The discussion in the previous chapters was predicated on the distinction between tradables and nontradables. Moreover, it postulated the existence of a systematic relationship between the level of development and the relative prices of tradables and nontradables. The analysis in effect implies that whereas the distinction may not matter greatly for DCs, not only is it valid for LDCs but, if ignored, it introduces a systematic element of resource misallocation in the economy. For LDCs in specific the signals emitted by border prices (of tradables) do not always correspond to the opportunity cost of resources of producing tradables in terms of nontradables.

The empirical question of tradability and the observed patterns in the price deviations between tradables and nontradables are especially important for our argument. The empirical evidence in Tables 5.1 and 5.2 related directly to the law of one price and only indirectly to tradability. The systematic deviations between the aggregate price indexes and the levels of development captured by the ICP are consonant with the predictions of the tradable–nontradable differential productivity model, as Chapter 5 indicated. Unless, however, tradables and nontradables are specifically identified, and their price movements analyzed, the link between the ICP price indexes and the Ricardo Principle is incomplete. The purpose of this chapter is to provide such a link.

The elements of tradability

As noted in Chapter 3, the foundation of Ricardo's distinction between tradables and nontradables lies in the specification of the production function, particularly with respect to factor proportions and technology. Agriculture, with traditionally high labor intensity, is the stylized Ricardian nontradable. Manufactures, on the other hand, which are capital- and technology-intensive, are tradables.

The previous chapter demonstrated that the distinction between tradables and nontradables becomes important in a variety of circumstances that often prevail in LDCs. The empirical investigation of purchasing power parities in this chapter will reveal the regularities that exist between relative prices of tradables and nontradables in the process of development. The empirical links between the real and nominal exchange rates will also be investigated.

Purchasing power parity and exchange rates

The measurement of purchasing power parity (PPP) was designed to lead to comparisons of real incomes across countries. Such comparisons, however, are based on price level comparisons. Prices have multiple uses, among others as guides for the allocation of resources and as markers of efficiency. Should inappropriate prices arise, Pareto losses can be related to the violation of the restrictions of the fundamental theorems of welfare economics.

Suppose that certain price index calculations revealed that the price level at region X is 50% higher than at region Y. A new price emerges, the “bridge price,” which is the ratio of price in Y to price in X, or 0.66. This is the number by which one multiplies a given national income in X to give it the same purchasing power as a corresponding income in Y. Such “bridge prices” are often fairly uninteresting when they are used merely as income-ranking devices. In certain cases, however, they cease being simply “bridges” and assume a role in allocating resources. Any bias that exists in defining and constructing such prices would carry over to the allocation process as well.

By the time of its independence and for at least the next 10 years the Philippines had a high growth rate of GDP and one of the highest per-capita incomes in Asia. The 9% aggregate annual growth rate of the 1950s declined to 5% in the 1960s, briefly increased 6.8% in 1973–1979, hovered around zero till the end of the Marcos era in 1985, peaked briefly at 5.8% in the early Aquino period, and has stagnated since 1990 (Table 10.1). Considering the sizeable rate of population growth of 2.7%, this aggregate growth record produced an annual growth rate of 1.3% on a per-capita basis for the period 1965–1990. Incomes are only the tip of the iceberg. In fact, the economy has unravelled so rapidly since the 1960s that today the Philippines is considered a distinct development failure.

The development play of the Philippines was enacted on a stage of some enduring institutional features and in the shifting setting of various policy regimes. The stage and the setting are discussed in the next section. They are followed by a more detailed analysis of various policy initiatives and of the development outcomes.

The stage and the setting

Land concentration and land reform

The Spanish colonial period bequeathed the Philippines the legacy of large agricultural estates run by landlord elites. The U.S., which succeeded Spain as colonial master at the beginning of the 20th century, was primarily interested in the Philippine cash-crop exports and in placing American consumer goods in the local market. This led to a long period of a dualistic economic and agrarian structure and to the neglect of subsistence agriculture (Ranis and Stewart, 1993).

