INTRODUCTION - SARPN · the initially proposed charter of the International Trade Organization (ITO), whose mandate would also have included to coordinate national eco-nomic policies

Introduction 75

Beginning in the mid-1980s, many develop-ing countries made close integration into theinternational trading system a pillar of their eco-nomic reform agenda. They sought to achieve thisnot only through active participation in multilat-eral trade negotiations, but also through rapidunilateral trade liberalization. In many countries,trade liberalization was accompanied by an open-ing up of their financial sector and capital account.Rapid liberalization and increased exposure tointernational market forces and competition wereexpected to boost efficiency and competitiveness,which in turn would underpin a more rapid rate ofeconomic growth and a narrowing of the incomegap with developed countries. However, by theearly 1990s there were many instances where theoutcome of this policy strategy did not live up toexpectations.

The prevailing analysis suggests that the of-ten disappointing developmental effects of closerintegration into the world economy are due to per-sistent market access barriers to a number of keydeveloping-country exports. They are also due tothe absence in many developing countries, andparticularly the poorest among them, of appropri-ate governance and institutional frameworks andto a lack of productive capacities to respondquickly to export opportunities, even when theybenefit from preferential market access conditions.

The disappointing developmental effects ofcloser integration led to increasing pressure on de-veloped countries to abolish market access barri-ers to products of export interest to developing

countries. At the same time, developing-countrypolicy-makers began to be encouraged to adoptmeasures designed to strengthen the supply ca-pacity of their economies with a view to buildingcompetitive industries and benefiting from im-proved access to world markets. Increasing atten-tion was given to improving macroeconomic andexchange-rate management; appropriate se-quencing of liberalization of the trade, financialand capital-account regimes, underpinned by pru-dential regulation and financial sector reform; re-inforcing domestic institutional capacity; andattracting foreign direct investment (FDI). Thispolicy package was expected to enable develop-ing countries to overcome the constraints they facewith regard to fixed investment and technologi-cal upgrading, and to raise productivity.

Underlying the advice to adopt this policypackage is the assumption that all economies, re-gardless of their size, institutional histories or levelof development, respond in much the same wayto a uniform set of price incentives. Further, thereis an implicit suggestion that achieving such auniform set of price incentives and keeping it freefrom distortions is best guaranteed by allowinginternational markets to set prices. It is argued thatthis is in large part because the higher degree ofcompetition in those markets comes closest to anideal level of contestability, and because theabsence of government interference helps mini-mize the distortive impact of rent seeking ordirectly unproductive profit-seeking activities.Proposing this development strategy which maybe called the openness model implies the view

INTRODUCTION

Trade and Development Report, 200476

that coherent policy-making is based on a sharedunderstanding of a uniform set of instruments oftrade, macroeconomic, financial and developmentpolicies. It has also meant, in practice, that devel-oping countries trade discretionary policy measuresfor the promise of improved access to internationalmarkets for their goods, and to finance and tech-nology. On this account, while making this bargainwork depends principally on actions taken athome, it also implies strengthened policy surveil-lance from, and more effective collaboration among,international economic institutions (Mussa, 1997;Winters, 2001).

To date, adopting this strategy has still notenabled most developing countries to establish thevirtuous interaction between international finance,domestic capital formation and export growth,which underpinned the catching-up process ofWestern Europe after the Second World War andof the East Asian newly industrializing economies(NIEs) during the 1980s and early 1990s. Criticshave attributed this to the uniform application ofneo-liberal policies, which does not take accountof the diversity of economic conditions and chal-lenges found in low and middle-income econo-mies. Others have pointed to growing socialtensions accompanying rapid opening up, whichhave had an adverse impact on efficiency andgrowth. Moreover, in an increasingly interdepend-ent world, the very idea of a spontaneous economicorder in which developing countries, by puttingtheir own house in order through opening up tointernational market forces can guarantee the kindof stability needed for sustained growth in incomesand employment, appears to many as decidedlyutopian (Rodrik, 2002: 24).1

Part Two of this Report suggests that efforts atdesigning a feasible development agenda requirea more complex analytical and policy frameworkthan that offered by the openness model. Thisframework must explore how the virtuous inter-actions between export activities, domestic capitalformation and structural change are established.It should further consider potentially destabilizinginteractions between trade and other elements ofthe integration process, particularly those associ-ated with international finance. And it shouldexplicitly include the legitimate role that economicinstitutions at the national level play instead ofrelying on a vision of the world in which indi-

vidual economic agents will react to prices thatreflect relative scarcities of goods and productionfactors at the global level. In this way, it wouldprovide a framework for identifying the combi-nation of domestic policy-making and collectiveactions at the international level needed to managethe potential adjustment costs and tendencies to-wards economic divergence that accompany deeperintegration, particularly where it brings togethercountries at very different levels of development.

In what follows it is suggested that a policypackage based on the concept of coherence willenable better management of contemporary glo-balization processes in the interest of economicdevelopment. It is shown that the openness ap-proach, in order to work, requires coherence betweennational development strategies and global proc-esses and disciplines, as well as policy coherencebetween and within the various aspects/sectors ofthe global economy that impact on developmentprospects of developing countries. All these arelacking to some extent in todays global economy.

A coherent treatment of the interdependencebetween trade, development and financial issueswas an important element in the debate leading tothe set-up of the post-war international economicsystem. This debate arose from the desire to avoiddeflationary adjustments and beggar-thy-neighbourpolicies of the kind that had severely disruptedeconomies in the inter-war period.

The present institutional set-up has its rootsin the arrangements that resulted from the reor-ganization of international economic relationsafter the Second World War. The set-up of the post-war international trade regime was predicated onthe belief that, in conditions of strictly limitedprivate international capital flows, an internationalmonetary system on an intergovernmental basiswith convertible currencies at fixed, but adjustable,exchange rates would provide a stable environ-ment conducive to trade and investment. Underthe aegis of the General Agreement on Tariffs andTrade (GATT), this regime considered the tariffas the only legitimate trade policy measure. Othertrade measures (i.e. those affecting quantities orthe fixing of import prices) were prohibited, ex-cept in certain clearly defined circumstances. Theconvertibility of currencies at fixed, but adjust-able, exchange rates supported the GATT approach,

Introduction 77

as participants in international trade negotiationscould predict the full extent to which the com-petitive position of domestic industries would beaffected by tariff cuts without having to be undulyconcerned about other exogenous factors or re-sorting to competitive devaluations to balanceunanticipated adverse consequences of trade lib-eralization.

The rules-based system of trade negotiationsin the form of the GATT was all that survived fromthe initially proposed charter of the InternationalTrade Organization (ITO), whose mandate wouldalso have included to coordinate national eco-nomic policies to ensure adequate levels of globaldemand and employment in support of the devel-opment of low-income countries. As such, thespecific problems of developing countries partici-pating in the post-war international trading systemwere largely absent from the mandates of the inter-governmental institutions created immediatelyafter the Second World War. Multilateral effortsto remedy this neglect culminated in the FirstUNCTAD Conference in 1964. Central to that dis-cussion was the idea that developing countries canbase economic development on their own effortsonly if they have sufficient policy space to accel-erate capital formation, diversify their economicstructure and give development a greater socialdepth. This discussion also emphasized the in-terdependence between trade, macroeconomic andfinancial policy issues.

The need for a coherent treatment of these is-sues has gained in importance with the abandoningof the system of fixed, but adjustable, exchangerates and the adoption of widespread floating,combined with a return of private internationalcapital flows to levels similar to those that hadcaused instability in the inter-war period. Indeed,there are growing concerns about the adverse im-pact on trade of exchange rate instability createdby financial factors, in particular, in the contextof the financial crises that have hit a number ofemerging-market economies over the past decade.The risk of sharp currency depreciations, which,as demonstrated by the Asian crisis, can arise evenin countries with sound macroeconomic and ex-ternal positions, increases the perceived cost anduncertainty of trade, and discourages governmentsfrom lifting trade restrictions. In practice, largecurrency depreciations by some crisis-hit coun-

tries have provoked claims of unfair trade fromimport-sensitive sectors in some of their maintrading partners and pressure for a trade policyresponse. This runs counter the generally recog-nized principle that trade restrictions should notbe used to offset a rise in the international costcompetitiveness of competitors resulting from fluc-tuations in exchange rates.

