocked, tiny Botswana has consistently been a star performer in recent decades. Landlocked Uganda emerged very rapidly from the days of civil war and dictatorship and experienced a strong growth episode in the 1990s. The tiny island of Mauritius became one of Africa's best performing economies.

- Recovery is possible from civil strife. Civil war ended in El Salvador in 1992. Six years later per capita income had increased by 17 percent. Its human development index was up 8 percent, all without increasing the debt burden. Indeed, El Salvador became the third country in Latin America to receive an investment grade bond rating in 1998 - before Mexico.

- Countries that languish for many decades can turn around. Ireland, which suffered decades of emigration and economic stagnation, overtook the United Kingdom in per capita income in the 1990s, driven by productivity growth from foreign investment.

- Even deeply entrenched dysfunctional institutions may be overcome. Several' former communist countries-constrained by a formidable set of growth

> 26 Gallup et al., 1998.

> 27 Collier, 2000; Collier and Gunning, 1999.

> 28 Acemoglu and Robinson, 2000; Havrylyshyn and Odling-Smee, 2000; Hellman, 1998.

> 29 Collier, 1998; Fukuyama, 2000.

> 30 There was hardly a free-standing house in Iceland a hundred years ago and people lived half underground in grass-covered huts.
_11_ _Ways Out of Poverty - Diffysinj_<sup>_Best Practices and Creating Capabilities_</sup> restraining institutions, policies,<sup>and vestedinterests-turnedaround within a</sup> decade, particularly China and Central<sup>Europe.</sup>

**Arrested development.** Precisely<sup>because many countrieshave becomeso much richer,</sup> we now see that some may run<sup>into "traps" at higher incomes.Argentina, once among the</sup> most advanced in the world,<sup>has stagnatedrelativeto others since the1930s.Stagnation</sup> could also befall Japan. The communist<sup>countriesthat initially grew in the early phases of</sup> industrialization are the most<sup>dramatic illustrationof the phenomenon. We do not know</sup> how to predict such cases, but<sup>it seems clear that, after initial success,development may</sup> be arrested for some time.

Overall, while many countries have<sup>emerged from traps, many othershave not or are</sup> getting trapped again. The upshot<sup>appearsto be that thereare indeeda variety of factors</sup> that make it hard for a country<sup>to develop,but they can in principle be overcome-often</sup> in fairly short time. What it<sup>takesto do so is the issue.</sup>

# C. **The key to development: Capable**<sup>**institutions**</sup>

**Countries.** One way to reduce<sup>poverty is to allow poor people to move to richer</sup> countries. Immigrants in the<sup>UnitedStates of America producemore than 4.5 timesmore</sup> there than in their country of<sup>origin.Their skill level is the same. They benefitfrom extra</sup> and more advanced physical<sup>capitalin the UnitedStates.But that explainsonly abouta</sup> third of the difference (figure<sup>5). The main explanationis the capability of institutions-</sup> be they firms or governments-that<sup>allowindividuals to performat higher levels of</sup> productivity.

**Figure 5: Factor accumulation**<sup>**accountsforonly**</sup> **a fraction of income differences**<sup>**(in percent)**</sup>

<!-- Start of picture text --> Otilput pa Output paworka Diffarcein Diffaercein<br>iningrarn worka in honrcroutry outpLAdueto outpLAdueto<br>in US Ngna physical Inlstutiorna<br>capital in US environmret<br>Source: Calculatons based on Hendricks (2002).<br><!-- End of picture text --> Looking at output in 127 countries,<sup>Hall andJones (1998) find that humanand physical</sup> capital differences account<sup>for only a modest amount of the difference(figure 6).The</sup>
_Ways Out of Poverty - DiffiLsing Best Practices and Creating Capabilities_ _12_ biggest factor remains hard to capture. It is not new that unexplained residuals in statistical studies of growth are large for particular countries. But comparing productivity across countries shows the full extent of the elusive "unexplained residual." <!-- Start of picture text --> Figure 6: The difference in output per worker is due to<br>difference In Institutional environment<br>(ratio of the 5 richest to the 5 poorest countries)<br>315<br>Differeice in O%iput Cortributlonof Cordributionof Cortributionof<br>perWorker capitalintensity hrsncEpitae per instiutiornd<br>worker envirorrneTt<br><!-- End of picture text --> Source: Calculatons are based on Hall and Jones (1999).

Various things have to come together to raise productivity and incomes. For example, the more open an economy is-and with it presumably the ability to learn-the more education becomes useful.<sup>3 2</sup> For another example, the higher the level of domestic education, the more productive foreign investment becomes.<sup>3 3</sup> All this points to the power of institutions that enhance the division of labor.

**Regions.** Productivity also differs among regions within countries. Consider the coastal and interior provinces in China, or the North East of Brazil compared with Sao Paolo. Even where labor is mobile and the free movement of goods, services, and capital reigns, significant productivity differences can persist. A study of Italy suggests that longstanding differences between the North and South of Italy reflect differences in trust among people based on long-standing patterns of behavior, what the author calls "social capital."<sup>34</sup> In short, the environment people operate in makes a real difference to productivity.

**Cities and clusters.** Also critical, cities tend to be more productive than other parts of a country. More ideas are generated there, and incomes are higher. Why? Because cities allow for flexible labor markets and work arrangements, production and subcontracting methods, and easier flows of ideas (figure 7).35

31 Denison, 1967; Solow, 1957.

32 Krueger, Alan B. and Mikael Lindahl, 2001; Lopez et al., 1998. 33 Borenzstein et al., 1994; World Bank, 200 la. 34 Putnarl, 1993.

> 35 Glaeser, 1998; Jacobs, 1969.
_13_ _Ways Out of Poverty - DiffiLsing Best Practices and Creating Capabilities_ <!-- Start of picture text --> Figure 7: Location of new product innovation<br>in the United States (percent)<br>Other<br>4%<br>New York,<br>LA, Othe r<br>Boston, A large<br>San cities<br>Francisco -- 51%<br>45%<br><!-- End of picture text -->

**Source: Glaeser (1998).**

Clusters of firms as in Silicon Valley (information and communication technology) and in Northern Italy (textiles and garments) provide benefits similar to those in cities. ' As executives in Silicon Valley expressed it: ". . .People change jobs without changing carpools.. ." and "...the network in Silicon Valley transcends company loyalties. We treat people fairly and they are loyal to us, but there is an even higher level of loyalty - to their<sup>7</sup> network..."<sup>3</sup> Cities are forms of clusters, the best known way to incubate small enterprises.

