IMAGE: ASHISH KOIRALA
A YOUNG FIRM in America, if it survives to middle age, will typically grow sevenfold. Its counterpart in India, Mexico or Peru expands by a factor below three. That gap in ambition and scale captures an economic bind gripping 100-odd countries including Nepal. They climbed from low to middle incomes, only to find progress grinding to a halt. Growth has slowed because a vital economic force never took hold: creative destruction, through which new technologies and firms displace old ones.
The exit route involves two shifts, according to the World Bank. First, economies must move from simple capital accumulation towards spreading global technology and know-how across their industries. Then they must learn to innovate at the frontier themselves. The driver of these shifts was described a century ago by Joseph Schumpeter. Growth unfolds through disruption and replacement. New entrants and adapting incumbents overtake the established and obsolete. In too many middle-income countries, that engine has stalled. Forces defending the status quo overpower those that generate the new.
India’s software industry provides a useful example. Its origin lay in Tata Consultancy Services (TCS), launched in the 1960s by a sprawling industrial conglomerate coping with import restrictions. This incumbent possessed the scale and patience needed to build a new business. Its success then produced the conditions and demonstration effect that drew in ambitious entrants such as Infosys. Competition between them enlarged the sector. This paired view—where established firms and newcomers both propel progress—corrects an older assumption. Economic models for decades credited innovation almost entirely to nimble entrants toppling sluggish giants. Reality shows greater nuance: incumbents can drive change when they choose competition over cartel behaviour.
Stalled economies suffer because neither group fulfils its role. Disruptive entrants remain scarce; incumbents rarely spread technology or innovate. The market is crowded with micro-enterprises that neither grow nor shut down, but just carry on. In India, Mexico and Peru, more than 80% of firms employ fewer than five people. Many arise from necessity rather than opportunity. At the same time, large firms with the capacity to deploy scale and adopt foreign technology often owe their dominance to political ties or sheltered markets, rather than operational excellence. Their focus stays on defending rents rather than upgrading products.
Public policy frequently deepens the damage. Rules designed with benign goals—shielding small businesses or restraining corporate power—end up penalising success and locking in stagnation. For decades India’s Small-Scale Reservation Laws barred big firms from producing hundreds of goods, using limits on plant machinery to define “small”. The outcome was fragmentation that stripped away incentives to expand or modernise. Comparable distortions appear elsewhere. In Peru firms crossing 21 employees must share profits with workers, creating an ugly deterrent at that line. In France a bundle of consultative and tax obligations activates at 50 employees. Such thresholds generate “size traps”, actively punishing productivity gains and expansion.
The trouble runs further. State-owned enterprises—usually leftovers from an earlier development model—enjoy subsidised credit and friendly regulation, yanking up costs for more efficient private rivals. Weak competition enforcement lets politically favoured incumbents cement their dominance. Mexico’s telecommunications market stood formally open for years yet stayed under the grip of Carlos Slim’s Telmex, delaying rivalry and innovation until a tougher regulator stepped in. When market power flows from privilege rather than performance, incumbents gain every incentive to lobby for preservation and little reason to invest in renewal.
Breaking free calls for a deliberate rebalancing of Schumpeter’s three forces. Policymakers must boost creation, restrain preservation and manage destruction. This starts by replacing blunt, size-based rules with precise diagnostics. Modern analysis can identify whether high concentration in an industry stems from efficient scale or anti-competitive excess. It draws on micro-level evidence—from full business censuses to real-time digital traces—to track the movement of jobs, capital and ideas. Alice Chen of Gavekal Dragonomics observes that data quality in emerging economies has been transformed. “We have shifted from economic X-rays to MRIs,” she says. “The view is three-dimensional and dynamic.”
The resulting policy is balanced. It neither automatically favours small firms nor targets big ones, so all can compete fairly. That calls for competition law strong enough to stop incumbents from crushing rivals. It calls for financial systems able to direct credit towards young firms with strong ideas but limited collateral. It calls for ending preferential treatment of state-owned champions in favour of a level field. And it calls for accepting that creative destruction carries social costs; safety nets and retraining schemes help absorb the loss of outdated jobs, keeping technological change politically viable.
The difficulty is institutional and intensely political. Forces of preservation extend far past economics: they are embedded in social hierarchies and political alliances. Unlocking creation tends to follow a shock that breaks the deadlock—a fiscal crisis or a technological rupture or a climate imperative that renders the status quo untenable. The shift to cleaner energy, for example, acts as a powerful agent of destruction while opening space for creation across new industries.
The route out of the middle-income trap is narrow. It lies between a state that smothers change and one too weak to restrain rent-seekers or handle the upheaval of progress. It calls for a state that plays referee and enabler at once: disciplining dominant incumbents; backing new entrants; and preparing its workforce for churn. For countries stuck today, the lesson is this: reaching middle-income status was a victory of accumulation. Reaching high-income status will hinge on economic reinvention. ■
