“Import substitution as implemented failed, and the justifications for out ward orientation are being increasingly undermined” – Guy Bentley
From World War II until the 1970’s many developing countries have attempted to accelerate their development by limiting imports of manufactured goods, in an attempt to foster a manufacturing sector to serve the domestic market. This paper will follow the structure of Henry J Brutons’- A reconsideration of import substitution by first examining the theory of import substitution, as a method of manipulation foreign exchange. I will then look at the justifications for the failure of this implemented policy by looking at the example of 19th century Japanese trade liberalization. Succeeding that, I will describe the dramatic policy transition from inward looking strategies to outward orientation whilst examining the example of Taiwan and Korea. Finally I will examine the reasons why certain individuals undermine this development strategy, in an attempt to pursue the most effective and appropriate combination of policies to promote economic development.
During the last few decades there has clearly been an unprecedented integration of national economies where globalisation has been driven by constant Technological advances. This has eased the movement of goods and information by lowering barriers to trade thus stimulating a change in the economic policy which countries choose to pursue. However before the 1970’s the global situation was completely different, with protectionist policies such as tariffs, voluntary export restraints and anti-dumping duties, inhibiting the free flow of trade and factors of production. Import substitution (IS) was one of these policies and stemmed from the need to protect an economy from imports of developed countries allowing them to concentrate on producing an array of manufactured products domestically rather than importing them. Bruton argues that IS occurred as a result of a rejection of free market solutions as the need for comprehensive planning and accumulation of physical capital came to surpass any trust held in Adam Smith’s invisible hand. The primary justification for IS was based on the infant industry argument; which stated that initially inefficient developing countries could have a potential comparative advantage in manufacturing. However they can’t compete with the well-established manufacturing sectors present in developed countries that already reap the benefits of economies of scale. History supports this theory as the US and Germany both had excessively high tariff rates on manufacturing in the 19th Century equally Japan had extensive import controls until the 1970’s (Krugman). Other arguments that justify this means of protectionism include the appropriability argument which governs an innovators ability to capture profits generated by new entrance into a market (Krugman). The idea is that innovative firm should be rewarded for their entrance into a new industry with some sort of tariff protection offsetting the initial sunk costs. If this was not in place, isomorphism from other firms may exist where they could follow the innovator into the new industry without paying the sunk cost. Finally Bruton explains that IS was used in countries where the domestic capital goods market was relatively small and the need for physical capital to promote productivity and growth was substantial. One way of solving this was to encourage investment by maintaining an exchange range that kept capital’s domestic price low by constantly overvaluing the currency. However this created balance of payments pressures which consequently led to the erection of tariffs, quotas and other restraints in an attempt to combat these pressures. Krugman, Obstfeld, Maurice and Melitz highlighted a few counterpoints to the infant industry argument in their book International Economics: Theory and Policy. Firstly protection doesn’t help unless it makes the industry...
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