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Lawrence B. Krause is Professor of International Relations and Pacific Studies at the University of California, San Diego. Kim Kihwan is President of the Sejong Institute.

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Liberalization in the Process of Economic Development

University of California Press

The story of development is one that mixes economics and politics. Economic development so profoundly changes a society that political change must be involved on both sides of the equation—that is, as a cause of economic development and also as a result of it. Many economists and other social scientists thus view economic development as part of a process of overall modernization; some, however, argue that growth initiated and controlled from abroad does not lead to the modernization of a society. Such a case could exist in theory; in reality, however, whenever a country has managed to raise per capita income for an extended period of time, significant societal change has taken place.

No matter how abruptly change may occur, the evolution of a society reflects its previous history. Thus the story of development is different in every country. There are similarities among countries (the science of development is aimed at discerning these similarities), but unique elements always mark the development experience in a given country.

The story of development is also one of a swinging pendulum. Pressures force public policy in one direction to a point of exaggeration, followed by a reaction in the opposite direction. Upon achieving political independence, most developing countries found Adam Smith's invisible hand wanting and the lure of free markets not very appealing. Laissezfaire did not satisfy the desire of Third World governments to be active and do something to speed development.

In the early literature of economic development, economists viewed the state as a solitary, benevolent actor behaving solely in the societal interest. The state was seen as being able to obtain needed information, and then, with that knowledge and the policy instruments available

to it, to intervene in an optimal way to correct any market failure and capture positive externalities. It would thereby in theory not only promote rapid development but also achieve distributive justice. With this in mind, policies were instituted to control the primary sector (mainly agriculture), to create and structure an industrial sector, to interfere with the trade and payments regime to provide needed incentives and distribute resources according to a plan, to constrain the labor market to make it conform to a desired wage structure, and to mold the capital market to allocate resources according to a distribution selected by policymakers.

However, the pendulum was pushed too far. The view of the state as a benevolent actor was dissipated by the reality of governmental actions that often did more harm than good. Government failure became more serious than market failure. Government bureaucrats were often forced to make business decisions with even less information than was available to the private sector. Politicians and bureaucrats turned out to be motivated by personal ambition and desires that did not necessarily lead to public good. And government power was manipulated by private agents to benefit particular groups, often at the expense of the general welfare. The policy of liberalization was devised to counter and correct these exaggerations.

Liberalization, by which we mean a policy shift toward market or marketlike devices, is a reaction to excessive intrusion of governments into national economies. The pressure to liberalize may arise because of widespread government failures (for example, it has been suggested that agricultural liberalization in China following the death of Mao grew out of a spectacular crop failure in the province of Anhui), or it may come from the fear of potential government failures in the future, despite generally good results in the past (such is reported to be the case in Singapore). If as economies grow and become more complex, the role of government remains large or even expands, then significant problems can be anticipated. Liberalization is a way of avoiding these problems, or at least of depoliticizing them.

Liberalization is itself a policy of government, and therefore the political setting in which it takes place must be part of the analysis. Rarely is the promise of significant economic gain sufficient to bring about a fundamental change of policy. Policy change occurs as a result of a crisis. If the status quo cannot be maintained, then change will be contemplated. If the situation is very difficult, then a change of policy direction has a chance of being considered.

What kind of government is best suited to bring about liberalization? The evidence is by no means clear on this issue. It has been noted that some of the most successful liberalization programs have been undertaken either by authoritarian governments or by ones whose quality of democracy falls far short of Western ideals. Some have even suggested that a regime that does not have to seek approval from an electorate has greater freedom to make difficult decisions and take actions involving short-term losses in order to obtain long-term benefits. Experience indicates. however, that many authoritarian regimes do not take liberalizing measures or introduce economic reforms of any sort. Indeed, some of the most market-distorting policies are followed by "populist" authoritarian governments in Latin America. Furthermore, under the right conditions, democratic governments can introduce liberalization—New Zealand is the most recent example. What appears to be the case is that in order to devise and make effective a program of liberalization, a government must be able to command a consensus within the society, and this can be achieved under several different political forms.

While a liberalization program may need a crisis to trigger it, not all crises lead to desirable policy adjustments—some just debilitate. The job of the analyst is to discern which elements promote effective policy adjustment and which simply retard it. This is a task that cannot be done by one academic discipline, but rather requires inputs from many branches of social science. One observation that seems to be a common feature of most crises is that a workable policy strategy for adjustment cannot be devised in the country after a crisis has begun, especially by the policymakers who are responsible for crisis management. Either the alternative policy direction must long have been under discussion within the country, or major elements in the plan must be suggested from the outside. Often both occur. Thus it is difficult for historians to unravel the story, to document the date when "reform" began, and to give proper identification to its origin.

This volume systematically explores the theory and practice of liberalization as it has been applied in a number of developing countries. The experiences of the East Asian newly industrializing countries (NICs)—and especially South Korea—have been given the most attention, as is appropriate in a volume dedicated to the memory of Kim Jae-Ik.

The volume takes the perspective of economics, since all of the authors are professional economists. This means that it is economic issues that are selected for analysis and primarily economic forces and instruments that are turned to for explanations. While economics is tremendously important in studying the Asian NICs, it is not the whole story of modernization. Some fascinating political issues, including the role of the military, are obviously worthy of intensive study, but are not addressed here. For example why should a currency devaluation (just another price to an economist) initiate a military coup in Thailand? While intrigued by the question, we do not believe that we are properly prepared to find an answer. Economists believe in comparative advantage, and we have limited ourselves to our expertise. Obviously not everything can be done in one volume. We leave it to our colleagues in political science to answer these questions.

Industrial Development and Liberalization

In chapter 1, Anne O. Krueger describes a simple model of economic development that captures the essence of countries that, like the Asian NICs, have a high ratio of labor to land (natural resources). Traditional trade theory suggests that such countries have a comparative advantage in labor-intensive industries. The model traces an efficient development path whereby the country is transformed from one producing primarily agricultural products and providing a meager standard of living to one specializing in the production of industrial goods.

