1

Development Economics Lecture 1

03.10.2024

are developing countries developing – emergence of development economics

theory of comparative advantages

Who is developing?

Development economics is the branch of economics focused on the economic development

issues of countries considered not developed.

The term economic development was not current in the English language in its present
meaning until after the Second World War. Before the war, research on the social and
economic issues of poor countries was mostly categorized as colonial studies. At the time,
most poor countries were colonies of European states. Researchers perceived the socio-
economic problems of colonies and other poor countries as their failure to make ‘progress’, as
their failure to ‘modernize’ or to ‘westernize’. After 1945 the term ‘economic development’
came to be used.

In this course we consider economic development to mean a society moving out of a state of
backward-ness, or un-developed-ness, or under-development, relative to the countries
considered developed.1 After World War II the terms ‘backward’ or ‘underdeveloped’ were
commonly used to describe the poor countries. Since the 1980s these terms are not deemed
politically correct (politically polite). Nowadays, countries for which economic development
problems are discussed are called ‘developing economies’, ‘emerging markets’, ‘frontier
economies’ etc. These terms imply that economic development is something that is
happening.2

Are any countries actually achieving economic development? If so, which ones? How are they
developing? If others are not developing, why not? We try to address these questions in this
course.

The most widely used criterion for classifying countries in terms of level of development is
per capita gross domestic product (GDP). GDP is the total value of final goods and services

1
This is not a universally accepted definition. Another view would see development as any ‘economic progress’
that happens in an underdeveloped country. In this view, the mere fact that factories, highways, schools are being
built in an underdeveloped country, and that its GDP is increasing, are evidence that it is developing. With such
a conception, all underdeveloped countries are developing. Then there would be no problem to discuss.
2
In the 1960s and 1970s in Turkish the adjectives ‘az gelişmiş ülke’, ‘geri kalmış ülke’ were commonly used.
Note that the word development (gelişme) can mean a transformation or evolution without any positive
connotation (e.g. ‘the development of Adolf Hitler’s character’). But it usually includes a sense of maturation, so
it becomes an organic metaphor (a fetus develops into a baby, which develops into an adult). Hence ‘to develop’
may imply a teleological process, so that developing countries are destined to become developed one day.
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produced in a country in a year. Per capita GDP is accepted as a crude indicator of the average
welfare of the inhabitants of a country. In the following discussion we ignore the fact that the
per capita gross domestic product figures do not reflect social disparities in welfare within
societies arising from skewed income distributions.3

Gross national income (GNI) is also used in welfare comparisons across countries. GNI is
GDP plus factor incomes received from abroad, minus factor incomes that are paid abroad. It
is a fact that flows of profit and interest incomes between countries have been increasing in
recent decades. However we shall use GDP for welfare comparisons because most available
statistics are based on gross domestic product. And the GDP and GNI orderings of countries
are not very different.

The World Bank classifies countries into high income, middle income and low income country
groups. The benchmarks separating these groups are adjusted every year.4

Table 1.1 may be useful to start investigating whether economic development has been
happening in any group of underdeveloped countries. The first three rows show average per
capita GDPs of country groups classified by incomes over time: high income countries, middle
income countries, low income countries.

The World Bank (the source for the statistics) also provides average per capita GDPs for the
middle income countries and low income countries in each geographical region. So these
regional average per capita GDPs exclude the high income countries in that region. In other
words the regional figures in Table 1.1 cover only the middle income and low income countries
in each region. Hence in Table 1.1, e.g. Japan is not included in the East Asian and Pacific
group, Saudi Arabia and Israel are not included in the Middle East and North Africa group,
and the Cayman Islands are not included in the Latin America and Caribbean group.

The figures for country groups are weighted by populations, so China’s figures strongly
influence the average figures for the East Asia and Pacific countries group, and also for the
middle income countries group.

The figures in Table 1.1 present the average per capita GDPs of country groups in current US
dollars. This means, for each country the per capita GDP in local currency units has been
converted into US dollars at current market exchange rates.

3
In all economies, some production activities that should be included in GDP are not officially recorded, either
because they are criminal activities, or for the purpose of avoiding taxes or avoiding labor law or avoiding
transaction costs. These ‘informal economies’ concealed in national economies probably distort international
GDP comparisons, but we have to ignore this complication here.
4
At present the World Bank’s benchmark separating high income countries from middle income ones is $14,005
GNI in 2023, and its benchmark separating middle income countries from low income countries is $1,145 GNI
in 2023.
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In Table 1.1 all the average per capita GDP figures for middle and low income country groups
appear to have been increased over time. Do these increasing per capita GDP figures indicate
that these countries gave been making real progress in overcoming their underdevelopment
since 1960?
Table 1.1
Average per capita GDP in country groups (current US dollars)
1960 1970 1980 1990 2000 2010 2023
High income 1204 2442 8430 16532 22306 35575 48220
Middle income 137 206 661 808 1240 3610 6267
Low income .. .. 343 465 324 730 895
East Asia & Pacific 90 114 278 416 956 4012 9913
Europe & Central Asia .. .. .. 1690 1807 6023 8479
Latin America & Caribbean .. .. .. 2416 4276 8614 10070
Middle East & North Africa .. 322 1817 2205 1672 4116 3822
South Asia 83 118 260 357 460 1254 2309
Sub-Saharan Africa 145 240 747 723 637 1645 1635
World 450 813 2570 4311 5507 9543 13138
Source: World Bank World Development Indicators (26.09.2024).
Note: The average per capita GDP figures for regional country groups include only the middle income
and low income countries in the region. World includes all countries.

Table 1.2
Ratios of average per capita GDP in country groups
to average per capita GDP in high income countries (current US dollars)
1960 1970 1980 1990 2000 2010 2023
Middle income 0.11 0.08 0.08 0.05 0.06 0.10 0.13
Low income … … 0.04 0.03 0.01 0.02 0.02
East Asia & Pacific 0.07 0.05 0.03 0.03 0.04 0.11 0.21
Europe & Central Asia … … … 0.10 0.08 0.17 0.18
Latin America & Caribbean … … … 0.15 0.19 0.24 0.21
Middle East & North Africa … 0.13 0.22 0.13 0.07 0.12 0.08
South Asia 0.07 0.05 0.03 0.02 0.02 0.04 0.05
Sub-Saharan Africa 0.12 0.10 0.09 0.04 0.03 0.05 0.03
World 0.37 0.33 0.30 0.26 0.25 0.27 0.27
Source: Table 1.1.

In Table 1.2 we take the ratios of the regional and total middle and low income country groups’
per capita GDP averages (in current dollars) to the per capita GDP average of the high income
countries, using the figures in Table 1.1. When we study the ratios in each row across decades,
we see that the middle income countries as a group and the low income countries as a group
have not experienced a substantial improvement in their average per capita GDPs compared
to the high income countries over 60 years. The average per capita GDPs of the middle and
low income countries in South Asia and Sub-Saharan Africa have even deteriorated in
comparison to the high income countries from 1960 to 2023. Average per capita GDPs have,
at best, stagnated since 1970 in the case of the Middle East and North Africa. In Latin America
and Caribbean ratios of the average per capita GDPs of the middle and low income countries
to that of the high income countries has moved from 0.19 to 0.21 in the last 23 years, a slow
increase.
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The middle and low income countries in Europe and Central Asia are what used to be called
transition economies (countries which made a transition to capitalism in the 1990s). So the
relative improvement in their per capita GDPs since 1990 largely reflects their recovery from
the severe recession they suffered during the transition in the 1990s. The figures for the Middle
East and North Africa are influenced by the swings in the prices of fossil fuels.

So there seems to be evidence of ‘catching up’ in the East Asia and the Pacific region, but
hardly any evidence of a steady catching up in the other regions. Then one may ask: why are
the countries in the stagnating regions all designated as ‘developing countries’?

Purchasing Power Parity

However, the figures in Tables 1.1 and 1.2 may not be accurate for welfare comparisons. It is
known that current dollar exchange rates (i.e. market exchange rates) do not reflect the
purchasing powers of national currencies relative to the US dollar. E.g. when the dollar rate of
the TL is 35.00 TL/$, we know that 35.00 TL can generally buy more goods and services in
Türkiye (particularly non-traded goods, services and labor) than one dollar can buy in the
United States. This holds true for the exchange rates of the currencies of all ‘developing
countries’. Hence, comparing per capita GDPs converted to dollars by current exchange rates
may not give a good idea of the relative average welfare levels of nations.

To make GDP figures more meaningful for welfare comparisons, the United Nations
organization started an International Comparison Program (ICP) in the 1970s. This is a project
to calculate and publish hypothetical dollar exchange rates for all currencies. The hypothetical
dollar exchange rates are meant to reflect the relative purchasing power of individual
currencies and the purchasing power of the US dollar. These hypothetical exchange rates are
called Purchasing Power Parities (PPP). The Purchasing Power Parity of a national currency
is a dollar exchange rate which is calculated by comparing the cost in the national currency of
a carefully constructed comprehensive basket of goods and services, with the dollar cost of
that same basket in the United States.

For example, suppose in a certain year the cost of the basket of goods and services in country
X is 4,000 local currency units (LCU), and its cost in the US is 1,000 dollars. Using this
information, statisticians calculate the PPP of the currency of country X for that year as 4,000
LCU/$1,000 = 4 LCU/$. This figure may be quite different from the current (actual) dollar
exchange rate of the LCU in X. In poor countries the PPP is always lower, often much lower,
than the actual current dollar exchange rate. It means that the GDPs of developing countries
are almost always under-valued when current exchange rates are used in converting GDPs into
dollars, compared to their GDPs converted to dollars by purchasing power parities.

GDP figures converted into dollars using the PPP rates are indicated in statistical tables as
given in ‘current international dollars’.
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Table 1.3 presents the average per capita GDPs of the country groupings in current
international dollars. At present the World Bank publishes these data beginning in 1990.

First, notice that the per capita GDP figures for middle and low income countries in Table 1.3
are all higher than the corresponding figures in Table 1.1. This reflects the basic fact mentioned
above: that the purchasing power parities of the middle and low incomes countries are almost
always lower than their current exchange rates. (If you take a quick look at Table 1.6 you can
see examples of this fact for six individual developing countries.)

GDP (LCU) / current exchange rate (LCU/$) < GDP (LCU ) / PPP (LCU/$),
because
current exchange rate (LCU/$) > PPP (LCU/$).

We shall see the structural reason for this divergence of current dollar exchange rates from the
purchasing power parities of developing countries’ currencies later in this course. We shall
also see its negative consequences in trade for these countries.

Table 1.3
Average per capita GDP in country groups
and ratios of average per capita GDP in country groups
to average per capita GDP in high income countries (current international US dollars)
GDP per capita ratio to high income
1990 2000 2010 2023 1990 2000 2010 2023
High income 16820 24994 37008 63340 - - - -
Middle income 2451 3865 7761 15946 0.15 0.15 0.21 0.25
Low income 767 975 1567 2398 0.05 0.04 0.04 0.04
East Asia & Pacific 1459 3312 8737 21271 0.09 0.13 0.24 0.34
Europe & Central Asia 6405 5764 12083 27907 0.38 0.23 0.33 0.44
Latin America &
Caribbean 6178 8569 13038 20899 0.37 0.34 0.35 0.33
Middle East & North
Africa 4816 7288 11262 14347 0.29 0.29 0.30 0.23
South Asia 1263 2097 4039 9388 0.08 0.08 0.11 0.15
Sub-Saharan Africa 1784 2102 3332 4834 0.11 0.08 0.09 0.08
World 5588 8020 12894 23010 0.33 0.32 0.35 0.36
Source: World Bank World Development Indicators (26.09.2024).
Notes: (1) Current international dollars refers to conversion to dollars at Purchasing Power Parity rates.
(2) The average per capita GDP figures for regional country groups include only the middle income and low
income countries in the region. World includes all countries.

To return to the issue of whether economic development is happening: the right hand part of
Table 1.3 gives the average per capita GDPs of the country groupings in current international
dollars relative to the high income countries. In these figures East Asia and the Pacific show a
substantial improvement in time. There is some sluggish improvement in South Asia and in
the transition economies (Europe and Central Asia) since 2000. On the other hand, we observe
a retrogression in Sub-Saharan African and Latin American middle and low income countries
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in terms of convergence with the high income countries in the last 30 years. Why are these
called ‘developing countries’?

Although using per capita GDPs in PPPs is more accurate for welfare comparisons,
comparison of the per capita GDP figures in current dollars in Tables 1.1 and 1.2 is not entirely
devoid of meaning. Actually, per capita GDP figures in current dollars reflect the purchasing
power of the average per capita GDPs of nations over internationally traded goods. If we want
to compare the number of cellular phones a person earning the average GDP in Turkey can
buy in a year, with the number of cellular phones an American earning the average GDP in the
US can buy, then we should compare per capita GDPs in current dollars, because traded
goods’ local prices are determined by current (actual) exchange rates.

Still, there grounds for objecting to the analysis so far. The World Bank’s classification of
countries by per capita GDPs involves an anomaly. In the World Bank’s classification of
countries by per capita GDP, Saudi Arabia and the Cayman Islands are high income countries,
but few people would deem these countries to be developed. Saudi Arabia’s high per capita
GDP is due to its high crude oil production, and the Cayman Islands’ to its being a tax haven.

In contrast to the World Bank, the International Monetary Fund classifies countries as
‘Advanced’ and ‘Emerging and Developing’. It also gives figures for regional groups of the
Emerging and Developing countries. ‘Advanced’ is a qualitative adjective, in contrast to ‘high
income’ which is a quantitative concept. So the IMF uses other criteria and places countries
such as Saudi Arabia and the Cayman Islands among Emerging and Developing countries. So
it may be interesting to construct Table 1.3 with the IMF’s data to see if a different picture
emerges. Table 1.4 is the result.

Table 1.4
Average per capita GDP in country groups and ratios of average per capita GDP in country groups
to average per capita GDP in advanced economies (current international US dollars)
GDP per capita ratio to advanced economies
1980 1990 2000 2010 2023 1980 1990 2000 2010 2023
Advanced
economies 10,222 19,849 29,485 40,403 66,359 - - - -
Emerging market
and developing
economies 1,612 2,623 4,399 8,387 15,311 0.16 0.13 0.15 0.21 0.23
Emerging and
developing Asia 578 1,371 2,827 6,829 15,639 0.06 0.07 0.10 0.17 0.24
Emerging and
developing
Europe 4,455 7,415 9,386 17,881 35,641 0.44 0.37 0.32 0.44 0.54
Latin America
and the Caribbean 4,713 6,629 9,406 13,789 20,052 0.46 0.33 0.32 0.34 0.30
Middle East and
Central Asia 4,938 6,075 7,881 12,214 15,589 0.48 0.31 0.27 0.30 0.23
Sub-Saharan
Africa 1,307 1,804 2,110 3,423 4,828 0.13 0.09 0.07 0.08 0.07
Source: International Monetary Fund. World Economic Outlook Database, April 2024 (26.09.2024).
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The ‘emerging market and developing economies’ in the IMF classification comprise the
middle and low incomes countries in the World Bank classification, plus the high income
countries which are not ‘advanced’. Another difference is that, the IMF lumps together the
World Bank’s East Asia and the Pacific group and the South Asia group in one category:
‘emerging and developing Asia’.

The overall convergence picture in Table 1.4 is not different from that of Table 1.3. Clearly,
emerging and developing Asia is the only region among emerging market and developing
economies that shows a substantial convergence with the advanced economies in per capita
GDPs in purchasing power parities. In the other ‘emerging and developing’ regions, the
convergence performance is dismal. So again, why are all these countries designated as
‘developing’?

Is population growth the problem?

Annual per capita GDP growth is the resultant of annual GDP growth and annual population
growth. In order to understand how these two affect per capita GDP growth rates across
country groupings, one can compare GDP growth rates and population growth rates. In Table
1.5 one can see that population growth rates have been higher in low income and middle
income countries compared to the high income countries since 1960s. So higher population
growth rates in the former group of countries must have had a negative effect on the
convergence of average per capita GDPs. For example, in the 1960s, the average GDP growth
rate of Latin American and Caribbean countries (5.5 percent) was higher than that of the high
income countries (5.3 percent). But the higher average population growth rate in Latin America
and the Caribbean (2.8 percent) was also higher than the population growth rate in the high
income countries (1.1 percent), and higher by a greater margin. This combination of GDP
growth rates and population growth rates necessarily result in a divergence in per capita GDPs
between these country groups.

Such observations led some development economists in the 1960s and 1970s to argue that part
of the solution to the problem of economic development and eradication of poverty was to
resolve the ‘population problem’.5

Yet differences in population growth rates are not the sole explanation for the lack of
convergence with the high income countries. For example, Table 1.5 shows that the average
population growth rates in East Asia and Pacific has always been higher than the population

5
On this basis international institutions encouraged developing country states to take measures to undertake
programs to curb population growth, tying economic aid to such programs. The Bangladeshi state bribed starving
women with food to accept sterilization. The Indonesian government coerced women to accept IUDs, and
threatened to impose heavy fines on women who got pregnant. The Sri Lankan government made payments to
women for getting sterilized. The Indian government implemented forced mass sterilization of poor Indian men.
In a single year (1975) 6.2 million Indian men were sterilized. Of these, two thousand men died from botched
operations (Hartmann 1987, 67, 80, 231; BBC 2014; Williams 2014, 477). Human rights violations abounded in
these practices.
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growth rates in the high income countries across the decades. But the average per capita GDPs
in East Asia and the Pacific has been converging to those of the high income countries. This
is because these countries had higher GDP growth rates by a greater margin since the 1970s.
So the question is, how has the East Asian region achieved these high GDP growth rates, and
why have countries in the other regions not made the same achievement?

To return to Tables 1.2, 1.3 and 1.4, apart from the East Asian region, there seems to be little
or no convergence trend in regional middle and low income country groups in per capita GDPs
with the high income countries or advanced economies. If economic development involves a
kind of catching-up or convergence, neither Table 1.2, Table 1.3 nor Table 1.4 indicates a
world-wide catching-up. The figures also suggest that regional developing country groups are
becoming more heterogenous in terms of their convergence with the high-income countries.
Average per capita GDPs are diverging between the middle income countries and the low
income countries.

However, the figures pertaining to the middle-income country group and the East Asian and
the Pacific country group are influenced by the GDP figures of China, which are weighted by
China’s population. China’s population was 1,412 million in 2022, comprising 66 percent of
developing East Asia and Pacific populations, and 24 percent of middle income countries’
populations. China has had above-average per capita GDP growth rates. When China is
excluded, the convergence figures for middle income countries and for the East Asian and the
Pacific country group would decline.

Table 1.5
Annual average GDP growth and population growth rates in groups of countries (percent)
1961-1969 1970-1979 1980-1989 1990-1999 2000-2009 2010-2023
high GDP 5.3 3.7 2.9 2.4 2.0 1.9
income population 1.1 0.9 0.7 0.6 0.6 0.4
middle GDP 5.2 5.7 3.6 4.4 6.2 5.0
income population 2.3 2.2 2.1 1.7 1.3 1.1
low GDP 4.6a 2.6 2.0 2.5 5.2 2.4
income population 2.5 2.6 2.5 2.8 2.9 2.7
East Asia GDP 3.8 7.1 7.7 8.2 9.1 6.4
and Pacific population 2.2 2.1 1.7 1.3 0.8 0.6
Europe and GDP … … 2.3b -0.7 5.3 4.6
Central Asia population 2.0 1.5 1.4 0.6 0.5 0.6
Latin America GDP 5.5 6.3 2.1 2.7 2.8 2.0
and Caribbean population 2.8 2.4 2.1 1.7 1.3 1.0
Middle East and GDP 9.0 5.8 1.2 4.2 4.4 2.2
North Africa population 2.7 2.8 3.1 2.4 1.9 1.8
South Asia GDP 4.2 3.0 5.6 5.4 6.0 5.7
population 2.4 2.3 2.4 2.1 1.7 1.2
Sub-Saharan GDP 4.1 4.2 1.5 2.0 5.1 3.2
Africa population 2.6 2.8 2.9 2.7 2.7 2.7
world GDP 5.3 4.0 3.0 2.8 3.0 2.9
population 2.0 1.9 1.8 1.5 1.3 1.1
Source: World Bank. World Development Indicators. (27.09.2024)
a
1968-1969. b 1988-1989.
Note: Regional country groups include only the middle income and low income countries in the region. World
includes all countries.
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The figures and ratios in all the tables above show average per capita GDPs for country groups.
To highlight the glaring differences in average levels of welfare between individual rich
countries and poor countries we can compare the per capita GDPs of selected countries (Table
1.6).

Why are there so great disparities in per capita GDPs between nations? Why have they not
been eliminated in the 60-70 years since ‘economic development’ began? This is the question
of this course.

Table 1.6
Per capita GDP in selected countries in 2021
current US dollars current international dollars
Switzerland 93446 77181
United States 70219 70219
Sweden 61418 60397
Türkiye 9743 30711
Azerbaijan 5408 15927
Pakistan 1506 5775
Haiti 1824 3179
Niger 591 1309
Burundi 221 788
Source: World Bank, World Development Indicators (16.02.2024)

We have to review the economic history of underdeveloped countries after World War II,
because it was then that economic development came to be recognized as an international
problem. However, since then the conception of development, of development policies and the
importance attached to the issue have undergone profound changes. This course discusses how
and why those changes occurred, and the outcomes, in a historical perspective.

Decolonization after World War II

In World War II (1939-1945) the United Kingdom, the Union of Soviet Socialist Republics
(USSR) and the United States (the ‘Allied Powers’) fought against Nazi Germany, Fascist Italy
and Imperial Japan (the ‘Axis Powers’) in order to stop the expansion of Germany and Italy in
Europe and Africa and to stop the expansion of Japan in Asia.

During the war the British, French, Belgians and Dutch recruited soldiers from their colonies
in Africa and Asia to fight the Axis Powers. They raised expectations of independence after
the war. Alongside the soldiers from the Allied countries, soldiers from the colonies fought
Japanese occupation forces in Indochina (Southeast Asia). Soldiers from colonies fought the
German and Italian armies in North Africa and in Europe.

In 1945 the Allies defeated the Axis powers. The Allied states divided Germany and the
liberated European countries into ‘spheres of influence’. Then, political confrontation and
 10

ideological competition between the major capitalist countries and the USSR intensified. This
competition became what was called the Cold War. It id not erupt into a real (hot) war because
the US and the USSR had invented nuclear weapons, and they did not want to start a war of
mutual destruction.

The USSR’s political doctrine was that socialism was superior to capitalism in the social
sphere (it provided full employment, free education and health services, relatively egalitarian
income distribution), and that their planned economy was also superior in achieving economic
growth. Indeed the USSR had, during the Great Depression of the 1930s, not experienced
unemployment and had achieved rapid industrialization.

The US, the UK, France and the other major capitalist countries held that their pluralistic
political systems and individual freedoms (liberal democracy) were morally superior to a one-
party state. These states condemned the USSR as a totalitarian state.

In the countries in East and Central Europe liberated by the Soviet army, political structures
and economic systems similar to that of the USSR were established (in East Germany, Poland,
Czechoslovakia, Hungary, Romania, Bulgaria and Albania). In Asia socialist states were
established in the north of Vietnam, the north of Korea and on mainland China.

When the war ended, the European colonial powers were reluctant to grant independence to
their colonies. After the war, many of the colonized peoples (e.g. Algerians, Indonesians,
Kenyans, Laotians, Malagasy, Moroccans, Tunisians, Vietnamese and others) had to conduct
bloody struggles against the European colonizers and colonists to end foreign domination and
achieve independence.

Beginning in the late 1940s and continuing into the 1960s, colonies in Asia, Africa and the
Caribbean eventually succeeded in gaining independence. The newly independent peoples
adopted the European idea of national identity. They formed nation states in boundaries which
had been previously drawn by the colonizers. However these boundaries often did not
correspond to the geographic distributions of ethnic groups. The newly formed states adopted
many of the laws and administrative structures of the colonial regimes. The newly liberated
peoples expected that, with independence, they would be able to achieve social and economic
development.

After World War II, among the large group of underdeveloped nations that aspired to economic
development, there were also some Asian and African nations that had not been colonized and
had always been formally independent: Afghanistan, China, Ethiopia, Iran, Liberia, Thailand
and Türkiye. But these countries had histories of semi-colonial subjugation through economic
integration into the capitalist world-economy. So at the end of World War II, these countries
had economies similar to those of the former colonies. Among the group of underdeveloped
countries there were also the Latin American countries. These had been colonies of Spain and
Portugal. They had gained their independence during the Napoleonic Wars in Europe in the
early nineteenth century. As the result of centuries of colonial subjugation by and semi-
 11

colonial economic relations with the European countries, the economies of Latin American
countries also had become similar to those of the former colonies - i.e. impoverished.

All these underdeveloped countries had other common features besides poverty. All of the
poor countries had a similar position in the international division of labor. These countries
exported mostly unprocessed minerals (fuels and raw materials) and/or unprocessed or partly
processed agricultural products (food and raw materials). Such goods are called primary
commodities. These countries imported manufactured goods. This international division of
labor had been created by centuries of trade between the colonies and semi-colonies, and the
metropolises. Trade between these two groups of countries, and the investment of the
colonizers in the colonies and semi-colonies, had destroyed the manufacturing capabilities in
the colonies and semi-colonies, forcing them to specialize in the production and exportation
of primary commodities. (This was also the case with the Ottoman Empire.) The colonizers’
various trade policies, such as escalatory tariffs6, obstructed attempts at industrialization in the
colonies and semi-colonies.

Hence, what manufacturing existed in the colonies and semi-colonies consisted mainly of
small-scale production using traditional labor-intensive techniques. The developed capitalist
countries, on the other hand, had manufacturing industries producing sophisticated consumer
goods, capital goods and intermediate goods, using capital-intensive techniques (i.e. large-
scale production in factories). Some of the developed countries (e.g. the US, Canada, France,
Australia) also produced abundant quantities of agricultural goods using modern farming
techniques, and exported them in large quantities.

The post-war world order

Before the war ended, representatives of the US and the UK met at Bretton Woods in the US
in 1944 to plan the organization of the post-war world trading and monetary system. The
Bretton Woods Conference agreed on an international fixed exchange rate regime in which
national currencies’ values with respect to the US dollar were fixed.7 The value of the US
dollar was fixed in gold ($35 per ounce of gold). Thus the previous Gold Standard, with the
British pound at its center, which had been applied for over a century, was terminated. A new
international monetary system with the US dollar at its center was founded. The dollar became
the main international means of payment, besides gold.

At the conference the US and the UK also established the International Monetary Fund to
provide loans to countries with transitory trade balance difficulties. They established the World
Bank (the International Bank for Reconstruction and Development) to extend long-term loans
to governments for reconstruction and development projects.

6
Tariff escalation is the policy of applying zero or low tariff rates on imports of raw materials, progressively
higher tariff rates on imports of semi-finished goods, and highest tariff rates on imports of finished goods.
7
It was agreed that a state could change the dollar exchange rate of its currency (and hence all exchange rates
of its currency) in case the country’s central bank suffered a severe decline in its dollar reserves, due for
example to a persistent current account deficit.
 12

In 1945 the Allied powers established the United Nations Organization to work for the
preservation of world peace. As decolonization progressed, an increasing number of
underdeveloped former colony countries joined the UN. They participated with equal votes in
the UN General Assembly. There was a general awareness that the newly-independent poor
nations had been subjected to foreign exploitation for a long periods. This awareness naturally
made it easy for the newly-independent states to push their economic development needs onto
the agenda of the UN and other international organizations, and to press the rich countries to
give economic aid and lenient treatment in trade (e.g. low tariffs on imports from poor
countries).

After the war the US government was alarmed by the popularity of communist parties in West
European countries such as France and Italy. So it undertook massive aid to capitalist European
states (the Marshall Plan, 1948-1951) to help them recover from the war and to raise the living
standards of the common people there. In return for aid, the European states were obliged to
restrict their trade with the USSR (Chandra 2004, 2292).

In the struggle for global supremacy the US and the USSR competed to build political-military
alliances with poor countries outside Europe. Türkiye, Iran, Saudi Arabia, Taiwan, South
Korea joined military alliances with the US. But most poor countries tried to balance their
relations with both blocs and remained neutral (non-aligned). Algeria, India, Indonesia and
Yugoslavia led the international non-aligned bloc. The countries of the world were divided
into three blocs: the first bloc was the US, other rich capitalist countries and their allies; the
second bloc was the USSR and its allies; and the third bloc was the so-called Third World (the
non-aligned developing countries). The competition for political alliances during the Cold War
created incentives for both the rich capitalist states and the socialist states to support the
development projects of the poor countries.

This political environment not only gave advantages to underdeveloped countries in their
external economic relations, but also induced states in the rich capitalist countries to allocate
funds to studies of economic development issues in their universities and public institutions
and in international organizations. An economic development literature emerged.

It should be noted that large-scale US economic and military aid to war-torn European
countries and the developing countries also benefited the US economy. When the war ended
the enormous US military budget and expenditures had to be reduced, and the discharged
soldiers had to be given jobs. Economic and military aid to the European countries and to poor
countries by the US government maintained and created jobs in the US, and helped boost
domestic consumption expenditure through the multiplier effect. The aid thus prevented an
otherwise inevitable economic contraction after the war in the US.
 13

Ideological and political trends

It may be useful at this point to sketch the intellectual climate in economics in the major
capitalist countries after the war, as it has changed since then.

Globalization (increases in international trade and investment) in the 19th century had
exacerbated inequalities in incomes and wealth in Western European societies and in former
British settler-colonies (US, Canada, Australia, New Zealand). Income inequality reached its
peak in 1900-1914. When the First World War broke out, some Marxist writers (John Hobson,
Rosa Luxembourg, V. I. Lenin) held that the causes of the war were economic, and were rooted
in social inequality. The explanation went like this: income inequality meant that the working
classes in the rich capitalist economies were not able to purchase the increasing supply of
goods produced. So the states in these countries warred against each other in order seize each
other’s colonies to export their goods (because each colony was a market primarily for its
colonizer)8 (Milanovic 2016, 65, 95-97).

Many writers in the rich capitalist countries also attributed the 1917 Russian Revolution and
the establishment of fascist regimes in European countries in the 1920s and 1930s to social
inequalities in these countries.

So after World War II, policymakers in Europe and the US were convinced that poverty and
unemployment are dangerous for liberal democracy and for capitalism. On the other hand, the
Great Depression of the 1930s had severely discredited liberal economic thinking and lowered
confidence in the stability and the self-regulating capacity of market economies. Keynes’ The
General Theory of Employment, Interest and Money (1936) convinced public opinion in the
developed countries that market economies were prone to recurrent recessions. Keynes
explained how governments could prevent economic contractions through monetary and fiscal
policies. And he argued that governments should prevent economic contractions.

So after the Second World War, Keynes’ view that governments could and should aim at full
employment was accepted by political parties across the political spectrum (including
conservative and liberal parties) in the developed countries. Institutions were established in
those countries to redistribute income (e.g. social security, progressive taxation, free public
services and social transfers). Workers’ rights in the workplace were expanded. A social
democratic consensus emerged in these societies.

The 1944 Bretton Woods agreement reflected this concern of US and UK policymakers for
full employment. It was stipulated in the IMF charter that member states have the right to
restrict private international financial flows. Therefore central banks could pursue interest rate
policies free of the pressures of private international capital flows. This would enable
governments to implement monetary policies for macroeconomic stability with full

8
The widespread practice of colonialism was: colonies were allowed to trade only with the metropolis, goods to
and from colonies could only be transported on the metropolis’s ships, and colonies were not permitted to
produce manufactured goods (Milanovic 2016, 95).
 14

employment.

So, for 30 years after World War II, governments in the advanced capitalist countries
implemented more or less expansionary monetary policies to stabilize employment and GDP
growth.

There were some nuances in monetary policies among the developed countries. In Germany,
France, Japan, Italy the labor movements were weak. Wages were fixed in nominal terms, and
trade unions could not react quickly and strongly to the erosion of their real wages. So in these
countries, governments generally were able to pursue expansionary monetary policies.

By contrast in the United States and the United Kingdom the labor movements were stronger
than in the four countries mentioned above. Trade unions were able to demand wage increases
when the price level rose. Moreover, central banks in the US and the UK were ‘independent’.
This meant that these central banks were aligned with the interests of the financial sector,
which prioritizes price stability. The US and the UK were global financial centers. Their
financial sectors had an interest in keeping the dollar and the pound ‘strong’. So, these
governments were determined not to allow their currencies to depreciate with respect to other
currencies, and to maintain the dollar and the pound as a good store of value throughout the
world. Consequently, monetary policy was relatively restrictive in the United States and the
United Kingdom compared to Germany, France, Japan and Italy.

Such differences notwithstanding, for roughly 30 years after World War II, states in the
developed capitalist countries implemented fiscal and monetary policies aimed at maintaining
high employment and ensuring stable GDP growth.

In the 1950s the American economist Simon Kuznets observed that income inequality was
declining in the developed countries. He hypothesized, that in modern societies, as per capita
incomes increase, income inequality first increases, then after a certain per capita income level
is reached income inequality decreases. This he depicted with an inverted U shaped curve,
where income inequality is mapped against per capital incomes. It was called the Kuznets
Curve.9 This hypothesis reflected the expansion of welfare state policies in the developed
capitalist countries after World War II.

The theory of comparative advantages

We have sketched the historical conditions after the Second World War at the time when the
problem of economic development became an international issue.

Now it seemed obvious to many policymakers in poor countries that, since the affluent
developed countries were industrialized, i.e. were specialized in producing and exporting
manufactured goods, then economic development in poor countries must involve

9
We shall see that developments after 1980 invalidated this hypothesis.
 15

industrialization. It seemed clear that economic development necessitated a structural

transformation of their economies that would expand and modernize their manufacturing
sectors.

However, liberal economists in the developed countries argued that developing countries
should not focus on transforming their economies. They based their argument on an old idea:
Ricardo’s theory of comparative advantages. This theory had been proposed in the early 19th
century, and liberal economists revived it after World War II. The theory is still the basis for
arguments in favor of free trade. Mainstream economists frequently refer to the ‘gains from
trade’. What these gains are is seldom explained. For this reason we have to understand the
theory.

Ricardo's theory of comparative advantages recommends that countries specialize in the

production of commodities in which they have a comparative advantage in production costs,
relative to other commodities. The justification is that, such a specialization among countries
will increase global output, and thus increase all countries’ possibilities to consume.

As countries specialize in the production of goods which they can produce cheaper relatively
to other goods, global production will increase. The increase in global production can be
shared among countries. How it is shared is determined by the relative prices of the traded
goods. The point of the theory is that, although the gains from increase in global output may
be distributed among countries equitably or inequitably, no country can be harmed by such
specialization.

After World War II, Ricardo’s theory of comparative advantages was revived by liberal
economists to push the view that, it is not rational for poor countries to make an effort to
industrialize.

How comparative advantages work

The theory of comparative advantages was developed by David Ricardo at the beginning of
the 19th century. At that time all paper money was backed by gold reserves, and trade
imbalances were paid for by flows of gold from deficit countries to surplus countries. This
system was called the Gold Standard.

We study the theory with a simple numerical example. Consider two countries, A and B.
Assume for simplicity that they have the same endowments of factors of production. Assume
all their factors of production are fully employed. Both societies produce and consume two
commodities. Let us call them the agricultural good and the manufactured good. The factors
of production (labor, capital) cannot move between the countries; however they can be shifted
within each country between the sectors. Perfect competition in markets ensures that the prices
of the two commodities are equal to their costs of production. Further, assume that the price
of each factor of production is the same in both countries. All prices are denominated in units
of a universal measure of value (in Ricardo’s time it was gold).
 16

Let us assume that if country A were to allocate all of its factors to agriculture it could produce
100 units (e.g. tons) of the agricultural good. If country B were to allocate all of its factors to
agriculture it could produce 200 units of the agricultural good. If country A were to allocate
all of its factors to manufacturing, it could produce 100 units of the manufactured good. If
country B were to allocate all of its factors to manufacturing, it could produce 400 units of
the manufactured good (Table 1.7).

Employing the same quantity of factors, B can produce more both of the agricultural good
and of the manufactured good compared to country A. The factors of production in B are more
‘productive’ in both sectors than in A. Since the unit prices of each factor are the same across
the two countries, both commodities can be produced in country B cheaper than in country A.
Hence country B has an absolute advantage in production costs over country A.

Table 1.7: Maximum production in each sector

agriculture manufacturing
A 100 100
B 200 400
Total 300 500

However, the difference in costs of production between A and B is less in agriculture than in
manufacturing, because the productivity difference is less in agriculture between the two
countries. This means that A has a comparative advantage in agriculture and B has a
comparative advantage in manufacturing.

In the absence of trade (in autarky), both countries would produce both commodities in the
quantities that they consume them. Assume that in autarky, the consumption demands are such
that, in each country half of the factors are utilized in agriculture and the other half are
employed in manufacturing. In country A, society demands 50 units of the agricultural good,
and in B society demands 100 units of the agricultural good. The remaining factors in each
country produce the manufactured good (Table 1.8).

Table 1.8: Production and consumption in autarky

agriculture manufacturing
A 50 50
B 100 200
Total 150 250

Now we study what happens when these two countries decide to trade with each other. When
these two countries start to trade with each other, A will be unable to export from either sector.
B will export from both sectors because both commodities are produced more cheaply in B
than in A. The trade imbalance will lead to a flow of gold from A to B. The inflow of gold to
country B will expand the money supply there and (according to the quantity theory of money)
cause a rise in prices in B. The outflow of gold from A will cause a contraction of the money
supply there and a decline -deflation- in prices. The rise in prices in B and the decline in prices
 17

in A will continue - until the price of the agricultural good in A equals the price of the
agricultural good in B.

As prices rise in B and decline in A, the prices of the agricultural good produced in A and in
B converge before the prices of the manufactured good, because the productivity difference
between the two countries is less in agriculture than in manufacturing. When the prices of the
agricultural good have converged, the price of the manufactured good in B is still lower than
its price in A. Merchants in A will continue to import the manufactured good from B; but they
can now export the competitively priced agricultural good from A to B. These changes in trade
will shift the factors of production in A from manufacturing to agriculture, and will shift factors
of production in B from agriculture to manufacturing. This shifting of factors of production
between sectors will continue until all the opportunities for profitable exports and imports have
been fully exploited.

In this specific numerical example, the adjustment ends with A specializing completely in
agriculture and B specializing mostly in manufacturing (Table 1.9). B does not specialize
entirely in the production of the agricultural good. This is because, in this example, country A
by itself cannot satisfy the total demand for the agricultural good of both countries. Hence, in
this specific example, A specializes completely (produces only the agricultural good) whereas
B undergoes a partial specialization.

Table 1.9: Production under specialization

agriculture manufacturing
A 100 0
B 50 300
Total 150 300

The result is that, liberalizing trade and specialization in the two countries increases the total
production of the manufactured good from 250 to 300. This is the ‘gains from trade’. But how
are the 50 extra units of the manufactured good to be allocated between the two countries?
That depends on the relative prices of the two goods in trade, i.e. on the terms of trade.

The terms of a trade of a country is the ratio of the average price of its exports to the average
price of its imports. In this simple model there are only two goods being exchanged. So the
terms of trade for country A is the price of the agricultural good / price of manufactured good.
This is equal to the quantity of manufactured good that can be imported for one unit of the
agricultural good. Similarly, the terms of trade for country B is the price of the manufactured
good / price of agricultural good.

For example when the two countries trade with one another, if the terms of trade is such that B
exports two units of the manufactured good for one unit of the agricultural good, all of the total
increase in manufactures is captured by country A. (Compare Table 1.10 with Table 1.8.
Compare the consumption in A under autarky, and its consumption under trade with an
exchange of two units of manufactured good for one unit of agricultural good).
 18

Table 1.10: Consumption under specialization and trade

(1.0 unit agricultural good for 2.0 units manufactured good)
agriculture manufacturing
A 50 100
B 100 200
Total 150 300

In this situation, if country B has any bargaining power, it will try to bring down the price of
the agricultural good with respect to the manufactured good. For example B might succeed in
changing the prices so that it can import one unit of agricultural good for 1.5 units of the
manufactured good (Table 1.11). Then country A will exchange its 50 units of surplus
agricultural good for 75 units of the manufactured good. For country B this is better than
importing one unit of agricultural good for 2 units of the manufactured good, as its
consumption of the manufactured good now has increased by 25 units (compare Table 1.12
with Table 1.11).

Table 1.11: Consumption under specialization and trade

(1.0 unit agricultural good for 1.5 units manufactured good)
agriculture manufacturing
A 50 75
B 100 225
Total 150 300

If country B can use political or business power in price bargaining, it may be able to reduce
the quantity of the manufactured good it exports for one unit of agricultural good to 1.2. In
that case country A will be able to import only 60 units of the manufactured good from B for
its exports of 50 units of surplus agricultural production (Table 1.12).

Table 1.12: Consumption under specialization and trade

(1.0 unit agricultural good for 1.2 units manufactured good)
agriculture manufacturing
A 50 60
B 100 240
Total 150 300

If country B succeeds in imposing on country A the prices that are most advantageous to
itself, it will export one unit of the manufactured good in exchange for one unit of the
agricultural good (Table 1.13). Then all of the gains from specialization and trade will accrue
to country B. Country A gains nothing from trade; it continues to consume the same quantities
of goods as it did under autarky.

In the series of examples above, the terms of trade of country A (ratio of the price of the
exported good to the price of the imported good) declines from 2.0 to 1.5, to 1.2, to 1.0. The
terms of trade worsens for country A. The terms of trade of country B increases from 0.5 to
0.7 to 0.8 to 1.0. The terms of trade improves for B.
 19

Table 1.13: Consumption under specialization and trade

(1.0 unit agricultural good for 1.0 unit manufactured good)
agriculture manufacturing
A 50 50
B 100 250
Total 150 300

So Ricardo’s theory only shows the gains from trade and specialization from the viewpoint of
global output, but says nothing about what individual countries may gain from specialization.
In this numerical example, country A has to de-industrialize completely, giving up its self-
sufficiency in manufacturing in exchange for the possibility of consuming more of the
manufactured good through importation. Country B also partially gives up its self-sufficiency
in the agricultural good. This outcome is contrasts with the idea of self-sufficiency and
economic independence.

The theory promotes the idea that nations benefit from increasing economic interdependence.
Liberal thinkers also hold that economic interdependence strengthens peaceful relations
between nations.

Critique of the theory of comparative advantages

For over two centuries economists have used Ricardo’s model to argue for reducing tariff
rates, eventually abolishing tariffs, and for the removal of all quantity restrictions on trade.

Some of the assumptions in the example above are made simply to facilitate calculation. The
assumption of equal endowments of factors of production in the two countries, and the
assumption of equal prices of factors between countries can be discarded without affecting
the logic of the model.

But some other assumptions are critical to realization of the predictions of the theory. First,
the old Gold Standard is no longer applied since the Great Depression of the 1930s. However
the adjustment mechanism to imbalances in trade based on gold flows could theoretically now
be realized by the adjustment of exchange rates between currencies. Under flexible exchange
rates, if country A has a trade deficit with B in both sectors, its currency should depreciate
with respect to the currency of B until the foreign currency price of the good in which it has
a comparative advantage (the agricultural good) will equal the price of that good in country
B, so that it can begin to export the agricultural good. So it seems that specialization according
to comparative advantages could be realized with paper currencies.

But such an exchange rate adjustment to trade imbalances can work only if foreign currencies
are used only for trade. In the real world, exchange rates between currencies are not
determined by trade balances alone, because foreign currencies are demanded for purposes
other than trade. Foreign currencies are also demanded for purchases of foreign assets. In fact,
international financial flows unrelated to trade dominate exchange rates. These international
financial flows are much greater in magnitude than the payments in trade. So, international
 20

financial flows determine exchange rates; so exchange rates do not adjust to eliminate trade
imbalances. Therefore, in a world with international capital flows unrelated to trade, exchange
rate adjustments cannot be relied on to realize the specialization of countries according to
their comparative advantages.

If exchange rates do not adjust to balance trade and allow specialization according to
comparative advantages of the countries, then trade will be determined by absolute
advantages in production costs. In the example above, it means that if there is a flow of money
savings from B to A (foreign direct investment, deposits, portfolio investment etc.) the
exchange rate may never depreciate the currency of A sufficiently to make the agricultural
exports competitive with those of B, despite the trade imbalance. So B may retain its price
competitiveness in its exports of both goods under free trade. In that case, A will run a
persistent trade deficit with B. This more or less describes the foreign trade deficits of many
developing countries today (e.g. of Türkiye).

There are other assumptions in Ricardo’s model that are unrealistic: (1) There are constant
returns of scale in production. If there are increasing or decreasing returns to scale in
production in any sector or country, the calculations of the model break down. (2) There are
no costs in shifting factors of production between sectors in a country. This not realistic in
the case of fixed capital assets. E.g. suppose a state reduces trade barriers, tariffs etc. and
allows specialization in agriculture. The machinery in the manufacturing sectors of the
country have to be converted into agricultural machinery. This has costs not considered in the
model. Similarly, if a state decides to allow free trade which leads to the collapse of certain
sectors, the people employed in those sectors may lose their employment. They may not be
able to find jobs in expanding sectors because they may not have requisite skills, or they
cannot easily relocate to regions with expanding sectors. These all entail social costs not
considered in the theory. (3) There is perfect competition in all goods markets. But today
many manufactured goods are sold in imperfectly competitive markets. Brand names and
fashions are created to prevent competition, to monopolize markets. This means that prices
of some traded goods may include monopoly rents. Thus production costs and prices are
disconnected. Relative prices may prevent specialization according to comparative
advantages based on costs of production. (4) Technologies do not change. In the model there
is no consideration that a country can gain a comparative advantage through investment and
learning-by-doing.

Extensions of the theory

Other economists made additions to Ricardo’s theory in the 20th century. In the simple
example presented above we assumed, for the sake of keeping the exposition simple, that
the two trading nations (A and B) have the same factor endowments. One extension of the
theory, the Heckscher-Ohlin theory, considers that trading nations do not have the same
factor endowments. In fact, comparative advantages among countries may arise from
different endowments of non-produced natural factors, such as different types of land,
climate, mineral resources, forests etc. According to the Heckscher-Ohlin theory, when
 21

countries with different factor endowments begin to trade freely, each country specializes in
the production of the commodities which necessitate intensive use of factors of production
which are abundant in the country. For example, countries with abundant low-skilled labor
specialize in the production of goods necessitating low-skilled labor, countries with abundant
forests specialize in the production of goods made of wood, and so forth.

