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returns of [Islamic banks] essentially match the explicitly interest-based returns of [conventional banks]” (Kuran 1995:161).

Profit sharing is problematic when businesses use double bookkeeping for tax evasion, making their profits difficult for banks to determine (Khan 1986:1–27). Because many borrowers hide information about their actual profits, many Islamic banks shun profit and loss sharing even in the presence of huge tax incentives. Indeed, Kuran finds that Islamic banks and enterprises do business much like their secular counterparts. Kuran (1995:155–173) asks why economic Islamization has generated so much excitement and participation without bringing about major substantive changes? The main reasons, he contends, are the desire of politicians to demonstrate a commitment to Islamic ideals, the efforts of Muslim business people who feel they behave in un-Islamic ways to assuage their guilt, and the attempts to foster networks of interpersonal trust among those with a shared commitment to Islam.

Conclusion

1.Central banks in LDCs generally have less effect on expenditure and output than in DCs because of an externally dependent banking system, a poorly developed securities market, the limited scope of bank loans, the low percentage of demand deposits divided by the total money supply, and the relative insensitivity of investment and employment to monetary policies.

2.Tax revenue as a percentage of GNP in LDCs is about 18 percent compared to 38 percent in DCs.

3.The increase in tax ratios with GNP per capita reflects both the growth in the demand for public services and the capacity to levy and pay taxes.

4.Direct taxes (such as taxes on property, wealth, inheritance, and income) account for about one-third of revenue sources in LDCs and about one-half to twothirds in DCs. Major indirect taxes in most LDCs are those on international trade, production, and internal transactions, which, however, distort resource allocation. Direct taxes generally have a higher elasticity (that is, percentage change in taxation/percentage change in GNP) than indirect taxes.

5.Some DCs use the progressive income tax to mobilize large amounts of public resources, improve income distribution, stabilize income and prices, and prevent inefficient use of resources, often arising from a heavy reliance on indirect taxes. However, import, export, and excise taxes are the major sources of tax revenue in LDCs. Most LDCs lack the administrative capacity to emphasize an income tax.

6.A number of LDCs have introduced the value-added tax, a tax on the difference between the sales of a firm and its purchases from other firms. The appeals of the value-added tax are simplicity, uniformity, and the generation of substantial revenues.

7.Developing countries cannot use fiscal policy to stabilize income and prices as effectively as developed countries can. The LDC governments have less control over the amount of taxes raised and less scope for speeding up or delaying expenditures.

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8.A relatively small percentage of government spending in LDCs is on health, social security, and welfare, and a relatively high percentage on infrastructure.

9.The annual inflation rate in LDCs increased from less than 10 percent in the 1960s to over 20 percent in the 1970s and over 70 percent in the 1980s, but fell to 16 percent in the 1990s. The highest inflation rates, in Latin America, dropped to about 30 percent yearly in the 1990s.

10.Demand–pull is not an adequate explanation for inflation in LDCs. Inflation may be cost–push (from the market power of businesses and unions), ratchet (from rigid prices downward), or structural (slow export growth and inelastic food supply), with added momentum, once started, from inflationary expectations. Policies to moderate inflation include market-clearing exchange rates, wage–price controls, antimonopoly measures, land reform, structural change from agriculture to industry, and improved income distribution. With the possible exception of exchange-rate policy, most LDCs lack the administrative and political strength to undertake these policies, especially in the immediate future.

11.Countries with high rates of inflation may use incomes policy – wage and price guidelines or controls, and exchange-rate fixing – together with monetary and fiscal stabilization to reduce increases in the price index.

12.Some economists argue that inflation can promote economic growth by redistributing income from low savers to high savers. However, inflation distorts resource allocation, weakens capital markets, imposes a tax on money holders, undermines rational business behavior, increases income inequality, hurts the balance of trade, and, beyond the early stages of inflation, probably does not redistribute income to high savers.

13.Yet, recent evidence indicates that inflation less than 30–40 percent yearly does not hamper growth, indicating that LDCs probably should not be preoccupied with controlling mild inflation.

14.The LDC money markets are often highly oligopolistic and financially repressive, distorting interest rates, foreign exchange rates, and other financial prices. Government protects oligopolistic banks to be able to tap savings at low interest rates. If political elites have the will to undertake financial liberalization, they can reduce inflation and spur growth.

