ECONOMIC

TRANSFORMATION AND

GROWTH IN GEORGIA
Dani Rodrik
August 2016

Key points
New development consensus: sustained growth requires

government that actively promotes structural change and

productive diversification
Constraints that block structural transformation differ
across countries
no single recipe or cookbook

Identifying binding constraint requires ongoing dialog and

strategic collaboration between government and private

sector
quality of the institutional context key

Progress since transition

Sources of growth: accumulation vs productivity

Distribution of employment by activity

The structural change imperative

Models of growth for emerging economies

the bad, the good, and the turbo-charged
External borrowing
Commodity booms

very few sustainable examples

Public investment

Accumulating fundamental capabilities

human capital, institutions

delivers steady, but low

growth

Structural change (esp. industrialization)

European periphery in 1950-1970s; East Asia since 1960s

Patterns of structural change

agriculture

informal

organized

manufacturing

services

Patterns of structural change: East Asia and

advanced countries
agriculture

informal

organized

manufacturing

services

Patterns of structural change: low-income

countries today
agriculture

informal

organized

manufacturing

services

Why services are not like manufactures

Typically, two segments of services:
A. High-productivity (tradable) segments of services cannot absorb

lots of labor
since they are typically skill-intensive
FIRE, business services

B. Low productivity (non-tradable) services cannot act as growth

poles
since they cannot expand without turning their terms of trade against

themselves
constrained by domestic demand (hence incomes)

continued expansion in one segment relies on expansion on others

limited gains from sectoral winners
e.g. hyper-markets in retail

Productivity versus innovation

Main goal: improve economy-wide labor productivity while

expanding employment
(weak) links between innovation and economy-wide
productivity
an innovation focus directs attention to digital, skill-intensive

activities that are bound to remain a small slice of overall economy

detracts attention for mid-range, less-than-high tech nontraditional
activities with greater employment absorption potential

Policies: how did successful countries promote

rapid structural transformation?
macro fundamentals
reasonably stable fiscal and monetary policies
reasonably business-friendly policy regimes

steady investment in human capital and institutions

but more important for sustaining growth past middle income than launching it

a development-friendly global context

access to markets, capital and technologies of advanced countries
benign neglect towards industrial policies in developing countries

pragmatic, opportunistic, often unorthodox government

policies to stimulate industrialization and modern activities

protection of home market, subsidization of exports, managed currencies, local-content

rules, development banking, special investment zones, with specific form varying
across contexts

Structural change is impeded by both market

failures and government failures
Government failures
generic
poor labor laws, inadequate property rights, lack of contract

enforcement, red tape, corruption, macro instability, high taxes,

sectoral/micro
specific regulations and taxes; lack of specific public inputs

Market failures
incomplete information
demonstration effects and learning spillovers from introduction of new products
or new technologies (cost discovery)
scale effects and complementarities
coordination and agglomeration externalities (e.g., clusters, vertical
relationships)

Orthodox development policy

Government failures
generic
poor labor laws, inadequate property rights, lack of contract

enforcement, red tape, corruption, macro instability, high taxes,

sectoral/micro
specific regulations and taxes; lack of specific public inputs

Market failures
incomplete information
demonstration effects and learning spillovers from introduction of new products
or new technologies (cost discovery)
scale effects and complementarities
coordination and agglomeration externalities (e.g., clusters, vertical
relationships)

fixing these are important, but take time, and deliver

moderate growth at best (e.g., Latin America since 1990)

The new industrial policy

Government failures
generic
poor labor laws, inadequate property rights, lack of contract

enforcement, red tape, corruption, macro instability, high taxes,

sectoral/micro
specific regulations and taxes; lack of specific public inputs

Market failures
incomplete information
demonstration effects and learning spillovers from introduction of new products
or new technologies (cost discovery)
scale effects and complementarities
coordination and agglomeration externalities (e.g., clusters, vertical
relationships)

is about removing bottlenecks to new economic activities,

whether due to market or government failures

Back to Georgia: issues

Small economy with very low barriers to trade
Exports have increased, but still account for relatively small

share of GDP (relative to successful comparators)

And exceptionally low share of manufacturing employment
(4%)
An economy where producing non-tradables/services for home
market is more profitable than exporting
as evidenced also by very large trade deficit (net exports of goods = -

20% of GDP)
and the destination of FDI towards non-tradables
Other symptoms of demand-led economy: low domestic

savings, bloated finance and construction sectors

Macro policy tools are as important in this context as micro
tools (and perhaps even more so)
exchange rate, fiscal, credit policies

Exports: some salient features

Considerable experimentation
half of all products exported are new (i.e., were not exported in
2006)

With little effect on overall diversification

new products account for less than a fifth of exports by value
Very low survival rate for new exports
75% of new exports do not survive more than a year
Share of firms that export has tended to decline

Source: World Bank (2014)

Labor: Skilled (proxy Financial and

Insurance Services)
Labor: Low-Skilled
(proxy Manufacturing
Services)
Labor cost (EU data:
2011)
Commercial bank
rates
Tax (Corporate)
Energy: Electricity
prices for industrial
consumers, second
half 2011 (EU data)
Trade Logistics:World
Bank Logistic
Performance Index,
2012
Burden of customs
procedure, WEF: 2012

Reported hourly
labor cost per
employee (yearly
indicators, ILO)
Reported hourly
labor cost per
employee (yearly
indicators, ILO)
cost per hour
Commercial bank
rates (for 6 -12
months local
currency loan)
%