Another addition to these theories was the Stolper-Samuelson theory. This posited that under
free trade, when countries specialize in the export of commodities that use factors that are
abundant in the country, the demand in the country for those abundant factors increases and
hence their prices also increase. And if countries start to cease to produce and begin to import
commodities that use factors that are scarce in the country, the demand in the country for
those scarce factors decrease and hence their prices also decrease.

For example, in underdeveloped countries many commodities are produced using the
abundant factor (unskilled labor) whose return (wages) is low. By contrast, in developed
countries unskilled labor is relatively scarce, and skilled labor relatively abundant. Under free
trade between the underdeveloped countries and the developed ones, the underdeveloped
countries will export goods produced using unskilled labor, and the developed countries
will export goods produced using skilled labor, according to Heckscher and Ohlin. This
trade (according to Stolper and Samuelson) should increase the real wages of unskilled labor
in the underdeveloped countries and should lower the real wages of unskilled labor in the
developed countries. Hence wages of unskilled labor in the two regions should converge.
And this process should lead to a convergence of wages of skilled workers too.10 So the
Stolper-Samuelson theory predicts that free trade tends to eliminate differences in the prices
of factors of production between nations.

So Ricardo’s theory, the Heckscher-Ohlin theory and the Stolper-Samuelson theory make
optimistic predictions about the benefits to countries which specialize in goods in the
production of which they have a comparative advantage. The theories do not distinguish
between manufacturing and other sectors in the distribution of benefits from free trade. The
theories are developed within sector-neutral models. Hence they imply that arguments for
industrialization in underdeveloped countries are groundless. In other words, there is no
difference in specializing in manufacturing and specializing in agriculture or mining for
benefitting from the ‘gains from trade’.

10
That is, increasing trade between Britain and Nigeria is supposed to raise the wages of unskilled workers
in Nigeria, and lower the wages of British unskilled workers. And increasing trade between the two
countries should lower the wages of Nigerian engineers and raise the wages of British engineers.
But notice: this can lead to a convergence of wages of engineers only if the wages of Nigerian engineers
were initially higher than the wages of British engineers. If wages of Nigerian engineers were initially lower
than the wages of British engineers, the difference between the wages of engineers in the two countries will
increase even further!
This absurdity is due to the abstract neoclassical assumption that if initially engineers are fewer in Nigeria
than in Britain, their wages must be higher than the wages of British engineers.
 22

Policy implications

In the post-World War II world, underdeveloped countries were specialized in the production and
exportation of primary commodities, and so appeared to have comparative advantages in these
commodities. Actually the apparent comparative advantages in primary commodities production
in underdeveloped countries in the 20th century was due to the historical legacy of European
colonialism and imperialism.11

So the question for policymakers in underdeveloped countries in the first decades after World
War II was: should they accept the mainstream trade theories and try to deepen their
countries’ integration into the world economy as exporters of primary commodities and
importers of manufactured goods? Or should they make an effort to industrialize?

For some countries in Latin America, the question was whether to continue the
industrialization they had begun in the 1930s during the Great Depression, when world
trade had contracted. Similarly in Türkiye in the 1950s the question was specifically whether
to revive the industrialization effort that had begun in the 1930s and that had been interrupted
by the war, or whether to focus on developing agriculture and to further develop its position
as an exporter of agricultural products (wheat, cotton, hazelnuts, tobacco and dried figs) and
continue to import manufactured products (which at the time included pharmaceuticals,
radios, cars, refrigerators, sewing machines, typewriters, textile machinery, printing presses,
chemicals etc.).

For example, a report submitted in 1950 to the Turkish government by a World Bank
delegation that visited Türkiye (‘Barker Raporu’) argued that Turkish policymakers had
focused excessively on industrialization (referring to the industrialization efforts in the
1930s) and had made a mistake in neglecting agriculture. The report explicitly stated that it
was not advisable for Türkiye to invest in heavy machinery, in metallic products, in heavy
chemicals or in paper and pulp production. According to the report, Türkiye either did not
have the necessary skilled workers, or the raw materials, or the financial means or the
domestic demand, for such industries to be viable.

Such views influenced Turkish economic policies through the 1950s.

In the second lecture we shall see how these suggestions were debated in developing
countries in the post-war period.

11
For example since antiquity India had been an exporter of the finest cotton and silk fabrics. After
colonizing India in the 18th century the British destroyed the Indian textile industry by many policies, e.g.
applying high tariffs on textile imports from India to Britain and low tariffs on British textile imports to
India.
The British militarily imposed ‘unequal treaties’ on the Ottoman state (1838) and on China (1842) which
eliminated these states’ right to determine their own trade policies.
On the other hand, Europeans’ investment in the 19th and early 20th centuries developed cotton and tobacco
production in Anatolia; developed cotton production in Sudan; developed sugar and coffee production and
mining in Latin America and in the Caribbean, all for exportation to Europe.
 23

Sources for the lecture

Arndt, H. W. 1981. Economic Development: A Semantic History. Economic Development

and Cultural Change. 29(3). 457-466.
BBC. 2014. India's dark history of sterilisation. 14 November 2014.
https://www.bbc.com/news/world-asia-india-30040790
Caldwell, Malcolm. 2009. Southeast Asia from Depression to Re-occupation, 1925-1945.
Journal of Contemporary Asia. 3(3). August. 327-344.
Chandra, Nirmal Kumar. 2004. Relevance of Soviet Economic Model for Non-socialist
Countries. Economic and Political Weekly. May 29, 2004.
Epstein G. A., J. B. Schor. 1990. Macropolicy and the rise and fall of the Golden Age. Chapter
3 in The Golden Age of Capitalism: Reinterpreting the Postwar Experience. S. A. Marglin
and J. B. Schor (eds). Oxford. The Clarendon Press. 126-152.
Hartmann, Betsy. 1987. Reproductive Rights and Wrongs: The Global Politics of Population
Control and Contraceptive Choice. New York. Harper and Row.
Hobsbawm, Eric. 1996. A History of the World: 1914-1991: The Age of Extremes. New York.
Vintage Books.
Milanovic, Branko. 2016. Global Inequality: A New Approach for the Age of Globalization.
Cambridge: Massachussetts: the Belknap Press for Harvard University.
Sonntag H. R., M. A. Contreras, J. Biardeau. 2001. Development as Modernization and
Modernity in Latin America. Review XXIV. 2. 219-51.
Valenzuela, J. Samuel and Arturo Valenzuela. 1979. Modernization and Dependence:
Alternative Perspectives in the Study of Latin American Underdevelopment, in
Transnational Capitalism and National Development: New Perspectives on Dependence.
José Villamil (ed.). Sussex. The Harvester Press.
Williams, Rebecca Jane. 2014. Storming the Citadels of Poverty: Family Planning under the
Emergency in India, 1975–1977. The Journal of Asian Studies. Vol. 73. 02. May. 471 – 492.
 1

Development Economics Lecture 2

10.10.2024

modernization theory – structuralist economics – dependency theory

Approaches to development: modernization

After World War II the developed capitalist states promoted development studies in
their academic institutions to provide explanations for economic underdevelopment,
and to propose policies for development. Political scientists, sociologists, economists
and other researchers in these countries produced a literature on the problems of
underdeveloped countries. Although there were differences of emphasis, these
studies all revolved around the concepts of modernity and modernization. A few
prominent names in this school of thought were Bert Hoselitz, Talcott Parson, Walt
W. Rostow and Daniel Lerner. Modernization theorists were supported by
institutions such as the Massachusetts Institute of Technology Center for
International Studies, the Ford Foundation, the United States Agency for
International Development (USAID).

The modernization approach held that all societies evolve toward modernity.
Contemporary modern societies have experienced this evolution earlier. The
underdeveloped societies today are in a state comparable to what the developed
societies had been before their transition to modernity, a process that began in the
sixteenth century.

Modernization theorists held that societies are pushed forward by, or are retarded by
their own internal dynamics. Transforming underdeveloped societies to become like
those in the developed capitalist countries is the ultimate aim of development. The
end result of development is modernity. “Development is the path toward modernity
and synonymous with it, its destination.” “The implicit model of modernity was the
US: Americanization became synonym for development” (Sonntag et al. 2001, 223,
224).

Modernization writers made use of comparisons of a stereotyped ‘modern society’

with a stereotyped ‘traditional society’. Traditional societies were described as those
that did not have the characteristics of modern societies.

Some writers in this school emphasized the differences in social structure between
modern societies and traditional societies. For example, in traditional societies one
observed households of extended families instead of nuclear families. One observed
patriarchy instead of gender equality. In traditional societies tribal affiliations,
regional affiliations, religious and sectarian affiliations were often stronger than
national affiliations. Strong kinship ties and strong mutual social bonds obstructed the
 2

ability of individuals to act independently to seek their personal interests. Examples

of pre-modern social behavior in traditional societies were: showing deference to age;
esteem shown to individuals for nobility of family rather than for personal merits;
preference for secure jobs in the public sector rather than entrepreneurial careers;
weak motivation to undertake enterprise in order to accumulate wealth; the preference
of affluent classes for conspicuous consumption instead of saving to accumulate
capital.

Some writers highlighted pre-modern political structures in traditional societies:

authoritarian regimes, political dynasties (even in republics), weak rule of law, weak
protection of human rights, weak sense of nationhood and citizenship.

Some writers focused on pre-modern mentalities in traditional societies, such as pre-

Newtonian unscientific conceptions of nature; fatalistic attitudes, superstition and
belief in magic.

Finally, traditional societies were economically underdeveloped. Traditional societies

in the post-war period typically had economies with a dual structure. These countries
had a predominant traditional sector with small-scale subsistence agriculture and
small-scale crafts production (manufacturing) using primitive techniques on the one
hand; and a modern sector with modern capitalist agriculture and mining activities
producing primary commodities for exportation on the other. The modern sector was
integrated with a modern banking system and a modern transportation infrastructure.
The traditional economic sector and the modern economic sector were weakly
integrated and had little interaction, except for the movement of labor from the
traditional economic sector to the modern one. For modernization writers, economic
underdevelopment in the traditional sector was due to social and cultural
backwardness.

Modernization writers held that traditional societies are by nature stagnant. The
reason was that, given the culture and mentality, people do not seek change or
improvement in material life. In these societies people adhere to customs and
traditional lifestyles, and are inclined to accept what providence has given them.
Traditional societies do not have histories of social progress. Their recorded histories
consist of successions of rulers and dynasties. By contrast, modern societies are
distinguished by permanent socio-economic change, driven by individuals’ desire to
improve one’s material circumstances. This contrasting of changing dynamic
historical societies versus stagnant a-historical societies had been used in the 17th-
19th centuries to justify colonization.

In their work on development, modernization writers considered the individual nation

as the unit to be studied. “The locus of development is the individual society, which
is crystallized in the nation…” (Sonntag et al., 2001: 223). Since the causes for
backwardness were in the internal dynamics of the society, the pace of modernization
 3

was determined by the struggle between progressive domestic social groups and
reactionary groups. Modernization writers observed that modernizing reforms are
initiated by educated élites. The élites enlighten and lead the ignorant traditional-
clinging masses to modernity. Modern education was crucial for combating
traditional attitudes. This included teaching European languages and teaching history
and sociology from the modernization viewpoint. Modern education was instrumental
in speeding up modernization.

Modernization writers tended to dismiss the legacy of colonialism as past history

without relevance for present problems. On the contrary, some writers pointed out
that societies started their modernization under external influences, provocations or
challenges. For example in the 19th century, in some countries (China, Iran, Japan,
the Ottoman State), the impulse for modernization came from external military
threats.

Modernization theorists argued that increasing underdeveloped countries’ economic

and cultural relations with the developed countries would accelerate their
socioeconomic development. Such relations could help diffuse Western attitudes,
Western values, Western institutions in the underdeveloped societies. Mutually
beneficial cooperation between the developed and the underdeveloped countries was
possible.1

The prominent writer on economic development in this approach was the economic
historian Walt Rostow. He published a book entitled The Stages of Economic Growth:
A Non-Communist Manifesto (1960). He described five stages of economic
development: traditional society, the preconditions for take-off, the take-off, the drive
to maturity, the age of mass consumption. He described how developed countries had
gone through these stages, and how developing countries were likewise doing so.2 In
Rostow’s view modernization in each underdeveloped country was to be achieved by
the spread of capitalism in the traditional sector, transforming subsistence agriculture
into commercial agriculture with the cultivation of cash crops using modern
techniques; and traditional workshop manufacturing being replaced by modern
factory manufacturing. Private entrepreneurs were the social force that would
modernize the economy.

1
This liberal view of possible harmony among nations contrasts with the opposing ‘realist’ view in
international relations theory which holds that the struggle for power, competition and conflict are
inherent in inter-state relations.
2
Maturity is the “…stage in which an economy demonstrates that it has the technological and
entrepreneurial skills to produce not everything, but anything it chooses to produce”. “Historically, it
would appear that something like sixty years was required to move a society from the beginning of
take-off to maturity”(Rostow, 1960, 10). In the frontspiece to the book, Rostow has a chart showing
that Turkey, Mexico, Argentina had begun their take-off just before World War II. The implications
of the sentences and the chart are that by the year 2000 Turkey, Mexico and Argentina would have
“the technological and entrepreneurial skills to produce anything they chose to produce”, i.e. would
have reached the global technological frontier.
 4

Economic development in underdeveloped countries could be speedened by

increasing trade with the developed countries and through investment by
multinational corporations. Multinational corporations’ investment would bring in
capital, provide employment opportunities and introduce advanced technology and
managerial skills to developing countries.

To summarize: modernization theorists’ main views were (1) that economic

development is an aspect of modernization, (2) that the modernization process was
determined by the internal dynamics of societies, (3) that assimilation to developed
Western societies -with all their cultural and institutional attributes- is the goal of
modernization, (4) that increasing economic, political and cultural relations with
modern societies would help accelerate modernization in underdeveloped societies.

By way of assessment: we should remember that the ideas that social progress is
inevitable, that social change has a clear orientation, that social change is historically
determined are rooted in the European Enlightenment of the 18th century. In this
view, the historical evolution of Western Europe is the standard by which to assess
societies. Social scientists who think in the modernization mode use this standard to
judge societies as ‘achievers’ and ‘failures’.

However, not all social scientists share this view. Other scholars accuse the practice
of using European history to pass judgements on other societies of being
‘eurocentric’.

The roots of the modernization approach can also be traced to earlier studies of the
colonized societies done by scholars of the colonizer countries in the 19th and early
20th centuries. These colonial studies aimed at justifying the colonization of peoples
by means of racist theories (e.g. white people are biologically more evolved than
people of other races), or culturalist theories (e.g. Hindu or Muslim cultures do not
encourage entrepreneurial behavior as much as Christian -especially Protestant-
culture), or ideas about geographic influences (e.g. people living in hot climates tend
to be more lethargic than people living in temperate and cold climates).

The modernization understanding of development was the basis of reforms in the

Ottoman Empire in the 19th century and in the Republic of Türkiye. It partly explains
the desire among some people in Türkiye to join the European Union. Although
modernization thinking has been subjected to much criticism, it still persists in many
people’s minds around the world, including policymakers and intellectuals in
developing countries.
 5

Approaches to development: structuralism

Economic structuralism was an economic development approach that emerged in

Latin America. Much of structuralist research was initiated in the late 1940s by
economists working at the United Nations Economic Commission for Latin America
(ECLA) in Santiago, Chile. Some well-known economists who contributed to this
literature were Paul Rosenstein-Rodan, Ragnar Nurkse, Arthur Lewis, Raúl Prebisch,
Hans Singer and Gunnar Myrdal.

In 1949 Prebisch presented the notion that the world economy comprised an
industrialized hegemonic core and an agrarian dependent periphery. He argued that
this global economic structure perpetuates itself in an unequal development process.
Hence economic structuralism suggests a holistic approach to study
underdevelopment and development, in contrast to the modernization approach that
focused on nations.

Structuralist economists focused on specific structural problems confronting

underdeveloped countries specialized in primary commodity exportation.

The first problem: Peripheral countries specialized in the exportation of primary

commodities are liable to suffer a secular decline in their terms of trade because of the
different effects of productivity increases in primary commodity production, and
in manufacturing industries.

A country’s terms of trade (TOT) is the ratio of the average price of exports of a
country to the average price of its imports.

𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑢𝑛𝑖𝑡 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑒𝑥𝑝𝑜𝑟𝑡𝑠

𝑇𝑂𝑇 =
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑢𝑛𝑖𝑡 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑖𝑚𝑝𝑜𝑟𝑡𝑠

Changes in a country’s terms of trade is calculated as the change in the ratio between
the price index of its exports and the price index of its imports. When the terms of
trade of a country is increasing, it can in time import more goods with the earnings of
a given quantity of exports. When the terms of trade of a country is decreasing, its
imports with the earnings of a given quantity of exports will diminish.

Prebisch argued that, in peripheral countries which export primary commodities and
import manufactured goods, the average price of their exports would tend to decline
relative to the average price of their imports.3

3
Some students confuse terms of trade deterioration with a static comparison between prices. Terms
of trade deterioration does not mean ‘manufactured goods are more highly priced than agricultural
goods’.
 6

The reason is that firms producing manufactured goods in the core countries are well-
organized in business organizations, and therefore sell their products in imperfectly
competitive markets. Workers in the manufacturing industries in core countries are
likewise well-organized in trade unions, and are able to negotiate their wages in
imperfectly competitive labor markets. Because of the low competition among firms
in product markets and low competition among workers in labor markets, productivity
gains from technological progress which reduce production costs in manufacturing
are not reflected in reductions in prices, but are reflected in increased factor incomes
(increased profits, or increased profits and wages).

By contrast, many of the producers of primary commodities (especially in agriculture

but also in some mining activities) in the periphery are small producers. They are not
organized among themselves, and sell their products to middlemen in highly
competitive conditions. Moreover, some primary commodities are produced by many
small producers in many countries. So increases in productivity and reductions in
production costs in the production of many primary commodities usually result in
reductions in their prices.

This asymmetry of the effects of productivity increases on the prices of manufactured

goods in the core, and of productivity increases on the prices of primary commodities in
the periphery causes a gradual terms of trade deterioration for countries exporting
these commodities. Countries which mainly export primary commodities and import
manufactured goods will have to export increasing quantities of primary commodities
in order to import a given quantity of manufactured goods. This famous argument is
known as the Prebisch-Singer hypothesis, or the Prebisch-Singer thesis.

Arthur Lewis gave an example from sugar production in developing countries.

Between 1870 and 1954 there was a well-documented increase in productivity
through technical progress in sugar cane production. But in this period the real wages
of sugar cane workers “failed to grow” despite unlimited supplies of labor at the
subsistence wage level (i.e. high competition among workers). Hence all the gains
in productivity gains in sugar cane production were passed onto consumers, most of
whom live in core countries (Hadass et al. 2002, 6).

Prebisch studied the terms of trade of the United Kingdom over 1876-1947. The
UK’s exports were manufactured goods and its imports comprised primary
commodities. He found a secular improvement in the UK’s terms of trade over this
period. This implied a deterioration of the terms of trade of its trading partners
(colonies and semi-colonies). So the finding confirmed his prediction. 4

4
Prebisch’s methodology has been criticized. One criticism was that in the period he studied there
were reductions in the transportation costs of primary commodities. Prebisch had considered
Britain’s c.i.f. import prices (cost with insurance and freight included). So the declining prices of
British primary commodity imports may have been due to declining freight costs.
Since the 1940s there have been many empirical studies on the course of the terms of trade between
 7

The second problem concerns countries specialized in the exportation of foodstuffs.

This problem arises from the difference between the income elasticity of demand for
food and the income elasticity of demand for manufactured goods. Structuralists held
that peripheral countries exporting foodstuffs are liable to suffer either trade deficits
in their trade with the core, or else had to accept GDP growth rates lower than in the
core countries. The reason is that the demand elasticity for food with respect to
income is generally low, and the demand elasticity for manufactured products with
respect to income is high. As incomes in both core and in peripheries rise, world
demand for manufactures increases more than the demand for food.

A numerical example can illustrate the problem. Assume a world with two countries,
U and D, which trade with each other, each exporting one of two goods. U exports a
foodstuff P, and D exports a manufactured good M. Assume that in general the
elasticity of demand for the manufactured good with respect to income is em = 2.0,
and that the elasticity of demand for the food item with respect to income is ef = 0.5.

Now suppose that the annual GDP growth rate of D is 5 percent, i.e. gd = 0.05. What
would be the warranted GDP growth rate of U (gu) to maintain a trade balance
between U and D?

Trade between D and U can be balanced only if the reciprocal demands for imports
in both countries grow at the same rate; i.e. if em * gu = ef * gd. Given the elasticities
of demand and the GDP growth rate of D, we can solve for gu from 2.0 x gu = 0.5 x
0.05. This yields a GDP growth rate for U of gu = 0.0125. The GDP of U must grow
at 1.25 percent annually for the trade between U and D to remain balanced.

Hence the equation gu / gd = ef / em imposes a trade balance constraint on the GDP

growth rate of U. If the GDP growth of U is pushed to a higher rate than is warranted
by balanced trade, U’s imports will grow at a higher rate than its exports, and U will
have to finance its excess imports with aid or financial inflows from D.

Moreover, if the population growth rate of U is greater than that of D, then the
difference in the growth rates of per capita GDP will be even greater than the
difference in their GDP growth rates. If the GDP of D grows at 5 percent, and the
GDP of U grows at the warranted growth rate 1.25 percent, over time the difference
between GDPs will increase, and the difference between per capita GDPs will
increase even faster.

core and periphery. There are many countries and many commodities involved. Some of the
research confirmed Prebisch’s prediction about declining terms-of-trade, some trivialized it or
rejected it. In any case the hypothesis was influential and taken seriously. This is one reason why
we discuss it here. Another reason is that the terms of trade deterioration problem seems to have
continued in the trade in manufactured goods between core and periphery into the 1990s. We shall
see this in the fifth lecture.
 8

This income elasticity difference is due to an observation called Engel’s Law: As

consumers’ incomes rise, the composition of their consumption expenditures
generally changes in favor of non-food products. This is the structuralists’ argument
against specialization in foodstuffs.

A third problem that the exporters of primary commodities face is that, the price
elasticity of demand for primary commodities is low. This means that peripheral
countries exporting primary commodities cannot increase their export revenues by
deliberate unit price reductions, or by devaluing their currencies.

Why are demand elasticities for primary commodities with respect to prices low?

For food: reducing prices does not increase food consumption proportionately for
obvious biological limitations.

As for industrial raw materials, the demand for these derives from the demand for the
final goods in the production of which the raw material is used. A numerical example
can help visualize the problem. Think of a raw material (e.g. cotton) whose cost
comprises 20 percent of a finished product (let us say, a blouse). Assume that the
demand elasticity for the final good with respect to its price is 3.0. If somehow the
price of the raw material is reduced by 20 percent, the price of the final product would
fall by 4 percent. Then the demand for the final product would increase by 12 percent.
So in this example, a decline in the price of the raw material by 20 percent increases
the demand for the raw material by 12 percent. The result is a decline in the revenue
of cotton producers.

One can see from the example that unless the raw material comprises a high share of
the production cost of the final product and the demand elasticity for the final product
with respect to price is quite high, the price elasticity of demand for a raw material is
likely to be lower than 1. So underdeveloped countries specialized in the exportation
of raw materials cannot generally improve their trade balances by lowering the unit
prices of their exports or by devaluing their currencies.

The fourth problem for primary commodity exporters is that, the low price elasticity
of supply of some primary commodities makes their prices sensitive to fluctuations in
demand. E.g. agricultural products take time to harvest; their production cannot be
rapidly adjusted to demand as it can be in manufactured goods. The volatility of the
world prices of some primary commodities (coffee is a typical example) make the
export earnings of these primary commodity exporters suffer wide swings.

A fifth problem for countries which mainly export primary commodities emerges,
oddly enough, when the demand for the primary commodity booms, and its price
rises during a business cycle upswing in the core. The boom in export earnings tends
 9

to cause an appreciation of the country’s currency against the dollar. The

appreciation of the currency hurts the price competitiveness of the other exports of
the country, particularly the exports of manufactured goods. This effect is called the
‘Dutch disease’. The name is due to an experience in Holland. When a large natural
gas reserve was discovered in Holland in 1959, the exports of gas caused an
appreciation of the Dutch currency, leading to a loss in price competitiveness of its
manufactured goods, and to a slump in the Dutch manufacturing industries. This
structural problem is important for developing countries that are trying to diversify
their economies and endeavoring to export manufactured goods.5 6

According to structuralist economists, all of these problems of primary commodity

exporting countries help maintain the core-periphery economic hierarchy and
differences in per capita GDP. They held that economic underdevelopment of
countries specialized in primary commodity exportation was part of the stable
unequal structure of the world economy.

The ideas of the structuralists -particularly the Prebisch-Singer thesis- provided a

strong argument for industrialization in underdeveloped countries. The United
Nations Industrial Development Organization (UNIDO) was established in 1966 to
provide technical support to underdeveloped countries to develop their manufacturing
industries. The United Nations Conference for Trade and Development (UNCTAD)
organization was established in 1964 to organize international trade in a way to
benefit economic development. Prebisch was appointed the first Secretary-General of
UNCTAD.

Structuralist economists who worked in the United Nations (e.g. Prebisch, Singer)
and in other international institutions tried to persuade policymakers in the core
countries to support the industrialization efforts of the peripheral countries.

Approaches to development: the dependency approach

The truth is the whole.

G. W. F. Hegel

In the 1960s the dependency approach to underdevelopment arose as a reaction to the

modernization approach, and in criticism of the way import-substituting
industrialization was being implemented in underdeveloped countries. (We study
import-substituting industrialization in the third lecture.) The dependency approach

5
The Dutch disease is observed to have blocked the industrialization of Saudi Arabia, Venezuela
and Brazil (Bresser-Pereira 2020, 645).
6
Notice the dilemma facing developing countries: when they enjoy a boom in the prices of their
commodity exports, their industrialization is thwarted because their manufactured products lose
competitiveness. When they suffer a decline in those prices, their industrialization is thwarted
because their capacity to import capital goods diminishes.
 10

reached the height of popularity in the 1970s. A few outstanding names were Osvaldo
Sunkel, Celso Furtado, Fernando Enrique Cardoso, Paul Baran, Andre Gunder Frank,
Samir Amin and Arghiri Emmanuel. Some people place Raùl Prebisch and Hans
Singer also in this school. The word dependency comes from the Spanish word
dependencia.

Let us first summarize the dependency writers’ critique of the modernization

approach. The dependency approach rejects the construction of stereotypes such as
‘traditional society’ and ‘modern society’. In the dependency view, the description of
‘traditional society’ cannot be based on any concrete social formation, given the wide
variations in pre-capitalist and peripheral social formations. Modernization writers
tended to categorize as ‘traditional’ all pre-capitalist social formations, which range
from ancient Egypt and Mesopotamia to medieval European societies, all the way to
colonized countries and sophisticated social formations such as the Ottoman and
Chinese Empires, and peripheral societies after World War II.

By contrast, the dependency approach does not study underdevelopment by

comparing contemporary underdeveloped and developed societies. It focuses on
studying the historical evolution of underdeveloped societies.

The dependency approach points out that the conditions of underdeveloped

economies of today are not comparable to earlier stages of development of today’s
advanced societies. European countries such as England and France did not ‘develop’
facing political and economic competition and pressure of other states that were much
more developed and more powerful than them.

History shows that underdevelopment is not solely the result of societies’ own
dynamics, but also the consequence of economic relations between countries. The
process of underdevelopment began in the sixteenth century when European
merchants began to create long-distance trade networks, forming a capitalist world-
economy. The formation of the world-economy was fostered by European
colonization of America, Asia and Africa.

According to the dependency approach, capitalism is not a system made up of

independent national socioeconomic units. Capitalism comprises an integrated world-
system. Underdevelopment in some parts of the world is both the result and the cause
-i.e. the mirror image- of the development of capitalism in other parts. The world-
system has created two economic zones: a core (center, metropolis) and a periphery.
The system has an inherent tendency to generate inequality in income and wealth
across countries. This tendency is called the law of unequal development. Trade and
investment activities in the world-economy lead to an accumulation of capital and
wealth in some regions and not in others.

In contrast to what modernization writers assert, dependency writers held that

 11

peripheral societies are not inherently stagnant or static. Peripheral societies are
constantly evolving in the ‘development of underdevelopment’. The economies both
in the core and in the periphery are constantly changing. The economic relations
between core and periphery also change. But unequal economic power relations,
economic dependence, and the underdevelopment of the periphery relative to the core
is continuously reproduced.7

The dependency approach rejects the modernization view that people in peripheral
societies are not rational when they behave differently from people in core societies.
People in peripheral societies can behave differently because they are in different
circumstances from those in the core. For example the risk-averse behavior of
entrepreneurs toward R&D in peripheral societies may be perfectly rational in their
circumstances. Entrepreneurs in peripheral countries are wary of investing in research
and development and in innovation, and prefer to buy licenses from core country
firms to produce manufactured goods, because they know they cannot compete against
the firms of core countries even when they innovate new products. Similarly, peasants
in peripheral countries who are cautious and unenthusiastic when experts try to sell
them new agricultural techniques are often behaving rationally, based on their
previous adverse experiences with experts.

The sustenance of ‘traditional’ economic sectors in peripheral economies is not due

to the resistance of conservative traditionalist segments of society to modern capitalist
production, as modernization writers assert. On the contrary, it is capitalist expansion
that has created the duality in peripheral economies by investing in and boosting the
exports of mining and commercial agriculture. It is international trade and investment
carried out by core country firms that has led to the specialization exemplified by “the
tea plantations of Ceylon, the oil wells of Iran, the copper mines of Chile, and the
cocoa industry of the Gold Coast” (Singer 1950, 476).

The unequal development between periphery and core suggests that an unrequited
transfer of resources from periphery to core takes place. One method of unrequited
resource transfers have been various forms of coercion. Making use of slave labor,
imposing taxes on the populations of colonies and transferring the tax revenues to the
metropolises, using military threat to impose unequal treaties on weak states to force
them to trade are some historical examples of the use of coercion to transfer resources
from periphery to core.8 However, the main channel of unrequited resource transfer
between countries is trade.

7
Note that ‘development’ denotes both (1) a (value-neutral) change or evolution, and (2) a positive
change, an improvement, an unfolding of a potential. The expression development of
underdevelopment plays upon this double meaning. “The development of underdevelopment” was
the title of an article by Andre Gunder Frank (1966).
8
Unequal treaties are trade agreements imposed by core states on peripheral states using military
threat, such as the 1838 Balta Limanı Treaty between the Ottoman State and Great Britain. Such
treaties were imposed on Iran, China, and Korea by European states and on Japan by the US in the
19th century. East Asians coined the term ‘unequal treaties’.
 12

Looking back in history, trade between pre-capitalist societies before the modern period
(e.g. trade along the Silk Road between the Roman Empire and China, trade between
the Islamic Califate and China, trade between the Ottoman State and the Mughal
Empire) did not integrate the economies of these trading countries, and did not create
a division of labor between them. By contrast, beginning in the sixteenth century, long-
distance trade in the capitalist world-system has created and reproduced specialization
and an international division of labor, differentiating countries into core and
periphery.

Dependency theorists hold that in the capitalist world-economy the prices of the
exports of the periphery and the prices of the exports of core countries are so
determined that trade involves an unequal exchange; that is, a transfer of resources
from periphery to core occurs. This transfer is not visible in trade figures. (Structuralist
economists’ analyses of terms of trade deterioration give an idea of this.)

Some dependency writers used classical economic theory to explain unrequited

transfers in trade (Emmanuel, 1969). The idea can be easily summarized. Classical
political economists (Ricardo, Marx etc.) held that demand and supply fluctuations
cause movements in prices of goods, but long-term equilibrium prices are determined
by costs of production. Costs of production are determined by technology, and by the
prices of the factors of production (wages, profits). As capital is mobile between
countries, the profit rates are roughly the same between countries. Therefore, it is
differences in wages that determine the differences in costs of production between
countries.

Now for historical and sociological reasons, real wages in peripheral countries are
lower than those in the core countries. Hence products exported from peripheral
countries are priced below the prices of comparable goods produced in the core. When
trade is balanced in value, the quantity of labor embodied in the exports of the
periphery is more than the labor embodied in their imports from the core.

Arghiri Emmanuel presented evidence for this argument. In core countries per capita
income in agriculture is higher than the per capita income in agriculture in peripheral
countries, because the workers in agriculture in the core demand a higher
remuneration for their labor. In core countries per capita income in manufacturing is
higher than the per capita income in manufacturing in peripheral countries for the
same reason. But Emmanuel also drew attention to the fact that, per capita income in
agriculture in core countries is also higher than the per capita income in
manufacturing in peripheral countries, due to wage level differences.9 Therefore,

9
Using UN statistics Emmanuel calculated that in the underdeveloped countries, product per person
engaged in manufactures increased from $592 in 1950 to $994 in 1970, while the product per person
engaged in agriculture in the advanced countries increased from $1,800 in 1950 to $4,488 in 1970,
and in North America from $3,638 to $8,095 (Emmanuel 1974, 66).
 13

wrote Emmanuel, economic underdevelopment is not due to the relative shares of

agriculture and manufacturing in poor countries, as structuralists thought. Economic
underdevelopment is rooted in the distributional relations in the world-system. So in
the end, this structure allows core countries to import goods containing more labor
than the labor contained in core exports, simply because unit labor costs are cheaper
in the periphery.10 This is the basis of unequal exchange according to Emmanuel.

The dependency explanation of unequal exchange is based in the labor theory of

value. It is not necessary to accept the labor theory of value, to see that some
unrequited transfer is occurring in trade. Five centuries of increasing global trade has
led to relative impoverishment in peripheral countries and to prosperity in the core
countries. Moreover, for centuries, the states of core countries have exerted pressure on
or forced peripheral states to open up their economies to trade. Such circumstantial
evidence suggests that trade between countries can cause uneven development,
benefiting some more than others.

Another unrequited transfer of resources from periphery to core has been the ‘brain
drain’. This is the migration to core countries of people educated in public institutions
funded by tax revenues in peripheral countries.

According to dependency writers, the law of uneven development operates not only
between countries, but also between regions within countries. It also operates between
cities, towns and rural hinterlands. Capitalist economic activities result in transfers
of economic resources from village to town, from town to city. For example, the south
of England is richer than the north, northern Italy is more affluent than the south, the
average incomes in the coastal provinces of China are higher than in the interior
provinces and the coastal states of the US are richer than the states in the interior.

Dependency writers provided evidence for these ideas from their empirical historical
research. They showed that Latin American societies were able to make attempts at
autonomous economic development whenever their trade with developed countries
was disrupted. Latin American countries experienced autonomous capitalist
development during the Napoleonic period when Europe was mired in wars, and
during World War I, and during the Great Depression and during World War II. The
Great Depression had a similar effect on Türkiye. Türkiye was able to embark on
state-led industrialization in the 1930s thanks to the Great Depression in the core
countries.

It is worth noting that the stark differences in welfare between rich and poor countries
(recall Table 1.6) is partly related to the fact that the capitalist world-system is

10
Unit labor cost is the labor cost of producing one unit of a good. It can be written as the money
wage of a unit of labor divided by quantity of production done by a unit of labor. If W is TL/worker-
month, and P is the number of units of the product produced by one worker in one month, then unit
labor cost is equal to W/P (TL/unit product).
 14

organized in territorial states with borders that prevent free migration. In prevalent
political thinking, states have the right to control immigration. This appears logical.
But if there were no obstacles to migration, it is probable that the differences in per
capita GDPs between countries would be much reduced.

Economic dependence

Samir Amin described the structure of dependence in books and articles he published in
the 1960s and 1970s.

According to Amin, the economies of the core countries exhibit autocentric

development, i.e. the evolution of their economies is determined by domestic
technological development and domestic class struggles. Hence, the business cycles in
core countries are generated within their economies.

Core economies are able to produce the consumer goods, capital goods and
intermediate goods they need. Hence core economies are articulated: that is, largely
self-contained.

The steady growth of labor productivity in the core economies makes it possible for real
wages to rise with increases in productivity. In fact, real wages in the core were
increasing in tandem with increases in productivity. (This held true until the 1980s).

In core countries, the state is national in character, because it supports autocentric

development in the economy. The core state uses its political and military power to
coerce weaker states into accepting economic relations that serve the requirements of
capital accumulation in its own (the core) economy. Autocentric accumulation and
socioeconomic policies mitigate class conflict in the core countries, and ensure
political stability which allows democratic processes to work. (This observation too
has been losing relevance since the 1980s.)

By contrast, economic development of the periphery is not autocentric. The peripheral

countries do not have the technology and the capital to produce all the goods
(especially the investment goods) they need, so they have to import such goods.
Therefore, the articulation of the peripheral economy is underdeveloped. The
peripheral economy has to export whatever it can to earn the foreign exchange
necessary to import investment and other goods.

How does dependence work in time? In periods when the core economies enjoy high
GDP growth rates in the upswings of their business cycles, their imports from the
periphery increase. Prices of primary commodities rise. Then the peripheral countries’
export earnings increase; they are able to import greater quantities of investment
goods, and they also enjoy high GDP growth rates. Furthermore, when the core
economies enjoy high GDP growth rates, capital flows (loans, investment, aid) to the
 15

periphery also increase, enabling peripheral countries to run trade deficits.

But when GDP growth rates in the core decline, their imports from the periphery
decrease. The prices of primary commodities fall. Then peripheral countries’ export
earnings fall, their capacities to import investment goods diminishes and their GDP
growth rates decline. In such periods capital flows from the core to the periphery also
dwindle, or can even be reversed: the peripheral countries may be obliged to repay
external debts. Peripheral economies do not generate their own business cycles
because their growth rates are conditioned by the growth rates of the core countries
(See Figure 2.1). This is one aspect of the economic dependence of peripheral
countries on the core.

In addition, under free trade, the sectoral growth pattern of the peripheral country,
its sectoral structure, is determined by competition from the exports of firms of core
countries and their foreign direct investment decisions.11 This is another aspect of
economic dependence.

This economic dependence is reflected in international relations. Samir Amin argued

that in the periphery, states generally cannot pursue their national interests. The role
of the peripheral state is to manage the economy according to the exigencies of capital
accumulation in the core. The state in the periphery cannot conduct policies for
national accumulation. When a peripheral state pursues independent economic
policies that do not accord with the interests of the core countries, it is exposed to the
threat of destabilization through political pressure, economic sanctions and even
military interventions by core states.12 Sanctions on and interventions in peripheral
countries aim at changing a policy, or at removing officials from their positions or
even at changing the regime.13 Hence, states in peripheral countries are the locus of
struggles between national and foreign interests and between domestic classes.

11
“How can a national government make an economic plan with any confidence if a board of
directors meeting 5,000 miles away can by altering its pattern of purchasing and production affect in
a major way the country’s economic life?” wrote George Ball, US Under Secretary of State for
Economic and Agricultural Affairs in 1961-1969 (Olson 1979, 481).
12
Sometimes core country corporations also play a role in such interventions. For example the
involvement of the American International Telephone & Telegraph Inc. (ITT) in the overthrow of
president Salvadore Allende in Chile in 1974 is well-known (Paul et al. 1985, 10). ITT had an
interest in Chile’s copper reserves.
13
“ The illegal US-led invasion of Iraq … was driven by US offense at Saddam Hussein’s
independence, his friendliness to Russia, and his threat to accept non-dollar payment for oil. That
threatened dollar hegemony, which is a pillar of US economic and geopolitical power. …
“2011 US-led military intervention in Libya …was driven by US offense at Gaddafi’s long-standing
independence, friendliness to Russia, and potential openness to non-dollar payments for oil. That
reality was cloaked with appeals to public opinion re punishment for the 1988 Libyan sponsored Pan
Am Lockerbie bombing, even though Libya had paid compensation and the lead perpetrator had been
convicted years earlier” (Palley, 2024).
 16

Figure 2.1

GDP growth rates (%)

10

0
Country/Series-…
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
2017
2019
2021
2023
-2

-4

-6

Advanced economies Gross domestic product, constant prices Percent change Units

Emerging market and developing economies Gross domestic product, constant

prices Percent change Units
Source: Chart based on data from IMF World Economic Outlook April 2024 database.
(04.10.2024)

Especially in low income countries where a large part of fiscal revenue is provided
by official foreign aid, the government feels more accountable to foreign donors than
to the tax-paying population.

On the other hand, there are some peripheral countries where both GDPs and fiscal
revenues are largely dependent on the export earnings from a natural resource-based
primary commodity such as petroleum. Such states are called ‘rentier states’. In such
countries the population cannot easily hold the government accountable for the
performance of the economy, because state revenues and GDP growth depend on
demand for the primary commodity and its price in international markets. The
economic dependence of such peripheral countries on conditions abroad obstruct the
development of democratic political systems wherein officials can be held to account
for the performance of the economy.

Dependency writers describe how economic relations with the core states nurtures a
social group in peripheral societies who prosper from the dependence relationship.
For example, in Latin America, formerly these were big landowners who were
producers and exporters of primary commodities and merchants in the export-import
business. After World War II, as foreign companies penetrated these countries with
investments, this social group came to include industrialists and managers and even
some of the working class.

In some peripheral countries, governments that have weak support from the domestic
population have to rely on foreign support to remain in power; so they are careful to
 17

protect the interests of foreign powers. Such peripheral states are potentially
repressive against their own populations. With no state to defend national interests,
the formation of the nation is weak in the periphery. In the words of Osvaldo Sunkel:
“International integration leads to national disintegration.”

Naturally the characterization of core economies as ‘articulated’ held more for larger
core countries such as the US, Japan, Germany, the UK, than for smaller core
countries such as Denmark, Switzerland and the Netherlands, which are more open
and more dependent on foreign trade. The observation that ‘core economies are
articulated’ does not mean that each core economy produces all or most of the final
goods it needs. It means that each core economy is technologically capable of
producing whatever intermediate goods and final goods it needs. The specialization
of core country economies in particular manufacturing industries is a matter of choice,
not due to technological or financial constraints. For example, the small core countries
mentioned above do not have car brands of their own, but these countries have the
capacity to design and produce their own cars that could compete with any others.

After globalization

The description of core economies as being articulated held true for the major core
economies for roughly 30-40 years in the post-World War II period. This description
gradually became less relevant due to the increasing relocation of manufacturing
production to peripheral countries by core firms after the 1980s. (We study this
globalization of manufacturing in the fifth lecture.) As these aspects of the world
economy changed, Samir Amin began in the 1990s to characterize the core as the
group of countries exercising global domination and control in five areas: technology,
finance, natural resources, mass communications and military power. The following
is a summary of this description.

The core countries have a superiority over peripheral countries in technology. They
have skilled labor, and attract skilled labor from other countries to do research and
development. The core countries have the financial means to invest in research in
science and technology. The core countries maintain their global control over
technology through enforcement of intellectual property rights.

The core countries dominate global financial activities. The biggest financial private
institutions in the world are located in and owned by shareholders in the core
countries. The currencies of the core countries (dollars, euros, yen, pound etc. i.e. the
reserve currencies) and financial assets denominated in those currencies, are
considered the safest assets to store wealth in. Hence the financial systems of the core
countries attract and control the allocation of most of the financial savings of the
world. Moreover, core country states dominate the governing bodies of international
 18

financial institutions.14

The monopoly of core countries over technology and financial resources enable their
firms to control the exploration for and exploitation of much of the natural resources
on the planet. The biggest mining and petroleum companies belong to shareholders
in core states. Core country states make sure that their firms are able to access the
natural resources in peripheral countries, in the seas and in the Arctic regions.

The monopoly of core countries over technology and financial resources also enables
their firms to control mass communications in the world. They control the internet,
the biggest news networks and the most influential media organizations. Thanks to
this control, core countries have an inordinate power to shape public opinion in the
world.15

Technological superiority and overwhelming financial resources also provide core

countries with immense military power (including stockpiles of weapons of mass
destruction), which is the ultimate instrument for maintaining the world political
order.16

Delinking

Dependency writers saw little hope for autonomous development as long as poor
countries remain within the periphery of the system and are exposed to the law of
unequal development. Hence, if the government of a peripheral country aims to
pursue a pattern of sectoral growth that it considers to be in the national interest, i.e.
if it aims at establishing ‘national control over accumulation’, it has to reduce the
influence of the law of unequal development of the world-system on the country
(Amin 1986,18). This strategy is called delinking (or decoupling or dissociation).

Delinking involves disconnecting the “rationality of the economic choices made in

the country from the rationality that governs the world system”. The criteria of
resource allocation that governs the world-system are profitability, efficiency and
comparative advantages. Economic policies based on these criteria serve to sustain

14
The control of core country states over global financial resources and activities is visibly
exercised when financial sanctions are imposed on individuals, firms and states that do not comply
with the policies of the core states.
15
Mass media organizations in core countries propagate the view that the policies that serve the
interests of the core also serve the interests of peripheral societies.
Control over mass communications ensures a hegemony producing a ‘false consciousness’ among
subordinate groups, such that the subordinate groups accept the systems that oppress them (Daniel
2012, 716).
16
Vietnam, Afghanistan, Iraq and Libya are some of the countries where the US armed forces or
US-led military coalitions have intervened with the aim of changing the regime in the post-World
War II period. There is a larger number of CIA-organized political interventions. (See the wikipedia
article entitled ‘United States involvement in regime change’).
 19

unequal development in the system. Economic development in a peripheral country

necessitates adoption of different economic criteria based on national priorities
(Amin, 1986: 19). Thus, delinking necessitates strengthening national control over
external economic relations: trade, financial flows and direct investment by foreign
companies.

Amin emphasized that delinking need not lead to a reduction of trade. Delinking does
not mean autarky. The necessary degree of openness (trade to GDP ratio) of a
genuinely developing economy is related to the size of the country, its resource
endowments, and its dependence on imports of capital goods. However, delinking
does imply implementing strategic trade and financial policies: a selective integration
into the world-economy.

Amin and some other dependency writers believed regional economic cooperation
among peripheral countries and increased South-South trade would facilitate
delinking.

