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Matías Vernengo

For a very long time Import Substitution Industrialization (ISI) was seen as a four-letter word. The notion was that ISI had led to extensive inefficiencies and that the debt crisis of the 1980s was its last breath. The old ideas about comparative advantage were back with a vengeance, and the prescription was for trade liberalization, encapsulated in the Washington Consensus. Export orientation was promoted, since it was widely believed that an emphasis on exports would force integration into world markets, more efficient allocation of resources, and that external markets would impose discipline by eliminating uncompetitive firms.

The problem with the conventional wisdom is that the ISI period corresponds to a high growth phase for most developing countries, one in which they caught up with the developed world despite the fast growth in the latter, which would not have been possible if ISI-driven growth did produce tremendous inefficiencies on an economy wide scale.

Further, the ISI period, which basically corresponds to the 1950s and 1960s, led to only moderate accumulation of foreign debt, and in many cases to falling debt-to-GDP or debt-to-exports ratios, which denotes sustainable debt dynamics.

It was the collapse of Bretton Woods that ushered an era of more deregulated and volatile financial markets. And it was the increase in foreign indebtedness associated with the oil shocks that led, after the hike in interest rates by Paul Volcker, to the Mexican default, the unraveling of the process of development in the periphery and the debt crisis.

To make matters worse the hike in interest rates was associated with a negative terms-of-trade shock that reduced the export revenues in developing countries. As a result debt-servicing requirements went up at the very moment that revenues dwindled. Debt-to-export and debt-to-GDP ratios went up, making financial markets less willing and able to foot the bill. ISI per se was not the problem, even if in some specific cases it did not produce rapid catch-up with the center, financial liberalization was.

The failure of the Washington Consensus during the 1990s, with the sequence of financial crises in Mexico, Russia, Brazil, Turkey and Argentina, showed that there was a serious need for rethinking development. Joseph Stiglitz’s resignation from the World Bank, which ended a very contentious relation, was a symbol of that need to rethink development theories and practices.

The economic boom after 2002, in particular in the periphery, in part pushed by the extraordinary growth in China and by higher commodity prices, allowed for a somewhat complacent attitude, with minimal changes in development strategies, just as the housing market boom and the introduction of the euro had allowed for the continuation of private debt-driven booms in the center. The 2008-9 crisis and its long and persistent aftershocks suggest that this time around developing countries will have to rethink their development strategies.

The question of whether developing countries can simply integrate on the basis of commodity exports, or manufacturing exports on the basis of cheap labor, in a relatively liberalized trade environment with deregulated financial markets, or a more serious push towards the development of domestic markets must be pursued is increasingly moot. China is already moving towards larger reliance on domestic markets. And other developing countries that can rely less and less on demand growth from developed countries will probably do the same.

In the center there is an analogous conundrum about the possibility of social democratic policies, that is, whether higher wages and a robust welfare state are even possible. Both policies were anathema after the fall of communism, and now, with the failure of the free market neoliberal experiment, seem more reasonable. Higher wages and more fiscal expansion to support the crumbling welfare system, in developed countries, are comparable to the need to revive ISI under new and changed circumstances in the developing world.

The new ISI strategies will take place in a new environment, where World Trade Organization rules have narrowed the policy space and where the rapid growth in Chinese manufacturing exports is changing the landscape. For example, several countries in Latin America have increasing access to credit from China, but as noted by Kevin Gallagher, Chinese loans tend to require “that borrowers purchase Chinese equipment, employ Chinese workers and suppliers, and sometimes sign oil sale agreements.” This could be an important limitation for countries that already have significant trade deficits with China. However, the question now is not whether ISI is possible in the periphery, but how it should be implemented.

The Triple Crisis blog invites your comments. Please share your thoughts below.

12 Responses to “Is Import Substitution Still Possible?”

  1. [...] here: Is Import Substitution Still Possible? » TripleCrisis Sponsered Links Further ReadingIs Import Substitution Still Possible? [...]

  2. JW Maso says:

    It’s a good question!

    Some thoughts:

    0. You are absolutely right that the ISI period was associated with much better economic performance in most “developing” countries than the neoliberal/Washington Consensus period since 1980. Can’t say that enough.