The model has two sectors, agriculture and industry, many commodities, and three factors of production—land, which is utilized only in agriculture; capital, which is employed only in industry; and labor, which is employed in both sectors. As capital is accumulated and devoted to its most profit-maximizing use (labor-intensive products), labor is rapidly drawn away from agriculture. The process continues until full employment is reached and labor productivity rises in agriculture. By now the country has not only replaced imports of labor-intensive goods, but is also exporting them. When the point of full employment is reached, wages are driven up, and capital will be diverted to more capitalintensive industries. The process continues as capital is accumulated, with production becoming more capital-intensive and comparative advantage shifting in that direction as well. If capital accumulation is faster in the country than in other industrial countries, it will begin to catch up with them both in the product composition of its production and exports and in its standard of living.

If the government should interfere with this process and distort the goods, labor, and/or capital market, then the capital/output ratio will rise prematurely and economic growth will suffer. Experience suggests that the most distorting interference comes in the trade and payments regime, especially if the exchange rate is kept in an overvalued disequilibrium. Liberalization reverses these distortions. While theory has little to say concerning many questions surrounding liberalization, experience has shown that liberalization of the trade regime and correction of an over valued exchange rate can have surprisingly good economic results.

Toward a Model of Development

In chapter 2, Gustav Ranis adds political elements to the theorizing concerning the development process and thereby supplements the Krueger model. He also shifts the emphasis from the accumulation of capital (in the Krueger model) to capturing and utilizing science and technology in its manifold applications. As a result, an underlying question is posed: What accounts for the relatively greater success of East Asian NICs such as Taiwan and South Korea when compared to Latin American countries such as Colombia and Mexico?

The Ranis model identifies the crucial points in the evolutionary process of development where governmental policies can be particularly important in determining subsequent outcomes. Though four stages of growth are identified (So –S3 >), the model does not depend upon the stages following one another in a mechanistic way. The model suggests that six instruments of policy are of particular importance in setting the policy framework: the interest rate, the growth of the money supply, the foreign exchange rate, levels of tariffs and other trade barriers, tax and subsidy rates, and the wage rate. Typical profiles are drawn of the use of these instruments in each substage.

A significant difference exists between the initial (predevelopment, or So ) conditions in typical East Asian NICs and the Latin American LDCs (less developed countries). The East Asian NICs (and Japan) all had heavy population pressure relative to usable land, a relatively small size, a good human-resource base, and a shortage of natural resources. They are termed natural-resource-poor (NRP). The Latin American LDCs, by comparison, are natural-resource-rich (NRR). In terms of economic structure and the like, the NRP and NRR countries are similar at point So , in that most production is of primary products, though the NRR achieve a higher standard of living out of it.

Transition growth begins in S1 as both groups start to import capital goods in order to produce consumer goods, rather than just importing the final manufactured goods. To encourage this shift, governments employ various protective devices designed to create incentives to support a new industrial class. Human resources are developed during this subphase to make factory workers productive and to train entrepreneurs. While protective trade policies lead to windfall profits and create many inefficiencies in the industrial sector, the traditional primary producing sector is discriminated against during this subphase. At this point, both the NRP and the NRR follow essentially the same policies, but in practice the East Asian countries neglected agriculture somewhat less and maintained somewhat lower levels of protection than did the Latin American countries. Subphase one comes to an end when domestic production more or less completely replaces imports of manufactured consumer products.

The policy choice made at the beginning of S2 is critical for subsequent development. Essentially, the choice is between promoting secondary import substitution, that is, replacing imported capital or producer goods with domestic production (usually done by NRR), and promoting the export of domestically manufactured consumer products (generally the route of NRP). This latter choice is called primary export substitution, since previously exported primary products are now replaced by consumer manufactures. Primary export substitution was chosen by the East Asian NICs—in the early 1960s in Taiwan and Korea—and exports as a share of gross domestic product increased dramatically.

The package of policy instruments used to promote primary export substitution generally includes monetary and fiscal measures to reduce inflation and provide resources to the government through explicit taxation, the reduction of protection, the adoption of a more realistic exchange rate, and the avoidance of both artificial increases in industrial wages and depression of the internal terms of trade for agriculturalists. These policies may be supplemented by export-promoting measures such as the creation of export-processing zones and rebates of import tariffs on exports. This can be considered the start of liberalization.

For the NRP the beginning of S3 is marked by the sustained rise of the wage rate of unskilled workers, signifying full utilization of the labor force. (During the previous subphase there is an accelerated shift of labor from agriculture to nonagricultural employment, and underemployment is reduced on a massive scale.) In order to stay competitive,

producers shift to more skilled labor and technologically intensive products and methods of production. The output from this upscaled manufacturing sector is simultaneously sold in the domestic market and exported. Typically food and other natural resources are imported in increasing amounts as economic growth outpaces the limited naturalresource base. Taiwan and Korea entered this phase between the mid and late 1970s.

The NRR countries, having chosen secondary import substitution at the end of S1 , remain on a different and less successful path of development than the NRR It may well be that the existence of the natural resources themselves is the most influential factor in determining this outcome. The purpose of S1 is to create profits in industry and revenues for the government at the expense of agriculture and the primary exporting sector. If the sector being squeezed is rich, then the process can continue for quite some time. Clearly the existence or absence of naturalresource rents is critical in the linkages between politicoeconomic developments and the policy outcomes they generate. It would appear that the more resources there are to waste, the longer the wastage will go on.

Public Finance for Developing Countries

In chapter 3, Assar Lindbeck traces the evolution of thinking about the budget in market-oriented developing countries. Originally considered just the main tool for mobilizing and allocating resources, the budget has become an instrument for promoting efficiency in the economy. Earlier policy thinking was defective mainly because it failed to take into account the nature of the political system and the administrative capabilities of the bureaucracy of the country for which it was designed. Successful policy may be less dependent on theoretical sophistication than on effective and honest implementation.

