Bill Totten's Weblog

Friday, March 07, 2008

Protecting the global poor

Almost all rich countries got wealthy by protecting infant industries and limiting foreign investment. But these countries are now denying poor ones the same chance to grow by forcing free-trade rules on them before they are strong enough

by Ha-Joon Chang (Issue 136, July 2007)

Once upon a time, the leading car-maker of a developing country exported its first passenger cars to the US. Until then, the company had only made poor copies of cars made by richer countries. The car was just a cheap subcompact ("four wheels and an ashtray") but it was a big moment for the country and its exporters felt proud.

Unfortunately, the car failed. Most people thought it looked lousy, and were reluctant to spend serious money on a family car that came from a place where only second-rate products were made. The car had to be withdrawn from the US. This disaster led to a major debate among the country's citizens. Many argued that the company should have stuck to its original business of making simple textile machinery. After all, the country's biggest export item was silk. If the company could not make decent cars after 25 years of trying, there was no future for it. The government had given the car-maker every chance. It had ensured high profits for it through high tariffs and tough controls on foreign investment. Less than ten years earlier, it had even given public money to save the company from bankruptcy. So, the critics argued, foreign cars should now be let in freely and foreign car-makers, who had been kicked out twenty years before, allowed back again. Others disagreed. They argued that no country had ever got anywhere without developing "serious" industries like car production. They just needed more time.

The year was 1958 and the country was Japan. The company was Toyota, and the car was called the Toyopet. Toyota started out as a manufacturer of textile machinery and moved into car production in 1933. The Japanese government kicked out General Motors and Ford in 1939, and bailed out Toyota with money from the central bank in 1949. Today, Japanese cars are considered as "natural" as Scottish salmon or French wine, but less than fifty years ago, most people, including many Japanese, thought the Japanese car industry simply should not exist.

Half a century after the Toyopet debacle, Toyota's luxury brand Lexus has become an icon of globalisation, thanks to the American journalist Thomas Friedman's book The Lexus and the Olive Tree (1999). The book owes its title to an epiphany that Friedman had in Japan in 1992. He had paid a visit to a Lexus factory, which deeply impressed him. On the bullet train back to Tokyo, he read yet another newspaper article about the troubles in the middle east, where he had been a correspondent. Then it hit him. He realised that "half the world seemed to be ... intent on building a better Lexus, dedicated to modernising, streamlining and privatising their economies in order to thrive in the system of globalisation. And half of the world - sometimes half the same country, sometimes half the same person - was still caught up in the fight over who owns which olive tree."

According to Friedman, countries in the olive-tree world will not be able to join the Lexus world unless they fit themselves into a particular set of economic policies he calls "the golden straitjacket". In describing the golden straitjacket, Friedman pretty much sums up today's neoliberal orthodoxy: countries should privatise state-owned enterprises, maintain low inflation, reduce the size of government, balance the budget, liberalise trade, deregulate foreign investment and capital markets, make the currency convertible, reduce corruption and privatise pensions. The golden straitjacket, Friedman argues, is the only clothing suitable for the harsh but exhilarating game of globalisation.

However, had the Japanese government followed the free-trade economists back in the early 1960s, there would have been no Lexus. Toyota today would at best be a junior partner to a western car manufacturer and Japan would have remained the third-rate industrial power it was in the 1960s - on the same level as Chile, Argentina and South Africa.

Had it just been Japan that became rich through the heretical policies of protection, subsidies and the restriction of foreign investment, the free-market champions might be able to dismiss it as the exception that proves the rule. But Japan is no exception. Practically all of today's developed countries, including Britain and the US, the supposed homes of the free market and free trade, have become rich on the basis of policy recipes that contradict today's orthodoxy.

In 1721, Robert Walpole, the first British prime minister, launched an industrial programme that protected and nurtured British manufacturers against superior competitors in the Low Countries, then the centre of European manufacturing. Walpole declared that "nothing so much contributes to promote the public wellbeing as the exportation of manufactured goods and the importation of foreign raw material". Between Walpole's time and the 1840s, when Britain started to reduce its tariffs (although it did not move to free trade until the 1860s), Britain's average industrial tariff rate was in the region of forty to fifty per cent, compared with twenty per cent and ten per cent in France and Germany respectively.

The US followed the British example. In fact, the first systematic argument that new industries in relatively backward economies need protection before they can compete with their foreign rivals - known as the "infant industry" argument - was developed by the first US treasury secretary, Alexander Hamilton. In 1789, Hamilton proposed a series of measures to achieve the industrialisation of his country, including protective tariffs, subsidies, import liberalisation of industrial inputs (so it wasn't blanket protection for everything), patents for inventions and the development of the banking system.

