Chapter Summary

Learning Objectives

After reading this chapter, students will be able to:

  • describe the major economic models and the theoretical background supporting each
  • describe how these models were applied in LDCs since World War II
  • evaluate the arguments for and against each model

Chapter Summary

This chapter surveys development models used by countries in the shaping of their economic policies. These models can be examined and classified on two factors: the extent upon which they support market production and the extent to which they allow for international trade. Five models are presented: socialism, import substitution industrialization (ISI), export promotion, state capitalism and the Washington consensus. These first four are examples of state led development, while the Washington consensus is the market oriented alternative, but most blend elements of market orientation and participation in international trade.

State-led development occurs when the government is involved in economic planning or ownership of enterprises, subsidizing production or managing competition. The economist John Maynard Keynes developed an economic philosophy that later became known as Keynesianism, where focus was put on increasing demand for goods and services as a way of dealing with economic depression and recession. Keynes suggested that governments manipulate taxing and spending policy to increase demand by supporting public works projects which paid wages to workers which they would then use to buy goods, stimulating production. Lowering of interest rates to make business expansion easier was another Keynsian suggestion. Development economists later adapted many of these ideas to the situation of LDCs, emphasizing state capital investment in firms that would hire workers and stimulate demand from both individuals and other businesses. Other economists viewed underdevelopment as an issue related to lack of entrepreneurial expertise in the global south. Here the state would need to take a more active role in selecting industries to invest in (or own) that would create backward and forward linkages within the economy and promote growth.

Structuralists recommended that the state take action that would allow for inward oriented development such as protection of domestic industries through high tariffs. They also supported control of the economy through high taxation and nationalization as well as land redistribution.

In practice, ISI was widely applied in various regions of the global south, but particularly in Latin America. One way of implementing ISI and other sate-led development theories was through state owned enterprises (SOEs). Governments created or nationalized existing (especially) foreign firms in strategic sectors. SOEs proliferated for several reasons. There was a feeling that there was little capital available for capital intensive heavy industry enterprises, so the government should provide it; foreign investment in certain strategic sectors was to be shunned. Additionally there were fears of opening up smaller economies to the volatility of international capital. Governments could subsidize short term losses for the good of the nation. The country would benefit from jobs and low priced goods even if the firm was unprofitable many governments thought.

Another state-led practice was industrial policy. These included measures such as tax credits, low interest loans, subsidized inputs and other measures to encourage entrepreneurs to establish businesses is favored sectors. A third practice was trade policy, which often included protectionist tariffs for favored industries.

In the Southeast and East Asian variant of these practices, the favored industries were export oriented. The above polices were used to help firms that were designed to compete in international trade. Whereas in other global regions, these practices, under ISI were focused primarily upon domestic production.

Two other regional variations are noted.  In Latin America, economic populism was used to gain political support from lower and middle income groups. Policies under this variant included extensive state spending, wage increases, price controls and other polices to benefit these groups. In sub-Saharan Africa marketing boards were used extensively. These parastatal organizations were made the sole buyers of agricultural products from farmers. They were designed to guarantee steady demand for farm output. They often, however bought products from farmers for low prices and sold them internationally at high prices, thereby providing a revenue stream for government at the expense of farmers.

There are many critiques of state-led development. Related to SOEs, because they did not compete against other firms, SOEs had little incentive to be efficient or produce quality products. In addition, when they lost money, the state subsidized them, often increasing national debt. Additionally, since SOEs were owned by the government, politician often used them for patronage, appointing ghost workers.

Industrial policy was criticized along similar lines. Input and credit subsidies produced inefficient and dependent enterprises. Owners and workers lobbied government to continue protectionist policies at the expense of consumers. Coupled with economic populism, government debt increased and there was often high inflation. Marketing boards also increased debt burdens when the government paid farmers one price but then sold foodstuffs to urban workers at a lower price, seeking to gain political favor.

There are also defenses of state-led development. First, compared to the prior era of free markets, state led capitalism in the post World War II era had some significant successes. The successes were both economic and related to human development. Second, the state intervention in the export oriented Asian Tigers can be interpreted as a success for certain kinds of interventions by the state rather than the absence of state intervention.

