Trade & Development I:Import Substitution Industrialization

International Political EconomyProf. Tyson Roberts

Brief history globalization & development

• Mercantilism (1500s-1700s) – Globalization through empire– Imperial goal: amass the most gold– Subsidize exports, tax imports

• Classical liberalism (1800s– early 1900s )– Increasing free trade promoted by Britain

hegemon– Continued promotion of trade within empires

How globalization helps developing countries according to classical liberalism

1st Age of Globalization

• Free trade: poor countries specialize in comparative advantage (e.g., agriculture) & import other products (e.g., manufactures)

• Free flow of labor: workers move from labor-abundant to labor-scarce economies => wages

• Free flow of capital: capital flows freely from capital-rich to capital scarce countries => investment, development

Example 1: Argentina in 1800s

• Economically backward compared to Britain• Land abundant• Labor scarce

What should we predict regarding policy preferences of each group, and the resulting political coalitions?

5

Commerce and Coalitions1st Age of Globalization (increasing free trade)

Labor scarce relative to Land

Labor abundant relative to Land

Capital rich (Developed countries)

Capitalists & Landowners for trade

Labor againstCapital & Labor for trade

Landowners against

Capital scarce (LDCs)

Landowners for trade Labor & Capitalists against

Labor for tradeLandowners & Capitalists

against

6

Commerce and Coalitions1st Age of Globalization (increasing free trade)

Labor scarce relative to Land

Labor abundant relative to Land

Capital rich (Developed countries)

Capitalists & Landowners for trade

Labor againstCapital & Labor for trade

Landowners against

Capital scarce (LDCs)

Landowners for trade Labor & Capitalists against

Labor for tradeLandowners & Capitalists

against

Argentina

In 1800s, Latin America ruled by landowners; much of Asia & Africa ruled by empires

Collective Action Cost

High Low

Factors Mobile & Majoritarian Inst. (e.g., democracy, not oligarchy)

Rampant free ridingNo trade policy coalitionsExit (?)

Rogowski

Factors Mobile &Non-maj. Inst. (e.g., oligarchy)

Rampant free ridingTrade policy coalitionsExit (?)

Class-based coalitions possible, but not necessary for victory

Factors Specific &Majoritarian Inst.

Individual interest groups unable to affect trade policyConsumer groups inactive Universalistic logroll (?)

Cross sector coalitions (logrolling) or coalitions with laborConsumer groups active

Factor Specific &Non-maj. Inst.

Standard trade policyModel (Pareto,Olson, etc)Lobbying for protectionConsumer groups inactive

Cross sector coalitions (logrolling) or coalitions with labor possible, but not necessary for victoryConsumer groups active

Brief history globalization & development

• Mercantilism (1500s-1700s) – Globalization through empire– Imperial goal: amass the most gold– Subsidize exports, tax imports

• Classical liberalism (1800s– early 1900s )– Increasing free trade promoted by Britain hegemon– Continued promotion of trade within empires

• World Wars & interwar period (1914-1945)– Breakdown of free trade system, nationalist, fascist &

communist movements

Crisis: WWI & Great Depression

• War => increased demand for labor => increased power of labor in economics (unions) and politics (votes) (esp. in sovereign nations)

• British Navy no longer strong enough to enforce free trade policies in developing countries

• Rich and poor countries respond to crisis by imposing controls on trade, capital, immigration

• Communists & Fascists extremely protectionist

War => increased demand for labor => increased power of labor in economics and politics (votes)

Collective Action Cost

High Low

Factors Mobile & Majoritarian Inst. (e.g., democracy, not oligarchy)

Rampant free ridingNo trade policy coalitionsExit (?)

Rogowski

Factors Mobile &Non-maj. Inst. (e.g., oligarchy)

Rampant free ridingTrade policy coalitionsExit (?)

Class-based coalitions possible, but not necessary for victory

Factors Specific &Majoritarian Inst.

Individual interest groups unable to affect trade policyConsumer groups inactive Universalistic logroll (?)

Cross sector coalitions (logrolling) or coalitions with laborConsumer groups active

Factor Specific &Non-maj. Inst.

Standard trade policyModel (Pareto,Olson, etc)Lobbying for protectionConsumer groups inactive

Cross sector coalitions (logrolling) or coalitions with labor possible, but not necessary for victoryConsumer groups active

Example 2: Argentina in 1930s

• Economically backward compared to Britain• Land abundant• Labor scarce

What should we predict regarding policy preferences of each group, and the resulting political coalitions?