**Firms and the diffusion of best practice.** Then there are firms.<sup>3 8</sup> Large, multi-plant firms-which exhibit some features similar to those of clusters, such as flexible internal labor markets, loyalty to the larger firm, flexible internal contracting-are more productive than smaller ones. In many developing countries foreign firms are more productive than local ones are, suggesting a way to import some types of capability. Most important, firms spread best practices and thus wealth through channels that may cross national boundaries. They equally function within a particular country. De facto, studies of cross-border links between firms have attracted more attention. Hence, some of the following discussion has a flavor of international learning channels. However, the same or similar mechanisms are at work within countries.

**Productive, new entrants from other areas.** One way of improving firm-level performance is for more productive firms to move into new markets through new investments or through mergers or acquisitions. Across borders we call this foreign direct investment. Foreign firms and joint ventures with foreign firms typically exhibit higher productivity than local firms in developing countries.<sup>3 9</sup> Foreign firms employ mostly local workers and managers, training them on the job in new technical and organizational

36 Porter, 1998.

**37** Saxenian, 1996.

> 38 Sutton, 2000.

> 39 Barberis et al., 1996; Blomstrom and Sjoholm, 1998; Djankov and Murrell, 2002; Earle and Estrm, 1998; Havrylyshyn and McGettigan, 1999.
_14_ _Ways Out of Poverty - Diffusing Best Practices and Creatingz Capabilities_ practices. The superior performance of direct foreign investors tends to provide them with greater market share in their sector. Over time, local competitors may be able<sup>to</sup> catch up as well, but initially they tend to lose market share.<sup>40</sup> Similar<sup>processesare at</sup> work within countries. Efficient companies from one part of a country<sup>move into other</sup> regions and improve productivity there.

**Learning by buyers and suppliers.** Subcontractors to foreign investors appear<sup>to be</sup> helped by their presence. Dealing with demanding foreign investors helps<sup>themupgrade</sup> their quality and reduce costs. In varying degrees foreign investors provide<sup>active support</sup> to their suppliers to improve performance.<sup>4</sup> ' Contracting also takes place<sup>across borders.</sup> Export opportunities provide the competent domestic firms with the option to expand their market, and firms can learn to upgrade their productivity, as studies<sup>of firms from</sup> East Asia and Mexico suggest (figure 8).42 Demanding customers in high-quality<sup>markets</sup> are a key force driving performance improvements.

**Figure 8: Exporters spend more on training and acquiring foreign technology (ratio of expenditure by exporters to domestic-oriented firms)**

<!-- Start of picture text --> Indonesia<br>Korea<br>RPilippines<br>Thailand<br>1.00 1.50 2.00 2.50 3.00<br>o Training * Foreign Tech<br><!-- End of picture text --> Source: Hallward-Driemeier (2001).

Firms as incubators for new entrepreneurs. Another important way<sup>for new and more</sup> productive firms to emerge is for people who learned in one firm to leave<sup>and set up their</sup> own firm. Take the garment industry in Bangladesh, where locals learned<sup>from a Korean</sup> company, Daewoo (box 2). They later set up their own businesses in Bangladesh,<sup>which</sup> in turn produced more small entrepreneurs. In a short time the garment<sup>industry became</sup> Bangladesh's leading export industry, accounting for almost 75 percent of the export earnings in 2001. In India the most efficient machine tool company was set up by employees from older, less efficient machine tool companies.

> 40 Aitken and Harrison, 1999; Djankov and Murrell, 2002.

> 4t Batra and Tan, 2000; Batra and Tan, 1995.

> 42 Hallberg et al., 2000.
_15_ _Ways_ **_Out_** _of Poverty - Diffyusing Best Practices and Creatzn2 Capabilities_

**Box 2: The role of policy reforms and diffusion of good practices in the growth of the Bangladesh garments industry**

The garment industry in Bangladesh grew from nothing in 1979 to about $5 billion of exports per year-a little over three-quarters of the current annual export earnings in Bangladesh. This phenomenal growth is due to the diffusion of good practices, from foreign to one local enterprise and from the local enterprise to many others. It is also due to a number of policy and administrative improvements that opened up investment opportunities for local entrepreneurs.

It all started in 1979 with the collaboration between the Korean company, Daewoo, and the Bangladeshi enterprise, Desh Garments. Daewoo did not make any capital investment in Desh, but it signed a five-year contract to help Desh purchase machinery and fabric (some of it on credit from Daewoo), to set up the factory and market the garments. The contract also included training of Desh employees in Daewoo's plant in Korea and at Desh facilities in Bangladesh. About 130 Desh employees received very intensive training in technical production skills, management, and marketing at Daewoo in Korea. They returned to Bangladesh with technical production and marketing know-how plus an appreciation of the corporate culture required for success in export markets. Daewoo sent its own technicians to Desh-to help set up the machines, oversee quality assurance in production, and train Desh workers who had not been to Korea.

Garment production began in 1980 with 450 machines and 500 workers. By June 1981, Desh already felt that it was ready to operate on its own and terminated its contract with Daewoo. In 1980 Desh produced 43,000 shirts at a value of $56,000. By 1987 sales had risen to 2.3 million shirts worth $5.3 million. The quality of Desh's garments had also improved significantly. The unit export price increased by 75% from $1.30 to $2.30. Between 1980 and 1987, Desh expanded from 450 machines to 750, and its workforce increased from 500 to 1,400. By 1987, Desh was handling its own export marketing and was buying all its raw material from sources other than Daewoo.

More interesting, of the initial batch of 130 employees who visited Korea in 1980, 115 left the company by mid-1981 to start their own garment-exporting businesses and began replicating Desh's success in other factories. By 1985 Bangladesh had 700 garment-export manufacturing factories.

