No Such Thing as a Free Lunch: Principles of Economics (Part 186)

Globalisation has powered economic growth in developing countries such as China. Global logistics, low domestic production costs, and strong consumer demand have let the country develop strong export-based manufacturing, making the country the workshop of the world.

Ma Jun

Economic Growth in Developing and Transitional Economies

(Part B)

by

Charles Lamson

Strategies for Economic Development

Just as no single theory appears to explain lack of economic advancement, no one development strategy will likely succeed in all nations. Many alternative development strategies have been proposed over the past 60 years. Although these strategies have been very different, all recognize that a developing economy faces basic trade-offs. An insufficient amount of both human and physical resources dictates that choices must be made, including those between agriculture and industry, exports and imports substitution, and central planning and free markets.

Agriculture or Industry? Most third world countries began to gain political independence just after World War II. The tradition of promoting industrialization as the solution to the problems of the developing world dates from this time. The early 5-year development plans of India called for promoting manufacturing.

Industry has several apparent attractions over agriculture. First, if it is true that capital shortages constrain economic growth (see last post), then the building of factories is an obvious step toward increasing a nation's stock of capital. Second, and perhaps most important, one of the primary characteristics of more developed economies is their structural transitions away from agriculture and toward manufacturing and modern services. Agriculture's share in GDP declines substantially as per capita income increases (Case & Fair, 2004). The share of services increases correspondingly, especially in the early phases of economic development.

Many economies have pursued industry at the expense of agriculture. In many countries, however, industrialization has been either unsuccessful or disappointing---that is, it has not brought the benefits that were expected. Experience suggests that simply trying to replicate the structure of developed economies does not in itself guarantee, or even promote, successful development.

Since the early 1970s, the agricultural sector has received considerably more attention. Agricultural development strategies have had numerous benefits. Although some agricultural projects (such as the building of major dams and irrigation networks) are very capital-intensive, many others (such as services to help teach better farming techniques and small-scale fertilizer programs) have low capital and import requirements. Programs like these can affect large numbers of households, and because their benefits are directed at rural areas, they are most likely to help a country's poorest families.

Experience over the last three decades suggests that some balance between these approaches leads to the best outcome---that is, it is important and effective to pay attention to both industry and agriculture. The Chinese have referred to this dual approach to development as "walking on two legs."

Export or Import Substitution? As developing nations expand their industrial activities, they must decide what type of trade strategy to pursue, usually one of two alternatives: import substitution or export promotion.

Import substitution is an industrial trade strategy to develop local industries that can manufacture goods to replace imports. For example, if fertilizer is imported, import substitution calls for a domestic fertilizer industry to produce replacements for fertilizer imports. This strategy gained prominence throughout South America in the 1950s. At that time, most developing nations exported agricultural and mineral products, goods that faced uncertain and often unstable international markets.

Under these conditions, the call for import-substitution policies was understandable. Special government actions, including tariff and quota protection and subsidized imports of machinery, were set up to encourage new domestic industries. Multinational corporations were also invited into many countries to begin domestic operations.

Most economists believe import-substitution strategies have failed almost everywhere they have been tried. With domestic industries sheltered from international competition by high tariffs (often as high as 200 percent), major economic inefficiencies were created. For example, Peru has a population of just over 33,500,000 (worldometers.info), only a tiny fraction of whom could afford to buy an automobile. Yet at one time the country had five or six different automobile manufacturers, each of which produced only a few thousand cars per year. Because there are substantial economies of scale in automobile production, the cost per car was much higher than it needed to be, and valuable resources that could have been devoted to another, more productive, activity were squandered producing cars.

Furthermore, policies designed to promote import-substitution often encourage capital-intensive production methods, which limited the creation of jobs and hurt export activities. A country like Peru could not export automobiles, because it could produce them only at a cost far greater than their price on the world market. Worse still, import-substitution policies encouraged the use of expensive domestic products, such as tractors and fertilizer, instead of lower-cost imports. These policies taxed the sectors that might have successfully competed in world markets. To the extent that the Peruvian sugar industry had to rely on domestically-produced, high-cost fertilizer, for example, its ability to compete in international markets was reduced, because its production costs were artificially raised.

As an alternative to import substitution, some nations have pursued strategies of export promotion. Export promotion is simply the policy of encouraging exports. As an industrial market economy, Japan is a striking example to the developing world of the economic success that exports can provide. With an average annual per capita real GDP growth rate of roughly 6 percent per year since 1960, Japan's achievements are in part based on industrial production oriented toward foreign consumers.

Several countries in the developing world have attempted to emulate Japan's success. Starting around 1970, Hong Kong, Singapore, Korea, and Taiwan (the "four little dragons" between the two big dragons, China and Japan) all began to pursue export promotion of manufactured goods. Today their growth rates have surpassed Japan's. Other nations, including Brazil, Colombia, and Turkey, have also had some success at pursuing an outward-looking trade policy.

Government support of export promotion has often taken the form of maintaining an exchange rate favorable enough to permit exports to compete with products manufactured in developed economies. For example, many people believe Japan kept the value of the Yen artificially low during the 1970s. Because a "cheap" Yen means inexpensive Japanese goods in the United States, sales of Japanese goods (especially automobiles) increase dramatically. Governments also have provided subsidies to export industries.

Central Planning or the Market? As part of its strategy for achieving economic development, a nation must decide how its economy will be directed. Its basic choices lie between a market-oriented economic system and a centrally planned one.

In the 1950s and into the 1960s, development strategies that called for national planning commanded wide support. The rapid economic growth of the Soviet Union, a centrally planned economy, provided an example of how fast a less-developed agrarian nation could be transformed into a modern industrial power. (The often appalling costs of this strategy---severe discipline, gross violation of human rights, and environmental damage---were less widely known.) In addition, the underdevelopment of many commodity and asset markets in the third world led many experts to believe that market forces could not direct an economy reliably and that major government intervention was therefore necessary. Even the United States, with its commitment to free enterprise in the marketplace, supported early central planning efforts in many developing nations. 

Today, planning takes many forms in the developing nations. In some, central planning has replaced market-based outcomes with direct, administratively determined controls over such economic variables as prices, output, and employment. In others, national planning amounts to little more than the formulation of general 5- or 10-year goals as rough blueprints for a nation's economic future.

The economic appeal of planning lies theoretically in its ability to channel savings into productive investment and to coordinate economic activities that private actors in the economy might not otherwise undertake. The reality of central planning, however, is that it is a technically difficult, highly politicized, nightmare to administer. Given the scarcity of human resources and the unstable political environment in many developing nations, planning itself---let alone the execution of the plan---becomes a formidable task.

The failure of many central planning efforts has brought increasing calls for less government intervention and more market orientation in developing economies. The elimination of price controls, privatization of state-run enterprises, and reductions in import restraints are examples of market-oriented reforms recommended by such international agencies as the International Monetary Fund (IMF), whose primary goals are to stabilize international exchange rates and to lend money to countries that have problems financing their international transactions, and the World Bank, which lends money to a country for projects that promote economic development.

Members' contributions to both organizations are determined by the size of their economies. The developing world is increasingly recognizing the value of market forces in determining the allocation of scarce resources. Nonetheless, government still has a major role to play. In the decades ahead, the governments of developing nations will need to determine those situations where planning is superior to the market and those where the market is superior to planning. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 733-737*

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