World-Systems Theory

In the 1970s another school of research akin to the dependency approach emerged. It
is known as world-systems theory. The writers in this movement modified the core-
periphery description by positing a three-layered world system hierarchy: core, semi-
periphery and periphery. The prominent name in this school is the American
sociologist Immanuel Wallerstein.

In this description, the core absorbs resources from the semi-periphery and the
periphery. The semi-periphery absorbs resources from the periphery. The semi-
periphery is a kind of economic buffer region between core and periphery in the
world-economy, and also functions as a political buffer. According to world-systems
theorists, throughout the history of capitalism there have been countries that seem to
occupy an intermediate position between the most affluent countries and the most
impoverished countries in the economic and political hierarchy. Brazil, China, Russia,
Malaysia, Türkiye may be a few contemporary examples.

The middle income countries in the World Bank’s classification (the so-called
‘emerging markets’), which today are the major recipients of foreign direct
investment from core countries, appear to occupy a middle place between the core
countries and the low income countries. They may be designated as the semi-
periphery according to the world-systems approach.

Concluding remarks

To conclude, in this lecture we have summarized various explanations offered in the

1950s, 1960s and 1970s for underdevelopment. In that period the modernization
 20

writers encouraged strengthening cultural, political, economic ties between the

‘advanced’ countries and the ‘developing’ ones in order to modernize the latter.
Modernization of the economy and industrialization would take place as a matter of
course. Structuralist economists and dependency writers had a different view. These
writers encouraged states in the periphery to pursue autonomous economic policies,
to try to diversify their economies.

After the 1970s, policymakers and intellectuals in peripheral countries turned away
from the ideas of breaking free of economic dependence. Interest in structuralist
economics and dependency analyses waned. Yet the tables in Lecture 1 suggest that
the economic hierarchy among nations is not disappearing. There are writers who
argue that the tools of structuralist economics and of the dependency approach are
still relevant for understanding the world (Fisher, 2015).

Sources for the lecture

Amin, Samir. 1976. Accumulation on a World Scale. New York. Monthly Review Press.
Amin, Samir. 1986. La déconnexion: pour sortir du système mondial. Paris. Editions La Découverte.
Amin, Samir. 1997. Capitalism in the Age of Globalization. London. Zed Books.
Bresser-Pereira, Luiz Carlos. 2020. New Developmentalism: development macroeconomics for
middle-income countries. Cambridge Journal of Economics. 44. 629-646.
Daniels, Shepard. 2012, Situating private equity capital in the land grab debate. The Journal of Peasant
Studies. 39(3-4). July-October. 703-729.
De la Barra, Ximena. 2010. Sacrificing Neoliberalism to Save Capitalism: Latin America Resists and
Offers Answers to Crises. Critical Sociology. 36(5). 635-666.
Emmanuel, Argiri. 1969. L’échange inégal: Essais sur les antagonismes dans les rapports
économiques internationaux. Paris: François Maspero.
Emmanuel, Arghiri. 1974. Myths of Development versus Myths of Underdevelopment. New Left
Review. I/85. May-June. 61-82.
Frank, Andre Gunder. 1966. The Development of Underdevelopment. Monthly Review. September
1966.
Fischer, Andrew. 2015. The End of the Peripheries? On the Enduring Relevance of Structuralism for
Contemporary Global Development. Development and Change.
Hadass Yael S., Jeffrey G. Williamson. 2002. Terms of Trade Shocks and Economic Performance
1870-1940: Prebisch and Singer Revisited. Harvard University. 2/2002.
Kay, Cristobal, Robert N. Gwynne. 2000. Relevance of Structuralism and Dependency Theoriesin the
Neoliberal Period: A Latin American Perspective. Journal of Developing Societies. 16(1).49-69.
Olson, Richard Stuart. 1979. Economic Coercion in World Politics: With a Focus on North-South
Relations. World Politics. 31(4) July. 471-494.
Palley, Thomas. 2024. Europe’s foreign policy has been hacked and the consequences are dire.
Economics for Democratic and Open Societies. February 13, 2024.
https://thomaspalley.com/?p=2402aspalley.com/
Paul, Karen and Robert Barbato. 1985. The Multinational Corporation in the Less Developed Country:
The Economic Development Model versus the North-South Model. The Academy of Management
Review. 10(1). January. 8-14.
Portes, Alejandro. 1976. On the Sociology of National Development: Theories and Issues. American
Journal of Sociology. 82(1). 55-85.
Rostow, W. W. 1960. The Stages of Economic Growth: A Non-Communist Manifesto. Massachusetts:
Cambridge University Press.
Singer, H. W. 1950. The distribution of gains between investing and borrowing countries. American
Economic Review, Papers and Proceedings. 40(2). 473-485.
Sonntag H. R., M. A. Contreras, J. Biardeau. 2001. Development as Modernization and Modernity in
Latin America. Review. XXIV(2). 219-251.
Waterbury, John. 1999. The Long Gestation and Brief Triumph of Import-Substitution
Industrialization. World Development. Vol. 27. No. 2.
 1

Development Economics Lecture 3

17.10.2024

logic of import substitution – implementation – results

Import substituting industrialization

In the post-World War II period structuralist arguments against specialization in the

exportation of primary commodities and the influence of dependency thinking led to the
conviction that industrialization was a necessary step in the economic development of
peripheral countries. Industrialization would proceed by investment in manufacturing
sectors, creating and expanding the capacity to produce substitutes for imported
manufactured goods.

Import substituting industrialization has a long history. Examples of attempts to establish

domestic manufacturing of goods that were currently imported can be traced to the 16th
century. In the 16th century, English rulers strove to develop English woollen cloth
manufacturing, in competition against woollen imports from Flanders. In the sixteenth and
following centuries, potters in Holland, the Ottoman state and Japan strove to reproduce the
porcelain products imported from China. After the Industrial Revolution in Great Britain in
the late 18th and early 19th centuries, many states undertook to develop their manufacturing
industries similar to those of Britain. Some states in Europe, the US and Japan succeeded.

Some Latin American countries had experienced spontaneous import substituting

industrialization during the two world wars and during the Great Depression. These
countries did not participate in the wars, but their economies were affected by the wars and
the Depression. Their spontaneous industrialization was induced by the difficulties in
exportation of primary commodities and in importation of manufactured goods in these
periods, and was facilitated by the fact that the core countries were not in a position to
interfere in the economic policies of these countries.

Spontaneous import substituting industrialization occurs when external constraints on

importation in a country lead to shortages of imported goods and cause their prices to rise,
so that domestic entrepreneurs find it feasible to produce the imported goods locally. It is
called spontaneous because the state is not involved in the process. Spontaneous import
substitution was also experienced in Türkiye in the latter 1950s. In that period Türkiye
experienced balance-of-payments difficulties resulting in shortages of imported
manufactured goods. This induced firms such as Koç and Sabancı, which were big family
firms with capital accumulated from commerce and agriculture, to invest in manufacturing,
although the governments at that time had no aim or policy to industrialize the country.

After World War II, economists believed that planned state-led import substituting
industrialization would be better organized and more rapid than spontaneous processes
prompted by bottlenecks in importation.
 2

This industrialization was to be accomplished in stages: first, substitution of basic

consumer goods imports; next, substitution of intermediate goods and durable consumer
goods imports, and finally, substitution of capital goods imports.

The industrialization process had to rely on support from the state in the form of incentives
to private capitalists to invest in manufacturing. These were mainly: selective temporary
protection of the internal market for incipient manufacturing industries, tax advantages,
public construction of infrastructure and social policies to expand internal markets.

The import substituting industrialization (ISI) strategy entailed more than just expansion of
manufacturing. ISI was also expected to yield social change. In Latin America the advocates
of the strategy expected it to be supported by an alliance of most social classes - excluding
the landed oligarchy which did not have an interest in diversifying the economy. An
industrialist class was to be created, a class that would counter the political power of
landowners and importer merchants.

Creating an industrial bourgeoisie from the ethnically dominant group was also an objective
in some countries such as Malaysia, where ethnic minorities were dominant in the economy.

Moreover ISI was also expected to help develop the administrative capabilities of the state:
“Progressive Latin Americans had long hoped that industry would introduce new, much
needed disciplines into the behavior of their governments. The very nature of industrial
operations - their precision, the need for exact timing, punctuality, reliability, predictability,
and all-round rationality -was expected to infuse these same qualities into policy-making
and perhaps even into the political process itself” (Hirschman 1968, 12).

Export pessimism
Irak yere tacirler
Assı için varırlar
Çün gevher elimdedir
Irak ne bazarım var
Yunus Emre1

The term ‘import substitution’ implies that the industrialization was aimed at satisfying
domestic demand for manufactured goods. But why was priority given to satisfying
domestic demand?

One answer was: Production for domestic markets seemed to be a characteristic of

modern economies. It should be recalled that, in the post-war period (i.e. before the
globalization of manufacturing production after the 1970s), the larger core countries were
relatively closed economies compared to today. Table 3.1 shows the low proportion of
foreign trade to GDP in1970 in major core economies (the World Bank does not give these

1
The 13th-century sufi poet says: merchants travel to faraway places / in search of profit / as I already
possess the gem / what need have I for distant markets.
 3

figures before 1970).

Exports of goods and services plus imports of goods and services as percentage of GDP is
a measure of the ‘openness’ of an economy to trade. Since policymakers in developing
countries were taking the characteristics of larger core countries as goals to be attained, it
seemed that development involved the internal articulation and integration of the national
economy.

Table 3.1
Exports of goods and services plus imports of goods and services
as percentage of GDP
1970 1980 1990 2000 2010 2019 2022
France 31 44 43 56 55 64 73
Germany 32 42 46 62 80 88 100
Japan 19 27 19 20 28 35 47
United Kingdom 43 51 48 53 59 65 70
United States 11 20 20 25 28 26 27
world 25 41 38 47 57 56 62
Source: World Bank. World Development Indicators. (01.03.2024)

Moreover, in the first decades following World War II, there was a general export
pessimism regarding the expansion of world trade. This pessimism was a result of the
experience of the Great Depression. In that period world trade had contracted, due both
to the decline in aggregate demand in the depressed countries, and also to the protective
measures against imports taken by states in an attempt to protect domestic employment.
Furthermore, Keynes had argued in The General Theory of Employment, Interest and
Money (1936) that capitalist economies are prone to periods of low economic activity - if
governments did not manage aggregate expenditures. This view bred pessimism with
regard to the growth of world trade. So with memories of the collapse of world trade in the
1930s still fresh in their minds, policymakers in the 1940s and 1950s contemplating how
industrialization should be conducted did not think it was realistic to rely on the expansion
of export markets.
In 1963 Prebisch wrote:
“Until recently, circumstances did not favour expansion of foreign trade. In the years in which
the effects of the Great Depression and the post-war period -not to speak of the Second World
War itself- were still making themselves felt, there was no reason to think that the major
industrial countries would open their doors to peripheral manufactures, or that the Latin
American countries would be prepared to strive for a foothold in the external market, so long
as easy import substitutions offered them a growing and reliable internal market, protected
against imports in every possible way. Hence, there was no vital need to export industrial
goods” (Prebisch 1963, 71).

This alludes to the protectionis policies of the core countries. Another reason for export
pessimism was the awareness that the products of newly established industries could not
compete in foreign markets in price or quality against their substitutes produced in the core
countries.
 4

Export pessimism was exacerbated by the fact that the US had replaced the UK as the new
hegemon after the war. The UK, the hegemon throughout the 19th century, was an open
economy (it had been a major importer of primary commodities). The US was a relatively
closed economy, due to its rich endowment of natural resources, and a tradition of
protecting its manufacturing industries. This change of the main core trading partner for
developing countries did not raise hopes for the expansion of their exports, whether they be
manufactured or primary commodities (Kay 1989, 37).

However, the proponents of import substituting industrialization were not opposed to the
exportation of manufactured goods. Manufactured goods should be exported (if possible)
when there was a surplus of production of manufactured goods over domestic demand. It
was expected that import substitution was eventually to be followed by export substitution:
manufactured exports were to gradually replace mining and agricultural exports. This was
to be achieved as the new ‘infant’ industries gained experience and eventually became
competitive in price and quality of their products.

Gaining experience i.e. the learning process would take time. Hence newly established industries
had to be protected from the competition of the manufactured exports of developed countries
in the domestic markets until these industries became competitive in conditions of free
trade. This argument for the protection of infant industries had been developed by the
German economist Friedrich List in the 19th century for Germany’s industrialization. That
was when Great Britain was the sole industrialized country in the world, and continental
European countries and the United States were striving to develop their manufacturing
industries.

Industrialization was expected to eliminate both the low level of ‘capital accumulation’ in
manufacturing in peripheral countries, and their lags in technology, compared with the core
countries. The technological gap was reflected in insufficiency of people competent in
engineering and management of manufacturing, in the low number of patents, in the lack
of research institutions and technical education.

The economists who formulated the ISI strategy saw importation of capital goods as the
solution to the technological gap. When equipment embodying sophisticated technology
was imported, installed and operated by the domestic workforce, it was assumed that a
technology transfer had taken place. As for the capital accumulation -investment-
deficiency, it was to be solved by either raising the domestic saving rate, or else by making
use of foreign savings (foreign investment, foreign aid and foreign loans).

There was an alternative strand of import substituting industrialization implemented in the

Union of Soviet Socialist Republics in the 1930s. The Soviet government gave initial
precedence to investment in heavy industries, i.e. intermediate goods such as iron, steel and
chemicals, and capital goods such as machinery and transportation goods.
 5

In comparison to peripheral countries in the post-war years, in the 1930s the USSR had an
advantage: it did not have a substantial technological gap with the core countries, and it
eliminated the gap with an emphasis on technical education. But the USSR was largely an
agrarian economy with a small manufacturing sector. The Soviet governments solved the
capital accumulation problem in the 1930s by concentrating most of their manufacturing
investment in the intermediate and capital goods sectors, and allocating a small share of
investment to the consumer goods sectors. This investment strategy kept the growth rate of
consumer goods production low. The low growth of consumer goods production resulted
in high levels of domestic saving. This strategy realized a high rate of manufacturing
capacity growth. This industrialization enabled the USSR to prepare for war against
Germany.

Industrialization policies

The policies implemented in import substituting industrialization typically included the

following.

The most important policy instrument was protection. States protected the newly
established manufacturing industries from imports in the domestic markets. This protection
was to be temporary, because it was based on the infant industry argument. The tools of
protection were high tariffs on imports or restricted quotas on importation of goods for which
domestic substitutes now were produced locally; low tariffs on imports of capital goods and
of intermediate goods for the new manufacturing establishments, or their duty-free
importation.

It was acknowledged that such protection would incur costs to consumers, because
consumers had to pay higher prices for and to bear the inferior quality of the products of
the new domestic manufacturing industries, in comparison to imported substitutes. But
these costs were justified as a social investment -a sacrifice- which would yield social benefits
later on.

States implemented capital controls in order to keep exchange rates fixed.2 In many
countries central banks implemented multiple exchange rates: central banks would apply
preferential lower exchange rates when selling foreign currencies to the importers of
intermediate goods and of capital goods for the newly established industries, compared to
the exchange rates implemented when the central bank sold foreign exchange to importers
of non-essential goods and to purchasers of non-essential services (e.g. tourism abroad).

2
We shall study capital controls in a later lecture. Capital controls meant that international private financial
transactions (depositing money savings abroad, purchasing bonds and shares abroad, giving bank loans
abroad, accepting money deposits from abroad, allowing non-residents to purchase domestic bonds and
shares, borrowing from foreign banks) were restricted or prohibited. These restrictions were aimed at
strengthening central bank control over exchange rates and making sure that scarce foreign currency
earnings would be used for imports necessary for industrialization. These restrictions also enabled the
governments to manage interest rates to promote industrialization.
 6

States also utilized financial policies for industrialization. These included state-regulated
low lending rates of banks for investments in priority sectors. States imposed guidelines in
the allocation of bank loans in favor of projects to carry out investment in priority sectors.

States also applied fiscal policies which promoted priority industries through preferential
tax treatment and subsidized public services. Notably among the preferential tax policies,
‘investment tax credit’ allowed the firms that undertook investment in manufacturing to
deduct their investment expenditures from their taxable profit incomes.

All these policies aimed at enhancing the profitability of private investment in

manufacturing. They were designed according to investment targets with specific sectoral
production targets in development plans. In different countries plans spanned 4, 5 or 7 year
periods.

Planning the investments in manufacturing was deemed necessary because some investment
projects are complementary. If in a region or in a country, several manufacturing industries
are built at the same time, each may contribute to the rate of return of the others by generating
increasing the demand of newly employed workers for consumption goods, or by generating
a demand for intermediate goods. In the absence of planning, calculations of the private rate
of return to each project in itself may not justify the investments, so these projects will not
be realized by private initiatives on their own. This was the justification for coordinating
private investments through state planning.

Economic planning was also needed to achieve balanced growth among sectors. There was
a need for balance in the growth of industries and in the growth of agriculture, as rising
incomes of workers in industries would increase demand for food, which meant that
bottlenecks in food supply had to be prevented by planning agricultural growth.

In many developing countries the state encouraged foreign direct investment in

manufacturing. However states frequently imposed certain conditions on foreign firms.
For example the state would require that the foreign venture use locally-produced
intermediate goods in order to boost domestic industries producing intermediate goods; or
that the foreign venture export some of its production so that the investment was not a
burden on the trade balance; or that the foreign venture should employ some minimum
percentage of local workers and administrative staff for them to learn technologies and
acquire managerial skills . A research paper of 1981 reported that US multinational
companies were as likely to be subjected to performance requirements, as to benefit from
incentives to invest in underdeveloped countries. “Of 23,641 United States-based MNCs in
LDCs [Less Developed Countries] (banking affiliates excluded) surveyed by the US
Department of Commerce in 1977, 27 percent reported investment incentives and 29
percent reported performance requirements by which LDCs aim to shape MNC activities
so as to make progress toward national goals” (Paul et al. 1985, 12).
 7

In some countries, policies were implemented to increase the purchasing power of the
working people so as to expand domestic demand for manufactured goods. For example in
Türkiye, the right of workers to form trade unions and to strike was enshrined in the 1961
constitution.3 Throughout the 1960s and 1970s, the Turkish social security system was
expanded to include a greater number of groups (farmers, self-employed etc.). State-owned
economic enterprises implemented generous wage policies that put pressure on private
companies to raise their wages. Finally, in Türkiye, the state implemented price support
schemes for many agricultural products, so these prices were not left to the mercy of
wholesale merchants or ‘market forces’. Thanks to the agricultural price support policy,
farmer families could afford to purchase manufactured consumer goods, as well as
agricultural equipment and inputs (Boratav, 1983).

In most countries implementing the import substituting industrialization strategy, the state
itself also carried out investment in manufacturing and other sectors. “At one time the
Brazilian public sector handled about half the gross domestic product and represented
nineteen out of the twenty largest companies, while in Mexico it employed a fifth of the
total workforce and paid two fifths of the national wage-bill” (Hobsbawm 1996, 351).

In sectors where capitalists did not have the resources to undertake large-scale projects, the
state carried out such investment itself through state-owned enterprises. The state used its
capacity to allocate the large investment funds from public revenues, and to take the risks
of large-scale investment projects which private entrepreneurs would not undertake.

Another justification for state investment in manufacturing was promoting the economic
development of poorer regions. Some investment projects can have external benefits for
an underdeveloped region, benefits which are important for social or political reasons.
Private firms will not consider such external benefits, as these are not reflected in profits.
Hence such projects had to be undertaken by the state.

Results of industrialization policies

The major results of ISI were that the share of manufacturing industries in GDP expanded
in the countries implementing the strategy. The share of manufacturing in employment also
increased, accompanied by migration from countryside to cities and urban growth.

However, as early as the 1960s there was a concern among some development economists
that ISI was encountering certain difficulties common to many peripheral countries
implementing it.

One problem was a lack of progress in vertical integration in manufacturing (developing

backward linkages in manufacturing) in these countries. Private industrialists producing
manufactured consumer goods were content to use imported intermediate goods and

3
The 1961 Constitution in Türkiye also stipulated socio-economic planning. Import substituting
industrialization under comprehensive plans in Türkiye began in 1961.
 8

imported capital goods. Their profits depended on protection for their own final products,
together with low tariffs on the imported intermediate and capital goods. Hence
manufacturers of consumer goods were inclined to resist domestic production of the
intermediate and capital goods they used, knowing that if these goods were produced
domestically, they would also enjoy protection, making them more costly than imported
intermediate and capital goods. Manufacturers of consumer goods also considered that the
intermediate and capital goods that could be produced in the country would be of inferior
quality compared to imported ones. So import substituting industrialization in the private
sector emerged largely as production of consumer goods, dependent on imports of imported
intermediate goods.

Türkiye is an example. Here private manufacturers concentrated on producing consumer

goods, largely by assembling imported components.4 It was mainly the state that carried
out large investments in basic intermediate and capital goods such as iron and steel, metal
products, chemicals and machinery, thus realizing some vertical integration in
manufacturing. (State-owned enterprises in Türkiye also produced low-cost basic consumer
goods such as garments, leatherware and processed food.)

There were a few countries where the state pressed manufacturers to develop backward
linkages.

It has been in fact due to the regulations issued by the tecnicos of the Kubitschek
administration that backward linkage was enforced rapidly in the Brazilian automotive
industry in the late fifties. In Mexico, on the other hand, assembly plants had existed for
decades without any progress being made toward the local manufacture of motors and parts
until measures similar to those of Brazil were adopted in the sixties. Thus the resistance of the
initial industrialists to the backward linkage combine with other already noted characteristics
of late late industrialization to enhance the potential contribution of public policy to the
progress (Hirschman 1968, 19).5

State pressure on private industrialists to achieve vertical integration was not a component
of import-substituting industrial policies as applied in most countries. Even the
exceptional examples of Brazil and Mexico refer to its application in only one industry.

A second problem of import substituting industrializing countries was the failure to

achieve competitiveness in price and quality against the goods manufactured in core
countries. Gaining competitiveness in price requires reducing the costs of production.
Costs of production depend (among other things) on the scale of production, on producing

4
In student demonstrations in Türkiye in the late 1960s a slogan that appeared frequently on placards was
“Montaj sanayiine hayır!” [“No to assembler industries!”] indicating students’ awareness of and objection to
the superficial industrialization going on in the private sector.
5
By “late late industrialization” Hirschman is referring to the industrialization efforts after the Second
World War, in contrast to the industrialization of countries like Germany and the US which he calls “late
industrialization”.
 9

at the minimum efficient scale.6 The difficulty here was that modern manufacturing
equipments are designed in core countries, with the scale of production planned with their
own large domestic markets in mind. So in many sectors, there was a discrepancy between
minimum efficient scales -as determined by modern manufacturing equipment- and the
size of domestic demand for those goods in developing countries. So limited domestic
markets prevented the realization of economies of scale in manufacturing, and the inability
to realize economies of scale was an obstacle to achieving price competitiveness against
the manufacturing industries of the core countries.7

One may ask: did the earlier industrializers not face the problem of limited markets? In the
19th century the newly developing manufacturing industries in continental Europe and in
North America benefited from the increasing demand of their rural populations for
manufactured consumer goods and for manufactured agricultural inputs, the use of which
helped raise agricultural production and increase farmer incomes. In European countries
this virtuous circle (mutually reinforcing growth of manufacturing and of agriculture) was
based on a relatively even distribution of landownership, i.e. on an agriculture based
largely on small family farms. In the United States the expansion of rural markets for
manufactures was also facilitated by the settlement of white farmers on indigenous lands
in the west of the country.8

By contrast in many developing countries (e.g. in Argentina, Brazil etc.) ownership of land
was concentrated in the hands of a small wealthy class. In these countries land reform -
redistribution of land- was needed to increase rural incomes and boost demand for the
products of the new industries. Land reform was implemented in very few countries.

Due to the inability to become competitive against the goods manufactured in the core
countries, the protection of infant industries that was intended to be temporary became
permanent. As early as 1958, Hans Singer was lamenting “the difficulty of terminating
protection given to infant industries” and that “there is the ever-present danger that
‘nothing is so lasting as the provisional’” (quoted in Ho 2012, 877).

Ultimately, in the policy mix implemented in import substituting industrializing countries

there were few incentives for manufacturers to increase locally produced intermediate
goods (to increase the local content) in their products, to improve the quality of their
products, or to make their products price-competitive in foreign markets. The
manufacturers enjoyed the profits they made under permanent protection from external
competition. They faced no pressure from the state to make their products more
competitive. This impasse can be attributed to the influence of these manufacturers over

6
The lowest point on the long run average cost curve.
7
For this reason Prebisch recommended that import substitution be implemented “within groupings of
countries” so that capital and intermediate goods industries would be established and integrated on a
regional basis. He observed that there was little trade in manufactures among Latin American countries, and
was critical of the industrialization implemented in “water-tight compartments” in national economies (Ho
2012, 874, 876-877).
8
Involving forced expulsion and massacres of Native Americans.
 10

government policies, to the political economy of import substituting industrialization in

peripheral countries.

So with the expansion of manufactured goods production dependent on imported

intermediate and capital goods, the balance of payments in countries implementing import
substituting industrialization remained fragile. As the importation of manufactured
consumer goods declined with the progress of industrialization, imports of intermediate
goods and capital goods rose (including spare parts for the installed capital goods), while
exports still largely comprised primary commodities.

The problem of lack of price competitiveness due to low volumes of production might
have been mitigated through exportation of the manufactured goods. The problems of high
cost and low quality might have been mitigated by undervaluing the currency (you can sell
low quality goods if you make them cheap enough). But under the fixed exchange rate
system, exchange rates were not frequently adjusted to balance trade. So the exchange
rates of peripheral countries tended to rise in real terms most of the time, because inflation
rates in those countries were typically higher than inflation rates in the core countries. This
tendency towards real overvaluation of the national currencies with respect to the dollar
caused persistent trade balance deficits - until the growing trade deficit forced a
devaluation. But given the aim of the system to keep exchange rates stable, they were
adjusted infrequently. Hence the overvaluation of currencies in the countries implementing
ISI remained an impediment to the effort to export manufactured goods.9

Exportation of manufactured goods was also hindered by core country firms that imposed
their global marketing plans on their joint ventures and their subsidiaries in peripheral
countries, and on peripheral firms producing manufactured goods with foreign licenses.

Hence through the 1950s and 1960s, most developing countries implementing import
substituting industrialization policies experienced chronic foreign exchange shortages.
These countries had to rely on foreign investment, foreign loans or foreign aid to relieve
balance of payments difficulties.

Another problem was that, starting import substituting industrialization in consumer goods
sectors contradicted the need to increase the domestic saving rate in order to finance
investment from domestic resources. In 1989 Singer criticized the tendency to concentrate
“on items of luxury consumption of the type previously imported” (quoted in Ho 2012, 877

9
Price inflation was a chronic problem in many Latin American countries. Monetarist economists held
that price inflation was caused by lack of monetary and fiscal discipline on the part of the state.
Structuralist economists had a different explanation for inflation in Latin America. They argued that
economic growth leads to increases in demand for agricultural raw materials and rising incomes leads to
increases in demand for food. Agricultural production in Latin America could not respond to the increase
in demand because of supply rigidities: peasant farms were too small for investment to increase
productivity, and large-scale latifundia were mostly managed by rich families who were not interested in
increasing productivity. The continuous rise in prices of agricultural goods caused chronic inflation. Thus
monetary expansion was not the cause of price inflation (Wachter 1979, 230).
 11

fn. 17).

There was a difference of opinions on whether foreign direct investment could be useful in
industrialization. Some dependency writers argued that foreign investment merely
increased dependence. For example Osvaldo Sunkel wrote:

“In Latin America in its initial period from 1930 to around 1955 the strategy stimulated the
growth of a significant manufacturing industry and of the corresponding national entrepreneurial
class. But subsequently industry was taken over to a large extent by foreign subsidiaries. This
effectively denationalized and eroded the local entrepreneurial class. Although the massive
penetration of foreign firms accelerated growth rates, especially industrial, it also accentuated
the uneven nature of development. On the one hand a partial process of modernization and
expansion of capital-intensive activities; on the other, a process of disruption, contraction and
disorganization of traditional labor-intensive activities. … The capitalist world system
determined the discriminatory nature of the local process of development. Access to means and
benefits of development were selective: rather than spreading them the process tended to ensure
a self-reinforcing accumulation of privilege for special groups as well as the continued existence
of a marginal class. … The post-war economic expansion of the US was reflected abroad as the
new multinational corporations spread throughout the world economy. Their activities followed
a pattern: first, they export their finished products; then they establish their sales organizations
abroad; then they proceed to allow foreign producers to use their licenses and patents to
manufacture the product locally; finally, they buy off the local producer and establish a partially
or wholly owned subsidiary. In the process a new process of international economic relations
emerges … . For the decade 1960-1970 around a fourth of all manufacturing exports from the
US were intra-firm transfers. ... The large expansion of large US multinational corporations in
Latin America really gained momentum around the mid-1950s; but only in the late 1960s did it
reach the stage of the wholesale buying up of local firms and integrating associates closely with
headquarters and with each other.”

“A study of the operations of 187 transnational corporations in Latin America shows that while
in 1945 there were only 74 of these firms with manufacturing subsidiaries in the region, in 1967
the number of their subsidiaries in the region had increased from 182 to 950, and the total
number of subsidiaries from 452 to 1,924” (Sunkel 1972, 518, 519, 521, 523).

Researchers showed that between 1960 and 1968, profit remittances by multinational
corporations to the United States from Latin America exceeded their new investment by
6.7 billion dollars. Policymakers in developing countries were caught in a dilemma with
respect to foreign companies’ profit repatriation, because if the foreign companies
reinvested a significant part of their profits in the host country, the share of foreign
ownership in the countries productive capacity would increase (Paul et al. 1985, 9-10).

As early as the mid-1950s some economists in ECLA began to point out these problems
and to criticize the way import substituting industrialization was implemented in Latin
America. However, it would be inaccurate to think that import substituting industrialization
was a complete failure in terms of transforming peripheral economies. It is simply that
many expectations (improving the balance of payments, increasing economic
 12

independence, alleviation of mass poverty) were not realized. We shall see that import
substituting industries provided a manufacturing base for the globalization of
manufacturing through core country firms after the 1970s. In spite of the difficulties, some
developing countries did succeed in making progress in exporting manufactured goods in
low technology sectors such as textiles. The share of manufactured exports in total
merchandise exports in Pakistan was 36 percent in 1965, 54 percent in 1975; in Türkiye it
was 2 percent in 1965, 23 percent in 1975.

The advantageous conditions in the capitalist world-economy during the roughly thirty
years of import-substituting industrialization should be mentioned here. In the core
economies, Keynesian macroeconomic stabilization policies and the opportunities given
by post-war reconstruction in Europe ensured stable GDP growth in the core (figures are
given in a table in the next lecture note). Moreover the Korean War in 1950-1953 boosted
primary commodity prices, providing peripheral exporters high revenues for a short
period.10 And the oligopoly of big oil firms (the Seven Sisters) controlling the global oil
market kept the price of oil fixed. In real dollar terms the price of oil was even declining,
so energy was becoming cheaper in the world. (The fourth lecture note presents data on
oil prices.) These are some of the global economic conditions that facilitated the
implementation of import substituting industrialization in peripheral countries, besides the
political advantages provided by the Cold War.

Other consequences of the industrialization strategy

The industrialization strategies pursued in developing countries after World War II were
largely shaped by the political economy in each country. In some countries foreign
companies and their local partners dominated the process more than in others. In a few
countries land reforms were carried out.

In many developing countries there were social groups who did not benefit from or were
even harmed by ‘developmentalism’. In many countries, people who lived in remote
interior regions or mountainous regions such as pastoral nomads (e.g. the Tuaregs in
Algeria, the Fur people in Sudan) and ethnic and racial minorities (e.g. the tribals in India,
the Quechua in Peru, the people of South Sudan), and small peasants in many areas
suffered from environmentally harmful resource extraction (mining, deforestation etc.),
ecologically damaging energy projects, loss of land to commercial agriculture, and
attempts at cultural assimilation (‘nation-building’). The priority given to industrial
investment led to a neglect of investment in housing, which caused a proliferation of
shantytowns (slums, bidonvilles) around cities.11

10
Türkiye had accumulated foreign exchange and gold reserves during World War II. The government
began to liberalize importation in the late 1940s, beginning a period of chronic trade deficits. However,
Türkiye’s trade balance benefited from the primary commodity price boom during the Korean War. After
the boom ended, Türkiye began to suffer severe balance of payments difficulties in the latter 1950s.
11
The shantytowns and bidonvilles in some Latin American and Sub-Saharan African countries are
known to be much more overcrowded, constructed of worse materials and more deprived of infrastructure
than Turkish gecekondu districts.
 13

This development paradigm did not offer much to women of poor families suffering from
all of the above problems. Industrialization and urbanization drew many women into the
labor market, to jobs in which they were paid lower wages than male workers.

Some dependency writers pointed out that attempts at cultural and social modernization
that accompanied import substituting industrialization damaged regional and local power
structures, extended family networks and religious authorities, thus disrupting customary
forms of social coherence and integration (Paul et al. 1985, 11).

“It was for such reasons that developmentalism had become, by 1968, a ‘dirty word’ in
Latin America” (Sharper 2006, 56).

Concluding remark

The experience of industrialization as it happened in the three decades after World War II
led dependency writers to argue that delinking is necessary for autonomous economic
development. Import substituting industrialization seemed to fail to reduce dependence,
because of the reluctance of industrialists to carry out investment in risky projects for
producing intermediate and capital goods, and also because foreign companies got
involved in the industrialization process. On the other hand, classes of large land-holders
were in general able to prevent radical land reforms that were required in many countries
to broaden the mass market for industrial goods.
 14

Sources for the lecture

Boratav, K. 1983. Türkiye’de Popülizm: 1962-76 Dönemi Üzerine Bazı Notlar. Yapıt. 1. 7-
18.
Bresser-Pereira, Luiz Carlos. 2020. New Developmentalism: development macroeconomics
for middle-income countries. Cambridge Journal of Economics. 44. 629-646.
Epstein G. A., Schor J. B. 1990. Macropolicy and the rise and fall of the Golden Age.
Chapter 3 in The Golden Age of Capitalism: Reinterpreting the Postwar Experience. S.
A. Marglin and J. B. Schor (eds). Oxford. The Clarendon Press. 126-152.
Finlay, Robert. 1998. The Pilgrim Art: The Culture of Porcelain in World History. Journal
of World History. Fall. 9(2). 141-187.
Fischer, Andrew. 2015. The End of the Peripheries? On the Enduring Relevance of
Structuralism for Contemporary Global Development. Development and Change.
https://doi.org/10.1111/dech.12180.
Hobsbawm, Eric. 1996. The Age of Extremes: A History of the World, 1914-1991. New
York: Vintage Books.
Hirschman, Albert O. 1968. The Political Economy of Import-Substituting Industrialization
in Latin America. Quarterly Journal of Economics. LXXXII(1). February. 1-32.
Ho, P. Sai-wing. 2012. Revisiting Prebisch and Singer: beyond the declining terms of trade
thesis and on to technological capability development. Cambridge Journal of Economics.
36. 869-893.
Kay, Cristóbal. 1989. Latin American Theories of Development and Underdevelopment.
London. Routledge.
Krueger, Anne. 1984. Trade Policies in Developing Countries. Ch. 11 in Handbook of
International Economics. Vol. I. ed. R. W. Jones and P. Kenen. Elsevier Science
Publishers.
Nath, S. K. 1962. The Theory of Balanced Growth. Oxford Economic Papers. 14.138-151.
Paul, Karen and Robert Barbato. 1985. The Multinational Corporation in the Less
Developed Country: The Economic Development Model versus the North-South Model.
The Academy of Management Review. 10(1). January. 8-14.
Prebisch, Raul. 1963. Towards a Dynamic Development Policy for Latin America. New
York. United Nations.
Sharper, Stephen B. 2006. Liberation Theology’s Critique of the Developmentalist
Worldview: Implications for Religious Environmental Engagement. Environmental
Philosophy. 3(1). Spring. 47-69.
Sonntag H. R., M. A. Contreras, J. Biardeau. 2001. Development as Modernization and
Modernity in Latin America. Review. XXIV(2). 219-251
Sunkel, Osvaldo. 1972. Big Business and ‘Dependencia’: A Latin American View.
Foreign Affairs. 50(3). April.
Wachter, Susan M. 1979. Structuralism vs. Monetarism: Inflation in Chile. Chapter 8 in
Short-term Macroeconomic Policy in Latin America. Jere R. Behrman and James Hanson
(eds.). NBER. 227-256.
 1

Development Economics Lecture 4

24.10.2024

end of gold-backed dollar – oil price crisis – neoliberalism

end of import substituting industrialization

The history of the twenty years after 1973 is that of a world which
lost its bearings and slid into instability and crisis. And, yet, until
the 1980s, it was not clear how irretrievably the foundations of the
Golden Age had crumbled.
Eric Hobsbawm (1996, 403)

In previous lectures we summarized views on economic development which were current for
roughly thirty years after the end of World War II, and the industrialization policies
implemented in many peripheral countries in that period. In the 1970s some macroeconomic
changes occurred in the core countries, changes which were perceived as a ‘crisis’. These
changes led to a radical reorientation of economic and social policies in the core around 1980.
The policy changes were then transmitted to the periphery. These events led to abandoning
import substituting industrialization and induced governments in the periphery to integrate their
economies into the capitalist world-economy.

In retrospect Keynesians began to refer to the first post-war decades as the ‘Golden Age’ of
capitalism.

The crisis of the 1970s

First, we note some empirical observations on macroeconomic developments in the core

countries, then discuss their possible causes and their repercussions.

In the 1970s GDP growth rates in the core countries declined and became more unstable. See
the average GDP growth rates of major core countries in Table 4.1. Compare the figures for
the 1960s with those for the 1970s.

The growth rate of gross real fixed capital formation in the core declined. In the OECD region1
this growth rate was 6.5% in 1960-1968, 5.8% in 1968-1973, 1.1% in 1973-1979, 3.1% in 1979-
1990.

1
The Organisation for Economic Co-operation and Development, founded in 1961, is an international organization
for coordinating economic policies among states. In 1980 the member states of the OECD were Australia, Austria,
Belgium, Canada, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Japan, Luxembourg, the
Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, Türkiye, the United Kingdom and the
United States. So in the 1970s the OECD countries were largely the group of ‘developed’ or ‘advanced’ countries,
with the exception of Türkiye. Eventually other middle-income countries joined the organization.
 2

Labor productivity growth rates also fell in the core countries. The slowdown in labor
productivity growth, plus the oil price shock in 1973-1974 (discussed below) intensified the
class struggle over income distribution. Oil price shocks and the struggle over income
distribution in the core countries led to rises in inflation rates. Note the consumer price index
growth rates in the core in Table 4.4.

Rising inflation rates led to declines in real aggregate expenditure (upward shifts of the
aggregate supply curve). Unemployment rates rose. In the 1970s core country governments
generally accommodated price and wage rises with expansionary monetary policies to prevent
unemployment from rising (shifting the aggregate demand curves up). The result was
‘stagflation’: high unemployment rates coinciding with high inflation (both high compared to
the 1960s). These unprecedented adverse phenomena were perceived as a crisis.

Table 4.1
GDP growth rates and per capita GDP growth rates in major core countries
(average annual percentage growth rates)
1961-1970 1971-1980 1981-1990 1991-2000 2001-2010 2011-2020
France GDP 5.7 3.6 2.5 2.1 1.3 0.4
p.c.GDP 4.7 3.0 1.9 1.6 0.6 0.1
Germany GDP … 2.9 2.3 1.9 0.9 1.2
p.c.GDP … 2.9 2.2 1.6 0.9 1.0
Japan GDP 9.6 4.5 4.5 1.3 0.6 0.4
p.c.GDP 8.5 3.2 3.9 1.0 0.5 0.5
United GDP 3.5 2.2 2.9 2.5 1.5 0.7
Kingdom p.c.GDP 2.9 2.0 2.8 2.2 0.8 0.0
United GDP 4.2 3.2 3.3 3.4 1.8 1.7
States p.c.GDP 2.9 2.1 2.4 2.2 0.8 1.0
Source: World Bank. World Development Indicators. (19.10.2023)

Table 4.2
World GDP growth rate and per capita GDP growth rate
(average annual percentage growth rate)
1961-1970 1971-1980 1981-1989 1991-2000 2001-2010 2011-2020
GDP 5.2 3.8 3.2 3.0 3.0 2.4
p.c.GDP 3.1 1.9 1.4 1.4 1.7 1.2
Source: World Bank. World Development Indicators. (19.10.2023)

Class struggle

Researchers attributed these macroeconomic changes to three political developments: the rise
of worker militancy, the breakdown of the Bretton Woods rules, and OPEC’s oil price hikes.

Toward the end of the 1960s labor markets in European countries had become tighter, and
workers and civil servants had become more active in protecting their real wages. In France in
May 1968, workers’ general strikes and demonstrations paralyzed the economy. Subsequently
 3

strikes spread throughout capitalist European countries. This led to “a real wage explosion”
(Epstein et al. 1990, 135). Trade unions, who used to bargain over nominal wages and acquiesce
to real wage erosion between collective agreements, now switched to defending real wages, i.e.
to fighting for nominal wage increases as prices rose.

The rises in inflation rates and the decline in real fixed capital formation growth rates were
attributed by some writers to increased workers’ militancy.

Breakdown of the Bretton Woods system

Another important development in the early 1970s in the world-economy was the breakdown
of the Bretton Woods exchange rate system.

The 1944 Bretton Woods Agreement stipulated the obligation of the US Fed (the Federal
Reserve System) to sell gold at a fixed price ($35 per ounce) to any central bank that demanded
gold for dollars. Other currencies were to have fixed exchange rates to the dollar. Most countries
restricted private international financial transactions (deposit transfer transactions, portfolio
investment transactions, bank lending transactions) in order to maintain fixed exchange rates.
The system wherein the dollar was backed by US gold reserves, and other currencies had a fixed
exchange rate to the dollar, was designed to maintain the stability of money supplies of all
countries.

On the other hand, throughout the 1950s and 1960s the demand for the international medium of
exchange increased as international trade grew. The US supplied this by expanding the dollar
supply circulating in the world. In the 1950s and 1960s the US ran trade surpluses. In other
words, the US was receiving more dollars through its exports than it was transferring abroad
for its imports. (Note in Table 4.3 the positive sums of merchandise trade plus services and
remittances in this period.2) So the US could not inject dollars to the rest of the world through
trade. In addition, the US was receiving more profits and interest from US investments abroad
than the profits and interest it was transferring to foreign firms and banks; so it was drawing
dollars from abroad through this account too. (See in Table 4.3 the positive figures for net
interest and dividends received.) Hence, through its transactions on its overall current account,
the US was receiving more dollars from the rest of the world than it was giving. So how was
the demand for dollars in the rest of the world satisfied?

Table 4.3 reveals that in the 1950-1959 and 1960-1967 periods the US injected dollars to the
world economy through ‘net military transactions’ (payments to US military forces abroad and
military aid to foreign states); US government grants to foreign states; US firms’ direct
investments abroad; purchases by US firms, banks and individuals of bonds and shares abroad;
and US government loans to foreign states.

2
We study the balance of payments in the ninth lecture. The format of Table 4.3 is not exactly the standard format
used today, but the table is sufficiently clear. The small arithmetic discrepancy in the figures in the 1960-1967
column is from the source.
 4

In Table 4.3 the expansion of dollars circulating abroad is seen in the increases in the ‘dollars
held abroad by the private sector’ and the ‘dollars held abroad in official reserves’ figures.

Eventually in 1960 the growing dollar reserves in foreign central banks had surpassed the value
of US official gold reserves. This raised the possibility that the US Fed might have trouble
meeting official demands to convert dollars into gold (Obstfeld and Taylor 2017, 12).

Table 4.3
US Balance of Payments (1950-1974) ($ billion)
1950-1959 1960-1967 1968-1974
Merchandise trade 29.3 39.6 -9.3
Services and remittances -5.3 -8.5 -10.2
Net military transactions -23.1 -20.5 -19.8
US government grants (excl. military) -20.5 -14.8 -16.7
Net interest and dividends received 25.5 36.5 61.4

Current account balance 6.0 32.3 5.4

Direct investment (net) -17.2 -27.9 -42.2

Investment in shares and bonds (net) -3.7 -6.4 10.8
Government loans -4.1 -10.6 -11.1

Long term capital -25.0 -44.9 -42.5

Balance on current and long term capital -19.0 -12.6 -37.1

Dollars held abroad by private sector 1.5 -2.8 -22.5

Financed by
Dollars held abroad in official reserves 13.0 8.1 58.1
Reduction in US reserves 4.5 6.7 1.5
(of which gold) (5.1) (7.4) (2.4)
Source: Philip Armstrong, Andrew Glyn, John Harrison. Capitalism since 1945. Oxford. Basil Blackwell. 1991.
Tables 10.7 and 12.2 on pp. 164 and 213. Original source: US Government. Survey of Current Business, June
1975, October 1972, June 1982.

Additionally, towards the 1970s the US trade balance began to deteriorate. Other core countries
such as Germany and Japan, having recovered from the effects of World War II, emerged as
strong rivals to the US in manufactured exports. The US government increasingly felt the need
to devalue the dollar against other core country currencies, but was prevented by the rules of
the Bretton Woods agreement. In 1970 the US government relaxed its monetary policy. The
interest rate decline in the US caused a massive outflow of dollars from the US to other OECD
countries, especially to those with strong currencies (Germany, Switzerland, Austria, the
Netherlands). The central banks of these countries were forced to accumulate the dollars that
were flowing in. At the beginning of 1971, US gold reserves covered just 32 percent of foreign
dollar holdings. In the second quarter of 1971 US trade showed a deficit for the first time. This
news fueled private speculation against the dollar. European central banks also sensed the
danger that the US might devalue the dollar against gold. So they began to convert some of their
dollar reserves into gold as a precaution. This accelerated the depletion of US official gold
reserves (Armstrong et al. 1991, 208).
 5

Eventually, on August 15, 1971 the US government under President Nixon suspended the
convertibility of dollars into gold. This move effectively ended the last remaining piece of the
old gold standard system that had been applied for over a century. The US government
simultaneously raised the dollar price of gold, thus devaluing the dollar relative to gold. In
December 1971 the G10 (ten core countries) signed the Smithsonian Agreement, wherein the
other nine states agreed to revalue their currencies against the US dollar. In 1973 the gold value
of the dollar had to be readjusted once again, this time from $38.02 to $42.22, and the dollar
was devalued again against the European currencies.

