one way or many

KSG PED-259“One Way or Many”

Final ExamHarvard ID – 905 1277 30

1. One Way Or Many 905127730

Introduction

The course “One Way or Many” addresses the question of institutional convergence. Its

reading begins with Fukuyama’si dramatic proclamation of the “end of history” - he

observes that since the downfall of communism neo-liberal thinking is now accepted

universally (dominant in the psyche if not yet dominant in practice). Without

challengers, he assumes, the possibility of improving or removing the system is

impossible. This then must signal the end to mankind’s ideological evolution. Although

neither Sachs nor Unger would necessarily agree with Fukuyama’s overstatement of the

situation their dialogue addresses a similar concern. The world is clearly converging

towards a single economic structure and set of institutions and policies. Is this something

we should accept as progress or lament as the death of ideological imagination?

An Outline of the Debate

Sachs represents the “convergence as progress” view. His analysis focuses on explaining

the differences in income levels between the developed nations and the developing

nations. The reasons for these differences, he posits, come from multiple sources –

economic policy as well as geography and climate, demography and history. Although

the last three factors may mean that nations have different capacities for wealth creation,

in many cases failure to grow is a consequence of poor policy. Sachs sees institutional

convergence as a way for poor nations to reach their full potential. By adopting the

institutions and policies of the rich nations they may accelerate their economic growth.

The rich nations, especially the US, serve as successful role models for the poorer nations

(there should be “no need to reinvent the wheel”). Although there may be a number of


ways to successfully structure ones institutions (ie Sachs downplays the difference

between the US system and the European system), having common institutions lowers

transactions costs and thus allows increased market-based trade.

Underlying Sachs’ view that the US can serve as a useful economic model for less

wealthy nations is a strong believe in the market as the principal intermediary of

development. He believes when the market is allowed to set prices and allocate resources

(within a sound institutional setting) progress will ensue. This thinking is applied both

within countries and in the international economic system. For example, according to

market principles the existence of a differential between rich and poor creates efficiency

and dynamism. Those striving to increase their personal wealth acquire skills to meet the

changing demands of the market. Similarly poor countries with cheap labor as their

comparative advantage will move up the ladder of development as they acquire skills

needed for more valuable activities. Openness, Sachs preaches, is the key driver of

growth as it diffuses knowledge, allows capital to find the highest return and increases

specialization and economies of scale. In this view there is only a limited role for

government. It exists merely to oil the gears of the market.

Ungerii agrees that a market-based system provides the best hope for progress. However,

he considers the US system to be deeply flawed and therefore advises against using it as a

model for the rest of the world. Instead he encourages the search for a new way. He

contests the belief that a country will develop naturally given a setting of strong property

rights and adherence to the global economic ordering. Rather he believes a form of


permanent “dualism” to be the necessary outcome of such a system. This dualism is

evident is business, finance and politics. In the business arena unskilled workers (“the

rearguard”) are permanently disconnected from skilled workers (“vanguard”), unable to

catch-up. A major reason for this is that the vanguard is defined not just by physical,

point-in-time characteristics (such as access to technology) but by harder-to-acquire

characteristics (such as ability to continuously learn and innovate). Existing market

based systems (both US model and the Rhineland model) seek only to attenuate this

dualism but offer no remedy to it. A remedy would require a massive redistribution of

wealth unacceptable to the productive sector.

Similarly in the financial arena, only a chosen few have access to the capital of the rich

nations. In his view new ventures are often under-funded and many poor countries have

access to capital only on the worst of terms, if at all. Finally in the political arena, the

wealthy classes exert undue influence on the political process to ensure their interests are

protected. They lobby to shrink forces that could challenge their dominance (ie

democracy and government power). Thus the promise of neo-liberalism (ie efficient

markets) never eventuates as resources are allocated not by merit but by wealth and

privilege.