There is no disputing that trade must continueto occupy a central place in an effective globalpartnership for development, or that all countrieshave a mutual interest in the effective function-ing of the multilateral trading system. However,trade and financial linkages with the world econo-my can only complement, but not substitute, fordomestic forces of growth. Moreover, these link-ages need to be coherent with national developmentstrategies designed to generate virtuous interactionbetween domestic capital formation and exportactivities. Establishing such virtuous interactionscan be achieved by a national development strat-egy that is successful in augmenting the existingstock of physical and human capital, enabling theuse of more efficient technologies, and shiftingresources away from traditional, low-productivityactivities towards activities that offer a high po-tential for productivity growth. Under some cir-cumstances, and particularly when a period of realcurrency appreciation has hampered export per-formance, real currency depreciations can improveinternational cost competitiveness and boost ex-ports. On the other hand, sizeable exchange ratevolatility can offset annual gains in domestic pro-ductivity and drastically alter international costcompetitiveness virtually overnight. Moreover,sharp and abrupt depreciations can make it diffi-cult for exporters to take advantage of the rise ininternational cost competitiveness resulting fromsuch depreciations. The fact that sizeable ex-change rate volatility and major exchange ratedepreciations have typically been associated withshifts in the direction of short-term internationalcapital flows shows that insufficient coherence inthe international monetary and financial systemcan jeopardize the successful implementation ofnational development strategies designed to fos-ter domestic supply capacities.

The following discussion documents the lackof policy coherence in todays global economy andproposes ways to approach the issues of coher-


ence so as to maximize the developmental effectsof integration into the world economy.

Chapter III first discusses the issues arisingfrom greater trade and financial integration lookedat from the perspective of interdependence be-tween trade, macroeconomic and financial issuesas well as between openness and integration inthe world economy, and domestic policy space.Chapter IV shifts the focus to the impact of mon-etary and financial factors on the supply side ofdeveloping-country exports. It examines the par-ticular effects caused by sharp and abrupt currency

depreciations on the trade performance of devel-oping countries and goes on to analyse monetarypolicy options with regard to fixed or flexibleexchange rates in the context of high volatility ofshort-term capital flows. The concluding sectionsummarizes the main arguments and discussespolicy challenges to enhance coherence betweenthe international trading, monetary and financialsystems with a view to establishing a virtuous in-teraction between international finance, domesticcapital formation and export growth and maximiz-ing the developmental effects of integration intothe world economy.

1 For the evidence on growth performance, see TDRs1997 and 2003 and UNCTAD, 2002; on the prob-lems of applying uniform policy advice, for Africasee TDR 1998 and UNCTAD, 2001, for Latin

America see ECLAC, 2002, and for countries inCentral and Eastern Europe see ECE, 1990. On thedamaging social impact of these policies see UNDP,1999; UN-HABITAT, 2003; and ILO, 2004.

Note

Openness, Integration and National Policy Space 79

The move to unrestricted cross-border flowsof goods, services and capital has always been oneof the principles of globalization. Since the late1970s, the propensity to truck, barter and ex-change one thing for another (Adam Smith),unhindered by political boundaries, has beenregarded as the cornerstone of a global system thatwould produce efficiency gains from allowingresources to be directed to their most efficient use,and specialization gains from accessing a greatervariety of intermediate and capital goods. If im-proved institutional quality and technology spill-over are added, trade and capital openness shouldautomatically allow for catch-up growth in poorercountries and bring about income convergence atthe global level (see, for example, IMF, 2002;WTO, 1998; World Bank, 2002; Winters, 2004).But the empirical evidence supporting this ap-proach has been elusive. In fact, most of the evi-dence suggests that the impact of trade opennesshas been highly uneven, and contingent on a vari-ety of institutional factors, and that there is roomfor discretionary policy measures at the micro andmacro level.1

A more balanced perspective, also taking itscue from Adam Smith, links a process of success-

ful integration back to productivity gains fromspecialization, gains that are amplified throughinnovation, the use of better equipment, scaleeconomies at the firm level and by externalitiessuch as learning and improvements in human capi-tal. This ties economic success to a heighteneddegree of economic interdependence through themutually reinforcing interactions between expand-ing markets and an increasingly complex divisionof labour (Young, 1928). Extending and deepen-ing such interactions depends on new investmentsunder conditions of objective uncertainty. To im-prove and expand existing capacity as well as tointroduce new products and processes, a profit-investment nexus is needed that requires support-ing financial arrangements, including accommo-dative monetary policy and relatively stable legalinstitutions.2 Under the right conditions, high prof-its will increase the incentive of firms to invest,as well as their capacity to finance new invest-ment; this in turn boosts profits by enhancing therates of capital utilization and the pace of produc-tivity growth. For most countries, this nexus isclosely linked to industrialization, where the pres-ence of scale economies, externalities and an ar-ray of indivisibilities and complementarities inproduction and consumption are strongest, and

Chapter III

OPENNESS, INTEGRATION ANDNATIONAL POLICY SPACE

A. Introduction


from where productivity growth feeds into a widerprocess of structural change as labour shifts outof lower value-added sectors into more capital-and technology-intensive activities and comple-mentary service activities.

At the same time, as theincreasingly interdependentnature of industrial activityheightens the gains from spe-cialization, it also exposes moreand more individuals, firmsand communities to an in-creased threat from disconti-nuities and disruptions. Rup-tures occur from myriad shocksand coordination failures acrossimperfectly functioning (ormissing) factor and product markets.3 As a result,a successful and sustained take-off requires theevolution of a range of complementary norms,policies and regulations that help discipline andrestrain the more destructive and nurture the morecreative forces of the emergent industrial economy.A general lesson from history is that policy spaceexpands considerably with the transition from aworld dominated by agriculture, slow-movingtechnology and small-scale business to one domi-nated by manufactured goods, rapidly evolvingtechnology and big firms.4

Hence, the potential benefits from participat-ing in a more detailed international division of la-bour must be weighed against the coordination andadjustment costs arising from the heightened in-terdependence accompanyingfurther specialization in, andfragmentation of, economicactivities. Indeed, the fact thatinterdependence is now takingplace across borders adds newconstraints, rivalries and risksto sustained economic progress.However, there remains a basicchallenge for economic policy-makers: to decide whether andto what extent market forcescan be left alone to ensure that progress is con-sistent with increased participation in the interna-tional economy, and when and what kinds of poli-cies and institutional arrangements might beneeded to better manage the process.

The evolving international division of labouris further complicated as large national firms inmore advanced economies acquire the capabili-ties and the possibilities to organize and controltheir production activities across borders (Hymer,

1976; Dunning, 1981). Whilethe timing and the directionwill vary among countries andsectors, the decisive elementsin the internationalization ofproduction are firm size, con-trol over rent-creating strate-gic assets and market penetra-tion. Since large firms tend tohave more capital at their dis-posal and more control overmarket forces, they will do themost overseas investing.

Finally, the growth of trade and the rise ofinternational firms accelerate the mobility of capi-tal and extend the reach of financial institutions.At the domestic level, these institutions essentiallyhelp to channel resources for investment purposesby reconciling the differences between borrowersand lenders in the timing of payments, and trans-forming short-term liquid liabilities into long-termilliquid assets. The efficiency of the system willbe reflected in its ability to minimize the liquiditypremium and the risk of erroneous investment de-cisions (TDR 1991). As international trade andproduction expand, specialized financial institu-tions are joined by international banks seeking towiden the scope and reach of their services to sov-ereign and local governments, to local financial

institutions and non-bank firms.They concentrate their borrow-ing in markets with the lowestinterest rates and their lendingin markets with the highest,with funds moving wheneverthe differential is greater thanthe transaction costs.

The resulting cross-borderflows of capital can help deepenthe international division of la-

bour by offsetting structural weaknesses result-ing from persistent trade deficits, and allowing afaster pace of investment than might otherwise bepossible from domestic resources. In poorereconomies, such flows can thereby reinforce a

The increasinglyinterdependent nature ofindustrial activity exposesmore and more individuals,firms and communities to anincreased threat from dis-continuities and disruptions.

Integration is not just aboutthe efficient use of givenresources, but aboutextending and reinforcingthe cumulative gains of localdynamic growth forces.


catch-up growth dynamic. However, these flowsare highly information sensitive, and vulnerableto information asymmetries, contract-enforcementproblems and macroeconomic risks. They alsotend to be more footloose than other cross-bordereconomic flows, in part, because of its opennessto innovative techniques in search of the preferredcombination of liquidity and returns. Under theseconditions, both the direction and the terms ofborrowing can become major sources of disconti-nuity across the international division of labour.Moreover, an expanding international economypresents new and riskier profit opportunities, al-lowing liquid capital a greater margin to seek outshort-term arbitrage positions and speculativegains. As a result, such flows can be extremelyvolatile and subject to pro-cyclical bandwagoneffects; they can cause gyrations in security prices,exchange rates and trade balances, and make fi-nancial crisis a hardy perennial of the interna-tional market economy (Kindleberger, 1975).

Thus, integration is not just, or even mostimportantly, about the efficient use of given re-sources, but rather about extending and reinforcing

the cumulative gains of local dynamic growthforces through exports and capital flows. How-ever, and as at the domestic level, those forcesintroduce discontinuities, shocks and potentialconflicts of interest, which can generate sizeableadjustment costs for national economies partici-pating in the international division of labour; theymay even trigger divergence away from leadingeconomies. From this perspective, the real chal-lenge is not so much about the extent or thesequencing of liberalization, but about finding theparticular combination of international marketforces, policy space and collective action neededby countries with different institutional and indus-trial capacities, to ensure that the integrationprocess is welfare-enhancing for all participantsin the international division of labour.

