The Second Generation: Return to the Mainstream

While early development economists had placed great confidence in state-led development planning, they had been less mindful of problems of implementation and political governance. Consequently, many of the early development policies had produced uneven results and distortions in the economic systems of developing countries. This was a main reason why in the late 1960s, the first generation’s development theories were increasingly challenged by mainstream neoclassical economists who focused on government failure and price distortions as main reasons for the lack of progress in the developing world. The early development economists had seen problems of underdevelopment primarily as structural in nature and thus not amenable to price and income changes. The neoclassical economists instead argued that this view produced policies which violated fundamental principles of neoclassical theory and thus resulted in a misallocation of resources. Policy-induced price distortions prevailed, for instance, in the labour market, where relatively high wages for unskilled labour did not correspond with conditions of “unlimited” supply of labour. Conversely, in the capital market, real interest rates were considered too low in view of an undersupply of capital in developing countries. And given large current account deficits, especially in countries which had pursued import-substitution policies, the consequent foreign exchange shortages were not adequately reflected in their prevailing exchange rates, which were mostly overvalued.