Development, Duality and the International Economic Regime:
Essays in Honor of Gustav Ranis

Edited by Gary R. Saxonhouse and T.N. Srinivasan
Hanover Press, 1999

Preface

When Gustav Ranis began his scholarly career in the field of economic development, the global economy presented a landscape of widely contrasting conditions. Almost two-thirds of the global population was ill-fed, ill-housed, illiterate, and lacking access to proper medical care. Today, four decades later, while standards of living have generally improved and some areas of Asia, Latin America, and the Middle East have joined the highly productive economies, the gap between the wealthy few and the rest of the world has widened. Very significant areas of the globe remain desperately poor.

In a much-needed effort to assess the current issues facing developing countries and development economics, Ranis's former students, present and past colleagues at Yale, and fellow development economists honor him with this volume. Contributors examine and evaluate four areas of concern: duality and the evolution of labor markets in developing economies; trade, technological transfer, and economic development; the international economic regime and economic development; and finance and economic development. Among many important findings in this volume, evidence is presented that: (1) duality in labor markets may be self-perpetuating without selective government intervention; (2) contrary to earlier conjectures, trade liberalization will have more than just a one-time impact on national economic performance; and (3) using a nominal exchange rate anchor as a tool of stabilization policy in developing economies is fraught with difficulties.

Gary Saxonhouse is Professor of Economics and Director of the Committee on Comparative and Historical Research on Market Economics (CCHROME) at the University of Michigan. He has written widely on the structure and operation of the Japanese economy and on many other topics in international economics and economic history. During academic year 1995–96, he was a Fellow at the Center for Advanced Study in the Behavioral Sciences.

T.N. Srinivasan is Samuel C. Park, Jr., Professor of Economics and Chair of the Department of Economics at Yale University. His work in international and development economics has given rise to widely read publications, including India's Economic Reforms (with Jagdish Bhagwati) and multiple volumes of the coedited Handbook of Development Economics.

Introduction

When Gustav Ranis began his scholarly career, the global economy presented a landscape of widely contrasting conditions for its participants. Notwithstanding a few spires of immense prosperity, almost two-thirds of the global population was ill fed, ill housed, illiterate, and lacking in access to proper medical care. Today, four decades later, while standards of living have generally improved and some areas of Asia, Latin America, and the Middle East have joined Western Europe and areas of Western European settlement as highly productive economies, the gap between the few wealthy economies and the rest of the world has widened. Very significant areas of the globe remain desperately poor.

To assess the current issues facing developing economies and development economics and to honor Gustav Ranis, Yale's Economic Growth Center hosted his former students, his present and past colleagues at Yale, and his fellow development economists in a conference in May 1996. From the proceedings at this lively conference, sixteen chapters have been culled and revised for this volume. With the exception of the review essay by Albert Berry and Frances Stewart, these chapters are grouped under four headings: (1) duality and the evolution of labor markets in developing economies; (2) trade, technological transfer, and economic development; (3) the international economic regime and economic development; and (4) finance and economic development. Each of these headings is related to major themes in the study of the process of economic development. Taken together, their scope includes much, though inevitably not all, of what is interesting about the study of economic development today. The topics covered by these four headings are tied together by Ranis's conception of the process of economic development.

The evolution of Ranis's view of how economic development proceeds is outlined in the review essay by Berry and Stewart, the first chapter in this volume. Their essay is as much of review of the evolution of development economics as it is on Gustav Ranis's scholarship — after all, there are few areas of development economics to which he has not made seminal contributions and fewer still that failed to attract his interest throughout his distinguished career. Berry and Stewart show how the concerns of policymakers have interacted with more general changes in economic thinking to produce what they regard as the distinctive field of development economics. At almost every step of the way in this process Ranis has made a significant contribution.

Ranis first made his mark as a major figure in development economics by showing that dualism in labor markets can play a decisive role in shaping the process and patterns of economic development. As Joseph Stiglitz, now the chief economist at the World Bank, notes in the lead chapter in the first section of this volume, duality has long been a challenge to neoclassical economics. In particular, wage differentials within a single economy have been viewed as a particular problem. A combination of labor and capital mobility and trade in goods and services should be sufficient to remove such differentials. Indeed, no one of these factors should be necessary for the removal of wage differentials. Any one of them might be sufficient by itself.