Historically, finding that balance has proveddifficult, making for an ebbing and flowing of theintegration process. The following sections exam-ine a number of episodes where incoherence hasarisen as a result of a lopsided emphasis by policy-makers on openness, at the expense of policy spaceand coordinated actions.

The inter-war period is often flagged as awarning of what can happen when the virtues ofopenness are foregone in favour of narrowernational and sectoral interests. From this per-spective, a series of ill-judged interventionistmeasures, particularly a retreat into tariff protec-tion, but also misguided monetary interventionismby central banks, excessive social spending andrestrictions on labour mobility, have been blamedfor plunging the world economy into a destruc-tive pattern of autarkic development (Crucini andKahn, 1996; World Bank, 2002; Wolf, 2004).

But while there can be no doubting the scaleor extent of economic damage from the crisis thatengulfed the global economy in the early 1930s,or the political turmoil that followed in its wake,such accounts are often guilty of painting the in-ter-war economic experience in unduly simpleterms. In particular, they downplay the relativelystrong recovery in international economic relationsin the 1920s, marked by an overall rise in the shareof trade in world GDP, as well as a revival of capi-tal flows, notably a boom in sovereign borrowingand some growth in FDI (tables 3.1 and 3.2). They

B. Unbalanced integration in the 1920s


also ignore the general policy direction taken bythe international community to reorganize post-war economic relations around the goal of open-ness, and, consequently, fail to consider how thatpolicy agenda contributed to mismanaging thereturn to stability.

Although the end of the First World War leftEurope in a state of political and moral uncertainty,

economic policy-makers held up the economicorder in the period before 1914 the belle époque as a state of normalcy which needed to be restoredas quickly as possible (Bayen, 1954). Indeed, thiswas seen as the most fundamental step to achiev-ing wider peace and stability, and was premisedon restoring the pre-war international monetarysystem, which was expected to guarantee pricestability under a system of fixed exchange ratestied to gold.

From this starting point, a policy consensuswas forged, which aimed at restoring flexibilityat the microeconomic level through the elimina-tion of trade barriers and other market distortionserected during the war, and the establishment ofharmonious trade conditions around the principleof non-discrimination (as proposed in Article 3 ofthe Versailles Peace Accord). It also aimed at re-covering stability at the macroeconomic level byfirst reducing the high level of public debts ac-quired during the war, through fiscal surplusesachieved by an initial round of expenditure cutsand increased taxes, followed by tight restrictionson any subsequent efforts to expand governmentspending. At the same time, monetary policywould be put back in the hands of technocratsworking through independent central banks, andin accordance with the requirements for freelyflowing international capital.

Primary responsibility for implementing thisagenda rested with domestic policy-makers. How-ever, it was acknowledged that, as a consequenceof the war, privileging international market forcesmight cause political resistance, and that, conse-quently, pressure could usefully be brought to bearon policy-makers to push them in the desired di-rection. The initiative was taken in a series ofinternational economic conferences beginning inBrussels in 1920, and followed up over the next13 years in Genoa, Portorose, Geneva, Lausanneand London (Pauly, 1997). Efforts were also madeto bring about closer central bank cooperation(Eichengreen, 1996). More radically still, in caseswhere economic imbalances and political uncer-tainties were particularly pronounced, stabilizationwould be achieved through adjustment programmesmanaged by the League of Nations.

By assuming an underlying natural stateof fully employed resources, adjustments accom-

Table 3.1

MERCHANDISE EXPORTS AS A SHAREOF GDP, 1913 AND 1929

(Per cent)

1913 1929

Western Europe 16.3 13.3France 7.8 8.6Germany 16.1 12.8Netherlands 17.3 17.2United Kingdom 17.5 13.3

United States 3.7 3.6Canada 12.2 15.8Latin America 9.5 9.7

Asia 2.6 2.8Japan 2.4 3.5

World 7.9 9.0

Source: ORourke (2002: table 2).

Table 3.2

FOREIGN DIRECT INVESTMENT,1913 AND 1938

(Outward stock of FDI/GDP, per cent)

1913 1938

Canada 6 14France 23 21Germany 11 1Japan 11 21Netherlands 82 91United Kingdom 49 38United States 7 8

Source: Twomey (2000).


panying economic openness were expected to besmall in scale and short in duration, allowing in-ternational markets to establish the right priceincentives, and bringing about a rapid return togrowth and stability. With eyes firmly fixed onthe past, the sequence of reforms aimed to getlong-term capital flowing again before openingup trade, although it was generally accepted thatsuccess ultimately hinged on re-creating the mu-tually supportive pattern of trade and capital flowsthat existed before 1914.

With economic policy-makers expecting thegold standard to deliver long-term growth and sta-bility, the room for policy action to bring aboutan orderly adjustment in and across countries wassqueezed between measures to regain and main-tain the confidence of financial markets and toallow competitive pressures to re-establish exter-nal balance. Little attention was given to whetherpre-war monetary arrangements were appropriatefor the emerging post-war pattern of economic in-tegration, or whether the steps taken by individualcountries to regain stability might actually add tothe incoherence in international economic relations.

The belief that marginal adjustments throughthe marketplace would bring global stability cloudedthe judgement of policy-makers as to the scale ofinvestment, both private and public, needed torebuild and modernize a European economic spacetransformed by the dislocations of war, the break-up of old empires and the rising voice of organizedlabour. In particular, the economic consequencesof accumulated wartime debts and German repara-tions were greatly underestimated. In the absenceof their cancellation, highly indebted countrieswere faced with the onerous task of generatingboth a fiscal and a trade surplus to meet their in-ternational financial obligations, even as theystruggled to repair the damage to productive ca-pacity and investment prospects. Moreover, theproblem was not just one of managing sovereigndebt; in many countries, bank capital, depleted bypost-war inflation, had to be shored up by foreignborrowing, and corporate debts accumulated dur-ing the war increased further under the post-warrestructuring efforts through both foreign bondissues and bank borrowing supported by foreignloans (Kregel, 1996a); in agriculture too, whichremained a major source of foreign-exchangeearnings and employment for many countries in-

cluding the United States and France risinglevels of indebtedness anticipated a pattern of in-stability previously confined to primary exporterson the periphery.5

As the constraints on investment were under-estimated, so the prospects for strong and rapidexport recoveries were overestimated, particularlyfor the industrial heartland of Europe, where arapid return to pre-war export performance wasessential to meet financial obligations withoutfurther damaging the domestic economy. A dis-appointing trade performance cannot, however, beexplained simply as being the result of an unfore-seen protectionist wave. In fact, trade policieswere broadly re-established along pre-war lines:quantitative controls were quickly abolished, tar-iff levels returned to earlier levels which werequite high, particularly for manufactures (table 3.3) and the commitment to non-discrimination (inthe form of most-favoured-nation (MFN) treat-ment) was generally confirmed.6 In Germany, aseverely weakened manufacturing sector facedadded obstacles, as newly independent economiesin Eastern Europe looked to support their own in-fant industries through tariff protection, and thepersistence of high tariffs in surplus economies,notably the United States, dampened prospects foran export-led recovery (Chang, 2002). In the caseof Britain, the loss of markets in key sectors such

Table 3.3

AVERAGE TARIFF RATES ONMANUFACTURED PRODUCTS FOR

SELECTED COUNTRIES, 19131931(Weighted average in percentage of value)

1913 1925 1931

Belgium 9 15 14France 20 21 30Germany 13 20 21Italy 18 22 46Japan 30 .. ..Sweden 20 16 21Switzerland 9 14 19United Kingdom 0 5 ..United States 44 37 48

Source: Bairoch (1993).


as coal, textiles and shipbuilding also reflected therise of new competitors in its traditional colonialmarkets. But the real challenge facing these olderindustrial economies was to respond to the new andstrengthened manufacturingcapacity that had emerged else-where during the war throughrenewed investment in moredynamic industries.

Under these conditions,the decision of Europes lead-ing industrial centres to returnto the gold standard at the pre-war parity level damaged pros-pects of a strong export recov-ery,7 and the resort to tight macroeconomic poli-cies to defend that decision further compromisedefforts to re-establish a dynamic profit-investmentnexus. The resulting sharp slowdown of growthin the European industrial heartland was itself animportant contributory source of weak trade per-formance and a major reason why trade levels in1929 were below what might otherwise have beenexpected. By contrast, countries that re-enteredthe gold standard with devalued currencies sawstrong growth in trade, persistent surpluses, anearlier recovery in investment and comparativelylower levels of unemployment. This was notablytrue of France which was still an industrial lag-gard and Belgium, as well as other smaller Eu-ropean countries.

