THE JOURNAL OF ECONOMIC HISTORY

VOLUME 58 MARCH 1998 NUMBER 1

On the Costs of Inward-Looking

Development: Price Distortions, Growth,
and Divergence in Latin America
ALAN M. TAYLOR

From the 1930s to the 1980s, economic policies in Latin America epitomized the
inward-looking model of development. The model emerged in the Depression, and
was later codified in unorthodox economic theories. Even though economic per-
formance was seen as disappointing by the 1960s, the distortions persisted and
worsened into the 1970s and 1980s. This article examines the costs of distortions and
explores the structural differences between growth dynamics in Latin America and
elsewhere. Distortions had profound effects on many aspects of the growth process,
help explain divergent development, and raise important questions about economic
growth and the evolution of institutions.

T he mechanisms of economic development and long-run growth have

always been of central concern to economic historians and development
economists, and are now even the subject of a subfield of economic growth
that has come to the fore in recent years. Economic welfare in the long run
has also been an essential focus of the Latin American historiography, and
slow growth and relative retardation have been seen as having important
implications for institutional, social, and political developments in the
region. This article attempts a synthesis, and addresses two questions. How
can the field of Latin American history learn from new quantitative
approaches to the analysis of economic growth? And, conversely, how can
an examination of the historical, political, and institutional record provide
a deeper understanding of the development process than quantitative eco-
nomic methods alone?
A review of current approaches to economic growth is beyond the scope

The Journal of Economic History, Vol. 58, No. 1 (Mar. 1998). © The Economic History
Association. All rights reserved. ISSN 0022-0507.
Alan M. Taylor is Assistant Professor, Department of Economics, Northwestern University, 2003
Sheridan Road, Evanston, IL 60208-2600, a Faculty Research Fellow at the National Bureau of
Economic Research, and a National Fellow at the Hoover Institution, Stanford University, in 1997/98.
I thank Andrew Warner for sharing his data and for helpful discussions. I acknowledge the useful
comments of Nick Crafts, Steve Dowrick, Cynthia Taft Morris, the editors of this journal, two anony-
mous referees, and audiences at the Economic History Association Annual Meetings, the University
of Warwick, the University of Illinois at Urbana-Champaign, and Washington University in St. Louis.
I am solely responsible for all errors.

1
2 Taylor

of this article. However, the key concepts will be familiar enough to eco-
nomic historians from the seminal works of Alexander Gerschenkron, Si-
mon Kuznets, and Moses Abramovitz.1 In their works, factor accumulation
was at center stage as a source of growth, and capital deepening through
investment was a prime source of increases in income per capita. This dura-
ble insight found theoretical representation in the models of Frank Ramsey
and Robert Solow, and it remains the basis for the essential textbook neo-
classical approach of today, even as augmented to include both physical and
human capital. Despite its simplicity, its defenders claim that—in its mod-
ern, augmented form—the classic approach seems empirically just as cap-
able of explaining postwar economic growth as any of the "new growth
theories" based on externalities, increasing returns, or imperfect competi-
tion.2
This article's approach to explaining Latin America's slow economic
growth will be in the classic tradition of Kuznets and Abramovitz, and will
claim to identify obstacles to accumulation (and primarily physical capital
accumulation) as the main culprit. Of course, growth is not monocausal. The
claim is merely that the variation in cross-section postwar growth perfor-
mance (that is, across countries) can be attributed primarily to accumulation
differences. In contrast, other sources of growth do not seem to correlate so
well with success and failure. The main contender here would be technologi-
cal change, a source of growth omitted (or left exogenous and unexplained)
in the neoclassical model, though highlighted by Abramovitz, and associated
with Gerschenkron's notion of the "advantages of backwardness." Yet re-
cent empirical accounting studies cast doubt on the idea that cross-section
differences in technological progress (expressed in the Solow residual, or
total factor productivity, TFP) could explain some important differences in
growth outcomes in the postwar era.3 Beyond growth accounting, the role
of accumulation and capital deepening as a principal and robust explanator
of cross-sectional differences in postwar economic growth has received
overwhelming support from the multitude of econometric studies of growth.4
One aim of this article is to place our understanding of Latin American
political, institutional, and historical experience in such an economic con-
text, it being essential to note that much of the dismal growth performance
'Abramovitz, "Catching Up" and "Resource and Output Trends"; Gerschenkron, Economic Back-
wardness; and Kuznets, Economic Growth and Income and Wealth.
2
Dowrick and Nguyen, "OECD"; Barro and Sala-i-Martin, Economic Growth; Mankiw, Romer, and
Weil, "Contribution"; and Solow, "Contribution."
'The striking findings of Alwyn Young overturned the idea that the "East Asian miracle" was due
to spectacular productivity catch-up in the fast-growing East Asian economies: rather, growth was
almost wholly attributable to factor accumulation and capital deepening; they invested very heavily
indeed; the residual TFP growth was small, and much less than TFP growth in the developed countries.
Krugman, "Myth"; and Young, "Tyranny."
"Levine and Renelt, "Sensitivity Analysis."
 On the Costs of Inward-Looking Development 3

of the region was due to the absence of favorable accumulation trends. Thus,
another point is to disentangle these accumulation patterns with a new struc-
tural approach to growth econometrics, one that allows us to see how Latin
America's failure to achieve rapid capital deepening was attributable to an
array of economic distortions deriving from unfortunate policy choices. That
is, we can indeed provide some sense of how costly inward-looking devel-
opment policies were, asking how distortions affected accumulation and,
hence, growth. The empirical results force us to ask how such institutional
choices in Latin America, if so inefficient, came into being and persisted for
so long. These issues are at the heart of recent debates on politics,
(inefficient institutions, and economic growth, as seen in the works of Gary
Becker, Sam Peltzman, Douglass North, Oliver Williamson, Donald Witt-
man, and others.5 There are few better laboratories for the study of ineffi-
cient institutions than postwar Latin America.

HISTORY
Inward-Looking Development: Origins, 1930 to 1950
As noted by Carlos Diaz Alejandro, the Great Depression still stands as
the watershed in the economic history of modern Latin America:
Latin American development experienced a turning-point during the 1930s. The
contrast between 'before and after 1929' may often be exaggerated, but there is little
doubt that the decade witnessed a closing toward international trade and finance, and
a relative upsurge of import-substituting activities, primarily but not exclusively in
manufacturing.... Memories of the 1930s have profoundly influenced the region's
attitude toward international trade and finance; per capita foreign trade indicators
reached by the late 1920s were not surpassed in many nations until the 1960s.6

Since the colonial period, according to the standard view, the region had
clung to export-orientation and the policies of openness and macroeconomic
orthodoxy it required. The policy orientation had held firm even through the
comings and goings of the gold standard, a disruptive war, and the trade and
capital-market volatility which beset small open economies, many of them
poorly diversified and subject to the vicissitudes of the commodity lottery.
The thumbnail sketch blurs the details, of course. The pre-1929 export-led
growth was not an unqualified success. The region could not hold on to a
claim for the highest per capita incomes in the world, as it might have in the
colonial period pre-1700 before industrialization enriched the core.7 How-

5
Becker, "Theory"; North, Institutions and Structure; Peltzman, "Toward"; Williamson, Mechan-
isms; and Wittman, "Why Democracies."
6
Diaz Alejandro, "Latin America," p. 17.
'One source places Latin American income per capita at S245 (1960 prices) in 1800, just above that
of North America's S239. Bairoch and Levy-Leboyer, Disparities, cited in Bulmer-Thomas, "Eco-
nomic History," p. 27.
4 Taylor