Hamilton was perfectly aware of the potential pitfalls of infant industry protection, and cautioned against taking these policies too far. He knew that just as some parents are overprotective, governments can cosset infant industries too much. And in the way that some children manipulate their parents into supporting them beyond childhood, there are industries that prolong government protection through clever lobbying. But the existence of dysfunctional families is hardly an argument against parenting itself. Likewise, the examples of bad protectionism merely tell us that the policy needs to be used wisely.

In recommending an infant industry programme for his young country, Hamilton, an impudent 35-year-old finance minister with only a liberal arts degree from a then second-rate college (King's College of New York, now Columbia University) was openly ignoring the advice of the world's most famous economist, Adam Smith. Like most European economists at the time, Smith advised the Americans not to develop manufacturing. He argued that any attempt to "stop the importation of European manufactures" would "obstruct ... the progress of their country towards real wealth and greatness".

Many Americans - notably Thomas Jefferson, secretary of state at the time and Hamilton's arch-enemy - disagreed with Hamilton. They argued that it was better to import high-quality manufactured products from Europe with the proceeds that the country earned from agricultural exports than to try to produce second-rate manufactured goods. As a result, congress only half-heartedly accepted Hamilton's recommendations - raising the average tariff rate from five per cent to 12.5 per cent.

In 1804, Hamilton was killed in a duel by the then vice-president Aaron Burr. Had he lived for another decade or so, he would have seen his programme adopted in full. Following the Anglo-American war in 1812, the US started shifting to a protectionist policy; by the 1820s, its average industrial tariff had risen to forty per cent. By the 1830s, America's average industrial tariff rate was the highest in the world and, except for a few brief periods, remained so until the second world war, at which point its manufacturing supremacy was absolute.

Britain and the US were not the only practitioners of infant industry protection. Virtually all of today's rich countries used policy measures to protect and nurture their infant industries. Even when the overall level of protection was relatively low, some strategic sectors could get very high protection. For example, in the late 19th and early 20th centuries, Germany, while maintaining a relatively moderate average industrial tariff rate (five to fifteen per cent), accorded strong protection to industries like iron and steel. During the same period, Sweden provided high protection to its emerging engineering industries, although its average tariff rate was fifteen to twenty per cent. In the first half of the 20th century, Belgium maintained moderate levels of overall protection but heavily protected key textile sectors and the iron industry.

Tariffs were not the only tool of trade policy used by rich countries. When deemed necessary for the protection of infant industries, they banned imports or imposed import quotas. They also gave export subsidies - sometimes to all exports (Japan and Korea) but often to specific items (in the 18th century, Britain gave export subsidies to gunpowder, sailcloth, refined sugar and silk). Some of them also gave a rebate on the tariffs paid on the imported industrial inputs used for manufacturing export goods, in order to encourage such exports. Many believe that this measure was invented in Japan in the 1950s, but it was in fact invented in Britain in the 17th century.

It is not just in the realm of trade that the historical records of today's rich countries burst the bindings of Friedman's golden straitjacket. The history of controls on foreign investment tells a similar story. In the 19th century, the US placed restrictions on foreign investment in banking, shipping, mining and logging. The restrictions were particularly severe in banking; throughout the 19th century, non-resident shareholders could not even vote in a shareholders' meeting and only American citizens could become directors in a national (as opposed to state) bank.

Some countries went further than the US. Japan closed off most industries to foreign investment and imposed 49 per cent ownership ceilings on the others until the 1970s. Korea basically followed this model until it was forced to liberalise after the 1997 financial crisis. Between the 1930s and the 1980s, Finland officially classified all firms with more than twenty per cent foreign ownership as "dangerous enterprises". It was not that these countries were against foreign companies per se - after all, Korea actively courted foreign investment in export processing zones. They restricted foreign investors because they believed - rightly in my view - that there is nothing like learning how to do something yourself, even if it takes more time and effort.

The wealthy nations of today may support the privatisation of state-owned enterprises in developing countries, but many of them built their industries through state ownership. At the beginning of their industrialisation, Germany and Japan set up state-owned enterprises in key industries - textiles, steel and shipbuilding. In France, the reader may be surprised to learn that many household names - like Renault (cars), Alcatel (telecoms equipment), Thomson (electronics) and Elf Aquitaine (oil and gas) - have been state-owned enterprises. Finland, Austria and Norway also developed their industries through extensive state ownership after the second world war. Taiwan has achieved its economic "miracle" with a state sector more than one-and-a-half times the size of the international average, while Singapore's state sector is one of the largest in the world, and includes world-class companies like Singapore Airlines.