Croatia

Armenia

Estonia

China

Latvia

Romani
a

Turkey

Georgia

Comparative costs
3.95

10.7

6.2

1.58

3.94

4.4

5.6

1.26

1.81

4.6

4.2

5.7

2.25

7.9

11.43

5.86

5.00

5.55

16.47

9.21

21.38

15

20

16

15

25

21

20

20

EUR per kWh

0.062

0.096

0.083

0.111

0.075

0.082

0.06

0.094

1 is the lowest score

and 5 is the maximum
score

2.77

3.51

2.78

4.12

2.86

2.56

3.16

(1=extremely
inefficient to
7=extremely efficient)

5.2

3.6

4.1

4.2

5.2

3.2

3.9

Access to finance as a constraint

Figure 1 Georgia: Percent of Firms Identifying the Problem as the Main Obstacle (2008)
21.9

19.3

18.6

Access to Finance

17.7

Electricity

18.2

20

21.6
18.7

Political Inestability

22.1

Practices Informal Sector

25

14.9

15
10
5

Small firms
(1-19 Employees)

Medium firms
(20-99 Employees)

Inadequately Educated
workforce

Political Inestability

Political Inestability

Electricity

Access to Finance

Large firms
(100+ Employees)

Note: This table shows the main three issues identified by Georgian firms as main business
environment obstacles, by firm size.
Source: Enterprise Survey Data.

Source: World Bank (2013)

Where are the constraints in Georgia?

Underlying macro (saving-investment) balance is highly

unfavorable to the productive development of tradable

industries
large trade deficit
and high interest rates
but labor costs remain low by international standards
Q: why not more FDI into manufacturing?

At the micro level, evidence of significant productive

experimentation
informational and scale constraints may bite for some, but not all

firms

Constraints likely to be highly-specific to individual

industries and potential clusters

From policies to institutions

Specific instruments of IP
subsidies, trade policies, credit policies, investment coordination,
local-content rules,
preferable from standpoint of economic logic when appropriately
targeted, but presume considerable knowledge on the part of policy
makers

Traditional IP: list of favored sectors, list of policy

instruments
Modern IP: an institutional setup of ongoing dialog and
collaboration with private sector with the aim of
uncovering bottlenecks, generating remedies, and
revising policies over time
less focused on specific policies, more focused on process

What does such an institutional setup look like?

Institutional design for IP

Must be built on three ideas, each of which leads to a different
design principle:
1. The requisite knowledge about the existence and location of
the spillovers, market failures, and constraints that block
structural change are diffused widely within society
=> embeddedness
2. Businesses have strong incentives to game the
government
=> carrots and sticks, discipline
3. The intended beneficiary of IP is neither bureaucrats nor
business, but society at large
=> accountability

Design features for IP institutions (1):

Embeddedness
Economists tend to think of policy design in top-down,

principal-agent terms
Takes informational incompleteness and asymmetries as given,

while keeping the private-sector at arms length

This model has the advantage that it gives bureaucrats

autonomy and protection from private sector rentseeking

But it has the disadvantage that it severely restricts the
flow of information from below
Businesses cannot communicate information about the constraints

they face other than through their actions

Capture model also obviously wrong, since it leaves

bureaucrats in the pockets of business.

Design features for IP institutions (1):

Embeddedness
Right model lies in between the two extremes:
strategic collaboration and coordination between the private sector
and the government with the aim of uncovering where the most
significant bottlenecks are
deliberation councils, supplier development forums, search networks,

investment advisory councils, sectoral round-tables, private-public

venture funds
IP as a process of discovery rather than as a list of policy

instruments
focusing on learning where the binding constraints lie, rather than on

whether you should use tax breaks, R&D subsidies, credit incentives,
and so on
eliciting information on private sectors willingness to invest subject to
the removal of obstacles (or provision of incentives)
combination of autonomy and embeddedness

Design features for IP institutions (2):

Carrots and sticks
Without rents for entrepreneurs, there is too little

investment in cost discovery and other activities that

promote structural change
Schumpeters insight: entrepreneurship requires rents
rents as second-best mechanisms to alleviate market failures

discussed previously
patents are the obvious rich-country example

But open-ended rents bottle up resources in unproductive

activities

Design features for IP institutions (2):

Carrots and sticks
Hence a two-pronged strategy:
encourage investments in non-traditional areas (carrot);
weed out projects/investments that fail (stick)
conditional subsidies
sunset clauses
monitoring and evaluation

Empirical background:
East Asia 1960-90: both incentives and discipline
Lots of new activities, closely monitored for performance

Latin America under ISI (1950-1980): lots of incentives, but too little

discipline
Lots of new activities, some world-class performers, but many duds

Latin America in the 1990s: lots of discipline, but too little incentives
Too few new activities

Design features for IP institutions (2):

Carrots and sticks
Success in IP is determined not by picking winners but

by letting losers go
given uncertainty, optimal policy outcomes will necessarily lead to

mistakes
trick is not to avoid mistakes altogether, but to ensure that
mistakes are recognized as such
and entail phasing out of support

a much weaker requirement than omniscience

governments may not be able to pick winners, but they can

recognize losers

Design features for IP institutions (3):

Accountability
If bureaucrats monitor businesses, who monitors the

bureaucrats?
Need for mechanisms of transparency and accountability
A high-level political principal and champion for IP activities
someone associated with IP activities and who can be held politically

responsible
as with education policy or monetary policy
Mechanisms of transparency
publication of activities

accounting of expenditures
processes that are open to new entrants as well as incumbents