ever, Latin America was still relatively rich by the standards of the periph-
ery, countries which, in the international division of labor, had chosen to
trade with the core rather than imitate it.8
Heterogeneity of individual country experience intrudes after 1929 as
well.9 Diaz Alejandro highlighted a key dimension along which policies dif-
fered: larger countries and those with more autonomous public sectors en-
gaged in "reactive" policy responses (for example, Argentina, Brazil, Uru-
guay), whereas smaller countries and those with dependent governments
were more "passive" (for example, Cuba, Honduras, and Caribbean
colonies).10
On the foreign exchanges the "reactive" countries pursued aggressive
devaluation strategies, with widespread use of multiple-exchange-rate sys-
tems to discourage imports by twisting relative prices. Restoration of parity
was given only lip service. Only the "passive" countries fought to maintain
their pegs." Exchange controls were needed to maintain external equilib-
rium because genuinely floating currencies were rare.12 These competitive
devaluations were typical of policy response elsewhere in the world, and
worked with some success, winning respectability for the unorthodox mone-
tary experiments.13 Fiscal experimentation was limited, in part a con-
sequence of limited tax bases, but some aggressive public works programs
rounded out the aggregate demand management.14
It was through trade and commodity markets that the first shocks hit, with
sharp exogenous declines in the terms of trade in the period from 1929 to
1933 for most countries.15 Trade volumes collapsed. With a shift to import-
competing activity seen as an inevitable long-term result of price changes,
the process was ushered along, not only by devaluations, but by price
distortions in trade policy, with tariffs and quantitative restrictions both in
use. In capital markets, little new foreign borrowing came in after 1930 and
debt burdens grew large as real interest rates climbed during deflation. Crisis
drew scarce domestic resources away from debt servicing and defaults
ensued.16 Recovery was built around import-substituting industrialization
(ISI), home demand, and export growth, though the first usually garners the
8
Lewis, Evolution. John Coatsworth ascribes this slow pattern of growth and modernization to
natural and institutional barriers that persisted until late into the nineteenth century, a pattern reminis-
cent of the southern European periphery. Coatsworth, "Economic Retardation."
'Undeniably, the simple description is surely correct in pointing to the enormous 'before and after
1929' contrast on the policy dimension, and to the dramatic relative retardation of the region ever since.
Maddison, World Economy.
l0
Diaz Alejandro, "Latin America," p. 18.
"Ibid., pp. 23-25.
l2
Bulmer-Thomas, "Economic History," p. 204.
l3
Campa, "Exchange Rates"; and Eichengreen and Sachs, "Exchange Rates."
l4
Diaz Alejandro, "Latin America," pp. 29-36.
l5
Ibid.,p. 19.
16
Ibid., pp. 20-21,27-28.
 On the Costs of Inward-Looking Development
TABLE 1
LATIN AMERICA'S DECLINING SHARE OF WORLD EXPORTS (percentages)
Latin Major Other
Year America Countries Countries Argentina Brazil
1946 13.5 8.9 4.6 3.4 2.9
1948 12.1 7.3 4.8 3.0 2.2
1950 10.7 6.7 4.0 2.0 2.3
1955 8.9 4.9 4.0 1.1 1.6
1960 7.0 3.5 3.5 0.9 1.1
1965 6.2 3.2 3.0 0.9 0.9
1970 5.1 2.8 2.3 0.6 0.9
1975 4.4 2.2 2.2 0.4 1.1
Source: See Bulmer-Thomas, Economic History, p. 271.
most attention.17
The 1930s rebound was more rapid than elsewhere, encouraging contin-
ued use of the same instruments. Enforced autarky through World War II did
nothing to dislodge the new policy regime, but rather appeared to augment
its reputation: indeed, even in the words of one of ISI's critics, the 1940s
were the "golden age of import-substituting industrialization in Latin
America."18 Thus, the 1950 structure of the Latin American economies
differed markedly from that of 1929. The policy response to external shocks
had created a new self-sufficient posture for the region, most notably in the
reactive Southern Cone: retreat from the global economy was rapid, and
persisted long into the future, as Latin America's share of trade began a
long-run secular decline (Table I).19

Inward-Looking Development: Codification, 1950 to 1970

The new policies did not come as a result of new economic theory, but
rather the force of circumstance in extreme economic crisis. This was to
change, however: starting in the 1950s the unorthodox policy experiments
that had softened the blow of the depression and the war had been clothed
with the trappings of a new economic theory, propounded now as a "model"
of economic development by new schools of thought.
In 1949 Raul Prebisch joined CEPAL (the United Nations Economic
Commission for Latin America). Prebisch's personal experience as an
economist—his faith in free trade shattered by the events of the 1930s—
mirrored the historical experience and political realities that gave the
inward-looking model its force, credibility, and influence. Under his intel-
lectual leadership, CEPAL became the home and champion of the Struc-
turalist school of economic thought, closely aligned with the ideology of the
dependency school and scholars such as Hans Singer, Ragnar Nurkse, and
"Bulmer-Thomas, "Economic History," p. 212.
l8
Diaz Alejandro, "1940s," p. 341.
"The Southern Cone includes Argentina, Brazil, Chile, Paraguay, and Uruguay.
6 Taylor

Paul Rosenstein-Rodan.20
The Prebisch-Singer thesis centered on the alleged properties of unequal
exchange embedded in the international economic system and perpetuated
by economic orthodoxy. Its principal manifestation was thought to be in
trade: hence "elasticity pessimism," a belief in an inexorable tendency for
the terms-of-trade to turn against the "periphery" (poor countries, commod-
ity exporters), favoring the "center" (rich countries, exporters of manufac-
tures). To break the "center-periphery" system called for economic unortho-
doxy in the form of autarkic responses: delinking, protectionism, and trade
and capital controls.
To this end, ISI was the strategy of choice for postwar Latin America. Un-
orthodox monetary policies such as exchange controls and multiple ex-
change rate schemes, tolerated in depression and war, were discouraged by
international pressure in the Bretton Woods era, and declined in prominence.
The tariff emerged as the most important policy instrument. Tariffs averag-
ing over 100 percent were the norm by the end of the 1950s.21 Moreover, the
Structuralist school favored micromanagement, regulatory apparatuses, and
a variegated nominal protection structure, which allowed differential protec-
tion and further relative price twists as between intermediates inputs and the
final goods, that is, even higher effective rates of protection, such as Brazil's
1966 nominal 154 percent tariff on consumer durables that was effectively
285 percent.22
The distortions were "legendary" if judged by endurance. The measures
of distortions used for empirical purposes in this article are consistent with
the descriptions of distortions that emerged in the 1950s and 1960s. Table
2 shows measures of black-market premia, the relative price of capital, and
the rate of devaluation for the Latin America sample and other subsamples
used later.23
What do these distortion measures reveal? Perhaps surprisingly, at this
stage, the alternating attempts at promoting and reforming the ISI approach
in Latin America resulted in distortions little different from those in the
Asia-Pacific group. The Southern Cone had moderately higher distortions,
^Prebisch, "Five Stages"; ECLA, Economic Development and Economic Survey; Nurkse, Patterns;
Rosenstein-Rodan, "Problems"; and Singer, "Division."
21
See Bulmer-Thomas, "Economic History," pp. 278-81.
22
For this and other examples see Edwards, "Openness," p. 1363.
23
Some explanation of these variables is required. The black-market premium measures the diver-
gence between official (fixed) exchange rates and rates on unofficial (black) markets, and measures dis-
tortions in the foreign exchange market due to currency and capital controls, exchange rationing, and
other regulations and restrictions. The relative price ofcapital is the ratio of the local to the internation-
al price of investment goods, and measures distortions due to a lack of arbitrage between local and
world markets, arising from tariffs, quotas, exchange controls, rationing, or other policies. The rate of
depreciation is simply the rate at which the domestic currency depreciates (relative to the U.S. dollar)
and is closely related to monetary expansion and domestic inflation, and reflects distortions in financial
markets, especially when prices grow at high or hyperinflationary rates.
 On the Costs of Inward-Looking Development 7
TABLE 2
DISTORTIONS IN LATIN AMERICA, 1960-1970
(Annual averages from cross-section dam)
Black Market Price of Capital Depreciation
All 0.17 0.41 0.03
Latin America 0.12 0.25 0.07
Southern Cone 0.16 0.39 0.21
Asia-Pacific 0.08 0.21 0.08
NIC4 0.10 0.25 0.04
Notes: Black Market: black-market premium on the exchange rate; Price of Capital: relative price of
capital goods; Depreciation: rate of depreciation of the currency. Southern Cone: Argentina, Brazil,
Chile, Paraguay, and Uruguay. NIC4: South Korea, Taiwan, Hong Kong, and Singapore.
Sources: See the text and Appendix 2.
as expected, but (judging from this data) the periodic attempts in the region
to foster export promotion and increased openness were not a total failure,
creating some genuine hopes for improved economic performance.24 This
era of moderate distortions and an attempt to turn away from the inward-
looking model appears as a brief hiatus, a lost opportunity.

Inward-Looking Development: Persistence, 1970 to 1990

For many countries, despite an early realization that ISI was unsustain-
able, the autarkic stance was hard to break. And the region must still grapple
with the implications today. Though the ideological grip of the old ISI has
been thoroughly broken, "the economic structure in place today contains
vestiges of this attempt to achieve industrial self-sufficiency. Factories con-
structed under ISI continue to operate today, and policies from this era
remained intact well into the 1980s despite disillusionment with them. As
antecedents to current economic problems in the region, ISI policies have
had a profound effect."25
ISI was losing credibility. The critique: distortions hurt growth, causing
the region to retard and diverge. This claim need not be merely conjectural.
The distortions persisted into the 1970s and 1980s, and, given the richer data
sources developed for these decades, the empirical content of the critique
can be assessed and the costs of inward-looking development can be
weighed.
The summary data on distortions for the period are shown in Table 3,
including now a fourth distortion, a measure of average tariff. This measure
is a direct estimate of tariff levels, weighted by import levels, and is a proxy
for commercial-policy distortions in domestic goods markets. A Latin versus
Asian divergence in openness emerged between the 1960s and the 1980s
(compare Table 2). It is here that Latin American growth prospects were

24
Diaz Alejandro, "Some Characteristics."
"Cardoso and Helwege, Latin America's Economy, p. 84.
8 Taylor
TABLE 3
DISTORTIONS AND GROWTH IN LATIN AMERICA, 1970-1990
(Annual averages from cross-section data)
(a) Distortions (b) Growth

