In 1960, South Korea was poorer than many sub-Saharan African countries, and Taiwan not much richer. Since then these two countries have achieved average annual increases in per-capita income of 6.8% and 6.2% respectively, leaving far behind not only these African countries but also much richer countries such as Mexico and Argentina. How have these two countries managed to transform themselves from basket cases into powerhouses?

The standard explanation is one of export-led growth. During the 1950s, the story goes, both countries engaged in traditional import-substitution

policies. By the late 1950s, each country had exhausted the 'easy stage' of import substitution. Together with the impending reduction of US aid (the main source of foreign exchange for both economies) this led policy-makers to reverse their economic strategy and adopt export-oriented policies. These included the unification of exchange rates (accompanied by devaluations), other measures to stimulate exports (including most significantly duty-free access for exporters to imported inputs), higher interest rates, and some liberalization of the import regime. With a broadly supportive policy environment, encompassing macroeconomic stability and public investment in infrastructure and in human capital, exports took off in the mid-1960s. Export orientation led both economies to specialize according to comparative advantage, resulting in rising incomes, investment, savings and productivity.

The standard account recognizes that East Asian governments – save for Hong Kong – have played active roles in shaping the allocation of domestic resources. But the tendency, as revealed most clearly in the World Bank's recent study The East Asian Miracle: Economic Growth and Public Policy, is to downplay the significance and effectiveness of government intervention.

A closer look at the evidence, however, suggests that the standard story is at best incomplete, because it attaches too much importance to the role of export orientation in achieving high growth. The increase in the relative profitability of exports around the mid-1960s was modest in both South Korea and in Taiwan and cannot account fully for the increase in the ratio of exports to GDP. Second, neither export incentives nor the actual increase in exports can in themselves account for the phenomenal increase in investment that took place, which appears to be the proximate determinant of economic growth in the two countries. Third, since the export base was so small initially (less than 5% of GDP in Korea), the contribution of exports to output growth could not have been very high until the mid-1970s at the earliest. Fourth, there is no evidence that exports were associated with significant externalities or productivity spillovers to the rest of the economy. Finally, the increasing outward orientation of the two economies can be explained by the sharp increase in investment: since capital goods had to be imported, an increase in investment demand necessarily made these economies more open to trade.

Hence a much more plausible explanation for the economic take-off is the increase in investment that took place in the early 1960s. The origin of this investment boom is the key issue that must be addressed in any account of the East Asian experience.

Initial conditions were important: both Korea and Taiwan had a skilled labour force relative to their physical capital stock and income levels, which made them ready for economic take-off. In the early 1960s and thereafter the Korean and Taiwanese governments managed to engineer a significant increase in the private return to capital. They did so not only by removing a number of impediments to investment and establishing a sound investment climate, but more importantly by alleviating a coordination failure which had blocked economic take-off. The latter required a range of strategic interventions including investment subsidies, administrative guidance, and the use of public enterprise – which went considerably beyond those discussed in the standard growth story.

While this account helps us understand why government intervention could have played a productive role in these East Asian countries, it does not explain why pervasive intervention did not lead to rent-seeking and defeat the objectives of the policy makers. Here again, initial conditions are likely to have played a very important role. A relatively equal distribution of income and wealth was critical. Compared with other developing countries in 1960, Korea and Taiwan stood out in having exceptionally equal distributions of income and wealth. This was due in part to history, and in part due to the serious land reforms undertaken in both countries during the 1950s.

How did equality help? First, neither government had to contend with powerful industrial or landed interest groups. Governments could intervene effectively in Korea and Taiwan because they enjoyed an extraordinary degree of insulation from pressure groups, and were able to exercise leadership over them. Nor did governments feel immediate political pressure to adopt redistributive or populist policies, and so were free to focus on economic goals.This helps explain why so many other developing countries have failed miserably with government interventions that bear more than a passing resemblance to those employed in East Asia. The Asian experience with government intervention is perhaps of limited relevance to other countries facing the growth challenge.