Given that what, in theory, should hardly exist remains in practice, Stiglitz asks how can duality be reduced. He argues that growth strategies will be different whether or not duality is taken as a permanent fact of economic life. In this connection, he notes that a major lesson from the success of the East Asian economies is that there need not be a trade-off between equity and growth. Indeed, policies that ensure equity may enhance growth. Stiglitz presents a series of models that depict several sources of the vicious cycles that allow poverty to perpetuate itself, but that may be broken with selective government intervention. Increasing access to education provides the clearest example of such an intervention; others include assistance in the diffusion of improvements in capital markets, actions designed to reduce the force of discrimination, and programs affecting fertility rates.

How rural labor markets operate is clearly central to an understanding of duality in developing economies. In his essay, Yujiro Hayami examines the Lewis-Ranis-Fei conjecture that wages of labor in agriculture are dictated by community norms and not by marginal productivity. Following T. W. Schultz, Hayami does find that wages in agriculture are linked to marginal productivity, but that this linkage occurs within a framework of community norms that minimizes costly transactions and stimulates employment. Hayami calls this the community-based wage.

While the community-based wage regime virtually excludes the possibility of Lewis–Ranis–Fei-style labor surplus at the onset of industrialization, as Ranis and Fei themselves observe, increases in agricultural productivity can insure the ready availability of labor for the industrial sector. Unfortunately, in Hayami's viewdeveloping economies today have prematurely encouraged the establishment of advanced-economy institutions such as labor unions and have enacted minimum-wage laws. These factors have created dualism in developing-economy labor markets by artificially constricting access to employment in the modern industrial sector. In the Ranis tradition, Hayami recommends the promotion of rurally based small and medium enterprises as an antidote to this problem. This recommendation is in the spirit of the policy proposals outlined by Stiglitz in the concluding section of his chapter.

Stiglitz's chapter outlines how investment in education can help break down duality in labor markets. Mark Rosenzweig, in his essay, seeks to assess education's role in contributing to the overall process of economic growth. To date, the testing of alternative views and theories about the determinants of economic growth has relied on aggregate data that describe different economies at different points in time. Such aggregate cross-country data must be used because micro or household survey data typically depict a single economy at a point in time or over a time period in which there is little growth. As tests of growth theories require variations in levels of development across observations, such data are not very helpful.

Making use of newly available household data from India that cover a long time interval and different regions with differing growth experiences (driven by the differential impact of the green revolution) makes it possible for Rosenzweig to examine systematically competing hypotheses about the role of education in economic growth. Rosenzweig is able to show that the use of aggregate data can provide a very misleading picture of the role of schooling in growth. Aggregate data hides the very real and significant role that increased schooling has played in promoting economic growth in India.

Stiglitz's observation that there be no trade-off between increasing income equality and increasing economic growth is based, at least, in part on the research undertaken by Ranis, the late John Fei, and Shirley Kuo on Taiwan's experience prior to 1972. In their essay, Gary Fields and Jennifer O'Hara Mitchell find, however, that this relationship reverses after 1980. Increases in earnings differentials by gender and educational attainment between 1980 and 1993 appear to play a disproportionate role in accounting for this reversal. This is true despite educational attainment becoming more equitably distributed over this period. Perhaps only the boldest of policy interventions aimed at radically increasing access to higher education could have prevented the observed decline in income equality as the Taiwanese economy's demands for labor became ever more skill-intensive.

In their review essay, Berry and Stewart note the changing role the external sector has played in the thinking of development economists. In the 1950s and early 1960s, the latent potential of surplus labor and the key position of industrialization were stressed, while the role of the external sector was neglected. By the 1970s, as the open economy versions of the Ranis-Fei theory of economic development gained wide-spread acceptance, the external sector came to be seen as the critical facilitator of growth and development. More recently, it has been argued that economists have oversold the benefits of trade liberalization to developing economies. Indeed, it has been argued that trade liberalization will have no more than a onetime impact on national economic performance. T.N. Srinivasan, however, in the chapter that opens the section of the volume devoted to trade, technological transfer, and economic growth, demonstrates, using many of the traditional models of economic growth, that this view is in error. Trade liberalization can increase the long-run rate of economic growth. An examination of more recently developed models of endogenous growth in which technological transfer through trade plays a major role just reinforces this conclusion.

Srinivasan also finds that analysis of the East Asian economies' success in achieving rapid growth supports the conclusion that far from being the result of a wise government picking industrial winners and actively promoting them so as to create an investment boom, "it is their emphasis on education, enabling government intervention," as Ranis noted, "in fashioning the appropriate organizational and institutional infrastructure, reducing transaction costs and, above all, their outward orientation that are more likely to have been the driving forces."