15.When financial markets channel funds to those with productive investment opportunities poorly, the economy operates inefficiently, as in Asia during the 1997–98 financial crisis.

TERMS TO REVIEW

adverse selection

capital market

cascade tax

consumer price index (CPI)

cost–push inflation

crawling peg

currency board

current account

demand–pull inflation

direct taxes

elastic tax

financial liberalization

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financial repression

fiscal incentives

fiscal policy

GDP deflator

Group of 10

hyperinflation

import substitutes

incomes policy

indirect taxes

inflation

inflationary expectations

inflation tax

international balance of merchandise trade

QUESTIONS TO DISCUSS

monetary policy

monopoly rents

moral hazard

political inflation

progressive tax

ratchet inflation

regressive tax

seigniorage

social goods

stagflation

value-added tax (VAT)

Wagner’s law

1.What prevents LDC use of monetary, fiscal, and incomes policies from attaining goals of output and employment growth and price stability?

2.Why are taxes as a percentage of GNP generally lower for LDCs than for DCs?

3.What are the goals of LDC tax policy? What obstacles do LDCs encounter in reaching their tax policy goals?

4.Why are direct taxes as a percentage of GDP generally lower, and indirect taxes as a percentage of GDP generally higher, for LDCs than DCs? Why is heavy reliance on indirect taxes as sources of revenue often disadvantageous to LDCs?

5.Indicate the benefits and difficulties associated with using value-added taxes in developing countries.

6.What tax measures can LDCs take to reduce income inequality? To increase capital and enterprise?

7.What, if any, is the tradeoff between tax policies that reduce income and wealth concentration and those that increase capital formation?

8.Why is health, social security, and welfare spending as a percentage of GDP less in LDCs than DCs? Why is health, social security, and welfare spending as a percentage of total government spending less in LDCs than DCs?

9.Why are military expenditures as a percentage of GDP high in low-income countries?

10.Why did the LDC inflation rate increase from the 1960s to the 1980s? Why did the LDC inflation rate fall from the 1980s to the 1990s?

11.What causes LDC inflation? Which causes are most important? How might LDCs reduce inflation?

12.Why was inflation so rapid in Latin America in the 1960s, 1970s, and 1980s?

13.In what way might inflation avert civil war or political violence?

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14.How important are monetary factors in contributing to LDC inflation?

15.What are the costs and benefits of inflation?

16.What is the role of the foreign-exchange rate in stabilizing inflation?

17.What is the empirical relationship between inflation and growth?

18.Compare the monetary, fiscal, and incomes policies to use in high-inflation countries to policies to use in countries with low inflation.

19.Explain the political and economic reasons for frequent LDC government financial repression and the effects it has on economic development. Indicate policies for LDC financial liberalization and ways in which they could affect inflation and real growth.

20.What effect might financial liberalization have on individual firms in LDCs?

21.What explains financial markets performing poorly in channeling funds to productive investment opportunities?

GUIDE TO READINGS

Tanzi and Zee (2000) discuss tax policy for LDCs. Tanzi (1990) analyzes fiscal policy in LDCs. Alesina and Rodrik (1994:465–490) have an article on tax policy, income distribution, and capital formation. Mishkin (1999:3–20) discusses the monetary factors contributing to global financial instability. Tun Wai (1956:249–278) discusses the limitations of monetary policy in LDCs. Teera and Hudson’s (2004:785–802) regression measures a country’s tax effort.

Bruno and Easterly (1998:3–24), Stiglitz (1998:4; 2002a:27, 45, 107), and Khan and Senhadji (2001:1–21) analyze the relationship between inflation and growth in LDCs.

Dornbusch (1993) analyzes how to stabilize an LDC experiencing high inflation. Marcet and Nicolini’s (2003:1476–1498) model shows how countries that experienced hyperinflation learn to lower seignorage and impose tight fiscal controls, thus avoiding recurrent hyperinflation. See Sachs and Larrain B (1993) on definitions of inflation and stopping high inflation.

De Oliveira Campos (1964:129–137) analyzes the controversy between monetarists and structuralists concerning Latin American inflation.

Stiglitz (2000: 1075–1086) examines how capital market liberalization affects economic growth. Stein, Ajakaiye, and Lewis (2001) have an insightful study into banking deregulation and corruption in Nigeria.