Latin Latin
America America
Black Price of rank rank
Market Tariff Capital Depreciation (avg. of 4) Growth (inverse)
All 0.27 0.17 0.44 0.10 0.014
Latin America 0.26 0.22 0.27 0.37 0.005
Southern Cone 0.32 0.27 0.19 0.60 0.010
Asia-Pacific 0.06 0.13 0.23 0.02 0.034
NIC4 0.03 0.06 0.14 0.00 0.065
Southern Cone 0.32 0.27 0.19 0.60 0.010
Argentina 0.33' 0.29' 0.34' 1.16' 1 -0.009 4
Paraguay 0.29' 0.46" 0.46" 0.11 4 0.021 15
Chile 0.52' 0.21* 0.04 0.51' 5 0.009 12
Brazil 0.29' 0.16 0.09 0.83* 8 0.025 18
Uruguay 0.14 0.21* 0.04 0.41' 12 0.006 10.
Others 0.24 0.19 0.30 0.28 0.003
Nicaragua 0.62* 0.15 0.48" 0.90* 2 -0.030 1
Peru 0.26 0.41' 0.25 0.77' 3 -0.011 3
El Salvador 0.56' 0.13 0.68* 0.06 6 0.000 6
Bolivia 0.32' 0.13 0.26* 0.62' 7 -0.000 5
Venezuela 0.33* 0.18* 0.21 0.12 9 -0.012 2
Costa Rica 0.18 0.16 0.33* 0.13 10 0.009 13
Colombia 0.08 0.31* 0.21 0.17 11 0.022 17
Ecuador 0.18 0.28* -0.08 0.18 12 0.022 16
Guatemala 0.14 0.08 0.51* 0.08 14 0.002 7
Mexico 0.10 0.08 0.22 0.27* 15 0.019 14
Honduras 0.14 — 0.36* 0.04 — 0.005 9
Panama 0.00 - 0.12 0.00 - 0.006 11
" denotes top eight within Latin America in each category.
Notes: Growth: growth rate of per capita GDP; Black Market: black-market premium on the exchange
rate; Tariff: own-weight tariff incidence; Price of Capital: relative price of capital goods; Depreciation:
rate of depreciation of the currency. Southern Cone: Argentina, Brazil, Chile, Paraguay, and Uruguay;
N1C4: South Korea, Taiwan, Hong Kong, and Singapore.
Sources: See the text and Appendix 2.

compromised; at earlier dates a policy contrast was harder to spot. This idea
is echoed in the more subjective indices of trade policy: Korea, for example,
often scores low on openness for the 1960s, whereas Brazil and Chile can
sometimes rank quite high by the same criteria.26
Table 3 allows a cursory comparison of distortions and growth perfor-
mance in various subsamples. Look at the columns labeled "distortions."
The "most virtuous" Newly Industrializing Countries (NIC4) group of four
had, on average, relatively low black-market premia (6 percent), low tariffs
(6 percent), small capital price distortions (14 percent), and exchange rate

6
See, for example, the discussion in Edwards, "Openness," pp. 1386-07.
 On the Costs of Inward-Looking Development 9

stability (the rate of depreciation is zero).21 The larger Asia-Pacific sample

is not far behind, and better than the world average. Latin America is the
other side of the stoiy—relatively high black-market premia (26 percent),
tariffs (22 percent), capital price distortions (27 percent), and rates of depre-
ciation (37 percent per annum). The Southern Cone ranks worse, excepting
capital prices. Outside the Cone, some smaller and previously export-led
economies rose high in the distortion rankings (for example, Peru, Bolivia).
Within the Cone every country ranks above the Latin median level of distor-
tions on at least two criteria out of four. Argentina is above the median on
every count, ranks first on average distortion levels, and is, so to speak, the
canonical Conical.
Turn to the columns labeled "growth." Argentina ranks low, with negative
growth rates. Between Latin America and the Asia-Pacific group, the
contrasts are stark: the NICs grew at 6.5 percent per annum and the Asia-
Pacific group as a whole at 3.4 percent per annum. All of the Latins sit in the
Sachs-Warner nonqualifying group (they all fail on openness), a subset that
grew at 0.6 percent per annum on average, five times slower than the quali-
fiers' 3.2 percent per annum. Why was this so? How costly was the inward-
looking development path?28

EMPIRICS
Why was Latin American growth so slow? Sebastian Edwards succinctly
summarized the paradigm shift in the last decade, a transformation built on
the accumulated findings of years of empirical research: that inward-looking
development strategies were costly for growth: the distortions they engen-
dered in the economic system compromised economic efficiency both stati-
cally and dynamically; those counties that avoided such pitfalls stood to
benefit from allocative efficiency and fast growth; those that did not risked
short-run dead-weight losses and long-run retardation and divergence rela-
tive to rich and fast-growing economies. Yet the evidence, even the techni-
cally adept, late-vintage findings from the "new" growth empirics, was, as
Edwards noted in conclusion, still fragmentary, fragile, and in need of fur-
ther attention: an important challenge for researchers was to obtain more
reliable measures of openness and to "investigate in greater detail the chan-
nels through which greater outward orientation affects growth."29 Two is-
sues raised previously deserve emphasis.
First, how can we measure "openness" in the broadest sense? There is a
27
The NIC4 group includes South Korea, Taiwan, Hong Kong, and Singapore.
^For an analysis of Argentina, see Taylor, "Tres fases." Several authors have examined the roles of
distortions in economic growth, often with reference to Latin America: see Agarwala, "Price
Distortions"; Barro, "Economic Growth"; Brander and Dowrick, "Role"; De Gregorio, "Economic
Growth"; Easterly, "How Much Do?"; Edwards, "Trade Orientation"; and Jones, "Economic Growth."
"Edwards, "Openness," pp. 1359,1390.
 10 Taylor

case for using both price and quantity criteria, the former being preferred.30
Further, we might also profitably examine openness in capital markets and
financial markets, including relative prices, exchange-rate stability, and
black-market currency activity.
Second, aside from a correlation of openness and growth, can we say
anything about the channels or mechanisms that might underlie this seeming
empirical regularity? Appendix 1 discusses the theoretical basis for the
reduced-form modeling approach so central to growth empirics at present,
only to then discard it in favor of structural modeling—an approach that at
least promises a description of the channels, mechanisms, and processes
whereby distortions affect growth. The results accord well with theory and
are applied to examine the relationship between openness and growth, with
special reference to Latin America.
The empirical work thus extends the current economic history literature
in a couple of directions. First, formal, quantitative, historical studies of
postwar Latin American economic development are few.31 To my knowl-
edge, no previous study exploits the type of detailed structural models em-
ployed here. The econometric results here do help us better understand the
multiple causes of Latin American underdevelopment by focusing on the
underlying mechanics of economic behavior. Secondly, these channels are
easily related to the previous discussion of the institutional history of Latin
America since the 1930s. One of the major new directions of economic
history has been to integrate institutional development and economic perfor-
mance, as suggested by Douglass North and his followers.32 Such a research
agenda requires us to measure institutional differences within or across
economies. The more microeconomic focus of the econometric analysis
allows us to pinpoint certain aspects of the political economy of Latin Amer-
ican development as it affected prices, both in levels and volatility, by look-
ing at exchange rates, black-market prices, tariffs, and capital prices, and
thus to trace out the implications for factor accumulation, and ultimately
growth.33
30
Edwards rightly points to the futility of using trade to GDP ratios as an index of openness, because
trade flows depend on endowments and the economic structure of the economy. Still the use of this
openness measure is commonly seen in the empirical literature. A thought experiment suffices to
dismiss this approach: suppose two identical autarkic Heckscher-Ohlin economies stand adjacent but
separated by an infinitely high wall; the wall falls down, and they then open to trade, becoming one
market; their autarky prices would be identical, equal to the free-trade prices, and no trade would result.
Edwards likewise considered inadequate the subjective measures of openness constructed by the World
Bank and others; the preferred approach was a direct measurement of price distortions, the method
followed here. Edwards, "Openness," pp. 1386-88, 1390.
31
An exception would be the work of Elias, Sources.
32
North, Institutions.
33
In this paper 1 present a selected set of results, due to space constraints. The reader may see the full
set of results, with attention to their robustness to various specifications, in the original working paper
version of this paper, Taylor, "On the Costs."
 On the Costs of Inward-Looking Development 11
TABLE 4
GROWTH DETERMINANTS: REDUCED FORM ESTIMATION
(Regression number 1: Dependent variable, GROWTH)
ANOVA
Variable Coefficient f-statistic Sums of Squares
N 250
R2 0.31
SEE 0.0279
Constant 0.2147 (4.56) 0.0598
INITIAL INCOME -0.0156 (3.69) 0.0106
INITIAL SCHOOLING 0.0001 (0.11) 0.0000
YOUNG -0.0906 (1.55) 0.0019
OLD -0.1455 (1.20) 0.0011
POLITICS -0.0033 (0.66) 0.0003
BLACK MARKET -0.0213 (4.22) 0.0139
TARIFF -0.0063 (0.57) 0.0003
GOVERNMENT -0.0009 (3.01) 0.0070
PRICE OF CAPITAL -0.0214 (3.56) 0.0099
DEPRECIATION -0.0332 (3.89) 0.0118
FINANCIAL DEPTH 0.0035 (0.40) 0.0001
NATURAL RESOURCES -0.0129 (0.78) 0.0005
Residual 0.1847
Total 0.2686
Sources: See the text and Appendix 2.

