Ryan McCarty
I.P.E Exam 2
3/24/15
Question 1
During the mid to late 20th century, Import Substitution Industrialization was a
very popular and successful economic trend in various countries across the globe. It
brought fast growth to the economy and gave countries a nationalistic strength that hadn’t
previously experienced. ISI was not sustainable, however, and its various flaws led to its
eventual downfall on a global scale. Some of the issues included severe budgetary
problems and a detrimental trade imbalance. In Frieden’s Global Capitalism, he describes
the growing problems ISI created, “ISI caused chronic problems with the balance of trade
and payments. Import substitution was supposed to reduce reliance on world trade, but
every nation needed to import something not available locally-raw materials, machinery,
spare parts. The more a country industrialized, the more it needed these imports.”
In addition to issues with imports, ISI countries tended to incur extensive inflation
and budget deficits, which made the economic situation worse. Near the end of the 1960s
many ISI countries were forced to try and manage their balance of payments deficits,
inflation, and recession all at once. Many countries that had ISI in Latin America waited
too long before they addressed the massive deficits they were incurring, which became
was one contributing factor in the Latin American Debt Crisis.
Frieden also mentions how ISI also seemed to contribute to high levels of poverty
and unfair income distribution. The bias towards the industrial sector continued to grow
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and poverty worsened in rural agricultural societies. “ISI countries ended up with “dual”
economies: on the one hand, modern, capital-intensive industries with skilled, wellorganized workers earning relatively high wages; on the other, a mass of struggling
farmers and urban poor frozen out of the modern economy, consigned to subsistence
wages, and excluded from the social protections modern-sector workers received.” This
poverty started to cause widespread discontent among large population groups in ISI
countries, causing governments to reconsider their economic policies. The world fell into
a period of deep polarization between the East-West and between capitalism and
socialism.
After the widespread decline of ISI many countries began searching for an
economic alternative. One such policy was “The East Asia Model”. This model was
started in the 1960s in countries like South Korea, Hong Kong and Taiwan. It focused on
an export-oriented economy with some government involvement. This model was very
different from ISI due to the limited role of the state in decision-making and the narrow
focus on exports versus imports. The countries listed above saw periods of incredible
growth, particularly South Korea, which experienced 20 years of uninterrupted economic
development. In Oatley’s International Political Economy, he describes this transition.
“Import substitution generated severe economic imbalances that created pressure for
reform of some type. The success of East Asian countries that adopted an export-oriented
development strategy provided an alternative model for development.”
While some nations saw the post-ISI era of a period of growth, a lot of the
world’s economies found themselves in a very difficult position. Frieden describes this
period, “The world faced difficult times from 1973 until the early 1980s. Growth slowed,
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prices rose, recessions hit, and unemployment grew. Governments accustomed to the
growth and prosperity of the previous thirty years seemed unable to deal with the
downturn and its resulting conflicts.” The 1970s were hindered by high and rising
inflation among developed nations and during the 1980s these nations were able to defeat
inflation but at the cost of budget deficits. Finally, during the 1990s governments were
able to reduced and even eliminate these deficits and global trade and capitalism began to
spread again.
Now we will turn our attention to the Washington Consensus. In the article Fads
and Fashions in Economic Reforms: Washington Consensus or Washington Confusion?
Moises Naim writes, “During the 1990s there was a clear and robust consensus about
what a poor country should do to become prosperous. John Williamson named a list of 10
policy recommendations for countries willing to reform their economies the Washington
Consensus. The general ideas derived from the Washington Consensus had a huge
influence on the economic reforms of many countries.” The ten elements of the
Consensus are: 1. Fiscal Disciple, 2. Reorientation of Public Expenditures, 3. Tax
Reform, 4. Financial Liberalization, 5. Unified and Competitive Exchange Rates, 6.
Trade Liberalization, 7. Openness to FDI, 8. Privatization, 9. Deregulation, 10. Secure
Property Rights.
