The political economics of import substitution industrialization

The political economics of import substitution industrialization

Why did Chile use ISI for so long, and why did it finally stop?

During 1950-1973, Chile adopted a policy of import substitution industrialisation (ISI), involving a closed economy (high tariff barriers, quotas and exchange controls) and a strong role for the state (high government expenditure, extensive regulations, and increasing numbers of state-owned firms). This paper discusses economic policy choices in Chile during the ISI period, with an emphasis on how the ISI strategy was sustained and what led to its demise. It describes the course of post-war development in Latin America, arguing that:

  • although GDP growth appeared high during the ISI period, this did not reflect a real growth in purchasing power
  • distortions in prices for exports meant that export earnings were dominated by a handful of traditional exports
  • the ISI strategy did not solve the balance of payments problems it was intended to eliminate, and vulnerability to external shocks remained acute.

Given these problems with ISI, the paper asks why successive governments chose to continue using the strategy. It suggests answers to this question using a theoretical model in which governments seek to maximise the level of rents they can obtain through taxation, and are less interested in future than current income because of the possibility that they will not be able to stay in power. The model predicts that the government will choose an overly high level of taxation in order to raise its current income, at the cost of future economic growth.

Finally, the paper incorporates the effect of a loan given by an international financial institution (IFI) into the model. It predicts that such a loan can overcome the incentives problems facing a government attempting to reform its economic policy, but that the loan must be sufficiently large and with a high degree of conditionality; otherwise the government will fool both investors and the IFI by taking the loan but not reforming.

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