Growth determinants and conditional convergence: Reduced-form

estimation
The analysis begins by introducing policy variables into a full reduced-
form estimation, as shown in Table 4, regression 1 for the full sample of
countries in the pooled data.34 The data are discussed in Appendix 2, and use
five-year periods for 1970 through 1989 for a cross section of countries. The
dependent variable is the rate of per capita income growth. The independent
variables are the policy variables introduced thus far (measures of dis-
tortions—black-market premium, relative price of capital, rate of deprecia-
tion, average tariffs—all expected to discourage growth), plus other conven-
tional controls.35
The results are striking. All variables are signed correctly. Still, only a
^Estimation is by OLS.
35
The controls are: log initial income level (a "catch-up" control—which may reflect productivity
or factor convergence), initial human capital endowments (primary and secondary years of school-
ing—expected to promote growth); demographic structure (youth and age dependency mea-
sures—expected to slow growth); government size (a measure of fiscal distortions, the size of govern-
ment spending as a share of GDP—expected to slow growth); financial development (proxied by the
King-Levine measure of the ratio of liquid liabilities in the financial system to GDP—expected to
promote growth); political problems (a political "non qualifier" according to the Sachs-Warner classifi-
cation, a dummy variable that is one for regimes with poor political and civil rights or political
instability—expected to be bad for growth); and a high dependence on natural resources (the natural
resource share of export values, expected to be potentially bad for growth as in the "Dutch disease"
model).
 12 Taylor

few appear significant. The catch-up term matters: conditional convergence

operates at about 1.6 percent per annum. Of all the other controls, only the
set of distortion measures matter in a significant way (though, of those,
tariffs have minimal import). This characterization is true in terms of statisti-
cal significance and in terms of the more important quantitative significance
revealed by the ANOVA sums of squares.36

Growth determinants and conditional convergence: Structural estimation

Thus, taken at face value, the results offer little support for claims that a
principal trade distortion like tariffs retards growth, or that financial devel-
opment enhances growth, or that resource endowments may lead to dynamic
comparative disadvantage. Such a perspective is flawed: in many ways, the
reduced form regression 1 gets us only marginally closer to an answer to the
problem of "why growth rates differ": for although it suggests that distor-
tions matter, we want to know how they matter. That is a structural ques-
tion—it asks how the environmental and state variables affect evolution:
how the behavioral equations shift in response to perturbation. How does
environment affect accumulation, investment, and population growth? Are
the exogeneity assumptions justified in estimating the reduced-form model?
First, Table 5, regression 2, presents a structural growth regression,
which naively estimates a growth equation (a differenced production func-
tion) for physical capital inputs (the rate of investment as a fraction of
GDP), human capital inputs (primary and secondary enrollment rates),
population growth, plus a catch-up term (to admit pure technological catch-
ing up). This is a totally standard "growth accounting" type of regression
(see Appendix 1). The first two variables are expected to enhance growth,
the latter two to repress it. Political and openness dummy variables can play
a role here, the latter being a binary choice variable depending on "high" and
"low" distortions and due to Sachs and Warner. The results are as expected:
investment in physical capital has a return of about 15 percent. Population
growth congests resources and has a negative effect on growth, commen-
surate with a 45 percent labor share of output. As for the dummy variables,
both have growth implications: policies that suppress openness are costly (2
percent per annum growth cost), as are poor political and civil rights or
instability (1 percent growth cost).

36
By the latter criteria the measure of our ignorance is large, a residual sum of squares equal to 0.185
out of a total of 0.269. Of the explained part, the first order contributions derive from the conditional
convergence effect (via initial income) and four key distortions (black-market premium, size of
government, rate of depreciation, relative price of capital), each term accounting for around 0.010 of
explained variance. All other effects, including demographic, human capital, natural resource, and
financial effects, are an order of magnitude smaller, or smaller still.
 TABLE 5
GROWTH DETERMINANTS: STRUCTURAL EQUATION ESTIMATION
(a) Growth Equation (b) Behaviora1 Equations (c) Endogenous Distortion Equations
Regression no. (2) (3) (4) (5]1 (6]I (7) (8) §>
INVESTMENT POPULATION ENROLLMENT BLACK FINANCIAL PRICE OF
Dependent variable GROWTH RATE GROWTH RATE MARKET DEPTH CAPITAL TO
N 413 236 225 230 143 223 236
R2 0.26 0.74 0.54 0.85 0.52 0.51 0.29 03

SEE 0.0305 4.562 0.0083 0.1657 0.1891 0.2029 0.3414 Co

Constant 0.1579 (7.63) 73.7032 (4.84) 0.0334 (3.44) -1.2867 (4.44) 0.4788 (1.31) -0.3757 (1.56) -0.1911 (3.23)
INITIAL INCOME -0.0188 (6.14) -14.0049 (3.69) 0.0012 (0.77) 0.3001 (9.63) -0.0648 (1.44) 0.0701 (2.00)
ENROLLMENT RATE 0.0034 (0.56)
INVESTMENT RATE 0.0015 (6.41) 0.0002 (1.45) 0.0090 (4.38) 0.0189 (4.39)t I
POPULATION GROWTH -0.4475 (2.71) 2,059.0300 (3.8l)t -38.3005 (7.72)t
OPENNESS -0.0224 (4.73)
POLITICS -0.0102 (2.74) 5.7502 (3.20) 0.0011 (0.74) 0.0039 (0-13) 0.1816 (3.19) -0.0124 (0.30)
?-
INITIAL SCHOOLING -1.0449 (3.26) -0.0008 (1.65) 0.0402 (4.69) -0.0032 (0.23) -0.0173 (1.97)
YOUNG -100.9020 (4.01) 2.2437 (4.48)
OLD 143.7300 (2.35) -3.6764 (4.26) a:
BUCK MARKET -23.2958 (3.85) 0.0788 (2.06) 0.1654 (2.16)t
TARIFF -12.4540 (3.85) -0.0449 (0.33) -0.2262 (2.80) 0.2772 (2.26)
GOVERNMENT -0.0407 (0.56) 0.0001 (0.74) 0.0070 (3.74) 0.0106 (3.17) 0.0022 (0.94) 0.0219 (6.64)
PRICE OF CAPITAL -16.1287 (7.07)t
DEPRECIATION 9.8495 (2.64) 0.4751 (5.99) -0.2110 (2.97)
FINANCIAL DEPTH 18.5170 (5.38) -0.0029 (1.09) -0.2283 (3.12)t
NATURAL RESOURCES -17.8299 (3.06) 0.0234 (4.84) 0.2272 (2.08) -0.0124 (0.07) -0.3661 (3.14) 0.2390 (1.34) 3
ENROLLMENT RATE 39.2374 (4.22)t -0.0186 (3.96)t a
t = significantly endogenous right-hand side variables. See the text.
Note: /-statistics are in parentheses.
Source: See the text and Appendix 2.
 14 Taylor

Growth determinants: Behavioral equation estimation

However, besides these simple shift effects captured by dummy variables
in estimates of the growth equation, we still have no clear idea through
which channels politics and policies affect growth. Only a structural estima-
tion of growth determinants can expose these links, and Table 5 tries to do
that. Regressions 3 through 8 estimate "behavioral equations" for the proxi-
mate determinants of six putatively endogenous variables in the system.
Firstly, we can endogenize three behavioral variables—investment in physi-
cal and human capital, and population growth. We may also try to en-
dogenize three environmental or policy parameters—black-market premia,
financial depth, and the relative price of capital. Finally, the "behavioral"
regressions (regressions 3, 4, and 5) can then be coupled with information
on the marginal contribution to growth of the various factor inputs (regres-
sion 1) to help identify what made Latin America such a slow-growth area.
Essentially, as a counterfactual, one can ask what growth would have looked
like in Latin America with East Asian policy parameters.37

Investment
Regression 3 pinpoints some key determinants of investment. The coeffi-
cient of lagged per capita income is negative: richer countries would be
expected to have high capital intensity and lower marginal product of capital
in the standard growth model, hence less investment. A higher initial stock
of human capital also discourages further accumulation, as might be ex-
pected with unbalanced growth paths in the two-sector models of growth.
Children constitute a major investment drag, consistent with a labor-supply
impact on investment demand. The size of government per se does not lower
investment, but all other distortions do, and most emphatically so in the case
of the relative price of capital, as expected. A weak financial system inhibits
capital accumulation significantly, as expected if intermediation and effi-
ciency are inhibited in the capital market. A natural resource comparative
advantage inhibits investment, as would be the case if primary product
manufacture were less capital intense. Physical capital accumulation rises to
complement rapid human capital accumulation and to offset capital dilution
via high population growth rates.

Population growth
Regression 4 explores the determinants of population growth. The results
are consistent with the view that fertility choice may embody elements of a
37
A11 six of these regressions were estimated with 2SLS, and Hausman simultaneity tests were
employed to eliminate all except the significantly endogenous right-hand side variables (denoted t)-
The fit in all cases is quite respectable (only the last equation has an R2 below 0.5, and that is 0.29).
 On the Costs of Inward-Looking Development 15

quality-quantity trade-off, in that population growth seems to be negatively

correlated with human capital stocks and flows. This is suggestive of possi-
ble multiple equilibria consistent with high- and low-human capital develop-
ment paths. Interestingly, population growth does seem to be positively
associated with natural resource endowments, which would be consistent
with theories of agricultural labor supply within the household, and also
theories of saving (asset accumulation) via investment in children.