The government, through its budget expenditure, has to achieve certain tasks that it alone is qualified to perform. These include supplying public (collective) goods such as the legal system and protection of the environment and making infrastructural investment in human and physical capital. Furthermore, the government may want to help develop market-oriented institutions and should utilize policy instruments that are market conforming. In order to make these policies successful, macroeconomic stabilization must also be achieved.

Compared to industrial countries, the level of tax revenues in developing countries is generally low to moderate. However, serious problems

exist in tax collection, which may reflect the difficulty of dealing with many small firms, the lack of administrative capability on the part of tax collectors, and possibly a low level of country identification and loyalty. Thus, as massive cheating may be taking place, improving tax collection may be the most productive form of tax reform.

However, questions do also arise concerning tax structure. While theoretical advances have been made in describing an optima! tax, they provide little guidance for policy in a real world setting. Rather, developing countries are well advised to stick to a simple, nondistorting structure of taxes (a uniform commodity tax is a good base), which may include an income tax, tariffs, and some subsidies. The less selective the tax, the less will be the political lobbying and corruption.

The process of liberalization will change public finances, but the net effect is ambiguous. While collection of tariff revenues may be reduced, expenditures on subsidies and the like will also be less. The transition to a fully liberalized system merits careful attention.

Attention is also given to the issue of equity in the economy, as the budget is often used as an instrument of income redistribution. While greater income equality (particularly raising the status of the poorest members of society) is recognized as an appropriate goal of policy, great caution is counseled. The best approach to income equality may be through additional increases in economic efficiency—especially if it includes the reaching of full employment, an outward-oriented industrial policy, and geographic dispersion of economic activity.

The Role of Medium-Term Plans in Development

Over the years, "plans" have become standard tare in developing (and many industrial) countries. In chapter 4, Chen Sun recognizes that since all of the major factors determining development can be subjected to government policy, they can therefore be included in government planning and incorporated into a comprehensive development plan. Development plans are of various lengths and kinds, but generally include a survey of current economic conditions, a statement of proposed government expenditures, a forecast of likely developments in the private sector, some macroeconomic projections, and a review of government policy. The objectives of planning are to encourage fast economic growth both in the aggregate and on a per capita basis, high utilization of the labor force, stable prices, improved income distribution, and a manageable balance-of-payments position. While these objectives are laudable, a question remains as to whether development planning promotes them

or not—especially since some of the objectives are in conflict with each other. In the main, analysts are skeptical of the efficacy of comprehensive development planning, and planning advocates have generally been disappointed in their accomplishments. Whether the unsatisfactory outcomes are the result of poor planning or bad execution is a matter of contention.

Planning to promote growth can attempt to increase either the labor force or labor productivity, or do a bit of both. In practice, while some attempts are made to mobilize the labor force, most effort is directed at improving labor productivity by promoting domestic savings (and thereby permitting more domestic investment), attracting foreign investment, increasing education, encouraging research and development expenditures, and improving sociocultural conditions in general.

In most developing countries the government takes a direct hand in increasing national savings. Unfortunately, these efforts have usually been disappointing, especially when the losses of state-owned enterprises are recognized. In general, less than 25 percent of government expenditures in LDCs (about 3 to 4 percent of GDP) have been for economic development—so the amount of savings being mobilized is rather small, even when the budget is balanced. Furthermore, high taxes may be counterproductive for savings of the private sector, and moreover, the lack of technical progress in many LDCs because of a lack of incentive depresses both domestic savings and domestic investment. In recognition of this, less attention is now being given to just increasing investment as a route to faster growth,

One critical question that governments must face is how to allocate investment between social infrastructure (with long-term benefits) and productive investment (with immediate returns). In the earlier stages of development, the government may use direct methods to make this allocation; however, after some liberalization occurs, more indirect methods are used in order to gain some guidance from the market.

Because education is critical for improving labor productivity, but the lead times are quite long, much attention in development planning is addressed to it. Again, the allocative decision as between general and vocational education, and broad-based knowledge and higher technical skills, is very difficult to make, but a necessary part of development planning.

Further trade-offs may appear between such things as stability and equity or stability and growth. The choice appears in this form because when resources are not available for implementing development plans,

the temptation is to go forward anyway, knowing that inflation is likely to result. Some of the disappointment in development planning is certainly the result of plans implemented without adequate resources.

Ironically, development planning grew out of Keynesian economics, with its emphasis on demand management. Successful development planning, however, occurs only when supply capability is enhanced. Thus true development planning can only occur with a medium-term time horizon.

Adjustment to External Shocks

In chapter 5, Parvez Hasan examines the experiences of developing countries in response to external shocks—both positive and negative. During the 1970s and early 1980s, the world economy was marked by numerous sudden changes: the end of the Bretton Woods monetary system, oil price increases and decreases, rises and falls of real interest rates, and significant fluctuations in the prices of raw materials. An external change (such as a change in terms of trade, losses or openings of markets, immigration of workers, or a financial disturbance) can be considered a shock if it is long-lasting (that is, not reversed within a year or two) and large relative to both GNP and export earnings

Following a major shock, there is often a second shock, which may either offset or reinforce the first one. For example, after the first oil shock in 1973–74, an offsetting shock occurred for oil-importing developing countries—negative real interest rates were made available on international borrowings, opportunities were created for workers to go abroad and earn large incomes in OPEC countries, and concessionary assistance was increased. After the second oil shock in 1979—80, however, the secondary shock was reinforcing—real interest rates rose sharply, a deep worldwide recession occurred, and credit availability from foreign banks dried up. These secondary shocks make measuring shocks quite difficult.