Source: Mahmood (2002).

Many successful small companies are founded by ex-employees of larger companies, where they learned their job. Often they learned about opportunities that their previous employer did not recognize or did not wish to exploit. The former employer might have been stuck in routines that were too hard to change or might have been reluctant to embark on new ventures that would undermine or cannibalize successful product lines.<sup>43</sup> The most detailed attempt at studying the phenomenon comes from the United States: more than 70 percent of new ventures were set up by employees who got their business idea when employed by another company (figure 9).

43 Chnstensen, 1997.
_16_ _Ways Out ofPovert - Diffising Best Practices and Creating Capabilities_ <!-- Start of picture text --> Figure 9: Origin of Innovation In the United States<br>(percentage of 1989 Inc. 500 founders surveyed)<br>ro ea caufrom previLous<br>errploynlat<br>* Id caethroug h<br>.eperinitation<br>- -. oldea carrettrough research<br>DIdeacarrebyaccidend<br>Source: Bhide (2000).<br><!-- End of picture text --> D. **Poverty reduction: The diffusion of best practice and the creation of capability** _"... The engine (of development) is the advance of technology and the difusion of technical capacities ofpeople, firms and governments... "_ Robert Wade _"...If as I believe, the difference in efficiency between U.S. and developing-countryfirms is typically large, there is much room for quite rapid improvements in the developing countries as they learn how to adopt and adapt alreadyknown techniques from the advanced countries... "_ Armold Harberger So what does all this imply for poverty reduction?" Critical to creating wealth is the capability of institutions that allow people to work together and that create productive jobs in the process. For poverty to be eradicated quickly, these institutions must be open to learning and adapting know-how that already exists-and be capable of applying it efficiently. The traditional factors of production are not too hard to obtain: natural resources, capital goods, finance, ideas, and reasonably competent labor.

> **44** Whether we call it poverty reduction or wealth creation or growth, the widespread rise in individual incomes requires productivity improvements and the provision of better products or services. After all standards of living improve when people can get existing products or services at lower cost or better ones at acceptable costs.
_Ways Out of Poverty - Diffiusing Best Practices and Creating Capabilities_ _17_ But because poor people cannot simply move to areas where capable institutions already exist, pro-poor growth involves diffusing best practices and capabilities to areas where poor people live.

The mechanics of organizing institutions can be learned. For firms, organizational practices can also be "imported," through foreign direct investment or the movement of firms within countries. The really critical local element of good institutions that is hard to import is the ability of people to work well together-their behavior and their culture. Even firms cannot transplant cultures. A study of a large firm in Italy with operations in both the North and the South shows that worker behavior varies significantly in different parts of the country. When workers from the North move South, they start behaving like those in the South and vice versa (figure 10).

**Figure 10: Frequencies of misconduct of workers In an Italian firm, by region of birth**

<!-- Start of picture text --> Workers In the North Workers in the South<br>0 016 0.016<br>0.012 0.012<br>0 008 - 0.008 -<br>0 004 - 0.004 -<br>0 000 _ 0.000<br>* Born north a Born center * Born south * Born north 3 Born center * Born south<br>Source: Ichino and Ichino (1997).<br><!-- End of picture text -->
_18_ _Ways Out of Poverty - Diffusing Best_<sup>_Practices and Creating Capabilities_</sup>

# V. CORE INSTITUTIONS: MARKETS,<sup>FIRMSAND GOVERNMENTS</sup>

_"Trying to stop a market is like_<sup>_trying to stop a river. "_</sup> A Vietnamese proverb _a nation's economic growth and_<sup>_competitive strength_</sup> _rest on more than natural resources,_<sup>_labor and managerial_</sup> _skills, available capital or even the_<sup>_sizeof internal markets._</sup> _The wealth of nations during_<sup>_the past hundred years has_</sup> _been based more on the ability of_<sup>_industrial enterprises to_</sup> _adopt and to develop_ ... _technologies_<sup>_andtodevise_</sup> _administrative structures to co-ordinate_<sup>_the_...</sup><sup>_processes of_</sup> _production and distribution. "_

## Alfred Chandler

_"...What distinguishes modern_<sup>_government_</sup> _from personal control is its unremitting character. To be governed_<sup>_is to be_</sup> _subjected to the regular pressure_<sup>_of an_</sup> _authority operating to fixed_<sup>_rules.._</sup><sup>**_._**</sup><sup>_In the_</sup> _full sense of the word, it_<sup>_is arguable that_</sup> _nobody was governed before_<sup>_the later_</sup> _1 9_<sup>_ah_</sup> _century..."_ Jean Dunbabin45

**Spontaneous emergence of**<sup>**markets.**Marketsare institutionsthat arise spontaneously</sup> even without government intervention.<sup>In the most desolate placesmerchantsply their</sup> trade and supply people with goods<sup>and services.Lawless placeslike Somalia today</sup> show that trade in almost all goods<sup>at world pricesis being organized in theabsence of</sup> government. Even cell phone<sup>service with pre-paidcards is availableinSomalia as is</sup> basic electricity service - for<sup>those who can pay.Tiny enterprisesand farmsoperatein</sup> all societies.<sup>46</sup>

The rise of firms and government.<sup>Substantialandsustained wealth creation requiresa</sup> complex division of labor and<sup>morecomplex organizations than arisespontaneously</sup> almost everywhere. The rise of<sup>modemfirms,operating in marketsshaped by modem</sup> government, provides the institutional<sup>fabricfor factorsof productionto combinemore</sup> and more productively. To be productive,<sup>firmsneed to play by certain rulesand beable</sup> and willing to co-operate. They<sup>need to respect basic rulessuch as property rightsand</sup> contracts so that they have incentives<sup>to invest and co-operatewith buyersandsuppliers.</sup> To ensure that products and production<sup>processes fit society'sexpectations about socially</sup>