The end of the system came in March 1973 when the governments of the major core countries
decided to float their currencies against each other, as these governments had difficulties
maintaining the exchange rates within the (+/-) 2% band around the official fixed rates. So a
floating exchange rate system emerged, wherein exchange rates were determined by market
supply and demand. The dollar had become a purely fiat money, disconnected from any
commodity.

Since then the US has been running current account deficits. Through these current account
deficits the US has been expanding the global dollar supply. The US current account deficit
must have recessionary effects on its economy, which the government and the Fed have to
manage. However, some of the dollars circulating abroad in private hands are placed in assets
in the US. So some of the dollars issued by the Fed and transferred abroad through the current
account deficit are then lent back to the US. So the US accumulates external debt – in dollars
which it prints. Furthermore, foreign central banks also place their reserves in US Treasury bills
and other Federal government securities. The result is that the US government is able to spend
more than its revenues would allow it to. The increase in holdings of dollar assets by private
firms, banks and individuals in the rest of the world, in addition to the increases in dollar assets
held by central banks, enables the US as a nation to maintain levels of consumption and
investment in excess of its GDP. This is the international monetary system that emerged in the
early 1970s. It is still functioning.

The oil price hikes

The international oil market in the capitalist world economy had for a long time been dominated
by seven major oil companies (an oligopoly) owned by shareholders in core countries.3 These
companies extracted most of the oil in peripheral countries. These countries did not have the
capital or technology to extract and market the oil from reserves in their territories. In the post-
war decades the states of various peripheral countries possessing oil reserves (the Gulf states,
Venezuela, Mexico, Libya etc.) bargained with the oil companies over the sharing of oil
revenues (rents), resulting in various arrangements that were renegotiated over time. The
Organization of Oil Exporting Countries (OPEC) was established in this process in 1965.

3
These were the Anglo-Iranian Oil Company, Royal Dutch Shell, Standard Oil of California, Gulf Oil, Texaco,
Standard Oil of New Jersey (Esso), Standard Oil of New York.
 6

Tables 4.5, 4.6 and 4.7 show the ‘posted price’ of a barrel of crude oil, set by the seven major
oil companies in the first half of the twentieth century and in the period under consideration.
This is the official price of oil used as a basis for taxes paid to the states in the countries
possessing oil reserves. Actual sales prices fluctuate according to supply and demand. The
tables show how, as of 1960, the posted price of a barrel of oil was kept fixed by the oligopoly
over a long period, in spite of rising world demand and the gradual erosion of the purchasing
power of the US dollar. This means that the terms of trade of countries dependent on oil exports
(price of oil/price of US goods) declined continuously in the 1960s. The economies of the core
countries and the oil-importing peripheral countries benefited from this cheapening of oil in real
terms.

In October 1973 a war broke out between Israel on one side and Egypt and Syria on the other
(the October War, or Yom Kippur War). The US and its allies supported Israel, while the USSR
and its allies supported Egypt and Syria. The Arab member states of OPEC decided to reduce
their oil production without informing the oil companies, and imposed an oil sales embargo on
the US, Canada, Japan, the Netherlands and the United Kingdom in retaliation for their support
for Israel. The embargo lasted from October 1973 to March 1974. In this period the cutdown in
oil production raised the international price of oil by nearly 300 per cent, from $3 per barrel to
nearly $12. The increase in the price of oil can be seen in Table 4.7.

Oil is a crucial source of energy and a raw material. The jump in the price of oil increased
production costs and prices in the core countries. The rise in price levels increased
unemployment. (Recall the recessionary effect of rising costs of production, as depicted in the
aggregate demand-aggregate supply model.) In the countries of the present euro area (which
did not exist then), the loss of real income due to the deterioration of terms of trade was 1.3
percent of GDP in 1974. The income drain was 0.8% during the second oil crisis in 1980 and
1981 (Strauch 2022). (See Table 4.4 for the inflationary impact in the core countries i.e. the
high income OECD countries4.)

The rise in price levels also eroded real wages. Workers in the core countries pushed for higher
nominal wages. Firms passed the higher labor costs onto their product prices. Thus in the core
countries a wage-price spiral ensued, with workers trying to push the burden of higher oil prices
onto the capitalists, and the capitalists trying to push the burden onto the workers.

The rising price levels in the core countries gradually eroded the terms of trade improvements
of 1973-1974 in the oil exporting countries. These states strove to ensure higher dollar prices
for their oil. Meanwhile, the US Federal government made moves which accommodated the
upward pressure on oil prices, e.g. by reducing taxes on US oil company profits. The reasons
for this policy (as suggested by some writers) was that, although increases in the price of oil
imposed costs on the US population, higher oil prices made old unproductive oil wells in the
United States viable, and also gave a boost to small American oil companies. The oil price rises

4
The ‘high income OECD countries’ was a useful grouping in World Bank statistics, as it comprised the core
countries (the IMF’s ‘Advanced Economies’). The World Bank World Development Indicators no longer has this
grouping.
 7

also imposed economic burdens on West European countries and on Japan, who were
competing against the US in manufactured exports.

The struggle over profits and wages in the core countries and over the price of oil continued
until the next major global oil price shock. This shock was triggered by the Islamic Revolution
in Iran in 1979. The Revolution unfolded over a period of time, and caused disruptions in oil
exports from Iran, leading to another discrete jump in the international price of oil (see Table
4.7).

Perceptions of the crisis

In the 1970s and into the 1980s, economists sought to understand the fundamental cause of the
macroeconomic changes in the core countries. We summarize some offered explanations.

Some saw the oil price shock as the main problem, and interpreted the oil price rises as the
consequence of the gradual depletion of underground oil reserves.

Some Marxists saw the root cause of the crisis elsewhere. They held that the possibilities of
increasing labor productivity from expanding Fordist assembly line factory production had
reached their limits. Larger factories were leading to diminishing returns to scale. Hence labor
productivity growth was declining, leading to distributional struggles between capitalists and
workers who had become used to steadily rising real incomes.

On the other hand, the Fordist factory production design (assembly-line production)
implemented in the US since the beginning of the twentieth century now faced a new challenge.
The challenge came from the new lean, flexible, just-in-time production system (called
Toyotism, pioneered in the Toyota car factories in Japan). Assembly-line factories in the US
were losing in the competition to reduce production costs to Japanese firms. So the economic
crisis in the 1970s appeared to some as resulting simply from the intensified export competition
among core countries, a consequence of the rise of Japan, Germany, France and other core
countries as rivals to the United States in exporting manufactured goods.

In contrast to these views, liberal economists blamed Keynesian policies and the welfare state
for the crisis. They argued that excessive state regulation of private enterprises prevented market
economies from allocating resources efficiently. They said that full employment policies made
workers unreasonably demanding in wage negotiations; that the welfare state made workers
lazy; and that high rates of direct taxes discouraged enterprising individuals from starting
businesses. Liberal political forces in core countries succeeded in convincing people of these
views. Not only did liberal and conservative parties endorse this new liberal (neoliberal)
thinking, but social democratic parties, socialist parties and even communist parties in the core
were also influenced by the new thinking. This ideological shift reflected a change in the
balance of forces between social classes in core countries, because it was the working people
who had benefitted from Keynesian policies and the welfare state.
 8

In the core countries the change in opinions was partly due to a new macroeconomic problem.
Keynes (who died in 1946) had not studied stagflation because he had never seen it: inflation
appearing with high unemployment had never been experienced before the 1970s. The reason
was that stagflation was connected to the new flexibility of money supplies in the 1970s, which
was made possible by the decoupling of the dollar from gold and allowing exchange rates to
fluctuate. But the Keynesian income expenditure model had been conceived in the 1930s when
national money supplies were still anchored to official gold reserves.5 So Keynes’s model did
not have an explanation for inflation appearing together with high unemployment. Liberals used
the inability of Keynes’s income expenditure model to explain stagflation to discredit Keynes’s
macroeconomic theory, and especially to reject his views on the necessity of demand
management altogether.6

Thus, in the 1970s, monetarism (the old view that expansionary monetary policy will ultimately
result only in a rise of the price level) became reputable again among economists. Tightening
monetary policy was recommended to reduce the inflation rate. New economic theories (the
expectations-augmented Phillips curve, the natural rate of unemployment, theories of rational
expectations and perfect foresight) were developed in this period. All of these theories
converged on the idea that the state cannot influence the business cycle or the unemployment
rate in the long run - or even in the short run. Liberal economists recommended that central
bank managements be made independent of governments, and that their mandate should be
ensuring price stability rather than employment.

Behind this change in the balance of power between working classes and the propertied classes
was another important phenomenon: socialism as an alternative social project had begun to lose
its appeal and influence in the world. In the 1970s the economic indicators of the USSR began
to deteriorate. Inefficiency, mismanagement, corruption began to corrode the Soviet economic
system. In an attempt to solve the economic problems, Soviet reformers introduced profit as a
performance indicator in the governance of state enterprises, and introduced material incentives
for workers, in order to increase their productivity. These efforts to mend the Soviet economy
continued in the 1980s. Similar reforms were carried out in the East European socialist
countries. Meanwhile in 1976, after the death of Mao Tse-tung, the Chinese Communist Party
started a gradual transition to capitalism in China.

The apparent loss of dynamism in the socialist economies was utilized by liberals in the core
countries to convince the working classes that egalitarian social orders are not viable, and that
there is no real alternative to a liberal market economy.

By 1992 states comprising one third of the world population were making a transition to
capitalism. This convinced populations in the core that the unregulated market economy was
the best option.

5
Although adherence to the gold standard was suspended in many countries during the Great Depression, such
suspensions were intended to be temporary.
6
Actually Keynesians did develop a macroeconomic Keynesian model that explained stagflation. This was the
aggregate demand-aggregate supply model, and its dynamic variations.
 9

The policy reorientation in the core

After the second major oil price hike in 1979 a broad range of social and economic policies that
had been implemented since 1945 in the core countries were overhauled, spearheaded by
President Ronald Reagan in the US and Prime Minister Margaret Thatcher in the UK. The
dramatic tightening in monetary policies beginning in 1979 can be observed in Table 4.13.
Table 4.14 shows a tightening also in fiscal policy in the UK, the US, Germany and Japan.
Table 4.3 shows that GDP growth in the high-income OECD countries and in the world fell to
0 percent in 1982.

We summarize the broad policy changes in core countries in this period. In monetary policy,
price stability was given priority over maintaining a high level of employment. The very
concept of full employment was changed to become ‘maximum employment consistent with
price stability’. This was named the ‘non-accelerating inflation rate of unemployment’
(NAIRU). Econometrics was used to estimate the minimum rate of unemployment which would
keep wages stable; in other words, the minimum rate of unemployment which would deter
workers from pressing for wage increases. This depended on the recent inflation and wage
experience of the country. When the unemployment rate fell to the estimated NAIRU for a
country, liberal economists began to claim that full employment had been attained and that the
central bank should push the monetary brake. It did not matter what percentage the NAIRU was
(6%? 8%? 10%?) and how many millions of households were suffering from that rate of
unemployment.

In many countries, laws and regulations protecting working people were abrogated. Hiring and
firing employees in the private sector were made more flexible (numerical flexibility). The right
of employers to assign any job to employees at the workplace, irrespective of what was specified
in the contract, was institutionalized (functional flexibility).

Unemployment compensation schemes were revised. Unemployment benefits were reduced and
the duration of the entitlement to unemployment benefits were shortened. Social security
institutions came under pressure to balance their revenues and expenditures so as to end
transfers from government budgets to these institutions.7

‘Supply side policies’ aiming at stimulating output and investment were implemented. Tax rates
on income and wealth (direct taxes) were reduced, and the decline in revenues from direct taxes
was compensated by increasing indirect taxes. The tax reforms shifted the burden of taxes from
the rich to the poor. Many economic activities were deregulated. For example, zoning
regulations on construction companies to preserve city landscapes and public areas, regulations
against pollution to protect the natural environment, regulations to protect the self-employed
(e.g. licensing taxis to restrict their numbers, restricting shops working on Sundays) were either
relaxed or abolished.

7
The confrontations over pension reform, low wages and bad working conditions at the present time in some core
countries (France, Germany, the UK) are the consequence of the continuation of this process.
 10

In some core countries, public assets (e.g. the state railway network in the UK) were privatized.
The provision of services in education, health, transportation, communications, social security
was opened up to profit-seeking private enterprises. This began a gradual privatization of public
services.

The activities of financial institutions were also deregulated. This led to a proliferation of new
financial instruments and more intense competition between financial institutions. Deregulating
the activities of banks induced them to take more risks. The end result was an increase in
financial fragility and recurring financial crises. Liberalization of international financial
transactions increased the integration of national financial systems. Capital controls were
reduced or abolished, allowing private capital to move freely across borders. (We shall study
financial reforms in greater detail in later lectures.)

These policy changes gave rise to fiscal problems in the core countries. Lowering tax rates
reduced tax revenues, while public expenditures could not be reduced so easily. Despite the
measures to reduce social transfers, increases in poverty and unemployment led to increases in
social transfers. As liberal thinking disapproved of the monetization of fiscal deficits,
governments were obliged to cover budget deficits by borrowing in financial markets at market
interest rates. Public debt levels rose. Markets of public securities grew.

The new policies resulted in a redistribution in favor of property incomes and of skilled labor
in the core. For example in the US labor productivity increased by more than 80 per cent over
1973-2006, while the average real hourly wage increased by just 0.5 per cent over the same
period (Baker 2007, 4).

These new policies reflected a change in the balance of power between the working classes and
propertied classes in the core, a shift from working people to property owners. The balance of
power had been shifting in favor of the working classes since around 1848, when a great number
of European countries witnessed popular upheavals demanding democracy, national liberation
and social justice. The social advancement of working classes in the core had accelerated after
1917. The advent of neoliberalism at the end of the 1970s ended and reversed this trend.

The Newly Industrializing Countries

In this section and the following one we study the developments in this period in the periphery.

In the 1970s the manufactured exports of some peripheral countries began to increase, mostly
in low-technology and labor-intensive goods, chiefly textiles. Economists called these countries
Newly Industrializing Countries (NICs). South Korea, Taiwan, Singapore, Hong Kong8 were
always named among the NICs. Brazil, India, Mexico were also usually included.

8
At the time Hong Kong was a British colony.
 11

Table 4.4
Gross domestic product growth rates and rates of increases in consumer prices
in country groups classified by per capita GDP (1961-2011)
GDP growth rate (%) CPI growth rate (%)
High income High Middle Low World High income High Middle Low World
OECD income income income OECD income income income
1961 5 5 4 .. 5 2 .. .. .. ..
1962 6 6 1 .. 5 4 .. .. .. ..
1963 5 5 4 .. 5 3 .. .. .. ..
1964 6 6 7 .. 7 4 .. .. .. ..
1965 6 6 6 .. 6 4 .. .. .. ..
1966 6 6 5 .. 6 4 .. .. .. ..
1967 4 4 5 1 5 4 .. .. .. ..
1968 6 6 6 5 6 4 .. .. .. ..
1969 6 6 6 5 6 3 .. .. .. ..
1970 3 4 7 4 4 6 .. .. .. ..
1971 4 4 7 3 4 6 .. .. .. ..
1972 5 5 7 -2 6 6 .. .. .. ..
1973 6 6 7 3 6 8 .. .. .. ..
1974 1 1 6 5 2 14 .. .. .. ..
1975 0 0 5 -2 1 12 .. .. .. ..
1976 5 5 7 2 5 10 .. 10 .. ..
1977 4 4 4 3 4 11 .. 12 .. ..
1978 4 4 4 2 4 9 .. 9 .. ..
1979 4 4 5 3 4 9 .. 11 .. ..
1980 1 1 5 2 2 13 .. 17 .. ..
1981 2 2 3 3 2 13 12 13 12 12
1982 0 0 2 1 0 11 9 10 12 10
1983 3 3 1 2 3 9 7 10 11 9
1984 5 5 4 3 5 6 6 10 10 8
1985 4 4 4 2 4 6 4 8 10 7
1986 3 3 4 4 3 4 3 9 4 6
1987 3 3 4 3 3 4 3 8 9 6
1988 5 5 4 4 5 5 4 9 10 7
1989 4 4 3 2 4 5 5 10 9 7
1990 3 3 2 2 3 6 5 12 12 8
1991 1 1 2 1 1 4 5 13 15 9
1992 2 2 3 -2 2 3 4 10 15 7
1993 1 1 4 0 2 3 4 11 9 7
1994 3 3 5 2 3 2 3 13 25 10
1995 3 3 4 4 3 3 4 12 15 9
1996 3 3 6 5 3 2 3 10 9 7
1997 3 3 5 4 4 2 2 7 8 6
1998 3 2 3 4 3 2 2 7 6 5
1999 3 3 3 4 3 2 2 5 4 3
2000 4 4 5 3 4 3 3 5 4 4
2001 1 1 3 5 2 3 3 5 5 4
2002 2 2 4 3 2 2 2 5 3 3
2003 2 2 5 4 3 2 2 5 7 3
2004 3 3 8 6 4 2 2 5 5 4
2005 3 3 7 6 4 2 2 5 8 4
2006 3 3 8 6 4 2 2 6 7 4
2007 3 3 8 6 4 2 3 6 8 5
2008 0 0 5 5 1 4 4 10 11 9
2009 -4 -4 3 5 -2 1 1 4 5 3
2010 3 3 8 6 4 2 2 5 5 3
2011 2 2 6 6 3 3 3 6 8 5
Source.World Bank. World Development Indicators. (06.07.2014)
Note: GDP (Gross Domestic Product) annual growth rates are based on growth of GDP in domestic currencies at
constant prices. CPI is the consumer price index.
 12

The manufactured exports of the NICs hurt some manufacturers in the core due to the lower
unit labor costs in the NICs. So in 1974 core states imposed the Multifibre Agreement (MFA)
on peripheral countries. This agreement set quotas on the volumes of textiles peripheral
countries could export to the core countries. The MFA remained in effect until 2004.

Core states also imposed Voluntary Export Restraints (VERs) on peripheral countries. A
Voluntary Export Restraint is an agreement between an importing country and an exporting
country on restricting the volume of exports. The restrictions are called ‘voluntary’ because the
exporting country is obliged to limit its own exports. Core country governments also introduced
wider definitions of dumping to protect their producers from cheap imports. They established
restrictive quality standards on imports from the periphery. These protectionist measures were
obviously not helpful for the industrialization efforts in peripheral countries.

Consequences of the crisis for developing countries

The oil price hike in 1973-1974 increased the oil revenues of the oil-exporting countries, as well
as the profits of the oil companies. In some of these countries, oil revenues constituted a large
share in state revenues and in gross domestic product. (The Iranian economist Mahdavy (1970)
coined the term ‘rentier states’ for these and analyzed their political economies.9) Although
their oil revenues increased substantially, the rentier states did not utilize them to accelerate
industrialization and to diversify their economies, either because they did not have the capacity
to do so, or because they did not have the incentive. In the 1970s, most of these states (e.g. Iran
under the Shah and other Gulf countries) increased their imports of sophisticated military
equipment and luxury consumer goods, and spent part of the increased oil revenues on lavish
state expenditures. Still, much of the ‘petrodollar’ revenues of these states accumulated in
accounts in international banks. This means that the oil exporters were exporting a real resource
(energy) in exchange for tokens of purchasing power (dollar accounts) which they were unable
to make use of. Economists call this impasse the ‘resource curse’. It became clear that, although
a bonanza in export earnings removes the foreign exchange constraint on investment, it does
not of itself does not bring about investment and industrialization.

Tables 4.8, 4.9, 4.10, 4.11 show that the price of oil declined after 1980 in real terms, and did
not attain the 1980 level until 2008.10

9
A rentier state is one with the following characteristics: Revenue from the exportation of a natural resource
comprises a sizable share of government revenues. The state does not need to build institutions to tax the domestic
economy. The state uses the export revenue to benefit social groups that support it. People do not hold the state
accountable for increases and decreases in GDP growth because their causes are external. Social groups that are
deprived of a share of the export revenues are alienated from the state (Mahdavy 1970).
10
In an article published in 1974 Arghiri Emmanuel predicted that the increase in oil prices engineered by the
political decisions of OPEC states could not be sustained because the cost of oil extraction had not increased (it
was 10-20 cents a barrel in the Middle East). He pointed out that, if the increases in the price of oil had been caused
by a wave of oil workers’ strikes resulting in substantial increases in their wages, which increased the real cost of
extraction in the oil-exporting countries, then the oil price increases would have been durably consolidated.
 13

As for the oil-importing peripheral countries, the impact of the oil price shocks and the
slowdown of growth in the core countries in the mid-1970s created balance of payments
difficulties for them. These difficulties were alleviated by loans from international banks
wherein the petrodollar deposits were accumulating. Thus the oil revenues of oil-exporting
countries were recycled by major international banks to oil-importing peripheral countries. The
banks’ lending rates were low due to the expansionary monetary policies in the core countries.
The loan rates were also low in real terms because of the price inflation in the US. All this
ended with monetary tightening in 1979.

Through the mid-10970s, the bank loans allowed middle income oil-importing peripheral
countries to continue their import substituting industrialization policies. In some countries such
as South Korea, Malaysia and Thailand the external loans were used to carry out export oriented
industrial investment, the revenues from which serviced debt repayments. But in many countries
in Latin America and Sub-Saharan Africa, the loans were used to fund projects that were not
geared to earning foreign exchange. And part of the foreign exchange borrowed from
international banks was used by residents to move their wealth abroad, i.e. in (mostly illegal)
capital outflows to US banks and to offshore tax havens.

Table 4.5 Crude oil price per barrel (US dollars) (1928-1959)
year nominal price per barrel price in 2014 dollars year nominal price per barrel price in 2014 dollars
1928 1.17 16.16 1944 1.21 16.27
1929 1.27 17.54 1945 1.05 13.80
1930 1.19 16.86 1946 1.12 13.56
1931 0.65 10.10 1947 1.90 20.12
1932 0.87 15.07 1948 1.99 19.56
1933 0.67 12.23 1949 1.78 17.67
1934 1.00 17.67 1950 1.71 16.80
1935 0.97 16.72 1951 1.71 15.57
1936 1.09 18.61 1952 1.71 15.24
1937 1.18 19.45 1953 1.93 17.07
1938 1.13 18.97 1954 1.93 16.98
1939 1.02 17.37 1955 1.93 17.05
1940 1.02 17.21 1956 1.93 16.80
1941 1.14 18.32 1957 1.90 15.96
1942 1.19 17.27 1958 2.08 17.02
1943 1.20 16.42 1959 2.08 16.87
Source: British Petroleum. (2.10.2015)
http://www.bp.com/en/global/corporate/about-bp/energy-economics/statistical-review-of-world-energy.html.
1928-1944: Average US price. 1945-1959: Listing price for crude ‘Arabian light’ price at Ras Tanura.

Table 4.6 Crude oil price per barrel (US dollars) (1960-1968)
1960 1961 1962 1963 1964 1965 1966 1967 1968

Dollars/barrel 1.90 1.80 1.80 1.80 1.80 1.80 1.80 1.80 1.80
Index (1960=100) 100 94 93 92 90 89 86 84 81
Source: www.bp.com/en/global/corporate/about-bp/energy-economics/statistical-review-of-world-energy.html
(15.03.2016) Listing price for crude ‘Arabian light’ price at Ras Tanura.
Index (1960=100): Oil prices adjusted for US consumer price inflation (2010=100) (given in the World Bank’s
World Development Indicators) and converted into an index with 1960=100.
 14

Table 4.7 Crude oil price per barrel (US dollars) (1969-1979)
1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979
Dollars/barrel 1.80 1.80 2.24 2.48 3.29 11.58 11.53 12.80 13.92 14.02 31.61
Index (1960=100) 76 72 86 92 115 366 334 350 358 335 678
Source: www.bp.com/en/global/corporate/about-bp/energy-economics/statistical-review-of-world-energy.html
(15.03.2016) Listing price for crude ‘Arabian light’ price at Ras Tanura.
Index (1960=100): Oil prices adjusted for US consumer price inflation (2010=100) (given in the World Bank’s
World Development Indicators) and converted into an index with 1960=100.

Table 4.8 Crude oil price per barrel (US dollars) (1980-1989)
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989
Dollars/barrel 36.83 35.93 32.97 29.55 28.78 27.56 14.43 18.44 14.92 18.23
Index (1960=100) 696 616 532 462 431 399 205 253 197 229
Source: www.bp.com/en/global/corporate/about-bp/energy-economics/statistical-review-of-world-energy.html
(15.03.2016)
1980-1983: Listing price for crude ‘Arabian light’ price at Ras Tanura. 1984-1989: Brent crude oil price. Index
(1960=100): Oil prices adjusted for US consumer price inflation (2010=100) (given in the World Bank’s World
Development Indicators) and converted into an index with 1960=100.

Table 4.9 Crude oil price per barrel (US dollars) (1990-1997)
1990 1991 1992 1993 1994 1995 1996 1997
Dollars/barrel 23.73 20.00 19.32 16.97 15.82 17.02 20.67 19.09
Index (1960=100) 283 229 214 183 166 174 205 185
Source: www.bp.com/en/global/corporate/about-bp/energy-economics/statistical-review-of-world-energy.html
(15.03.2016)
Brent crude oil price.
Index (1960=100): Oil prices adjusted for US consumer price inflation (2010=100) (given in the World Bank’s
World Development Indicators) and converted into an index with 1960=100.

Table 4.10 Crude oil price per barrel (US dollars) (1998-2005)
1998 1999 2000 2001 2002 2003 2004 2005
Dollars/barrel 12.72 17.97 28.50 24.44 25.02 28.83 38.27 54.52
Index (1960=100) 122 168 258 215 217 244 316 435
Source: www.bp.com/en/global/corporate/about-bp/energy-economics/statistical-review-of-world-energy.html
(15.03.2016)
Brent crude oil price.
Index (1960=100): Oil prices adjusted for US consumer price inflation (2010=100) (given in the World Bank’s
World Development Indicators) and converted into an index with 1960=100.

Table 4.11 Crude oil price per barrel (US dollars) (2006-2014)
2006 2007 2008 2009 2010 2011 2012 2013 2014
Dollars/barrel 65.14 72.39 97.26 61.67 79.50 111.26 111.67 108.66 98.95
Index (1960=100) 503 544 704 448 568 770 758 727 651
Source: www.bp.com/en/global/corporate/about-bp/energy-economics/statistical-review-of-world-energy.html
(15.03.2016)
Brent crude oil price.
Index (1960=100): Oil prices adjusted for US consumer price inflation (2010=100) (given in the World Bank’s
World Development Indicators) and converted into an index with 1960=100.
 15

Table 4.12 Crude oil price per barrel (US dollars) (2015-2023)
2015 2016 2017 2018 2019 2020 2021 2022 2023
Dollars/barrel 52.32 43.67 54.25 71.34 64.30 41.96 70.86 100.93 82.49
Index (1960=100) 344 283 345 443 392 253 407 537 422
Source: For Brent crude oil price: statistica.com/statistics/262860/uk-brent-crude-oil-price-changes-since-1960
(20.10.2024)
For the index (1960=100): Oil prices adjusted for US consumer price inflation (2010=100) (World Bank World
Development Indicators) and converted into an index with 1960=100.

Table 4.13
Real money growth (average annual change, percent)
1958-1970 1970-1972 1973-1978 1979-1982
France 4.5 5.9 0.7 -0.8
Germany 6.0 6.0 4.2 -2.4
Italy 10.5 13.5 2.7 -2.0
Japan 10.7 15.5 0.9 -0.6
UK -0.4 4.1 -0.9 -1.9
US 1.2 2.3 -1.8 -3.4
Source: Epstein et al. 1990, the first column from Table 3.6 on p. 141, the remaining columns from
Table 3.8 on p. 143.
Table 4.14
Structural budget balances (percent of potential GNP/GDP)a
1970-1972 1973-1978 1979-1984
France 0.7 -0.2 -0.3
Germany -0.1 -1.3 -0.9
Italy -6.8 -8.5 -10.2
Japan 1.4 -2.0 -0.3
UK 1.2 -3.2 0.7
US 0.2 0.3 0.5
Source: Epstein et al. 1990, Table 3.7 on p. 142.
Note: a Average surplus (+) or deficit (-).

The long term public and publicly guaranteed external debts of 71 non-oil producing developing
countries increased from 57 billion dollars at the end of 1973 to 110 billion dollars at the end
of 1976. Much of this debt was concentrated in US banks (DeWitte 1980, 151, 154).

In 1979 the core states, now governed by neoliberal politicians, reacted to the second big oil
price rise by tightening their monetary policies (Table 4.13), raising interest rates (Tables 4.15
and 4.16). They thereby engineered recessions in their economies in order to reduce inflation
rates and to suppress the wage demands of the working class. These policies in core countries
increased the costs of external borrowing for the peripheral countries, reduced the volumes of
these countries’ exports to the core and led to the collapse of primary commodity prices.
 16

The decline in the export earnings of peripheral countries made debt servicing more difficult
for them. An international debt crisis erupted when, in August 1982, Mexico declared a
moratorium on its payments on external debt. This was followed by Brazil and other states
throughout the indebted periphery and in Eastern Europe. The IMF and the World Bank (the
‘international financial community’) undertook to ensure the financial integrity of the creditor
banks. Individual debtor countries were given injections of new loans and their debt payments
were rolled over - on condition that they commit themselves to implementing Structural
Adjustment Programs (SAPs).

Table 4.15
Bank lending rates in advanced countries (percent)
1960 1961 1962 1963 1964 1965 1966 1967 1968 1969
US 5 5 5 5 5 5 6 6 6 8
Japan 8 8 8 8 8 8 7 7 7 7
Germany .. .. .. .. .. .. .. .. .. ..
France 4 4 4 4 4 3 3 3 4 7
UK .. .. .. .. .. .. .. 6 6 7
1970 1971 1972 1973 1974 1975 1976 1977 1978 1979
US 8 6 5 8 11 8 7 7 9 13
Japan 8 8 7 7 9 9 8 8 6 6
Germany .. .. .. .. .. .. .. .. 7 9
France 8 7 6 9 12 10 9 10 9 10
UK 7 8 8 8 9 10 11 9 9 14
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989
US 15 19 15 11 12 10 8 8 9 11
Japan 8 8 7 7 7 7 6 5 5 5
Germany 12 15 14 10 10 10 9 8 8 10
France 13 14 14 12 12 11 10 10 9 10
UK 16 13 12 10 10 12 11 10 10 14
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
US 10 8 6 6 7 9 8 8 8 8
Japan 7 8 6 5 4 4 3 2 2 2
Germany 12 12 14 13 11 11 10 9 9 9
France 11 10 10 9 8 8 7 6 7 6
UK 15 12 9 6 5 7 6 7 7 5
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
US 9 7 5 4 4 6 8 8 5 3
Japan 2 2 2 2 2 2 2 2 2 2
Germany 10 10 10 .. .. .. .. .. .. ..
France 7 7 7 7 7 .. .. .. .. ..
UK 6 5 4 4 4 5 5 6 5 1
Source: World Bank World Development Indicators.
Note: Lending rates are the lowest lending rates applied by banks to their best clients.
 17

The end of import substituting industrialization

When the debt crisis began in 1982, the core states authorized the World Bank to design
Structural Adjustment Programs (SAPs) for peripheral states that applied for loans from
international financial institutions. The SAPs that the World Bank set as conditions for loans to
different peripheral countries were so standardized, and so similar, that in 1989 the British
economist John Williamson coined the term ‘the Washington Consensus’ to describe the
uniform conditions imposed upon indebted developing countries in the 1980s.11

These conditions were: (1) fiscal discipline; (2) a redirection of public expenditure priorities
towards fields offering both high economic returns and the potential to improve income
distribution, such as primary education, health care and infrastructure; (3) tax reform (to lower
marginal tax rates and broaden the tax base); (4) interest rate liberalization; (5) a competitive
exchange rate [meaning devaluation and crawling peg]; (6) trade liberalization; (7)
liberalization of flows of foreign investment; (8) privatization; (9) deregulation to abolish
barriers to entry and exit; (10) securing property rights.

Table 4.16
Average interest rate on new external borrowing of developing country groups (percent)
1970 1971 1972 1973 1974 1975 1976 1977 1978 1979
Low income countries 3 5 3 4 4 4 4 4 4 4
Middle income countries 5 5 6 7 7 7 7 7 8 10
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989
Low income countries 4 4 4 4 4 3 3 3 3 2
Middle income countries 10 11 11 9 9 8 7 7 7 7
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
Low income countries 3 3 2 2 2 2 2 2 2 1
Middle income countries 7 7 6 6 6 6 7 7 7 7
2000 2001 2020 2003 2004 2005 2006 2007 2008 2009
Low income countries 1 1 1 1 1 2 2 1 1 2
Middle income countries 7 6 5 5 5 5 5 5 4 4
2010 2011 2012 2013 2014 2015 2016 2017 2018
Low income countries 1 1 1 2 2 1 1 2 2
Middle income countries 3 3 3 3 3 3 4 4 4
Source: World Bank World Development Indicators. (23.10.2019)
Note: The interest rates are the weighted averages of public and private external debt.

The second item among the conditions implies a cessation of state investment in agriculture and
industry (manufacturing, mining, energy). The fourth item is aimed at ending governments’
regulation of banks, i.e. ending the regulation of deposit and lending rates. The sixth item
actually means import liberalization and is a demand to end tariff protection of new industries.
The seventh demand means an end to governments’ imposing conditions on foreign direct

11
Washington D.C. is where the federal government of the United States, the IMF and the World Bank have their
headquarters. The consensus refers to the consensus of these three.
 18

investment, such as designating the sectors where FDI is allowed, or that the investment should
involve technology transfers, or that it should generate export earnings etc. The eighth condition
involved selling state-owned enterprises to the private sector. The tenth demand was that
governments should give guarantees against nationalization of foreign investment.

So the implementation of import substituting industrialization came to an end with the Structural
Adjustment Programs.

The deregulation demands imposed on peripheral countries eventually included external

financial liberalization. In the 1980s and 1990s one peripheral country after another abolished
capital controls and switched to currency convertibility. We shall study this process and its
consequences in the ninth lecture.

The indebted peripheral countries spent the 1980s paying external debts. The consequences of
external debt repayment were lower investment, lower social spending, lower growth and
increased impoverishment. In Latin America the 1980s came to be called the ‘Lost Decade’.
The effects of the SAPs in that region were that, for example in 1987, the average rate of
unemployment in indebted Latin American countries rose to over 18 percent, living standards
fell throughout the 1980s, the proportion of export earnings allocated allocated to debt servicing
rose to over 25 percent, and episodes of hyperinflation broke out in the wake of currency
devaluations (Corbridge et al. 1991, 84-85). Turkey began to experienced the effects of the
global changes earlier, in 1978-1980.

The structural adjustment programs summarized as the Washington Consensus were obviously
contractionary for economies and detrimental to the welfare of broad sections of working
people. These programs were presented as ‘reforms’, implying an improvement. The advocates
of these reforms argued that economic policymaking should be kept separate from politics. They
meant that the liberal reforms should be implemented by technocrats, rather than by elected
politicians. Technocrats were assumed to be independent of interest groups. Elected politicians
were prone to pressures from their voters, so they were likely to be soft on reforms and give in
to ‘populism’. Therefore the implementation of the reforms was entrusted to technocrat
economists. Many of these were of the view that import substituting industrialization policies
had been mistaken from the beginning. For example Gustavo Franco, president of the central
bank of Brazil in 1997-1999, said in 1996 that “his policy objective was ‘to undo forty years of
stupidity’ and that the only choice was between ‘to be neo-liberal or to be neo-idiotic’” (Chang
2008, 27).

Liberals argued that the negative social effects of the reforms were necessary short term costs
of adjustment to new global conditions. It was necessary for people to bear the short term pains
of liberal reforms in order to benefit from their long term benefits. It was argued that every
change in policies brings ‘risks and opportunities’. If people suffered from the new economic
policies, this was because they did not seize the opportunities that the policies opened up, and
hence their suffering was their own fault.
 19

Because of the burdens of the reforms on working people, in some developing countries
structural adjustment programs had to be carried out by repressive military regimes (e.g. in
Chile, Argentina, Pakistan, Turkey) or at least with a suspension of parliamentary democracy
(India). In these countries authoritarian regimes ensured the implementation of the SAPs. After
the reform process gained momentum and opposition to the reforms was crushed, pluralistic
democracy was restored, and the reforms were now carried on by elected governments.

Meanwhile, it was noticed that while many peripheral countries implementing the import
substituting industrialization strategy experienced external debt crises which affected their
industrialization efforts and GDP growth, some East Asian countries that were more export
oriented in their industrialization survived the oil shocks and the recession of the early 1980s
without suffering big setbacks in their industrialization processes and GDP growth rates. The
export oriented East Asian countries were presented as examples by liberal economists and
international institutions to persuade other peripheral governments to give up import
substituting industrialization.

The new liberal policies increased global trade in the 1980s. Liberal economists presented the
appearance of Nike sports shoes, Marlboro cigarettes, Lacoste shirts, Starbucks coffee shops,
McDonalds restaurants all over the world to give the impression that globalization was
achieving a convergence of living standards across countries. The implication was that the
distinction between core and periphery was disappearing.

In the next lecture we study the globalization of manufacturing production by core country firms
that gained an impetus with these policy changes.
 20

Sources for the lecture

Armstrong Philip, Andrew Glyn, John Harrison. 1991. Capitalism Since 1945. Oxford: Basil
Blackwell.
Baker, Dean. 2007. The Productivity to Paycheck Gap: What the Data Show: The Real Cause
of Lagging Wages. CEPR (Center for Economic and Policy Research). April 2007.
Chang, Ha-Joon. 2008. Bad Samaritans: The Myth of Free Trade and the Secret History of
Capitalism. New York. Bloomsbury Press.
Corbridge, S. and J. Agnew 1991. The US trade and budget deficits in global perspective: an
essay in geopolitical-economy. Environment and Planning D: Society and Space. 1991.
Volume 9. 84-85.
De la Barra, Ximena. Sacrificing Neoliberalism to Save Capitalism: Latin America Resists and
Offers Answers to Crises. Critical Sociology. 36(5) 2010. 635-666.
DeWitt, Peter R. 1980. The Crisis in International Debt Management. Contemporary Crises. 4.
141-159.
Emmanuel, Arghiri. 1974. Myths of Development versus Myths of Underdevelopment. New
Left Review. I/85. May-June. 61-82.
Epstein G. A., Schor J. B. 1990. Macropolicy and the rise and fall of the Golden Age. Chapter
3 in The Golden Age of Capitalism: Reinterpreting the Postwar Experience. S. A. Marglin
and J. B. Schor (eds). Oxford. The Clarendon Press. 126-152.
Hobsbawm, Eric. 1996. A History of the World, 1914-1991: The Age of Extremes. New York.
Vintage Books.
Mahdavy, Hossein. 1970. The Pattern and Problems of Economic Development in Rentier
States: The Case of Iran. In Studies in the Economic History of the Middle East, M. A. Cook
(ed.). Oxford University Press: Oxford. 428-467.
Obstfeld, Maurice, Alan M. Taylor. 2017. International Monetary Relations: Taking Finance
Seriously. Journal of Economic Perspectives. 31(3). Summer. 3-28.
Palley, Thomas. 2024. Europe’s foreign policy has been hacked and the consequences are dire.
https://thomaspalley.com/?p=2402aspalley.com/ (16.02.2024)
Patnaik, Prabhat. 2006. Diffusion of Development. Economic and Political Weekly. May 6,
2006. 1766-1772.
Strauch, Rolf. 2022. Euronomics: The current terms of trade shock and the loss of wealth – are
we heading back to the 1970s? https://www.esm.europa.eu/blog/euronomics-current-terms-
trade-shock-and-loss-wealth-are-we-heading-back-1970s. 29/03/2022 (12.03.2024)
 1

Development Economics Lecture 5

31.10.2024

relocation of manufacturing – commodity chains – working conditions

terms of trade

Outsourcing in manufacturing

The decline in labor productivity growth and the demand for rising living standards
and real wages in the core countries in the 1970s tended to raise unit labor
costs in manufacturing industries. Unit labor cost is the wage per unit of labor,
divided by the quantity of goods produced by one unit of labor. So it is the money
cost of labor embodied in a manufactured good.

The rises in oil prices in that period also increased production costs in the core
countries.

The increases in costs of production in core countries induced their

manufacturing firms to seek ways to reduce these costs in order to remain
competitive and profitable. In order to reduce costs of production, many
manufacturing firms in core countries resorted to outsourcing some of the
production activities in their factories to other firms in their countries, that is, to
firms which were specialized suppliers of intermediate goods and suppliers of
services such as catering, accounting, transportation and research.

Some manufacturing firms in the core countries also began to outsource some of
their manufacturing production to firms in peripheral countries. Some relocated
their own factories to peripheral countries. Some established business relations
with peripheral manufacturers and began to import intermediate or final goods
from them. This process began in the 1970s and accelerated thereafter.1

Certain technological developments have facilitated the outsourcing of

manufacturing to other countries. The speed of communications has increased.
Costs of transportation, communication and data processing have been reduced.
These developments have made it easier to fragment production processes and
to distribute manufacturing geographically.

1
In this course we focus on the relocation of manufacturing to peripheral countries. However,
manufacturing firms in core countries have also been relocating their production to other core
countries. One aim is to circumvent trade protection measures. E.g. in the 1980s when the US
began restricting imports of cars, TVs, and steel from Japan, Japanese firms began to establish
factories in the US (Maswood 2021, 9-11).
 2

However, the outsourcing and relocation of manufacturing to peripheral

countries necessitated that economic policies in these countries change. For
example, some of the manufacturing in peripheral countries for core country
firms necessitated exporting components to peripheral countries. So the trade
liberalization in the 1980s and 1990s in peripheral countries under Structural
Adjustment Programs removed an important obstacle to relocating industrial
production to these countries.

Why would outsourcing manufacturing production from core to periphery, or

transferring production facilities there reduce the costs of production? Several
factors make for lower unit production costs in peripheral countries.

The first factor is lower unit labor costs. Lower wages in the peripheral countries
(lower compared to labor productivity differentials between core and periphery)
made for lower unit labor costs compared to those in the core countries in the
same sectors. Although in many sectors physical labor productivity in peripheral
countries is generally lower than that in core countries, the wages in the periphery
are often much lower than wages in the core compared to productivity
differences, so that the wage difference outweighs the productivity differences,
making unit labor costs in corresponding manufacturing activities in the
periphery lower than in the core.

A recent research found that in 2021 “Southern wages are 87–95% less than
Northern wages at the same skill level, i.e. for equal work as defined by the ILO.
Southern wages are 87% less for high-skill labor, 93% less for medium-skill
labor, and 95% less for low-skill labor.” It notes that the wage disparity is on an
increasing trend (Hickel et al. 2024, 6).

Other factors that have made relocation of production to the periphery attractive
are government policies such as comparatively lax environmental protection
regulations, tax concessions given to peripheral suppliers who export, and tax
concessions to foreign direct investments.

The ultimate factor that contributes to lower production costs is the

undervaluation of currencies in underdeveloped countries compared to their
purchasing powers. This makes not only labor costs, but all the costs of locally
produced inputs, public services, taxes etc. cheaper for core country firms when
converted to core countries’ currencies at market exchange rates.

Wages in the periphery

But why are wages much lower in peripheral countries compared to those in the
core countries? The reasons suggested are that the economies in underdeveloped
countries are a combination of forms of capitalistic and non-capitalistic
 3

production and distribution. Various types of non-capitalistic production and

distribution (i.e. production and distribution outside the sphere of the market
economy) underpin the reproduction of labor in the periphery, sustaining wage
earners, allowing them to survive with a lower real wage income compared to
core countries. The main example of non-capitalistic production is the various
types of production done in the household especially by women, but also by
children and men (producing food at home, preparing meals, cleaning the house,
caring for the children and elderly, washing clothes, doing repairs at home etc.).
An example of non-capitalist distribution is foodstuffs sent to urban worker
families by relatives in villages, and sharing incomes within extended family
networks. All these are described as ‘unpaid services of the extended family
provided from non-capitalist production’. Sending children to work for a wage,
and adults taking on second jobs e.g. on week-ends and holidays, are additional
ways in which workers supplement their low wages. These enable the employers
to pay workers low wages. Such practices -typical in peripheral societies- enable
worker households to survive on lower wages compared to the households in core
countries.

Table 5.1
Wages and productivity in industrialized and developing countries
(dollars per year)
Average hours worked Yearly minimum wage Labor cost per worker Value added per
per week in manufacturing worker
in manufacturing
1980-84 1990-94 1980-84 1990-94 1980-84 1990-94 1980-84 1990-94
North
America
United 35 34 6,006 8,056b 19,103 32,013b 47,276 81,353
States
Canada 32 33 4,974 7,897b 17,710 28,346b 36,903 60,712

Mexico -- 34 1,002 843 3,772 6,138 17,448 25,991

Europe
Denmark -- 37 9,170 19,933b 16,169 35,615b 27,919 49,273
France 39 39 10,812 22,955b 16,060 38,900b 26,751 61,019e
a a
Germany 41 40 21,846d 63,956b,d -- --
Greece -- 41 -- 5,246 6,461 15,899b 14,561 30,429
Ireland 41c 41c -- -- 10,190 25,414b 26,510 86,036
Netherlands 40 39 9,074 15,170b 18,891 39,865b 27,491 56,801

Asia
China -- -- -- -- 472 434d 3,061 2,885
Hong 48 46 -- -- 4,127 13,539b 7,886 19,533
Kong
India 48 48 -- 408 1,035 1,192 2,108 3,118
Indonesia -- -- -- 241 898 1,008 3,807 5,139
Japan 47 46 3,920 8,327b 12,306 40,104b 34,456 92,582
South 52 48 -- 3,903b 3,153 15,819b 11,617 40,916
Korea
a
Malaysia -- -- -- 2,519 3,429 8,454 12,661
Philippines -- 43 -- 1,067 1,240 2,459 5,266 9,339
Singapore -- 46 -- -- 5,576 21,534b 16,442 40,674
Thailand 48 -- -- 1,083 2,305 2,705 11,072 19,946
Source: Spar (2002), 19, Exhibit 7.
a
Country has sectoral minimum wage but no minimum wage policy.
b
Data refer to 1995-1999.
c
Data refer to hours per week worked in manufacturing.
d
International Labor Organization data.
 4

Notice that, as subsistence work done in households sustains the wage-earning

classes, the household (especially in the periphery) is obviously an essential
institution of the capitalist world-economy. This role of the household is ignored
in mainstream economics. Mainstream economics depicts the household merely
as a social unit that supplies labor in labor markets, money saving in financial
markets, and purchases consumer goods in consumer goods markets. Economics
ignores the vital production going on in households, simply because such
production does not involve money and market transactions.