    1. I’ve had the idea (from Prebisch among other sources) that the name is a bit of a misnomer. The policy was much more about the industrialization than the import substitution. Import restrictions *were* important, but not mainly to create a protected home market. Rather, they were a tool to (1) ration scarce foreign exchange and make it possible to maintain a relatively overvalued exchange rate so as to reduce the relative price of imported capital goods and intermediate goods.

    1.5. Related to this, a lot of countries that followed a basically ISI mode (e.g. Korea) ended up having the best export performance in the later postwar period. You need something like ISI to depart from comparative advantage, which is basically what it means to develop.

    2. Arguably developments in commodity (esp. oil) markets were deadlier for ISI than developments in financial markets. Without the spike in oil prices, most of these countries would not have needed large capital inflows in the first place, as you say. Lots of left-Keynesians talk about reviving the original Bretton Woods structure, but few people remember that an integral part of Keynes’ original vision, along with fixed exchange rates, automatic official flows from creditors to debtors, and restrictions on private cross-border financial flows, was a system of official commodity buffer stocks. Some kind of commodity-price stabilization board was the stillborn third BW sibling, along with the IBRD/World Bank and IMF.

    3. Today, the key first step for any new ISI-like development program is to be to end dependence on private or public financial inflows by running c.a. surpluses and accumulating reserves. Post 1997 developing Asia is the model. I think it is a dead end to propose — as I heard the estimable Prabhat Panaik do last night — a new benevolent system of channeling lending to developing countries, in the original spirit of Bretton Woods. The Bretton Woods institutions started out in the original spirit of Bretton Woods too! For countries that don’t have a voice in the governance of the international financial system, maintaining their own policy space is key.

    3.5 … which brings me to own hobbyhorse, that we on the left/Keynesian camp(s) need to think much more critically about whether we really want the US to stop running current account deficits. Those deficits are, after all, the condition of reserve accumulation in the developing world, that is the sine qua non of independent demand management there. Meanwhile, the US current account deficit, unlike deficits elsewhere, does not create deflationary pressures b/c the US does not face a balance-of-payments constraint.

    4. The case of China is complicated! But it is certainly not mercantilism, as it is often called. Anyway, tied loans as you describe here are certainly a good thing from the point of view of the stability of the international financial system. We *want* a tight connection between trade flows and the capital flows that finance them. The institutional delinking of these two sets of flows is one of the big causes of instability in recent decades, because — contrary to textbook theory — there is no reliable price mechanism to equilibrate them.

  3. JW Mason says:

    That should be Mason, of course, not “Maso”…

  4. Matías Vernengo says:

    Thanks for the extensive and great comments. A few replies. Yes ISI is a misnomer, probably the best would be develpment led by the State (as Cardenas, Ocampo and Thorp) do, but it is, for good or bad, an established brand. Korea and other Asian countries had also, what my friends Franklin Serrano and Carlos Medeiros call development by invitation, more open markets in the US, partly for geopolitical reasons, than Latin America. Yes commodity buffers (and the elimination of derivatives in those markets, something that has been discussed in TC in the context of financialization of commodity markets) is essential. UNCTAD still talks about it. I, for one, do not want the US to stop the deficits. Said so here http://triplecrisis.com/currency-wars-and-global-rebalancing/ Tied loans are not necessarily good for Latin American countries that already have deficits with China. For us to get indebted in dollars or in yuans is the same; both a re foreign currencies that must be earned with exports, and lead to debt-cycles with terrible consequences.

  5. JW Mason says:

    Thanks for the link (and reply). I had not seen your earlier post. Yes, exactly: “One of the key roles of the country with the reserve currency is to act as the source of effective demand in the midst of a crisis”.

    To be honest it’s a relief to hear someone else saying this. To me it seems absolutely obvious and yet when you spell it out — that the crisis would have been worse if US c.a. deficits were smaller — people look at you like you are crazy. Or at least that’s been my experience…

  6. JW Mason says:

    O the tied loans question my comment may not have been fully considered …. but I do believe that this is an area where flexibility may look attractive from the point of view of the individual country but is destructive for the system as a whole. Keynes certainly was of the opinion (and I think he was right) that the stability of the classical gold standard system had much less to do with its supposed inherent equilibrating mechanisms and much more with the fact that investment goods and investment finance happened to flow along the same channels.