The landscape of development is strewn with overvalued domestic currencies. This phenomenon flies in the face of conventional wisdom, which emphasizes the salubrious effects of devaluation: by “setting the prices right,” devaluation restores competitiveness and through its effect on the balance of payments leads to an expansion in output and employment. The leading explanation of this paradox considers overvaluation as one of the instruments that debauched politicians employ for capturing economic rents (Krueger, 1974; Bhagwati, 1982). Yet, again paradoxically, in the majority of the 24 cases of devaluation that Cooper (1971a) analyzed, the finance minister who had presided over the devaluation had been ousted from office within the next 18 months. This uncharitable verdict on hapless ministers is easier to understand if devaluations perchance turn out to be contractionary, thus imposing a real cost to the economy. Even then, the former paradox would still remain. If an overvalued nominal exchange rate rests on base motivations, why isn't the world replete with venal, rent-seeking bureaucrats?

This chapter first sets the stage by providing a short review of the literature on the effects of devaluations. Next, nominal exchange rate devaluation is introduced in a quasi-Australian model in real variables that includes tradables, nontradables, and their respective prices, which define the real exchange rate. The model is not dynamic. As a result, it cannot compare the real gross domestic product at time t with that at time 0 in terms of purchasing power parity in order to capture the output effects of devaluation.

Uruguay is an anomaly for the maintained hypothesis of this book. In 1975 and 1980, the two years for which micro-ICP data are available, Uruguay ranked close to the bottom of the LDC distribution of the RER index (Table 6.1). The expectation of the rate of growth in real GDP per capita that one might have associated with the apparent severe overvaluation of the peso has never been matched by meritorious development performance. Uruguay has certainly not helped the goodness of fit of the endogenous growth regressions (Chapter 7). This is what makes it a good candidate for demonstrating that overvaluation may be a necessary but certainly not a sufficient condition for success in development. The refractory characteristics of good governance have an important role to play in generating development policy outcomes. The ex-post operational definition of good governance is pluralistic economic development. There is general agreement that Uruguay has failed this test (Table 11.1). But defining good governance teleologically, in terms of achieving egalitarian development outcomes, is circular. The crucial question arises: To what extent can one predict ex ante that specific types of intervention are likely not to lead to pluralistic economic development? This is a more difficult task. The issue can best be explored by comparing two sets of interventions and using the good governance case as a control to judge the deviations of the alternative. The control case for this discussion is Taiwan.

The comparison of Uruguay and Taiwan may strike one as unfelicitous. The analytical difficulty arises because the micro-ICP data that are scant for Uruguay are totally nonexistent for Taiwan.

This book builds on the theme that distortions inherent in free currency markets lead LDCs systematically to misallocate resources. The intuition behind this theme is traightforward. Consider an equilibrium situation in the real world, where a bundle of resources produces tradables or nontradables, measured such that one unit of each is worth $1. Entrepreneurs should be indifferent between producing one unit of tradables or one of nontradables. Now introduce a slight complication that is ubiquitous in the real world of LDCs: tradables trade in dollars, a hard currency, whereas nontradables trade, say, in pesos, which is a soft currency. The soft currency may be devalued. Then it becomes risky for the Mexican entrepreneur to produce (or hold) one unit of nontradables that could not be converted into $1 for later spending. Expressed in another way, entrepreneurs are attracted to producing tradables because that is the only way they can acquire $1 they wish to hold for asset purposes. Thus, relative to productivities measured at “normal” prices, nontradables become undervalued and resources are drawn away towards tradables. This is manifest in a relative price of nontradables that is too low compared with productivities, or too high an RER.

This dilemma does not exist for the DC producer. In hard currency, $1 of tradables will always be worth $1 of nontradables, as opposed to the soft currency, where the expectation of devaluation becomes a self-fulfilling prophecy. In the process of converting soft currency into hard for asset-holding purposes the market-clearing NER becomes too high. This is manifest in a relative price of tradables that is too high compared with productivities – again too high an RER.

An empirical analysis of economic development that relies on international cross-section data is bound to grapple with the question (first featured in Chapter 2) that Arrow (1974) raised in his Nobel Prize lecture. Arrow observed that cross-country inequality in economic development is not readily amenable to the neoclassical explanation of differences in physical and human assets per capita. Two stylized facts about the experience of economic growth beg for an explanation (Kaldor, 1961; Kuznets, 1966). First, output per worker has risen secularly, and rates of productivity growth show no systematic tendency to decline. Thus growth in per capita incomes has been sustained in many instances. Second, there is great variance in growth performance across countries. This divergence does not seem to be random. But it is not autoregressive either, since there does not exist a strong correlation between the level of income at the beginning of the period and the growth outcome at the end.