Other factors that make for lower wages in peripheral countries compared to the
core are the repression of trade union activities, longer working days and longer
working weeks.

Table 5.1 shows the average working hours per week, minimum wages, labor
cost per worker in manufacturing and value added per worker in manufacturing
in selected developed and underdeveloped countries. A rough comparison of the
ratios of labor cost per worker to value added per worker reveals the differences
in income distribution in manufacturing between these groups of countries. For
example, in 1990-1994 the average ratio of labor cost per worker to value added
per worker was 0.39 in the US, 0.70 in the Netherlands, 0.24 in Mexico and 0.26
in the Philippines. This makes the main motivation for the relocation of
manufacturing clear.

Foreign direct investment and subcontracting

Foreign direct investment (FDI) mainly refers to a firm’s establishing a firm in

another country, or forming a joint venture with a local firm in another country, or
acquiring the ownership of an existing firm in another country.

In the post-war period when peripheral states were pursuing import substituting
industrialization, core countries’ firms’ direct investments in peripheral countries
had two main motivations: one was to use the natural resources in those countries,
and the other was to avoid those countries’ protectionist trade barriers and thus to
penetrate their markets.

However, under the pressure to reduce production costs, the motives of core
country firms to carry out foreign direct investment (FDI) in peripheral countries
changed as of the 1980s. FDI now aims to manufacture products at facilities in
countries where production costs are low, and to export the products back home or
to other countries.

Since the 1980s, a second motivation in core country firms’ FDI in peripheral
countries has been to circumvent the protectionism of other core countries. For
example, one of the known motivations of Japanese and South Korean FDI in
 5

Southeast Asian countries is to avoid political friction with the US, as the US
government is concerned about the US trade deficits with these two countries. The
exports to the US of goods manufactured in Indonesia by Japanese companies are
recorded as Indonesian exports, not Japanese exports. Hence Japanese firms
aiming to avoid US protectionist tariff measures against their exports from Japan
prefer to export to the US from production sites in Indonesia and other countries.

Another circumstance that has induced core country firms to relocate their
production is changes in exchange rates. In 1985 the US government made an
agreement (the Plaza Accord) with Japan, Germany, France and the UK. The US
pressed these governments to intervene in currency markets to depreciate the
dollar against the Japanese yen, the Deutsche Mark, the French franc and the
pound sterling. The forced revaluation of the yen eroded the price competitiveness
of Japanese exports. This induced Japanese manufacturers to relocate some of their
manufacturing operations to China and to Southeast Asian countries where labor
and production costs were cheaper than in Japan. Similarly the revaluation of the
German Mark prompted German car manufacturers to relocate some of their
production activities to East European countries (Maswood 2021, 12-13).

A final motivation for foreign direct investment of core country firms to middle-
income peripheral countries with large populations (e.g. China, India, Brazil) is to
gain a share in the markets of those countries.

These observations shed a light on the requirements in Structural Adjustment

Programs that peripheral states liberalize trade and deregulate foreign direct
investment.

Beside FDI, the other method of relocating manufacturing is subcontracting.

Subcontracting is outsourcing the production of components or of the finished
items to supplier manufacturers in peripheral countries. The manufacturing
capabilities achieved during import substituting industrialization provided the
basis for the relocation of manufacturing production to these countries.

Table 5.2 shows the share of manufactured goods in total merchandise exports
rising in several developing countries. In some countries such as Indonesia,
Pakistan and Türkiye manufactures must have displaced primary commodity
exports, while in other countries such as Argentina and Brazil a more diversified
composition of manufactured and primary commodity exports seems to have
emerged.

The subcontracting of manufacturing to peripheral countries led to the

emergence of new types of relations between firms in core and firms in peripheral
countries, relations called ‘commodity chains’. We now focus on this.
 6

Table 5.2
Share of manufactured goods in merchandise exports (percent)
1970 1980 1990 2000 2010 2020
Argentina 14 23 .. 32 32 14
Brazil 13 37 52 58 35 25
Egypt 27 11 .. 38 42 48
Guatemala 28 24 .. 31 43 43
India 52 59 70 78 63 71
Indonesia 1 2 35 57 37 47
Kenya .. 12 29 21 34 28
Malaysia 7 19 54 80 67 73
Morocco 10 24 .. 64 63 70
Pakistan 57 48 79 85 74 75
Philippines 7 21 .. 91 56 80
Türkiye 9 27 68 81 78 78
Source: World Bank. World Development Indicators. (27.10.2023)

Commodity chains

A commodity chain is a network of production processes whose end result is a

finished commodity. The term commodity chain was coined by world-systems
researchers Terence Hopkins and Immanuel Wallerstein in 1974. Another
frequently used term is value chain. Research in global commodity chains took off
in the 1990s.

Commodity chains are stable contractual linkages of formally independent firms

which have emerged from the fragmentation and outsourcing of some of the
previously integrated manufacturing activities of core country firms. Suppliers
who previously strove to export through casual market transactions now became
subordinated under contracts which established more or less stable business
relationships. Global commodity chains became the export channels for
manufacturers in peripheral countries.

The organizing dominant firm in a commodity chain is called the key agent or lead
agent. The subcontracted manufacturers working for a lead firm may be distributed
among many countries. Sometimes subcontractors themselves also do
subcontracting, so that networks of subcontractors emerge, with tier-1
subcontractors, tier-2 subcontractors, tier-3 subcontractors etc. participating in a
single chain.2

2
The term ‘chain’ is actually not a good metaphor for these relations, because in a chain each
piece is linked to two other pieces. In a commodity chain a manufacturer may be supplied by
many suppliers and may be supplying many other firms; hence the charts of commodity ‘chains’
look more like a web (a net) than a chain.
 7

Types of commodity chains

Researchers describe two archetypes of commodity chains. One type is called

‘producer-driven’ commodity chains. These are networks of producers in which
“large integrated industrial enterprises play the central role in controlling the
production system (including its backward and forward linkages)”. “This is most
characteristic of capital- and technology-intensive industries dominated by
transnational corporations” (Appelbaum 2004, 2). Examples are seen in the
automobile and aircraft sectors. Large-scale, high-technology production
facilities, involving heavy investment and scale economies, constitute barriers to
entry. In producer-driven commodity chains the key agents own factories where
they produce the final product.

In producer-driven commodity chains, low-profit activities are outsourced

upstream to networks of suppliers, who are bound by contracts to produce
according to tightly specified conditions. The suppliers compete against each other
to supply the key agents, who therefore have an advantage in bargaining the terms
of the contracts (Raikes et al. 2000, 396).

In producer-driven commodity chains other low value-added activities

downstream of the manufacturing of the final product are often outsourced to
similarly competitive networks of retailers.

The second archetypal commodity chain is called ‘buyer-driven commodity

chains’. In these, “large retailers, marketers and branded manufacturers play the
pivotal role in setting up decentralized production networks in a variety of
exporting countries, typically located in developing countries. This pattern of
trade-led industrialization has become common in labor intensive consumer goods
industries such as garments, footwear, toys, handicrafts and consumer electronics.
Large retailers or marketers that order the goods supply the specifications”
(Appelbaum 2004, 2). The technical barriers to entry in these sectors are low,
because the suppliers have the capacity and skills to produce the finished
commodity. However, these direct producers are unable to market or export these
products on their own. Producers are subordinated to the key agents, because the
latter control design and marketing, which means they control brand names and
retailing. Control over brand names and skills in retailing comprise high barriers
to entry and ensure high profits to the lead firms. So in buyer-driven commodity
chains the lead firms are described as ‘brand-name producers without factories’.

In buyer-driven commodity chains the primary source of competitive advantage is

making aesthetic products, creating new styles, fads, mystique. Therefore the share
of designers in the value of the product is high. The proportion of value-added
accruing to design-intensive activities is high relative to the value-added of
manufacture and assembly activities (Appelbaum 2004, 3). However, among
 8

buyer-driven chains, while some lead firms (buyers) consider the development of
new designs as part of their core competence, others do not. Some lead firms in
producer-driven chains hardly possess any design capabilities. These firms
outsource even the designing of new products.3 But this does not weaken the lead
firm’s powerful position in the chain, as it is based on its strength in marketing
and control over the brand.

When the subcontractor produces a finished product for a key agent this is called
an original equipment manufacturing (OEM) arrangement. In some cases highly
competent suppliers “assume responsibility for a full range of activities beyond
‘basic’ production (such as design and inventory/logistics management).” This is
called ‘turn-key supply’ in the electronics industry; ‘full-package supply’ in the
apparel industry (Bair 2005, 13).

There are cases of commodity chains where the producer-driven/buyer-driven

distinction is difficult to apply. There are agricultural commodity chains that fit
neither the producer-driven nor the buyer-driven archetypes. For example, coffee
commodity chains are dominated by large trading companies. These buy the beans
from the producers, process them and sell the ground coffee to retailers (coffee
shops who create a consumption pattern) or they market it as instant coffee (Bair
2009, 17-18).

Giant retailing conglomerates have also been emerging as lead firms in buyer-
driven chains. Some familiar retail conglomerate names in Türkiye are Carrefour,
Migros, Metro, Ikea and Bauhaus.

Many-layered subcontracting

Some global ready-made garment retailers maintain centralized merchandising

offices in India. These offices select suppliers for the brand-owning lead firms.
The offices place orders and negotiate over the price, quality, delivery dates etc.
Indian supplier manufacturers are disciplined by the threat of instant ‘relocation’
and they are subject to the just-in-time requirements of the global ready-made
garment retailers (Kalhan 2008, 117).

Some Taiwanese and South Korean firms have become multinational buyer-
suppliers. In an article published in 2004 the following examples were given: (1)

3
CEOs of major firms have claimed that the necessary quantity of high-skilled engineering
labour to support their production is not available in the core states and hence this production
must be performed abroad. Apple’s former CEO Steve Jobs indicated that his company required
30,000 engineers. He stated, “You can’t find that many in America to hire”. Current CEO Tim
Cook has noted that Apple’s production relies on large quantities of high-skilled labour in China
for advanced engineering, tooling and innovation. “In the US, you could have a meeting of
tooling engineers and I‘m not sure we could fill the room. In China, you could fill multiple
football fields” (Hickel et al. 2024, 8).
 9

Nien Hsing Corporation, founded in 1986 in Taiwan, employed more than 20,000
workers in five Central American countries, and thousands of workers in a
Mexican factory and two in Lesotho, producing jeans and denim; (2) Yupoong,
Inc., a South Korean firm, was the world’s second largest cap manufacturer; (3)
Boolim, a South Korean firm, was producing casual athletic ware and knitwear in
China, Indonesia, Sri Lanka, Bangladesh, Saipan, Thailand, Philippines, Malaysia,
Myanmar, Guatemala, Mexico, Dominican Republic, Nicaragua, Honduras, El
Salvador and Vietnam for clients including Nike, Polo Ralph Lauren, Kenneth
Cole, Calvin Klein and NBA Properties; (4) Pou Chen, a Taiwanese company,
employed 150,000-170,000 workers worldwide, producing shoes for Nike,
Reebok, New Balance, Asics Tiger, Converse, Puma, Keds, Timberland,
Rockport. Pou Chen controlled 17 percent of the world market (Appelbaum 2004,
9).

Power and profits

Global commodity chain analysis has revealed a major change in the structure of
international trade and the necessity of a new approach to its study. The old
conventional trade theories consider trade in isolation from investment, finance,
technology transfer. They ignore bargaining power relations between trading
partners. They assume that participants are independent of each other and that
transactions may be singular one-off events.

Global commodity chain researchers draw attention to the organizational aspects of

international trade. They study a wide range of activities from primary commodity
production to final consumption. They try to understand how key agents build,
coordinate and control the linkages and flow of produce between raw material
suppliers, processors, primary traders, wholesalers and retailers. They study the
many different types of contracts in the networks.

In commodity chain analysis power is an important concept. Some aspects of power

are the ability to (1) set prices, (2) set up barriers to entry, (3) outsource lower value-
added activities and to retain activities with higher value-added, (4) enforce
standards of quality and reliability in subcontracted produce flows (Raikes et al.
2000, 402). Lead agents subordinate suppliers through their control of brand names
and market access and of information. This includes technological information and
information on markets.

Implications for economic development

What have been the consequences of the globalization of manufacturing for

convergence of welfare between rich and poor societies? Some scholars have
argued that the globalization of manufacturing through commodity chains is the
new key to economic development.
 10

It is argued that subordinate participation in a global commodity chain provides

small manufacturers in the periphery access to core markets in North America and
Europe. “One of the major hypotheses of the global commodity chain approach is
that development requires linking up with the most significant lead firms in the
industry” (Gereffi et al. 2001, 1622). “Understanding how ... value chains operate
is very important for developing country firms and policy-makers because the way
chains are structured has implications for newcomers. How can economic actors
gain access to the skills, competencies and supporting services required to
participate in global commodity chains? What potential is there for firms,
industries and societies from the developing world to ‘upgrade’ by actively
changing the way they are linked to global value chains?” (Gereffi et al. 2001, 2).

Upgrading means improving a firm’s position in the chain, possibly securing more
value-added. A supplier firm may upgrade its position by producing more
sophisticated goods with higher value added (product upgrading), or by improving
the technology it uses (process upgrading). A supplier may upgrade its position
by moving from one industry to another (inter-chain upgrading) (Bair 2004, 16).
A supplier firm may increase the range of functions it performs to become a ‘turn-
key’ or ‘full-package’ manufacturer (functional upgrading).

According to commodity chain enthusiasts, technological information acquired by

participating in commodity chains and learning-by-doing enable peripheral
suppliers to move up chain hierarchies. However, these producers have to accept
the terms defined by the key agents. Without accepting chain discipline, a firm
cannot partake in the process of learning from the links with agents in the more
advanced segments of the chain. This learning is necessary to move into the higher
value-added and higher-skill sections of the chain (Schmitz and Knorriga 2000,
179).

Indeed, in the 1990s suppliers in a handful of peripheral countries, mostly in East

Asia, made headway in industrial upgrading, shifting away from commodities
such as textiles, apparel, footwear to higher-value added, technologically
sophisticated products. In the electronics industry some Asian producers became
‘original-design manufacturers’. It was reported that firms such as Dell, Motorola
and Philips now put their brand names on complete products that are designed,
engineered and manufactured in Asia by original-design manufacturers. The lead
firms are having to depend on their suppliers to design whole products.
Around 2010 technology companies as Hewlett Packard, Cisco, Motorola, Lucent
Technologies, Ericsson, and Nokia were reported to be scaling back their own
research and development budgets. US corporations were being reduced to brand
names with sales forces selling foreign-designed, engineered and manufactured
goods.
 11

However, the East Asian success stories in upgrading by suppliers do not mean
that participation in chains automatically leads to upgrading.

Research shows that upgrading by supplier firms in peripheral countries depends

to a large extent on the state’s industrial policies to facilitate the domestic firms’
acquisition of foreign technologies, to pressure foreign lead firms to share their
technology, to pressure firms to increase the local content (percentage of
domestically produced intermediate goods), to train technicians and engineers.
The most successful examples of state action promoting upgrading are seen in
East Asian countries (Dünhaupt et al. 2020). (We shall discuss these policies in
South Korea and China.)

Where coherent state policies to support upgrading are lacking, there is little
technology transfer, and little improvement in value-added share. Then integration
into commodity chains remains stuck in an international ‘race to the bottom’ in
repressing wages, in worsening working conditions, in loosening environmental
protection standards, in increasing tax concessions, in providing better
infrastructure, in facilitating customs procedures.

It should be noted that the integration of manufacturers in a developing country

into global commodity chains results in the disintegration of the national
manufacturing sector. Integration into international production networks can
disintegrate existing domestic supplier-assembler linkages, i.e. domestic vertical
linkages.

To get an idea of the breakdown of value-added of various goods produced in a

peripheral country and consumed in a core country, see the empirical evidence in
the appendix at the end of this lecture note. In all the examples the greater part of
the value-added seems to accrue to the lead firm plus retailers, transporters,
insurers and to the state as taxes in the importing core country.

The global relocation of manufacturing is reflected in the increasing share of

foreign value-added in exports. As the share of the cost of imported intermediate
goods in the prices of exports increases, the share of domestic value-added in the
value of exports decreases. Table 5.3 shows that the share of foreign value-added
(costs of imported intermediate goods) in exports of aggregates of countries has
an increasing trend. Table 5.4 shows the same statistic for a number of countries
and the EU in the year 2004. In Table 5.4 the percentage of foreign value-added
in East Asian countries and in Mexico is quite high, while figures for the US, EU-
15 and Japan are conspicuously lower. The low figures for Brazil and Russia may
be due to the high percentage of primary commodities in the exports of these
countries, as the production of most primary commodities does not involve many
imported intermediate goods.
 12

Table 5.3
Foreign value added share in exports (percent)
1970a 1990a 1995b 2005b
0.18 0.24 0.27 0.33
Source. IMF 2011. P. 10, Table 1.
Note: a : Original source for 1970 and 1990 figures is Ishii, Hummels and Yi (2001).
Countries covered: EU (15 countries), Australia, Canada, China, Indonesia, Hong Kong,
Japan, Malaysia, Mexico, Singapore, South Korea, Taiwan, Thailand and USA.
b
: 1995 and 2005 figures estimated by IMF economists. Countries covered: EU (15
countries), Australia, Brazil, China, Czech Republic, Hungary, India, Indonesia, Israel,
New Zealand, Norway, Poland, Russia, Singapore, Slovakia, Switzerland, Taiwan,
Türkiye and USA.

Table 5.4
Foreign value-added share in exports, 2004 (percent)
Brazil 12.7 Indonesia 22.9 Malaysia 40.5 Taiwan 41.1
China 35.7 India 20.1 Mexico 48.0 Thailand 39.7

EU-15 11.4 Japan 12.2 Philippines 41.9 USA 12.9

EU-new 30.8 Korea, 33.9 Russia 10.2 Vietnam 37.0

South
Source: Koopman et al. 2010, 44, Table 4.
Note: EU-15: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland,
Italy, Luxemburg, Netherlands, Portugal, Spain, Sweden, UK.
AB-new: Cyprus, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland,
Slovakia, Slovenia.

Table 5.5 completes the picture given in the tables above. In Table 5.2 in most
of the developing countries the share of manufactured goods in merchandise
exports rose between 1970 and 2000. In Table 5.5 it is difficult to discern any
upward trend in the share of manufacturing value-added in GDP in the same
countries.

Table 5.5
Share of manufacturing value added in GDP (percent)
1970 1980 1990 2000 2010 2020
Argentina 32 29 27 16 16 14
Brazil 25 30 23 13 13 11
Egypt .. 12 17 18 16 16
Guatemala 16 17 15 13 19 14
India 14 17 17 16 17 14
Indonesia .. .. 20 23 22 20
Kenya 11 11 10 10 11 8
Malaysia 14 22 24 31 23 22
Morocco 16 18 19 17 14 15
Pakistan 15 14 15 10 13 11
Philippines .. .. .. 25 22 18
Türkiye 16 17 22 19 15 19
Source: World Bank. World Development Indicators. (27.10.2023)
 13

Working conditions in globalized manufacturing

As the relocation of manufacturing to peripheral countries progressed after the

1970s, the working classes in the developed countries became aware that this
causes unemployment in their countries. So they have been opposing it. The
defenders of relocation of manufacturing to the periphery argue that new jobs are
being created at home as old jobs move offshore, and that the new jobs will be
better-paid clean jobs, such as computer-based designing of new products. But
all manufacturing workers in core countries who lose jobs due to relocation
abroad do not have the skills for designing or innovation. As manufacturing jobs
in core countries were relocated abroad, the composition of employment in core
countries has changed in favor of service sectors (many of them low wage
‘McJobs’). In service sectors, wage differentials are greater than in
manufacturing. And it is more difficult for workers to unionize in many service
sectors (Milanovic 206, 103-105). The expansion of service sector jobs has thus
led to increasing income inequality in core countries.

Both unemployment concerns and humanitarian motives in core countries have

given rise to consumer activism opposing exploitative working conditions in
peripheral supplier firms. Non-governmental organizations such as anti-
sweatshop groups have emerged that promote movements such as ‘clean clothes’
and ‘fair trade coffee’ campaigns. Labor abuses in Latin American and Asian
farms and factories producing for well-known brands have been publicized,
raising consumer awareness of how the products are produced (Bair 2005, 10-
11). However, the many-layered structure of subcontracting makes the scrutiny
of working conditions and holding lead firms responsible for abuses difficult.

The globalization of manufacturing production has created jobs in the periphery.

It has also created conditions in which workers are pressed to accept low wages
and bad working conditions because the firms blackmail them with the threat of
relocating their production abroad. And the transition to capitalism in the
countries of the former Soviet Union, of East Europe, China and Vietnam in the
1990s massively expanded the total labor force in the capitalist world-economy,
increasing the global competition for employment.

Moreover, the supply of people seeking employment in the periphery is

expanding through the dispossession of people in rural areas. Core country firms
have been purchasing fertile land in peripheral countries to increase large-scale
commercial agricultural there, and to increase agricultural exports from these
countries to stock supermarkets in the core. These land purchases -recorded as
FDI- are often facilitated by the state in the country. The process has been
dispossessing peasant cultivators of their land, forcing them to join the urban
labor forces in peripheral countries (McMichael 2006).
 14

One result of the massive increase in workers seeking jobs in the world-economy
is the informalizing (casualization) of employment throughout the world.

In the 1945-1980 period formal, stable, secure employment was the standard
practice in the core countries. In that era, informal employment, typical in
peripheral countries, was regarded as an indicator of underdevelopment, bound
to disappear with the modernization of the economy.4 But with the globalization
of manufacturing, the distinction between secure formal employment in core
countries for white male workers in major established major industries on the one
hand, and informal employment in the peripheral countries and in marginalized
sectors in the core on the other, has been rapidly disappearing. Some economists
see informalization as an essential component of globalization (Chang 2009,
165).

Informalization involves employment practices that may comply with

regulations, but are less secure than the standards of the International Labor
Organization (ILO) and are not protected by a trade union movement. Contract
workers5, temporary workers6, agency workers7 and part-time workers are
virtually informal workers, because although they may be subject to a regulatory
framework, the precarious nature of their employment and their high turnover
rates exclude them from the solidarity-based protection of the labor movement.
Despite being protected by laws on labor standards, these workers face numerous
barriers to organizing (Chang 2009, 170).8

For example, agency employment (or dispatched workers) enables managers to

escape their legal obligations as direct employers, and to adjust the number of
their workers easily through annual tenders and agreements with the agencies
(sub-contractors). Agency workers have little or no legal relationship with their
real employers (the managers of their workplaces). gency workers have no say
in the stipulations of the contract between the agency and the real employer.

4
Ha-Joon Chang points out that actually even in the core countries during the post-war boom,
secure formal employment was restricted to some industrial workers in certain sectors, co-
existing with informal employment. The trade unions that represented formally employed male
white workers mostly turned their backs on women and migrants, obliging them to take informal
jobs (Chang 2009, 168).
5
A contract worker is a worker who signs a contract with an employer that specifies the task the
worker must complete and how much she will be paid. The contract ends with the completion of
the task.
6
A temporary worker is a worker who is not permanently hired but hired just for limited period of
time.
7
An agency worker is a person employed by an employment agency and sent to work for another
employer (i.e. is hired to another employer). (The agency is called ‘taşeron’ or ‘alt işveren’ in
Turkish.)
8
The discussion of informalization of employment here is focused on wage-employment. By
contrast, in other contexts, the term ‘informal sector’ may refer to a wide range of activities poor
people do on their own to survive. In some poor countries these include “[s]treet hawking,
scavenging, petty production in the home, and the provision of services ranging from sex to
transportation…” (McNally, 2011, 225-226).
 15

Employment of regular workers and agency workers on the same production site
creates divisions between them, and serves to subdue the regular workers.

In Türkiye it is nearly impossible for agency workers to unionize to defend their

rights, since the workers employed by the same employment agency are
subcontracted to different firms in different locations, even in different cities.
Further, some employment agencies regularly shut down and appear under a new
name, re-employing the same workers, to deprive their workers of the right to
severance payment.

“The spread of agency work is no longer confined to labor-intensive industries.

Even Toyota, one of the most cutting-edge of automobile firms, employs agency
workers; agency and other forms of contract workers now account for about
50% of its [Toyota’s] Thai subsidiary work force…” “Often large scale
enterprises, such as Samsung in Thailand and Hyundai Motors in Korea, establish
sub-contract firms and work agencies…” “In recent years Hyundai Motors
actually increased the number of agency workers on the same lines as permanent
workers. As of 2004 there are reports of more than 10,000 workers, dispatched
from more than a hundred work agents (disguised as sub-contractors), working
in Hyundai’s production lines…” “The electronics industry shows the same
trend in regional patterns of production, both in the core and peripheral
countries of the industry” (Chang 2009, 174).9

The increased mobility of firms world-wide has not only enhanced the ability of
firms to apply pressure on workers in industrial relations. Firms are also observed
to blackmail governments in the areas of environmental policies and taxation with
the threat of relocation. The expression ‘race to the bottom’ is often used to
describe the competition among peripheral states and even core states to make
concessions in environmental protection and in tax policies, so as to prevent
relocation of manufacturing activities to other countries.

The switch to export-led growth in peripheral countries has led to the proliferation
of various types of special zones (export processing zones etc.) where states make
concessions to manufacturers and service firms in taxes, tariffs and in worker
protection.

Still, research shows that even in sectors in which firms are globally integrated, in
countries where the level of workers’ unionization is high and trade unions are
strong, workers’ wages are higher and working conditions are comparatively better

9
Agency employment is not confined to developing countries. It is also spreading across the
private and public sectors in core countries such as the UK (Wills 2009). The practice of some
firms (such as Uber Technologies) of treating the taxi drivers and couriers they employ as
independent contractors is another example of the informalization of employment.
 16

than in countries where unionization is low and unions are weak. For example, in
the automotive industries in the Union of South Africa and in Brazil, gains in real
wages, working conditions and labor rights have been achieved despite minor
upgrading, thanks to the influence of trade union movements and “governments
that enforced labor laws and were at least not hostile to trade unions” (Dünhaupt et
al. 2020, 12, 15).

By contrast, in the garment industry in Bangladesh, despite an overall increase in

productivity, the firms are captive in low value-added activities, unionization is low
and wages are low. The poor working conditions in Bangladesh were highlighted
in December 2012 when a fire at the Tazreen Fashions factory in Dhaka killed 112
workers trapped inside, and in April 2013 when the Rana Plaza building in Dhaka
which housed five garment factories collapsed, killing at least 1,132 people and
injuring more than 2,500. Similarly, in the Vietnam garment industry there is no
upgrading, unions are weak, wages are low and working conditions are bad. In the
garment industry in China the unions are weak; yet wages in recent years have
risen due to an increase in minimum wages and growing labor shortages in some
regions (Dünhaupt et al. 2020, 8-10).

Another result of the globalization of manufacturing has been the feminization of

the global labor force. The demand for cheap labor, pressures on household
budgets due to declining real wages of male workers, and the curtailment of
public services under structural adjustment have been forcing women to join the
labor force throughout the world. Women’s wages are generally lower than men’s
(in some countries even women with higher qualifications earn less than men with
lower qualifications).10 One cultural explanation for the wage difference is that
women are not seen as the ‘main bread-winner’ for the family (although working
women can be single or can be the head a family). All women are assumed to be
supplementary wage earners. Feminists point out that women’s increased
participation in labor markets has not been generally accompanied by a
redistribution of domestic and childcare responsibilities in households. In some
Muslim countries the increase in women’s participation in the labor force has
been accompanied by social pressures for occupational and spatial segregation
and stricter dress codes (Moghadam 1999).

Finally, the globalization of manufacturing production distorted the shape of the

Kuznets curve in many core countries, including the US, the UK, Germany,
Sweden. Recall the Kuznets hypothesis, developed in the 1950s, that in all
countries, after a certain level of per capita income, income inequality would tend
to fall. Indeed, income inequality in West European countries and the former
settler colonies (US, Canada, Australia, New Zealand) increased in the 19th

10
It was reported in 1999 that “[o]n average women earn 75 percent of men’s wages” (Moghadam
1999, from the United Nations, The World’s Women 1995: Trends and Statistics, New York UN.)
 17

century and reached peaks in 1900-1914 (in the US the peak of inequality was
some time between 1910 and 1933). Then inequality in those countries gradually
declined through the twentieth century until the 1980s. Since then, the
globalization of manufacturing production started a process of deterioration of
income distribution in the core countries. The Kuznets curve bent upwards
(Milanovic 2016, 65, 74, 98-114).

Another consequence of the globalization of manufacturing production has been in

increasing inequality between the developed countries and the developing countries
outside Asia (as the tables in the first lecture attest). This increasing inequality has
intensified the motivation among people in developing countries to migrate to the
developed countries.11

Shareholder versus stakeholder governance

A development in the liberal period in the core that increased the pressure on firms
to reduce production costs is the rise of shareholder governance in private
businesses.

In the 1970s and 1980s institutionalist economists noticed that Japanese and
German firms enjoyed lower costs in external funding (lower interest rates in
borrowing, lower costs of floating new shares) and lower rates of bankruptcies
compared to US and UK firms. This observation stimulated studies of the different
ways of governance -business practices and regulations- in the US and the UK on
the one hand, and in other core countries on the other. Economists studied how
management practices and legal rules in Germany and Japan tended to protect the
interests of all the stakeholders of firms, whereas in the US and the UK management
practices and legal rules were more focused on protecting the interests of
shareholders.

A stakeholder of a firm is anyone who has an interest in the governance in the firm.
The stakeholders of a firm are its employees, managers, customers, suppliers,
creditors, the community where the enterprise is located, the state and the
shareholders. So stakeholder governance means a type of governance which
considers the interests of all stakeholders, and wherein the risks of firms are born
by all stakeholders. The basic idea is that, a firm is more than a collection of factors
of production. A firm is a social organism which is of value to society, and not just
the property of shareholders. When a firm goes bankrupt and is liquidated, this is a
loss for all the stakeholders, hence for society in general.

11
According to Gallup polls taken in 2010-2012, 13 percent of the world’s adult population would
like to move to another country. The actual numbers of people who have migrated is 3 percent of
the world population, so the potential migrants would be 16 percent (Milaonovic, 2016, 150).
 18

In Japan an institution underpinning stakeholder governance was the ‘main

bank’. For each firm, among its creditor banks, there was one bank that took the
responsibility of monitoring the finances of the firm, giving advice when necessary
to the management of the firm and preventing its bankruptcy - on behalf of all the
stakeholders of the firm.12

In Germany, the stakeholder system was reflected in the practice of representatives

of creditor banks and of trade unions participating in the boards of large firms.

Stakeholder governance is generally upheld by a structure of stable shareholdings.

In this type of governance most corporations are owned either by families or by
other firms. Ownership by other firms appears as cross-shareholdings among
‘management allies’ in conglomerate groups. In these ownership structures the
shares of firms are not frequently traded in stock markets. Hence managers do not
have to worry about the short-term ‘performance’ of the firm’s shares in stock
markets, but can focus on long-term objectives for the firm.

Table 5.6 reveals the effect of stakeholder governance on industrial relations. The
lower numbers of days occupied in strikes in Germany and Japan suggests that
stakeholder governance enabled managements and workers to resolve their disputes
without strikes in those countries.

Table 5.6
Days occupied in strikes, 1953-1987
1953-61 1962-66 1967-71 1972-76 1977-81 1982-87
US 113 79 165 105 90 28
Japan 45 25 19 21 5 2
France 41 32 350 34 23 13
Germany 7 3 8 3 8 9
Italy 64 134 161 200 151 93
UK 28 23 60 97 112 88
Note: Average number of days per year occupied in strikes per 100 workers in industry and
transport.
Source: Armstrong et al. Capitalism Since 1945. Oxford: Basil Blackwell.
Original source: Employment Gazette, October 1963, October 1972, March 1983, March
1984 and June 1989.

In contrast to stakeholder governance, shareholder governance refers to business

practices focused on maximizing the returns to shareholders, and a legal
environment that supports these practices.

In the liberal era there has been a shift to shareholder capitalism in core countries
that traditionally had a stakeholder governance culture. The trend towards
shareholder governance was strengthened by the rise of institutional investors who

12
The Japanese main bank was not an institution established by law. It was an informal practice
that had emerged during World War II.
 19

have become prominent traders in stock markets.13 Institutional investors do not

have an interest in the long term prospects of firms, but only in the price
fluctuations of the shares of firms.

The rise of shareholder governance has fostered the practice of rewarding top
executives with stock options. This has exacerbated income inequality. “In the last
four decades, CEO pay at large corporations has increased from 20 to 30 times the
pay of the typical worker, to more than 200 times the pay of a typical worker. It is
not uncommon to see CEOs of major corporations earn more than $20 million in a
single year, and paychecks of $30 or $40 million are no longer rare” (Baker 2020,
54). The argument in support of these CEO salaries is that their pay reflects the
returns CEOs ensure to shareholders. In this story, if shareholders gave CEOs lower
salaries, they would get less talented people as CEOs, and CEOs would not work as
hard. The result would be lower stock returns. Yet empirical research shows that
returns to shareholders are not closely correlated to CEO salaries.14 Which suggests
that the actual beneficiaries of this kind of pay policy -and this kind of governance-
are not the shareholders, but the top managers.

The shift to shareholder governance is said to have contributed to the pressure on

lead firms in global commodity chains to focus on retaining higher value-added
activities and outsourcing lower value-added activities. It induces lead firms to
monitor their suppliers more closely. It induces lead firms to make higher demands
on suppliers with regard to flexibility, risk transfer, inventory-management services
and price reductions. These are all reflected onto the working conditions of workers
in supplier firms: longer working hours, lower wages, increasing health problems,
workplace safety deterioration and trade union repression.

Income inequality

The globalization of manufacturing has led to the shrinking of the middle classes
in core countries. On the other hand, the increasing numbers and affluence of the
middle class in China has been changing the landscape in terms of the global
distribution of poverty. In Table 1.4 in the first lecture note, we can see that the
average per capita GDPs of the aggregate of ‘emerging market and developing
economies’ shows a very gradual convergence with the average per capita GDP of
the advanced countries -largely due to the high GDP growth in China in recent
decades.

Global inequality is no longer simply a problem between rich and poor nations.

13
An institutional investor is a company or organization that invests money on behalf of other
people. Mutual funds, pensions and insurance companies are examples. Institutional investors
often buy and sell substantial blocks of stocks, bonds, or other securities, in contrast to retail
investors. (https://www.investopedia.com/terms/i/institutionalinvestor.asp)
14
Baker (2020) refers to four research work which found no evidence for a correlation between
CEO paychecks and returns to shares.
 20

Milanovic (2016) decomposes global inequality in the following way:

Global inequality = inequality among nations + inequality within nations

= local component + class component.

Milanovic provides evidence that the ‘local’ component of global inequality is

slowly diminishing, and its class component is slowly increasing. The social class
into which one is born in is becoming a greater determinant of one’s chances in life
than the country one is born in.

The terms of trade once again

In the second lecture we mentioned structuralist economists’ prediction that the

terms of trade of countries which export primary commodities and import
manufactured goods would tend to decrease. This meant that the price indices of
the primary commodity exports of such countries would tend to rise at a lower rate
than the price indices of the manufactured imports of those countries, making the
index of the ratio of the average export prices to average import prices decline.

Since Prebisch, there have been numerous studies of the terms of trade (TOT) of
peripheral countries. The three tables on the terms of trade of developing countries
covering the 1970s, 1980s and 1990s shown below suggest that even after the
globalization of manufacturing production, the problem of terms of trade
deterioration was not eliminated in the 1980s and 1990s.

In Table 5.7 the export volume, purchasing power of exports and terms of trade of
non-oil-exporting developing countries is given for 1982-1996. Oil-exporting
developing countries are excluded to eliminate the effects of oil price fluctuations
on the aggregate figures.

The ‘purchasing power of exports’ means the ‘income terms of trade’. This is an
index showing the rate of change of the ratio of the index of export earnings (total
value of exports) to the index of average unit price of imports. In other words,
income terms of trade is

= (export volume x average unit price of exports) / (average unit price of imports).

A rising income terms of trade for a country indicates that the country’s capacity to
import (in volume terms) is increasing. This is beneficial for the country.

But notice that a country’s income terms of trade can increase while its terms of
trade is deteriorating, because the income terms of trade
 21

= (export volume) x [(average unit price of exports) / (average unit price of

imports)]

= (export volume) x (terms of trade).

The figures in Table 5.7 show that the terms of trade have decreased in 1982-1988
by an annual average of -1.3 percent and in 1989-1996 by -1.5 percent. However,
because of the increase in export volumes, the non-oil-exporting developing
countries benefited from an increase in their capacity to import from their export
revenues, as can be seen in the positive average annual percentage changes in their
purchasing power of exports, 7.2 and 9.9 percent. This the annual rate of change of
their income terms of trade.

Economists who are in favor of free trade argue that the relevant measure of the
benefits of trade to countries is not the terms of trade, but is the income terms of
trade. If a country’s income terms of trade increases, in time it can import greater
volumes of goods, which is beneficial for the economy, even if its terms of trade is
deteriorating. This is one point of view.

The counter view is that, when the terms of trade is declining, the country is forced
to export greater volumes of goods (i.e. a greater amount of labor and natural
resources) to import the same volume of goods. This does not indicate an increase
in benefits from trade for the country, but rather a decline - even though the
country’s capacity to import may increase.

Table 5.7
Export volume, purchasing power of exports and terms of trade
of non-oil exporting developing countries, 1982-1996
(average annual percentage change)
1982-1988 1989-1996
Export volume 8.6 11.6
Terms of trade -1.3 -1.5
Purchasing power of exports 7.2 9.9
Source: UNCTAD 1999, 85.

Table 5.8 is based on a study of the time trends of the terms of trade of 26 developing
countries. The study found only 5 countries out of 26 with positive terms of trade
trends over 1970-1999, and 12 countries out of 26 with positive trends over 1980-
1999. So there were still a significant number of countries with deteriorating terms
of trade trends in 1980-1999.

Table 5.9 is more interesting in that the researchers focused on the terms of trade
between the manufactured exports and the manufactured imports of developing
countries (and subgroups of developing countries) in their trade with the European
 22

Union over 1979-1994.15 So the prices of primary commodity exports and imports
are not included.

Table 5.8
Terms of trade time trends in developing countries, 1970-1999
1970-99 1980-99
Number of countries 21 14
with negative trends
Number of countries 5 12
with positive trends
Total 26 26
Source: Ram 2004, 246.
Note: the countries covered are Argentina, Bangladesh, Brazil, Burkina Faso, Colombia,
Cyprus, India, Ivory Coast, Jordan, Kenya, Korea (South), Liberia, Malawi, Malta,
Mauritius, Morocco, Pakistan, Philippines, Senegal, Singapore, South Africa, Sri Lanka,
Syria, Thailand, Trinidad and Tobago, Tunisia.

Table 5.9
Manufacturing terms of trade
between developing countries and the European Union, 1979-1994
(percentage change per annum)
All developing Least ACP Latin Mediterranean East Asiac
countriesa Developed countries America Basinb
Countries
Change in
unit value
EU imports 2.0 -1.3 -0.1 1.3 2.1 2.9
EU exports 4.2 4.4 4.6 4.9 4.4 4.1
Change in
developing
countries’
terms of
trade
Terms
of trade -2.2 -5.7 -4.7 -3.6 -2.3 -1.2
Income
terms of 5.5 ... 0.4 1.0 4.1 6.8
trade
Source: UNCTAD 1996, 148.
Original source: A. Maisels, T. B. Palaskas and T. Crowe, “The Prebisch-Singer Hypothesis
Revisited” in D. Sapsford and J. R. Chen (eds.) Development Economics and Policy: Essays in
Honour of Sir Hans Singer, St. Martins, 1998.
a
China excluded.
b
Algeria, Cyprus, Egypt, Israel, Jordan, Malta, Morocco, Lebanon, Tunisia, Turkey and
Yugoslavia.
c
Brunei Darussalam and Macao included.

The average annual percent change in unit (average) prices of EU manufactured

exports to the developing countries was 4.2 percent, and the average annual percent

15
ACP countries are 79 developing countries (former colonies) in Africa, the Caribbean region
and the Pacific region which signed the Georgetown Agreement with the EU in 1975, establishing
the Organization of African, Caribbean and Pacific States with the aim of coordinating EU aid to
these countries.
 23

change in unit prices of EU manufactured imports from the developing countries

was 2.0 percent over 15 years. Hence the annual rate of change of the terms of trade
of the developing countries was -2.2 percent.

When we compare the figures for different developing country groups, we see that the
variation between the rates of terms of trade deterioration is due not so much to
differences in the average price increases in manufactured imports from the EU, but
due more to the differences in the average price increases of manufactured exports
to the EU.

Notice that even East Asia suffered terms of trade deterioration in its manufactured
trade with the EU in that period. Notice also that the developing countries’ income
terms of trade in their trade in manufactured goods appears to have increased over
the period.

Why does evidence show deteriorating terms of trade for developing countries after
the globalization of manufacturing in the 1980s-1990s? Was industrialization not
to have eliminated this tendency, according to the structuralist economists?

Prebisch’s explanation for the terms of trade deterioration of primary commodity

exporting countries actually provides the answer to this question. It is due to the
differences in intensity of competition among producers of different kinds of
manufactured goods. Although manufacturing has spread to developing countries
in the 1980s, there is still an imbalance in control over prices between core country
firms and peripheral firms, even in reciprocal trade in manufactures. Firms in core
countries have greater control over the prices of the manufactured goods that they
export, because they have lower competition thanks to their control over
technologies and brand names. By contrast, manufacturing firms in peripheral
countries are trapped in a fierce global competition against each other in order to
become and remain suppliers to the firms of the core countries, which puts them at
a disadvantage in price negotiations with the firms in the core.

In Table 5.9 the negative figures in the average annual percentage changes in unit
values of the manufactured exports of the Least Developed Countries and of the ACP
countries suggests that the manufacturers in these countries may have been
competing by bidding down their price offers. Of course, it is possible that those
negative figures result from composition effects (the composition of EU imports
from these countries might be changing in favor of cheaper products) rather than a
reduction of the prices of the same products.

However, the correspondence between the average annual percentage changes in

unit values of manufactured exports with the perception of the different levels of
industrialization among the subgroups (from Least Developed Countries and ACP
 24

countries to Latin America and the Mediterranean basin to East Asia) in the table
gives reason to suspect that the structural difference in the power to set prices of
goods (even of manufactured goods) between core and periphery, and between
peripheral countries, persists. In this period an increasing part of the growing trade
in manufactured goods between developed and developing countries was taking
place within commodity chains.

So if the empirical evidence in this section has any validity, it seems to confirm that
international trade is still maintaining and reproducing inequality between nations
through uneven benefits from trade - even after the globalization of manufacturing.

Concluding remarks

Events in recent years seem to be changing the conditions in which the global
relocation of manufacturing took place. For one, the Covid-19 pandemic in 2020-
2021 led to disruptions in commodity chains. Businesspeople in core countries have
become aware of the vulnerability of their production networks to global health
disasters, which may very well recur.

Secondly recent armed conflicts have caused disruptions in international

transportation and trade. The war between Russia and Ukraine disrupted sea
transportation on the Black Sea. US sanctions on Russia, and the sabotage of the
Nord Stream pipelines affected trade on the European continent. Israel’s war on
Gaza has led to disruption of transportation on the sea route between the Indian
Ocean and the Mediterranean Sea.

Thirdly, although the melting of Arctic ice is promising to facilitate sea trade
around the Arctic, climate change has lowered the water level in the Panama Canal,
causing a congestion of ships waiting to cross the Canal.

Finally, trade friction and power politics in an increasingly multi-polar world are
making the prospects for deeper international economic integration doubtful. This
may possibly reverse the trends described in this lecture.
 25

Sources for the lecture

Appelbaum, Richard P. 2004. Commodity Chains and Economic Development: One and a
Half Proposals for Spatially-Oriented Research. Global & International Studies Program.
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Basil Blackwell.
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transnational markets, mobile commodities, and bordered North-South differences.
Environment and Planning A. Vol. 43. 1057-1078.
Blair, Jennifer. 2004. From Commodity Chains to Value Chains and Back Again?
https://irows.ucr.edu/conferences/globgis/papers/Bair.htm
Blair, Jennifer. 2009. Global Commodity Chains: Genealogy and Review, in Frontiers of
Commodity Chain Research. Jennifer Blair (ed.). Stanford, California. Stanford
University Press.
Chang, Dae-Oup Chang. 2009. Informalising Labor in Asia’s Global Factory. Journal
of Contemporary Asia. 39(2). May.
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Development Through Integration in Global Value Chains?A Cross-sectoral and Cross-
national Comparison. IPE Working Papers140/2020, Berlin School of Economics and
Law, Institute for International Political Economy (IPE).
Gereffi G. 2001. Shifting Governance Structures in Global Commodity Chains, With
Special Reference to the Internet. American Behavioral Scientist. 44(10). 1617-1637.
Gereffi, G., J. Humphrey, R. Kaplinsky, T. Sturgeon. 2001. Introduction: Globalization,
Value Chains and Development. IDS Bulletin. 32 (3). 1-8.
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in the world economy. Nature Communications. https://doi.org/10.1038/s41467-024-
49687-y (04.08.2024.)
IMF. 2011. Changing Patterns of Global Trade. Prepared by the Strategy, Policy and
Review Department. Approved by Tamim Bayoumi. June 15, 2011. Jones, Marc. The
Contradictions of Globalization. Journal of Australian Political Economy. No. 48. Dec
2001.
Kalhan, Anuradha. 2008. Permanently Temporary Workers in the Global Ready-Made
Garment Hub of Bangalore. The Indian Journal of Labor Economics. 51(1). 115-128.
Koopman, Robert, William Powers, Zhi Wang, Shang-Jin Wei. 2010. Give Credit Where
Credit Is Due: Tracing Value Added in Global ProductionChains. NBER Working Paper
No. 16426. September.
Maswood, Syed Javed. 2021. Origins and consequences of economic globalization:
moving beyond a flawed orthodoxy. European Journal of International Relations. 1–22.
DOI: 10.1177/1354066120983423.
McMichael, Philip. 2006. Peasant Prospects in the Neoliberal Age. New Political
Economy. 11(3). September. 407-418.
McNally, David. 2011. Monsters of the Market: Zombies, Vampires and Global
Capitalism. Historical Materialism 30. Leiden: Brill.
Milanovic, Branko. 2016. Global Inequality: A new approach for the age of globalization.
Cambridge MA: the Belknap Press.
 26

Moghadam, M. Valentine. 1999. Gender and Globalization: Female Labor and Women’s
Mobilization. Journal of World Systems Research. Vol. V. No. 2. Summer 1999. 367-
388.
Raikes P, M. F. Jensen, S. Ponte. 2000. Global commodity chain analysis and theFrench
filière approach: comparison and critique. Economy and Society. 29(3) August. 390-417.
Ram, R. 2004. Trends in Developing Countries’ Terms-of-Trade since 1970. Review of
Radical Political Economy. Spring. 36(2).
Schmitz H., P. Knorringa. 2000. Learning from global buyers. Journal o f Development
Studies. 37(2). December.
Simmons, Beth A. 1999. The Internationalization of Capital. Chapter 2 in Change
and Continuity in Contemporary Capitalism. John Stephens, H. Kitschelt, P.
Lange and G. Marks (eds.). New York. Cambridge University Press. 36-69.
Spar Debora L. 2002. Hitting the Wall: Nike and the International Labor Practices. Harvard
Business School 9-700-047 REV: September.
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World Economy. Review 23. 1-13.
Wills, Jane. 2009. Subcontracted Employment and Its Challenge to Labor. Labor
Studies Journal. 34(4). December.
 27

Appendix to Lecture 5
Empirical evidence on value added distribution
in commodity chains

Gereffi (1989, 525) observed that “[t]he distributors’ margins in the footwear
industry in the United States … averaged 50% in the mid-1970s, but were closer to
60% for imported goods.”