Given these conditions, and with no hope ofa coordinated debt write-off, exposure to a seriesof unfamiliar dangers from ris-ing debt charges, falling pricesand the shifting sentimentsof financial markets, madepolicy-makers in the 1920s agood deal more balance-of-payments conscious (ECLA,1965: 15). Effective manage-ment of the resulting policytrade-offs was complicated bythe shifting interests of lead-ing creditor and debtor countries. Under the goldstandard, long-term capital flows and an increas-ingly complex multilateral trading system weremutually supportive, largely because the UnitedKingdoms foreign lending was a substitute forits domestic investment. In addition, its deficit on

the trade account was offset by a surplus on thecurrent account due to earnings on foreign invest-ment, which allowed it to maintain open markets,even in the face of rising protectionism abroad.

Moreover, a general sense ofcredibility centred on confi-dence in the stability of thepound sterling, allowing short-term capital flows to play acomplementary stabilizing role,at least in the core countries(Eichengreen, 1996).8

With no clear leadershipof the financial system andpersistent worries about a gold

shortage, economic uncertainty was added to thepolitical doubts of the post-war world, thus de-laying further any recovery in long-term capitalflows. In the absence of policy coordination be-tween surplus and deficit countries, the systemrelied increasingly on short-term capital, throughportfolio flows and bank lending, to maintain adegree of balance and to bolster reserves. Suchflows occurred on an unprecedented scale, led byUnited States investors who were attracted by highreturns thanks to tight European monetary poli-cies and minimal exchange rate risks. These flowsintroduced a much more speculative dimension tothe recovery, which had started in the second halfof the 1920s following the Dawes Plan and therestoration of the gold standard in the United King-dom. Indeed, with limits to an export-led recov-ery, and domestic expansion restricted by highdomestic interest rates and persistently high lev-

els of unemployment, capitalinflows were used increas-ingly to meet debt repaymentsin a Ponzi-type of financing9(Bayen, 1954).

Thus, the internationaleconomy which took shape inthe 1920s was very differentfrom the one that had col-lapsed in 1914. The combina-

tion of exchange rate risk, volatile capital move-ments and a high and rising debt stock meant thatdeflationary pressures, financial fragility and thethreat of contagion were closely intertwined. Un-der these circumstances, a countrys balance-of-payments position and its reserve situation became

The international economywhich took shape in the1920s was very differentfrom the one that hadcollapsed in 1914.

By assuming an underlyingnatural state of fullyemployed resources,adjustments were expectedto be small in scale andshort in duration.


much more prominent indicators of economic vul-nerability and distress, and triggers for short-termcapital movements.10 The boom in the second halfof the 1920s failed to stimulate productive invest-ment or create sufficient jobs in the leading in-dustrial economies; it provided only a temporarycover for these structural problems, even as tradeexpanded and the openness agenda was given arenewed sense of vigour.

In 1927, with the gold standard back in place,the attention of policy-makers shifted to tradeopenness. Although the International EconomicConference in Geneva produced few concrete out-comes, it added momentum to extending theprinciples of the Manchester School and the ad-vantages of free competition to the trading systemthrough a beefed-up League of Nations secre-tariat (Pauly, 1997: 5561). But within six monthsafter that Conference, capital flows from the UnitedStates to Europe dropped off sharply followingan equity surge on Wall Street, and continued tofall when United States interest rates were hikedin an effort to curb irrational exuberance. Theresult was a further tightening of monetary policyin Europe. At the same time, agricultural prices,which had been falling for some years, showed amarked downward fall in 1929, as exporters in-tensified their efforts to generate foreign exchangein the face of dwindling capital inflows and mount-

ing payment difficulties on outstanding loans.The remaining policy option, of deflationarymeasures to counter widening imbalances in ex-ternal payments by cutting imports, simply shiftedthe problem elsewhere. This made a bust in heav-ily indebted European economies inevitable, andonce it happened, it ensured there was little to stopit spilling over into twin banking and currencycrises.

With sensible collective responses ruled outby an absence of leadership at the internationallevel, and little thought given to the peculiar cir-cumstances under which the international financialand trading system had operated before the war,the idea of a return to normalcy in internationaleconomic relations was, from its inception, builton unstable foundations. Still, economists belief,propagated through international conferences, thatthe only option was to build the confidence of fi-nancial markets as a prelude to the recovery ofinternational capital flows and the reduction oftrade barriers, led to an unhealthy restriction onpolicy space at home, even as it promoted a blindfaith in international market forces as a means toregaining stability. Given the size and nature ofadjustments to be made, such thinking contributedto a destabilizing mix of deflationary pressures andvolatile capital flows, which eventually culminatedin the beggar-thy-neighbour policies of the 1930s.

C. Recasting multilateralism: development challengesand the origins of UNCTAD

The post-World War II multilateral agendaarose from the desire to avoid deflationary adjust-ments and beggar-thy-neighbour policies of thekind that had severely disrupted the inter-wareconomy. It was premised on an expanded policyspace which would allow policy-makers to com-bine a reasonable degree of price stability with

full employment and growth. But, perhaps just asimportantly, the inter-war period had confirmedthat industrial countries were too specialized andinterdependent to achieve economic stability andlasting improvements in economic welfare with-out the establishment of some kind of new inter-national economic order. Thus, and quite unlike


the years following the First World War, policy-makers were not only willing to consider a range ofmore active international policy instruments andmeasures an international cur-rency, provision of internationalliquidity, multilaterally negoti-ated trade rules, a managed ex-change rate system, controllingof destabilizing capital flows but to discuss what kinds of in-ternational arrangements wouldbe needed to manage these mosteffectively.

Discussions about thesewere already under way in thelate 1930s, and as plans on thereorganization of post-war international economicrelations advanced, the institutional arrangementsproposed included:

An international monetary fund to ensure anorderly system of multilateral payments bymeans of stable but adjustable exchangerates, in conditions of strictly limited privateinternational capital flows;

An international bank for reconstruction anddevelopment to provide long-term capital forpost-war reconstruction by encouraging andsupplementing private capital flows;

An international trade organization to pro-vide a rules-based framework to facilitatemultilaterally negotiated reductions in tradebarriers, as well as to coordinate nationaleconomic policies to ensure adequate levelsof global demand and employment in sup-port of the development of low-income mem-ber countries;

An international commodity stabilizationfund for bringing about stability of prices ofraw materials and primary commoditiesthrough the creation of international bufferstocks; and

An international employment agreementwhich would commit countries to full em-ployment along with the requisite interna-tional measures and arrangements to overseeand implement such an obligation.

Common to the proposed mandates of all theseinstitutions was the recognized need for coordi-nated policy efforts to create an open multilateral

trading system that would ben-efit, rather than threaten, do-mestic income and employ-ment, and tether unruly capi-tal flows to ensure financialand exchange rate stability(TDR 1984). This institutionalproject was never completed;the final outcome reflectedprolonged (and noticeablyasymmetric) negotiations be-tween the passing globalhegemonic power (the UnitedKingdom) and the ascendant

one (the United States). In the end, only the Inter-national Monetary Fund (IMF) was established,on the lines of a stabilization fund proposed byHarry White and the United States delegation,along with the (under funded) International Bankfor Reconstruction and Development (IBRD). Aninternational agreement on employment wasstrongly opposed by the United States (as a purelydomestic issue), but was eventually tied to thetrade agenda through a proposed charter for anInternational Trade Organization (ITO). However,this subsequently failed to gain ratification in keycountries, notably the United States. A limitedportion of the ITO mandate was reworked into theGeneral Agreement on Tariffs and Trade (GATT),but the idea of a Stabilization Fund for commodi-ties was dropped altogether.11

The formative years of these multilateral ar-rangements produced mixed outcomes. The GATTnegotiations were primarily concerned with theexchange of tariff concessions extended on amultilateral basis under the unconditional MFNclause. A series of tariff-reducing rounds between1947 and 1956 saw average tariffs fall, albeit front-loaded on the opening Geneva Round (when theUnited States reduced its tariffs by an average of20 per cent on all dutiable imports); while theirimmediate economic impact was probably not sig-nificant, they did help to establish the principleof a tariff-based multilateral system and a com-mitment to a measured liberalization process(TDR 1984: 63). By contrast, the scale of the re-construction challenge, and the transition back toa situation where the IMF could begin to fulfil its

The post-war multilateralagenda arose from thedesire to avoid deflationaryadjustments and beggar-thy-neighbour policies ofthe kind that had severelydisrupted the inter-wareconomy.


responsibility to promote exchange rate stabilityand manage orderly balance-of-payments adjust-ments, were greatly underestimated, and transi-tional arrangements were required to manage theprocess. However, the predicted return of economicstagnation did not materialize, so that the prob-lems of short-term adjustment were easier to solve,and United States authorities and financial insti-tutions were able to assume a pivotal role in man-aging the system.12

While the reliance of the system on the eco-nomic fortunes of the dominant economic powerwas inevitable in the short run, it left a series ofweaknesses and shortcomings; some of thesewould only become fully apparent once post-wareconomic relations stabilized in the late 1950s(Panic, 1995; Eichengreen, 2004). The arrange-ments were, nevertheless, successful in bringingtogether a club of similar economies that had beenconverging on each other for some time (Baumol,1986), and their economic closeness made the taskof learning to work together easier. The combina-tion of favourable economic conditions, a consen-sus on policy objectives with sufficient policyspace, and supportive multilateral institutionsprovided a climate of predictability and stability

in an increasingly interdependent internationaleconomy. It also allowed the building of a strongnexus between investment and exports. Recoveryled to rapid and sustained growth, which ensuredthat the adjustment costs associated with closertrade integration were contained and the benefitsbroadly shared (TDR 1997). The result was a quar-ter of a century of unprecedented economic growthand stability (table 3.4).