Human capital accumulation

Regression 5 reinforces support for the quality-quantity trade-off, in that
population growth is negatively correlated with human capital accumulation
measured by enrollments. A large share of children in the population is
associated with high enrollments too, as expected. Rich countries have
higher enrollments too, again suggesting multiple-equilibria possibilities. In
a rare positive impact, high government spending does spill over into eco-
nomic growth as it promotes human capital accumulation, probably via
public-good effects of education spending. Human capital accumulation
complements investment, just as vice versa in regression 3.

Black-market premium
Regression 6 examines the determinants of the black-market premium. In
keeping with the characterization of this variable as not directly tied to
commercial policy, tariffs have little impact. However, premia are associated
with big government and, most robustly of all, with monetary instability
(depreciation). Both seem highly plausible; to the extent that big government
is associated with intervention in the form of currency controls or other
distortions in the financial system, and to the extent that exchange risk is
driven by expectations of depreciation of the currency, both variables should
have predictive power for the black-market premium.

Financial depth
Regression 7 investigates the determinants of financial depth.38 Financial
development is associated with high per capita incomes—possibly reflecting
a demand for financial services as a normal good. It is also readily apparent
that increased investment, an activity that is largely predicated on financial
intermediation, is strongly associated with increased financial depth. Trade
38
Financial development is expected to have positive effects of lower transactions costs and enhanced
allocative efficiency in the capital market, and hence to promote accumulation and growth; see Davis,
"Capital Immobilities"; Gurley and Shaw, "Financial Aspects"; McKinnon, Money; and Shaw,
Financial Deepening. See also King and Levine, "Finance and Growth" and "Finance, Entrepreneur-
ship, and Growth."
 16 Taylor

policy seems to matter, in that tariffs are associated with reduced financial
depth, a plausible result. There appears to be a negative association between
monetary instability measured by depreciation and financial depth, as might
be expected given the increased risk in financial markets. Countries with
comparative advantage in primary products appear to have lower financial
depth, which seems intuitively obvious—much saving and investment in
agriculture and other primary sectors is outside the scope of financial inter-
mediaries.

Relative price of capital

Regression 8, finally, examines the determinants of the relative price of

capital, seen to be such a vital determinant of investment demand in regres-
sion 3.39 As expected, the relative price of capital is associated with the
presence of distortions at various points in the economy. About one quarter
of any tariff-rate change passes through into the capital price, which is un-
surprising in that a large share of contemporary investment is in the form of
tradable machinery and equipment. About one-sixth of any change in the
black-market premium also passes through to the capital price. The most
robust association, however, is between the broad measure of public finance
distortions and the capital price, suggesting that beyond trade and the black-
market premium, distortions and government interventions at many levels
in the economy are associated with higher investment prices.

OPENNESS AND GROWTH: LATIN AMERICA IN PERSPECTIVE

Table 5 confirms our intuition regarding some of the channels by which

environmental variables affect each other and affect economic growth per-
formance. Yet if these forces matter, how much do they matter? Table 6 uses
knowledge of the structural parameters in Table 5 with information on the
differences in variables and parameters to explain why growth environments
differ.
Summary statistics in section (a) indicate the basis for comparisons be-
tween two regions, Latin America and Asia-Pacific. Some immediate differ-
ences are apparent: the Asia-Pacific region enjoyed much higher rates of
investment and human capital accumulation, and lower rates of population
growth: all favorable growth traits. In addition, Asia-Pacific had the lower
distortions already noted (Table 3).
In section (b) we can explore whether the regression estimates can explain

"The relative price of capital is expected to be lower in more open economies with freely traded
capital goods, and should have negative impact on investment activity and, hence, on growth; see
Brander and Dowrick, "Role"; Jones, "Economic Growth"; and Taylor, "Domestic Saving" and "Tres
fases."
 TABLE 6
SAMPLE STATISTICS AND GROWTH-RATE DIFFERENCES IN LATIN AMERICA
(a) Sample Means of Variables (b) Growth Determinants: Latin America versus Asia-Pacific O
(bl) (b2) (b3) (b4) (b5) (b6)
Latin America Investment Population Enrollment Black Financial Price of TO
Latin minus Rate Growth Rate Market Depth Capital
Variables America Asia-Pacific Asia-Pacific A due to: A due to: A due to: A due to: A due to: A due to: O
Co
GROWTH 0.0049 0.0340 -0.0291 E?
INITIAL INCOME 7.9840 8.0555 -0.0715 1.0012 -0.0001 -0.0215 0.0046 -0.0050
INITIAL SCHOOLING 4.0040 5.5290 -1.5250 1.5934 0.0011 -0.0613 0.0050 0.0264 i—,
YOUNG 0.4117 0.3508 0.0610 -6.1512 0.1368
OLD 0.0413 0.0487 -0.0074 -1.0638 0.0272 1
POLITICS 0.4118 0.2308 0.1810 1.0408 0.0002 0.0007 0.0329 -0.0022
BUCK MARKET 0.2623 0.0553 0.2070 -4.8224 0.0163 0.0342 a
TARIFF 0.2163 0.1268 0.0896 -1.1157 -0.0040 -0.0203 0.0248
GOVERNMENT 16.2744 15.7123 0.5621 -0.0229 0.0000 0.0040 0.0060 0.0012 0.0123 o
PRICE OF CAPITAL 0.2662 0.2266 0.0396 -0.6387
DEPRECIATION 0.3737 0.0210 0.3527 3.4735 0.1675 -0.0744 3
ss:
FINANCIAL DEPTH 0.2596 0.5505 -0.2909 -5.3872 0.0008 0.0664
NATURAL RESOURCES 0.1026 0.0525 0.0501 -0.8930 0.0012 0.0114 -0.0006 -0.0183 0.0120
ENROLLMENT RATE 1.3218 1.5170 -0.1952 -7.6591 0.0036
INVESTMENT RATE 16.2371 23.1917 -6.9546 -0.0011 -0.0624 -0.1316 TO
POPULATION GROWTH 0.0234 0.0174 0.0060 12.3253 -0.2293 ,o
sum explained -8.3201 0.0059 -0.1280 0.2113 -0.2079 0.0833 a
actual difference -6.9546 0.0060 -0.1952 0.2070 -0.2909 0.0396 TO
difference in GROWTH -0.0129 -0.0026 0.0029 a
<••».

Notes: In (b): columns from Regressions (3) to (8); "difference in GROWTH" derived from Regression (2).
Sources: See the text, Appendix 2, and Table 5.
18 Taylor

the differences. Predictions are based on variable differences multiplied by

regression coefficients for each equation. The results are satisfying. Latin
America grew about 3 percent per annum more slowly, and about half of
this difference is explained by structural shifts in the behavioral equations,
particularly the markedly lower investment rates in Latin America.
Of great interest are columns b 1 to b3 in Table 6, describing the shift in
the mechanics of factor accumulation between the two samples. Investment
was about 7 percentage points lower in Latin America (16 percent versus 23
percent), a gap explained principally by a high dependency rate, higher
distortions, lower levels of financial development, and slower complemen-
tary human capital accumulation. This is a rich description of the obstacles
to accumulation, one that highlights the many interactions at work, not just
distortions. Faster population growth of 0.6 percent per annum appears to
be associated primarily with a human capital interaction suggestive of an
adverse choice in the quantity-quality trade off in family size. Slower human
capital accumulation reflected the symmetry of that relationship, although
offset in part by a youth component of the dependency rate that was harmful
for physical capital accumulation.
Beyond factor accumulation patterns, columns b4 through b6 of Table 6
explain differences in some probably endogenous distortion measures.
Higher black-market premia (at 26 percent versus 6 percent) followed prin-
cipally from unstable exchange rates, that is, from profligate monetary poli-
cies (depreciation rates of 37 percent versus 2 percent per annum). The
weaker financial depth derived in part from the same monetary instability
(perhaps via risk disincentives), yet also from weak investment demand,
suggesting a symbiotic supply-and-demand relationship between the finan-
cial sector (mobilization) and the saving-investment nexus itself (accumula-
tion). Lastly, the investment-goods price distortion is not much different
between the two regions on average, and appears to be driven by black-
market premia and tariffs, perhaps through the traded capital-goods channel.
This modeling points to significant interactions between policies, distor-
tions, and factor accumulation that relate to structural differences in the
mechanics of economic growth in Latin America and its standard counter-
point, the Asia-Pacific region. Much of the poor relative performance of
Latin America during the period from 1970 to 1990 can be so explained.40

CONCLUSION
From the 1930s to the 1980s, economic policies in Latin America epito-
mized the inward-looking model of economic development. The model was
born of the experience of a peripheral region in the Depression, and codified