Agenor and Montiel (1996) discuss market structure, behavioral functions, exchange rate management, stabilization, structural reforms, and economic growth in an open-economy developing country.

McKinnon (1993) analyzes optimal strategies for financial liberalization in LDCs and transitional economies. Fry (1988), McKinnon (1973), Shaw (1973), and Blejer (1983:437–448) examine financial repression and liberalization and their impacts on development.

Ahluwalia (2002:67–88) shows how India’s economic reforms affected economic performance.

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Recent information on inflation is available from the International Monetary Fund’s annual World Economic Outlook and the World Bank’s annual World Development Indicators. Kindleberger, Manias, Panics and Crashes (1996), analyzes how speculative excess, often associated with the peaks of business cycles, spur financial crises.

Johnson (1965:22–28) has a systematic discussion of arguments for and against inflation.

Kuran (1995:155–173) has an excellent review article and bibliography on Islamic banking and economics.

The U.N. Development Program (1994:47–60, 170–171) discusses military spending and the peace dividend.

15Balance of Payments, Aid, and Foreign Investment

Scope of the Chapter

This chapter discusses international aid and investment. We look first at globalization and its meaning. Second, we examine LDC economic interdependence. The third section discusses capital inflows, and the fourth, their roles in reducing savings and foreign exchange gaps. The fifth section reviews the balance of payments. Finally, the last section analyzes how to finance the deficit.

Globalization and Its Contented and Discontented

Globalization1 is the expansion of economic activities across nation-states, including deepening economic integration, increasing economic openness, and growing economic interdependence among countries in the international economy (Nayyar 1997). For Harvard’s Dani Rodrik (1998:1–3), globalization involves the increasing international integration of markets for goods, services, and capital, pressuring societies to alter their traditional practices to be competitive in the world economy.

As University of Delhi Vice-Chancellor2 Deepak Nayyar (1997) points out, globalization took place during an earlier period, 1870–1913, as well as a later period, since 1950, especially since the 1970s and early 1980s. Similarities between the two periods include increases in export/GDP, capital flows, and technological change; trade then financial liberalization, the dominance of economic liberalism, the power of a hegemon or dominant economic power (early in Britain and later in the United States, other OECD economies, the World Bank, and the IMF), the dominance of the British pound (£) early and the U.S. dollar later, and scale economies (with new forms of industrial organization). Differences between the two periods included higher tariffs early, more non-tariff barriers late, strong externalization of services later, few foreign exchange flows early, greater capital flows/GNP early, more rapid expansion of international banking later, the dominance of intersectoral trade early, high labor flows (immigration/GNP) early, the disproportionate share of intra-industry trade (especially manufactures) later, and the increasing share of international trade that is intrafirm trade, that is, between affiliates of the same multinational corporation.

1 The title of this section is a modification of Stiglitz’s title (2002b).

2 A vice-chancellor in India is equivalent to a university president in the United States.

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Although liberal trade and capital flows benefit the world generally in the long run, globalization does reduce the autonomy of the nation-state economically and politically. Still, the state plays an important role in creating conditions for the development of specialized services, investment in education, industrial policy, establishment of institutions, facilitation and governance of markets, macromanagement of the economy, and minimization of social costs essential for globalization to contribute to the development of industrial capitalism (Nayyar 1997:17–18).

Dani Rodrik (1998:16–34) points out that an economy more open to foreign trade and investment faces a more elastic demand for workers, especially the unskilled, meaning that employers and consumers can more readily replace domestic workers with foreign workers by investing abroad or buying imports. Globalization increases job insecurity and shifts the cost of achieving improved working conditions from capital to labor. Rodrik thus supports DC protection against foreign sweatshops or low environmental standards. According to him, DCs have the right to restrict trade when it conflicts with widely held domestic norms. He asks: Aren’t DCs justified in opposing foreign workers working 12-hour days, earning below minimum wage, and lacking union protection in the same way that they would oppose domestic workers exploited in that way?

Columbia’s Jagdish Bhagwati agrees that the road to globalization has its rough sides, such as free flows of capital. Bhagwati criticizes the U.S. administrations’ inability to distinguish between free trade, with its “tremendous upside,” with the danger of free capital movements for LDCs with poorly developed financial institutions that need to borrow in dollars or euros. Bhagwati contends that governments need only modest assistance for those in import-competing industries facing adjustment from trade. However, the IMF and U.S. Treasury’s insistence on free capital movements for middle-income Asian countries contributed to the Asian financial crisis, 1997– 98, that “put in the hands of the foes of globalization the dagger they were seeking” (Bhagwati and Tarullo 2003; Radin 2000, quoting Bhagwati).