For those outside this club, the kind of export-based profit-investment nexus underpinning growthin the more advanced economies appeared to beweak or absent. Moreover, while the obstaclesto growth facing developing countries had sur-faced in the context of wartime military andpolitical alliances, these remained marginal in theBretton Woods negotiations.13 A truly developmentproblématique did not begin to take shape in theWorld Bank until the mid-1950s, and was not re-ally completed until the early 1960s when theInternational Development Association (IDA) wasestablished. Moreover, the World Banks originalmandate as a guarantor of medium- and long-termloans meant it lacked an independent capacity tocreate development finance, and its dependenceon funds raised from the main capital markets ham-

Table 3.4

ECONOMIC PERFORMANCE BEFORE THE FIRST WORLD WAR ANDAFTER THE SECOND WORLD WAR IN SELECTED COUNTRIES

(Average annual growth rates)

18701913 19501973

Investment Export GDP Investment Export GDP

Canada .. 3.1 3.8 5.5 7.0 5.2

France .. 2.8 1.7 4.5 8.2 5.1

Germany 3.1 4.1 2.8 6.1 12.4 6.0

Italy 2.5 2.2 1.5 5.1 11.7 5.5

Japan 2.7 8.5 2.5 9.2 15.4 9.7

United Kingdom 1.4 2.8 1.9 3.9 3.9 3.0

United States 4.7 4.9 4.1 4.0 6.3 3.7

Source: Maddison (1982: tables 3.2, 3.7 and 5.4).


pered its ability to meet the emerging structuralneeds of developing countries (Akyüz, 2004).14Perhaps more damaging still, in this respect, wasthe failure to adopt the HavanaCharter, which contained anumber of elements of moreimmediate interest to poorercountries.

Consequently, the firstreal strides in developmentpolicy analysis occurred out-side the Bretton Woods insti-tutions. They drew heavily onthe newly emerging disciplineof growth theory, but wereconceived more broadly in thecontext of a transition from industrial backward-ness. The resulting development strategy wasbuilt around two main challenges facing low-in-come economies: the shortage of capital was seenas the biggest constraint on the structural trans-formation needed in poorer countries to sustainfaster growth; and it was believed that breakingthat constraint could not rely on market forcesalone. Given low private domestic savings rates,along with low income, a non-inflationary way toclose the gap between domestic savings and in-vestment was found in external flows of capitalfrom rich to poor countries in the form of privateinvestment, loans and development assistance. Butthe scale of the challenge was underestimated.While early estimates by the United Nations putthe resource requirements ofdeveloping countries from for-eign sources at $15 billion ayear, World Bank loans aver-aged between $200 millionand $400 million annually dur-ing the 1950s, with bilateralflows averaging $2 billion an-nually from 1950 to 1955, ris-ing to over $4 billion by theend of the decade (TDR 1984:90).15 Private capital flowswere even more limited, andalmost exclusively took theform of direct investments in the commodity sec-tor. Moreover, as economic thinking on develop-ment grew in sophistication, and was deepenedand refined by academics and policy-makers fromthe developing countries themselves, efforts to

measure the size of the resource gap revealed de-veloping countries to be net exporters of capital,once the repayment of loans, terms-of-trade losses

and capital flight were includedin the calculation.16

With international privatecapital flows constrained anddevelopment assistance stilllimited (and often tied), in-creasing attention was focusedon the role of internationaltrade as a more dependablemeans of removing the re-source constraints on eco-nomic growth in poorer coun-tries. This marked something

of a break with the trade pessimism which hadbeen a powerful current both before and after thewar (Rayment, 1983), particularly in developingcountries, where the collapse of the trading sys-tem in the 1930s had forced a greater reliance onthe domestic market. However, neither the multi-lateral trading arrangements, where the GATT hadbecome a largely technical instrument for manag-ing trade between rich countries, nor the most dy-namic regional trading arrangements, notably theevolving European Common Market (TDR 2003),were appropriate venues for improving develop-ing-country participation. Between 1950 and1960, the share of developing countries in worldtrade fell from 31 per cent to 21 per cent, and evenin primary commodities, their share fell from

41 per cent to 29 per cent. Asa result, the kind of export-based profit-investment nexusthat was underpinning the suc-cessful pattern of interdepend-ence among advanced econo-mies, appeared to be weak ormissing altogether in the de-veloping world.

An examination of thecomparative trade perform-ance of rich and poor countriespublished by the GATT in 1958

and prepared by the noted economist GottfriedHaberler, confirmed that tariff and other barriers,particularly against food-exporting developingcountries, was one source of the problem.17 Still,the Haberler Report reflected conventional think-

The combination offavourable economicconditions, a consensus onpolicy objectives andsupportive multilateralinstitutions provided aclimate of predictability andstability.

The point in the inter-national trading systemwhere asymmetriesbetween centre andperiphery appeared insharpest focus was in theterms of trade for primaryexports.


ing on the trade openness model, based on theclassic concept that the free play of internationaleconomic forces by itself leads to the optimumexpansion of trade and the most efficient utiliza-tion of the worlds productive resources (UNCTAD,1964: 18); its assumption of near equality of ini-tial conditions leading to convergence and com-mon trading interests was inconsistent with theburgeoning literature on economic development.As Nurkse (1959: 26) noted at the time,

In a world in which (outside the Soviet area)over nine-tenths of the manufacturing andfour-fifths of the total productive activityare concentrated in the advanced industrialcountries, the ideas of symmetry, reciproc-ity and mutual dependence which are asso-ciated with the traditional theory of inter-national trade are of rather questionablerelevance to trade relations between centreand periphery.

The point in the international trading systemwhere asymmetries between centre and peripheryappeared in sharpest focus was in the terms oftrade for primary exports. Empirical studies re-ported a long-term decline, coupled with highinstability, in the terms of trade between primaryand manufactured exports. The explanationpointed to price and income inelasticity for thedemand of primary commodities. This, combinedwith competitive market conditions, meant thatinvestment and technical progress, which, in thedeveloped countries, led to higher wages and liv-ing standards of those employed, in the developingcountries tended to result in lower prices for theirexports. The secular tendency for the terms oftrade to move against developing countries andespecially for those exporting primary products,seriously constrained the capacity of developingcountries to import the capital goods needed toaccelerate capital formation and to diversify intomore dynamic areas of international trade. Giventhat industrial development offered the best chanceof raising productivity growth (through scaleeconomies and innovation), and producing a vir-tuous growth circle between demand expansionand development of productive capacities, a ba-sic objective of development policy was to findways of redressing the structural constraints oncatch-up growth.18

Raul Prebisch developed the policy optionsfor countries locked into a pattern of slow growth

and adverse terms-of-trade movements. Alreadyin the mid-1950s as head of the then EconomicCommission for Latin America (ECLA), he hadorganized a series of country studies examiningthe disappointing results of the inward-orientedindustrialization model adopted in Latin Americain the inter-war years. A 1956 report on the Argen-tinean economy prepared under his guidanceoutlined an outward-oriented growth strategywhich aimed for a better balance between agri-culture and industrial development, whilst shiftingthe orientation of industry from domestic to foreignmarkets to achieve more dynamic scale economies(Rosenthal, 2003: 181183).19

Linking trade prospects to a structuralist de-velopment model also cast the working of theinternational trading system in a different light. Ifthe consistent application of liberalization meas-ures through universal trade rules and principles,combined with the gradual absorption of importedtechnologies, could not be relied upon to eliminatethe external imbalances accompanying economicdevelopment, or to bring about rapid productivitygrowth and income convergence along the linesachieved by the late industrializing economies inthe late nineteenth and early twentieth centuries,then a rules-based system supportive of an indus-try-led growth strategy for poorer countries wouldhave to accommodate an element of asymmetri-cal integration into the world economy. As notedin the Report of the Secretary-General of UNCTAD(UNCTAD, 1964: 19),

The request for reciprocity in negotiationsbetween countries that have no structuraldisparity in their demands is logical. In thecase of trade between the developing andthe industrial countries, the situation is dif-ferent. Since the former tend to import morethan they export owing to the internationaldisparity in demand concessions grantedby the industrial countries tend to rectify thisdisparity and are soon reflected in an ex-pansion of their exports to developingcountries. In other words, the developingeconomies, given their potential demand forimports, can import more than they wouldotherwise have been able to do had theseconcessions not been granted. Thus there isa real or implicit reciprocity, independentof the play of conventional concessions.