•""More discussion and results are shown in Taylor, "On the Costs."
 On the Costs of Inward-Looking Development 19

by the 1950s in unorthodox economic theories. Even though its performance

in the shape of the ISI strategy was seen as disappointing by the 1960s, and
its narrow strictures were often ignored for practical purposes, the distor-
tions created by the autarkic policy regime were long lived, persisting, and
indeed worsening, relative to the rest of the world, in the 1970s and 1980s.
This article examines the mechanics of economic growth in Latin Amer-
ica and elsewhere. Some features of the empirical approach stand out from
previous work. Structural analysis can offset the rapidly diminishing returns
to the now familiar and repetitive reduced-form growth regressions. Not-
withstanding the ultimate constraints on the macroeconomic methodology,
this article considers some of the still unexplored dimensions of growth and
its determinants. To illustrate the possibilities, this article examined the
canonical contrast of development "failure" in a region in the late twentieth
century, Latin America, set against the "success" case, the Asia-Pacific
region. There is a rich set of interactions between policy, distortions, accu-
mulation, and growth. Overall, the structural approach explained much of
the difference in growth rates between the two regions; the greater part
derived from differences in investment in physical capital accumulation.41
There can always be further qualifications to the extent that other omitted
or unmeasurable variables remain outside the scope of the study, and one
can immediately enumerate several important caveats and competing expla-
nations. A puzzle remains as to why the Latin countries persisted with dis-
tortive policies after the 1960s, whilst the East Asian countries reduced
distortion measures. Authors such as Eliana Cardoso and Albert Fishlow
acknowledge that policymakers knew that import substitution was failing
but were constrained in the 1970s by oil shocks and the resulting increase
in indebtedness.42 It is not clear, however, how the Asian group, equally or
even more oil-scarce, was able to evade this problem. On debt problems, it
might be objected that the differential impact of the debt crisis within and
beyond Latin America had some explanatory power—but my analysis went
through for a sample period from 1970 to 1989, and for periods both before
and after the onset of serious debt overhangs. Another quibble might be that
the supposedly open Asia-Pacific region had its own forms of government
intervention to promote exports and that these policies were distortive and
good for growth, whilst being far from a natural definition of "openness";
however, microeconomic work cast doubts on this claim.43 As Bradford
""Relative to the pooled sample, there is a reduction in the explanatory role of the "regional (Asia or
Latin America) dummy variable" so often used to mop up residual regional differences in growth
regressions. Indeed, explaining this much variation in growth rates across the regions without a dummy
can be seen as an empirical accomplishment. Compare, World Bank, East Asian Miracle.
42
Cardoso and Fishlow, "Latin American Development."
43
One recent sectoral study suggests that even the supposedly beneficial and well-intentioned
government interventions that composed Korean industrial policy after the 1960s had adverse or zero
effects, and thatfreetrade would have been a better alternative. See Lee, "Government Interventions."
20 Taylor

De Long and Lawrence Summers note, the key difference was that interven-
tions in East Asia might have been numerous, but they were not price dis-
torting, and left incentives intact. In contrast, Latin American conditions
seemed to reflect a desire to insulate domestic constituencies from world
market forces: thus poor performers (like Latin America) "confused support
for industrialization with support for industrialists" and created distortions
that raised capital prices (a subsidy to local firms) but at the same time
reduced the quantities invested for the long run.44 Redistribution came hand
in hand with the distortion of incentives, as exemplified in the Argentinian
case as early as 1955, here described by Carlos Diaz Alejandro:
The corporate-state mentality of the Peron regime had resulted in an economy with
a low capacity to transform, where producers, workers, and consumers expected the
government to shield them from undesirable trends arising from the market. The
price mechanism became a tool to redistribute income rather than to allocate
resources. The structure of production showed some glaring imbalances after years
of neglecting marginal adjustments. . . . The system of protection not only created
quasi-monopolistic positions but also hampered new exports of manufactures.
Efficient activities that had export potential were often forced to buy costly inputs
from inefficient domestic sources.45

On the other hand East Asian economies were not bereft of policy inter-
vention. The recent work of Dani Rodrik highlights the potential for certain
policies in the East Asian NICs to promote and coordinate private invest-
ment initiatives.46 Such coordination strategies might have been necessary
in a world of multiple equilibria, and were possibly lacking in Latin Amer-
ica. Such theories are entirely consistent with the results here, which favor
an interpretation of investment-led growth rather than export-led growth.
The causation is indirect from exports, as they permit long-run capital im-
ports, both financial (foreign saving) and physical (foreign investment
goods), which underlie the accumulation response that massively differenti-
ates East Asia from Latin America.
However, the basic strength of the "East Asian miracle" derived not from
remarkable total factor productivity gains or some such "technological" leap;
rather, as noted by Paul Krugman and Alwyn Young, the NICs epitomized
the classic Solovian growth strategy, by mustering impressively high
investment rates and experiencing dramatic capital deepening that carried
them to higher income levels.47 The lesson of this article is that through a
variety of distortions and policy choices, the institutional structure of Latin

•"See De Long and Summers, "Equipment Investment." The quote appears on p. 486. The example,
par excellence, is Argentina, as was noted by Diaz Alejandro. See Diaz Alejandro, Essays; and Taylor,
"Tres fases."
45
Diaz Alejandro, Essays, p. 128.
"'Rodrik, "Coordination Failures," "Getting Interventions Right," and "Trade Strategy."
47
Krugman, "Myth"; and Young, "Tyranny."
 On the Costs of Inward-Looking Development 21

America took the region down a low investment path in much of the postwar
period, with predictable results for per capita income divergence.
Now the conundrum concerns the institutional setting in which this retar-
dation took place. For if the damaging results were so predictable, why did
the political-economic nexus not generate pressure groups who could push
forward the needed reforms, and allow Latin America to escape such a bad
outcome? Indeed, some of the literature on political choices and economic
outcomes stresses the tendency of the political process to yield efficient
economic outcomes.48 And even in a world of redistributive politics—which
is how most (like Diaz Alejandro) saw the functioning of ISI in Latin
America—there is still scope for these policies to be relatively efficient
compared to other possible political outcomes.49 Instead, Latin America
ended up with inefficient institutions that persisted for five or six decades,
with the beginnings of reform only visible in the region from the mid-1980s;
and to some observers even these reforms seem still tentative, and far from
thorough and complete in many countries.50 This history accords more with
pessimistic theories of growth and institutions (North's, for example),
theories that allow for inefficient institutions to persist for long periods.51
Why was this so? Why was the enforced autarky of the 1930s and 1940s
supplanted by a self-inflicted autarky for most of the postwar era until now?
Why did the kind of outward-looking policies seen in the Asia-Pacific re-
gion not take hold sooner? This is a topic worthy of another article, and
much more research, but which deserves some comment and speculation in
passing. A first observation worth noting is that in no way did the Asia-
Pacific region hurry with its reforms in the period from 1950 through 1970,
at least as measured using objective distortion variables. A second observa-
tion is that both regions were operating as small economies in a much larger
world economy, and the existence of such an external sector might pro-
foundly change the impetus for institutional change within an economy.
And, indeed, the world economy was changing in dramatic ways after 1950
that had profound effects for these peripheral economies.
As investment has been such a prime focus, it is worth noting the rise in
capital mobility in the postwar era, especially after the fall of fixed exchange
rates, and the lifting of capital controls in the 1970s and 1980s.52 Such de-
velopments paralleled a decline in tariffs under GATT and a rise in world
trade volumes. Yet Latin America, by delaying reforms, was not a major
player in the expansion of capital flows to, and exports from, the developing
countries that ensued. Was there a reason for such delay? Did internal
48
See Becker, "Theory"; Peltzman, "Toward"; and Wittman, "Why Democracies."
49
See Williamson, Mechanisms.
Edwards, Crisis.
5l
North, Institutions and Structure.
52
Obstfeld and Taylor, "Great Depression."
22 Taylor

politics, interest groups, or some kinds of "transaction costs" prevent a

change of "trade technology" from inward- to outward-orientation? Was
Latin American policy just foolish, or Asia-Pacific policy just lucky?
One dimension that appears important here, especially in understanding
the willingness of countries to isolate themselves in capital markets, is the
inevitable tension facing policymakers who must choose between domestic
monetary policy objectives, fixed exchange rates, and capital mobility—the
"inconsistent trinity," or "trilemma," only two out of three being feasible.53
Barry Eichengreen, focusing largely on the core economies of Europe and
the United States, highlights the increased demands on governments in the
early twentieth century (and particularly in response to the Great Depres-
sion) to sacrifice monetary orthodoxy for other goals, and sees this response
as a function of the widening of the franchise and the interests of the broader
polity. Thus did Bretton Woods eventually come to enshrine the (unortho-
dox) principle of restricted capital mobility as a means to "save" the (ortho-
dox) principle of fixed exchange rates—though, even then, only for a time,
until growing international market forces could not be contained, hi this
context, autarkic policies and a desire to accommodate domestic interest
groups were rather unremarkable.54
It would be interesting to see a comparable analysis of policies toward
capital market integration applied to the economies of the periphery, for then
we might better understand the origins of postwar policy choices, and Latin
America's path might not seem so unusual. However, the punishment for
such a choice was surely higher than in the core, simply because Latin
America was an underdeveloped, capital-scarce area with much to gain from
capital inflows and specialization via trade. What seems more unusual now,
perhaps, is the Asia-Pacific policy choice of openness, even in a less-than-
open world economy at the time.55
However, the political conditions in the Asia-Pacific region, and espe-
cially in the NIC4, differed markedly from those in Latin America, in terms
of the popular enfranchisement of competing interest groups lobbying for
protection and, thus, the pressure on governments to subordinate openness
in trade and capital markets to domestic political interests. Latin American
politics in the 1930s and since have been marked by dramatic cleavages
between different classes and competing groups, being even more polarized
53
Obstfeld and Taylor refer to this as the "macroeconomic policy trilemma" for open economies.
Obstfeld and Taylor, "Great Depression."
^See Eichengreen, Globalizing Capital, especially the introduction. Eichengreen considers this story
an elaboration of the ideas of Karl Polanyi concerning the political reaction in the twentieth century
against the laissez faire market system of the nineteenth-century world economy, especially as
epitomized in the classical gold standard. Polanyi, Great Transformation.
"For as Eichengreen points out, such policy choices are not taken in isolation, but reflect the
interdependence of nations and complex network externalities: as an extreme example, it benefits me
nothing to open trade and capital accounts if my trading partners remain closed.
 On the Costs of Inward-Looking Development 23