In order to overcome a negative external shock, a country must adjust. It must reduce national expenditures to compensate for the loss of national income, and it must switch expenditures from foreign to domestic resources to correct the balance of payments. Given the need for time to bring about a proper adjustment, foreign borrowing is an option that can be usefully employed, provided that a country has not already used up its borrowing capacity. However, foreign borrowing should not be used merely to postpone adjustment and should be invested in assets that can provide a flow of goods and services that can service the foreign

debt. A reasonable time horizon for adjusting to a true external shock might be from five to seven years. During that time, a country must expand its capacity to export and its capacity to replace imports. It is likely that in order to do this, domestic prices relative to the rest of the world will have to be adjusted—probably through an exchange-rate devaluation—and domestic savings must be raised relative to domestic investment—probably through an improvement in the fiscal position of the government. Furthermore, an improvement in the allocation of investment resources is almost essential—that is, the incremental capital/output ratio and, if possible, import elasticity with respect to income should be reduced.

A review of ten oil-importing developing countries (that is, countries that experienced negative oil shocks) for the period 1974–84 indicates a wide variety of experiences: great difficulties were encountered, and among the most seriously affected countries only Korea managed to sustain overall economic growth rates close to previous levels while avoiding a major debt problem. Five of the ten countries failed to make an adjustment during this period, with Turkey only turning around (but then with a vengeance) in 1980.

Five oil-exporting countries that experienced positive shocks in the 1974—84 period are also examined in chapter 5. A positive shock increases both resource availability and borrowing capacity. Whether the positive shocks of the period gave lasting help on balance to these countries is an open question; they clearly had a downside to them. In most countries, waste increased, corruption flourished, and consumption expanded tremendously. Several went into excessive foreign debt. In fact, only Indonesia avoided a serious debt problem. The contrast between Indonesia and Egypt is marked, with Indonesia performing much better, even in the execution of similar types of programs. The better Indonesian experience seems to be the result of better use of pricing signals (the exchange rate was kept closer to equilibrium and domestic pricing of energy was more realistic), lower public sector subsidies, larger government savings, and a quicker response to the reversal of oil prices.

A number of lessons can be deduced from these experiences, not the least of which is that a shift from an inward-to an outward-oriented approach is robust strategy, regardless of whether a country is subject to positive or negative shocks. Second, the ability to adjust to external shocks depends primarily on the quality of macroeconomic management—relying on market signals, selectivity in public sector intervention, fiscal discipline, and quick reaction, as well as maintaining an

outward orientation—all seem to be important. Third, it appears that countries should put more emphasis on the quality of their investments rather than just concentrating on increasing the quantity. Fourth, a country's ability to adjust to a shock seems to bear little relationship to the size of the shock. Fifth, preexisting external debts are a major constraint to adjustment, and extreme swings in the real interest rate make adjustment quite difficult. Sixth, a negative shock can be a blessing in disguise if, as in the case of Turkey, adjustments that have long been required are finally made politically feasible. Finally, shocks by their very nature cannot be predicted, but the uncertainty created by external shocks can be better managed if countries treat shocks symmetrically, rather than assuming that positive shocks will last forever and negative shocks will quickly be reversed.

Export Liberalization

In chapter 6, Juergen Donges and Ulrich Hiemenz analyze the theory of export liberalization and the adoption of an outward-oriented trade regime; they also examine the experience of countries attempting the transformation. Arguments against adopting an outward orientation include concerns over excessively high adjustment costs in countries that have long had import-substitution (IS) policies, fear of social upheavals in response to the necessary adjustments, and a belief that foreignexchange shortages will necessarily occur, forcing a reversal of liberalization, and a return to IS.

A distinction needs to be drawn between activist governments that choose to intervene intensively in their economies and governments that distort prices through IS policies. Many governments give up IS and become outward-oriented, but remain interventionists. To make interventionism compatible with outward orientation, incentives to industrialize and the like must be consistent with an optimal allocation of resources— that is, relative prices must not be distorted. Export incentives should be no greater than necessary to offset export discrimination, and no sectoral preferences should be introduced. While it is possible to promote exports beyond what would occur in a distortion-free environment, the danger from this distortion is much greater in an IS regime, where budget constraint, which often limits export subsidies, is lacking.

The way to adopt an outward orientation is to expose the domestic economy to international competition for the purpose of improving allocative efficiency, capturing economies of scale, managing risk through export diversification, and accelerating technological innovation and the

formation of human capital. Two tasks that need to be undertaken are the substitution of price signals for administrative controls and the adjustment of domestic relative prices so that they conform to relative prices internationally.

The need and desire for outward orientation grows out of the inadequacies of the IS regime. Even protective tariffs of the infant industry type disadvantage the unprotected sector, including export industries. Efforts to avoid and evade restrictions force governments increasingly to use more distorting devices. When easy IS is completed, the economy is saddled with a complex network of controls. Balance-of-payments difficulties, resulting in part from overvalued exchange rates, bring pressures for capital controls and foreign borrowing. The extension of controls to the capital market is most serious, since an efficient capital market is essential in order for resources to be allocated properly. Often these controls lead to an excessive use of capital (too little use of labor), especially if real wages themselves are elevated by artificial means.

When there are multiple distortions in an economy, theory demands liberalization in all major markets. Theory would also suggest that the liberalization be instantaneous in every market. In the absence of constraints, abrupt liberalization would be best, since it would cause a rapid adjustment, could be in place before political opposition was mobilized against it, and would reduce uncertainty (inasmuch as the policy would become credible quite rapidly).

Unfortunately, concerns over adjustment costs and political disruption may make this unfeasible. The first tasks therefore are to remove the obstacles to export expansion that result from trade policies and to effect a real devaluation of the currency. Since there are risks and unknowns in export expansion, greater reliance should be placed on import liberalization rather than on export subsidies. Also, a rational exchange-rate policy may require frequent changes, which because of their impact on domestic prices will require strict stabilization policies. This will be made easier if the capital market is deregulated so that funds can be properly allocated to promote sectoral shifts of resources.