Richard Nelson and Howard Pack also use their essay to argue strenuously against the view that the capacity for technological transfer is not an important determinant of an economy's potential for growth and development. In particular, they argue that growth accounting inevitably begs all the important questions. Complementing Srinivasan's analysis, Nelson and Pack find that in order to understand East Asian economic success, it is important to look behind their rapid rate of capital accumulation and focus on the nature of the firms there and their decision-making processes, the economic capabilities lent by the presence of a well-educated labor force, and the role of exports.

Like the Srinivasan and Nelson-Pack essays that precede it, Keijiro Otsuka's essay analyzes critical strands in the relationship between technological adaptation and East Asian economic development. Otsuka'sanalysis has been aided by the collection of a unique dataset that allows him to probe the sources of total factor productivity change in township and village enterprises (TVEs) in China. TVEs are generally recognized to be the major force in China's economic transformation. Surprisingly, Otsuka finds that technological transfer from the much-maligned state-owned and state-subsidized enterprises (SOEs) have played a critical role in the TVEs' success.

It is generally observed that part of the capacity to successfully use imported technology is proper maintenance. In his essay, Mark Gersovitz shows that, in fact, poor maintenance may be a rational strategy in a developing-economy environment of capital scarcity. The higher interest rates that are the result of capital scarcity can paradoxically lead to poorer maintenance of capital because maintenance, by incurring expenses in exchange for future benefits, is similar to investment, which, in turn, is generally discouraged by higher interest rates. This seemingly counterintuitive result is quite consistent with Ranis's earliest work on capital-saving technological change.

While Srinivasan demonstrates the benefits to long-run growth of trade liberalization, his analysis takes the international economic regime as given. In contrast, Koichi Hamada's essay, which introduces the third section of this volume, emphasizes the changing character of the international regime and the consequences of this change for developing economies. Hamada examines the dual role a hegemon plays as a provider of international public goods and as an extractor of economic rents through the use of its global market power. He finds the logic for these two roles quite different. As American hegemonic status has declined, it has be-come less interested in providing public goods and more interested in exploiting its market power.

Hamada concludes that only by introducing the element of domes-tic conflict into the analysis of international economic negotiations, as the theory of the two-level game suggests, can one fully account for the present state of international political economy. The domestic political structure in the United States does not seem to allow the first best solution for the United States as a nation. Similarly, other countries are bound by internal domestic conflicts. As American hegemonic power has declined, it is no longer fully capable of mitigating the impasse created by domestic economic conflicts. It is no longer fully capable of widening the "win-set" by reducing uncertainty, by changing the perception of pressure groups, and/or by creating credible threats. In this environment developing economies are the losers.

Jonathan Eaton, Robert Evenson, and their associates in their essay deal with one important element of the international economic regime as it has operated over the past century. They find a very strong home bias in the use of technology. Contrary to widespread belief, most patents have relatively little impact beyond their country of production. While, as Srinivasan and Nelson-Pack note, technological transfer has been the major force driving economic development, this transfer has taken place outside the international patent system. The originators of internationally transferred technology are receiving relatively little in the way of rents. This view is at variance with the conventional wisdom in many developing countries, which holds that economically advanced countries use their monopoly of superior technologies to exploit their poorer trading partners. Eaton, Evenson, and their associates have not yet found evidence in this area of international economic transactions that would support Hamada's conjectures.

While there is little evidence that economically advanced countries have exploited their monopoly of superior technologies, concerns that they might in the future have helped spawn proposals that poorer countries use their own near-monopoly over the world's agricultural genetic resources to bargain for a larger share of global income. In his chapter, Brian Wright examines whether the need for proper feeding of a rapidly expanding global population will actually confer this kind of market power on poorer countries. Wright finds that a rapid increase in global food supply can only come from increases in yields. Expanded cultivation and irrigation will account for very little in the way of increased supply. Increases in yields means having better breeds, but Wright finds that breeders of major crops are not highly dependent on new flows of germplasm from poorer countries. For example, there have been continuing advances in the yields of hybrid corn and soybeans despite an extremely narrow genetic base. Wright concludes that the real danger is that the attempt to capture the meager rents from the flow of new germplasm to breeders will severely compromise a worldwide enterprise that has enjoyed unprecedented success in increasing food supplies to the benefit of all consumers.

Hamada's analysis suggests that the political economy of developing countries often makes it difficult for them to remove protective barriers on their own. Gary Saxonhouse's chapter shows why Hamada is correct in arguing that the imposition of voluntary import expansions (VIES) is outside of the "win-set." VIES, while lowering prices in the developing countries adopting them, may still entail a loss in welfare. The benefits to developing-country consumers from a decline in prices can be outweighed by the decline in profits to developing-country firms. Surprisingly, this is likely to be the case when the hegemon's initial market share in the developing country is very small.