than many core countries. Highly "reactive" policies were not surprising in
such a political atmosphere, and their persistence was likely so long as exter-
nal conditions and internal polarizations continued.
So what brought this phase to an end, assuming current Latin American
reforms do prove more than transitory? Some argue it was the gradual
realization of the costs of the choice relative to successful states abroad (for
example, the Asia-Pacific success), and the increasing costs of maintaining
the strategy during the debt and hyperinflation years of the 1980s.56 In
Northian terms:
If, however, growth is destabilizing, so is no growth, when a political-economic unit
exists in a world of competing political-economic units. Relatively inefficient prop-
erty rights threaten the survival of a state in the context of more efficient neighbors,
and the ruler faces the choice of extinction or of modifying the fundamental owner-
ship structure to enable the society to reduce transaction costs and raise the rate of
growth.... Stagnant states can survive as long as there is no change in the opportu-
nity cost of the constituents at home or in the relative strength of competitor states.57

Eventually the costs of inward-looking development could no longer be

ignored.

Appendices
APPENDIX 1: THEORY

In order to explain the empirical methodology in the article, this appendix reviews the
bases of dynamic models in "new" and "old" growth theory, and their empirical
application.
The state variables follow trajectories x, and include conventional economic stock vari-
ables: endowments such as physical and human capital, population, and also "technology,"
suitably measured. Conventionally, and since it is a function of these state variables, output
is often included as another implicit state variable, as it is the major growth variable of
interest. Control variables u, may be endogenously determined and include the conventional
economic flow variables: investment in the accumulation of physical or human capital,
population growth, research as it affects technology, and so forth. The control variables
affect the rate of change of the state variables through what we may term a "laws-of-
motion" equation

dx,/dt=f(u,;a) (1)
where a is a set of environmental parameters that might also affect the evolution of the state
variables, including economic policies such as taxes and institutional structures such as
property rights.
56
See Edwards, Crisis.
"See North, Structure, p. 29. Though North cautions that the story is not so straightforward with
competing interest groups, this perspective seems to match the stories of commentators who saw the
crisis and falling behind of the 1980s as being "the straw that broke the camel's back"—yielding
dramatic changes in political power in Latin America, and popular sentiments that provided a powerful
mandate for economic reforms.
24 Taylor

Often, attention is given to only one element on the left-hand side of equation 1. When
dx, / dt is just the growth rate of output d In y, / dt, and the controls u, are the growth rates
of inputs d In v, / dt , essentially equation 1 reduces to the production function once-
differentiated, and its estimation leads to what we may term a "growth accounting"
regression

dlny / dt = ao + a, din v/dt + a2 a + s (la)

This approach has been widely used, but it suffers from a potential weakness; as the
"new" growth theory stresses, the controls u, are probably endogenous variables deter-
mined according to some behavioral rule. Thus, equation 1 should be complemented by a
"behavioral" equation, rounding out the description of the dynamical system, of the form
u, = g(x,;b) (2)
that describes the endogenous control choices u, as a function of the current state x, and
another set of putatively exogenous environmental parameters b.
The dynamical system is fully described by equations 1 and 2; theoretical attention is
then given to an analysis of the (possibly multiple) equilibria and trajectories of the system.
Econometrically, equations 1 and 2 should be viewed as a system of simultaneous equa-
tions, and equation la should be estimated with care for simultaneity bias arising from
endogenous controls. In its own right, equation 2 may be usefully estimated as a "behav-
ioral" regression

K = P0 + p , x + P 2 & + T) (2a)
to provide details of the channels through which state variables and environmental parame-
ters affect controls (for example, factor accumulation) and, hence, growth.
Integrating the dynamical system of equations 1 and 2 forward over time yields a
"trajectory" equation
x(T) = h(x(0);a,b) (3)
Such an approach may be applied to the trajectory of output to derive a reduced form
"trajectory regression" where state evolution (in this case, the growth rate of output) de-
pends only on initial conditions x (0) and environmental parameters
dlny/dt = y0 + y]x(0) + y2a + yib + E> (3a)
The attraction of the last specification is clear; the initial conditions are predetermined
and the endogeneity problem is finessed because the controls u do not enter. There is a
cost: a specification like that in equation 3a cannot reveal the channels through which the
environment affects growth. The benefit is that equation 3a might suggest some relevant
environmental parameters that affect growth, and hence inspire investigation of likely
channels through which such forces might operate.
My empirical design follows three approaches, corresponding to the specifications in
equations la through 3a. We can begin by estimating the simplest specification, the
reduced form equation 3a, which may serve to identify important exogenous influences on
the growth rate. As a second step, we can estimate a structural growth regression of the
form in equation la, looking at the obvious flow (control) variables for factor
accumulation. In a third step, estimation of the behavioral regression in equation 2a yields
insights into growth mechanisms.
The last estimations are the most novel element in this article. Estimation of behavioral
 On the Costs of Inward-Looking Development 25

regressions (like equation 2a) is quite scarce in the current literature, yet remains the only
way to identify the channels through which the economic environment affects growth.
Almost exclusive attention has been lavished on the reduced-form estimation (as in equa-
tion 3a) throughout the empirical growth literature. This imbalance in the empirical litera-
ture has prevented us from exploring the mechanics of economic development, as they are
manifested at the behavioral level. Reduced-form equations answer the question "what
mattered for growth?"; but only a structural analysis of the behavioral regressions can
answer the immediate follow-on question: "how did it matter?"

APPENDIX 2: DATA
All the data employed are publicly available in electronic form from three major sources:
the World Data file compiled by the World Bank (WD); the latest Penn World Table due
to Heston et al. (PWT); and compilations of panel data by Barro and Lee (BL), and Sachs
and Warner (SW). This study uses a pooled cross-county data set as averages for four
successive five-year periods 1970 through 1974, 1975 through 1979, 1980 through 1984,
and 1985 through 1989; sources appear in parentheses:
GROWTH: Annual growth rate of real per capita GDP (PWT);
INITIAL INCOME: Log of initial real per capita GDP (PWT);
INITIAL SCHOOLING: Initial years primary/secondary schooling per person (BL);
ENROLLMENT RATE: Average enrollment rate in primary/secondary schools (BL);
INVESTMENT RATE: Ratio of real gross investment to real GDP, percent (PWT);
POPULATION GROWTH: Annual growth rate of population (PWT);
NATURAL RESOURCES: SW-type measure of primary product export intensity (WD);
YOUNG, OLD: Initial share of population aged under 15, over 65 (PWT);
GOVERNMENT: Share of government spending in GDP, percent (PWT);
POLITICS: Equal to one for SW-political-non-qualifier country (SW);
PRICE OF CAPITAL: Relative log price of capital goods, world prices (PWT);
BLACK MARKET: Log black-market premium on the exchange rate (BL);
TARIFF: Own-weight tariff incidence, percent (BL);
OPENNESS: Equal to one for SW-openness-non-qualifier country (SW);
DEPRECIATION: Annual rate of depreciation of currency, per U.S. dollar (PWT);
FINANCIAL DEPTH: Ratio of liquid liabilities in financial system to GDP (BL).