Arrow's observation inspired a thriving literature that focused on issues of “convergence” (initiated by Baumol, 1986). A subset of this literature is the “endogenous growth” of the Romer-Lucas class of models (Romer, 1986, 1990; Lucas, 1988; Grossman and Helpman, 1992; Barro, 1990,1991; Rivera-Batiz and Romer, 1991; Levine and Renelt, 1992).

The empirical analysis in this chapter builds upon the tradition of this literature. The conventional reduced-form equations of endogenous growth models incorporate variables that can account for the exceptions to the static version of the fundamental theorems of welfare economics, such as the existence of economies of scale.

The preceding chapters were devoted to building a case for the existence of systematic incompleteness in certain markets in LDCs. One important implication of such a case is that the debate in development economics may have to change from “whether governments hould intervene in the process of development” to “how can governments intervene appropriately for development success.”

In what follows, the reinterpretation of the Japanese development success since World War II will focus on state intervention that resulted in systematically overriding certain crucial incomplete markets, especially the labor market and the foreign exchange/trade markets. The analysis will examine specific policy packages that allowed Japan to find shortcuts to the long road from underdevelopment to development.

The discussion of the new development economics in Chapter 3 emphasized the importance of leapfrogging the process of economic development. The empirical handle used in this book to make operational the concept of leapfrogging is the Ricardo Principle and the relative prices of tradables and nontradables at various stages of development. At the two extremes of the continuum of economic development that the Ricardo Principle maps, we can distinguish two stages. Stage I, underdevelopment, is characterized by cheap labor and expensive capital, and implies a comparative advantage for an opene-conomy LDC of specializing in labor-intensive, low-value added exports. Low wages, absence of significant technological rents, and low living standards follow. Stage II, development, is characterized by expensive labor and relatively cheap capital, and implies specialization in capital- and technologyintensive exports with high value added, and significant technological rents associated with products that have high income elasticity of demand and, conceivably, low price elasticity. High wages and high living standards follow.

Conventional trade theory has generally credited free-market, free-trade, laissez-faire capitalism with producing equilibrium, market-clearing prices and leading to Pareto optimality. An economy is considered efficient in production if the supply of any good (or service) cannot be increased without reducing the supply of another good. The last qualification about decreasing the supply of another good has to be interpreted broadly in an open economy, since trade is considered an indirect form of production: a certain good whose supply was decreased for producing another can now become available by exchanging exports for it. The point of operation in this trade-extended production possibility frontier is determined by the relative border prices of exports and imports. Border prices, therefore, determine the opportunity cost of a good and of the resources used to produce it, if the alternative of using a good were to export it. Similarly, scarcity values measure what the good is worth to the economy, which can be calculated from the production possibility frontier (PPF) by the value of the additional exports a good could be turned into. Opportunity costs are equated with scarcity values for production efficiency. Border prices, therefore, represent efficiency prices, and no need for shadow-pricing of inputs or outputs arises.

The above describes fully the conventional textbook approach to international trade where the commodity produced, and exports and imports, are considered a Hicksian composite good of all commodities that enter consumption and trade in the economy.

I learned my economics when economic development was an active, and an activist field. It was also a popular field of economics that provided excitement – and fun – for its practitioners. Part of the excitement came from an agenda that was big. After World War II, economic development became a universal nostrum, an overriding objective of poor and rich nations alike. The new nations, in particular, came to see development as a continuation of the political struggle that brought their independence. In the all-consuming fire for development, new policy tools were forged and governments wielded them, as the case might be, with care or abandon. Import substitution industrialization, to mention just one, was at the heart of development strategy. It was backed by fixed exchange rates, foreign exchange restrictions, and controls on trade. The fun part came because things were happening. For at least 25 years, to the middle of the 1970s, the world experienced an unprecedented spurt of economic growth that was spread to most corners of the earth.

There was a profound development-paradigm shift in the early 1980s. The mainstream view on development became free markets and sound money. In an economic development setting, the ultimate test of sound money is placing the domestic currency in direct competition with other contries' currencies, especially the world's reserve currencies, by liberalization of the foreign exchange market. Again in a development setting, floating exchange rates are a prerequisite for extending the free-market idea to its logical conclusion – across national borders. Free-market, free-trade, laissez-faire is thus relied upon for the optimal allocation of resources. “Setting the prices right” weeds out inefficiency and yields an efficiency dividend for a growing economy.