While the second and third preceding sections of this volume discuss international technology and trade flows, the final section is devoted to the highly topical issue of international capital flows and financial policy in developing economies. Many of the regime issues that Hamada treats in his analysis of the international trading system re-emerge when the international financial system is examined. There are certainly many in developing economies who believe that as American hegemonic status has declined it has become less interested in providing public goods for the international financial system and more interested in exploiting its market power.

In the face of such an international financial environment, domestic financial stability is an issue of continuing concern to policymakers in developing economies. For policymakers confronted with crisis situations involving triple-digit rates of inflation, inability to maintain voluntary debt service, and high protectionist trade regimes, a frequent policy prescription has been to adjust the underlying fiscal imbalance and to undertake a once-and-for-all devaluation; thereafter the exchange rate should be used as a "nominal anchor for slowing down the rate of inflation."

In her chapter Anne Krueger finds that the use of the nominal exchange rate anchor is fraught with difficulties. Foremost among them is the inevitability of the collapse of the regime when reserves are sufficiently reduced so that agents are no longer willing to bet on the continuation of the regime. Even if exit from the nominal anchor can be managed prior to the breakdown of the regime, the realignment of production toward the international economy will be retarded, if not entirely postponed during the period when a nominal anchor holds sway. In addition, as long as the policy is in effect, it is equivalent to a subsidy on foreign investment in local assets, in that foreigners are assured a real return above that in domestic currency.

Krueger concludes that in societies where the costs of inflation are sufficiently high and the domestic currency has lost all credibility, however, it is possible that the very large benefits of controlling inflation outweigh the very high costs of a nominal-anchor exchange rate policy. In her view, unless circumstances are truly exceptional, however, it is doubtful whether a nominal-anchor exchange rate policy is warranted.

The underlying fiscal imbalances that provoke the crises that lead policymakers in developing economies to adopt the exchange rate as a nominal anchor are typically a set of inconsistent and known to be unsustainable policies that are being pursued for domestic reasons. To better understand the unfolding of this process, Willem Buiter provides in his chapter an examination of such medium-term and longer-term issues as government solvency and a government's fiscal, financial, and monetary policies. The empirical background for Buiter's analysis is provided by twelve former Soviet-bloc economies that have been under International Monetary Fund surveillance programs for at least some of the time since they initiated their transitions from plan to market.

One element in the adjustment process that both Krueger and Buiter discuss is foreign aid. In the final chapter of this volume, Howard Pack and Janet Rothenberg Pack analyze the long-held belief, based on a priori grounds, that foreign aid is fungible, that is, aid designated for individual sectors will be reallocated among them. Using data from Sri Lanka during the period 1960-86, they find that categorical aid was indeed fungible. Aid intended by the donor for development was converted into unconstrained income used for purposes more consistent with Sri Lanka's policymakers' preferences ignoring donor intentions. Aid was diverted not only among development categories but from development spending to current spending, revenue reduction, and deficit finance. This suggests that a government's fiscal needs can frustrate the intentions of foreign donors. For example, the many economic interventions suggested by Stiglitz in the second chapter of this volume will likely fail if they are the objective of the foreign donor alone.

The editors have had considerable help in both organizing and bringing this project to a successful conclusion. In particular they would like to thank Louise Danishevsky and the late Dorothy Nitschke of the Economic Growth Center at Yale and Irita Grierson of the Department of Economics at the University of Michigan. This project would have never come to fruition without the continuing guidance of Ellen McCarthy at the University of Michigan Press. Financial support for the conference out of which this publication grew was provided by the Department of Economics and the Economic Growth Center at Yale University and by the Committee on Comparative and Historical Research on Market Economies (CCHROME) at the University of Michigan. Much of the organization of this project took place while one of the editors (Gary R. Saxonhouse) was on a fellowship provided by the Center for Advanced Study in the Behavioral Sciences. He is grateful for their support of his work.

The editors would also like to thank Michael Boozer, William Cline, Ricardo Paes de Barros, Richard Eckaus, Robert Evenson, Albert Fishlow, Philip Levy, William Nordhaus, Dwight Perkins, Richard Porter, T. Paul Schultz, Jaime Serra, Nirola Spatafora, and John Strauss, who served as discussants of the essays that appear in this volume. Their thoughtful comments are greatly appreciated.