> _45_ Quoted in Fmner, 1997, p. 70. **_46_** McMillan, 2002.
_19_ _Ways Out ofPovert - Di(ffsing Best_<sup>_Practices and Creating Capabilities_</sup> and environmentally sound practices<sup>firms needto respecta variety of regulationsthat</sup> condition their property rights.<sup>Under such rules,which requirethe governmentto</sup> establish and enforce them, a<sup>symbiosisof smallandlargefirms emerges,which</sup> compete, trade and contract with<sup>each other.Considernow the key featuresthat</sup> characterize effective institutional<sup>fabricscombiningfirns, markets andgovernments.</sup>

# **A. Experiments and routines-freedom**<sup>**toenter and to fail**</sup>

Firms spread best practices and<sup>productive jobs to areaswhere poor people live.But the</sup> diffusion is not straightforward.<sup>As discussedbefore,various channelsfor improving</sup> firm-level perforrnance exist that<sup>transfer best practice already invented elsewhere.</sup> However, not all firrns are capable<sup>of benefitingfrom them -even when newfirmentry</sup> is allowed and when openness to<sup>new methods of organizationand productionexist.</sup> There are two fundamental reasons<sup>for this. First,all entrepreneurialactivity is fraught</sup> with uncertainty and thus requires<sup>experiments.Second,firms,or any organizationsneed</sup> to create routines to cope with complex<sup>tasks.Sofailure isunavoidable for firms that</sup> make the wrong bet or choose unsustainable<sup>routines.</sup>

**Experiments.** Start with uncertainty.<sup>Adopting best practiceis not straightforward.Even</sup> simple production technologies,<sup>suchas planting new farm crops, requireadaptation to</sup> local circumstances. More complex<sup>technologies, such as car manufacturing,require</sup> extensive learning on the job. It<sup>took Korea's Hyundaicorporation14 monthsof trials to</sup> design its first prototype car. It<sup>then took experimentswith11prototypes,2,888engine</sup> design changes, 97 test engines,<sup>and more than 200 test transmissionsand 150test</sup> vehicles to produce its first commercial<sup>car in1992.47</sup>

**Routines.** Now consider routines.<sup>The Indian machine toolsindustry showsthatthe staff</sup> of mediocre firms could do much<sup>better than the firmsthey worked in.Managementmay</sup> not have listened to them, may<sup>not have giventhem a chance,or may have been unable to</sup> restructure existing operations.<sup>The old companies werestuck in routines that prevented</sup> them from improving.

There is no avoiding routines.<sup>Butthere often are differentwaysof pursuinga productive</sup> activity. Even in everyday life<sup>we benefitfrom routines that simplify our tasks.Routines</sup> are even more important when<sup>it comesto aligning work practicesin a firm.They are not</sup> bureaucratic aberrations. They<sup>are a way of coping with complexity.But they may fail to</sup> deliver. They are a consequence of<sup>what economistscallbounded rationality.</sup>

# **B. Competition-the mechanism**<sup>**to selectthe most productive firms**</sup>

Information problems, uncertainty,<sup>and the limited ability tocope with complexityare the</sup> root causes of unavoidable failure<sup>of firms.So forfirms to adoptbest practice, there must</sup> be mechanisms that deal reasonably<sup>well with the failure of firms. Such mechanisms need</sup>

> **47** Kim, 1997.
_Ways Out of Povertv - Dzffusinsg Best Practices and Creating Capabilities_ _20_ to allow physical assets, ideas, people, and funds to be used again in new and better ways when a firm fails. This is where the competition in markets comes in. Competitive markets select firms that pursue particular experiments or routines. They also provide incentives for market participants to improve and to adjust when they are facing failure. In some cases, incumbent firms adapt successfully. In others, new entrants drive out nonperforming firms.

> Over the last twenty years considerable work has been carried out to understand better the

> way markets with firms work. Most of this work covers advanced countries.<sup>48</sup> However,

> a significant amount of work has also been carried out in developing countries of all types. The picture is similar in developed as well as developing countries with the main

> difference that developing economies tend to have smaller firms than advanced

> economies (figure 1). 49

Figure **11: Distribution of employment by firm size** <!-- Start of picture text --> 90%<br>100% - X<br>2 80%<br>70% -<br>6 60%<br>5 50%<br>4 0%<br>30%<br>20%<br>10%<br>100-500 500-1000 1000- 2000- 5000+<br>2000 5000<br>GNP Per Capita, US$<br>oi Mcro (1-4) Srmall (5-19) 0 Mediumr(20-99) o Large (100+)<br>Source: Snodgrass and Biggs (1996).<br><!-- End of picture text -->

**Heterogeneity among firms.** Traditional economic textbooks treat markets as if all firms are efficient, driven by the incentives from the price signals in markets. When demand increases new firms would enter, and when it decreases some incumbents would fail. In reality the picture is quite different. Typically existing firms are not similarly efficient. Instead, they are quite heterogeneous with substantial dispersion in productivity among firms and among sectors. A detailed review of firm-level performance in 44 different

> 48 Caves 1998; Sutton, 1997; Tybout, 2000.

> 4 9 Audretsch, 2000; Aw, 2001; Nugent and Yhee, 2001. Also see the World Bank's RPED micro-studies for Afnca over the last decade (A list of available studies can be found at

> http://www.worldbank.org/afr/findings/frenchIrped.htm ).
_21_ _Ways Out of Povertv - Diffusinz Best Practices and Creatiniz Capabilities_ manufacturing sectors in Mexico shows in each sector that some firms add value while some barely contribute and others destroy value.<sup>50</sup> The average productivity of firms in different sectors in India varies substantially, and remains significantly below best practice (figure 12).

**Competition and the dispersion of productivity.** In general, bringing average practice closer to best practice is of enormous value for wealth creation. Individual firms often have similar opportunities to learn and improve, but fail to do so for the reasons given above. Competition turns out to be the key to bringing average practice closer to best practice. Hence competition is a key part of the diffusion mechanism for best practice. A number of studies support this for countries such as Brazil, India, Korea, Japan, Russia and Thailand.<sup>5</sup> "

<!-- Start of picture text --> Figure 12: Indla - Current and potential labor productivity<br>(Indexed to US, 1998 = 100)<br>Current productivity Expected productivity in 2010<br>Software 44 Software 85<br>Retal barking Ml 12 Reai bwig 62<br>Reail iN 12 Retail 32<br>io.ising cornstruction i 15<br>Powr T&D Housing construtlon 28<br>Power Geneatlon 9 Power T80 9<br>Telecom 25 Power Generation 52<br>Appard 26 Telecom 100<br>Wheat miling 7 Apparel at 65<br>Daityprocessing is 16<br>Autonotiveasseibly 24<br>Steel i 11 Daltyprocessing 46<br>Automotive assem'bly 78<br>Sted 1 7<br><!-- End of picture text --> Note: Figures for expected productivity are derived on the assumption that all productivity barriers are removed. Most of the productivity improvements are expected to come from rationalizing the workforce, improving the organizadon of funcUons and tasks and investing in viable assets. Source: McKinsey Global Institute (2001).