In another study Gereffi reported that “[o]f the $75 billion spent on U.S. apparel
imports … $25 billion corresponded to the foreign-port value of imported clothing,
$14 billion to landing, distribution, and other costs, and $36 billion to the retailers’
average mark-up of 48 percent on imported goods… . The consumer’s retail price
thus amounts to three times the overseas factory cost for imported clothing” (1994,
102-3).

According to Feenstra, the export price of Barbie dolls produced in China and
exported from Hong Kong is two dollars, and “[t]he dolls sell for about $10 in the
United States, of which Mattel earns at least $1, and the rest covers transportation,
marketing, wholesaling and retailing in the United States. The majority of value-
added is therefore from U.S. activity” (1998, 36).

Kaplan and Kaplinsky (1999, 1794) found that South African producers received 43
percent of the market value of canned peaches that they export to European markets.

Chossudovsky (1998, 88-90) reported that five percent of the market value of shirts
sewn in a Bangladeshi factory (from imported inputs) and marketed in the US accrued
to Bangladesh in 1992.

Shirts sewn in El Salvador for 18-19 cents a piece are sold in the US for between 12-
20 dollars (Figueroa 1996, 37, 39).

According to Talbot (1997, page 18 on internet version) “from the early 1960s to the
late 1980s roughly half of the total surplus generated along the entire [coffee] chain
was retained in the producing countries”, but after 1986 with the collapse of the
International Coffee Agreement “there was a massive shift of surplus from the coffee
producing countries to TNCs in the core, who used their market power to hold down
the price of green coffee while inflating the price of coffee processed for final
consumption.”

The Survey of Vietnamese and Indonesian Domestic Expenditure Levels (1997)

conducted by students of Amos Tuck School of Business in Dartmouth reported that
the average Vietnamese worker working at Nike supplier factories earned about
$1.67 a day; whereas the price of a pair of Nike sneakers advertised by Penny
Hardaway retailed at $150 (Spar 2002, 10).
 28

Chossudovsky (1998, 87-88) indicates that only 10 percent of the value of

coffee sold in the US accrued to the producing countries in the early 1990s.

Table 5A.1 below gives an estimate of the cost breakdown of Nike shoesproduced in
Vietnam in 1999.

Table 5A.1
Estimated cost breakdown of an average Nike shoe, 1999
Labor costs $3.37
Manufacturer’s overhead $3.41
Materials $14.60
Profit to factory $1.12
Factory price to Nike $22.50
Wholesale price $45.00
Retail price $90.00
Source: Spar 2002, 15. Original source: Jennifer Lin, “Vietnam Gives Nike a Run For Its
Money”, The Philadelphia Inquirer, March 23, 1998, p. 1.

Dikmen (2000, 215, 243) found that in 1999 manufacturers in Istanbul and Denizli
(Turkey) producing garments for foreign firms earned between 20-25 percent of the
price of their products in the final destination.

According to Carr, Chen and Tate (2000, 134) in Chile “for seedless grapes in 1993/4,
producers accounted for 11 percent of costs (of which 5 percent were for wages),
while exporters, importers, and Northern retailers accounted for 28, 26 and 35 percent
respectively (Barrientos et al. 1999). ...[i]n Zimbabwe, producers [of nontraditional
agricultural exports] account for 12 percent (of which wages are about half) of total
costs, while exporters (including packaging and air freight) account for 30 percent,
importers for 12 percent and retailers for 46 percent of costs (Dolan, Humphrey and
Harris-Pascal 1999).”

Baiman (2004, 87), reporting from Li (2005): The retail price of globes for
schoolchildren in 2002 sold in the US and produced in China was 88 dollars. Chinese
producers and merchants earned 10.5 percent, Hong Kong merchants earned 26.3
percent and US companies earned 63.2 percent of the price.

Table 5A.2 below shows the distribution of value added in the production chain of
iPods in 2005.
 29

Table 5A.2
Value added composition of an iPod sold in the US (2005) (dollars)
USA Japan Korea, Taiwan Total
South
Lead firm Apple 76 - - - 76
(product development, marketing)
Production 7 27 1 4 39
(intermediate parts and assembly)*
Logistics 30 - - - 30
(transportation, wholesale commerce)
Retail 45 - - - 45
Total 158 27 1 4 190
Source: Fischer, Reiner and Staritz (2010, 9)
* 24 dollars’ worth of small intermediate goods have not been included.

Table 5A.3 shows the composition of value added in the final consumer price of
exported Ugandan coffee (year for data not given).

Table 5A.3
Ugandan coffee value chain (percent of value added)
dry processing wet processing
farm (dry cherry) (parchment) 10 21
producing
country factory unwashed green beans washed green beans 20 9
exporter beans for export 7
freight-insurance 4
beans cleared for market
import agents wholesale dealer 8

consuming processing company coffee house

country factory instant coffee roasted ground coffee 29
retailer shop retail coffee shop 22
Source: Hertz 2020, table adapted from chart 11.1 on p. 52.
Original source: Robert Fitter, Raphael Kaplinsky. 2009. Who Gains from Product Rents as
the Coffee Market Becomes More Differentiated? A Value-chain Analysis. IDS Bulletin.
 30

Sources for appendix

Baiman, Ron. 2004. “Unequal Exchange Without a Labor Theory of Value: On the Need
Fora Global Marshall Plan and a Solidarity Trading Regime”. Review of Radical Political
Economics. 38(1). Winter. 71-89.
Barrientos, Stephanie (editor), Ann Bee, Ann Matear, Isabel Vogel, Cristobal Kay (Preface).
1999. Women and Agribusiness: Working Miracles in the Chilean Fruit Export Sector.
London. Macmillan.
Carr, Marilyn, Martha Alter Chen and Jane Tate. Globalization and Home-based
Workers. 2000. Feminist Economics 6(3), 123-152.
Chossudovsky, M. 1998. The Globalization of Poverty: Impacts of IMF and WorldBank
Reforms. London. Zed Books.
Dikmen, A. A. 2000. Global Commodity Production and Ideologies of Work: Cases of
Textiles Production in Turkey. Unpublished Ph.D. dissertation. Middle East Technical
University, Graduate School for Social Sciences.
Dolan, Catherine, John Humphrey, and Carla Harris-Pascal. 1999. Horticulture Commodity
Chains: The Impact of the U.K. Market on the African Fresh Vegetable Industry. IDS
Working Paper No. 96. Brighton U.K.. Institute of Development Studies.
Feenstra, R. C. 1998. Integration of Trade and Disintegration of Production in the Global
Economy. Journal of Economic Perspectives. 12:4. Fall. 31-50.
Figueroa, H. 1996. In the Name of Fashion: Exploitation in the Garment Industry. NACLA
Report on the Americas. XXIX(4). 34-40.
Fischer Karin; Christian Reiner; Cormelia Staritz. 2010. Einleitung: Globale Güterketten,
weltweite Arbeitsteilung und ungleiche Entwicklung. Wien: Promedia Verlag.
Gereffi, G. 1989. Rethinking Development Theory: Insights from East Asia and Latin
America. Sociological Forum. 4(4). 505-533.
Gereffi, G. 1994. The Organization of Buyer-Driven Global Commodity Chains: How U.S.
Retailers Shape Overseas Production Networks. in G. Gereffi and M. Korzeniewicz (eds.),
Commodity Chains and Global Capitalism. Westport, Connecticut. Praeger. 95-122.
Hertz, Erik. 2020. Taking the Bitterness Out of Coffee: A Case Study of the Value Chain
Transformation in Ugandan Coffee Companies. 2020. Lund University School of
Economics and Management. http://lup.lub.lu.se/student-papers/record/9016778
Kaplan, D. and Kaplinsky, R. 1999. Trade and Industrial Policy on an Uneven Playing Field:
The Case of the Deciduous Fruit Canning Industry in South Africa. World Development.
27(10). 1787-1801.
Li, M. 2005. The Rise of China and the demise of the capitalist world economy: Exploring
historical possibilities in the 21.st century. Science and Society. 69(3). Summer.
Spar Debora L. 2002. Hitting the Wall: Nike and the International Labor Practices. Harvard
Business School 9-700-047 REV: September.
Talbot, J. M. 1997. Where does your coffee dollar go?: The division of income and surplus
along the coffee commodity chain. Studies in Comparative International Development.
32(1). 56-92.
 1

Development Economics Lecture 6

07.11.2024

South Korea’s late industrialization

The previous lectures described the international division of labor at the end of the World War
II. that seemed to sustain unequal development between core and periphery. Import substituting
industrialization in the following decades was an attempt in peripheral countries to break out of
that division of labor, facilitated by the favorable conditions of the Cold War. This attempt ended
with the debt crisis of the 1980s. The new policy environment opened the way for core country
firms to relocate some of their manufacturing activities to the periphery. However, the tables
presented in the first lecture, showing per capita GDP comparisons between groups of countries,
suggest that import substituting industrialization and the global relocation of manufacturing have
merely resulted in the ‘development of underdevelopment’ in most of the periphery. These
policies and practices have not led to perceptible convergences in average per capita GDPs of
low and middle income countries in Sub-Saharan Africa, South Asia, the Middle East and North
Africa and Latin America with the high income countries. The only region where a gradual
convergence is seen is East Asia.

The lecture note on the globalization of manufacturing suggests that, what distinguishes the rich
industrialized countries from the poor industrialized countries is possession of technologies plus
management skills that enable firms to market products under their own brand names. There are
only one or two developing countries that have succeeded in achieving this in the post-World
War II period: South Korea and possibly Taiwan. China is also in the process of achieving this.
In this course we study the economic policies in South Korea and China.1

In 1980-1982 when the world GDP growth rate declined, South Korea (the Republic of Korea)
and Taiwan (self-styled ‘Republic of China’, referred to as ‘Taiwan Province of China’ in China)
continued to increase manufactured exports and avoided debt servicing problems. These were
among the small group of countries called the ‘Newly Industrializing Countries’ (NICs) in the
1970s. Four East Asian countries (South Korea, Taiwan, Hong Kong and Singapore) were at the
top of lists of NICs, and were called the ‘Four Asian Tigers’.

South Korea and Taiwan elevated themselves to the high income group in the second half of the
twentieth century. As South Korea’s industrialization has been more extensively researched, we
will focus on South Korean economic policies. South Korea’s catching up was achieved roughly

1
In this course we focus on the development experiences since the Second World War, and therefore do not study
Japan’s catching-up. Japan had succeeded in becoming part of the core in the late 19th century.
 2

in twenty-five years, between 1961 and the mid-1980s. However, there are similarities between
the economic policies implemented in Japan (in its economic revival after the war), and in South
Korea and Taiwan (in their economic development after the war). So some researchers have
found it fruitful to study these countries as a group. We shall touch upon these comparisons in
this and next lectures.

Historical background

A brief historical review may be useful. Japan began colonizing the Korean peninsula in 1910
as part of its imperial ambition to control all of East Asia. Korea remained a Japanese colony in
1916-1945. At the end of World War II Japan was defeated by the Allies. Korea was partitioned
under US and Soviet military occupations. In 1948 the Republic of Korea (ROK in the south)
and the Democratic People’s Republic of Korea (DPRK in the north) were founded, each of
which claimed to represent the Korean nation. Each accused the other of being a puppet regime
supported by a foreign power. The two Korean states fought a war in 1950-1953, in which the
UN, the US and China were involved. The war ended in a military stalemate, with a ceasefire
and no peace treaty.

In the 1950s South Korea was a poor peripheral state. It was heavily dependent on US economic
and military aid. The US gave aid to South Korea because of its importance for the US strategy
of militarily encircling the USSR and China. In 1961 an army officer, Park Chung Hee, carried
out a coup against the dictator in power, and became the new dictator. Park was worried about
South Korea’s economic and military dependence on the US, and resolved to end this
dependence. He began an economic development drive in South Korea that eventually changed
the country’ position in the world-economy. At that time North Korea was rapidly
industrializing. So South Korean economic development was set against a background of
military, political and ideological rivalry against the DPRK.

As for Taiwan, the regime on the island was established after World War II. In mainland China
the armies of the nationalist Kuomintang Party were defeated in a civil war by the armies of
Chinese Communist Party. The nationalists fled to the island of Taiwan. The new regime
established in Taiwan claimed to represent all of China. It was heavily dependent on US
economic and military aid. The state in Taiwan (the Republic of China) was in political-
ideological rivalry with the People’s Republic of China. So there was a certain similarity to the
political situation on the Korean peninsula.

To return to South Korea, in Table 6.1 one can observe the change in the ratio of South Korea’s
per capita GDP ratio to that of the high-income countries and to that of the world. The ratio to
high income countries rose from 12 percent in 1960 to 71 percent in 2019, and that its ratio to
the world average rose from 35 percent in 1960 to 278 percent in 2019. One can compare these
 3

figures with the Turkish figures. The data for the People’s Republic of China have been included
for future reference.

Table 6.1
Per capita GDP in current US dollars of
China, South Korea, Turkey, averages for high income countries and the world
and ratios of per capita GDPs to high income countries and to the world
1960 1970 1980 1990 2000 2010 2019
China ($) 90 113 195 318 959 4550 10262
S. Korea ($) 158 279 1715 6610 12257 23087 31762
Turkey ($) 509 490 1564 2794 4317 10672 9042
high income countries ($) 1364 2726 9349 18440 25103 38650 44540
world ($) 452 804 2533 4285 5498 9551 11429
Ratios
China's ratio to high income countries 0.07 0.04 0.02 0.02 0.04 0.12 0.23
China's ratio to world 0.20 0.14 0.08 0.07 0.17 0.48 0.90
Korea's ratio to high income countries 0.12 0.10 0.18 0.36 0.49 0.60 0.71
Korea's ratio to world 0.35 0.35 0.68 1.54 2.23 2.42 2.78
Turkey's ratio to high income countries 0.37 0.18 0.17 0.15 0.17 0.28 0.20
Turkey's ratio to world 1.13 0.61 0.62 0.65 0.79 1.12 0.79
Source: World Bank. World Development Indicators. (28.09.2020)

Table 6.2
Per capita GDP in current international US dollars of China, South Korea, Turkey, high income
countries and the world
and ratios of per capita GDPs to high income countries and to the world
1990 2000 2010 2019
China ($) 982 2921 9254 16785
S. Korea ($) 8392 18551 31740 43029
Turkey ($) 8519 9586 17439 27875
high income countries ($) 18011 27481 39053 52029
world ($) 5549 8004 12898 17673
Ratios
China's ratio to high income countries 0.05 0.11 0.24 0.32
China's ratio to world 0.18 0.36 0.72 0.95
S. Korea's ratio to high income countries 0.47 0.68 0.81 0.83
S. Korea's ratio to world 1.51 2.32 2.46 2.43
Turkey's ratio to high income countries 0.47 0.35 0.45 0.54
Turkey's ratio to world 1.54 1.20 1.35 1.58
Source: World Bank. World Development Indicators. (28.09.2020)
 4

The per capita GDP figures in Table 6.1 have been converted to US dollars at the official (actual)
exchange rates. Table 6.2 shows the per capita GDPs converted to US dollars by the Purchasing
Power Parities. Here, too, the ratios of South Korean per capita GDP to that of high income
countries indicate a catching-up.

The theory of late industrialization

In the 1980s there appeared three interpretations of South Korean industrialization, and of East
Asian industrialization in general.

The first was the interpretation of mainstream economists. They initially argued that East Asian
countries followed export-led growth strategies (implying liberal policies) and that their high
growth rates were due to these policies. In response to these arguments, institutionalist
economists’ research revealed that, on the contrary, East Asian industrialization owed much to
active state interventions in the economies. Then the line of the mainstream economists shifted
to the admission that states in East Asia have been intervening in the market mechanism, but that
“they got the prices right”, meaning that the states happened to set prices at levels that market
forces would have determined anyway; so that state interventions did not distort the allocation
of resources much (Burmeister 1990, 197).

In 1989 the American economist Alice Amsden published a book Asia's Next Giant: South Korea
and Late Industrialization. The book gave a detailed and elaborate institutionalist explanation of
the Korean experience between 1961-1986. In answer to the mainstream argument about “getting
the prices right”, Amsden retorted that “they got the prices wrong”, meaning that the South
Korean state set prices and incentives unrelated to market equilibria in order to achieve
development objectives.

With evidence accumulating in the 1980s on the success of state policies in South Korea and
Taiwan, the Japanese government pressed the World Bank to undertake a study of East Asian
economic policies. The World Bank did the study and in 1993 published a book entitled The
East Asian Miracle. The book conceded that East Asian states did obtain positive results in their
interventions in their economies. But it recommended that other developing countries should not
imitate them, because other states do not have the administrative capacity to succeed in effective
intervention (Wade 1996).

Another mainstream liberal argument was that, even if East Asian economies achieved
remarkable growth rates under interventionist states, they would have achieved even higher
growth rates had the states been less interventionist (Wade 1988, 148).
 5

In addition to these conflicting interpretations of mainstream economists and institutionalist

economists, the third interpretation was that of dependency writers. These writers generally
interpreted the apparent high rates of growth and industrialization in South Korea and Taiwan as
the transformation of these countries into a semiperiphery around the (core) Japanese economy
in accordance with the needs of Japanese capitalism. The critical attitude of the dependency
writers stemmed in part from their dislike for the repressive political regimes in these countries,
the working conditions of workers and environmental degradation.

In this lecture note we focus on South Korea’s economic policies between 1961 and (roughly)
1986, largely based on the studies carried out by institutionalist economists.

Amsden labeled South Korea’s experience ‘late industrialization’ which is “industrialization not
based on indigenous technology”. In her account, the first industrial revolution in Great Britain
was characterized by inventions realized by small entrepreneurs and inventors, commercialized
in small family firms under a régime of laissez-faire. The second industrial revolution in the US,
Germany, France, Italy, Japan etc. was characterized by inventions developed in the laboratories
of large firms, and commercialized on a large scale under a régime of infant industry protection.

Late industrialization differs from the first and second industrial revolutions in that it is not based
on indigenous technology. It is characterized by first learning foreign technologies, and then
improving them. In late industrialization the learning process in firms is supported by state
protection and subsidies. The learning process eventually makes the economy internationally
competitive in the production of manufactures.

In the second industrial revolution, technological development was realized by engineers. The
sites of innovation were laboratories and management offices. By contrast, said Amsden,
technological learning in late industrialization is done by engineers, technicians and workers
working on the shop floors of factories.2 They first disassemble a foreign manufactured good,
figure out how it has been produced, start to produce imitations of the foreign good, and then
begin to modify and improve it. This procedure is called reverse engineering. Normally
engineers design a product and then produce according to the design. In reverse engineering,
engineers study a foreign product, draw the design; then production begins according to the
design.

According to Amsden, another difference of late industrialization from the second industrial
revolution is that manufacturers in the US, Germany, France etc. were able to produce their own
capital goods and intermediate goods from early on. Late industrialization begins with
production of consumer goods, while intermediate goods and capital goods are imported. Late

2
The shop-floor is the part of the factory were production is done (tezgâh başı).
 6

industrialization proceeds by stages, from simple consumer goods to more sophisticated

consumer goods and then to intermediate goods and to capital goods.

Yet another difference was that, in the second industrial revolution expanding manufactured
production was absorbed by expanding domestic markets. In late industrialization exportation
plays a critical role because of the country’s dependence on importation of intermediate and
capital goods.

In the second industrial revolution, protection from imports was the dominant economic policy
instrument supporting industrialization. In late industrialization the critical economic policy
instruments are subsidies as well as protection, according to Amsden.

Reciprocity in government incentives

Some of the policy instruments and incentives that the South Korean state used to push capitalists
into manufacturing and innovation were trade policies (protection from imports, access to
foreign exchange), fiscal policies (subsidies and tax incentives) and financial policies
(preferential cheap credit). We have seen that in other peripheral countries, states implementing
the import substituting industrialization strategy also used the same policy instruments. What
was it that led to a different outcome in South Korea?

The difference between the incentive policies implemented in South Korea and those
implemented in other industrializing developing countries was that the South Korean state
monitored individual manufacturers’ performance improvement by setting performance targets
for them. These targets were transparent, easy-to-monitor indicators. They were namely (1)
export targets (in volumes), (2) local content targets (as percentages), and (3) R&D expenditure
targets.

Moreover, the incentives given by the South Korean state to private firms were based on
reciprocity. That is, the state granted incentives on condition that the firms realize the
performance targets given them. The state ensured fulfilment of the performance targets with the
threat of cancelling the incentives.

Subsidies were among the most important incentives. One of the main channels of subsidization
was bank loans at low interest rates. If a firm did not achieve its targets in increasing the volume
of its exports, increasing the proportion of domestically produced intermediate goods in its
production, or in increasing R&D according to schedule, the state would suspend bank loans to
the firm, or recall the bank loans owed by the firm.
 7

The debt-equity ratio of most Korean firms was very high, usually exceeding 3:1. The banks
normally ‘rolled over’ short term loans, i.e. extended the loans repeatedly. Thus Korean firms
operated with high levels of loans owed to banks. Firms used bank credit even for their working
capital. So when the state cut off the supply of bank credit to a highly-leveraged firm and recalled
the bank loans, it could drive the firm to bankruptcy.

The state also utilized other means to penalize firms that did not achieve their targets. One was
tax audits. Thorough investigations by tax officials of firms’ offices were used to discipline firms
which did not comply with government economic policies. Such tax inspections were lengthy,
sometimes lasting as long as six months. Penalized firms were driven to bankruptcy by tax
investigations.

Another form of punishment was the disconnection of infrastructure services. The state cut off
the supply of public utility services (electricity, water, telephone) to punish firms that did not
comply with government economic policies. For example, the Ministry of Trade and Industry
often disconnected electricity to firms that did not comply with the export targets set by the
government (Song 1994, 144-5).

This monitoring of performance is in stark contrast to the way import substituting

industrialization was implemented in other countries such as in Turkey and in Latin American
countries. In these countries governments tried to induce firms to comply with industrialization
plans through incentives, but did not impose any targets on firms. In these countries the state did
not make performance demands of firms in exchange for the incentives given.

But how were South Korean manufacturers able to export their products, in view of the
impediments to exporting by infant industries described in the third lecture?

Trade, financial and fiscal policies

The South Korean state imposed export volume targets on each manufacturing firm as soon as a
new import-substituting factory began operating. Initially, the firms could achieve these export
targets only by cutting prices and making losses on their exports. However, because the state
protected the exporting firms with tariffs, the firms could make profits in the home market, thus
compensating their losses in exports.3 “Even by 1983 when Korea’s success was an established
fact most sectors were still protected by some combination of tariffs and non-tariff barriers”
(World Bank 1993, 297).

3
“Domestic firms routinely used the protected domestic market to subsidize exports. A 14-inch black-and-white
television sold for export at $42 brought $180 domestically” (Haggard et al. 1983, 161).
 8

South Korean manufacturing firms were thus coerced into exporting manufactured goods,
despite making losses on their exports. This created an incentive for firm managers to exert
themselves to reduce production costs and to improve the quality of their products, so as to make
their exports profitable. Thanks to the persistence with which this export targeting policy was
implemented, South Korean manufacturers eventually became competitive in their exports and
made their exports profitable.

The South Korean state also imposed exportation conditions on foreign direct investment in the
country. It thereby made sure that firms established by foreign capital did not pose a burden on
the balance of payments.

In the field of finance the state used the allocation of bank loans for the industrialization aims.
In 1962 the Minister of Finance was made head of the Monetary Board of the Bank of Korea,
bringing the central bank under the direct control of the government. In 1962 a law limited
private bank shareholders’ voting rights. A stipulation in the Banking Act of 1981 set a 8 percent
ceiling on private bank share ownership for any individual or a group of related shareholders.
The state also established special-purpose banks (Korea Development Bank, Korea Exchange
Bank, Korea Housing Bank, Bank for Medium and Small-Sized Enterprises) which were 100
percent state-owned. Thus all banks, whether publicly or privately owned, were controlled by
the state to serve industrialization plans.

South Korea had a bank-based financial system, i.e. a financial system where most of
households’ money savings are held in bank deposits. Capital markets are not developed
sufficiently to provide investment funding. Hence, most of the financial intermediation in the
economy was done by banks. The state kept bank deposit interest rates at low levels which were
often negative in real terms. ‘Policy loans’ to prioritized industries and firms were subsidized.
In 1964 the Bank of Korea was given the authority to designate the sectors to receive special
attention. Banks were required to concentrate their loan portfolios in those sectors. These loans
were one of the key instruments in the industrialization of South Korea.

Capital controls (restrictions over private international financial transactions) prevented Korean
firms from borrowing abroad, thus constraining them to borrowing from the domestic financial
system. The state controlled foreign borrowing and the use of foreign loans through the Foreign
Exchange Management Act (1961) and the Law for Payment Guarantee of Foreign Borrowing
(1962). Restrictions on activities in the capital market prevented households from purchasing
shares and thus ensured that household money savings were deposited in banks.
 9

Table 6.3
Plan Targets and Realization in South Korea (1962-1991) (per cent)
First Five-Year Plan (1962-1966)
Target Performance
GNP growth 7.1 7.8
Investment/GNP 22.6 17.0
Domestic saving/GNP 9.2 8.8
Foreign saving/GNP 13.4 8.2
Second Five-Year Plan (1967-1971)
Target Performance
GNP growth 7.0 9.5
Investment/GNP 19.0 26.1
Domestic saving/GNP 11.6 16.6
Foreign saving/GNP 7.5 10.2
Third Five-Year Plan (1972-1976)
Target Performance
GNP growth 8.6 9.1
Investment/GNP 27.6 27.1
Domestic saving/GNP 19.5 20.8
Foreign saving/GNP 5.4 6.7
Fourth Five-Year Plan (1977-1981)
Target Performance
GNP growth 9.2 5.7
Investment/GNP 26.2 30.3
Domestic saving/GNP 24.2 23.5
Foreign saving/GNP 2.0 0.6
Fifth Five-Year Plan (1982-1986)
Target Performance
GNP growth 7.6 9.8
Investment/GNP 31.6 30.0
Domestic saving/GNP 27.4 27.2
Foreign saving/GNP 4.2 2.6
Sixth Five-Year Plan (1987-1991)
Target Performance
GNP growth 7.2 10.0
Investment/GNP 30.7 34.5
Domestic saving/GNP 32.3 36.3
Foreign saving/GNP -1.6 -2.3
Source : Soon 1994.

South Korea suffered from trade deficits and foreign exchange shortages during its
industrialization. So capital account transactions were (private international financial
transactions) were restricted. All foreign exchange earned had to be sold to the central bank. The
state also controlled the use of foreign exchange, e.g. it imposed limits on remittances overseas,
on real estate acquisition overseas, and on expenditure on tourism abroad (which was severely
restricted until the late 1980s). The aim was to prevent ‘unnecessary’ and ‘wasteful’ use of scarce
foreign exchange (Chang and Yoo 1999).
 10

In the fiscal area the South Korean state used instruments such as tax exemptions, accelerated
depreciation allowances, low tariffs for imported capital goods and intermediate goods, and the
establishment of industrial estates.

Technology and competition policies

In addition to the policy of setting performance targets for individual firms and enforcing
compliance with them, there were two other features of South Korean industrialization that
distinguished it from other import substituting industrialization practices. These were the Korean
state’s active involvement in technology transfers, and its competition policies.

The South Korean state monitored technology transfers from foreign firms to Korean firms. It
encouraged technology transfer in modes which were most conducive for the learning of foreign
technology by the domestic labor force.

A brief review of modes of technology transfer may be useful to understand this policy.
Technologies can be transferred through market transactions or through non-market channels.
Non-market channels include: learning from foreign scientific publications, sending students to
study abroad, reverse engineering, and industrial espionage.

As for technology transfers through market transactions, these are grouped as externalized
transfer modes and internalized transfer modes. In externalized modes of technology transfer,
the owner of the technology loses control over the use of the technology by the acquiring firm.
Examples of externalized transfer modes are the purchase of a capital good, or having a foreign
firm build a complete production facility (turnkey projects), or the purchase of a patent. By
contrast in internalized modes of technology transfer, the provider of the technology retains some
control over the use of the technology by the acquiring firm. The main examples of internalized
modes of technology transfer are purchasing a license to produce a good, or foreign direct
investment.

Each of these different channels of technology transfer has features which make it more suitable
or less suitable for the employees of the recipient firm to master the technology. For example,
merely importing, installing and using an equipment (a capital good) may not be useful for
learning if the workers in the recipient firm are so ignorant of the embodied technology that they
are incapable of maintaining or repairing the equipment on their own. In this situation,
establishing a joint venture where the equipment is operated and maintained and repaired by
foreign technicians may be preferable for the domestic workers to learn the technology.
Importing the equipment and using it until it breaks down then waiting for foreign repair
 11

technicians or for spare parts to arrive can be a waste of resources. This is one type of wasteful
mistake that can occur in technology transfer.

On the other hand, consider a situation where a technology is transferred through foreign direct
investment (for example a joint venture) even though the domestic workers could easily operate,
maintain and repair the imported equipment and manage the production process on thir own. In
such a case, acquiring the foreign technology through foreign direct investment wastes the
opportunity to establish a wholly domestic industry, which could have been done by obtaining
the technology through importation of the equipment. This is another possible mistake in the
choice of mode of technology transfer.

Hence, in every instance of market-mediated technology transfer, there is an optimal mode of

transfer that is conducive to the fastest learning, and which avoids waste of resources and
opportunities.

Obviously, the mode of technology transfer preferred by the foreign firm, or the mode agreed
upon by the foreign firm and domestic firm, may not be optimal for the domestic workforce to
learn it. This is why the state should monitor technology transfers, select the modes of technology
transfer, and get involved in domestic firms’ negotiations with foreign firms over the terms of
technology transfer. This is what the state did in South Korea. The South Korean state
encouraged foreign direct investment only in the sectors that needed the presence of foreign
engineers and technicians for Korean workers and engineers to learn new technologies.

Another area were the South Korean state was active was the regulation of competition. In
competition policy the South Koreans emulated Japanese policies. The state promoted large
diversified business groups called chaebols. These were modeled after the diversified Japanese
business groups called keiretsus.

The South Korean state encouraged mergers and restricted entry into specific industries where
competition was deemed excessive. It encouraged collusion among infant-industry firms, and
especially among firms exporting to foreign markets in order to prevent Korean firms from
competing against each other in foreign markets. Coordination among firms was encouraged.
The South Korean state did not permit hostile takeovers.

On the other hand, in mature industries where the state deemed competition in the home market
to be insufficient, it encouraged entry by other chaebols into that industry in order to prevent
monopolization.
 12

The policies to regulate excessive competition are said to be aimed at preventing ‘destructive
competition’. The concepts of ‘destructive competition’ and of an ‘optimal level of competition’
are peculiar to East Asian policy-makers. These ideas contrast with the neoclassical conception
of competition. Neoclassical economics considers competition as absolutely beneficial to the
economy and society. In the neoclassical conception, competition in a market cannot be
excessive.

The policies of the South Korean state described above were aimed at private firms. However in
South Korea the government also established state-owned enterprises which undertook
investment in manufacturing.

All these policies were designed and implemented by a small but powerful bureaucracy working
in coordination with domestic firms.

Was the South Korean industrialization strategy an export-led growth? It was not export-led
growth based on static comparative advantages, because South Korea was continuously
establishing new industries wherein it was initially not efficient. The South Korean state
deliberately strove to create new comparative advantages for the economy. It promoted
investment in sectors producing products with high value-added and high income elasticities of
income. So South Korea’s integration with the world-economy was a strategically planned
integration.

Table 33 from UNCTAD’s 1996 report shows how the greater part of South Korea’s exports
steadily shifted from natural resource-based goods to labor-intensive goods, then to scale-
intensive medium-technology goods, eventually to high technology goods from 1965 to 1994.

Comparison with Taiwan

South Korean and Taiwanese policies were similar in that both states implemented
protectionism, restricted foreign capital flows and controlled their financial systems in order to
promote the development of indigenous capacity in key industries. The banking system in
Taiwan was state-owned.

Yet there were some differences in policies. Taiwan’s population was 18 million in 1981, in
contrast to South Korea’s population of 37 million in 1980. Consequently Taiwan did not aim at
attaining industrial self-sufficiency in as many sectors as could Korea.

Secondly, the regime in Taiwan became more politically isolated as a growing number of states
recognized the People’s Republic of China as the legitimate state of China and severed relations
 13

with Taiwan. This motivated the state in Taiwan to be more flexible in its policy toward foreign
direct investment than the South Korean state. Still, the state in Taiwan promoted foreign direct
investment selectively (it encouraged FDI in high-technology sectors) and it pursued a conscious
strategy to ensure that foreign firms built strong linkages with domestic suppliers and exported
an agreed proportion of their output. The state also implemented policies to gradually indigenize
sectors that were dominated by foreign firms in the initial stage of development (Pirie 2013, 152-
153).

Another difference was that, in contrast to South Korea where the state pursued a policy of
developing key industrial sectors through large private firms within chaebols, in Taiwan large
state-owned firms were the main organizations that spearheaded the same effort.

Justification for industrial policies

To understand East Asian industrialization it is useful to separate two aspects of industrialization:

these are the success in allocating resources for industrial upgrading, and the success in elevating
the rate of accumulation. We study these in turn.

To understand the necessity for state involvement in technologically upgrading industry, it is

useful to describe the process of upgrading (UNCTAD 1996). Before industrialization, exports
consist of primary commodities (food, raw materials etc.), while imports comprise mainly
manufactured goods. The first step in industrialization is to process the primary commodities
that are produced in the country (processing food, mineral ores, fossil fuels). However, the
possibilities of continuing industrialization by deepening primary commodity processing are
limited. So industrialization proceeds with expansion of labor-intensive low technology
manufactures (e.g. garments, toys).

Eventually industrialization in labor-intensive manufactures reaches limits. In a rapidly

industrializing country wages rise, increasing labor costs. Competition from lower-cost
producers in other countries erode the export competitiveness of the country’s labor-intensive
manufactures.

Hence, the next logical step in upgrading industry is to produce and export consumer goods and
intermediate goods in more scale-intensive and knowledge-intensive industries (e.g. metallurgy,
metal products, vehicles) and capital goods.

Institutionalist economists argue that it is not possible to rely on market forces and private
initiative alone to move economies through these stages of industrial upgrading and export
substitution. As the country builds industries where the firms of core countries are already
 14

established and specialized, the technological and organizational capabilities necessary to

compete internationally become more difficult and more costly to acquire. In high technology
sectors, firm-level technological and marketing capabilities are developed in networks of
relations with suppliers of inputs, retailers, customers, consultants, technological research and
educational establishments. The overhead costs of developing such relationships are high, and
the uncertainties are great.

Private manufacturers in peripheral countries typically cannot bear such costs and risks. So they
prefer to join partnerships with foreign companies rather than pursue industrial upgrading on
their own. For this reason, it is essential that the state coordinate firms and socialize their risks
for in technological upgrading. What does this mean? Examples are provided by the World Bank:

“In some high-performance Asian economies, most frequently in Japan and Korea, troubled priority
projects have been bailed out by government. Often the financial costs of the bailout was large. In
Japan the government took over some losses associated with financing declining industries, such as in
coal mining. When government-supported heavy and chemical industries experienced severe excess
capacity and financial difficulties in the 1980s, the government provided 28 distressed firms with new
subsidized loans (totaling 16 percent of commercial bank loans) and rescheduled outstanding ones.
The government also provided banks, whose non-performing loans rose substantially and whose
profits declined (partly because lending rates were cut) with subsidized credit from the central bank
and allowed them entry into attractive areas of financial services” (World Bank 1993, 234).

This is what is meant by ‘the state socializing risks’. A Korean economist writes:

“…there were occasions where individual firms belonging to a chaebol were assisted [by the state
when in financial difficulty], but this invariably involved a government-mediated take-over of the
firm (by another chaebol or by the government-owned banks), or the imposition of terms of enterprise
restructuring that severely restricted managerial autonomy (e.g. Daewoo shipbuilding in the late
1980s). In this situation, there is little room for moral hazard, as the managers know that they will
lose control over the enterprise if they fail to perform. The important point in relation to the moral
hazard theory is not whether some struggling enterprises have been helped out by the government
(which they have), but whether or not bad management is punished…” (Chang et al. 1998, 743).
To return to the historical record, in the 1950s primary commodities comprised the bulk of
exports of South Korea and Taiwan. Then these countries moved into labor-intensive
manufactures such as textiles, clothing, paper and wood products. The share of labor-intensive
manufactures in exports rose quickly while the share of primary exports fell - to 18 percent in
South Korea and to 20 percent in Taiwan in 1975. Low wages were an important factor in labor-
intensive exporting in the 1960s (UNCTAD 1996).

However, in South Korea in the late 1960s, labor was fully employed and wages were rising,
weakening South Korea’s advantage in labor intensive low technology manufacturing. There
 15

was also an increasing protectionist trend among OECD states (i.e. the core countries) against
manufactured imports from developing countries in labor-intensive industries (recall the
Multifibre Agreement). Moreover in the 1970s, some countries such as Malaysia and Thailand
also began to export labor-intensive manufactures. So both South Korea and Taiwan accelerated
investment in scale- and skill-intensive industries. South Korean government’s decision was
driven by security concerns as well as economic ones, steel production being necessary for an
indigenous defense industry.4 In 1973 the South Korean government announced the Heavy and
Chemical Industrialization Program, with an emphasis on six strategic industries: steel, non-
ferrous metal, machinery, shipbuilding, chemicals, and electronics. In this period the South
Korean state and the Taiwanese state began to build domestic capital goods industries. Korean
manufacturing was transformed from a sector based on small and medium sized enterprises to a
sector where large chaebol firms became prominent (Lim 2010, 195-197; UNCTAD 1996).

In the late 1980s in South Korea, as labor unions grew stronger and labor costs rose following
democratization, the state began to concentrate its efforts on developing the information and
communications industry (Lim 2010, 197-199).

Boosting the saving rate

Amsden and other writers focused their attention on the resource allocation process and the
microeconomics of learning and upgrading manufacturing in East Asia. Akyüz and Gore (1996)
drew attention to another aspect of East Asian industrialization. They highlighted the importance
of the investment-profits nexus and the export-investment nexus in industrialization.

Akyüz and Gore emphasized the fact that rapid industrial upgrading necessitates a high level of
investment (high investment to GDP ratio). This is because upgrading involves scrapping old
equipment and producing, building or buying new ones.5 But high levels of investment cannot
be perpetually maintained by relying on foreign saving. South Korea and Taiwan initially
benefitted from foreign saving to raise their investment ratios above their domestic saving ratios.
But they steadily increased their domestic saving rates.

What were the policies and institutions that boosted saving rates? In Japan, South Korea and
Taiwan the state boosted domestic saving rates mainly by policies promoting the growth of

4
In the 1970s the US recognized the People’s Republic of China and relations between the US and the People’s
Republic of China improved. This policy change raised the prospect of diminishing US military aid to South Korea.
5
The necessity of scrapping equipment and purchasing new equipment for technological upgrading is ignored by
neoclassical growth models (e.g. Solow’s famous growth model). These models typically assume that capital is
“malleable”, i.e. it can be remolded and reshaped easily. So in abstract models sewing needles can be transformed
into sewing machines, picks and shovels can be transformed into bulldozers, and vice versa, without any cost. This
not the case in the real world.
 16

corporate profits. The state boosted profits by fiscal incentives (tax credits, tax exemptions and
special depreciation allowances). In South Korea the state continuously fine-tuned its tax
policies. From 1953 to 1986 there were nine major tax reforms (World Bank 1993, 229).

The state also enhanced corporate saving by implementing measures encouraging the retention
of earnings through generous provision (allowance) policies. Firms were allowed to set aside
substantial parts of their net profits as provisions for foreseen or unforeseen contingencies such
as severance payments to employees, losses in inventories, unpaid consumer credit, etc. These
provisions were deductible from the corporate profit incomes that were taxed. The provisions
also reduced the corporate profit incomes that could be distributed as dividends. So the
provisions policy enabled firm managers to accumulate funds for investment expenditures.

Another factor that ensured a high level of corporate saving in East Asia was the ownership
structure of corporations. When majority shares of corporations are held by families or business
groups that have long-term stakes in the companies (typical in East Asia) there is less pressure
on managers to distribute dividends, so a greater proportion of profits are retained than would be
otherwise.6

The other component of private saving was the saving done by households. East Asian states
boosted household saving by restricting the consumption of luxury goods. They restricted the
importation and the domestic production of such goods or taxed them heavily. The states also
restricted consumer credit. Lack of consumer credit to purchase housing and consumer durables
obliged households to save for such expenditures. So in Japan, South Korea and Taiwan, as
household incomes increased, household saving rates (household saving/household disposable
income) rose rapidly (World Bank 1993, 220).

The practice of paying remunerations partly in the form of profit-linked bonuses also contributed
to raising household saving rates. In Japan and in South Korea such bonuses amounted to 15
percent or more of workers’ total compensation, and to 40 percent or more of corporate profits
(World Bank 1993, 270).

How do profit-linked bonuses boost household saving? Institutionalist economists explained the
effect of profit-linked bonuses on household saving rates with reference to Milton Friedman’s
permanent income theory of consumption. According to this theory, each household makes an
estimation of what its long-term average income (‘permanent income’) is, and determines its
average consumption (‘permanent consumption’) accordingly. The actual income may fluctuate,
falling short of or exceeding the permanent income, but the household will stick to its
consumption habits. Of course, actual consumption expenditures can also deviate from what is

6
As is the case in shareholder capitalism.
 17

planned. The point of the theory is that households adjust their consumption habits to what they
think their permanent income is.

Now as firms in East Asian countries paid their workers profit-linked bonuses (which are not
fixed sums), the worker households receiving them apparently treated the bonuses as temporary
incomes, not as part of their permanent incomes. In other words households did not consider
(expected) bonuses when deciding on their normal consumption. Hence the bonuses were
generally saved. So the practice of paying workers’ compensation partly in unpredictable profit-
linked bonuses can explain the high household saving rates in East Asia. One may assume that
the profit-linked bonuses also had an incentive effect on labor productivity.

In connection with corporate saving and investment, the Indian economist Prabhat Patnaik makes
an interesting point:

“The social legitimacy of capitalism … lies in the fact that capitalists undertake investment. The view
that capitalists may operate enterprises better, even if this were true, will not in itself justify their social
existence, if the surplus produced under such better operation was fully or largely consumed. The better
running of enterprises by capitalists will then have relevance for their own private consumption, but
none for society as a whole. It is the fact that they invest the bulk of the surplus value produced under
their supervision which provides the basis for claiming that they have social relevance, that they play a
role in social advance” (Patnaik 2006).

Table 6.3 shows that in South Korea through the five-year plan periods, domestic saving
gradually replaced foreign saving, the GDP growth targets were exceeded in every planning
period except for the fourth, which coincides with the world recession. The investment rate
(investment/GDP) came to exceed 30 percent in the sixth plan period.

The export-investment nexus

What is the connection between exports and economic development? Mainstream economics
holds that exposure to competition in international markets puts pressure on firms to use their
resources more efficiently and thereby increases productivity. Exposure to international
competition is expected to ensure an improvement in the allocation of resources in the economy
and enhanced cost-efficiency at the enterprise level.

According to institutionalist economists, there are stronger connections between exportation and
industrialization than this causality. An important linkage is through market size. Firms in
developing countries may have difficulties in realizing returns to scale, because the minimum
efficient scale of production exceeds the production required to meet domestic demand.
Exportation helps overcome this constraint by allowing firms to benefit from economies of scale.
 18

Increasing production for exportation may also provide a range of externalities at the industry
level, including economies of specialization.

Another role of exports in economic development is its effect on the balance-of-payments

constraint. Industrializing developing countries are obliged to import capital goods and
intermediate goods. In an economy where the investment to GDP ratio is growing, exports have
to grow faster than GDP, because a foreign exchange constraint on importation can constrain
investment if exports are not increasing sufficiently. The continuous upgrading of industry
necessitates continuous investment, and until the developing country builds its own capital goods
industries, it has to import these goods. Thus the links between exports and productivity connect
exporting to increasing the imports of investment goods, to more investment and thereby to
increasing productivity.

However, exports are a necessary condition for investment and growth. They are not a sufficient
condition. Export earnings can be used to import weapons or luxury consumer goods or
intermediate goods for the production of luxury goods or for tourism expenditures (recall how
oil exporting states utilized the increase in export earnings in the 1970s). Export earnings can
also be diverted to private capital outflows.