Many analysts (including some other authors in this volume) prefer to delay capital market liberalization. The case can be made, however, that the difficulties some countries encountered in liberalizing capital markets were the result of inconsistent domestic policies rather than of liberalization per se.

What keeps liberalization from occurring is often not a lack of knowledge of what to do but an absence of political will to do it. Liberalization

redistributes benefits from import-competing industries, organized labor, and the government bureaucracy in favor of consumers, unorganized labor, export industries, and agriculture. The potential losers may well have more political power than the potential gainers, and the change is thus likely to be thwarted.

The evidence indicates that countries that chose outward orientation during the 1960s and 1970s have performed spectacularly well. Their exports grew twice as fast as world trade, and that growth can be attributed to trade and trade-related policies. Exports have been the major force promoting growth in these countries and have also led directly to creation of employment. There have been two generations of outward-oriented NICs, and the threat of the markets of developed countries becoming clogged, thus inhibiting latecorners, has not materialized. The fear of a glut in markets results from a fallacy of composition, in that demand as well as supply is created. Indeed, trade among NICs themselves provides an expanding market opportunity. However, as growth is a supply phenomenon, there must be world demand for the products of the NICs in order for the outward-oriented strategy to work. Fear of protectionism is thus well-founded.

Import Restriction and Liberalization

In chapter 7 Wontack Hong uses the experience of Korea to examine import restraints and their liberalization in the context of an economy that is promoting exports. Economic theory strongly supports the proposition that as restrictive devices, quotas are much worse than tariffs, and, moreover, that rather than using tariffs, governments should use general taxes and subsidies to achieve desired goals. Nevertheless, developing countries invariably enforce trade restrictions, and usually use import quotas quite extensively. Why the disparity between theory and reality? Apparently domestic political forces that benefit from protection cannot be constrained during the process of development, and policymakers remain convinced that infant industry protection is superior to other devices for promoting development and maximizing foreign sales from existing export industries.

The analytical framework designed to examine import restraints recognizes that an export-promotion regime is superior to a generalized import-substitution regime because it promotes the upgrading of human resources and production technology, is better at achieving economies of scale, is less likely to be abused because of external pressures, is better at relieving foreign-exchange constraints, and captures the static

efficiency gain of larger trade and the induced growth benefit from larger savings propensities. However, given that import restraints are inevitable, serious welfare loss will be avoided if the biases created in favor of certain products and industries conform to a country's comparative advantage.

The use of tariffs puts a country in a second-best world, but if policies are adopted that offset the distortions created, little efficiency loss need occur. However, offsetting policies will be required as long as the tariffs are maintained—even as growth raises the production possibility frontier. Protection of a monopolistic export industry may even increase the share of exports out of total sales by permitting the firm to practice price discrimination, but at the expense of the welfare of domestic consumers.

If, however, policies (such as allocating credit to industries in which there is no comparative advantage) reinforce the distortion of protective tariffs, significant costs will be incurred, and an immiserizing structural adjustment will result.

Korea in the 1950s had a heavy bias toward import substitution and badly distorted markets. In 1961 a multifaceted program to move the country toward export promotion was begun. Since import protection is equivalent to a tax on exports, it was clear that export promotion could not be launched while maintaining drastic import restrictions. Thus a tariff exemption was given to products used in export production and the general level of quantitative restrictions was lifted. A real and symbolic change occurred when the system was altered from one in which it was presumed that an import was not allowed unless specifically approved to one in which it was presumed that an import was allowed unless expressly prohibited.

Between 1967 and 1978 very little progress was made in liberalizing Korea's import restrictions. However, during this period remarkable progress was made in expanding exports, because the surviving import restrictions were maintained in such a way as not to inhibit exports. Korea shifted from being a tiny exporter of primary goods to being a significant exporter of manufactured consumer goods, and the growth of the Korean economy was phenomenal. Even though there had only been a minimum degree of import liberalization, the export-promotion measures more than offset the import-substitution bias. Indeed, tariff protection may even have promoted growth, since tariff receipts made up 40 percent of government revenue, and a growing government surplus was important for increasing the national savings rate.

Beginning in the mid 1970s, Korea began to promote domestic production of intermediate and investment goods, not only for the purpose of being self-sufficient, but also to create new export industries. As part of the effort, imports of competing goods were newly restricted—even when they were to go into export production. By the end of the 1970s, Korea's export basket had shifted considerably to include heavy and chemical industry products, and imports of such products were sharply reduced (as a share of total imports). As this was done at a time when Korea had no comparative advantage in such products, however, the cost was considerable. It led to very high capital intensity in production of both exports and import-replacements, greatly raising total production costs. As a result, the growth rate of exports declined and the rate of growth of the entire economy also ebbed.

By 1978 it was recognized that extensive import liberalization was necessary to improve efficiency. A small effort was mounted in that year, but the bureaucracy remained very skeptical. The only products to be covered were ones not currently produced in Korea and for which no plans existed to start domestic production. This effort was halted by the economic difficulties of 1980, restarted in 1981, turned off again in 1982 in the face of a deteriorating balance-of-paymems position, and finally started again in 1983—this time with a firm schedule that looked forward to complete liberalization. As theory suggested, quotas were removed first, even if it required a temporary increase in tariffs to ease the adjustment.

From the perspective of political economy, i (might be concluded that since consumers have little organized political muscle, the products of direct importance to them are likely to be highly protected in the early stages of development, at significant expense to their welfare. In later stages of development, however, a large number of intermediate and investment goods producers emerge. They sell substantial portions of their products to domestic industries. These buyers, or so-called endusers, are better organized than consumers in general to mobilize a concerted effort against the protection accorded to the producers of intermediate and investment goods. Domination by sellers and uncontested protection rents tend to disappear in these sectors, since there finally exists an equally powerful group who stand to benefit by eliminating import restrictions. Then the chances of liberalizing consumer products improve, as the interests of the newer producers are aligned with those of consumers. In fact, in Korea consumer items were among the first to

be liberalized and consumer welfare was quickly improved. Subsequently liberalization has gone forward on schedule.