Multilateral efforts at designing this newtrading geometry culminated in the First UNCTAD


Conference in 1964. The Report to the Confer-ence, entitled Towards a New Trade Policy forDevelopment, set out to show that the free play ofinternational economic forces would not by itselflead to the most desirable utilization of the worldsproductive resources, given the structural obsta-cles to growth at the domestic and internationallevels. It also spelt out the implications for tradeand related finance if the minimum target of 5 percent growth for developing countries was to beachieved.20 In specifying what was to be done, theReport rejected both the import substitution modelhanded down from the inter-war period and theopenness model embodied in the GATT. Instead,it spelt out an alternative strategy which wouldhelp poorer countries develop outwardly throughstrong capital formation and continuing and ac-celerated expansion of exports both traditionaland non-traditional. Central tothat agenda was the idea thatif developing countries wereto rely on their own efforts,they would need to have suf-ficient policy space to accel-erate capital formation, diver-sify their economic structuresand give development a greatersocial depth. There wouldalso need to be a change in theorientation of international co-operation to ensure that this strategy was consist-ent with the international goal of poverty allevia-tion (UNCTAD, 1964: 64).

This reorientation would require a much moreflexibly managed trading system to accommodatecountries at different levels of development. In asense, a case for greater flexibility had alreadybeen accepted by advanced industrial economiesin the GATT when they sought more orderly ad-justments for their own peripheral areas and sunsetactivities.21 Such flexibilities were provided bynon-application of the Agreement between particu-lar Contracting Parties under Article XXXV andthe Grandfather Clause, under which original con-tracting parties to the GATT agreed to apply majorobligations of the agreement only to the extent oftheir consistence with existing national legislation.This was most notably applied in the case of agri-culture. Favourable terms were also extended totextiles and clothing, which were eventually ac-corded their own separate trade regime. Extending

this idea of preferential treatment to industries indeveloping countries would, however, have to ac-commodate the wider productivity gaps due tostructural differences and differing technologicaldensities which existed with the advanced econo-mies. Allowing more favourable access to theirmarkets would be one way to overcome initial costdisadvantages. Additionally, appropriate fiscalsupport and other incentives for infant industrieswould be needed, along with supplementary meas-ures, where possible, to ensure a more effectivelymanaged exchange rate. All such measures wouldhave to be carefully monitored and subject to clearbounds in line with improving technological ca-pacities and productivity improvements.

The UNCTAD agenda also addressed the in-terdependence of trade and finance, given that,

particularly in the early stagesof industrialization, importswould almost certainly growfaster than exports, and that fi-nancing the resulting trade gapwould be key to acceleratinggrowth. This would requireadditional development assist-ance or compensatory financefor deteriorating terms of tradeand debt relief. The Report toUNCTAD I also recognized

that any new trade geometry in support of devel-opment would hinge on fast and stable growth inthe developed countries, and that the internationalfinancial arrangements would require sufficient re-sources to prevent disruptive stop-go cycles inthose countries. Furthermore, it raised concernsabout the adequacy of balance-of-payments financ-ing in light of the growing volume of trade, per-sistent trade surpluses in some economies, and theneed to supplement gold reserves with new instru-ments to allow for additional credit expansion byinternational financial institutions.

In the absence of sufficient finance for meet-ing the structural demands of developing countries,external equilibrium could only be maintainedthrough the suspension of commitments made inthe multilateral trading system (Johnson, 1967:114115). The GATT had accepted this principlefor developed countries in support of the post-warfull-employment agenda. For example, Article VIIprovided for exchange controls and trade restric-

The Report to UNCTAD Irecognized that any newtrade geometry in support ofdevelopment would hinge onfast and stable growth in thedeveloped countries.


tions when the currency required to finance ex-ternal imbalances was declared scarce.22 Thisimplicit acceptance of the priority of meetingfinancial obligations over the observance of com-mitments to free trade was reflected in GATTArticles XII (Restrictions to Safeguard the Bal-ance of Payments) and XV (outlining the terms ofGATT and IMF collaboration on exchange ratequestions). These exemptions were granted, es-sentially, to address temporary liquidity problems.Similar exemptions for longer run adjustments,included in the ITO proposals, had not been in-corporated into the GATT, and were only seriouslyconsidered after the creation of UNCTAD. It wasonly in 1979 that special and differential treatmentwas accepted as a general requirement for ena-bling the beneficial participation of developingcountries in the post-war international trading andfinancial system.

The creation of UNCTAD was part of thepost-war reformist wave, which extended thesearch for multilateral solutions to the economicchallenges of an interdependent world to encom-pass development problems largely ignored atBretton Woods. Its starting point was the need toaddress the structural obstacles to catch-upgrowth, and particularly those enforced throughinternational market forces. Rebalancing the sys-tem required a strategic pattern of integration inline with levels of industrial development andfavourable terms of market access, as well as ap-propriate levels of development finance. But justas importantly, as noted by Edward Heath, Headof the British delegation to UNCTAD I, it requiredthat the richer countries begin to see fuller coop-eration and greater interdependence as commonallies in the fight for a more prosperous and fairerworld.

D. Interdependence after Bretton Woods

As noted in the previous section, a centralfeature of the Bretton Woods system was afford-ing sufficient space to policy-makers to meetemployment, inflation and growth targets, accept-ing that, in an increasingly interdependent globaleconomy, policies should be employed with a clearsense of any potential negative externalities theymight generate.23 This was achieved through asystem of fixed but adjustable exchange rates, withtight controls on international capital movementsalong with the global provision of liquidity, ena-bling countries to pursue expansionary policiesthat would bring positive externalities for tradingpartners (Stiglitz, 2003). On this basis, an earlyWashington policy consensus articulated byTreasury Secretary Morgenthau and the chiefUnited States negotiator at Bretton Woods, HarryWhite allowed for restrictions on destabilizing

capital flows and placed clear limits on thesurveillance and conditionality attached to inter-national lending. According to White, as cited inFelix (1996: 64),

To use international monetary arrangementsas a cloak for the enforcement of unpopularpolicies, whose merits or demerits rest noton international monetary considerations assuch but on the whole economic programand philosophy of the country concerned,would poison the atmosphere of interna-tional financial stability.

This consensus quickly unravelled with thecollapse of the Bretton Woods system in the early1970s, and the transfer of the management of for-eign exchange risk to the private financial sector(Eatwell and Taylor, 2000). The collapse was fol-


lowed by the removal of capital controls, and bya move to financial deregulation in the developedeconomies, which was transmitted swiftly to therest of the world, in no smallpart thanks to the efforts of theinternational financial institu-tions to lock in the freedomof capital movements alreadyachieved and encourage widerliberalization (Camdessus,1995). These efforts implied ashift in focus from guarantee-ing systemic financial stabil-ity to catalysing private capi-tal flows by building confi-dence, including through intrusive adjustment pro-grammes in debt-ridden developing countries.

This change of direction assumes that finan-cial deepening, brought about by the liberalizationof domestic financial markets and the opening upof the capital account, would lead to a more effi-cient allocation of resources and faster and morestable growth.24 The removal of controls over inter-national capital was followed by a marked increasein flows to developing countries, beginning withsyndicated bank lending in the mid-1970s, and,since the late 1980s, in equity flows and FDI (TDR1999). This has frequently led to comparisons withthe earlier period of rapid globalization under thegold standard, when large private capital flowsunderpinned strong economic performances, in-cluding on the periphery. This parallel impliesthe presence of a number of features in currentarrangements: first, capital flows are predomi-nantly long-term, triggered by productive profitopportunities in an emerging international divi-sion of labour, and supported by complementarytrade and labour flows; second, stability rests onstrong domestic capital accumulation, which is notsacrificed to emerging trade imbalances; and third,short-term capital flows play a subordinate andstabilizing role.

Under the gold standard, such flows and ad-justments were managed through a socially-constructed monetary arrangement that includeda simple set of rules around which core lendersand borrowers could build expectations of a sta-ble future. It also included a willingness to subor-dinate domestic policy goals in times of crisis; andthere was a lead economy with a vested economic

interest in maintaining a stable currency and freetrade, even as it was channelling domestic sav-ings abroad.25 Strong States channelled funds into

productive public investment,while they used policy spaceto manage a fast pace of capi-tal accumulation and to en-courage exporting that couldhelp service the capital flowsneeded to cover large tradedeficits.