Thus economic development involves a dynamic interaction between saving, exports and
investment. During the industrialization process exports, investment and saving would have to
rise as a proportion of GDP. Table 31 from UNCTAD’s 1996 report show South Korea’s saving,
investment and exports rising as a percentage of GDP.

South Korea’s high saving and investment rates were achieved not with what might be called
price stability, but with moderate rates of price inflation. “During its ‘miracle’ years, when its
economy was growing at 7% a year in per capita terms, Korea had inflation rates close to 20%-
17.4% in the 1960s and 19.8% in the 1970s” (Chang 2008, 149-150).

Agricultural policies

The South Korean state implemented a land reform in the 1950s which eliminated the large land-
owning class in the countryside.7 Hence in the industrialization period South Korea’s agriculture
was based on small family farms. These were a politically weak class. The Grain Management
Law of 1950 gave the government wide-ranging authority to purchase, store, transport, allocate
and establish prices for agricultural commodities. After the 1961 coup, the National Agricultural

7
This was in reaction to the landlords’ collaboration with the Japanese occupation administration, and to demands
for land reform in South Korea after the 1946 land reform in North Korea.
 19

Cooperatives Federation was tightly integrated into the central bureaucracy (Haggard et al.
1983, 142; Burmeister 1990, 203-204).

In the 1960s South Korean scientists decided that the japonica rice breed cultivated in Korea had
reached a ceiling in productivity. They collaborated with other scientists at a research institution
in the Philippines to develop a breed of rice that had a yield that was 30 percent higher. The
South Korean state decided to use this new breed to achieve self-sufficiency in rice. Local and
provincial authorities, the police and other agencies exerted pressure on farmers to cultivate the
new rice breed. The new rice required more field work and more fertilizer, and its taste was not
preferred by the Koreans. However, a campaign with production targets achieved the goal of
self-sufficiency in rice (Burmeister 1990, 205-210). These policies generated increases in farm
incomes, and enabled rural households to purchase domestically produced consumer goods and
industrial agroinputs (Burmeister 1990, 199).

South Korea also carried out import substituting investment in fertilizers in the 1970s and
became an exporter of fertilizers in 1975.

In the next lecture we shall see how these policies were phased out as South Korean
industrialization progressed in the 1980s and 1990s.

Sources for the lecture

Akyüz, Yılmaz and Gore, Charles. 1996. The Investment-Profits Nexus in East Asian
Industrialization. World Development. 24(3). March. 461-470.
Amin, Samir. 1999. Spectres of Capitalism: A Critique of Current Intellectual Fashions. Delhi:
Rainbow Publishers.
Amsden, Alice. 1989. Asia's Next Giant: South Korea and Late Industrialization. Oxford
University Press..
Amsden, Alice. 1990. Third World Industrialization: "Global Fordism" or a New Model? New
Left Review. I/182. July-August.
Burmeister, Larry. 1990. State, Industrialization and Agricultural Policy in Korea. Development
and Change. 29.
Chang Ha-Joon, Park Hong-Jae, Yoo Chul-Gyue. 1998. Interpreting the Korean crisis: financial
liberalization, industrial policy and corporate governance. Cambridge Journal of Economics.
22. 735-746
 20

Chang Ha-Joon, Yoo Chul-Gyue. 1999. The Triumph of the Rentiers? The 1997 Korean Crisis
in a Historical Perspective. Centre for Economic Policy Analysis Working Paper No. 12.
November.
Chang, Ha-Joon. 2008. Bad Samaritans: The Myth of Free Trade and the Secret History of
Capitalism. New York. Bloomsbury Press.
Haggard, Stephan, Chung-in Moon. 1983. The South Korean State in the International Political
Economy: Liberal, Dependent or Mercantile? Chapter 3 in The Antinomies of Interdependence:
National Welfare and the International Division of Labor. John Gerard Ruggie (ed.). New
York: Columbia University Press. 131-189.
Patnaik, Prabhat. 2006. An Aspect of Neoliberalism. networkideas.org.
http://www.networkideas.org/news/dec2006/print/prnt181206_Neo_Liberalism.htm
Pirie, Iain. 2013. Globaliation and the Decline of the Developmental State. Ch. 6 in Beyond the
Developmental State: Industrial Policy into the 21st Century. Ben Fine, Jyoti Saraswati,
Daniela Tavasci (ed.). Pluto Press.
Song, Byun-nak. 1994. The Rise of the Korean Economy. Oxford: Oxford University Press.
Soon, Cho. 1994. The Dynamics of Korean Development, Washington D.C. Institute for
International Economics.
UNCTAD United Nations Conference on Trade and Development. 1996. Trade and
Development Report 1996. New York: UN.
Wade, Robert. 1988. The Role of Government in overcoming market failure: Taiwan, Republic
of Korea and Japan. Chapter 5 in Achieving Industrialization in East Asia. Helen Hughes (ed.).
Cambridge University Press. 129-163.
Wade, Robert H. 1996. Japan, the World Bank, and the art of paradigm maintenance: The East
Asıan Miracle in political perspective. New Left Review. 217. May-June.
World Bank. 1993. The East Asian Miracle: Economic Growth and Public Policy. Washington,
D. C.: the World Bank Group.
 1

Development Economics Lecture 7

14.11.2024

liberalization in Korea – developmental state – World Trade Organization –

Investor-State Dispute Settlement

This lecture comprises a summary of South Korean economic liberalization in the 1990s, the
critical interpretation of South Korean industrialization, institutionalist economists’
observations on East Asian developmental states, and institutional changes in the international
economic order in that decade.

Liberalization of the Korean economy

Park Chung Hee, the president who directed South Korea’s industrialization for nearly two
decades, was assassinated in 1979. Another officer, Chun Doo Hwan, took his place. However
the orientation and methods in economic policies remained much the same. Eventually, in 1988,
South Korea shifted to a pluralistic regime.

The liberal economic ideas that spread throughout the world in the 1970s and 1980s affected
South Korea. Moreover many South Koreans detested the regime for its repression of political
opponents, and they associated the economic policies with the regime. There was also popular
resentment against the chaebols, which had grown strong economically and politically.

Under the pressure of domestic demands, and under external pressures, including pressure from
the US government, the South Korean state gradually liberalized its financial policies in the
1980s. In the early 1990s, the state significantly relaxed its control over the financial sector.
The decision by the Korean government in 1993 to apply for OECD membership also subjected
Korea to further external demands for financial liberalization.

The South Korean government’s control over the financial sector weakened as non-bank
financial institutions sprang up. The share of commercial bank assets in total assets of financial
institutions fell from an average of 80 percent in 1971-1976 to an average of 42 percent in 1993-
1996 (Chang et al. 1999, 18). This indicates a transformation away from a bank-based financial
system. The transformation weakened state control over allocation of financial resources.

South Korea’s economic growth improved the credit ratings of Korean corporations and banks
in international financial markets. Previously the private sector had not had sufficient
creditworthiness to borrow in international financial markets without government guarantees.
This had justified the control of the government over borrowing from abroad. But by the late
1980s the private sector began to perceive this control as a burden rather than a necessity (Chang
et al. 1999, 18). So the government deregulated corporate borrowing from abroad. The stock
 2

and bond markets in South Korea were also opened up to foreigners. State control over foreign
debt accumulation weakened.

South Korea had a large trade surplus between 1986 and 1989. The trade surplus created excess
liquidity in the economy. Although the trade surplus subsequently diminished, a surge of capital
inflows in the 1990s fueled the further expansion of domestic liquidity. These inflows of foreign
exchange induced the state to raise the ceilings on private foreign exchange holdings by
residents. Eventually restrictions on foreign exchange holdings were reduced to near
insignificance in 1995 (Chang et al. 1999, 18).

The South Korean state abandoned five-year planning in 1993. The government deregulated
interest rates, put an end to policy loans, granted more managerial autonomy to the banks,
reduced entry barriers to the financial sector and liberalized the capital account – i.e. relaxed
restrictions on international private financial transactions (Chang et al. 1998, 736, 740, 741).

In 1996 South Korea joined the OECD. The OECD demanded relaxation of rules on mergers
and acquisitions, which weakened state control over competition. The OECD also demanded
an end to restrictions on foreign investment.

In the mid-1990s the chaebols carried out highly-leveraged investments abroad using foreign
loans. They purchased privatized state enterprises in the former USSR and the East European
countries. South Korea’s foreign debt accumulated, rising from $44 billion in 1993 to $120
billion in September 1997. Its foreign debt grew at 34 percent annually between 1994-1996.
The share of external short-term debt within total debt rose from 44 percent in 1993 to 58
percent at the end of 1996.

Financial liberalization in South Korea increased the country’s vulnerability to an external

debt/foreign exchange crisis. Eventually the country experienced such a crisis in 1997 (the East
Asian crisis which we discuss later).1

Skeptical interpretations of South Korean economic development

In lecture 6 we focused on institutionalist economists’ analysis of South Korean economic

development policies. Other writers have emphasized Korea’s historical and political
peculiarities in explaining its industrialization. This viewpoint casts doubt on the usefulness of
South Korea’s industrialization for drawing lessons for other developing countries.

1
The Polish economist Kalecki (1899-1970) wrote that, in underdeveloped countries that lack a substantial upper
bourgeoisie, petty bourgeois elites had to pursue a “state capitalism” to industrialize the country. “Over time, petty
bourgeois elites will either nurture a true bourgeoisie which will capture the state, or they will succumb to
international capitalism” (quoted by Waterbury, 1999, 332). It seems that the outcome of industrialization has
been the former in South Korea, and the second in most other underdeveloped countries.
 3

These writers point out that, firstly, South Korea inherited the experience of an efficient
administration, an infrastructure and some industrial base from the Japanese colonial period.
The Japanese had established an effective colonial bureaucracy. After the Second World War
the US occupation forces in South Korea further strengthened the state administration to repress
left-wing political movements.

Secondly, as this country comprised quite a small market at the end of the Second World War
and is not rich in natural resources, its economy was not attractive for US firms. So South Korea
was not pressed by the US government to open up its economy to imports and to unrestricted
foreign investment. On the other hand, thanks to its strategic location, the country benefited
from generous US military and economic aid which helped finance its industrialization in its
early stages.

Thirdly, some held that the capitalist class in South Korea was weak in the first decades after
the Korean War. This facilitated the emergence of a developmental state which was not
controlled by private interests in its economic policies.

In the view of some critical writers, South Korean industrialization was the result of Japan’s
phasing out its labor intensive, low technology sectors. South Korean industrialization was
merely an example of the product cycle model, or of the flying geese paradigm2 (Haggard et al.
1983, 142; Kohli 1994; Aseniero 1996; Cumings 1998; Chhibber 2005).

Another view was that:

“… at any point of time, the size of western markets is limited. If textiles from Japan, Korea, Taiwan
or Hong Kong (and later in the 1980s from China) were to receive preferential treatment, those from
rival producers in India, Pakistan or Egypt had to be blocked through the Multifibres Arrangement,
sanctified by the GATT. More than 20 years ago Cline (1982) … calculated that if the east Asian
experience of export-led growth were to be generalised, total import of manufactures from
developing into industrial countries would have to rise sevenfold. Since that was hardly feasible,
Cline concluded that the significance of the east Asian model was limited.”

Hence the neoliberal recommendation to developing countries to strive for export-led growth
made little sense, given the limits of the capacity of the core countries to absorb imports
(Chandra 2004, 2300).

Whether the South Korean experience could be generally emulated in other developing
countries or not, in any case the set of international agreements established in 1994 at the end
of the Uruguay Round of trade negotiations imposed limitations on the scope for development

2
The flying geese paradigm is a theory of the Japanese economist Kaname Akamatsu. He observed that countries
in low stages of industrialization ascend to higher stages, as the countries in higher stages ascend to even higher
stages, and the leading country is constantly pioneering the highest stage. The dynamic is provided by the pressure
of rising labor costs. So the industrialization movement in East Asian nations resembles the V-shaped flying
formation of wild geese when migrating. The leading goose in the metaphor is Japan.
 4

policies, effectively ensuring that the South Korean model could not be replicated. These
agreements are explained further below.

Some common aspects of states in East Asia

At this point of concluding the discussion of South Korea’s development experience, it may be
asked why states in other developing countries in Latin America, South and Southeast Asia and
Africa did not implement policies similar to those in South Korea and Taiwan. One probable
driving force was the pressing need to establish the political legitimacy of the regime in these
countries. In both South Korea and Taiwan, governments had to deliver economic achievement
to justify their legitimacy as a separate state in the face of domestic pressures for national
reunification, and to justify their legitimacy in relations with other states.

On the other hand some researchers have asked whether differences in political and
administrative structures between the South Korean, Taiwanese and Japanese states on the one
hand and other developing countries on the other could help explain the relative success in
industrial catching-up in the former countries. This query developed the concept of ‘the
developmental state’. Research revealed common features of the state in the three East Asian
countries. These were the following.

One was centralized decision-making within the state. In South Korea the centralized decision-
making apparatus comprised the coordination between the Blue House (the president’s office),
the Economic Planning Board, the Ministry of Commerce and Industry, and the Ministry of
Finance. In Taiwan it was the coordination between the cabinet, the Council for Economic
Planning and Development, the Industrial Development Board and the central bank (Haggard
et al. 1983, 141; Wade, 1988, 157). In Japan economic policies were largely determined by the
Ministry of International Trade and Industry and the Ministry of Finance. These centralized
structures made for cohesion and consistency in economic policies.

In these countries, the states had executive branches which were more authoritarian relative to
Western core countries. The legislative branches was politically weak. In Japan the parliament
did not have much power to influence policies. In South Korea, even Park Chung Hee’s own
political party did not have influence over policies. This made it easier for governments in these
countries to curtail consumption expenditures in order to raise the domestic saving rate and the
investment rate, and to decide on economic priorities, protected from the pressures of particular
interest groups (Haggard et al. 1983, 143; Wade 1988, 158).

Another distinguishing feature in these East Asian countries was the prominent role of the
bureaucracy, as distinct from the politicians. Bureaucrats played an important role in the policy-
making process. In South Korea most policies were initiated by bureaucrats. These often
influenced the visions of political leaders (Lim 2010, 192).

According to researchers, there was a high degree of public-private cooperation in these

countries. In South Korea and in Japan the private sector was organized in centralized
 5

organizations, so that the centralized state could negotiate with a centralized private sector. In
Taiwan the private sector did not have an organization to allow such a cooperation; but an active
business press helped build a consensus on identifying the problems facing the economy (Wade
1988, 158; Lim 2010, 197).

In these three countries there were no powerful classes that owned natural resources such as
land or mineral resources. In contrast to these countries, in many developing countries (typically
in Latin America) there were politically powerful classes of owners of natural resources. They
were exporters of primary commodities. These classes typically favored free trade and
unrestricted imports of manufactured goods. They did not want to be constrained to consume
domestically produced manufactured goods, and so opposed policies for industrialization
(Wade 1988, 159-160). The absence of such classes was an advantage in the three East Asian
countries studied.

It most be noted that these political and administrative characteristics of East Asian
developmental states are factors that enabled these states to pursue industrialization policies.
The characteristics are not sufficient conditions for the emergence of a developmental state. For
instance, most developing countries in Latin America, Africa and Asia have regimes marked
by weak legislatures and powerful authoritarian executives, but where the regimes merely serve
the “development of underdevelopment”. E.g. Thailand, Indonesia and Malaysia have
authoritarian states that have undertaken various types of interventions (protecting and
subsidizing sectors etc.) since the 1980s. But business elites have maintained influence over the
allocation of incentives without imposition of performance requirements. In these countries the
administrators do not have the “enforcement capacities to discipline politically-connected firms
and follow effective industrial policies that are needed to further upgrade technological
capabilities” (Sen 2018, 5-6).

The World Trade Organization

In the post-war period, states periodically renegotiated the rules of international trade. These
negotiations were carried out within the framework of the General Agreement on Tariffs and
Trade (GATT), which was first signed in 1947. The trade negotiations were conducted in
‘rounds’. These were named the Geneva Round (1947), Annecy Round (1949), the Torquay
Round (1950-51), the Geneva Round (1956), the Dillon Round (1960-1961), the Kennedy
Round (1964-1967), the Tokyo Round (1973-1979) and the Uruguay Round (1986-1994).

The negotiations at the Uruguay Round lasted eight years. They ended in 1994 with the signing
of an array of agreements. One of these agreements established the World Trade Organization
(WTO). The WTO replaced the GATT organization as the framework for negotiating future
trade agreements, and for dispute resolution in the implementation of the agreements.

The core states demanded that new topics be added to the GATT agenda during the Uruguay
Round negotiations, despite resistance from the developing countries. As a result of this
 6

pressure, the agreements signed in 1994 included, besides further reductions in tariffs, the
deregulation of trade in services, the deregulation of foreign direct investment, the
strengthening of intellectual property protection, and restrictions on state subsidies. Previous
international trade agreements within the GATT framework had been restricted to reducing
obstacles to trade in goods. The agreements signed in 1994 restricted or prohibited many
developmental policies implemented after the Second World War under import substituting
industrialization and in East Asia.

“Under the WTO rules, developing countries cannot protect their industries after 2005 nor keep out
foreign firms from the domestic markets. From the beginning of the Uruguay Round of
Negotiations in 1986 it was the US that pushed for the change, while developing countries as a
body resisted it. Since nearly all non-socialist developing countries, including Brazil, Mexico and
India were reeling under the burden of external debts by the early 1990s, and their economic
policies were determined by the IMF and World Bank, it is no wonder that they signed the WTO
instruments” (Chandra 2004 2301)

We will summarize the contents of three specific agreements signed in 1994, the enforcement
of which the WTO now oversees.

Trade Related Intellectual Property Rights

The issue of strengthening the protection of intellectual property rights was imposed during the
Uruguay Round negotiations by core country states. The core states charged that their firms
were making losses from the copying, imitation and reverse engineering by foreign firms,
particularly by firms in developing countries.

In the decade leading up to 1994, the US federal government threatened or implemented trade
sanctions against Korea, Taiwan, Brazil, Chile, Thailand, Indonesia, India and China, to force
compliance with its demands related to intellectual property rights. A researcher has observed
that

“U.S. Department of Commerce's list of pirating nations is almost exactly the list of countries that
most economists would regard as having made significant progress in economic development over
the past thirty or forty years. The list is headed by Taiwan, South Korea, Hong Kong and Singapore
with Brazil, Mexico and Thailand following” (Evenson 1990).

The US government implemented trade sanctions not only on companies alleged to violate
property rights, but also restricted imports to the US from other firms in the same country who
were not involved in the intellectual property violation dispute. The US government thereby
pressed these latter firms to lobby with their governments to force the firm accused of violating
intellectual property rights to cease doing so.3

3
This kind of sanction is called cross-retaliation (çapraz misilleme).
 7

Protection of intellectual property rights is defended with the argument that such protection
provides a necessary incentive for innovation, invention, scientific research and artistic work
(we will refer to all such activities as ‘innovation’). It is argued that scarcity rents earned by
intellectual property owners are a reward for innovation, and are also needed to cover the
expenses of research and development. In the Uruguay Round negotiations, core country states
argued that strengthening intellectual property protection is also in the long-term interests of
developing countries, because they also benefit from innovations. Moreover, they argued that
stronger intellectual property protection in developing countries will encourage core country
firms to transfer technology to the firms in these countries, and even to relocate their research
and development activities to these countries.

Eventually the Uruguay Round negotiations on strengthening the international protection of

intellectual property rights culminated in the Agreement on Trade-Related Aspects of
Intellectual Property Rights (TRIPs). This agreement standardized intellectual property rights
protection across countries, regardless of their level of development. The agreement is based
on reciprocity in intellectual property rights protection between the signatory countries, even
though many of them are grossly unequal in intellectual property endowments and in their
capacities to produce intellectual property. TRIPs strengthened the global enforcement of the
protection régime. It also brought new technologies (such as integrated circuits, biotechnology,
software) within the protective framework.

The Agreement on Trade Related Aspects of Intellectual Property Rights specifies the areas of
intellectual property rights as (1) copyrights and related rights, (2) trademarks, (3) geographical
indications, (4) industrial designs, (5) patents, (6) lay-out designs (topographies) of integrated
circuits, (7) undisclosed information of commercial value belonging to natural or legal persons.4

The implementation of copyrights and related rights on artistic production (e.g. printed
publications, music, films) and the protection of trademarks (e.g. to prevent trade in counterfeit
goods) and the protection of geographical indications (e.g. to prevent Chilean winemakers from
using the name Bordeaux) do not directly affect the development of technological capability in
developing countries. However, this protection affects the size of payment flows related to
licenses, copyrights and trademarks from peripheral countries to the core, which appear as
primary incomes in the current accounts of core countries.

On the other hand, the stipulations regarding the protection of industrial designs, patents,
software and layout designs of integrated circuits do have consequences for the technological
learning and catching up in developing countries.

For example, Article 26 of the TRIPs agreement on the protection of industrial designs seems
intended to prevent firms in developing countries from making and selling manufactured
products which are modified versions of other firms’ industrial designs. This is what firms in

4
Annex 1C of the Final Act Embodying the Results of the Uruguay Round of Multilateral Trade Negotiations
dated 15 April 1994.
 8

developing countries do in their first attempts to innovate. The article stipulates: “The owner of
a protected industrial design shall have the right to prevent third parties not having the owner's
consent from making ... articles ... embodying a design which is a copy, or substantially a copy
of the protected design...” (my emphasis).

On the other hand, Article 27 defines “Patentable Subject Matter” and effectively makes a wide
range of agricultural and medical innovations subject to patents. These patents relate to products
concerning the well-being of poor people throughout the developing world.

Institutionalist assessment of intellectual property protection

We mentioned that one argument in defense of the TRIPS agreement was that it would increase
technology transfer to developing countries. Institutionalist economists argued that there was
no reason to expect a substantial increase in technology transfer to developing countries under
a strengthened intellectual property rights régime. The willingness of a company in possession
of an innovation to license it in a foreign country is known to depend on considerations such as
the market size in the country, the expected growth of the market, intensity of market
competition, the capabilities of the potential licensee, and the gains to the licensor from the
licensing the technology compared to alternatives. Stringent enforcement of intellectual
property protection has not created an extra incentive for transferring technologies, but has
merely strengthened the hand of the licensors in the bargaining over royalties.

Another argument was that TRIPs would encourage foreign direct investment into developing
countries. Institutionalist economists pointed out that there is little evidence that protection of
intellectual property in a country plays any role in foreign direct investment decisions. Indeed,
one of the constant complaints of the US government against China for decades has been that
Chinese firms are stealing intellectual property from US firms manufacturing in China.
Intellectual property protection is notoriously weak in China. But this does not deter US firms
or firms from other countries from carrying out foreign direct investment in China.

Institutionalist economists argue that excessive intellectual property protection has drawbacks
for society. Intellectual property protection enables firms to charge monopoly prices. This is
not conducive to social welfare. It is for this reason that many countries, including many
developed countries, did not provide patent protection for pharmaceutical products until the
GATT 1994 agreement. Some countries had special compulsory licensing rules for
pharmaceuticals (UNCTAD 1991, 179; UNCTAD 1994, 188). 5 TRIPs abolished the policy
space for states to restrict the monopoly practices of pharmaceutical firms. It is pointed out that
the pharmaceutical companies of developed countries sell their products for prices many times
their costs of production, even in their exports to very poor countries.

5
Compulsory licensing is the policy of obliging any foreign firm which applies for a patent in a country to give
the license for the production of the product to a local firm. The objective is to ensure that a foreign pharmaceutical
firm that wants its patent to be protected in another country with have that pharmaceutical produced in that country.
 9

Some economists hold that excessive protection may also slow down the production of new
ideas. Each new idea is a building block for the creation of new ideas. So there may be a trade-
off between protecting existing rights and promoting innovation. (The prohibition on producing
and selling products which are modifications of existing designs is a case in point.)

Some argue that weak intellectual property protection may increase the incentive to innovate
and the rate of innovation (Grossman et al. 1990, 90). When protection is limited in time,
innovators have to continue to innovate to stay ahead of their imitators.

Anyway, it is argued, in nearly every invention the innovator naturally has a market position
close to a monopoly on her innovation for some time. In some industries innovations cannot be
rapidly replicated, so protection is not needed to ensure a monopoly. In industries where
replication is easy (pharmaceuticals, software) protection should be given only for a reasonable
period (Chang et al. 2004, 96).

Some critics are concerned that some patents are granted to private firms for discoveries and
inventions that are actually the results of publicly funded research. For example, the anti-AIDS
drug AZT was first invented in 1964 by a US researcher working with a grant from the
government’s National Institute of Health (NIH). The patent on the drug was then bought by
the UK pharmaceutical company, Glaxo, for use on pet cats. When the AIDS epidemic broke
out, the NIH carried out research which proved that AZT works on the HIV virus. Glaxo found
out about the effect of AZT on the HIV virus and immediately took out a patent on it for use on
HIV. It reaped huge profits from the drug (Palast, 2000). This is a case of abuse of the patent
system, where a private firm makes monopoly profits from publicly funded research.

When the AIDS/HIV epidemic began in the late 20th century pharmaceutical companies in some
developing countries (Thailand, Brazil, India and Argentina) sought to export life-saving
AIDS/HIV drugs they produced at low prices to other developing countries, especially to
countries in sub-Saharan Africa. This became an issue because of the objections of the
pharmaceutical companies of developed countries.

It is observed that TRIPs enables firms to patent many natural processes and resources that have
always been public knowledge in developing countries. Core country firms are now able to
repackage and patent products and resources that have been a part of the traditional medical
knowledge legacy in developing countries since ancient times. As a result, people in developing
countries have to pay foreign firms for the use of substances that had always been produced and
available domestically. Critics call this abuse of traditional knowledge ‘biopiracy’.

For instance, in 1995 two American researchers applied for the patent for the medical use of the
spice turmeric.6 They got the idea from peasant remedies in India. This medical knowledge has

6
Zerdeçal.
 10

been known for thousands of years in that country. The application was prevented when the
government of India found out about the attempt, and took the company to court.

It is said that there are around 7,500 medicinal plants unique to India. These are documented in
the local languages. Agents of companies from America, Europe Japan and Australia have been
roaming Indian villages, searching for information on plant species of pharmaceutical value.7

On the other hand, some institutionalist economists point out that core countries did not adhere
to strong intellectual property protection during their industrialization.

“The historical record reveals that industrialised countries did not recognise or enforce patents until
after the process of industrialisation was complete. Switzerland introduced a patent law that
protected mechanical inventions in 1888, but a comprehensive patent law was introduced only in
1907 … . The Netherlands first introduced a patent law in 1817, but then abolished it in 1869 because
patents were seen to create a monopoly that was inconsistent with the country’s commitment to free
trade and free markets … . Patent law was reintroduced in the Netherlands only in 1912. The 19 th
century economists that were most committed to free trade and free markets rejected patents because
of the monopoly argument.

“Other industrialised countries had patent laws by the mid-19th century. But until well into the 20th
century these laws fell well short of the stringent standards now demanded of developing countries
through the TRIPS agreement. For instance, in the 19th century many countries granted patents to
inventions that were imported from abroad, and generally did not check for originality prior to
issuing a patent. Japan, Switzerland and Italy did not recognise patents on chemical and
pharmaceutical substances (as opposed to the processes of creating them) until the 1970s. Canada
and Spain did not recognise these types of patents until the early 1990s. Up until quite recently, India
took the same approach to patents on chemical and pharmaceutical substances” (Chang and Grabel
2004, 97).

The observation on the Netherlands reminds us that strengthening intellectual property

protection is actually incompatible with the principle of free competition. Standardizing
intellectual property protection across countries through the TRIPs agreement has reinforced
the core countries’ monopoly in science and technology, and increased the royalty and copyright
payment flows from the periphery to the core.

Since 1994 core country states are continuing to try to strengthen their monopoly in leading
technologies. The United States government has been exerting pressure on developing countries
in regional and bilateral trade agreements for tighter rules (“TRIPs-plus”) i.e. stronger and
lengthier protection of intellectual properties of its firms. “Thanks to subsequent trade
agreements, intellectual property protection has become broader and stronger” (Rodrick 2018,
76-77).

7
http://www.ens-newswire.com/ens/aug1999/199908-27-01.asp
 11

The agreements affecting FDI and subsidy policies

Another of the agreements signed in 1994 that has consequences for development policies is
the agreement on Trade-Related Investment Measures (TRIMs). This agreement is aimed at
prohibiting states from imposing conditions on foreign firms requesting permission for FDI.
Signatory states may not demand foreign firms to use domestically produced raw materials or
intermediate goods. In other words, local content requirements are prohibited. This effectively
prevents the state in the host country from compelling firms with foreign capital to help develop
local supplier industries. So it leaves the actualization of the technology transfer effects of FDI
and the development of vertical linkages to the discretion of foreign firms.

Another stipulation of the TRIMs agreement is that states may not impose conditions that a
foreign-owned enterprise must export some of its output (to bring in foreign exchange), or that
it should balance its imports with its export earnings. This prevents states from ensuring that
foreign direct investments do not pose a burden on the trade balance.

Another agreement signed in 1994 is the Agreement on Subsidies and Countervailing Measures
(ASCM). This agreement prohibits states and other public institutions from subsidizing export-
related production in individual firms, or sectors, or regions. Prohibited subsidies include
subsidies contingent on export performance (export subsidies) and subsidies contingent upon
the use of domestic over imported goods (local content subsidies). The agreement also stipulates
the rules by which a state may implement ‘countervailing measures’. Countervailing measures
are additional tariffs that an importing country that declares it is affected by the subsidies of the
exporting country may impose on those imports.

In February 2020 the US, the EU and Japanese governments initiated a proposal to further
restrict the policy space of developing countries to implement industrial subsidies. “The
trilateral proposal of the US, the EU, and Japan on industrial subsidies intends to ‘strengthen
existing WTO rules on industrial subsidies’. The proposal stated that “the current list of
prohibited subsidies provided for in Article 3.1 of the Agreement on Subsidies and
Countervailing Measures (ASCM) is insufficient to tackle market and trade distorting
subsidization existing in certain jurisdictions”. 8 “Therefore, new types of unconditionally
prohibited subsidies need to be added to the ASCM.”

“The US, the EU and Japan suggested that subsidies to state-owned enterprises, including
‘subsidies that prop up uncompetitive firms and prevent their exit from the market, [and]
subsidies creating massive manufacturing capacity, without private commercial participation,
and, subsidies that lower input prices domestically in comparison to prices of the same goods
when destined for export’, must be included in the prohibited list of the ASCM” (Third World
Network 2020).

8
They mean China.
 12

The significance of these moves is obvious in comparison to South Korean industrialization

policies and the discussion of the importance of socializing risks in industrialization.

Investor-State Dispute Settlement

Since the 1980s another development in the world-economy that has weakened the economic
policy space of states in developing countries is the increasing use of investor-state dispute
settlement (ISDS) procedures.

Before the advent of neoliberalism, disputes between foreign firms and host-country states were
normally resolved in that country’s courts, in accordance with that country’s laws. That
individuals and firms residing in a foreign country should be subject to the host country’s laws
and judicial system is a logical precondition of the sovereignty of a state. Yet even before the
liberal period, core country states were pushing developing country states to accept that foreign
firms be allowed to bypass local courts and to sue host country states directly in ‘independent’
arbitration panels in adjudicating alleged investment treaty violations.

Since the 1980s, core states have utilized the need of developing countries to gain access to
core country markets, to force them to accept investor-state dispute settlement provisions in
bilateral trade agreements and regional trade agreements (such as the North American Free
Trade Agreement NAFTA). Core states have also utilized the thirst of developing countries for
foreign direct investment to incorporate investor-state dispute settlement provisions into
bilateral investment treaties. The ISDS provisions stipulate how the states that are party to those
agreements are to treat foreign companies which carry out investment in their countries (e.g.
equal treatment with domestic companies and no expropriation). The ISDS provisions enable
foreign firms to sue host governments in special arbitration tribunals to seek monetary damages
for regulatory, tax, and other policy changes that reduce their profits (Rodrick 2018, 77-78).
Additionally, ISDS often involves prioritization of private rights over public interest.

The obligations of investment treaties are essentially one-way. Under international investment
agreements, states have obligations, but companies do not. A state cannot ‘win’ in a ISDS case.
Only foreign companies can bring claims to ISDS. States can make small or large material
losses or at best break even in these cases. ISDS grants foreign firms advantages that domestic
firms do not enjoy. With treaty protections and procedural rights to take a government directly
to arbitration, foreign companies enjoy rights under international investment law that domestic
companies do not.

ISDS provisions are formally reciprocal between the signatory states, but given that the greater
part of FDI originates in core countries, ISDS basically functions to protect core country firms.
In 2023 outflows of FDI from the developed economies was $1.059 trillion while that year low-
income and middle-income countries combined accounted for $0.491 trillion, with almost all
of that amount coming from middle-income countries (UNCTAD, World Investment Report
2024). So the system primarily protects the foreign direct investments of firms from high-
income countries.
 13

A study (Samples 2019) covering 936 cases of ISDS from 1987 to the end of 2017 found that
the claimants (suing foreign firms) were overwhelmingly from high-income countries
(86.25%). Claimants from upper-middle-income countries (10.34%) and from lower-middle-
income countries (3.41%) accounted for the rest of the claims, with no ISDS claims by
companies from low-income countries. States of high-income countries accounted for 27.55%,
states of upper-middle-income countries for 42.15%, states of lower-middle-income for 24.26%
and states of low-income countries accounted for 6.04% of cases as a respondent state (i.e. sued
by a foreign firm). Investor-state disputes have boomed from the beginning of the 1990s with
the increase in FDI. As of 2017, 3,324 international investment agreements had been signed.

The monetary costs of ISDS for states consist of awards, settlements, legal fees, and tribunal or
arbitration costs. Awards are monetary damages that a tribunal may order a state to pay a
company. Awards consist of monetary damages plus accumulated interest. Settlements take
place outside of the arbitral process and typically result in a money payment from the state to
the company. The costs can be heavy for the states concerned as seen in the examples in Table
7.1.

Table 7.1
Net ISDS Outcomes versus Government Spending in 2010
for High-Loss Countries
Country Net ISDS Outcomes/
Net ISDS Outcomes Government Spending
Belize -$209 million -93.6%
Bolivia -$733 million -27.0%
Ecuador -$2,608 million -28.4%
Kyrgyzstan -$242 million -27.8%
Libya -$1,951 million -22.5%
Source: Samples 2019, 167.

The privileging of private interests over public interests has far-reaching consequences. In 2015,
187 governments signed the Paris Agreement under the United Nations Framework Convention
on Climate Change (UNFCCC) pledging to keep average global temperature change below 2
degrees Celsius (°C) of warming above pre-industrial levels. Scientists have estimated that in
order to have a reasonable chance of meeting this commitment globally, a third of oil reserves,
half of gas reserves and over 80% of current coal reserves should remain unused from 2010 to
2050.
As of 2017 over 3,000 bilateral investment treaties include provisions to provide legal
protection for all forms of foreign investment. This protection includes investments in sectors
that must eventually be rendered obsolete to prevent warming beyond the 2°C limit set by the
Paris Agreement.
Regional trade agreements such as the North American Free Trade Agreement, the Trans-
Pacific Partnership, the Transatlantic Trade and Investment Partnership, the Regional
Comprehensive Economic Partnership all have chapters on investment protection with
provisions on access to ISDS.
 14

ISDS has raised concerns that it may be causing ‘regulatory chill’. It is feared that governments
fail to regulate in the public interest because of concerns about ISDS. ISDS has an effect on the
way in which host states exercise their regulatory powers because of the substantial financial
risk involved, and the difficulty in predicting outcomes of ISDS. For example, policy makers
may take into account potential disputes with foreign companies before they even begin to draft
a policy, preferring to avoid such disputes rather than develop efficient regulation in the public
interest (‘internalization chill’). Or ISDS may obstruct specific regulatory measures that have
been proposed by governments when a foreign firm threatens to go to arbitration (‘threat chill’).
A third effect is ‘cross-border chill’. Companies pursue this type of chilling effect when a
government adopts a policy that affects a form of investment likely to be emulated by other
governments. The company launches an ISDS case in one or more jurisdictions. The aim is not
necessarily to prevent a policy in the jurisdiction in which the claim is brought (this jurisdiction
might not even represent an important market or investment location) but to prevent the policy
in all other jurisdictions in which the investor is active. Hence the ISDS mechanism threatens
to prevent states from complying with environmental agreements or protecting the public
interest, such as public health (Tienhaara 2018).
Critics of ISDS point out that ISDS is secretive and that tribunals work as undemocratic offshore
courts against the will of the people. Transparency is inadequate. ISDS proceedings are largely
confidential. Though many awards are ultimately published, settlements reached between firms
and states are rarely announced. Approximately one-third of ISDS cases end in settlement, so
this amounts to a major information gap about the consequences of ISDS for public finances.
ISDS settlements frequently involve large sums of money. The lack in the accountability of
investment tribunals contributes to the perception of illegitimacy. Three-person panels resolve
disputes that can impact the lives of many people. There is no appeals process.
The appendix to this lecture describes three examples of investor-state dispute settlements.

Conclusion
Since the 1994 agreements signed at the end of the Uruguay Round, there have been attempts
to start a new round of trade negotiations. In 1999 representatives of the World Trade
Organization member states convened in Seattle, Washington, on November 30, 1999 to
launch a new round of trade negotiations. The conference provoked massive street protests
in Seattle. This was a reaction to five years of implementation of the 1994 WTO agreement. On
December 3rd the conference ended as delegations were unable to reach an agreement on
several topics, but partly under pressure from the protests. In 2001 the Doha Development
Round of trade negotiations was launched. It is still continuing.
The international developments described in this lecture have led to a questioning of whether
the concept of a developmental state has become “little more than a historical relic” because the
creation of the World Trade Organization, the related agreements, and the increasing
implementation of ISDS has limited the policy space of states in developing countries (Pirie
2013, 155-156).
 15

Appendix to Lecture 7
Examples of Investor-State Dispute Cases

An example of an investor-state dispute case: In 2004 the government of Uruguay enacted a

regulation to protect the public against smoking addiction. It stipulated that warning labels
should cover eighty percent of the front and back of cigarette packages and that only one variant
of cigarette per brand family should be allowed, effectively prohibiting color-coded variants
that indicate, for instance, light or menthol products. In 2010, Philip Morris brought a $25.7
million claim against the state of Uruguay, alleging that the tobacco regulations violated the
Switzerland-Uruguay bilateral investment treaty (BIT). Philip Morris claimed that the
Uruguayan regulations amounted to “expropriation, denied the company fair and equitable
treatment, impaired the use and enjoyment of investments and demanded compensation for
each of these claims”. Ultimately, the tribunal ruled against the claimants, judging that the
tobacco regulations were not expropriatory and fell within Uruguay’s sovereign powers to
protect public health. However, the Philip Morris versus Uruguay dispute involved enormous
legal fees and tribunal costs. The $27 million aggregate legal fees and tribunal costs (about
$16.9 million for Philip Morris and $10.3 million for Uruguay) exceeded the base value of the
claim itself. When the claim was brought in 2010, Uruguay’s GDP was about half Philip
Morris’s annual revenues (Samples 2019, 122-123). The Uruguayan government
acknowledged that it would not have been able to defend itself in the case without the financial
support of a foundation set up by Michael Bloomberg (Tienhaara 2017, 237).

Another second example of a ISDS case: The Indian government liberalized the Indian energy
sector in the early 1990s. Enron, Bechtel and General Electric started the Dabhol project, a gas-
powered electricity plant. The project was controversial from the beginning because of
allegations of corruption surrounding the contract arrangements between the foreign firms and
local Indian authorities, and public opposition due to human rights violations. In 2000, a review
of the project recommended that it be abandoned. That year the local government of
Maharashtra cancelled its payments for electricity which it considered overpriced. Nine
international arbitration lawsuits were launched against the Indian state by companies that had
invested in the project. Among them was the Mauritius subsidiary of US-based Bechtel. In July
2015, the case was settled for US$160 million in compensation in favor of Bechtel. The India-
Mauritius Bilateral Investment Treaty was invoked (ISDS Platform).

A third example of a ISDS case: The Mexican government imposed a tax on beverages
sweetened with high fructose corn syrup (HFCS). This is a sweetener that is linked to obesity.
The tax also helped protect the Mexican cane sugar industry which employs hundreds of
thousands of workers. The protection was against post-NAFTA imports of US-subsidized
HFCS that threatened those jobs. The Mexican government also argued that the tax was
legitimate as a counter to the US refusal to open its market to Mexican cane sugar, as stipulated
by NAFTA. Cargill, the producer of HFCS, made a claim in 2005 against the Mexican
government. Cargill reached a settlement with Mexico that resulted in a $77 million arbitration
award for the company in 2013. The NAFTA arbitration tribunal awarded Cargill this sum for
 16

losses from the trade barriers the company said Mexico erected against high-fructose corn syrup
in 2002-2007. The ISDS tribunal ruled that the tax was a violation of Cargill’s right to fair and
equitable treatment under NAFTA (ISDS Platform).

Sources for the lecture

Aseniero, George. 1996. Asia in the World-System. In The Underdevelopment of Development, ed.
Sing C. Chew, Robert A. Denemark. Thousand Oaks: Sage.
Chang Ha-Joon, Park Hong-Jae, Yoo Chul-Gyue. 1998. Interpreting the Korean crisis: financial
liberalization, industrial policy and corporate governance. Cambridge Journal of Economics. 22.
735-746.
Chang Ha-Joon, Yoo Chul-Gyue. 1999. The Triumph of the Rentiers? The 1997 Korean Crisis in a
Historical Perspective. Centre for Economic Policy Analysis Working Paper No. 12. November.
Chang, Ha-joon, Ilene Grable. 2004. Reclaiming Development: An Alternative Economic Policy
Manual (Critique Influence Change). London: Zed Books.
Chandra, Nirmal Kumar. 2004. Relevance of Soviet Economic Model for Non-socialist Countries.
Economic and Political Weekly. May 29, 2004. 2287-2305.
Chhibber, Vivek. 2005. Reviving the Developmental State? The Myth of the ‘National Bourgeoisie’.
Socialist Register. 226-246.
Cumings, Bruce. 1998. The Korean Crisis and the End of ‘Late’ Development. New Left Review.
231. Sept-Oct.
Evenson, R.E. 1990. Intellectual property rights, R & D, Inventions, Technology Purchase, and Piracy
in Economic Development: an International Comparative Study. Yale University Economic
Growth Center.
Grossman, H. I., E. Helpman. 1990. Trade, Innovation and Growth. American Economic Review.
80(2). May.
Haggard, Stephan, Chung-in Moon. 1983. The South Korean State in the International Political
Economy: Liberal, Dependent or Mercantile? Chapter 3 in The Antinomies of Interdependence:
National Welfare and the International Division of Labor. John Gerard Ruggie (ed.). New York:
Columbia University Press. 131-189.
ISDS Platform. Stop Investor-State Dispute Settlement: Resources for Movements.
https://isds.bilaterals.org/ (24.12.2022)
Kohli, Atul. 1994. Where do high growth political economies come from? The Japanese lineage of
Korea's “developmental state.” World Development. 22(9).
Lim, Haeran. 2010. The Transformation of the Developmental State and Economic Reform in Korea.
Journal of Contemporary Asia. 40(2). 188-201.
Pirie, Iain. 2013. Globalization and the Decline of the Developmental State. Ch. 6 in Beyond the
Developmental State: Industrial Policy into the 21st Century. Ben Fine, Jyoti Saraswati, Daniela
Tavasci (ed.). Pluto Press.
Rodrik, Dani. 2018. What Do Trade Agreements Really Do? Journal of Economic Perspectives. 32(2).
Spring 2018.
Samples, Tim R. 2019. Winning and Losing in Investor-State Dispute Settlement. American Business
Law Journal. 56(1). Spring. 115-175.
Sen, Kunal. 2018. Why have we seen so few developmental states? in Revisiting the developmental
state. SPERI Paper no. 43. 8 February 2018.
 17

Singer, Hans W. 1964. Effects of patents on the economies of underdeveloped countries. In UN

Secretary General, The Role of Patents in the Transfer of Technology to Developing Countries. New
York: United Nations.
Third World Network. 2020. Developing countries facing systemic crisis at the WTO. Published in
SUNS #9079 dated 2 March 2020. https://www.twn.my/title2/wto.info/2020/ti200304.htm
Tienhaara, Kyla. 2018. Regulatory Chill in a Warming World: The Threat to Climate Policy Posed by
Investor-State Dispute Settlement. Transnational Environmental Law. 7(2). 229-250.
UNCTAD. 1991. United Nations Conference on Trade and Development. Trade and Development
Report 1991. New York. United Nations.
UNCTAD. 1994. United Nations Conference on Trade and Development. Trade and Development
Report 1994. New York. United Nations.
Wade, Robert. 1988. The Role of Government in overcoming market failure: Taiwan, Republic of
Korea and Japan. Chapter 5 in Achieving Industrialization in East Asia. Helen Hughes (ed.).
Cambridge University Press. 129-163.
Waterbury, John. The Long Gestation and Brief Triumph of Import-Substitution Industrialization. World
Development. Vol. 27. No. 2. 1999.
 1

Development Economics Lecture 8

21.11.2024

financial repression – interest rates and saving – banking crises – stock markets – derivatives

This is the first lecture on financial policy problems in general and for developing countries. Financial
policies involve management of and restrictions on the activities of financial institutions. From the
end of World War II until the liberal era, the states of core countries implemented financial policies
that aimed at financial stability and macroeconomic stability (full employment). States in
developing countries implemented financial policies for the objectives of financial stability and
industrialization.

In the 1980s the neoliberal transformation brought about major changes in these policies. Since
then, developing countries have experienced crises in their banking systems, capital markets and
in their balances of payments with increasing frequency. In the developed countries, contractions
in financial markets have been causing recurrent recessions. The Global Financial Crisis of 2008
had its origins in the financial sector in the US. At present, the world faces the danger of a new
global debt crisis. The management of financial systems has become a major problem.

The theory of financial repression

In the 1970s, liberal economists developed the theory of financial repression. This theory guided
reforms in financial policies. According to this theory, state intervention in the financial system
distorts prices (interest rates, exchange rates) and leads to misallocation of resources.

