Government Policy & Economic Development

- A paper I wrote for a class "Political Processes in Underdeveloped Systems" : Fall 2013

Government Policy & Economic Development  

            Since the Industrial Revolution, countries have seen industrialization as a goal for the state’s economic prosperity as well as safety. Britain was the first to industrialize in the western world, giving them first mover advantage in some industries. This led the rest of the world to contemplate ways to catch up to British industrial power. The likes of Alexander Hamilton advocated for state led industrialization, what has now transformed into neo-mercantilist policy, while liberal advocates for development stem from the likes of Adam Smith. Today, there is still contention as to what works and what does not. Throughout the later half of the 20^th century there was a split between the two groups calling for state led development, leading many Latin American countries down the path of ISI strategies to try to develop. By contrast, the East Asian countries adopted an outward looking, export-oriented approach. In this essay I will first examine the debate between liberal and state-led development arguments, looking into which policies have had more success and reasons why. Next, I will examine both ISI and EOI policy and see how they differed and to what environment spawned them. Lastly, I will examine whether the results, or relative success, of EOI policies in East Asia support liberal ideology over neo-mercantilist in regard to industrialization for the developing world.

            The role of government with regard to economic development is a concerning issue for most of the developing world. Some argue that state-led development is the key to industrializing and increasing economic capacity while others advocate liberal, hands off markets that will attract foreign investment, thus leading to development and growth. The proponents of state-led development have followed a sort of dependency thesis, put forward by the likes of Andre Frank who argued; “the metropolis state (developed world) exploited and controlled the satellite (LDC’s) by extracting economic surplus and wealth from the latter” (Kukreja 2001). The core of this dependency view is that the LDC’s economies have a comparative advantage in primary products and raw materials relative to the developed countries that manufacture goods. Therefore, there is a system of trade in place in which developed countries and their transnational corporations move into LDC’s to purchase the raw materials, exporting them back to the industrialized countries for use in manufacturing. In essence, the advanced countries have first mover advantage in industrialization and therefore are able to undersell any other value-added good producers from the LDCs, forming an international division of labor. This was a problem, according to some like Raul Prebisch because, “the prices of the LDCs products tended to decline over time relative to the prices of the industrialized countries products… countries specializing in producing raw materials and farm products were at a fundamental disadvantage” (Frieden, Lake & Shultz 2009). This is permissible because the industrialized countries and the multinational corporations have large resources and can move capital across relatively freely. Furthermore, theses multinational corporations are able to circumvent any restrictive regulatory measures that the developing world may have in place and transfer profit out of the LDCs back to the developed world. These views, coupled with the breakout of the two world wars and the Great Depression, gave rise to ISI policies, stressing, “constraints on adverse external influences in order to promote self-sufficiency and internal development” (Kukreja 2001). Lastly, many dependency proponents believe the institutional system is stacked against the LDC, because the IMF and World Bank are all controlled and operated by the developed world. This is directly contrasted with a more liberal consensus that emphasizes the importance of domestic economic policies of the LDCs as the piece to the development puzzle. According to liberals, the greatest inhibitor to growth for LDCs is their own policies that distort the price mechanism and scare away foreign capital. Therefore, encouraging privatization, policies friendly to foreign capital, and easing regulations for the private sector were all seen as critical to development. That way, countries would be able to export what they have a comparative advantage in and integrate into the global economy. In the end, the argument for state-led development split into two separate strategies, on one hand ISI, an inward strategy adopted by many Latin American countries, while the Export Oriented Industrialization (EOI) was adopted largely by countries in East Asia.

            Import-Substitution strategy was put to practice in Latin America throughout the mid 20^th century up until around the 1980s. The main goal of ISI was to break the reliance of raw materials and build up a manufacturing base, stemming from the various dependency arguments from above. The state was to take an active role in economic development and industrial policy. This was done through government policy that created trade barriers for domestic manufacturers, giving out tax credits and cheap loans to industry, as well as government provision of basic industrial services (Packer Lecture 2013(a)). The policies were intended to increase industrial capacity, which would enable the country to end its dependence on foreign imports. To achieve this require large-scale government intervention that specifically targeted certain industries to give subsidies and tax credits to, while simultaneously offering protection from the outside market through trade barriers. Fortunately for the manufacturers, the domestic market for its good already existed and they did not have to go abroad to sell products. Unfortunately however, this stifled any incentive for a company to increase productivity or efficiency due to lack of competition. Domestically, these policies appealed to the urban working class, which saw a rise in employment due to increased industrial capacity. However, agrarian interests opposed these policies because they benefited from exporting agriculture. As Latin American countries began to subsidize industry, they also subsidized citizens living in the cities who worked in the factories, These subsidies exploited the agrarian interests by trying to depress food prices with an artificially high currency and other means. Basically, the development strategy called for “blocking the import of industrial goods so that domestic demand would stimulate domestic production” (Brawley 1998). In the end, a lack of state autonomy, allowing for interest groups to pressure government for favorable policy coupled with the rise in dependency arguments gave rise to ISI policies in Latin America that favored an inward looking development strategy.