It appears that when industries are promoted for the purpose of exporting, the harmful effects of protecting other import-competing industries are eliminated with the passage of time. However, if importsubstituting industries are the focus of promotion, significant costs occur and can rise over time. Also, although comprehensive import liberalization is not a condition for high-growth performance in the initial stages of development, it becomes necessary in the later stages of growth.

Agriculture in the Liberalization Process

In chapter 8, D. Gale Johnson discusses the special case of agriculture. To be effective, liberalization of agriculture must include permitting market forces to determine how agricultural products are produced, as well as how they are traded at the border. Significantly, governments distort agricultural prices to force them below world levels as well as to raise them above those levels. It is the poorest countries that tend to force farm prices down, thinking that it will help the industrial sector, but thereby failing to capture some of agriculture's important contributions to the development process. As countries become richer, the share of agriculture in the economy declines, setting the stage tor import protection.

While agriculture has always been treated differently from manufactured goods, the rationale for, and desirability of. agricultural free trade is in fact no different. Nevertheless, agricultural protectionism has had a long history. Before 1940 import restrictions were generally low to moderate, except in Japan, where rice was heavily protected even in the 1920s and 1930s. Since the formation of the European Community (EC), however, agricultural protection has been rising in Europe and also sharply in Japan and Korea.

Statistical analysis suggests that protection against agricultural imports is likely to be higher the greater a country's per capita income, the fewer its exports of agricultural products, and the smaller agriculture's share in the economy is. These findings support a political explanation for protection pursued by organized pressure groups.

Concern for food security is often presented as a rationale for agricultural protectionism, and it is apparently widely accepted in Japan. However, it is clearly a self-serving argument pushed by those wanting

high levels of protection, who exaggerate concerns over possible supply interruptions. Self-sufficiency in food production does not provide food security if the inputs into the food production process must be imported, as is the case in Japan.

There has been little success in liberalizing trade in agricultural products because the United States undermined such efforts in the General Agreement on Tariffs and Trade (GATT) in the 1950s and the European Community has been staunchly opposed since then. However because of the escalating costs of agricultural programs for both the EC and the United States, and the recognition of their failure in supporting farm incomes, there is more hope for the Uruguay round of GATT negotiations in the 1980s.

Liberalization of agricultural products is unlikely to really hurt the income level of farm families (except during a transit ion period) because farm incomes are determined by the educational level of rural peoples, the per capita income levels outside agriculture, and the accessibility of rural people to nonfarm employment. If agriculture were liberalized, world prices would tend to rise, helping agricultural producers, and there would also be significant efficiency gains from reallocating resources in the EC, Japan, and also Korea, where per capita income could rise by at least 7 percent.

Financial Repression and Liberalization

In chapter 9, Yung Chul Park tackles the difficult subject of liberalization of domestic financial markets. From almost all perspectives, financial liberalization is more difficult and more complex than trade liberalization, and in fact all efforts in developing countries to achieve comprehensive financial liberalization have failed. Whether the failures have been owing to inherent incompatibilities, external events, inappropriate macroeconomic policies, or inauspicious original conditions cannot be sorted out. Any of the above would be sufficient to cause failure. Chapter 9, however, is devoted primarily to examining the intriguing question of whether there are inherent incompatibilities, and if so, how they might be approached and understood.

At the outset it must be recognized that banks are different from other businesses. Society has a strong interest in having a well-working payments system and in sustaining confidence in its money. Since banks create money as well as being intermediate between savers and borrowers, they are agents of society—that is, the financial system has characteristics of a public good. In recognition of this, governments have

provided deposit insurance and lender-of-last-resort facilities for commercial banks. Given the existence of these government guarantees, the market will not judge the soundness of banks based on the banks' own behavior, and knowing this, bank management may not behave in a responsible manner. In other words, a classic moral hazard problem is necessarily created, which even in the best of circumstances will require extensive government regulation.

In developing countries the banking system is usually the only available capital market—indeed the absence of a nonbank capital market is, by definition, underdevelopment. Thus, banks perform the critical function of allocating resources among industries. Governments simply will not leave this critical function to the market—which they often distrust in general. Thus the government may choose to run the banks themselves, control bank management, or insist on loan allocation according to policy design, or all of the above. Though regulation is greater in LDCs, even in developed countries banks are heavily regulated.

Just because the government must be involved in bank regulation is no guarantee that it will do it well; indeed, all too often it is done badly. Interest-rate ceilings are usually enforced—often below inflation rates. Consequently, obtaining a bank loan constitutes a windfall, excess demand is created, favoritism and corruption flourish, and the financial system is repressed. Existing banks are protected from new entrants, both domestic and foreign. Private savers and unfavored borrowers are forced into an unofficial, or kerb, market at sharply higher interest rates, carrying huge risks, and efficient capital allocation is lost. If financial repression can be corrected, there are significant gains to be made. Thus there is reason enough to desire financial liberalization.

History demonstrates that a well-working financial system can make a major contribution to economic development, and that economic growth can help improve financial institutions. Recognition of this in developed countries has spurred financial deregulation there, and this has helped sustain financial liberalization in LDCs.

Monetary reform can be considered the first stage of financial liberalization and is often very successful in promoting development. It involves the curtailing of excess creation of money, establishing positive real rates of interest (especially to borrowers), and cracking down on some of the abuses in the allocation of bank credit. Monetary reform can be very successful in promoting development, as it has been in countries such as Korea.

The next step to complete financial liberalization has never been successfully mastered in developing countries, with the failures in the Southern Cone of Latin America being the most notable. There, financial liberalization complicated macroeconomic management by creating incentives for destabilizing behavior, failed to mobilize savings despite high real interest rates to depositors, did not lead to the establishment of a competitive structure in financial markets, did not produce efficiency gains as credit allocation was distorted, and acted to dry up longterm finance.