  7. Deus-DJ says:

    “1. I’ve had the idea (from Prebisch among other sources) that the name is a bit of a misnomer. The policy was much more about the industrialization than the import substitution. Import restrictions *were* important, but not mainly to create a protected home market. Rather, they were a tool to (1) ration scarce foreign exchange and make it possible to maintain a relatively overvalued exchange rate so as to reduce the relative price of imported capital goods and intermediate goods.”

    Of course it was about industrialization, that was the entire point. When you’re only exporting primary products, you’re stuck in a catch-22. On the one hand you depend on the primary product exports to feed ever rising incomes within the country, but you can’t depend on it as time passes, causing a loss in employment and output, not to mention a large distributive impact whereby any gains only go to the primary product exporters and/or their owners. On the other hand, even if you can depend on it for the time being, rising incomes in the primary product exporting country means you demand MORE industrialized goods and services from the industrialized country. Hence, the distributive impact is that any gains from trade go directly back to the industrialized country, while you continue to depend on them to continue importing the same level of primary products. On another level this means that if something happens to them, you’re fucked, while they can simply cut back on their purchases from you with no problems. After all, industrialization is associated with more employment opportunities for the population with every increase in technology, hence more income in everyone’s hands, whereas in the primary product exporting country the wealth is concentrated in the hands of only the primary product exporters.

    Your next sentence doesn’t follow from that though, on the one hand you said they did it for industrialization purposes and in the next sentence you’re saying it wasn’t important to protect the home market? the point of protecting the home market is that your industries are less productive than the industrialized goods from overseas and hence more expensive and of lower quality. The point of protecting them is to then prevent the scenario as I laid out above. It was not to reduce the price of imported goods.

    “2. Arguably developments in commodity (esp. oil) markets were deadlier for ISI than developments in financial markets. Without the spike in oil prices, most of these countries would not have needed large capital inflows in the first place, as you say.”

    Yes, no doubt it was, and for the reasons that Marcelo Diamand outlined. Actually, if you read Diamand you’d see that large capital inflows would do nothing to solve the problem anyway.

    “Today, the key first step for any new ISI-like development program is to be to end dependence on private or public financial inflows by running c.a. surpluses and accumulating reserves.”

    This is absolutely wrong. See Dutch Disease. If you want me to send you a list of things to read and to fully grasp how countries should respond to individual circumstances, reply here and I’ll send you a list of things.

    “3.5 … which brings me to own hobbyhorse, that we on the left/Keynesian camp(s) need to think much more critically about whether we really want the US to stop running current account deficits. Those deficits are, after all, the condition of reserve accumulation in the developing world, that is the sine qua non of independent demand management there. Meanwhile, the US current account deficit, unlike deficits elsewhere, does not create deflationary pressures b/c the US does not face a balance-of-payments constraint.”
    It’s not a question of whether we *want* to run something or not. It’s not like someone gets to choose whether they want to be the reserve currency or not. Whenever a country like China deliberately designs their economy to be an export led one, it’s ridiculous for anyone to then assume that they can be the reserve currency anytime soon.

    “4. The case of China is complicated! ”

    China is not complicated, they are running the policy they designed in the early 1980s, almost to the letter.

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  9. JW Mason says:

    Deus-DJ-

    Would love to see readings, if you are still looking at this.

  10. Magpie says:

    @JW Mason,

    “2. Arguably developments in commodity (esp. oil) markets were deadlier for ISI than developments in financial markets. Without the spike in oil prices, most of these countries would not have needed large capital inflows in the first place, as you say.”

    I am not sure about that statement in general, as formulated above. In other words, I reserve judgement about it in the majority of cases, which perhaps is what you mean.

    However, I am absolutely sure of something: you are not considering single primary product exporting countries, like Venezuela.

    For countries in that position, it was changes in financial AND commodity markets, that led to the abandonment of ISI.

    I can’t see any good reason to believe that, for Venezuela, oil price increases were deadlier than interest rate hikes.

    Further, I’d say that in that particular case, it was the fall in oil prices, together with higher interest rates over the foreign debt, that strangled their economy.

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