Bhagwati also led the Academic Consortium on International Trade (ACIT), a group of 242 economists trying to engage activists protesting the 2001 World Trade Organization meeting in Seattle. In an interview, Bhagwati argues that the MNC wage premium above local prevailing wages makes it difficult to argue that LDC apparel workers are “exploited.” Moreover, the ACIT contends that if activists drive up MNC wages, “the net result would be shifts in employment that will worsen the collective welfare of the very workers in poor countries who are supposed to be helped” (Featherstone and Henwood 2001).3

The gains of globalization were uneven across country, region, and class, and contributed to greater marginalization for some peripheral economies (such as subSaharan Africa). Although many believe that external openness is negatively correlated with income growth among the poorest 40 percent of the population of LDCs, Chapter 17 indicates that the results of empirical studies are mixed. Moreover, even

3Bhagwati was so impressed with the fervor of activist students at Seattle that he put their picture on the cover of his next book (Featherstone and Henwood 2001; Bhagwati 2004).

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some relatively prosperous groups are being hurt by globalization. Remember the discussion in Chapter 1 that indicated that DC middle classes are facing a deceleration in income growth, more competition from foreign (especially Asian) skills, and lowered expectations for a better life. Some of these middle classes may be part of the political mobilization against globalization.

Antiglobalization protests (perhaps misnamed, as many protesters may have been objecting to global industrial concentration and MNC domination and their effects on income distribution) increased during the 1990s and early years of the 21st century. People demonstrated, sometimes violently or were quelled violently by authorities, in opposition to the liberal economic agenda of leaders of DCs and international agencies. Protesters’ demonstrations frequently irritated or disrupted international meetings of the IMF, World Bank, World Trade Organization, Group of Seven (G-7), the Food and Agriculture Organization of the U.N., OECD, and the World Economic Forum for economic elites at the Davos, Switzerland, ski resort – at least when these meetings were held in accessible venues. Antiestablishment protesters held an antiDavos World Social Forum in Port Alegre, Brazil and Mumbai (Bombay), India. The Wall Street Journal – Europe (November 2, 2001, p. 3) supported the 2001 WTO meeting being held in Doha, “in the remote Persian Gulf state of Qatar,” glad that the “anti-globalization protesters who hijacked its last meeting two years [before] in Seattle won’t be there” (World Bank Development News, November 2, 2001).

North–South Interdependence

The countries of the North (DCs) and the South (third world) are economically interdependent. Even the United States, which, together with Japan, has the lowest ratio of international trade to GDP among DCs, depended more on the third world in the early 1990s than in the early 1970s. The U.S. merchandise imports as a percentage of GDP, which increased from 6 percent in 1970 to 12 percent in 1980, fell to 9 percent in 1987 before rising again to 10 percent in 1994 and 13 percent in 2001 (but, given the large U.S. trade deficit, exports were only 8 percent). However, U.S. exports to third-world countries (excluding Eastern Europe and the former Soviet Union) as a percentage of the total increased from 31 percent in 1970 to 38 percent in 1975 to 41 percent in 1981 before dropping to 34 percent in 1986 and 34 percent in 1990, but rising to 40 percent in 1994 and 43 percent in 2001. The U.S. imports from the third world increased from 25 percent in 1970 to 42 percent in 1975 (soon after the 1973–74 great oil price hike) to 46 percent in 1981 before declining to 34 percent in 1986, as oil prices fell and the United States became more competitive with dollar depreciation, but increased to 39 percent in 1990 and 42 percent in 1993 and 46 percent in 2001. The share of U.S. trade with the third world was more than that of Japan, Canada, the European Union-15, Australia, or New Zealand (U.S. Council of Economic Advisers 2003:269–404; World Bank 2004f:288).

In 2002, 54 percent of U.S. petroleum consumption was imported, of which 95 percent was from the third world. In about the same year, imports from the third world as a percentage of total consumption were high for a number of vital

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minerals – 100 percent for coltan (essential for cellphones) and strontium, 83 percent of columbium, 88 percent for natural graphite, 86 percent for bauxite and alumina, 80 percent for manganese ore, 74 percent for tin, 62 percent for flourspar, 58 percent for barite, 57 percent for diamonds, and 51 percent for cobalt (U.S. Department of Commerce 1994; Energy Information Administration 2004; Kelly, Buckingham, DiFrancesco, Porter, Goonan, Sznopek, Berry, and Crane 2004).