Entry and exit patterns. The key element in competition is the freedom to enter the market and to fail. Free entry means that exit from markets must be possible for substandard enterprises. Where inefficient but politically well-connected firms are sustained through protection or subsidies by governments or through bail-outs by

> _50_ Harberger, 1998.

> **5'** Driemeier, 2001; McKinsey Global Institute, various years.
_Ways Out of Poverty - Diffusing Best Practices and Creating Capabilities_ _22_ financial institution, new firms can compete only with difficulty. They have difficulty obtaining credit, and they tend not to enter.

When entry is possible, new firms do not enter only when demand is up, and old firms do not leave only when demand declines. Every year around 5 to 20 percent of all firms enter the market and a similar number of older firms go out of business. Most new firms are small, and some 40-60 percent go out of business within five years after entering. Data from developing countries suggest that the average new entrant is a little more productive than firms exiting the market. In most economies, the turnover of firms helps increase productivity. In part this reflects people being successful who have previously failed. In part it reflects new entrants altogether.

<!-- Start of picture text --> Figure 13: Plant turnover and market share of entrants<br>One-year old plants Five-year old plants<br>150 80.0<br>-60.0-<br>' 100 400<br>J ,U_<br>Jjm20.0<br>0.0 - Korea Taiw an United<br>Chge Cobmbia ?vbrocco States<br>E3Market share of entrants 5 Rant turover rates C Market share of entrants e lant turnover rates<br><!-- End of picture text --> Note: The plant tumover rate is the average of the entry rate and the exit rate of plants. Source: Tybout (2000).

**Opportunity for small** businesses and **farms.** Many of the key measures to help small farms and micro-enterprises are not fundamentally different from those affecting other firms. Hernando de Soto has demonstrated in writing and in his experiments with setting up new small firms that burdensome entry regulations, red tape, bureaucratic harassment, and the absence of clear property rights and contract security make it impossible for many small entrepreneurs to establish themselves, to become formal, and to grow. That spotlights the importance of programs to reduce entry regulations, reduce bureaucratic harassment, and clarify and formalize property rights (box 3).

**Box 3: Property rights and poverty reduction**

According to Hernando de Soto (2000), the total value of the fixed property held but not legally owned by the poor in developing countries is around $9.3 trillion. This is 93 times the amount of official development assistance to developing countries over the past 30 years and 20 times the stock of foreign direct investment in developing countries between 1989 and 1999. But, because the ownership of these assets is not formalized, the people in poor countries cannot use them as collateral to raise cash.
_23_ _Ways Out of Poverty - Diffusing Best Practices and Creatinz Capabilities_ Field research has shown that the reason why businessespstay<sup>informal and landownersdo not</sup> register their property is not so much because they have to pay taxes but because<sup>they are usually</sup> hindered by the bureaucracy. For example, de Soto and a team of<sup>his researcherstriedto registera</sup> one-man clothing workshop that they had set up outside Lima, Peru. It took 289<sup>days,involving</sup> many hours of filling forms, traveling by bus into central Lima,<sup>and queuingup to seethe relevant</sup> officials, to register their micro-enterprise. The whole operation cost $1,231 -<sup>31times the</sup> monthly minimum wage in Peru.

In Malawi, houses are built on "customary" land, i.e. land that the residents have<sup>noformaltitle to</sup> but that has been cultivated by their family for generations. The<sup>villagechief usuallyoverseesany</sup> disputes about boundaries. If a family breaks the rules of<sup>the tribeor leavesthe property</sup> unattended, the chief has the power to take the land away and give it to someone else.<sup>The contract</sup> may be oral, or it may be written and signed by the chief. The problem is that<sup>no bankwill accept</sup> it as a collateral. The land and the property built on it turns out to be what<sup>Hemandode Soto calls</sup> "dead" capital.

All rich industrialized countries have clear, enforceable and almost<sup>inclusiveproperty rights.</sup> Although better property laws are not the only reason why some countries are<sup>better off than</sup> others, de Soto insists that they make a significant difference.

Source: De Soto (2000).

**Internal growth.** Productivity growth comes not only from entry and exit,<sup>but alsofrom</sup> the growth of existing firms responding to market incentives. Some of the new<sup>entrants</sup> turn out to be successful and the best become large firms.<sup>5 2</sup> Productivity growth<sup>also</sup> comes from large firms branching out and entering new markets, sometimes<sup>through</sup> mergers and acquisitions of promising firms. As good firms become large they tend on average to have higher productivity than small firms. But the highest growth rates<sup>are</sup> found among small companies that happen to be particularly efficient. Firms<sup>are</sup> productive not because they have a particular size but because they<sup>aregood.5 3</sup>

In a new industry, small firms play the prime role in innovation and<sup>productivity</sup> development (box 4). The good firms continue to improve through internal<sup>growth,</sup> taking over less well-managed companies or buying up promising small firms that<sup>need</sup> capital.<sup>5 4</sup> Once firms have proven themselves and become large, they remain<sup>more</sup> productive and last much longer than the average smaller firm. Indeed, many<sup>large firms</sup> are like collections of small ones. They operate an internal market for corporate<sup>control,</sup> which can be superior to that of the broader market. And they owe their success<sup>to their</sup> ability to allocate people, capital, ideas, and assets better than firms operating<sup>at arms-</sup> length from each other.<sup>5 5</sup> But, there is no guarantee, and large firms may<sup>also fail</sup> eventually.