Of course, there were exceptions. The Netherlands and pre-first world war Switzerland did not adopt many tariffs or subsidies. But they did deviate from today's free-market orthodoxy in another, very important way - they refused to protect patents. Switzerland did not have patents until 1888 and did not protect chemical inventions until 1907. The Netherlands abolished its 1817 patent law in 1869, on the grounds that patents created artificial monopolies that went against the principle of free competition. It did not reintroduce a patent law until 1912, by which time Philips was firmly established as a leading producer of lightbulbs, whose production technology it "borrowed" from Thomas Edison.

Even countries that did have patent laws were lax about protecting intellectual property (IP) rights - especially those of foreigners. In most countries, including Britain, Austria, France and the US, patenting of imported inventions was explicitly allowed in the 19th century.

Despite this history of protection, subsidy and state ownership, the rich countries have been recommending to, or even forcing upon, developing countries policies that go directly against their own historical experience. For the past 25 years, rich countries have imposed trade liberalisation on many developing countries through IMF and World Bank loan conditions, as well as the conditions attached to their direct aid. The World Trade Organisation (WTO) does allow some tariff protection, especially for the poorest developing countries, but most developing countries have had to significantly reduce tariffs and other trade restrictions. Most subsidies have been banned by the WTO - except, of course, the ones that rich countries still use, such as on agriculture, and research and development. And while, of course, no poor country is obliged to accept foreign inward investment (and most receive none or very little) the IMF and the World Bank are always lobbying for more liberal foreign investment rules. The WTO has also tightened intellectual property laws, asking all but the poorest developing countries to comply with US standards - which even many Americans consider excessive.

Why are they doing this? In 1841, Friedrich List, a German economist, criticised Britain for preaching free trade to other countries when she had achieved her economic supremacy through tariffs and subsidies. He accused the British of "kicking away the ladder" that they had climbed to reach the world's top economic position. Today, there are certainly some people in rich countries who preach free trade to poor countries in order to capture larger shares of the latter's markets and to pre-empt the emergence of possible competitors. They are saying, "Do as we say, not as we did", and act as bad samaritans, taking advantage of others in trouble. But what is more worrying is that many of today's free traders do not realise that they are hurting the developing countries with their policies. History is written by the victors, and it is human nature to reinterpret the past from the point of view of the present. As a result, the rich countries have gradually, if often sub-consciously, rewritten their own histories to make them more consistent with how they see themselves today, rather than as they really were.

But the truth is that free traders make the lives of those whom they are trying to help more difficult. The evidence for this is everywhere. Despite adopting supposedly "good" policies, like liberal foreign trade and investment and strong patent protection, many developing countries have actually been performing rather badly over the last two and a half decades. The annual per capita growth rate of the developing world has halved in this period, compared to the "bad old days" of protectionism and government intervention in the 1960s and the 1970s. Even this modest rate has been achieved only because the average includes China and India - two fast-growing giants, which have gradually liberalised their economies but have resolutely refused to put on Thomas Friedman's golden straitjacket.

Growth failure has been particularly noticeable in Latin America and Africa, where orthodox neoliberal programmes were implemented more thoroughly than in Asia. In the 1960s and the 1970s, per capita income in Latin America grew at 3.1 per cent a year, slightly faster than the developing-country average. Brazil especially was growing almost as fast as the east Asian "miracle" economies. Since the 1980s, however, when the continent embraced neoliberalism, Latin America has been growing at less than a third of this rate. Even if we discount the 1980s as a decade of adjustment and look at the 1990s, we find that per capita income in the region grew at around half the rate of the "bad old days" (3.1 per cent vs 1.7 per cent). Between 2000 and 2005, the region has done even worse; it virtually stood still, with per capita income growing at only 0.6 per cent a year. As for Africa, its per capita income grew relatively slowly even in the 1960s and the 1970s (one to two per cent a year). But since the 1980s, the region has seen a fall in living standards. There are, of course, many reasons for this failure, but it is nonetheless a damning indictment of the neoliberal orthodoxy, because most of the African economies have been practically run by the IMF and the World Bank over the past quarter of a century.

In pushing for free-market policies that make life more difficult for poor countries, the bad samaritans frequently deploy the rhetoric of the "level playing field". They argue that developing countries should not be allowed to use extra policy tools for protection, subsidies and regulation, as these constitute unfair competition. Who can disagree?