Unger calls for a reinvention of the current market system. In the alternative the state

would partner with business to actively direct development and strategically mold

comparative advantage. Other key features of the alternative include decentralization of

i Francis Fukuyama. “The End of History”. The National Interest. 1989, Summer, pp 3 –18ii Roberto Mangabeira Unger. “Democracy Realized”. Verso, 1998.


access to resources and opportunities (“democratizing the market”), increasing political

mobilization to prevent capture by special interests (“high energy democracy”) and the

creation of new institutions capable of experimentation and innovation. He believes the

large, marginalized countries offer the best hope of creating this alternative – pushing

them towards institutional convergence will rob the world of this opportunity to find a

new way.

The Crux of The Debate

The crux of the difference between Sachs and Unger is in the relative roles of the nation

versus the global market. In the Sachs view, there appears little room for a state role in

development. The market is sufficient for progress and the main realm of innovation

should be in creating new international based institutions to increase the efficiency of the

global market (ie continued rules for international trade arbitration, facilities for country

bankruptcy). Unger, by contrast, considers the state crucial for development – markets

are necessary but should be subject to national policies. In this view the major realm of

innovation is at the country level. New national institutions are necessary to allow a

nation to harness the global market in a way appropriate for benign progress.

This central issue of the market versus the nation will be the focus of the remaining

essay. I will proceed by examining Sachs’ study of openness and growth. This is

important as the link between openness and growth is used by many as a platform to

shrink the role of the state. The common logic applied is “if we can prove some openness

is good then more openness must be better”. I will suggest the study does not support this


conclusion – it merely suggests that a minimum threshold of openness must be crossed

for a country to reach its full growth potential. Finally I examine Taiwan as a case study

of an “open” country. I will examine the role of the market versus the state in Taiwan’s

success. My hypothesis is that Sachs’ support of openness does allow for Unger’s active

government. Given the limits of time I will focus on per capita income growth as the

principal measure of success in my analysis. The equally important outcomes of tolerable

inequality and capacity for continuous institutional reinvention will be set aside for the

sake of brevity.

Role of Openness In Development

In their 1995 paper Sachs and Warneriii attempt to explain the lack of income

convergence between rich and poor countries throughout the 1970-1989 period. By

categorizing each country as either closed or open they find strong evidence of

convergence amongst the open countries. This is demonstrated using several analysis

techniques. First at a simple level, by comparing averaged growth rates between open and

closed countries (separating out developing from developed). Second with a more

complex analysis, by regressing the 1970-1989 growth rates of 79 countries against a

collection of demographic, geographic and policy variables. The regression shows a

large increase in explanatory power when the categorical measure of openness is added

(R-squared moves from 36% to 56%). Using these results the authors conclude that by

joining the global system of open trade and harmonized economic institutions poor

nations can enjoy faster growth.

iii Jeffrey D. Sachs and Andrew Warner. “Economic Reform and the Process of Global Integration”. Brooking Papers on Economic Activity I: Macroeconomics. 1995, pp 1 – 118.


But this conclusion does not necessarily follow from the analysis. The results do not by

themselves give evidence for the “one way” of institutional convergence. They simply

show a strong association between a degree of openness to trade and GDP growth. It

must be noted that the measure of openness is extremely coarse – in any one year a

country is categorized as either open or not, then a continuous measure is constructed as

the proportion of years the country met this minimum threshold level of openness.

However, within the group of countries classified as “mostly open” there is a vast range

of policies towards trade and approaches to development. For example, using Sachs and

Warner’s categorization a country with non-tariff barriers covering 39% of trade and

average tariff rates of 39% in each year would receive the maximum openness score of

one.

This form of measurement has a strong bearing on the conclusions we can draw from the

study. We can only conclude that as long as a country is above a fairly low level of

openness we would expect to see convergent growth1. Assuming more openness leads to

greater growth involves a substantial leap of faith. Such a conclusion would require a

reparameterization of openness that treated a country with a 38% average quota (ie

Taiwan) differently from a country with a 12% average quota (ie US). In short, you

cannot assume a continuous relationship from an essentially categorical analysis.