Socialism is another state led development strategy, but few LDC states adopted its most complete variant. It still had important influence in the global south. Underlying socialism is the theory developed by Karl Marx which viewed history as the struggle between social classes. Marx described capitalism as the exploitation of the proletariat by the bourgeoisie. He predicted the collapse of capitalism with socialism taking its place until a genuine communist system could develop. In socialism, the state owns the means of production. Socialist government could then move society toward stateless communism.

Socialism as applied in LDCs had several features. Agricultural collectives were established where agricultural land and inputs were jointly owned. Industrial enterprises were subject to central planning under a command economy. These allowed the government to decide not only which industries should be started or expanded, but also how much each should produce. Economic planning was coupled with social planning where governments established social safety nets and state sponsored health and education systems.

Socialism in LDCs is not viewed as successful, with nearly all LDC socialist economies having been replaced. Many of them experienced great failures such as China’s Great Leap forward under Mao which resulted in 30 million deaths; other failures were less spectacular. More mundanely, socialist economies experiences chronic shortages of food and consumer goods and rarely offered any choices among products. Socialism was almost always linked with authoritarian governance.

Despite these failures, socialism also had some successes. China was able to achieve a certain degree of industrialization under socialism. In addition, socialism encouraged a large degree of equality with development. Socialist countries such as Cuba were also able to achieve significant improvements in education and health.

Market oriented strategies were adopted by more countries after the collapse of socialism. These strategies are based on neoclassical economic thought which argued for laissez-faire economic policies and minimal state intervention. Thinkers like Friedrich Hayek argued against state planning, citing the fact that open markets solve problems of information better than any government agency could by creating incentives for producing the right kinds of products. Markets also reduced the likelihood of the concentration of political power according to Hayek. Economists like Milton Friedman criticized Keynsian economics. Friedman argued against boosting demand through state spending, arguing that state intervention should be limited to controlling the money supply. He also argued against social welfare programs because they encouraged dependence on the state.

By the 1980s, neoclassical thought dominated the World Bank and the IMF. What became known as the Washington Consensus dictated that entrepreneurs in LDCs should be encouraged and that state led development inhibited entrepreneurs. The policy recommendations included fiscal discipline for LDCs, trade liberalization and openness to foreign investment, as well as privatization of SOEs.

By the early 1990s, there was large numbers of privatizations of SOEs. Countries also carried out many of the other Washington Consensus prescriptions. Multinational corporations expanded their investments in LDCs as rules about foreign capital were relaxed.

The results of the Washington Consensus have disappointed some analysts. In comparison to the Asian Tiger economies, growth in Latin America and Africa was lackluster and below the rate experienced at the height of state-led development. From a human development perspective, there was increasing unemployment and inequality. In addition, even those economies that achieved a level of prosperity were subject to the volatility of the international economy.

Despite the failure of earlier state-led models, many states have opted for state capitalism which merges some of the features of state led development with those of the market orientation of the Washington Consensus. China, India and Russia have all adopted this approach. SOEs are maintained in important areas of the economy, but the state tries to maintain them as efficient enterprises.

In evaluating the Washington Consensus, supporters point to several important areas of success. Inflation and hyperinflation have virtually disappeared in countries practicing fiscal discipline. The sale and closure of inefficient SOEs has improved government debt situations. Consumer products are cheaper and more available. Most LDCs were also able to avoid the 2008 financial crisis and in the last decade, there has been increasing equality.

Some analysts see state capitalism as a step on the way to more market reliance rather than a way of moving back to more government intervention. Supporters of the Washington Consensus warn that too much state intervention will lead to the problems encountered in state-led development.

India is presented as a case study of the issues raised in the chapter. After independence India followed the path of state led development, and it became notorious for the License Raj, the bureaucracies that applied the various regulations that applied to businesses. This over-regulation made it difficult to establish new businesses in India or even to import needed technologies. When this policy was changed during the 1990s, India’s economy began to grow. On the other hand, it could be argued that by supporting different industries carefully during this time, sate-led development prepared the Indian economy to prosper in the more open environment through state led capitalism.

Elements of British colonial rule bequeathed both bureaucracy and suspicion of open international trade to India. Further, India’s geography presented obstacles for its participation in the global trading regime.