The diversity of econo-mies that make up the contem-porary international financial

system at least as measured by income gaps be-tween the main debtors and creditors is prob-ably greater than under the gold standard (WorldBank, 1999). However, the greater part of con-temporary financial flows are short term, amongthe developed countries themselves, and even thegreater part of global FDI is accounted for bymergers and acquisitions (M&As) amongst the ad-vanced industrialized countries. On balance, theliberalization of capital movements has had littleimpact on levels of development finance, and thebalance-of-payments constraint of developingcountries has not been removed. Moreover, nomajor region has successfully forged strong link-ages between net capital inflows, capital forma-tion and industrialization.

Behind these trends lies an emerging pictureof transnational finance (Kregel, 1994), with ac-tivities focused on providing hedging on foreign-exchange risk across a diversified internationalportfolio of foreign assets, and with a greatly ex-panded capacity to operate in a global market forfunding sources, borrowing in any currency andlending in any other currency. While the extent oftransnational finance remains the subject of on-going empirical analyses (Felix, 2001), there hasbeen a trend of de-linking international trade andfinancial flows. This is most clearly the case withshort-term flows, where over 80 per cent of trans-actions relate to round-trip operations of a weekor less, motivated by hedging, arbitrage and specu-lative considerations. But it is also true of somelonger term flows. A significant share of FDI flowshas been absorbed by M&As and the increasedcapacity of transnational corporations (TNCs) tocombine financial and locational engineering in

The removal of controlsover international capitalwas followed by a markedincrease in flows todeveloping countries inthe 1970s.


international production networks has often pro-duced footloose productive assets and ambiguouseffects on balance-of-payments positions (Kregel,1996b; TDRs 1999 and 2002). Moreover, and despitethe belief that a more open economic environmentwith unrestricted capital flows would demonstratethe superiority of markets over government inter-vention, the period since the collapse of the BrettonWoods system has been marked by an increasingincidence of financial crises (in both developedand developing countries), and their growing viru-lence in terms of lost output and jobs (TDRs 2000and 2001; Eichengreen and Bordo, 2002).

After the rapid opening up of their econo-mies in the 1980s, many developing countriesbecame increasingly preoccupied with ensuringsufficient flows of external funds, rather than im-proving domestic resource accumulation and pro-ductivity growth. In particular, foreign capitalflows were regarded as an instrument for acceler-ating growth. The monetary conditions created bythese flows and the policies to attract them werenot considered to hinder domestic investment. Itwas believed that high nominal and real interestrates, a rather stable nominal exchange rate andfiscal restraint should attract capital inflows andassure foreign investors about the seriousness ofpolicy efforts to leave the legacy of hyperinfla-tion behind. In some countries, domestic monetarypolicy was completely abandoned, and the ex-change rate anchor was supposed to stabilize theprice level through competition from cheap im-ports. In addition, it was expected that the sale ofState assets and a reduction ofgovernment intervention wouldimprove the overall efficiencyof the market system. But, theflip side of this sound policyapproach was that it directlylowered profits and profit ex-pectations of domestic compa-nies and prevented the profit-investment nexus from evolv-ing. Eventually, the efficiencygains of the pro-market policycould not make good the over-all restrictive stance of economic policy and thepressure from foreign competitors.

An imbalanced concentration on sound eco-nomic policies to fight inflation, and on getting

relative prices right by increasing the efficiencyof resource allocation, came at the expense of theoverall dynamics of the economy, because macro-economic prices the real interest rate and thereal exchange rate were not appropriate to thisend. Thus, the necessary conditions to foster pro-ductivity growth and to combine internationalcompetitiveness with strong growth of domesticdemand and company profits were not in place.The sound macroeconomic fundamentals did nottranslate into sound fundamentals capable of pro-ducing an environment for firms that was condu-cive to increasing investment, introducing newtechnologies and expanding exports.

Macroeconomic policy was successful infighting and eliminating hyperinflation, but onceprice stability had been achieved, it did not takeaccount of the fact that, in the global market, com-petition puts downward pressure on prices via costcompetition and the creation of excess supplies;this shifts the balance of risks from inflation andexcess demand towards deflation and lack of de-mand. Under these conditions, the increasingimportance of international production chains didnot allow the rapid introduction and full exploi-tation of technology for upgrading domesticindustry, because most basic research and the moretechnology- and skill-intensive slices of the pro-duction chain remained in the more advancedeconomies.

The consensus during the 1990s has beenthat there was no alternative to these orthodox

policies. Many observers pre-sumed that interest rates andmonetary policy cannot be re-laxed without a loss of ex-change rate stability, price sta-bility and positive capital in-flows. However, the combina-tion of low-income growth, anovervalued exchange rate andhigh interest rates inhibited in-vestment incentives and therestructuring of the domesticproductive sector. It also made

it virtually impossible to meet the conditions re-quired to stabilize or reduce the debt burden rela-tive to national income (as real interest rates re-mained above real growth rates) in the mediumterm.

After the rapid opening upof their economies in the1980s, many developingcountries becameincreasingly preoccupiedwith ensuring sufficientflows of external funds.


Because considerable emphasis was placedon fighting inflation through the establishment ofsound macroeconomic fundamentals, such as fis-cal restraint, control of monetary expansion andanchoring of the nominal exchange rate, the nega-tive impact on the sustainability of the externalbalance was neglected. Although external balancesgenerally improved during periods of declininginflation, this was usually achieved by reducingoverall income growth suffi-ciently to compress imports,rather than by raising exports.This is precisely the oppositeof the justification for openingthe economy to make trade anengine of growth, more spe-cifically to expand manufac-tured exports in order to beable to increase imports ofcapital goods for investmentand restructuring. These poli-cies also had an adverse im-pact on the shift from State-leddevelopment to market-led de-velopment based on international competition.High interest rates were detrimental not only tothe industrial sector, but also to primary commod-ity producers attempts to modernize their machin-ery and equipment. Overvalued exchange ratesoften gave foreign competitors an absolute advan-tage that could not be compensated by endeav-ours at the micro level.

In the presence of free capital flows it hasbeen difficult for many developing countries toavoid overvaluation, whether because of exces-sive optimism about domestic prospects or becauseof excessive pessimism about prospects in devel-oped countries. Although the international trad-ing system of rules and regulations has always in-cluded clauses that allow countries to opt out oftheir obligations and commitments to free tradewhen they are faced with extreme balance-of-

payments difficulties and dangerous declines intheir foreign-exchange reserves, these clauseswere not applied. Moreover, there were no regu-lations allowing a country to temporarily opt outof free international capital flows when such flowscreated excessive movements in exchange ratesthat had an impact on its external competitivenessand its balance of payments. Measures to keep out-flows to magnitudes that are commensurate with

a countrys ability to maintainexternal balance have not beenpart of the rules and regula-tions of the international trad-ing system and of the interna-tional financial system in thepost-Bretton Woods era.26

Overall, establishing a vir-tuous interaction between in-ternational finance, domesticcapital formation and exportgrowth has proved surpris-ingly uncommon since the col-lapse of Bretton Woods. In de-

veloping countries, dependence on external capi-tal flows has led markets to impose a risk pre-mium on domestic interest rates that has reducedthe space for domestic economic policy and,in some cases, constrained growth, fixed invest-ment and job creation. As a profit-investmentnexus failed to take root, development policiesbecame hostage to maintaining a steady increasein capital inflows and to retaining the confidenceof the financial institutions providing them. Thisis highlighted by Latin America which has exhib-ited a particularly high foreign-debt-to-export ra-tio and a greater vulnerability to external shocks(IMF, 2002). Additionally, this combination offorces pushes policy-makers to pursue policies thatenhance the short-term ability to pay, but they willpay the price of maintaining the confidence of fi-nancial markets in terms of reduced policy spaceto manage any future shocks (Kregel, 1996b).

Establishing a virtuousinteraction betweeninternational finance,domestic capital formationand export growth hasproved surprisinglyuncommon since thecollapse of Bretton Woods.


Pressures for greater openness, particularlyin an uncertain economic environment and an eraof dynamic structural change, have made it in-creasingly difficult for countries to pursue theirown national policies for development and inte-gration into the global economy. The opennessagenda overlooks the fact that the advanced in-dustrial economies engaged in very active eco-nomic policies in pursuit of their development, andit ignores their history of building hard Statesto guide that process (see Chang, 2002; and Bayly,2003).27 Instead, by concentrating on market forcesand getting prices right tomaximize the gains from agiven pattern of factor endow-ments, the openness agendahas perpetuated a lopsided viewof the forces driving economicintegration. It stresses the po-tential gains from participationin international markets whiledownplaying adjustment costs, and it stresses con-vergence tendencies while ignoring potentialsources of cumulative divergence.