1 In fact we cannot even conclude this. As the authors point out the trade policy has been used as a measure of overall economic policy. As open trade is often accompanied by other sound economic management such as macroeconomic stability we cannot assume that the convergent growth is a result of the trade policy exclusively. It would be enlightening to include a measure of price stability or exchange rate stability in the regression.


Understanding the boundaries of these results is important as it shows that Sachs results

allow room for Unger’s alternative. A country may be mostly open and responding to

market forces but through the use of selective tariffs and other policies the government

may be guiding development against the market. Sachs’ results do not contradict such an

arrangement actually leading to an improved result over the market alone. Next I consider

a specific country where the government has taken such a role. I will examine the

evidence for and against the role of state being critical to national success.

Taiwan’s Success

Taiwan, by all measures, has displayed extraordinary success over the last 30 years.

Between 1962 and 1986 Taiwan’s compound annual growth rate of 8% allowed it to

move from the 70th percentile to the 30th percentile of GDP per capitaiv. It has

transformed itself from an exporter of primary products into an exporter of mainly

industrial products. Despite accounting for only 0.4% of the worlds population Taiwan is

now the 10th largest producer of manufactured exports in the world. It has achieved these

feats whilst maintaining unusually equal income distribution, low debt and strong

macroeconomic and political stability. Entering the next millenium Taiwan continues to

move up the ladder of development by focusing on high-tech manufacturing. The

increasing moves towards democracy ensures the nation a political wealth to accompany

its material wealth.

iv Robert Wade. “Governing The Market”. Princeton University Press, 1990.


Simulated Market versus Governed Market

There is little disagreement that the state took an active role in the economy in Taiwan.

There are many examples of import substitution policies, use of tariffs, quotas and

subsidized credit. The key issue however is not whether this occurred but firstly, did it

aid development and secondly, did it do so by simply removing market distortions or by

creating positive market distortions. Wadeiv distinguishes between the “Simulated

Market” (SM) theory and the “Governed Market” (GM) theory of Asian success. Under

the SM theory the government’s role was simply to intervene to align domestic prices

with international prices where distortions existed. Effectively the market allocated

resources and Taiwan’s shifts in comparative advantage followed the market. The GM

theory is considerably more aggressive. It assumes the government distorted prices in

such a way that private enterprise took directions they would not otherwise have chosen.

Rather than simply following the market the theory believes government policy led the

development of Taiwan’s comparative advantage. The GM theory further assumes this

intervention was critical to Taiwan’s success.

Sachs’ Defense of a Simulated Markets in Taiwanv

Sachs comes strongly out on the SM side of the debate. He rejects the notion that

Taiwan’s success is due to special government intervention. First empirical evidence is

presented. He estimates a statistical model demonstrating “conditional convergence”.

This model explains growth in per capita income between 1965-1990 for 78 countries. It

uses each countries initial starting point income and a collection of demographic, policy

v Steven Radelet, Jeffrey D. Sachs and Jong-Wha Lee. . “Economic Growth In Asia”. Asian Development Bank – Emerging Asia : Changes and Challenges.


and structural variables to explain growth. The model has extremely strong explanatory

power (Adjusted R-squared of 87%). The general result applied to Taiwan suggests that

its growth is largely explained by low initial incomes, openness to trade, government

savings , lack of natural resources, location, demographics and strong institutions. The

reasoning here is if the model can explain such a large proportion of the data without the

inclusion of distinctive aspects of government policy then these policies cannot play an

important explanatory role. Sachs notes that a regional indicator for Asia is not found

significant - suggesting no measurable “Asian effect” in explaining growth (ie differences

between the role of government in Asia versus Rest Of World are largely irrelevant

according to the model).

This is fairly strong evidence. My single reservation is that as the fitted and actual data is

not reported for individual countries it is hard to draw conclusions specifically about

Taiwan2. It is possible that the overall relationship does not fit Taiwan especially well.