> 52 Rajan and Zingales, 1998.

" Aw, 2001.

54 Ravenscraft and Scherer, 1987.

55 Hellwig, 2000; Klein, 2000.
_Ways Out of Povertv - Dzffusine Best Practices and Creatingz Capabilities_ _24_

# **Box 4: Markets, innovation and the state**

In the 1920s and 30s, around 100,000 different varieties of airplane were flown. All over the world, enthusiastic inventors were selling airplanes to intrepid pilots and to fledging airlines. Many of the pilots crashed, and many of the airlines became bankrupt. Of 100,000 types of airplane, about 100 survived to form the basis of modem aviation. The evolution of airplane was a strictly Darwinian process in which almost all the varieties of airplane failed, just as almost all species became extinct. Because of the rigorous selection, the few surviving airplanes are reliable, economical, and safe.

## **Source: Dyson (1998).**

**The symbiosis of large and small firms.** All sectors in all market economies have a mix of many small, fewer medium-size, and a few large companies. The average size varies with economies of scale between sectors, but within sectors there are firns of many different sizes - not like in the textbooks that suggest all firms in an industry should look similar, reflecting relevant economies of scale. Small, medium, and large firms do not just exist next to each other in markets. They also interact through buyer-seller relationships, through various co-operative arrangements, through credit relations. Many times intricate networks of firms exist, within large companies, between large and smaller ones and in clusters of various types.

The way that a firm enters, grows, and exits varies from country to country, an area little studied so far. A recent OECD study shows that the average new entrant in the United States is less efficient than existing firms. But entry is valuable because it allows new ideas to be tried out and the companies that turn out to be good can easily grow to become larger. Most productivity growth in the United States is thus due to the internal growth of firms and not to the entry of more efficient firms. But in several European countries, the entry of better firms accounts for a large part of productivity growth, and internal growth appears less effective. This may reflect banriers to growth in those countries, such as labor regulations for firms above small sizes (figure 14). In developing countries very small informal enterprises proliferate, preferring to remain informal because of the burden of regulations and taxes on formal firms.
_25_ _Ways Out of Povertv - Diffising Best Practices and Creating Capabilities_ <!-- Start of picture text --> Figure 14: Decomposition of multifactor productivity growth<br>In manufacturing<br>(contribution of each component to total annual productivity growth)<br>1400<br>120.0<br>1000<br>*~80.0-<br>60 0-<br>0.. 40 0-<br>0.0<br>-20 0<br>Finland France Italy Netherlands United United<br>Kngsdom States<br>g Within-firm productivity growth * Output reallocation aniongst existing firms<br>o[]ntry of firms * Exit of firms<br>Source Scarpetta et al. (2002).<br><!-- End of picture text --> In this ecology of firms, markets leave ample room for new organizational<sup>species to</sup> emerge, spanning atomistic small firms, large hierarchical finns,<sup>internalfirm marketsfor</sup> corporate control, and all sorts of co-operative arrangements among firms.<sup>Customer</sup> demand provides the main feedback mechanism, as the firms survive<sup>that meet customer</sup> demand most effectively. The diffusion of best practice is accomplished<sup>this well-</sup> functioning ecology, not by any single measure or any single<sup>type of firm.Governments</sup> shape the ecology and the niches allowed by the way they set<sup>property rights, regulations,</sup> taxes and other relevant parameters.
_26_ _Ways Out of Povertv - Diffusing Best Practices and Creating Capabilities_

# VI. **Market failure and the politics of change**

When it comes to generating growth or establishing "competitiveness", special government support beyond allowing the ecology of firms to work is often justified<sup>with</sup> reference to market failures that may plague learning processes and access to finance. Learning needs time, hence it is argued that certain sectors that have potential for growth might need temporary protection of some type until they are ready to face the gale of full international competition. Learning also is to a degree embodied in individuals. When firms spend resources to train individuals the latter may decide to leave and reap the benefits for themselves. Hence firms might be overly reluctant to invest in training.<sup>56</sup> When it comes to access to finance, financial institutions may not be willing to lend to small and medium enterprises, because they have little track record, are likely to<sup>go</sup> bankrupt within a few years and are typically dependent on a single owner or just<sup>a few</sup> persons, who might be affected by illness or other sudden changes in life.

**Large firms as institutions** to **cope with market failure.** Special institutional innovations are needed to cope with such market failures. The larger firm itself is precisely such an institution. It is in fact, the first line of defense against market failure. It is capable of building a track record vis-a-vis financial institutions. It is less dependent on individuals than smaller firms. It can invest in small subsidiaries while they learn and it is more likely to retain staff and benefit from investment in training.

**Collateral and credit information systems.** As a second line of defense, governments can help with access to credit by establishing functioning property rights systems that allow collateral systems to function so that individuals and small finns can get access to credit.<sup>57</sup> In fact, everywhere in the world most of small enterprise finance is secured through collateral, for example through mortgages on the owner's real estate. Credit information systems that help track the payment record of individuals and small firms are another key mechanism to help small market participants to establish their credit, and hence access to finance.

**Support programs for small and medium enterprises and farmers.** Beyond these basic measures, on which there is relatively widespread consensus, governments can establish further programs to support particularly small and medium-sized firms. Directed and subsidized credit programs for small urban and rural enterprises and farms exist in most countries. Advisory services for farms and small firms, for example on new crops or farming techniques or on business management are also widespread. However, the most complete review of studies on the experience with such schemes worldwide suggests that very few schemes have been seriously evaluated.<sup>5 8</sup> Overall, many<sup>remain</sup>

56 Smaller firms can in particular overcome the problem of incentives to train as long as they are able to employ apprentices at very low wages as happens in a number of countries. Many people may then choose to learn at low wages in small firms in the expectation of higher income later rather than taking on an initially better paid job with the state, which, however, tends to yield a lower lifetime income. However, where labor regulations prohibit low wages for apprentices, small firms may not have the right incentives to invest in training.