Well, we all should, if we want to build an international system that promotes economic development. A level playing field leads to unfair competition when the players are unequal. Most sports have strict separation by age and gender, while boxing, wrestling and weightlifting have weight classes, which are often divided very finely. How is it that we think a bout between people with more than a couple of kilos' weight difference is unfair, and yet we accept that the US and Honduras should compete economically on equal terms?

Global economic competition is a game of unequal players. It pits against each other countries that range from Switzerland to Swaziland. Consequently, it is only fair that we "tilt the playing field" in favour of the weaker countries. In practice, this means allowing them to protect and subsidise their producers more vigorously, and to put stricter regulations on foreign investment. These countries should also be allowed to protect intellectual property rights less stringently, so that they can "borrow" ideas from richer countries. This will have the added benefit of making economic growth in poor countries more compatible with the need to fight global warming, as rich-country technologies tend to be far more energy-efficient.

I am not against markets, international trade or globalisation. And I acknowledge that WTO agreements contain "special and differential treatment" provisions which give poor country members certain rights, and which permit rich countries to treat developing countries more favourably than other rich WTO members. But these provisions are limited and generally just give poor countries longer time periods to liberalise their economic rules. The default position remains blind faith in indiscriminate free trade.

The best way to illustrate my general point is to look at my own native Korea - or, rather, to contrast the two bits that used to be one country until 1948. It is hard to believe today, but northern Korea used to be richer than the south. Japan developed the north industrially when it ruled the country from 1910 to 1945. Even after the Japanese left, North Korea's industrial legacy enabled it to maintain its economic lead over South Korea well into the 1960s.

Today, South Korea is one of the world's industrial powerhouses while North Korea languishes in poverty. Much of this is thanks to the fact that South Korea aggressively traded with the outside world and actively absorbed foreign technologies while North Korea pursued its doctrine of self-sufficiency. Through trade, South Korea learned about the existence of better technologies and earned the foreign currency to buy them. In its own way, North Korea has managed some technological feats. For example, it figured out a way to mass-produce vinalon, a synthetic fibre made out of limestone and anthracite, which has allowed it to be self-sufficient in clothing. But, overall, North Korea is technologically stuck in the past, with 1940s Japanese and 1950s Soviet technologies, while South Korea is one of the most technologically dynamic economies in the world.

In the end, economic development is about mastering advanced technologies. In theory, a country can develop such technologies on its own, but technological self-sufficiency quickly hits the wall, as seen in the North Korean case. This is why all successful cases of economic development have involved serious attempts to get hold of advanced foreign technologies. But in order to be able to import technologies from developed countries, developing nations need foreign currency to pay for them. Some of this foreign currency may be provided through foreign aid, but most has to be earned through exports. Without trade, therefore, there will be little technological progress and thus little economic development.

But there is a huge difference between saying that trade is essential for economic development and saying that free trade is best. It is this sleight of hand that free-trade economists have so effectively deployed against their opponents - if you are against free trade, they imply, you must be against trade itself, and so against economic progress.

As South Korea - together with Britain, the US, Japan, Taiwan and many others - shows, active participation in international trade does not require free trade. In the early stages of their development, these countries typically had tariff rates in the region of thirty to fifty per cent. Likewise, the Korean experience shows that actively absorbing foreign technologies does not require a liberal foreign investment policy.

Indeed, had South Korea donned Friedman's golden straitjacket in the 1960s, it would still be exporting raw materials like tungsten ore and seaweed. The secret of its success lay in a mix of protection and open trade, of government regulation and free(ish) market, of active courting of foreign investment and draconian regulation of it, and of private enterprise and state control - with the areas of protection constantly changing as new infant industries were developed and old ones became internationally competitive. This is how almost all of today's rich countries became rich, and it is at the root of almost all recent success stories in the developing world.

Therefore, if they are genuinely to help developing countries develop through trade, wealthy countries need to accept asymmetric protectionism, as they used to between the 1950s and the 1970s. The global economic system should support the efforts of developing countries by allowing them to use more freely the tools of infant industry promotion - such as tariff protection, subsidies, foreign investment regulation and weak intellectual property rights.

There are huge benefits from global integration if it is done in the right way, at the right speed. But if poor countries open up prematurely, the result will be negative. Globalisation is too important to be left to free-trade economists, whose policy advice has so ill served the developing world in the past 25 years.

Ha-Joon Chang's book Bad Samaritans - Rich Nations, Poor Policies and the Threat to the Developing World is published by Random House on 5th July

Bill Totten


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