As the previous sections have suggested, thisapproach has its limitations. Trade is just oneamong several interrelated factors shaping inte-gration. Its impact is largely contingent on thepresence of dynamic forces specialization, learn-ing and innovation, scale economies and capitalformation that do not respond in a simple or pre-dictable way to the incentives generated fromrapid opening up. Strengthening these forces re-quires a series of complementary institutional

reforms and discretionary macroeconomic, indus-trial and social policy measures. This impliesconsiderable diversity in the pattern of integra-tion, even among countries at similar levels ofeconomic development.

Development strategies that successfully har-ness trade to a strong growth dynamic will neces-sarily lead to closer links with the wider interna-tional economy, especially with neighbouringeconomies. This will make the success or failureof those strategies increasingly dependent on

trends and policies elsewhere.Moreover, as more countriesestablish successful growth re-gimes, an expansion of tradewill be accompanied by in-creased cross-border flows ofinvestment, technology andfinance. As a result, a coun-trys internal performance

(as measured by investment levels, productivitygrowth, employment creation and technologicalupgrading) and its external performance (asmeasured by the trade balance, net capital flowsand exchange rate stability) become much moreclosely intertwined and the policy trade-offs con-siderably more challenging.

It is unlikely that the policy trade-offs willever be satisfactorily resolved by privileging ex-ternal goals, even as countries seek to maximizethe benefits from closer participation in the inter-national division of labour. Rather, stability willdepend, in part, on the ability and willingness of

E. Interdependence, international collectiveaction and policy space

Trade is just one among anumber of interrelatedfactors shaping integration.


individual countries to pursue policies that arecompatible not only with their own national ob-jectives, but also with the objectives and policiesof other countries. It is therefore necessary to findcommon objectives among countries at varyinglevels of development around which a stable pat-tern of integration can be built.

The openness agenda has sought consensusaround common policy instruments and universalprice incentives. However, experience shows thatthere is a need for policy instruments specificallydesigned with the aim of helping countries at lowerstages of development to converge on the levelsof efficiency and affluence achieved by the moreadvanced economies, and to improve the welfareof all groups of the population. Making this theprinciple for policy design at both the domesticand the international level requires recognition ofthe fact that successful devel-opment and integration of thedeveloping countries is in themutual interest of all coun-tries, as longer-term growthand trading opportunities ofthe more advanced economiesalso depend on the expansionof industrial capacity and mar-kets in the poorer economies.

Under the gold standard,unprecedented private capitaland labour flows helped estab-lish mutually beneficial linkages between a wealthyindustrial core, primary exporters and a smallgroup of late industrializing economies. And eventhough the economic gap was relatively narrow,the latter were free to establish industrial capac-ity behind high and enduring levels of tariff pro-tection, while exporters were allowed unrestrictedaccess to the markets of the industrial core. Theopenness agenda during the inter-war period failedto strike the right balance between market forces,policy space and collective international action.Later, under the Bretton Woods system, both pri-vate capital flows and the movement of labourwere sharply curtailed, but policy space was ex-tended to allow both developed and developingcountries to pursue a broad economic agenda, andan institutional framework was set up for collec-tive international action in support of growth andstability and for managing economic integration.

As discussed earlier, this required a degree of flex-ibility in the workings of those arrangements inrecognition of the differences in initial conditionsand the varying pace of economic and industrialprogress.

In todays world of increased interdepend-ence dealing with the trade-offs between domes-tic and external objectives requires a much morepragmatic approach to policy-making than thatsuggested by the openness agenda. In the absenceof easy growth and adjustment formulas for eco-nomic catch-up through industrialization, strate-gies that seek to make convergence a commonpolicy objective have to allow a good deal moreroom for experimentation and discrimination infavour of countries with lower efficiency and in-come levels. To this end, policy-makers need toadopt a more pragmatic rule of thumb approach

to designing useful interven-tions consistent with the prac-tical world of politics (Krug-man, 1987).

Since developing coun-tries have become more vul-nerable to external shocks, andthe potential costs of adjustingto those shocks are significantand unevenly distributed, thereis a danger that countries willtry to use their available policyspace to solve economic prob-

lems at the expense of other countries throughbeggar-thy-neighbour policies. Accordingly,much like integration at the national level, whichrequires arrangements to ensure that all regionsand social groups benefit from growth, efforts tobring progress, stability and predictability to anincreasingly interdependent world also have toinvolve more collaborative and cooperative ar-rangements among countries.

As more countries seek to build domesticproductive capacity and potential conflicts andrivalries increase, success in moving towards moreopen multilateral economic arrangements impliesmore than aiming at agreements dealing with re-ductions of tariffs, quotas and subsidies, and otherimpediments to the expansion of trade. And at-tracting more FDI is not a substitute for rapid do-mestic capital accumulation. Rather, the entire

The entire internationaleconomic system must becapable of supportinggrowth and convergenceacross a wide spectrum ofcountries making up theinternational division oflabour.


international economic system should be capableof supporting growth and convergence across awide spectrum of countries making up the inter-national division of labour, with appropriateflexibilities built in to accom-modate the diversity of condi-tions. Currently, only a hand-ful of States are sufficientlylarge and dynamic enough toharness international forces toeconomic objectives, and evenfewer are able to dictate theterms of integration and, con-sequently, to influence the pros-pects of other countries. Undersuch conditions, a critical ingredient of stablemultilateralism is that the leadership of the strong-est participants must be oriented in the right di-rection (Kindleberger, 1986).

Not only are the leading economies in a bet-ter position to bear the short-term costs of thecollective actions needed to guarantee the long-term health of a more interdependent economicsystem, they also have an asymmetric bearing ongrowth prospects in the weaker economies throughtheir share in world demand, their level of tech-nological development and control over capital.They therefore have the added responsibility ofpursuing policies in a way that does not damagethe growth and stability of the weaker economies.Of particular concern are the potentially destabi-lizing and deflationary feedbacks between trade

and finance, which often create impediments todevelopment. Financial crises in the developingcountries frequently result, at least in part, fromvarious shocks and policy changes that originate

in the major reserve currencycountries. But at present, thereis no system of multilateralsurveillance that can insist ongreater coherence in the lat-ters monetary and exchangerate policies. In the absence ofmore balanced representationin multilateral institutions, thereis a need for arrangements thatmake it possible to accommo-

date the kind of discretionary policy action on thepart of countries at lower levels of efficiency andincome that was an important ingredient of thesuccessful integration of the more advanced econo-mies into the international economy.

Thus, contrary to the thrust of the opennessmodel, the search for economic stability and bal-ance is not between autarky and surrenderingnational sovereignty to the expansive logic ofmarkets. Nor does the latter provide the institu-tional standard against which development successshould be judged. Rather, in an interdependentworld, the balance between economic welfare atthe national level and integration at the internationallevel will continue to hinge on an appropriate mixof market forces, policy space and collective ac-tions.

The search for economicstability is not betweenautarky and surrenderingnational sovereignty to theexpansive logic of markets.


Notes

1 A recent review of the voluminous body of model-ling exercises, country studies and regression analy-ses, all reporting a strong link between increasedtrade openness and economic welfare (both posi-tive and negative), concludes that the whole casehas been exaggerated (Freeman, 2003). For areview of the evidence see Kozul-Wright andRayment, 2004.

2 For more on the profit-investment nexus in the de-velopment process, see TDRs 1996 and 1997;Amsden, 2001; and Ros, 2002.

3 Economic development is complicated by social andpolitical changes, particularly where this involvesthe separation of large numbers of people from theland and their growing concentration in urban cen-tres, and by the steady, albeit punctuated, rise ofdemocratic institutions; for a seminal discussion, seePolanyi, 1944; and Moore, 1966.

4 The literature describing this history is vast; see,for example, Rowthorn and Chang, 1993; Reinert,1999; Gomory and Baumol, 2000; and Bayly, 2003.

5 Over 40 per cent of the French labour force was infarming, and the figure was even higher on the Eu-ropean periphery and in the white-settler colonies.Even in the United States, where total farm mort-gages had risen from $3.3 billion in 1910 to $9.4 bil-lion in 1925, the agricultural sector accounted for aquarter of total employment and farm exports forover one quarter of farm incomes. With slowergrowth, weak international prices and protection-ism in some leading markets, the burden of externaldebt-servicing rose steadily for most primary ex-porters in the 1920s (Kindleberger, 1987: 8487).

6 According to Bairoch (1993: 45), the weighted av-erage of customs duties on manufactures in conti-nental Europe was 24.6 per cent in 1913 and 24.9 percent in 1927, and the figures were almost certainlylower in 1928 and 1929. As Bairoch notes, how-ever, there was plenty of variation around these av-erage figures, as was the case before 1914.

7 Germany returned to its pre-war parity in 1924 aspart of the Dawes Plan, and the United Kingdo

Documents

INTRODUCTION - SARPN · the initially proposed charter of the International Trade Organization (ITO), whose mandate would also have included to coordinate national eco-nomic policies