Failure in finance has at times brought down the entire liberalization effort. It is now conventional wisdom that undisciplined financial liberalization will not succeed. Analysis indicates that the moral hazard problem is an insuperable barrier to complete financial liberalization, particularly in the absence of stringent prudential regulation. Banks will take excessive risks, and then try to manage nonperforming loans by offering ever-higher real interest rates to depositors in a desperate attempt to stay afloat. Such a race necessarily ends in disaster. In this competition, the adventurous banker will drive out the responsible banker and then bring down the system. Furthermore, if at the time of deregulation banks are saddled with a portfolio of nonperforming loans (as a result of previous government policy lending), then they will begin in a weak profit position, and this will encourage speculative behavior from the start. Also, close association between banks and large nonfinancial business groups is difficult, if not impossible, to prevent, since it is only in such groups (or individuals behind such groups) that there exists a large enough pool of investable assets to operate a bank. Consequently, the temptation for self-dealing and other banking abuses is overwhelming. Finally, rapid deregulation does not provide enough time for bankers to adequately learn their trade. It appears that there is a cruel tradeoff between obtaining efficiency gains and safeguarding the safety and integrity of the financial system.

Recognizing that at least some financial liberalization is desirable along with liberalization in other markets, there are still questions about the optimal path and phasing of the effort. Theory gives little guidance. A case can be made for immediate and simultaneous liberalization, but that appears neither feasible nor desirable because of externalities, market imperfections, and political constraints. Thus a stages approach to both trade and financial liberalization is inevitable. To sustain credibility, the liberalization effort needs to be preannounced and adhered to. It would appear that current account liberalization (trade and nonfinan-

cial services) should precede liberalization of capital flows, since asset markets adjust faster than commodity markets and commodities therefore need a head start. Current account liberalization should also precede domestic financial liberalization. Actually some liberalization should begin simultaneously on all fronts, but they may proceed at different speeds. Of course, there is a dilemma in dealing with the second best, in that we can never be completely sure that welfare is promoted by removing one distortion while others are preserved. It may be that some things must be taken on faith or no change is possible.

Certain reform proposals do seem to follow from the analysis. First, safeguards need to be instituted to prevent close linkages from being formed between large financial intermediaries and large nonfinancial business groups. Second, it is wise to try to separate the monetary and intermediary functions of banks, possibly by creating several categories of deposit liabilities, each with different reserve requirements. Finally, it is desirable to develop nonbank financial intermediaries less subject to stringent government control.

Monetary Stabilization in LDCs

In chapter 10, Ronald I. McKinnon takes up the issue of stabilization in relation to liberalization and then draws some implications concerning the desirability of international capital flows during the process of liberalization. Like Park in chapter 9, he draws lessons from both Chile and Korea.

It is clear that without stabilization, liberalization cannot succeed. In the absence of stabilization, inflation rates will be both high and variable, and this uncertainty will translate into real interest-rate and exchange-rate uncertainty and undermine the possibility of a successful trade and/or domestic financial liberalization. Thus stabilization may be a prerequisite for liberalization, or at a minimum require simultaneous accomplishment. Complicating the task of stabilization and liberalization is the fact that in trying to cope with inflation uncertainty several critical prices in the economy may have been indexed to actual inflation experience.

The first element in stabilization is correction of the government's fiscal imbalance, because inflationary monetary growth cannot be curtailed without doing so. After this is accomplished, real interest rates can be made positive for depositors, borrowers, and financial intermediaries. Financial repression can be ended and liberalization of trade and finance begun.

A crucial decision must, however, be made as to where to set the real interest rate. In Korea the real interest rate was pegged below the market clearing rate, and credit allocation was required. This choice runs the risks of impropriety and of inefficiency in the allocation of credit. Alternatively, if the real interest rate is permitted to rise high enough to clear the market, as was done in Chile, several difficulties may follow. The economy may be faced with adverse risk selection and improper risktaking by the banking system. Furthermore, excessively large flows of capital may be attracted from abroad, which could lead to the appreciation of the currency or loss of monetary control and ultimately a rekindling of inflation. Both of these problems are worsened by the moral hazards resulting from guarantees by both domestic and foreign governments.

Overborrowing from abroad by countries during or following successful stabilization and liberalization programs is a result in part of a market imperfection. International banks, following herdlike instincts, rush to add new foreign assets to their portfolios without properly evaluating the risks. Regulatory restrictions on international lending by commercial banks plus elimination of government guarantees could solve this problem and permit the re-creation of an international market for longterm debt and equity paper of developing countries.

Several of the themes in this book appear in more than one chapter and in different contexts and various perspectives. In order to gain greater insight, four of them have been selected for further discussion. The first arises from the attempt to design a blueprint for liberalization that has some hope for success. This requires the intermingling of the substance of a liberalization program with the tactics of how to bring it about. If it is to occur at all, the decision to liberalize is likely to be made in the midst of a crisis. At first glance this seems peculiar, as it raises two related dilemmas: a crisis requires immediate action, but the benefits of liberalization occur only in the medium and long run; similarly, a crisis generally grows out of a problem of demand management, but the solution liberalization offers is improved supply capability. The resolving of these dilemmas may possibly be found in the discussion in chapter 10 of a stabilization program. A stabilization program is directed at demand management, and the results may occur immediately. Stabilization alone often appears as "all pain, no gain," but if it is presented as the first step

in a larger program of liberalization, a light is kindled at the end of the tunnel, and the whole effort can be made more politically appealing. The threat of the crisis can be used to form a political consensus between groups who find their position being undermined and those dissatisfied with the previous distribution of benefits.