            East Asian economic success is often seen as the accomplishment of Export Oriented Industrialization policies that propelled countries to industrialize and move away from raw material. Unlike ISI policies, the East Asian model subsidized and provided cheap credit to industries that were able to export their products abroad. If an industry could not show that it could compete in the global market, then it would stop receiving aid from the state. This provided an incentive for firms to create world-class goods that foreign markets would want to import; otherwise they would be cut off of government support. So, “raw material imports necessary for manufacturing industry were not suppressed, and selected domestic manufacturing industries were targeted with fiscal incentives to stimulate the level of exports” (Kukreja 2001). Just manufacturing for the domestic market was not enough. The goal was to move up in the commodity chain, increasing production of high quality, higher markup goods and away from the production of low value-added trinkets (Packer Lecture 2013(b)). This was further pushed through currency devaluation that made exports appear cheaper to foreign consumers, and therefore increased competitiveness (Brawley 1998). Also, the need for human capital, to provide workers for higher tech industries and higher skilled jobs that would be necessary to move up the commodity chain, the state heavily invested in education for the populace. Government initiatives in the reducing illiteracy coupled with access to job training programs were evident in high rates of government investment in creating an educated and skilled workforce (Kukreja 2001). This was essential to creating a more productive workforce that would go hand in hand with the goal of having competitive exports on the global market. Lastly, the fact that the state was largely insulated from interest group pressures and able to work in a technocratic manner enabled centralized decisions about the economy. This was beneficial because it allowed the creation of institutions such as the Economic Planning Board in South Korea, which was, “given authority over the setting of tariffs, administering direct subsidies to industries, and setting economic targets (Brawley 1998). This board had power over government budgets and was able to carry out its duties without referring to the legislative branch, keeping in insulated from interest group pressures. Basically, economic policy makers were highly centralized and allowed to function without consent of legislative authorities who might have contrary interests due to interest group and constituent pressure, allowing for EOI policies to take place and promoted stability in the policies, creating a suitable economic environment.

            The Washington Consensus was a set of policy recommendations advocated by developed countries in the 1980s and early 90s for developing countries. Theses policies included, trade liberalization that meant the removal of barriers to imports and exports, privatization of many government enterprises, fiscal and monetary policy that avoided large deficits and high inflation, as well as an openness to foreign investment an international capital flows (Frieden, Lake & Shultz 2009). These policy suggestions followed the liberal approach to development, meaning the need for capital formation inside a country is essential for economic growth. By integrating into the world economy, countries scarce in capital will get capital flows from areas of abundant capital, as long as there are solid economic policies in place that allow for the inflow of capital. Obviously, both EOI and ISI polies headed for a more state oriented approach, albeit they have some differences in the way the state operates to propel growth. However, both strategies see the need for an active state role to increase economic development. Liberals argue that government protection of domestic markets, showcased in both state led policies can have negative effects such as, harming exports and domestic agriculture, inducing rent seeking, and removing pressure on domestic producers to lower costs to international levels (Wade 1993). However, EOI policies were successful even with some degree of protection, quite possibly by accelerating the shift of comparative advantage into higher-value added activities in East Asia. Coupled with other government subsidies and programs that promoted exports, many East Asian countries were able to use the state to promote industrialization, contrary to neo-liberal economic decree. In the end, South Korean share of manufacturing as percentage of GDP increased from 14% in 1960, to 30% by 1983, and is around half in the present (Brawley 1998). This shows how EOI policies were largely successful, although East Asian countries did pay attention to some neo-liberal policy by creating economic environments friendly to growth.

            In the end, state-led development can play a crucial role in economic development and growth for LDCs. Although ISI was largely ill advised and no longer undertaken after the 1980s, EOI picked up where ISI left off and propelled East Asian economies into the global market. Today, companies like Samsung and Hyundai are a global force and produce quality products that are exported from South Korea throughout the world. Before the state started to pursue EOI policies, it might have been unthinkable that in less than 40 years a largely rural, less developed country could become a thriving, developed economy with a large manufacturing base and a GDP per capita close behind the developed economies of the world. Obviously, contrary to neo-liberal philosophy, there can be a role for the state in economic development and it can turn out to be quite a crucial role as is evidenced by East Asian economic success in the last half of the 20^th century into the 21^st century. 

References

Brawley, Mark R. "South Korea Opts for Export-Oriented Industrialization," in Turning Points: Decisions Shaping the Evolution of the International Political Economy. Ontario, Canada: Broadview Press, 1998, pp. 279-293.  

Frieden, J., Lake, D., & Shultz, K. (2009). World politics: Interests, interactions, Institutions. New York, NY: W.W. Norton & Company.

Kukreja, Sunil. "The Two Faces of Development," in Introduction to International Political Economy, 2nd edition, edited by David Balaam and Michael Veseth. Upper Saddle River, NJ: Prentice Hall, 2001, pp. 320-345.