REFERENCES
Abramovitz, Moses. "Resource and Output Trends in the United States Since 1870."
American Economic Review 46 (1956): 5—23.
. "Catching Up, Forging Ahead, and Falling Behind." this JOURNAL 46, no. 2
(1986): 385-406.
Agarwala, Robert. "Price Distortions and Growth in Developing Countries." World Bank
Staff Working Paper, No. 575, Washington, DC, 1983.
Bairoch, Paul, and Maurice Levy-Leboyer, eds. Disparities in Economic Development
Since the Industrial Revolution. Basingstoke: Macmillan, 1981.
Barro, Robert J. "Economic Growth in a Cross Section of Countries." Quarterly Journal
of Economics 106 (1991): 407-43.
Barro, Robert J., and Jong-Wha Lee. "Data Set for a Panel of 138 Countries." National
Bureau of Economic Research, Cambridge, MA, January 1994. Internet <http://
nber.harvard.edu>.
26 Taylor

Barro, Robert J., and Xavier Sala-i-Martin. Economic Growth. New York: McGraw-Hill,
1995.
Becker, Gary S. "A Theory of Competition Among Pressure Groups for Political Influ-
ence." Quarterly Journal of Economics 98 (1983): 371^00.
Brander, James A., and Steve Dowrick. "The Role of Fertility and Population in Economic
Growth: Empirical Results from Aggregate Cross-National Data." Journal of Popula-
tion Economics 7 (1994): 1-25.
Bulmer-Thomas, Victor. The Economic History of Latin America Since Independence.
Cambridge: Cambridge University Press, 1994.
Campa, Jose Manuel. "Exchange Rates and Economic Recovery in the 1930s: An
Extension to Latin America." this JOURNAL 50, no. 3 (1990): 677-82.
Cardoso, Eliana, and Albert Fishlow. "Latin American Development: 1950-1980." Journal
of Latin American Studies 24 (1992): 197-218.
Cardoso, Eliana, and Ann Helwege. Latin America's Economy: Diversity Trends and Con-
flicts. Cambridge, MA: MIT Press, 1992.
Coatsworth, John H. "Economic Retardation and Growth in Latin America and Southern
Europe Since 1700." Harvard University, December 1993. Photocopy.
Davis, Lance E. "Capital Immobilities and Finance Capitalism: A Study of Economic
Evolution in the United States." Explorations in Economic History 1 (1963): 88—105.
De Gregorio, Jose. "Economic Growth in Latin America." Journal of Development Eco-
nomics 39 (1992): 59-84.
De Long, J. Bradford, and Lawrence H. Summers. "Equipment Investment and Economic
Growth." Quarterly Journal of Economics 106 (1991): 445-502.
Diaz Alejandro, Carlos F. Essays on the Economic History of the Argentine Republic. New
Haven, CT: Yale University Press, 1970.
. "Some Characteristics of Recent Export Expansion in Latin America." In The
International Division of Labor: Problems and Perspectives, edited by Herbert
Giersch, pp. 215-36. Tubingen: Mohr, 1974.
. "Latin America in the 1930s." In Latin America in the 1930s: The Role of the
Periphery in World Crisis, edited by Rosemary Thorp, pp. 17-49. New York: St.
Martin's Press, 1984.
_. "The 1940s in Latin America." In Economic Structure and Performance: Essays
in Honor ofHollis B. Chenery, edited by Moshe Syrquin, Lance Taylor, and Larry E.
Westphal, pp. 341-62. Orlando, FL: Academic Press, 1984.
Dowrick, Steven, and Duc-Tho Nguyen. "OECD Comparative Economic Growth 1950-85:
Catch-Up and Convergence." American Economic Review 79 (1989): 1010—30.
Easterly, William. "How Much Do Distortions Affect Growth?" Journal of Monetary
Economics 32 (1993): 187-212.
ECLA (United Nations Economic Commission for Latin America). The Economic
Development of Latin America and Its Principal Problems. 5 vols. New York: United
Nations, 1950.
. Economic Survey of Latin America, 1949. 5 vols. New York: United Nations,
1950.
Edwards, Sebastian. "Trade Orientation, Distortions and Growth in Developing Countries."
Journal of Development Economics 39 (1992): 31—57.
Edwards, Sebastian. "Openness, Trade Liberalization and Growth in Developing Coun-
tries." Journal of Economic Literature 31 (1993): 1358-93.
Edwards, Sebastian. Crisis and Reform in Latin America: From Despair to Hope. New
York: Oxford University Press, 1995.
Eichengreen, Barry J. Globalizing Capital: A History of the International Monetary
 On the Costs of Inward-Looking Development 27

System. Princeton, NJ: Princeton University Press, 1996.

Eichengreen, Barry J., and Jeffrey D. Sachs. "Exchange Rates and Economic Recovery in
the 1930s." this JOURNAL 45, no. 4 (1985): 925-46.
Elias, Victor J. Sources of Growth: A Study of Seven Latin American Economies. San
Francisco: ICS Press, 1992.
Gerschenkron, Alexander. Economic Backwardness in Historical Perspective. Cambridge,
MA: Harvard University Press, 1962.
Gurley, John G., and Edward S. Shaw. "Financial Aspects of Economic Development."
American Economic Review 45 (1955): 515—38.
Heston, Alan et al. "The Perm World Table, Version 5.6." National Bureau of Economic
Research, Cambridge, MA, November 1994. Internet <http://nber.harvard.edu>.
Jones, Charles I. "Economic Growth and the Relative Price of Capital." Journal of Mone-
tary Economics 34 (1994): 359-82.
King, Robert G., and Ross Levine. "Finance and Growth: Schumpeter Might Be Right."
Quarterly Journal of Economics 108 (1993): 717-38.
King, Robert G., and Ross Levine. "Finance, Entrepreneurship, and Growth." Journal of
Monetary Economics 32 (1993): 513-42.
Krugman, Paul. "The Myth of Asia's Miracle." Foreign Affairs 73, no. 6 (1994): 62—79.
Kuznets, Simon, ed. Income and Wealth of the United States: Trends and Structure. Lon-
don: Bowes and Bowes, 1952.
. The Economic Growth of Nations. Cambridge, MA: Harvard University Press,
1971.
Lee, Jong-Wha. "Government Interventions and Productivity Growth in Korean Manufac-
turing Industries." Working Paper Series, No. 5060, National Bureau of Economic
Research, March 1995.
Levine, Ross, and David Renelt. "A Sensitivity Analysis of Cross-Country Growth Re-
gressions." American Economic Review 82 (1992): 942-63.
Lewis, W. Arthur. The Evolution of the International Economic Order. Princeton, NJ:
Princeton University Press, 1978.
Maddison, Angus. The World Economy in the 20th Century. Paris: OECD, 1989.
Mankiw, N. Gregory, David Romer, and David N. Weil. "A Contribution to the Empirics
of Economic Growth." Quarterly Journal of Economics 107 (1992): 407—37.
McKinnon, Ronald I. Money and Capital in Economic Development. Washington, DC:
The Brookings Institution, 1973.
North, Douglass C. Structure and Change in Economic History. New York: Norton, 1981.
. Institutions, Institutional Change, and Economic Performance. Cambridge: Cam-
bridge University Press, 1990.
Nurkse, Ragnar. Patterns of Trade and Development. The Wicksell Lectures. Oxford: Basil
Blackwell, 1961.
Obstfeld, Maurice, and Alan M. Taylor. "The Great Depression as a Watershed: Interna-
tional Capital Mobility in the Long Run." In The Defining Moment: The Great
Depression and the American Economy in the Twentieth Century, edited by Michael
D. Bordo, Claudia D. Goldin, and Eugene N. White, 353-402. Chicago: University
of Chicago Press, 1998.
Peltzman, Sam. "Toward a More General Theory of Regulation." Journal of Law and
Economics 19 (1976): 211^40.
Polanyi, Karl. The Great Transformation. New York: Rinehart, 1944.
Prebisch, Raul. "Five Stages in My Thinking on Development." In Pioneers in Develop-
ment, edited by Gerald M. Meier and Dudley Seers, pp. 173-91. New York: Oxford
University Press, 1984.
28 Taylor

Rodrik, Dani. "Getting Interventions Right: How South Korea and Taiwan Grew Rich."
Economic Policy (1995): 53-97.
. "Coordination Failures and Government Policy: A Model with Applications to
East Asia and Eastern Europe." Journal of International Economics 40 (1996): 1—22.
_. "Trade Strategy, Investment and Exports: Another Look at East Asia." Pacific
Economic Review (1997): 1—24.
Rosenstein-Rodan, Paul Narcyz. "Problems of Industrialization of Eastern and Southern
Europe." Economic Journal 53 (1943): 202-11.
Sachs, Jeffrey D., and Andrew M. Warner. "Economic Convergence and Economic Poli-
cies." Working Paper Series, No. 5039, National Bureau of Economic Research,
February 1995.
Shaw, Edward S. Financial Deepening in Economic Development. Oxford: Oxford Univer-
sity Press, 1973.
Singer, Hans. "The Division of Gains Between Investing and Borrowing Countries."
American Economic Review 40 (1950): 473—80.
Solow, Robert M. "A Contribution to the Theory of Economic Growth." Quarterly Journal
of Economics 70 (1956): 65-94.
Taylor, Alan M. "Tres fases del crecimiento economico argentino." Revista de Historia
Economica 12 (1994): 649-83.
. "Domestic Saving and International Capital Flows Reconsidered." Working Paper
Series, No. 4892, National Bureau of Economic Research, October 1994.
. "On the Costs of Inward-Looking Development: Price Distortions, Growth, and
Divergence in Latin America." Working Paper Series, No. 5432, National Bureau of
Economic Research, January 1996.
Williamson, Oliver E. The Mechanisms of Governance. Oxford: Oxford University Press,
1996.
Wittman, Donald. "Why Democracies Produce Efficient Results." Journal of Political
Economy 97 (1989): 1395-1424.
World Bank. The East Asian Miracle: Economic Growth and Public Policy. Oxford: Ox-
ford University Press, 1993.
. World Data 1994: World Bank Indicators on CD-ROM. Washington, DC: The
World Bank, 1994. CD-ROM.
Young, Alwyn. "The Tyranny of Numbers: Confronting the Statistical Realities of the East
Asian Growth Experience." Quarterly Journal of Economics 110 (1995): 641-80.