While this list directly confronted and resolved a lot of the issues in economies
across the globe, there still were areas that needed to be addressed. Naim writes,
“Changes in the international economic and political environment and new domestic
realities in the reforming countries created problems the Consensus did not envision or
encompass, thus forcing the search for new answers.” Some of the items on the “Post
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Washington Consensus” list include: Corporate Governance, Flexible Labor Markets,
WTO Agreements and Targeted Poverty Reduction. One of the major flaws charged
against the original Consensus was that is could lower the overall welfare of poorer
people in developing nations. Some also believed that the Consensus wasn’t in every
nation’s best interest, but an agreement was created that forced any nation who asked the
IMF for funds to implement the principles of the Consensus. Because of this agreement,
the IMF had a lot of power and if a nation came to them for help, they could impose these
ideals on them, which some have labeled as modern day colonization.
The last several decades can be characterized as a time of growing international
trade and FDI and we have seen several developing countries begin to “catch up” some of
the world powers. Frieden describes the end of the 20th century as being “reminiscent of
its beginning, dominated by globe-straddling markets. Trade was nearly twice as
important to national economies as it has been at the turn of the twentieth century.
Foreign investment was immeasurably greater, and global financial markets swamped
national markets. Goods and money moved around the world faster than ever before and
in much greater quantities. The global capitalism of the start of the century had returned.”
As capitalism and global trade has increased, so has the need for international
organizations and regulations. In the past few decades we have seen the creation of the
World Trade Organization and an increase in Regional Trade Agreements to combat the
increase in trade and we have also witnessed the growing importance of the International
Monetary Fund and other central banks.
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Question 2
In order for a corporation to gain multinational status, they must originally be
based in one country and create a new or buy an existing production facility in a foreign
country and extend its managerial functions internationally. This is never an easy process
due to cultural differences and conflicting business practices, but MNCs are a growing
trend and they expose organizations to a variety of benefits. “Multinational corporations
ship capital to where it is scarce, transfer technology and management expertise from one
country to another, and promote the efficient allocation of resources in the global
economy.”
Over the past 20 years, there has been an incredible rise in MNCs around the
world, with their numbers quadrupling to around 82,000 parent firms in the year 2008.
Currently 2/3rds of world trade passes through MNCs, as well as ½ of intra-firm trade.
The question then becomes, what is the economic explanation behind this rapid rise of
these international firms? Oatley writes that “the rapid growth of MNCs implies that an
increasing number of firms have opted to take their international transactions out of the
market and to internalize them within a single corporate structure.” There are a few key
contributing factors that lead corporations to expand internationally, while maintaining a
cohesive corporate structure.
First, we will look into locational advantages, which are specific characteristics
that countries posses that provide opportunities for external corporations. Oatley writes “a
firm based in one country will internationalize its activities in an attempt to profit from
one of these characteristics in a foreign country. National resource investment is a
common example of a locational advantage and can arise from the presence of large
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deposits of a particular natural resource in a foreign country.” This national resource
gathering is common in developing nations and sometimes has led to exploitation and the
unfair treatment of the host countries’ citizens. Another locational advantage that quite
often is sought after in developing nations, is their abundant and quite often, low cost
labor.
The other economic explanation for MNCs is an attempt to deal with market
imperfections. “A market imperfection arises when the price mechanism fails to promote
a welfare-improving transaction.” In a global economy, this means that when firms are
unable to profit from an existing locational advantage they are forced to look for another
other forms of internalization. The first alternative is horizontal integration. “This occurs
when a firm creates multiple production facilities, each of which produces the same
goods.” Automotive production is a good example of this type of integration. We have
seen an increase of multiple auto producers that have production facilities all around the
world that create the same line of automobiles for consumers all around the world.
Conversely, “vertical integration refers to instances in which firms internalize their
transactions for intermediate goods.” The American oil industry is a good example of this
type of integration. Oil producers made it so that they owned the oil wells, pipelines,
refineries and every other element in the oil production process. This ensured every step
of the production was contained under a single corporate structure.
An additional reason that corporations with international operations quite often
create their own facilities abroad is the issue of quality. Corporations are faced with the
choice to either create international operations or to contract out the work. While
contracting may be cheaper, by having their own international facilities, MNCs can
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ensure that all of their managerial functions are being executed properly and that their
products are meeting the quality they demand.