57 Fleisig, 1995.

5 Batra and Mahmood, 2001.
_27_ _Ways Out of Poverty - Diffuszn- Best Practices and Creating Capabilities_ ineffective or are abused, in particular subsidized schemes. The key hypothesis that emerges from existing experience is that the schemes with the greatest<sup>chanceof working</sup> well are those aligned with basic market principles. Decent credit support programs<sup>tend</sup> to avoid subsidized credit terms. Sound approaches to advisory services tend<sup>to</sup> emphasize creation of demand for such services and delivery via market mechanisms. In addition, special support schemes seem to require a sound basic overall policy<sup>framework</sup> for markets where they operate.

**Industrial policy.** Special government support for domestic firms of all types<sup>has</sup> typically been discussed under the heading of "infant industry" protection or "industrial policy", even though other sectors might be affected as well, such as services<sup>or</sup> agriculture. Essentially industrial policy consists of a mix of policies that<sup>create room for</sup> domestic firms to leam and to obtain finance so as to improve productivity. In a great number of countries such policies have been a disappointment. The above-cited case<sup>of</sup> the Indian machine tool industry provides an example, where a protected industry<sup>has not</sup> used protection to leam but to be satisfied with substandard performance. However, particularly in East Asian economies like Japan and Korea industrial policy is often<sup>seen</sup> to have helped. A recent study examined productivity performance in Japan and Korea sector by sector (figure 15). It tums out that the sectors that benefited from special support contributed only a modest amount to productivity growth. Overall, even<sup>in the</sup> two arguably most successful cases industrial policy has at best been a small factor<sup>for</sup> success.

**Figure 15: The effect of Industrial policy on growth of total factor**<sup>**productivity in themanufacturing**</sup> **sector and aggregate growth** (average annual rate of growth)

<!-- Start of picture text --> Korea - 1966-1985 Japan - 1960-1979<br>Xt00 900 880 V00 900 867<br>8a00 800-<br>600* 600-<br>400- 32 400- 236<br>200 200 137<br>With industrial policy Without industrial With industrial policy Without industrial<br>policy Policy<br>OTFPgrowth gGDPgrowth OTFPgrowth iGOPgrowth<br><!-- End of picture text --> Note: This analysis is based on the assumption that the growth in manufacturing<sup>sector</sup> accounted for only a third of the growth in GDP in both Korea and Japan. The<sup>TFP</sup> growth figures relate to the manufacturing sector only and not to the whole economy. Source. Pack (2000).

Clearly, to be successful industrial policy needs to expose the firms that are supported to some form of serious competition, for example, by tying continued support to export success in truly competitive markets as in the case of Korea and Japan.59 Openness to

**59** Stiglitz, 1998b.
_28_ _Ways Out of Povertv - Diffusing Best Practices_<sup>_and Creatin- Capabilities_</sup> best practice and exposure of firms to the<sup>selectionmechanism of competitionis critical</sup> for government intervention to help. Even<sup>analysts whoquestion economicorthodoxy</sup> and are open to "heterodox" approaches conclude<sup>that "we do not wantto leave the</sup> impression that we think trade protection<sup>isgood for economicgrowth.We know of no</sup> credible evidence - at least for the post- 1945<sup>period-that suggeststhat trade restrictions</sup> are systematically associated with higher growth<sup>rates."60</sup>

**The politics of support schemes.** Whatever<sup>formof government interventionin support</sup> of access to finance or learning one may consider<sup>for small and largefirms,in urban or</sup> rural areas, basic market forces appear needed<sup>to givethese policiesa chance to succeed.</sup> It may also be that the interventions "work"<sup>in placeswhere otherwisesound institutions</sup> and policies are in place anyway.61 Note that<sup>among successful specialschemes such as</sup> export promotion, industrial policy, and the<sup>like, thesamesmall groupof countriesis</sup> mentioned again and again - particularly Japan,<sup>Korea and Singapore.62</sup>

Doubts about their effectiveness have not<sup>reduced the attraction of variousforms of</sup> government support schemes, for example those<sup>for small and medium sized firms, which</sup> are popular all over the world. Other subsidy<sup>schemesare widespreadas well and the</sup> evidence about their effectiveness is neither<sup>stronger nor weaker.However,they meet</sup> with a bit more skepticism such as special fiscal<sup>incentivesforforeign directinvestment</sup> or some agricultural support schemes in major<sup>OECD economies.Thissuggests that it</sup> may well be that the drivers for support schemes<sup>have in factlittle to do with economic</sup> considerations per se. They may mostly<sup>be part of the political give-and-takeof any</sup> nation. In particular, the spread of best practices<sup>and more productivejob upsets old</sup> patterns of production, typically disrupts the<sup>lives of some peopleall the whileit</sup> improves those of others and in the end is<sup>the way to raise living standardsbroadly.The</sup> support schemes may thus help good policy<sup>because they may moderate the pain of</sup> adjustment and help build political backing<sup>for it.However,they may also helpentrench</sup> vested interests and the survival of inefficient<sup>firmsand thushold back productivity</sup> growth.

**Insurance schemes.** A major issue for policy-making<sup>is thus how to deal with demands</sup> for special support schemes. On the one<sup>hand politicalacceptability may requiresuch</sup> schemes. On the other hand they must be<sup>designed not to underminethe workingsof</sup> sound markets and the development of world-class<sup>capability in firms.While the politics</sup> of each country probably require somewhat<sup>different approaches, there may beone</sup> general principle to consider. As has been<sup>discussedabove, the creationof successful</sup> ventures or firms requires taking risks. Experimentation<sup>is neededand failureis</sup> unavoidable. People are more likely to take<sup>riskswhen they know that there is some</sup> safety net to fall back on in case of failure.<sup>Asensible social safety net is thus good for</sup> efficiency and growth, not just for equity<sup>and fairness.For example, the institutionof</sup> limited liability, which limits the losses of<sup>business owners,has helped promote</sup>

> 60 Rodriguez and Rodnk, 2000.

> 61 Same as aid effectiveness.

> 62 Keesing and Singer, 1990; Rhee et al.,<sup>1984;Thomas and Nash,1991.</sup>
_29_ _Ways Out of Poverty - Diffiusing Best Practices and Creatinz Capabilities_ entrepreneurship. Small farmers are more likely to invest in risky ventures<sup>when they</sup> have a way of insuring themselves.