For example, if Taiwan’s actual growth rate is significantly above its fitted value this

may be evidence that the government interventions lifted steady state growth. The paper

cites a 6.7% fitted growth rate for the four tigers versus a 6.6% actual growth. However,

this does not necessarily show the model fits each tiger well. It simply reflects a

regression model’s built-in characteristic that the prediction errors must balance out. (ie

aggregating the prediction errors of any four countries in the sample should yield a

similar result).

2 Note that Taiwan is excluded from later analysis in the paper because of incomplete data. Singapore and Hong Kong are excluded because they are considered “outliers”. It would be interesting to see if there are similar issues with these countries in the conditional convergence model.


Sachs follows up this empirical evidence with further analysis. He points out that much

of the government intervention in Taiwan was in the promotion of heavy industry

whereas Taiwan’s success was driven by manufactured exports. Manufactured exports

were largely produced in Export Processing Zones or bonded factories whose access to

duty-free imports simulated a free-trade environment. Sachs clearly outlines the value of

manufactured exports in creating new comparative advantages and speeding

development: the close links with multi-national firms fosters technological progress and

“learning by doing”, the push for international competitiveness spills over into labor and

supplier markets. However he asserts that Asia did not choose this strategy as much as

the strategy chose Asia (ie Asia had a comparative advantage in manufacturing exports

and was therefore selected by multi-nationals looking for off-shore production centers).

Sachs’ view of government promotion is that its successes arose from following the

market, little evidence is reported of the government going against the market and

succeeding.

Wade’s Evidence For a Governed Market in Taiwan.iv

Wade agrees that there is much evidence of free/simulated markets in Taiwan, especially

in the case of small-scale producers. Although he acknowledges that much of the

government intervention was centered around upstream large-scale producers he believes

there were considerable flow-on effects down-stream. Similar to Sachs he cites extensive

examples of low tariffs/duty drawback and unrestricted access to foreign exchange for

exporters, limited labor regulation and access to unregulated “curb” markets as creating


free trade conditions. However, he believes the government went beyond simply

correcting market distortions for exporters.

Government Intervention In the 1950s

Firstly he views government policies in the 1950s as crucial to the rapid export growth of

the following decades. By maintaining an overvalued exchange the government skewed

investment away from agriculture and towards industry. Taxes on land and compulsory

procurement of rice at below market prices also contributed to the push away from

agriculture. Throughout the 1950s the government was extensively involved in

industrialization. Often the government established the upstream industries itself. Wade

points out that public enterprises accounted for over half of industrial production during

the 1950s – a time when manufacturing output doubled. Importantly these enterprises

were handed over to private entrepreneurs once established – the state provides capital in

a time of limited accumulation but private interests are then responsible for on-going

efficient management. Additionally these private enterprises were protected from external

competition in the early stages by protective tariffs. He claims the role of government

has been downplayed by commentators due to Taiwan’s relatively low levels of average

tariffs. However Wade criticizes these analyses as ignoring legal tariffs and ignoring the

high dispersion of tariffs among sectors.

Effectiveness of Import Substitution Policies

Many commentators claim that Taiwan dropped import substitution policies in the 60s

due to their lack of success. Contrary to this Wade cites evidence that import substitution


contributed as much as one third of the total economic growth during this period (pg 84).

Additionally he points out that the private interests successful under import substitution

went on to be successful after the policy was ended. This is consistent with the view that

import substitution assisted firms in acquiring skills and capabilities necessary to become

successful exports in the following decade. The greatest weakness in the preceding

description is that it provides only evidence of the government speeding the natural

development process rather than necessarily building a new path through the market.

There is some evidence that government planning did lead the market rather than follow

it. Wade cites Taiwanese planning documents from the 1960s which recommend the

move away from labor-intensive industries (which were at that time still in surplus)

towards capital goods and electrical appliances.

Government Intervention In the 1970s & 1980s

Throughout the 1970s the government had limited need to provide capital to the private

sector – massive surplus capital was being accumulated through the export success. The

government continued to assist economic development by focusing on infrastructure.

