This article first appeared in Forum, The Edge Malaysia Weekly on October 2, 2023 - October 8, 2023

The “middle-income trap” started as a World Bank fable for Latin America to explain why most upper middle-income countries (MICs) have failed to become high-income economies. Recent decades have seen policy circles blame stalled economic progress on a supposed “MIC trap”. By suggesting failure to progress is due to entrapment, it obscures as much as it pretends to explain.

There has no longer been a rules-based international monetary system since the US ended the 1944 Bretton Woods arrangements in 1971. Despite the non-existence of this system, the US continues to enjoy its “exorbitant privilege” as if it were in place. Since the 1960s, using this privilege, the US Treasury has been borrowing from the rest of the world.

The US’ exorbitant privilege has enabled its government to borrow and spend well beyond its means, that is, revenue. This has enabled it to maintain its military presence in much of the world.

Arguably, exorbitant privilege has been sustained by a combination of US “soft power” and military expenditure. These arrangements also enable the US to maintain its massive trade and current account deficits.

Facing “stagflation” — economic stagnation with inflation — the US Federal Reserve raised interest rates sharply from 1980. This soon ended inflation in the US, but also its Keynesian “New Deal” legacy from the 1930s.

High nominal interest rates in the developing world had meant real interest rates were low due to high inflation. With growth high in the global South in the 1970s, borrowing from abroad to keep investments up remained attractive.

Fed chairman Paul Volcker’s interest rate hikes from 1980 triggered fiscal and sovereign debt crises in many countries. Poland was the first victim of this US Fed policy change in 1981, followed by various Latin American, African and other developing economies.

Faced with higher and rising real interest rates, many governments stopped borrowing from abroad and pursued contractionary monetary and fiscal policies domestically. Thus, the Fed interest rate spike brought stagnation to many developing countries.

With Anglo-American conservatives demanding contractionary macroeconomic policies, it was not long before the Washington DC-based Bretton Woods Institutions promoted such policies. These ended the post-Second World War Keynesian “Golden Age”.

The International Monetary Fund (IMF) required contractionary “stabilisation” policies to qualify for short-term credit facilities. For the longer-term financing, World Bank structural adjustment programmes demanded market liberalisation and privatisation.

The bank also prioritised foreign direct investment and export-oriented output. Japan’s post-war industrial resurgence was portrayed as a new model for emulation. But its miracle was ended by a US-demanded overvalued yen and its ill-advised financial “Big Bang”.

Thus, Latin American economies lost more than a decade from the 1980s while African economies lost a quarter century from the late 1970s. Low-interest Japanese credit helped East Asia, while South Asia took on less debt.

Thanks to the imposed stabilisation and structural adjustment programmes, Latin America did not recover strongly until the new century. Nonetheless, the limited industrial capacities developed earlier in Latin America were destroyed.

According to the new “neoliberal” thinking in Washington, their economies were not sufficiently open or liberalised. This was “rectified” from the 1980s by opening their economies, not only to international trade, but also foreign investment.

Following the 2008 global financial crisis, rich countries became more protectionist. But developing countries were still pressed to liberalise even more although they could no longer rely on now-shrinking export markets for growth.

Even East Asia has been told to rely less on export growth. But it is not easy to just switch market-oriented production at will, as World Trade Organization and other trade agreement commitments cannot be simply reversed.

In most rich economies, workers captured part of their productivity gains with higher wages. But the common claim that productivity increases have lagged behind wage increases is bogus. In most developing countries, subsistence levels set wage floors.

The supposed “middle-income trap” argument suggests MICs cannot sustain rapid economic growth and transformation for many reasons, often varying with the policy biases and predilections of its advocates.

For Malaysia, various parties claimed it was no longer possible to sustain the rapid manufacturing growth achieved before the 1997/98 Asian financial crisis for structural, cultural, political, behavioural and governance reasons. Malaysian manufacturing growth has declined sharply since then for various reasons.

The new official Malaysian narrative for the 2010s proclaimed “graduation” from secondary to tertiary economic activities to sustain growth and progress. Modern services growth was supposedly needed to become a high-income country.

In fact, much employment growth was in traditional services while most new modern service jobs were in the public sector. Government employment doubled from around 850,000 in 2003, when Tun Dr Mahathir Mohamad first stepped down as prime minister, to 1.7 million in 2017, Datuk Seri Najib Razak’s last full year.

Another popular argument in Malaysia is that the New Economic Policy (NEP) and other interventions have undermined growth. But in fact, the NEP’s first decade in the 1970s brought rapid output expansion.

Clearly, redistribution accelerated rather than subverted growth in Malaysia. Such claims about redistribution and growth need to be reviewed more generally. This seems more instructive than simply asserting that redistribution is bad for growth.

Looking at post-war European economies, it is now uncontroversial that the welfare state and redistribution were very important for sustaining growth in industrialised northern Europe.

Finland’s recent success suggests its education and other social policies have been very important for sustaining growth. Clearly, it is crucial to not throw the baby out with the bathwater when it comes to critically learning from economic history.

Undoubtedly, it is also important to recognise that discretionary state powers have been abused for political patronage or clientelism. Clientelism is undoubtedly a problem in many societies, and compromises in governance needed state interventions as well.

In Malaysia, it has taken a particularly toxic ethno-populist hue. Such abuses have been enabled by ethno-populist discourses since anti-colonial dissent surged during the 1930s’ Depression. These were met by increased ethnic “divide-and-rule” policies.

Historical evidence suggests that the best way to break out of the “middle-income trap” would be to formulate and effectively implement appropriate investment and technology policies.

Such a selective industrial policy is relevant for promoting growth, not only of manufacturing, but also high-end services as well as the provision of safe and nutritious food. But all this is not going to happen spontaneously. 

Reforms need to be deliberately developed through a variety of interventions — not only one-shot, but also as part of well-designed, coherent and sustained initiatives.

Jomo Kwame Sundaram is currently senior adviser at Khazanah Research Institute. A former economics professor, he was United Nations assistant secretary-general for economic development. He is the recipient of the Wassily Leontief Prize for Advancing the Frontiers of Economic Thought.

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