In 1980, an independent commission, consisting of 20 diplomats from five continents chaired by former German Chancellor Willy Brandt, stressed that interdependence created a mutual interest by both North and South in reforming the world economic order. However, in the 1980s, LDC government remained dissatisfied with the lack of progress made by North–South conferences in reshaping old international economic institutions (or setting up new ones) to implement the Brandt Commission recommendations or the U.N. General Assembly’s call for a new international economic order in the mid-1970s (see Nafziger 2006b). Among northern governments, the United States, still the world’s major trader, banker, investor, and aid-giver, despite a relative decline in international economic power after the mid-20th century, was the most vocal in arguing that major changes in international economic institutions were not in the U.S. interest and perhaps of limited benefit even to LDCs. Keep this background in mind as we discuss external financing and technology in LDCs.

In the past, economists remarked that when the United States sneezed, Europe and Asia caught pneumonia (see Krugman 1999:97 on a similar observation). But the United States may no longer be the sole economic superpower. Jonathan Heathcote and Fabrizio Perri (2003:63) find “that over the last 40 years the U.S. business cycles have become less synchronized with the cycle in the rest of the world.”

The increase in China’s GNI, a figure likely to surpass that of the United States by the end of the first quarter of the 20th century, and the emergence of the European Union as the world’s single largest market mean a decline in U.S. dominance. China’s consumption boom played a major role in Japan’s recovery in 2003 (Economist 2004b; Moffett and Dvorak 2004:A1) and may forestall East Asia’s exhausting its long-sustained growth based on the advantages of technological backwardness, learning by doing, and increasing returns to scale.

Capital Inflows

National-income equations show the relationship between saving, investment, and exports minus imports of goods and services (that is, the international balance on goods, services, and income) or capital inflows.

The following equation shows income (Y) equal to expenditures (or aggregate supply equal to aggregate demand). National income, when calculated on the expenditure side, is

Y = C + I + (X − M)

(15-1)

where C = consumption, I = domestic capital formation (or investment), X = exports of goods and services, and M = imports of goods and services.

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Savings (S) is that part of national income that is not spent for consumption, viz.

S = Y − C	(15-2)
Hence
Y = C + S	(15-3)
Thus, national income is equal to
C + I + (X − M) = C + S	(15-4)
If we subtract C from both sides of the equation,
I + (X − M) = S	(15-5)
Subtracting X from and adding M to both sides results in
I = S + (M − X)	(15-6)

If M exceeds X, the country has a deficit in its balance on goods, services, and income. It may finance the deficit by borrowing, attracting investment, or receiving grants from abroad (surplus items). Essentially

M − X = F

(15-7)

where F is a capital import, or inflow of capital from abroad. Substituting this variable in Equation 15-6 gives us

I = S + F	(15-8)
Equation 15-8 states that a country can increase	its new capital formation

(or investment) through its own domestic savings and by inflows of capital from abroad. (When a politically or economically unstable LDC exports capital through capital flight, there is an outflow of domestic savings; a net outflow means F is negative in Equation 15-8.)

LDCs obtain a capital inflow from abroad when institutions and individuals in other countries give grants or make loans or (equity) investments to pay for a balance on goods and services deficit (or import surplus). Thus, in 2001, Mexico received grants, remittances, and transfers of $9 billion and a net inflow of capital of $11 billion, and increased official liabilities by $7 billion to pay for a merchandise deficit of $10 billion and a service deficit of $17 billion. See Table 15-1 for the international balance of payments statement, an annual summary of a country’s international economic and financial transactions. A double-entry bookkeeping system ensures that current (income) and capital accounts equal zero.

This inflow of foreign funds enables a country to spend more than it produces, import more than it exports, and invest more than it saves (Equations 15-1–15-8), and thus fills the gaps that limit development. A study by MIT economists (McCarthy, Taylor, and Talati 1987:5–39) indicates that without capital goods imports (electrical, mechanical, and transport equipment, machinery, and instruments, not the same as capital imports in Equations 15-7 and 15-8), LDCs run an export surplus. The