12

Commerce and CoalitionsDepression of the 1930s (increasing protectionism)

Labor scarce relative to Land

Labor abundant relative to Land

Capital rich (Developed countries)

Capitalists & Landowners for trade

Labor againstCapital & Labor for trade

Landowners against

Capital scarce (LDCs)

Landowners for tradeLabor & Capitalists against

Labor for tradeLandowners & Capitalists

against

13

Commerce and CoalitionsDepression of the 1930s (increasing protectionism)

Labor scarce relative to Land

Labor abundant relative to Land

Capital rich (Developed countries)

Capitalists & Landowners for trade

Labor againstCapital & Labor for trade

Landowners against

Capital scarce (LDCs)

Landowners for tradeLabor & Capitalists against

Labor for tradeLandowners & Capitalists

against

Asian & East European Fascism

W. European FasicismUnited States: New Deal

South American Populism

Argentina 1940s-1950s

• Juan Peron rises to power with support of labor, industrialists (import competing sectors) and military

• Implements import substitution industrialization policies

• http://www.youtube.com/watch?v=WxnaZ0SANr8

Structuralist Critique of Economic Liberalism

• Market imperfections in developing countries– Industrialization in modern era requires

coordination• Complementary demand: need critical mass of wage

workers to buy manufactured products• Pecuniary external demand: need related industries to

invest simultaneously

Coordination ProblemElectricity Firm

Invest in Dam Don’t invest

Manufacturer Invest in factory 10, 10 -5, 0

Don’t invest 0, -5 0, 0

Coordination ProblemElectricity Firm

Invest in Dam Don’t invest

Manufacturer Invest in factory 10, 10 -5, 0

Don’t invest 0, -5 0, 0

Solution to coordination problem: “Big Push” by Government

Volta Dam, GhanaMajor electricity producer

Valco aluminum smelterMajor electricity user

Structuralist Critique of Economic Liberalism

• Market imperfections in developing countries– Industrialization in modern era requires

coordination– Declining terms of trade

• Imported manufactures prices rise• Export commodity prices fall• Result: core country real incomes rise, periphery

country real incomes fall

Solution to Declining Terms of Trade Problem: ISI

1. Easy ISI: – Promote local production of consumer goods

• Sufficient local demand to enable economies of scale• Sufficient local labor for labor intensive production• Necessary technology available for import (in part in

form of foreign capital: machines, etc.)• Benefits: wage-based employment, human capital

Solution to Declining Terms of Trade Problem: ISI

1. Easy ISI2. Second step options

– Secondary ISI• Move up to consumer durables (cars, etc.),

intermediate inputs (steel, etc.), and capital goods (machines, etc.)

• Common in Latin America, South Asia, etc.

– Export substitution• Expand consumer good production for export• Common in some East Asian countries

ISI Policies

• Government planning (5-year plans, etc.)• Government investment

– Roads, rail, electricity, telecom, etc.– State-owned & mixed-ownership enterprises

• Trade barriers– Tariffs (on manufactured goods)– Import quotas (on manufactured goods)– Overvalued and/or multitiered exchange rates to

enable import of capital goods

Sources of funds for investment

• Foreign aid• Foreign borrowing• Taxes on agricultural exports (marketing

boards)• Tariffs on imports

$2

$1$1

Winners & Losers from ISI Policies

Winners• Workers & firms in import-

competing industries – Higher market share & prices

for produced goods

• Government – Jobs, opportunities for rent-

seeking

• Urban residents– Subsidized government

services

Losers• Export-oriented farmers

– Lower producer prices => reduced production

• Consumers – Higher prices for

manufactured goods

• Manufacturers in export-oriented industries (if any)– Overvalued exchange rates

increase price of exports, etc.

Assume the world equilibrium price for cocoa is $2. How much would Ghana cocoa farmers be willing to produce?

Price of cocoa

3

2

1

2 64

SC

DC

Quantity of Ghanaian Cocoa

Assume the world equilibrium price for cocoa is $2. How much would Ghana cocoa farmers be willing to produce?

Price of cocoa

3

2

1

2 64

SC

DC

Quantity of Ghanaian Cocoa

How would cocoa farmers respond if the government sets the producer price at $1?

Price of cocoa

3

2

1

2 64

SC

DC

Quantity of Cocoa

How would cocoa farmers respond if the government sets the producer price at $1?

Price of cocoa

3

2

1

2 64

SC

DC

Quantity of Cocoa

ISI policies successfully promoted industrialization & GDP growth in 60s & 70s

GDP/capita growth1960s & 70s

Latin America 2.3%

Sub-Saharan Africa 1.4%

Middle East & N. Africa 3.7%

East Asia 5.2 %

South Asia 1.2%

Southeast Asia 3.1%

But for most countries (all but East Asia), those growth rates would not prove sustainable…

Conclusions

• International and domestic developments and new belief systems => ISI Policies– World Wars & Depression strengthened relatively

scarce factor owners– Political changes strengthened workers, domestic

industrialists, urban voters, etc. – Marxism, Structuralist critique of economic

liberalism, etc.

Conclusions

• ISI policies increased industrialization & GDP growth, but …

• Urban workers & industrialists benefitted to detriment of export-oriented farmers

• Governments (esp. in “weak states”) took advantage of rent-seeking opportunities to over-extend protection of inefficient manufacturers

• Budget & trade deficits left countries exposed to global downturn