One unique quality that MNCs currently posses, is that there is little to no
international regulation or oversight to monitor their activities. Oatley states, “There are
no comprehensive international rules governing the activities of MNCs. The conflict
between the capital-exporting advanced industrialized countries and the capital-importing
developing countries has prevented agreement on such rules.”
Now when examining FDI levels and directional flow, its important to first
understand what FDI is. Oatley writes, “Foreign direct investment occurs when a firm
based in one country builds a new plant or a factory, or purchases an existing one, in a
second country.” As world trade liberalized and multinational corporations grew in
popularity, foreign direct investment increased exponentially. “As a group, the
developing world saw its share of FDI inflows rise from one-quarter to almost one-half of
total world investment between 1980 and 1997, totaling about $190 billion. Over the next
decade, the absolute increase was even larger. By 2008, FDI inflows to the developing
world totaled over $620 billion.” Based off of these numbers, it is clear that FDI is
rapidly gaining popularity as a means of investment, but it is important to understand
why this has occurred. Latin America over the past 20 years is a prime example of what
causes FDI flows.
In the article The Political Economy of FDI in Latin America 1986–2006: A
Sector-Specific Approach, Hecock and Jepsen discuss the various methods nations
employ in order to attract FDI. The three core sectors of the economy that are used are
the primary, secondary, and tertiary. The article states, “The primary sector refers to the
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extraction of raw materials and production of basic foods. All types of agriculture fall
within this category, as well as mining and forestry. The secondary sector consists of the
manufacturing of finished goods. And finally, the tertiary sector comprises all types of
services.”
The article states that along with the 3 economic sectors mentioned above, there
are two main theoretical variable that have been used in regards to FDI flows: democracy
and economic liberalization. First, when examining democracy, some researches in
Jepsen and Hecock’s article found a correlational between levels of democracy and FDI
flows, while also highlighting that authoritarian regimes can be an attractive investment.
The article continues by highlighting these differences in ideology, “Democracies, much
more than authoritarian governments, ensure consistency and reliability through nonradical policy change due to checks and balances, “audience costs” for elected leaders
(the need to maintain a good reputation), and an array of possible veto points.”
Economic liberalization is the other variable used in garnering FDI flow and the
article outlines five key economic reforms that are attractive to FDI: financial
liberalization, domestic capital market liberalization, tax reform, tariff reform, and
privatization. All five of these steps have their own benefits. Financial liberalization will
lead to the greater availability of credit, capital account liberalization causes firms to be
more likely to invest because of fewer rules limiting divestment, tax reform will make a
nation more attractive to investors as they prefer lower costs to higher ones, tariff reform
is attractive because firms that operate in numerous countries want to minimize their
exposure to tariffs on intra-firm trade across borders, and lastly, privatization should have
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a positive impact on FDI because investors may be interested in purchasing domestic
firms that are being privatized.
On a side note, similar to MNCs, FDI creates a dilemma for host countries. “On the
one hand, FDI has the potential to make a positive contribution to the host country’s
economic welfare by providing resources that are not readily available elsewhere. On the
other hand, because MNC affiliates are managed by decision makers based in foreign
countries, there is no guarantee that FDI will in fact make such a contribution.”
Question 3
The Bretton Woods system served as an effective international monetary structure
for nearly 3 decades, but it wasn’t sustainable for a variety of reasons. First, it is
important to understand what this global summit entailed. The Bretton Woods monetary
system arose from a multilateral conference attended by 44 countries and over 1,000
people in Bretton Woods, New Hampshire in 1944. This system provided a clear set of
guidelines for international monetary relations and an institutional structure centered on
the IMF. The nations that were apart of this agreement sought greater exchange rate
flexibility, capital controls, and a stabilization fund in which everyone contributed to
based off of their financial power. The International Monetary Fund (IMF) also arose
from this meeting, which additionally added more rules and regulation to the
international economic community. The United States and the power of the dollar played
an integral role in the success and eventual failure of the Bretton Woods system.