The second issue relates to the allocative decisions that must be made in the process of liberalization and that often arise in the context of development planning. Despite the fact that liberalization itself is designed to let the market do more of the allocating, certain allocative decisions will still be required of the government because they involve things the state has a comparative advantage in supplying (such as education). The policymakers in a liberalized regime must be able to interpret market signals in order to guide their decisions. For example, if a country is soon to enter a phase of development beyond producing and exporting labor-intensive manufactured products (subphase three in chapter 2), human capital must be developed in time to be available when needed. Unfortunately, the market is notoriously poor in providing signals for its needs more than five years in the future. This is where policymakers can turn to the experiences of other countries for guidance. While industrial history does not exactly repeat itself, examination of other more advanced countries can give useful hints. This was the approach of MITI in Japan and of MTI in Korea—both with good results. Comprehensive economic planning may be neither possible nor desirable, but some systematic thought about the future is essential.

The third issue concerns the timing and phasing of a liberalization program and leads to several different views in this volume. Theory can provide some insight, but not an answer to the twin questions of what to do first and how fast to do it. The arguments for a comprehensive and an immediate liberalization program are mainly found in chapter 6, where Donges and Hiemenz contend that the only real assurance that a liberalization program will be welfare-promoting is to remove all distortions completely and simultaneously; the credibility of a program (which is essential for its success) is only assured when everything is in place, for only then are the politicians fully committed to it. These writers further argue that the length of time needed for the economy to adjust to the program is minimized, and the likelihood of consistent policies is maximized, if all elements in the liberalization program are present.

The arguments for a phased and gradual program rest on both theoretical and practical considerations, and seem to be supported by actual

experience. The adjustment costs involved in a program of liberalization can be huge, and a society's tolerance can be overwhelmed if too much is attempted at one time. (How much educational reform will French students accept in one gulp?) If the program is phased in on an anticipated schedule, then adjustment costs can be reduced and disruption contained.

Most authors agree that trade liberalization should come before financial liberalization. However, since monetary reform is part of stabilization policy, and stabilization policy should be the first step toward liberalization, it can be argued that trade and financial liberalization should be started together, but at different speeds. Theory does recognize that different markets adjust at different speeds and that asset markets adjust much faster than commodity markets, so that there is justification for placing trade liberalization on a faster track than financial liberalization. It is also probably true that financial managers have a great deal to unlearn about how to operate profitably under liberalization (even partial liberalization), since it is so different from accepted behavior under government control. It may take some time for bankers to learn how to be responsible. Nonfinancial firms must also adjust, but this merely involves paying more attention to business, and less to rent-seeking—which is an easier adjustment.

Within trade liberalization, there is little theoretical guidance as to what should come first, the export or the import side. The important requirement is to get relative prices set correctly, and this might require simultaneous liberalization. However, the Korean experience suggests that import liberalization can lag behind export promotion quite considerably without excessive costs, though there are dangers involved. Eventually external pressures will appear to force the pace of import liberalization if it is seen as lagging too far behind export promotion. For some countries external pressures for liberalization may be highly desirable as a way to keep the process going, but for others they may be counter-productive. To avoid the latter case, a country is well advised to have an announced (and adhered to) program for import liberalization that will satisfy its trading partners.

Within financial liberalization, the argument has been made, domestic financial markets should be liberalized before international capital flows. This is the experience of Chile as interpreted in chapter 10. A theoretical argument can also be constructed in support of this proposition by noting the disproportionate size of investable assets in the world at large as compared to a single country, and the difficulty of getting ef-

ficient price-clearing when institutions change in such circumstances. However, a counterargument can be made that as long as markets are separated artificially, an incentive remains to circumvent the restrictions, which will drain energies and misdirect resources. Given the history of the Southern Cone of Latin America, however, it is likely to be some time before a developing country tries anything other than a step-by-step, gradual liberalization of financial markets.

The final issue that needs to be discussed concerns the dependence that a country develops on the rest of the world as a result of liberalization. Of course, dependence is just interdependence viewed from one side, but when a country is small, it is understandable that it should feel unable to influence the actions of others, but be concerned about being influenced by them.

The first question a country must ask itself is whether the risk of exposure is worth taking. The answer, from analysis and experience, is overwhelmingly yes. De-linking is immensely expensive, unnecessary, and probably impossible. The next question, in abstract terms, is how a country can take out insurance against an external disturbance when no company or market exists to write such a policy. The solution to this problem is risk management. This can partly be done through diversification (by both product and market), and also by improving adjustment capability (reducing the time needed to recognize a new situation and then to react to it). Finally, a country should make use of any external leverage that it may have, make alliances with other like-minded countries, and work within the international community to keep disturbances from occurring. Experience has clearly shown that those countries operating in an outward fashion have coped better than inward-oriented countries in times of external shock.

At the beginning of this introduction, it was recognized that development is the story of a swinging pendulum. Is it possible that the pendulum could swing too far toward liberalization? The question is worth asking, even if only hypothetically. The pendulum will have swung too far if, in the atmosphere in which they must operate, free markets do not provide the best signal for adjustment within a country.

If, for instance, the international trade regime were characterized by mercantilism on the part of all major players, then a pure free-market approach might not be desirable for any country. To maintain its bar-

gaining position in such a situation, the government would have to accept the necessary role of moderating market outcomes. In the field of finance, if the market is unable or unwilling to properly evaluate financial intermediaries, there will be an important role for stringent prudential regulations by government. Finally, the pendulum will have swung too far with respect to certain markets if enterprises become too large to be controlled by the market, or distort other (such as financial) markets. Then again the government will be called upon to moderate the situation for the good of society. The implication of all this is that liberalization does not mean that there is no role for government. Rather, it implies that the role of government should conform to both the circumstances within the country and the existing external environment.

Excerpted from Liberalization in the Process of Economic Developmentby Lawrence Krause and Kim Kihwan, editors Copyright ©1991 by Lawrence Krause and Kim Kihwan, editors. Excerpted by permission.
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