According to the theory, low or negative real deposit rates repress household saving. Low deposit
rates also discourage households from holding bank deposits, inducing them to hold their savings
in non-financial assets (gold, land).

On the other hand, it is argued that low bank lending rates lower the ‘quality of investment’. The
explanation is that, with low interest rates on bank loans, firms with investment projects with low
rates of return can access credit, crowding out firms with projects with higher returns, projects
which should be preferred from an economic viewpoint. The reason for this adverse selection is
explained as follows: when loan rates are kept low at non-market-clearing levels, excess demand
for loans allows bank managers to allocate credit using their discretion, and bank managers may
be influenced by non-economic factors in their decisions (bank managers’ impression of loan
clients, nepotism, bribes etc.). Thus, bank managers’ discretion over allocation of loans can lower
the ‘quality’ of the projects receiving bank credit. The assumption is that, if lending rates are not
determined by the state, banks would determine lending rates at levels that would not leave room
 2

for bank managers’ discretion.

State interference in the allocation of bank loans also causes inefficiency in the use of savings,
because the state can use criteria unrelated to market signals (such as industrialization, and self-
sufficiency) in its allocation.

The theorists of financial repression also criticized the Bretton Woods system of fixed exchange
rates. Under fixed exchange rate régimes, currencies in underdeveloped countries tended to
appreciate in real terms. Overvaluation of national currencies created an anti-export bias, shifting
resources away from tradables sectors to non-tradables sectors in these countries.

Central banks’ practice of implementing multiple exchange rates (selling foreign currencies at
different exchange rates according to the use to be made) caused inefficiency in the use of scarce
foreign exchange. Firms that use foreign exchange in projects with higher returns might be
deprived of foreign exchange in favor of firms whose use of foreign exchange brought in lower
returns, according to the theory of financial repression.1

In the view of financial repression theorists, when the financial system is repressed, it is
underdeveloped. The level of financial intermediation in the economy remains low. According to
the theory, more financial intermediation i.e. financial deepening, is necessary to increase the private
saving rate, and to divert more savings into the financial system, and to raise the efficiency in the use
of savings. Financial deepening is reflected in an increasing ‘financial value added to GDP’ ratio.
Financial deepening can also be measured by the M2/GDP or M2Y/GDP ratios. These are
indicators of financial intermediation in an economy.2

According to the theory, financial deepening requires financial deregulation. These writers predicted
that financial liberalization would enhance economic growth.

The function of the financial sector

To assess the effects of the financial reforms implemented, it is useful to recall what the function of
the financial sector is, or what it should be.

In macroeconomics we define saving as the goods produced and not consumed in a given period.
Goods saved are available for private and public investment and for exporting. The money saving
of households, firms and the public sector corresponds to the value of the goods not consumed in the
period.

1
For example, if a project in the entertainment industry has a higher rate of return (promise of a greater profitability)
than a project in manufacturing, favoring the manufacturing investment project in allocating loans or foreign
exchange leads to an inefficient allocation according to the theory of financial repression.
2
Some call increases in the financial value added to GDP ratio the ‘financialization’ of the economy.
 3

Saving in the public sector is created by an excess of public revenues over public consumption expenditures.

Generally, the household sector has a net surplus in money saving, and private firms as a sector
have a net deficit in such saving. The public sector can have either a saving deficit or surplus. The
external trade balance can either provide saving to the economy from abroad (when imports exceed
exports), or it can channel excess saving to other countries (though a trade surplus).

The financial system mediates between the agents that have a shortage of money savings for their
planned expenditures, and the agents that have a surplus of money savings above their planned
expenditures. The intermediation of financial institutions between lenders and borrowers enables
firms to carry out investment, purchasing goods that have not been consumed. Financial institutions
also enable the public sector to make use of goods made available by households’ and firms’
saving. Finally, financial institutions serve in the payments for trade flows between countries that
have an excess of saving and those that have a shortage of saving.

Depositors to commercial banks desire the liquidity of their deposits, and that their deposits should
be safe. On the other hand, borrowers want to be able to use a loan for a determined period.
Commercial banks intermediate in a way that satisfies the requirements of depositors for liquidity
and risk avoidance, and debtors’ requirement of maturity, to be able to use a loan for a fixed period
before repayment.

Commercial banks’ liabilities (deposits) are short-term, so they naturally prefer to lend short-term.
The reluctance of commercial banks to extend long-term loans is a problem for entrepreneurs
planning to carry out investment projects with long gestation periods. So other financial institutions
have been created to provide long-term loans. One is capital markets, where firms can borrow long
term by issuing bonds, or obtain new capital by issuing new shares. The second institution providing
long term funds is specialized banks. Some specialized banks are national, e.g. the Industrial
Development Bank of Turkey (TSKB), and some are international, such as the World Bank (IBRD)
and the Asian Development Bank. Specialized banks do not collect deposits. Their funding sources
are their own capital, proceeds from the bonds that they issue, and loans from other specialized banks
(e.g. TSKB can borrow from IBRD).

In practice, commercial banks can provide long term finance to their loan clients by giving short-
term loans and ‘rolling over’ these loans when they mature (i.e. extending and re-extending the loan),
as long as the loan client is using the loan prudently. But this practice necessitates the lending bank’s
close supervision of its loan client’s finances. The creditor bank can monitor its client’s finances
e.g. by a representative sitting on the board of directors, or other arrangements such as the Japanese
main bank. Such arrangements are characteristic of stakeholder governance cultures.

Financial systems do not only do intermediation. Commercial banks create purchasing power
 4

through the fractional reserve credit system. Banks’ ability to create deposits breaks the causal link
between prior saving and investment; i.e. domestic saving does not have to increase before
investment expenditures can increase. In an economy with underutilized resources, expanding
bank credit can finance an increase in investment expenditures, if firms intend to do so. Banks
loans provide firms intending to carry out investment with purchasing power. When investment
increases, it generates increases in GDP and thereby saving, according to the Keynesian theory of
income determination. Thus banks play an enabling and facilitating role in raising GDP in an
economy with underutilized capacity.

The third role of financial systems is to absorb the shocks to firms that arise from economic and
political events, technological change, natural disasters etc. Financial institutions (banks, insurance
companies, social security institutions etc.) are expected to absorb the losses of the firms they lend
to. They are expected to protect the owners of the savings entrusted to them -depositors, insurance
policy holders, people with savings in the social security system- from the effects of the losses the
financial institutions suffer from their lending and investments. The financial system is thus
expected to provide stability to the economy by pooling (socializing) risks.
We shall see how financial deregulation in the last 40 years has transformed financial systems
from shock absorbers into generators of economic instability.

Interest rates and saving

The theory of financial repression held that low real interest rates (1) lead to low household saving
rates, and (2) induce households to keep their savings in non-financial assets. The first is the effect
of interest rates on the flow of new saving; the second is the effect on the allocation of the stock
of savings. Based on this theory, liberal economists recommended deregulating interest rates,
allowing financial institutions to raise them. It was expected that this would boost private saving
rates, and attract households’ savings into the financial system.
Financial liberalization across the world in the 1970s and 1980s led to sharp rises in nominal and
real interest rates in both core and peripheral countries. These increases in interest rates did not
generally increase private saving rates. In fact, in developing countries where Structural
Adjustment Programs caused economic contraction and falling incomes, saving rates actually fell.

Since the 1980s, researchers have studied the determinants of private saving rates in particular
countries and groups of countries. Here are six examples of research which conclude that there is
no causality from interest rates to private saving rates in the country or countries studied:
Giovannini (1983) studied data from seven developing Asian countries over the 1960s and 1970s.
Khatkhate (1985) did an internal study for the IMF covering 46 developing countries in the 1970-
1980 period. Ueda (1988, 242) estimated consumption functions for Japanese households over
1970-1985. Boratav et al. (1996, 13) reached the same conclusion for Turkey. Horioka and
 5

Watanabe (1997) studied Japanese household saving behavior. Özcan et al. (2003) studied
determinants of private savings behavior in Turkey.

For example, Horioka and Watanabe (1997) studied the saving motives of Japanese households
according to a survey conducted by the Japanese Ministry of Posts and Telecommunications in
1994. The survey asked Japanese households their motives for saving. The motives declared by
households were: (1) for living expenses during retirement, (2) for illness, disasters and other
unforeseen expenditures, (3) for one’s children’s educational expenses, (4) for one’s marriage
expenses, (5) for acquisition (including rebuilding and replacement purchase) of owner-occupied
housing (including land), (6) for the purchase of consumer durables, (7) for leisure expenses, (8) for
the payment of taxes, (9) for an independent business, (10) no specific motive but for peace of mind,
(11) in order to leave a bequest and (12) others. The writers found that the retirement motive and
the two precautionary motives (saving for illness and for peace of mind) were the dominant motives.
The writers explained that precautionary saving may be high because of capital and insurance market
imperfections in Japan; because of deficiencies in unemployment insurance, health insurance and
pension schemes in the Japanese social security system; and because of the high incidence of
earthquakes and other natural disasters in Japan, or because of a high degree of risk aversion. There
was no mention of interest rates.

A comprehensive research on saving behavior appeared in 2000. Three World Bank economists
(Loayza et al. 2000) published a research paper entitled “What Drives Private Saving around the
World?”. The writers used regression methods to investigate the variables determining private
saving rates in 150 developing and developed countries over 1965-1994, covering the period
before and after financial deregulations. Their findings were as follows.

Private saving rates show inertia. It takes several years for a change in a determining variable to show
its full effect on the private saving rate.

Private saving rates are affected by the level of real income per capita, and also by the growth rate
of real income per capita.

The level of urbanization reduces private saving rates.

The age-dependence ratio reduces private saving rates. The effect of dependent elderly people on
the private saving rate is greater than the effect of young dependents. This confirms the life-cycle
hypothesis of saving, which holds that households save in their working lives for retirement, when
they dissave.

The rate of inflation has a positive effect on private saving rates. A higher inflation rate means higher
economic uncertainty which strengthens the precautionary motive to increase saving.
 6

An increase in the level of public saving reduces the private saving rate. Consequently, raising the
level of public saving does not contribute as much to national saving.

Current account deficits reduce private saving rates. An inflow of foreign savings into an economy
weakens domestic private saving rates.

Financial deregulation reduces the private saving rate. Increased access to consumer credit reduces
the private saving rate. Financial deepening does not increase the private saving rate. A rise in the
real interest rate does not increase the private saving rate.

Why interest rates do not affect saving rates

It is possible to explain why the private saving rate may not be positively influenced by interest rates,
and indeed why even a negative relation may exist between them.

The neoclassical proposition that a positive correlation exists between interest rates and saving
rates is grounded in a model of household consumption behavior with intertemporal utility
maximization. In the model, a rise in the rate of interest increases the cost of current consumption
relative to future consumption. When the interest rate is higher, you lose more future consumption
per unit of current consumption, assuming you invest your money saving in the current period in
interest-bearing assets. Therefore you substitute future consumption for current consumption. So
when the interest rate rises, the household substitutes future consumption for current consumption
by cutting down current consumption. In other words, the positive correlation between the interest
rate and the saving rate in the model is based on the substitution effect of a change in relative costs
of current and future consumptions when the interest rate changes.

Whether this abstract model describes actual household consumption and saving decisions is
doubtful.3 But even within this model, it is possible that a higher interest rate may have a zero or
negative effect on the household saving rate. This is because changes in the interest rate may also
have an income effect on the consumption decision; and the income effect may outweigh the
substitution effect. If the income effect is stronger than the substitution effect, an increase in the
interest rate could very well allow the household to raise current consumption and without a loss
in future consumption. If the income effect is much stronger than the substitution effect, the
household could be able to raise both current consumption and future consumption. In such cases
the current saving would decline when the interest rate increased.

The plausible explanation for a negative relationship between the interest rate and the private
saving rate is based on actual household saving behavior. When households have specific savings

3
Do you know of anyone who takes interest rates into consideration when making consumption decisions?
 7

targets connected to specific expenditure plans (education, marriage, buying a house, retirement
etc.), then an increase in interest rates may induce these households to save less out of their current
incomes, because their savings targets can be attained with less saving effort, thanks to higher
interest incomes from accumulated savings.

In his General Theory of Employment, Interest and Money, Keynes described how saving behavior
is mostly motivated by plans for specific future expenditures or by precautionary motives This
behavior is also the basic assumption of the life-cycle hypothesis of consumption. And this saving
behavior is confirmed for Japan in the survey mentioned above.

Yılmaz Akyüz has suggested a macroeconomic explanation for the possibility of a negative
relationship between interest rates and private saving rates. Consider an economy where firms
hold a stock of outstanding debt to households. The firms pay interest on their outstanding debt to
households every period. The interest is paid out of the firms’gross profit incomes, and adds to the
households’ disposable incomes. Now the propensity to save out of profit incomes is one (firms do
not consume), and the propensity to save of households out of their incomes is less than one. In this
economy, a rise in interest rates on the stock of existing debt will (ceteris paribus) increase the
incomes of households and reduce the net profit incomes of firms. So an increase in interest rates
redistributes income from firms to households. The share of higher savers (firms) in total income
decreases, while the share of lower savers (households) increases. This lowers the average private
saving rate in the economy. Hence, the redistributive effect of increasing interest rates can depress
the overall private saving rate.

Relevance of the interest rate issue

Why do we dwell on the empirical evidence showing there is no positive causality from interest
rates to private saving rates? What is the relevance of the non-existence of this causality for
development policies?

First, recall that there is no disagreement among economists on the effect of interest rates on
investment expenditures. Mainstream economists and institutionalist economists all agree on what
experience undeniably shows: a rise in the cost of borrowing depresses the level of investment
expenditure in any economy, ceteris paribus.

So, we have two alternative models for deciding interest rate policy. One is the mainstream
neoclassical model. It holds that saving is an increasing function of the interest rate, and investment
expenditures are a decreasing function of the interest rate. If the interest rate is determined in
markets and is flexible, it will balance the supply of loanable funds and the demand for loanable
funds, i.e. the interest rate will balance saving and investment expenditures.4 Therefore, any

4
The model assumes that the demand for loanable funds and the supply of loanable funds interact in a market for
 8

attempt to reduce the interest rate below the ‘equilibrium’ level will reduce saving, generate an
excess demand for funds, and impose a constraint on investment. Hence, it is not wise for the
authorities to try to keep interest rates low.

The alternative is the Keynesian model. It holds that saving is determined mainly by the level of
income (given the average propensity to save). Saving behavior is not affected by nominal interest
rates or real interest rates. However, investment expenditures are a decreasing function of interest
rates. Therefore, a government can encourage investment expenditure by lowering interest rates -
without worrying about their effects on saving behavior.

According to the Keynesian liquidity preference theory of the demand for money, the market
interest rate balances the demand for money (for transactions and as a store of wealth) and the (stock)
supply of money.5 So the state can reduce interest rates by expanding the money supply. Or,
alternatively, the state can reduce interest rates administratively by imposing ceilings on deposit
interest rates and on bank lending interest rates.

In core economies, investment is viewed as an expenditure important for maintaining employment

through the multiplier. In developing countries, investment is important both to create jobs and
also to expand the productive capacity of the economy. This is crucial for economic development.

Hence, whether the state can use its means to keep interest rates low without adverse effects on
saving is of paramount importance in deciding on interest rate policies. If the neoclassical model
holds, governments should not try to influence or fix interest rates for macroeconomic or
development objectives. If the Keynesian model holds, governments may try to use interest rates
for macroeconomic or development objectives without worrying about saving. The relevance of
the issue is obvious.

Despite the evidence disproving the proposition that interest rates affect saving behavior, the
proposition that higher interest rates lead to higher saving rates still permeates textbooks, research
articles and official documents. Why is the evidence ignored? The only possible explanation is the
influence that social groups opposed to low interest rate policies have over economists and
policymakers. Rentiers who earn incomes from interest-bearing assets, and banks which earn fees
from their services involving interest payments, have a stake in maintaining high interest rates.
This may explain the persistence of a hypothesis that clearly is not true, and which is also detrimental
for economic development.

Moreover, the issue of interest rate policy has an added complication. In the liberal period, due to

debt securities.
5
Recall that, although demand and supply are flow concepts, ‘money demand’ and ‘money supply’ are stock
variables.
 9

the deregulation of private international financial flows, interest rates have gained importance also
as a determinant of these flows. We shall study this aspect of interest rates in the next lecture.

We should note that one proposition of the theory of financial repression does hold true. Rises in bank
deposit rates in the liberal period did draw savings into the financial sector, away from saving in kind,
in precious metals and in real estate, especially in developing countries. So financial deepening
was realized as a result of the deregulation of bank interest rates. But the benefits of this is doubtful
because of the destabilizing effects of the deregulation of bank lending activities.

Bank lending rates

Before studying how banking deregulation has caused financial instability in the liberal period, it is
worthwhile to take a close look at the implications of ‘a market-clearing bank lending rate’.

Is it true that when government interference in bank lending rates are removed, banks set their lending
rates at market-clearing levels? A theory by R. McKinnon, based on studies of failures of financial
liberalization in Latin America, suggests otherwise.

In bank loans, the interest rate charged on the loan is not equal to the expected rate of return on the
loan. The expected return of a loan to the bank is equal to the product of the interest rate and the
repayment probability of the borrower. This probability is less than 100 percent because of imperfect
or asymmetric information between banks and their borrowers. Borrowers have greater information
about their own default risks and intentions than do banks.

The probability of repayment is negatively related to the interest rate charged. As the interest rate on
a loan increases, the probability of its repayment declines. Beyond a certain interest rate level, the
repayment probability falls by more than the increase in the interest rate, so the expected return to the
bank declines with further increases in the interest rate. That is why risk-averse bank managers do not
lend to borrowers who are willing to pay very high interest rates. Bank managers have an idea of the
interest rate that will maximize the expected rate of return on their loans. This bank lending rate does
not the ‘clear the market’ for bank loans. That is, this bank lending rate does not eliminate excess
demand for bank loans. Hence it is observed that, risk-averse bank managers, even in competitive
banking markets, ration their credit among borrowers, and charge an interest rate below the level that
would ‘clear the market’.

The market-clearing lending rate is neither optimal nor efficient for a bank. If banks gave loans at
market-clearing levels, borrowers with high repayment probabilities would leave the market, and
borrowers with high default risks would get loans. The interest rate that maximizes the expected rate
of return on loans, however, is both optimal and efficient, because bank profits are at a maximum
level and risky borrowers not have access to bank loans.
 10

Obviously the repayment probability and the expected rate of return on any loan is a matter of
assessment. This assessment is formed by the perception of the bank managers of the borrower and
her project, and it can also change with changing macroeconomic conditions (Villanueva et al. 1990,
513-514).

This is how risk-averse banks lend in a regulated environment. As we shall see below, in the liberal
period financial deregulation has created incentives encouraging bank managers to engage in risky
lending, leading to bank failures.

Consequences of bank deregulation

Beginning in the 1970s, in most countries banking systems were deregulated. Restrictions on
deposit interest rates, on lending interest rates, and on the lending policies of banks were abolished.

Deregulation of banking systems led to a series of bank failures beginning in the 1970s. After an
increasing number of failures, in 1974 the Bank of International Settlements (BIS) organized a
Basle Agreement that set up the Basle Committee on Banking Supervision.

In the period between 1980 and 1996, more than two thirds of the IMF's 181 member countries
suffered banking crises (Wall Street Journal Europe 07.05.1997). In this period, 52 developing
countries lost most or all of their banking capital, and some more than once. A dozen developing
countries and some transition economies (Bulgaria and Hungary) spent sums equal to 10 percent or
more of their GDP to “clean up a banking mess” (Financial Times 21.10.1997). The cost of
repairing the banking systems of developing countries and those of the transition economies in
1980-1996 approached $250 billion. Venezuela spent 20 percent of GDP to repair its banks in the
wake of a banking crisis in 1994. Mexico spent nearly 15 percent of GDP for a banking crisis in 1994.
In the US in 1982-1992, 1543 banks closed through failure (Financial Times 03-04.03.2012). In
2003 two World Bank economists listed “117 systemic banking crises (defined as much or all of
bank capital being exhausted) that have occurred in 93 countries since the late 1970s”. In 27 of
these crises, the fiscal cost of the bailout was 10 percent of GDP or more (Caprio and Klingebiel
2003).

What does bank failure mean? It does not mean a liquidity problem: every deposit-taking bank can
occasionally experience a decline in its cash reserves due to unexpected withdrawals of deposits.
A bank that experiences a decline in its cash reserves has options that can enable it to tide over the
difficulty. It can borrow from other banks in the inter-bank market. Or it can present bills it has
for discounting6 at the central bank. Or it may obtain a direct loan from the central bank. Hence

6
Merkez bankasında senet reeskontu.
 11

bank failure is not a liquidity problem.

A bank fails when the quantity of bad loans (non-performing loans) on its balance sheet piles up
to a dangerous level. Then the bank runs the danger of not being able to repay the deposits. It
becomes insolvent.

There are three possible outcomes when a bank faces the danger of insolvency. The government
may decide to let the bank go bankrupt and close down. The depositors are paid something out of
the liquidated assets of the bank and from the deposit insurance scheme, but inevitably they lose
part of their deposits. If the depositors are too many, letting a bank go bankrupt may be politically
infeasible for the government. This situation is described as the bank being ‘too big to fail’. So the
government feels obliged to prevent the bank’s bankruptcy.

The government may decide to save the bank by providing capital to the bank with funds from
budget revenues e.g. by buying some shares of the bank, or by nationalizing it completely. Then,
the depositors’ deposits are saved. But society suffers from the loss of public services which have
to be curtailed because of the budgetary reallocation.

Another expedient is: the government saves the bank by providing capital to the bank by expanding
the monetary base (printing banknotes). Thus the depositors’ deposits are saved, but society suffers
the consequences of whatever price inflation occurs. When the price level rises, those who own
assets denominated in money units -cash, deposits, debt instruments- lose their savings in real
terms.

So, in each outcome of a bank failure, some group suffers. Moreover, the failure of a bank can
trigger a loss of confidence of depositors in other banks which are actually solvent. This loss of
confidence can start panicked withdrawals from all banks, forcing the government to decide
whether to provide liquidity to all the banks or not. Furthermore, when a bank becomes insolvent
and goes bankrupt, the losses of its depositors who are indebted to other banks may also lead to
losses in other banks too.

So, it seems vital to prevent bank failures. But should bank managers themselves not have an
interest in avoiding insolvency? And why have there been so many bank failures?

Why do banks fail?

In the period when financial liberalization became the norm across countries, deregulation of bank
deposit rates induced banks to compete for deposits by raising deposit rates. Lending rates had also
been deregulated. So banks were compelled to raise their lending rates to compensate for the
increases in their deposit rates. But it is not possible for banks to raise interest rates on existing
 12

(outstanding) loans. Therefore the rise in deposit interest payments occured faster than the rises in
interest incomes on outstanding loans. This reduced banks’ operating margins.

Banking deregulation had also removed restrictions on the types of loans banks could give. The
squeeze on operating margins induced bank managers to extend loans to risky projects/clients for
high interest rates, i.e. interest rates exceeding the average rate of return on capital. In time, this risky
lending increased the non-performing loans on banks' balance sheets, which pushed bank managers
to seek more deposits by raising deposit rates further. The process eventually led to the collapse
of many banks. This was a one-time effect of the deregulation of bank deposit and lending rates.

What type of lending did banking deregulation open the scope for? The deregulation of banks’ credit
allocation allowed banks to increase lending for consumption (which expanded with the invention
of credit cards) and lending to purchasers of houses (mortgaged loans). Risky lending to individuals
for consumption expenditures and for purchasing houses led to defaults in consumer loans and in
mortgaged loans.

In this period banks invented the expedient of securitizing some of their risky loans and thus getting
rid of them. For example, a bank could package a number of its mortgaged loans as a single security
and sell it to some other institution. Thus, debt securities markets grew in the core countries in the
1980s.

Deregulation of credit allocation also enabled banks to lend to speculators in real estate and stock
markets. Bank loans to speculators can contribute to inflating asset prices. When a price bubble
emerges in an asset market, speculators offer the assets with inflated prices as collateral to banks
for further borrowing, which can continue to inflate the asset prices. When the asset price bubble
bursts, some speculators cannot repay their bank loans, and banks cannot cover their losses on
these loans because the collateral has lost much of its value. So banks make losses. Bank lending
contracts, causing a credit crunch which leads to a macroeconomic contraction.

In 1985 under the Plaza Accord the US government obliged the Japanese government to deregulate
the Japanese financial system in the hope that this would alleviate the US trade deficit with Japan.
The result of the deregulation of the Japanese financial system was that, by the end of the 1980s,
real estate speculation in Japan had caused an explosion of real estate prices, and speculation on
the stock market had inflated stock prices. In 1990 the Tokyo stock market suffered a sudden
collapse of stock prices. Then real estate prices entered a long period of decline which lasted a
decade. Japanese banks which had given loans to households and firms who had speculated on
stocks and real estate suffered huge losses.

Another example: In the mid-2000s in Spain the construction sector experienced a boom. In the
late 2000s the property price bubble collapsed. Mortgage holders fell behind on their payments. In
 13

2012 Spanish banks, burdened with bad loans, were forced to set aside 54 billion euros as
provisions for their bad loans (Financial Times, 09.05.2012).

We shall discuss the consequences of deregulation of international private financial transactions

in detail in the next lecture. Here, among the causes of bank failures in the liberal period we can
mention international financial arbitrage, particularly by banks in developing countries. This is
arbitrage in interest rates. A bank in a developing country borrows money in developed country
financial markets (where interest rates are low), converts the foreign exchange into the national
currency, and lends the money in its own country (where interest rates are higher). The bank
expects to profit from the interest rate difference. But such arbitrage leads to an open position on
the bank’s balance sheet; that is, its foreign exchange liabilities exceed its foreign exchange assets.
Such a bank exposes itself to the danger of making losses if the national currency depreciates
against the foreign currency that the bank has borrowed in. International financial arbitrage is
another activity that has led to bank failures.

Regulation of banks

In order to understand what deregulation involves, it may be useful to summarize in what ways
banks used to be, or are regulated. Regulations -rules on bank activities- are grouped as prudential
regulations and protective regulations.

Prudential regulations are rules aimed at protecting banks’ balance sheets. These are mainly:
minimum capital-asset ratios (where assets are weighted according to their riskiness);
compulsory provisions for non-performing loans (banks should set aside some of their profits to
cover possible losses on loans); limits on lending to one customer; restrictions on lending to certain
sectors (e.g. to stockbrokers, consumers, real estate agencies); limits on foreign exchange exposure
(i.e. ceilings on the difference between foreign exchange liabilities and foreign exchange assets);
limits on exposure to shareholders and to personnel (especially compensations to chief executive
officers); restrictions on banks’ buying and selling assets in capital markets (for the bank’s own
portfolio, using deposits).

These prudential rules have been developed on the basis of historical experience of bank failures.
They are regularly revised at the Bank for International Settlements. For example, the
recommended minimum capital-asset ratio and the method of weighting assets according to their
risk are frequently revised in the light of experience.

Table 8.1 shows the sums the US federal government allocated from tax revenues to save certain
banks in 2008, and what those banks owed to their chief executive officers. The recommended
prudential measure on ‘limiting exposure to personnel’ is based on such experiences.
 14

Table 8.1
Executive IOUs
Company capital injection estimated debt to executives
Goldman Sachs $10 billion $11.8 billion
J.P. Morgan Chase $25 billion $8.2 billion
Citigroup $25 billion $5.0 billion
Bank of America $25 billion $1.3 billion
Source: Wall Street Journal Europe 3 November 2008 p. 15.

The second group of regulations are called protective regulations. These are aimed at protecting
depositors. One such regulation is the compulsory licensing of all deposit-taking institutions, which
makes it possible for the supervisory body to follow the activities of all deposit-taking institutions.
Another protective regulation is deposit insurance. The state obliges banks to contribute to a deposit
insurance fund. This insurance fund is used to compensate depositors when a bank becomes
insolvent. The insurance fund covers a part of the deposits.
A third protective measure is guarantees given by the government to depositors that it will protect
depositors, should a bank become insolvent, by saving the bank. Even when the government does
not explicitly give such a guarantee, such a guarantee is often assumed by banks and depositors,
because the bank is deemed ‘too big to fail’.

Some argue that government guarantees to depositors encourage risky behavior on the part of bank
managers. They say that the guarantees create a moral hazard problem. “Moral hazard arises
whenever the incentives surrounding actions are distorted by the existence of explicit or
implicit guarantees against loss. It evidently leads to over-investment with the systematic
discounting of downside risks” (Nixson et al. 1999, 503). When a bank manager perceives a
government guarantee for deposits, he can be tempted to give loans to risky borrowers at high rates
of interest. The bank manager’s calculation is: if the loans are repaid, the bank will make big profits
and the manager’s reputation in the sector will be enhanced. If the loans are not repaid, the
government will compensate the depositors, and the manager will go off to retirement. This is the
moral hazard created by government guarantees (actual or expected) to bail out failing banks.

All these rules are useful to the extent that they are enforced. Effective supervision requires
adequate numbers of skilled bank examiners, and the minimization of political interference in the
enforcement of prudential regulations. For rules to be enforced, it is also necessary that
government supervisors not be friendly to the banks.

As it is in all regulatory schemes, the institution supervising banks runs the risk of ‘regulatory
capture’. Regulatory capture occurs when the officials in the body supervising a sector expect to
find highly-paid employment in the sector after they retire. Such officials will naturally be lax in
their supervising and turn a blind eye to violations of regulations. Furthermore, regulations cannot
 15

be properly enforced by ‘independent’ regulatory boards, in which regulators have to negotiate

with representatives of the regulated firms.7

Examples of bank failures

Many banks in the core countries collapsed during the 2008 financial crisis. It appeared that some
banks in the US were not banks at all, but mere Ponzi schemes.8 A Ponzi scheme is an institution
that collects deposits promising to pay an extraordinarily high interest rate. The institution pays
deposit withdrawals and the high interest on deposits out of the inflow of new deposits. The
institution cannot repay the deposits and the interest out of revenues from its assets (e.g. loans) as
a normal bank would, because there are no assets or possible investments that have a rate of return
as high as the interest rate promised to the depositors. The high interest rates offered by Ponzi
schemes attract depositors, particularly low-income households. As long as the inflow of new
deposits exceeds the withdrawals of deposits and interest payments, the scheme expands and
expands… until a day comes when the cash inflow falls short of the cash outflow. Then the
institution collapses with a great quantity of debt owed to remaining depositors, and very little or no
assets to compensate them. The depositors who benefitted from the high interest income and
withdrew their deposits before the crash make windfall gains. The remaining depositors at the time
of the crash lose their deposits.

When a manager of a bank is alarmed by the rising proportion of non-performing loans, fears
insolvency and tries to overcome the problem by raising the bank’s deposit interest rates to attract
more deposits, he runs the danger of degenerating the bank into a Ponzi scheme. Most depositors
do not know the risk of depositing money savings in an institution which pays high interest rates. And
even when individuals are aware of the Ponzi scheme, some still take the risk, unable to resist the
temptation of the interest rate.

Large-scale Ponzi schemes emerged and collapsed in Russia, Romania and Albania in the 1990s when
these countries were making the transition to capitalism. Turkey had a similar experience in 1981-
1982 when Ponzi schemes called ‘banker’ were allowed to operate until they collapsed. Even in
the US, the largest core country with the most sophisticated financial system, lax supervision of
banks allowed Ponzi schemes to go unnoticed until 2008. For example someone named Joseph S.
Forte promised returns as high as 38 per cent and raised $50 million in 1995-2008. Nicholas Cosmo
promised between 48 and 80 per cent a year, raising $370 million in 2006-2008. The ‘Madoff Bank’
Ponzi scheme operated for decades, collecting $50 billion. It collapsed in 2008. Among the loss-
making depositors of Madoff Bank were charities, hedge funds, Asian and European banks. The US

7
In the run-up to the Global Financial Crisis of 2008-2009, “[l]obbying, … intellectual capture and revolving doors
between public and private employment roles coalesced to form fertile grounds for excess and irresponsibility”
(Wigan 2019, 307).
8
Also called pyramid investment schemes. In Turkish ‘saadet zinciri’.
 16

Securities and Exchange Commission investigated at least 15 Ponzi financing cases in 2007 and 23
in 2008. Wall Street Journal Europe reported on January 29, 2009 that in the US, six suspected
multi-million dollar fraud cases emerged in January 2009, many of them alleged Ponzi schemes.

The prevention of Ponzi schemes necessitates the licensing of all deposit-taking institutions,
whatever they are disguised as. In Turkey, when deposit-collecting institutions called ‘banker’
appeared in the early 1980s, they were not brought under official banking supervision. They were
not licensed as banks (banka), because they called themselves themselves ‘banker’. (The Turkish
officials turned a blind eye to a catastrophe unfolding in plain sight because they were reluctant to
interfere in private institutions, which was percieved as unwise in the euphoric period of
neoliberalism.) The collapse of the bankers led to the loss of savings of many low income
households in Turkey.

Finally, we have to remember that it is near impossible to effectively supervise banks that operate
internationally. The expansion of banks’ international activities accelerated with the opening up
of banking sectors to foreign banks in accordance with the 1994 General Agreement on Trade in
Services (GATS), plus the deregulation of private international flows. The problem is that, there is
no international banking supervising authority to monitor the global balance sheets of banks which
have subsidiaries or branches in many countries. Such banks can shift funds between their
subsidiaries and branches in different countries when reporting their local balance sheets to
national regulators. They can thus conceal from supervising authorities not only the weaknesses
in their overall balance sheets, but also criminal activities such as money laundering.

An example is provided by Iceland. Iceland suffered from the international activities of several of
its banks, when in the first week of October 2008, they collapsed.

In 2007 at the beginning of the financial crisis, Iceland’s banks were quite solvent. They had almost
no subprime loans in the US mortgage market. However, these banks were ‘oversized’. Icelandic
banks had accumulated assets throughout the European Economic Area (EEA)9. Their assets were
more than 10 times Iceland’s GDP. Hence the banks did not have a ‘lender of last resort’ to fall
back on, as the Icelandic central bank did not have the foreign exchange reserves to support them.
In 2008, when Iceland’s central bank tried to obtain credit lines from other central banks in the
EEA, it was refused. Suddenly, the foreign depositors of Icelandic banks realized there was no
credible lender of last resort in the Icelandic financial system. This triggered a run on Icelandic
banks, creating liquidity crises in these banks.

Two of these Icelandic banks (Kaupthing and Landsbanki) had been operating in the UK. The
British government decided to use the country’s anti-terrorist law to take over the assets and

9
The European Economic Area is a free trade area comprising the European Union and Iceland, Liechtenstein and
Norway.
 17

operations of these two banks in the UK. So one day, the Icelandic Ministry of Finance and
Iceland’s central bank found themselves briefly on the list of terrorist organizations, published on
the website of the British Treasury, alongside al-Qaeda and the Taliban. The British government
justified this on the grounds that the Icelandic government was unwilling to honor the obligations of
Icelandic banks to British depositors. Actually, the deposits in these banks were covered by the
Icelandic Depositors’ and Investors’ Guarantee Fund, set up under EEA rules. If the fund was
unable to cover all the deposits, there was no requirement under EEA rules for the Icelandic
government to assume the obligations of Icelandic banks. But the British government demanded
that Iceland’s government guarantee all British deposits in Iceland’s banks. The Icelandic
government succumbed to the pressure. It had to borrow from the IMF and from other countries.
The people of Iceland (population 300,000) were suddenly burdened with the external debt of their
banks. Consequently Iceland’s economy suffered a severe depression in 2008-2010.

The global losses in 2007-2009 and the criticism of financialization have not created a sufficient
political momentum in core countries to strengthen regulation of financial institutions in the public
interest. Bankruptcies of large banks continue. In 2023 Credit Suisse, a global bank with $540
billion in assets and the second-largest Swiss lender, failed. In the United States, Silicon Valley
Bank, Signature Bank and First Republic Bank failed at around the same time. The chart below
compares six major bank failures during the Global Financial Crisis to seven bank failures from
the last quarter of 2022 to the third quarter of 2023 in terms of percentage of deposits withdrawn
and the duration of the stress. It is remarkable to read that the problems that led to the 2008-2009
crisis have not been resolved, but still persist.

Growth of stock markets

Prior to the period of financial deregulation, in countries with bank-based financial systems the
secondary capital markets10 were inactive, and commercial banks often did the job of providing
long-term funds to firms by rolling over short-term loans. By contrast, capital markets played a
more important role in financial intermediation in the English-speaking core countries.11

In the 1980s institutionalist economists analyzed and compared the two types of financial systems
(bank- based and capital market-based). Their research revealed that bank-based systems provided
investment funds to firms at lower costs on average, compared to the capital market-based systems.

10
The secondary market is the market in which financial instruments such as stocks and bonds are bought and sold
after the initial sale.
11
In the literature, bank-based financial systems are also called credit-based financial systems. The other system is
called the capital market-based financial system. Capital markets comprise stock markets and bond markets.
 18

Nevertheless, liberal economists and international financial institutions advocated the view that
the capital market-based financial system was the mature, superior system. They argued that stock
markets grew with the natural evolution of financial systems. Financial systems with small and
inactive stock markets were deemed underdeveloped and immature, incapable of efficient resource
allocation. Moreover, the growth of stock markets was expected to encourage saving by offering
households alternative financial assets to hold savings in (alternatives to bank deposits). Finally,
stock markets were seen as a means to attract private foreign savings to developing countries.
 19

The International Finance Corporation, an affiliate of the World Bank, provided technical
assistance on legal, fiscal and organizational matters to these countries to develop their stock
markets.

Do stock markets actually improve efficiency in the allocation of funds? This requires an efficient share
pricing process that rewards comparatively well-managed firms by valuing their shares more highly,
and thereby lowering their cost of raising more capital. If shares are priced thus, well-managed
firms can benefit from the high valuation by issuing new shares at high prices and use the new
capital to undertake investment. Poorly managed firms experience falls in their share prices, which
may lead to hostile takeovers and a change in management.

However, evidence shows that most purchasers of shares are not concerned with the long-term
profitability and growth prospects of firms. They are more interested in the short-term profits they
can make on fluctuations in share prices, and from dividends. In 1936 Keynes wrote: “It is said
that, when Wall Street is active, at least half of the purchases or sales of investments are entered
upon with an intention on the part of the speculator to reverse them the same day” (Keynes 1976,
160, footnote 1).

Moreover, evidence shows that badly managed, unprofitable firms are not those that are exclusively
exposed to the risk of take-overs.The US and UK experience shows that the size of the company
plays a more important role in the probability of a take-over than its profitability. I.e. a small,
profitable firm runs a greater danger of a hostile take-over than a large but unprofitable firm. In
short, it is not clear that capital markets enhance static allocative efficiency.

The short-termism described by Keynes in the quotations above have been amplified by
developments in technology. Sophisticated tools are used to carry out high-frequency trading
(HFT) to buy and sell securities. HFT employs computerized algorithms to analyze incoming
market data and implement trading strategies. Firms using high-frequency trading hold an
investment position only for very brief periods of time (hours, minutes, even seconds). They trade
into and out of investment positions with transactions that run up to thousands or tens of thousands
a day. In the United States, HFT contributed approximately 52 percent of total equity trading in
2018 (Zaharudin et al. 2022, 75).

This type of short-termist shareholder behavior constrains managers of firms to focus attention on
the firm’s short-term performance indicators. Firm managers cannot concentrate on long-term
profitability and the long-term competitiveness of their firms. Short-termist shareholder behavior
discourages managers from undertaking investment with long gestation periods. So it is not clear
that capital markets, which do not seem to enhance static allocative efficiency, enhance dynamic
efficiency either. In truly efficient capital markets, one would expect share prices to reflect
assessments of firms’ long-term performance.
 20

A greater problem is that, as with any asset whose elasticity of supply with respect to price is very
low, stocks in liquid stock markets are prone to price trends moved by speculation. This renders
stock prices volatile. It is observed in core countries that a period of low interest rates causes money
savings to flow to stocks. Diversion of money savings into stocks can start a price bubble. A period of
steady GDP growth can help inflate the bubble. During a stock market boom, liberal economists
tend to interpret the rising share prices as reflecting rising productivity in firms. This happened for
example during the ‘dot-com bubble’ at the end of the 1990s, when IT firms’ shares prices rose to
very high levels. Such economists dismissed warnings that a speculative price bubble was forming,
arguing that the prices of IT stocks were rising due to increasing productivity in the sector. The
price bubble on IT shares burst in 2000.

Obviously, share prices that are influenced by price speculation make them an unreliable guide for
the allocation of resources. Keynes meant this when, in 1936, he wrote (1976, 159):

Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious
when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of
a country becomes the by-product of the activities of a casino, the job is likely to be ill-done.

True, a persistent speculative bubble in stock prices might be used by firms to issue new shares
and thereby obtain financial resources to increase investment in physical assets. But rising stock
prices often induce firm managers themselves to join the speculation, diverting funds and the
attention of managers away from physical investment. In the US, firms such as General Electric,
General Motors, Ford and Enron increased their financial activities substantially prior to the 2008
crisis. “General Electric … is as much a bank as it is a manufacturing corporation… Prior to its
collapse, Enron was essentially a derivatives-trading company, not an energy-firm” (McNally
2009, 56).

When a speculative bubble of share prices bursts, households who hold shares lose part of their
wealth, so they inevitably cut back on their consumption expenditures. This precipitates a
recession. When a stock price bubble bursts, firms who have investments in shares also make
losses. If firms and households making losses on stocks are indebted to banks, their losses can lead
to increases in non-performing bank loans. And if shares with inflated prices have been accepted
as collateral by banks, they cannot recover their losses from the collateral. And if financial
institutions (banks, insurance companies, pension schemes etc.) themselves have invested their
funds in shares, then the collapse of inflated share prices deteriorates their balance-sheets directly.

Stock markets are useful as a source of investment funds for firms. Stock markets are also beneficial
as an institution that enforces accounting discipline (firms are obliged to adhere to accounting rules
and provide accurate information on their balance sheets to be quoted on a stock exchange). But
in most countries they function mostly as source of financial instability, and are hardly efficient in
 21

the allocation of savings.

If stock markets are regulated to prevent manipulation of prices, insider trading, and persistent
price trends, then their destabilizing effects can be minimized. For example, the authorities can
close the market when prices reach certain upper or lower limits. It was reported by the Wall Street
Journal Europe on April 25-26, 1997 that the China Securities Regulatory Commission was
preparing to squeeze the stock exchanges’ single-day fluctuation limit to 5 per cent from the (then)
current 10 percent and to force investors to hold shares for three full days before selling. These are
examples of simple measures to cool down speculation in share prices.

Authorities can also curb stock price trends by preventing bank loans from being used for stock
purchases. Authorities can also use taxes to make frequent speculative dealings costly (a tax on
individual transactions would be effective). Authorities can reduce the gains from speculation by
imposing income taxes on capital gains from shares. (These are measures suggested by
institutionalist economists, but rarely implemented.)

Before the 1980s in Japan when there was close cooperation between government agencies and
the private sector, the central bank often used its moral authority on financial firms to informally
direct them to buy or sell certain shares in order to stop a continuous rise or decline in their prices.
This informal directing was called ‘window guidance’. Such practices are now deemed an
interference in the efficient functioning of financial markets.

Financial derivatives

Deregulation of financial systems allowed the growth of various new financial assets, such as
securitized loans, which was mentioned above. Derivatives are another type of asset, the market
of which has grown enormously in the liberal period.

A financial derivative is a contract, whose value for each party to the contract depends on the
performance of an underlying entity (called the ‘underlying’or ‘primitives’). The entity may be an
exchange rate, an interest rate, the price of a stock, the price of a commodity, the bankruptcy of a
firm, a weather event etc. For example, a ‘forward’ is a contract for one party to make a payment
to the other or receive a payment from the other at a future date, depending on the outcome of the
underlying event. An ‘option’ is a contract giving one party the option of buying something from
the other at a pre-specified price, depending on the underlying event.

A derivative contract can help hedge a firm against an risk. Firms use derivative contracts to reduce
cash flow and earnings volatility.

However, derivatives create problems. The first is that, if a party makes a derivative contract with
 22

borrowed money, the unexpected outcome in the underlying asset can lead to a default on the loan
(Wigham 2019, 302). This is similar in nature to speculating on house and share prices with
borrowed money.

The second problem is that, derivatives are not secondary to markets in the primitives (the
underlying bonds, equities, currencies, indicators etc.). It is not clear whether prices in derivatives
markets are a function of prices in underlying markets, or whether prices in underlying markets
are influenced by derivatives prices (Wigan 2019, 303). Growth in total value of certain groups of
derivatives can raise speculation on the underlying assets, making the financial markets more
volatile and adding more uncertainty to the economy (Duc et al. 2019). The growth of derivatives
markets in the lead-up to the 2008-2009 crisis created such a danger. In 2006, more than 450
trillion dollars of derivative contracts were sold. By contrast, the global stock market sales were
40 trillion and global bond sales were 65 trillion dollars that year (McNally 2009, 58-59).

The conditions for the 2008-2009 Global Financial Crisis were formed with an accumulation of
risky loans in the US housing market. House purchases with mortgaged loans inflated house prices.
Then, a crisis started with a deflation of the house price bubble. The loans could not be repaid and
the collateral, which was losing value, could not cover the losses of the creditors. The dense
linkages between assets and institutions forged by a global web of derivatives contracts acted as a
transmission mechanism which spread the crisis across the core countries. The solvency of a range
of institutions was endangered, due partly to their large derivatives positions. Leveraged portfolios
of derivatives that had hitherto generated outsized returns were transformed into dangerous
liabilities (Wigan 2019, 304-305).

Conclusion

The regulation of financial systems in core countries in the 1945-1980 period was based on the
experiences of the Great Depression of the 1930s. Experienced policymakers in core countries in
that period enacted laws and regulations aimed at curbing unsustainable risky activities of financial
institutions. As a result of these regulatory practices, core economies did not suffer financial crises
such as the 1929 Crash and the 2008-2009 Global Financial Crisis over the period from the end of
the Second World War up to the 1980s.

The deregulation of financial institutions and the growth of stock markets has increased the
potential of these markets to start financial crises that lead to recessions in the core of the world-
economy, with negative effects on the periphery. In the light of the economic and social benefits
expected of the financial sector, this is a problem.

The next lecture takes up the motives and consequences of deregulation of private international financial
transactions.
 23

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