Escaping the middle income trap, part 2

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A couple weeks ago, I mused a bit about how developing countries graduate into the leagues of the world’s richest nations, specifically looking at the case of Malaysia. That country has been stuck at a moderate level of wealth for some time – in other words, it’s caught in the “middle income trap.” There is one issue I wanted to explore in greater detail, which, though specific to Malaysia, can offer us another big lesson on achieving economic development.

The lesson: If you want to keep income growing, you must make that goal an absolute priority and implement the pragmatic policies necessary. Nothing short of that will do.

Malaysia hasn’t. Instead, the country has mixed its efforts to achieve higher incomes with a social agenda that, in certain respects, undermines its own development program and hampers its chances of escaping the “trap.” I’m referring here to Malaysia’s affirmative action policies, aimed at increasing the role of the Malays and other indigenous peoples, called the bumiputra, in the economy versus the richer immigrant Chinese and Indian communities. I’ve written an entire story on this issue in this week’s magazine, which you can read here. It includes my interview with Malaysia’s Prime Minister Najib Razak on his economic reform plans. Najib clearly realizes that the affirmative action policies, as they now stand, must be reformed if the country is to break the “trap.” Here’s a sampling of what he told me:

Affirmative action remains in place, but the way it is carried out would be different. When it comes to helping the poor and the vulnerable groups, it should be irrespective of race. But there are certain affirmative actions which are still necessary, because the bumiputra are still very much behind and they must be helped. We want to help those bumiputra who are potential winners.

Basically, he’s trying to refocus resources on eradicating poverty and eliminate the worst abuses of the current affirmative action regime in order to open up more opportunities for minorities, while at the same time maintaining some support for bumiputras to develop a Malay managerial class. My personal opinion is that he’s not going far enough for Malaysia to break out of the “middle income trap.” The affirmative action program needs to be entirely phased out if Malaysia is to progress.

Here’s why: If Malaysia is to reach the rich nation’s club, it is going to have to become a true meritocracy. The best and brightest managers and the most capable, dynamic companies have to be allowed to rise to the top, uplifting the Malaysian economy overall. Money has to flow to the most promising investments, projects and research. The best students need to receive the most support and the top jobs. But that can’t happen with the affirmative action program in place. The system of preferences dampens investment and scares off talent. It doesn’t allow the best to succeed, or resources to be allocated in the most efficient possible manner. Najib wants to make what remains of the affirmative action program more “market-friendly” and “merit-based,” through which the truly deserving Malays get preferential treatment. But I have little confidence that can work. As long as the bureaucrats can use regulations to determine who gets economic opportunities based on race, not ability, the entire progress of the economy will be held back. Malaysia needs to be a fairer, more open place where everyone has equal opportunities to advance.

We of course can debate over how to define fairness, and the benefits and costs of affirmative action. But what is clear from other examples in Asia is that developing economies need to identify policies and practices that allow politics or other agendas to distort economic opportunity if their rapid progress is to continue. Take, again, the case of South Korea. Though Korea never had an affirmative action program like Malaysia, it did have a corporate/financial system that caused resources to be wasted. Banks tended to direct funds to the big conglomerates (the chaebols) no matter how outlandish their business plans, while starving small companies, consumers and entrepreneurs of financing. That inherent flaw in Korea’s economy was a contributing cause of its 1997 financial crisis. The crisis, however, also forced that system to break down. Now it is easier for start-ups to find funding and consumers to get credit. That’s made Korea a more innovative economy with more sources of growth. The process still has some way to go, but Korea is benefiting from dismantling its old preferences and creating a more merit-based economy with smarter resource allocation.

Unfortunately, Korea required a major financial conflagration to see the light. Hopefully matters won’t reach that point in Malaysia. I don’t think they will. But I also fear Malaysia won’t escape the “middle income trap” unless it takes greater steps to allow the market, not the bureaucracy, to decide economic success and failure. How Malaysia deals with this problem should be a good case study for policymakers throughout the emerging world.