The Political Economics of Import Substitution Industrialization

Chile has shown in Latin America that an open economy can detach itself from the vicissitudes of its neighbors. It also has shown that it delivers growth. However, other countries in Latin America have considered reinventing the ALALC strategy of the sixties, a strategy of opening to regional trade while closing itself to trade outside the region. Chile followed that strategy at some point. How did it get from there to here? How is the political economics of the reform from an ISI strategy to an open economy? Is there a role for IFIs in that process? This paper discusses Chilean economic policy choices in the period 1950-1973, the period of the import substitution industrialization (ISI) strategy. The ISI model rested on two main pillars: a closed economy (high tariff barriers, quotas and exchange controls) and a strong role for the state (government expenditure as a large share of GDP, extensive regulations and an increasing presence of state-owned firms). Particular emphasis is put on trying to explain how the ISI strategy was sustained and what led to its demise. The framework of interpretation provided in the paper is also applied to Uruguay, in an attempt to gauge its capacity to interpret what happened in another Latin American country. Policy is endongenous, and hence reform is endogenous. Credibility can affect the chances of reform to succeed. According to the reasoning presented here, a key issue is to study the factors that affect the equilibrium rent extraction rate. There are many incentives to announce and then reverse a liberalization program. If investors believe in reform, and invest, then there is a short run boost to GDP, and then investors a repartially expropriated by the reversal (since without the liberalization their project was not profitable). Hence announcements are not credible unless signaling of commitment is present. This paper argues there is a role for IFIs in this process but that the loan size and the amount of conditionality are key in making the liberalization process credible. If the size is too small or there is not enough conditionality, then the rent seeking government will fool both the investors and the IFI by getting the investment, the loan, and not reforming. Investors know this moral hazard problem and hence invest less than expected initially, making the elasticity of supply to the RER lower, and making the optimal RER higher. The signaling of commitment is key to triggering investment. But if IFIs get into the problem and are unable to sustain conditionality or estimate the adequate size of the loan, then IFIs will lose credibility and this signaling device will be devoid of utility. IFIs can solve the time inconsistency problem faced by rent seeking governments that results in very low investment. However, if the donor agencies become unreliable in enforcing conditionality, they will result in countries free riding on the signal, the signal losing credibility, and IFIs will lose the ability to perform the role. This is a common property problem: each country individually would rather the IFI enforce the conditionality for all other countries and not for itself. If the negotiation process in the IFI permits this to occur sufficient times all are worse off since then a signaling device is lost.