Packer Lecture(a). 22 January, 2013

Packer Lecture(b). 24 January 2013

Wade, Robert. “The Visible Hand: The State and East Asia’s Economic Growth,” in Current History, Research Library, 1993, pp. 431-441.

 

Book Spotlight #1: "Why Nations Fail"

"Why Nations Fail: The Origins of Power, Prosperity, and Poverty" 

by: Daron Acemoglu & James A. Robinson

Quote Highlight: referring to why nations fail, "What they all share is extractive industries. In all these cases the basis of these institutions is an elite who design economic institutions in order to enrich themselves and perpetuate their power at the expense of the vast majority of people in society." (page 399)

I recently finished reading this book on why nations have failed to obtain growth. Specifically, this book attempts to answer the question of, why are countries still lacking economic growth in an age of unprecedented wealth? What has been the focal point of much research by many political scientists and economists specializing, is why have developing countries that gained Independence in the last 50 years actually gone in reverse in terms of wealth and progress. In particular, countries in Sub-Saharan Africa that upon Independence were on par in terms of GDP per capita with the countries such as South Korea. Since then, many countries have spiraled into a far worse state, meanwhile, today South Korea can no longer be considered a developing economy, it's joined the ranks of the industrialized west. Now, your smartphone might be produced by a large South Korean firm that you have probably heard of, Samsung. In the same context, Sub-Saharan Africa is looted for commodities that end up making up the parts to that very smartphone produced by Samsung. The result is that South Korea has a GDP per capita level that of many western countries, while the poorest people in the world are stuck in a "vicious cycle" taking place in Sub-Saharan Africa. This book tries to answer why this phenomenon has occurred, though it does so rather broadly, with an "institutional" theory. I'll attempt to quickly explain what this theory means and then summarize the book and my thoughts. 

The authors of this book distinguish between two types of institutions in the world, inclusive & extractive. This refers to the governing and civil institutions of a country, or the lack of governance separated into these two categories. Generally speaking, a society with inclusive institutions features a free press, a responsive government, a broad coalition of political inclusiveness and participation, property rights, public infrastructure projects, and public spending on healthcare and education. Conversely, an extractive institution is one in which there is no public infrastructure projects, there may be a lack of property rights, there is little political responsiveness to the public, and there is an elite group that maintains power and sees all the economic and political benefits of the system. Ultimately, the inclusive institutions create incentives for economic activity and thus bring about growth while extractive institutions siphon off all economic benefits of society to the controlling elite while killing any incentive to work. Put another way, why should a farmer invest in new technology or attempt to increase output if the government or warlords can come at anytime and take his crops, increase his tax burden exponentially or seize his land. Citing case studies ranging from Sub-Saharan Africa, Latin America, to East Asia, the authors speculate that the reason many countries remain poor today is solely because of the lack on inclusive institutions. The problem is, once extractive institutions are in place, it is very difficult for a country to break the mold and escape. There are huge incentives for other groups or factions to try to gain control of the extractive institution for its own benefit. Furthermore, there is no incentive for the system to be reformed when so many members of the elite are benefiting greatly, and any change may threaten their power, either economically or politically. Hence, countries get stuck in a "vicious cycle" where the extractive institution remains in place year and year, only changing hands between dictators or other groups.

This book is a good read if you find yourself interested in the economic development of the third world today. Increasingly, new literature is coming out against the use of foreign aid to developing countries, against the IMF and the World Bank policy programs, and more towards focusing on the internal institutional problems within those countries. This book has the view that foreign aid can help keep an elite group in control of the control by providing it with the funds to pay off supporters and increase its military capabilities for crackdowns, thereby limiting any economic activity. Compared with another book I read on the topic, Paul Collier's "The Bottom Billion" this book offers a different angle of attack and provokes a lot of thought about the role that institutions play. Collier focuses more on resource rich countries and the "resource trap", something I find convincing. Studying both explanations, you can begin to understand why countries are stuck in a poverty trap and why there seems to be little change year and year. This book also paints a very broad picture over large parts of history in its hypothesis, seemingly jumping to certain conclusions and giving the repeated explanation that inclusive institutions are necessary over and over again. I found the argument for exactly "why" these inclusive institutions developed in some parts of the world and not others lacking substance at some points. The authors immediately dismiss theories involving, geography, cultural, and poor economic policy decisions in the second chapter book. In my opinion, the development of inclusive institutions can be seen as somewhat "lucky" for many countries. I'll need to write an entire paper dissecting this statement I know but let me finish on this book first. On the whole, the Industrial Revolution came at a "critical juncture" as the authors put it, and those countries that were in a position to take advantage of this are the rich countries of today, while those that did not (because the institutions of the country forbid it) are still poor. Because technology moves so rapidly, the divergence between the really rich and really poor seems greater than ever. But how we have countries with no prior experience of inclusive institutions form them in a today's world, I'd be interested to know, for the authors do not provide any specific ideas.


This book was published in March 2012.