Political acceptability and economic efficiency may thus best be helped<sup>by designing</sup> forms of insurance appropriate for a particular economy. For example,<sup>large-scale</sup> unemployment insurance can be afforded by advanced economies. Smaller<sup>insurance</sup> schemes are practical in poor countries. This would include micro-finance<sup>programs,</sup> which are mostly not used to fund investment but to help deal with temporary<sup>inability to</sup> pay for consumption and which spread default risk among small groups<sup>of people.63</sup>

**The New Swedish Model.** The general picture that thus emerges<sup>fordesirable</sup> government policy might be termed the "New Swedish Model". Before<sup>the1990s,</sup> Swedish economic policy was often looked at as a "third way" between<sup>capitalismand</sup> socialism. After the economic crisis of the early 1990s Sweden and<sup>several other</sup> Scandinavian countries have remodeled themselves. The cornerstones of<sup>the current</sup> model are:

- prudent macro-economic policies and low inflation;64

- a highly competitive environment for firms with few barriers to entry and growth and minimum red tape (figure 16); and

- a strong social safety net.

<!-- Start of picture text --> Figure 1i: Lower levels of regulation in Sweden<br>Number of procedures Number of days it takes Index of formalism in<br>needed to to court enforcement<br>register a business register a business<br>Svveden OECD Ird'lSwede OECD irdn! Sweden OECD bIl'<br>Average Average Average Average Average Average<br>Note: The index of formalism measures substantive and procedural statutory intervention in judicial cases at lower<br>level civil trail courts.<br><!-- End of picture text --> Source: Doing Business Database As countries advance, the complexity and average size of institutions,<sup>be they firms or</sup> government agencies or other forms of organizations, increases.<sup>The shareof</sup> government in total economic activity also increases, not because government<sup>interferes</sup> with production decisions and the ecology of firms, but because of the<sup>growthof transfer</sup> payments that lie behind the social safety net of advanced societies,<sup>whichin turn</sup>

> **63** Morduch, 1999.

> **64** Dollar and Kraay, 2000.
_30_ _Ways Out of Povertv - Diffusing Best_<sup>_Practices and Creating Capabilites_</sup> supports risk-taking in the productive<sup>sectors.The "NewSwedish Model",whether we</sup> call it "capitalism with a heart" or<sup>"socialism with a head" appearsto be the mainavenue</sup> ahead.

**Partial and heterodox** reform.<sup>The question remains how good governancein society</sup> at large arises and what can be done<sup>to promoteit.A critical point is that we do not know</sup> how to engineer good governance. It<sup>is perfectlypossible and plausiblethat pure chance</sup> and luck play a large role in the creation<sup>of successfulsocieties.65Itisequally clearthat</sup> highly incomplete reforms have to<sup>be sufficientfor growthto take off.Otherwise no</sup> country could ever have developed.<sup>For example, countrieslike Bangladeshor China</sup> have seen progress, admittedly of<sup>varying degrees,by pursuing only partial reforms and</sup> despite continuing and pervasive governance<sup>issues.It is alsoclear that many successful</sup> countries have pursued policy mixes<sup>that appear "heterodox",like Japan, Korea,China or</sup> Vietnam. Others have successfully<sup>pursued relatively"orthodox" policieslikeChileand</sup> El Salvador, again with success of<sup>varyingdegrees.But partial reform and heterodox</sup> policy may equally be associated with<sup>arrested developmentasin the case of countries</sup> that unsuccessfully pursued import<sup>substitution.Likewisea heavy dose of orthodoxy has</sup> not by itself helped some countries,<sup>for example in Latin America, to grow rapidly.</sup>

**Creative destruction.** Also successful<sup>developmentmay requiredestructionof vested</sup> interests, i.e. some form of revolution.<sup>66It can thus be quite disruptivefor sometime</sup> with unavoidable winners and losers.<sup>Arguably Germany,Japan, Korea and Taiwan all</sup> benefited to some degree from the disruption<sup>of war andfrom policies in part imposed by</sup> the United States after World War<sup>II.It remains unclear how much disruption is</sup> unavoidable and how much disruption is excessive.

**Competition among jurisdictions.**<sup>Given the uncertainty about the exact mix of</sup> reforms and institutional change that<sup>makesfor successful development,it must surely be</sup> valuable to allow experimentation<sup>with differentmixes of institutional and governance</sup> reform. The reason we have advanced<sup>economiestoday is the industrialrevolutionthat</sup> came out of Europe. Competition<sup>amongsquabbling Europeanstatesand principalities</sup> led to the world's growth miracle,<sup>the "European Miracle"as historian EdwinJones</sup> called it.<sup>67</sup> China, the previously<sup>moreadvanced nation was left behind,however, as</sup> central control and the domination of<sup>mandarinsover merchantsarrested development.</sup>

So for the development of good governance<sup>a selectionmechanismisalsoimportant,</sup> namely competition among nations,<sup>or moregenerally among various typesof</sup> jurisdictions - across states or within,<sup>for example, federalsystems.Both for the firm</sup> and the government, a symbiosis of<sup>competition and rule-based co-operationseems</sup> required for complex societies to emerge<sup>and to allowtheir citizensto prosper.</sup> To sum up, effective wealth creation<sup>requirescapable institutions.A complex symbiosis</sup> of competition and co-operation on<sup>the basis of acceptedrules characterizessuccessful</sup>

> **65** Easterly, 2001. **6** Olson, 2000. **67** Jones, 1987.
_31_ _Ways Out of Poverty - Diffusing Best Practices and Creating Capabilities_ societies. Some basic measures to establish such societies are known, for example respect for property rights and contracts as well as freedom for firms of all types to enter markets as well as freedom to fail. Just as we cannot predict exactly which type of firm will succeed so we cannot predict which type of government policy and institutional mix will be most successful. Competition among jurisdictions is as important to institutional development as that among firms. We have leamed some basics on how to facilitate development, but we do not know how to engineer it and have to remain open to experiments. Hopefully we can improve the chances of success of unavoidable experiments by studying in more detail the way markets, firms and governments interact.<sup>68</sup>

**68** World Bank, 2001b.