World Development Report 2024: The Middle-Income Trap

Key messages

• When a crisis strikes, such as that surrounding global energy, middle-income countries should seize the opportunity to instigate the needed restructuring and reallocation. For example, the global energy and climate crises have spurred rapid progress in the development and deployment of low-carbon technologies.

• In middle-income countries, the rate of adoption of key clean energy technologies is growing more rapidly than in high-income countries, but levels of adoption by firms and households remain significantly lower, particularly for solar energy, wind energy, and electric vehicles.

• Incumbents in high-carbon industries, which tend to be state-owned enterprises in middle-income countries, erect barriers to the entry of low-carbon technology because they have the strongest incentive to maintain the status quo and limit competition from low-carbon energy providers.

• Middle-income countries run the risk of becoming stranded nations—not because of anything inherent in the scaling up of low-carbon technologies and the winding down of fossil fuels, but because of (1) outdated policies and rules of thumb that limit the growth of value-creating enterprises and the exit of unproductive ones; (2) limited improvements in human capital and the mobility of workers; and (3) a refusal to let go of state control of productive assets that are being decommissioned ahead of time.

Destruction: To be expected, managed, and mitigated

The Republic of Korea’s financial crisis in 1997–98 had paradoxical economic impacts on innovation, restructuring, and growth. Before the crisis, large family-owned industrial conglomerates, chaebols, enjoyed almost unrestrained market power and expansion thanks to excessive debt financing. They were then able to drive rival firms and small industries out of business by adopting predatory tactics, suppressing technological improvements, and persuading government to restrict new entry or open market policies. Therefore, the crisis, although triggered by external events, was largely a product of internal problems related to a weak system of corporate governance, a dysfunctional financial system, and poor labor relations.

The crisis triggered major reforms and a comprehensive restructuring of the financial sector and the chaebols. Nearly 500 nonviable financial institutions closed, including two-thirds of commercial banks, and 15 of the 30 top conglomerates went bankrupt. The collapse of many chaebols made room for venture capital–backed firms, which led to the rapid growth of the information and communication technology (ICT) sector. The ICT boom—spurred by new technologies such as mobile phones, thin film transistor liquid crystal displays, and broadband and wireless internet—kick-started an unusually swift recovery in 1999, with economic growth of 10.3 percent. The reforms and restructuring led to long-term innovation-led growth and contributed to Korea’s transition to high-income status. Overall, then, it took a crisis to lay bare the need for economic reforms and drive the reallocation of economic activity toward more productive, more innovative firms.

The destruction of outdated arrangements—enterprises, jobs, technologies, private contracts, policies, and public institutions—is essential to create value through investment and reallocation, infusion, and innovation. But in many countries these destructive forces are weak during boom times, with crises playing a disproportionate role in driving the process of resource reallocation. In some cases, downturns can serve as times of cleansing in which older, less-productive firms die, making way for newer, more productive firms. As Joseph A. Schumpeter (1942, 113), writing in the aftermath of the Great Depression, argued about crises:

They are but temporary. They are the means to reconstruct each time the economic system on a more efficient plan. But they inflict losses while they last, drive firms into the bankruptcy court, throw people out of employment, before the ground is clear and the way paved for new achievement of the kind which has created modern civilization and made the greatness of this country.

One of Schumpeter’s key observations is that the process of creating new industries does not go forward without sweeping away the existing order. For example, over the last 30 years in the United States, on average nearly 16 percent of jobs in the private sector have been destroyed each year. Literature on firm exit—stemming from seminal work by Hopenhayn (1992)—reveals that the exit of low-productivity firms contributes substantially to raising aggregate productivity. For example, the Great Depression (1929–39) ushered in a permanent structural change toward mass production and automation in the motor vehicle industry through the exit of smaller, less productive plants and the need for surviving plants to innovate—a process that likely would have taken much longer without the crisis.

Financial crises also spur readjustments of new technologies. For example, the financial crisis of 2007 accelerated skill-biased technological change. More recently, during the COVID-19 crisis economic activity was reallocated toward more productive firms, with reallocation effects higher than before the pandemic.

In the context of energy, the oil price shocks in the 1980s played a major role in accelerating investments in energy efficiency and the development of cleaner energy technologies. One impact of the oil price shocks was an increase in the relative cost of fossil fuels. Another was new policy support for less energy-intensive activities. More recently, the global financial crisis of 2007–09 coincided with a significant increase in the uptake of renewables. Renewable energy use grew rapidly in the United States, China, and Germany in part because of the stimulus programs governments enacted to address the crisis.

This chapter focuses on the process of creative destruction being accelerated today by two crises—the climate crisis and the 2022–23 global energy crisis triggered by the Russian Federation’s invasion of Ukraine. In this context, this chapter explores three questions:

• How is the energy crisis building momentum for change? The global energy crisis spurred rapid progress in the development and deployment of low-carbon technologies. It also triggered reshaping of the climate policy landscape in 2022 and 2023. Developed nations such as the United States and European Union (EU) member states introduced a wide variety of incentives for producing and deploying low-carbon technologies. In September 2023, the leaders of the Group of Twenty (G20) agreed to triple renewable energy capacity by 2030. Although fossil fuels have shaped the world’s economy and economic geography for over a century, low-carbon technologies favor new trends: urban agglomerations and new spatial clusters; the use of highly skilled workers to develop, modify, adapt, apply, and maintain new technologies; and the entry of younger firms in the private sector. Entrants are instigators of change.

• Who are the antagonists blocking creative destruction in energy markets? Incumbents may resist change. Many incumbents in the energy market have the strongest incentive to maintain the status quo and limit competition from low-carbon energy providers. High-carbon firms tend to lobby against pro-environmental regulations. Power purchase agreements (PPAs) with long time horizons and inflexible terms that create “lock-ins” impede change. These agreements often lock in polluting assets, resulting in significant inertia in energy systems.

• Do middle-income countries run the risk of becoming stranded nations? Yes, they do. But stranding is not driven by anything inherent in the scaling up of low-carbon technologies and the winding down of fossil fuels. It is the result of outdated policies and rules of thumb that limit the growth of value-creating enterprises and the exit of unproductive ones; limited improvements in human capital and mobility of workers; and not relinquishing state control of productive assets now being decommissioned ahead of time. To be sure, workers displaced from the transition will need targeted and time-bound support, but it is not a panacea for avoiding difficult reforms.