Bretton Woods failed for a variety of reasons: the system was undermined by the
dollars overhang, there were speculative attacks that forced governments to abandon
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fixed exchange rates, a crisis of confidence occurred and the large U.S balance of
payments deficits undermined the system’s ability to operate. All of the factors listed
were detrimental to Bretton Woods, but the U.S balance of payments deficit was
particularly costly due to the important economic and monetary responsibility the U.S
held.
Oatley summarizes the Bretton Woods situation: “the creation and collapse of the
Bretton Woods system highlights two central conclusions about the workings of the
international monetary system. First, even though governments would like to maintain
like stable exchange rates and simultaneously preserve their domestic economic
autonomy, no one has yet found a way to do so. Second, when forced to choose between
a fixed exchange rate and domestic economic autonomy, governments have opted for
domestic economic autonomy.”
An exchange rate is the value of one currency against another. Oatley writes, “A
currency’s exchange rate is determined by the interaction between the supply of and the
demand for currencies in the foreign exchange market or the market in which the worlds
currencies are traded.” The two standard systems for exchanging currency are the fixed
exchange-rate system and the floating exchange-rate system. “In a fixed exchange rate
system, governments establish a fixed price for their currencies in terms of external
standards, such as gold or another country’s currency. The government then maintains
this fixed price by buying and selling currencies in the foreign exchange market. In a
floating exchange-rate system there are no limits on how much a currency can move in
the foreign exchange market. Governments do not maintain a fixed price for their
currencies against gold or any other standard.”
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When considering the key differences between the society and state-centered
approaches to monetary policies, it is first necessary to examine each policy individually.
First is the society-centered approach. “The society-centered approach argues that
governments’ monetary and exchange-rate policies are shaped by politicians’ responses
to interest-group demands.” States that function in a society-centered system are exposed
to a myriad of public pressures-from voters, classes, and industry driven interest groups.
These pressures reach the government in a variety of ways, including mass elections,
class-centered party systems, and interest-group lobbying.
Next is the state-centered approach. “The state-centered approach is based on
economic theories that have replaced Keynesian models and assume that governments
face a stable trade-off between inflation and unemployment.” One key theory of this
approach is the natural rate of unemployment, which asserts that unemployment will
return to its natural rate after an economic recession or boom.
Now when looking at the differences in the two approaches and the debate
surrounding central banks and their independence, there are a few key points from both
sides. First a benefit for the society-centered approach is that by allowing a variety of
external pressures to impact monetary and exchange-rate policy, these policies may better
represent individual welfare and limit the power government has over such policies.
Society better than government understands what policies will benefit the people.
Conversely, a benefit of the state-centered approach is that “this approach to
monetary and exchange rate policies argues for the social welfare enhancing role of
independent central banks. By taking monetary policy out of politics and placing it in the
hands of officials tightly insulated form the push and pull of politics, society enjoys lower
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inflation and better overall economic performance than it would enjoy if governments
retained control of monetary policy.”
A few key flaws in the society-centered approach include lacking the ability to
explain outcomes, omitting the interests of noneconomic groups and the previously
mentioned pressures that could arise from a variety of external sources. The statecentered approach isn’t without its own flaws. The two key criticisms are that this
approach doesn’t account for the factors that could motivate elected officials when
creating an independent central bank and that it fails to explain how monetary officials in
charge of the independent banks will behave.
The term independent central bank played an important role in the society vs.
state conversation and the next step is to understand the key points of the central bank
independence debate. There has been a lot of international movement towards central
bank independence over the past couple decades and there are some clear advantages to
taking this step. Oatley outlines the situation, “Politically independent central banks can
pursue monetary and exchange-rate policies free from interest-groups pressures and from
partisan and electoral policies. In fact, over the last 15 years more and more governments
have granted their central banks greater independence, hoping to insulate monetary policy
from social and, more broadly, political pressures.”
Expanding upon this last point, if there is any incentive for interest groups to
pressure the government or the central bank to adopt particular monetary policy, they will
exploit it. By having a central bank that is independent, it may be insulated from political
pressures and outside influence. This argument isn’t perfect however, it is important to
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note that even if the central bank runs independently, it is still run by individuals with
there own motives.
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