Importantly this focus was not simply on physical infrastructure but also on intellectual

infrastructure. Beginning in the 1950s the government regularly published “Long Range

Scientific Development” plans. The government implemented these plans by starting

firms in targeted industries, recruiting foreign partners, providing incentives for high-tech

investment and offering support to firms for employee upskilling. Importantly the

government spearheaded the move into semi-conductor design and production

capabilities in the 1980s. The publicly owned Electronic and Service Organization


continues to lead the development of new technologies in public research labs.

Commercialization of the output is achieved through various public-private ventures.

Were The Interventions Market Leading?

Supporters of a purely free trade perspective often do not see the need for government

intervention in research and believe this is best carried out by private interests. This may

very well be an acceptable view for US and other large industrialized countries. Large-

scale businesses with a surplus of capital can easily support high fixed costs activities

such as multi-year research projects with no guaranteed outcome. However, given the

dominance of small scale businesses in Taiwan the same level of investment would have

been unlikely without government involvement to socialize the risk. Indeed several of

the great commercial technical innovations in US history have involved huge financial

risk which would have put the company out of business if they had not yielded results.3

Any country with institutions to decrease (but not remove) the risks from large scale

technical investment may have an important comparative advantage.

On a similar note the role of the government in supporting wide access to education must

be acknowledged. Both Sachs and Unger emphasize the importance of education for

creating and maintaining international competitiveness. Taiwan raised education

spending from 11.6% of current expenditure in the 1960s to over 20% in the 1970s

through to the present. As with investment in research this is an area which often sees

underinvestment when left to the market. The ideology that seeks to “shrink

3 IBMs development of System/360 in 1960 provides a good example. Investment in the development equalled three times its annual revenues and required the employment of 60,000 new workers!


government” is almost always accompanied by pressure to decrease social spending. As

the benefits of education are diffused across the economic system and also are hard to

quantify it is vulnerable at the hands of the market.

A final argument in support of the governed market perspective is that the degree of

export incentives surely stepped beyond the scope of simply simulating the market. The

level of support to the export sector in Taiwan surely resulted in a larger degree of focus

and investment than would have been the case under a pure free market scenario. For

example, Sachsv cites a typical incentive package for a firm in an EPZ as being “tax

holidays of up to 20 years, 100% profit repatriation, free access to foreign exchange,

efficient customs clearance, preferential access to financing and capital grants in the form

of subsidized factory space or worker training”. Assuming the EPZ is also a custom free

zone this appears to be a greater incentive for exporting than the market would provide.

Similarly the existence of government special purpose loan funds, development funds and

loan guarantees for small businesses effectively decreases project cost of capital below

market levels and thereby decreases the risk of investment.

Conclusions

There is clearly strong evidence on both sides of this debate. On the one hand, Sachs has

presented extremely strong evidence of the development benefits of openness. He

combines with the phenomenal success of the US economy to prescribe convergence

towards US institutions as a means of reaching full potential. However, on the other

hand, a close examination of the empirical work does not necessarily support institutional


convergence. The results simply show that as long as a country meets a minimum level

of openness then conditional convergence of income should apply. They do not preclude

some role for the government to guide the economy. The example of Taiwan illustrates

this well – Taiwan had significant government involvement in the economy and managed

to achieve fantastic growth. The question of whether this intervention helped Taiwan

achieve a higher potential or instead retarded its growth is unclear. The import

substitution policies of the 1950s can look either like moderate successes or large failures

depending on which evidence you find convincing. However, its role in driving increased

levels of research investment and maintaining high levels of education spending must

unanimously be regarded as successful. While this is an indirect role it was never-the-

less crucial to Taiwan’s development. Funding such fundamentals surely necessitates a

potent state that is both linked to the needs of business and has the resources to make

long term physical and intellectual infrastructure investments. If such a system is seen as

“idealistic” under the current institutional arrangements then maybe we have not yet

found a perfect model.


References


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