Import Substitution

The rise and fall of an economic growth model

The 20th century saw the implementation of many different economic models. At least three of these models failed to bring the promised results: Soviet Style Communism, Nazi / Italian War Preparations & Conflict Developed Economies, and the Import Substitution Model, pushed particularly after World War II. Of these, Import Substitution (IS) was the most popular and successful in Latin America, Africa and ex-colonies. Import Substitution turned out to have problems, but it was thought to be the best from the 1930s to the late 1970s.

Import Substitution has a mixed success rate. It worked most successfully in large Latin American countries: Mexico, Brazil, and Argentina. It was less successfully implemented elsewhere. Even in the successful situations, the measurement of success is questionable.

Basic Theory

Import Substitution is a response to the colonial model used for hundreds of years previously. In a colonial model, a colony produced raw goods or natural resources. The goods were then exported them to the colonial ruler. The colonizing country took in the raw goods, and added value to them and then the goods were sold with the profit going to the manufacturer, not the provider of raw goods.

For many countries, this model continued after independence because the economy and infrastructure were designed to support this export and the system rolled forward due to inertia. Slow growth in many countries combined with the attractiveness of the communist ideology created a need for a new solution.

The Import Substitution Model proposed a solution that the early United States used. Raise tariffs very high on imported goods, that way your country will produce those goods for your national population. This will increase prices in the country, but that will be offset by the better wages you can pay in manufacturing the items you know import. In this theory, the only losers would be the rich economies that make their money off the poorer countries’ resources.

Limitations of Import Substitution

Import Substitution has certain natural limitations as well as policy changes over time.

The IS model works better with large economies, already in growth mode. In 1960 the populations of Mexico, Brazil and Argentina were 40, 70 and 21 million people respectively. The population of the United States at the time was about 180 million. These 3 countries had a population base and infrastructure system large enough to support multiple growth sectors at a time. Many key export businesses were nationalized like the companies profiting off Mexican Oil business nationalized into Pemex. In Brazil new tariffs and requirements manufacturing inside Brazil the only way for foreign companies to compete on price. The large market in Brazil forced many industries to manufacture for the local market inside the country.

But for countries with smaller populations and less developed industries, IS was not successful. They did not have the economies of scale to build entire industries or supply chains. So IS raised prices but did not benefit most of the people.

Newly independent countries in Africa and Asia lacked the basic infrastructure for IS. The infrastructure: roads, airports, harbors, etc, were designed to get raw materials out of the country. In many countries businesses were nationalized under the guise of IS, but the benefits rolled to the politically connected not the people.

End of Import Substitution

Import Substitution depended on keeping tariff rates high to discourage or end imports. But the post-War trade systems for more developed nations encouraged trade among countries AND dropping tariffs. This can lead to a new balance of trade where countries focused on profitable exports rather than creating impediments to importation.

The General Agreement on Tariffs and Trade, GATT, was built on the assumption that lower tariffs were desirable and would increase trade, and therefore value, for all participating countries. GATT was established in 1947 to lower tariffs. The members held 8 meetings through 1993 when the World Trade Organization was established. The Import Substitution model was compared to the open trade model and was found lacking. Countries that had opened their markets to trade grew quicker than countries using the Import Substitution Model.

Note: The measurements and conclusions regarding model types at that point in time has been challenged since. Primarily because the major beneficiaries of freer trade were the richer countries. These included countries like the United States, France and Mexico who arguably became established economies via Import Substitution but then participated in free trade at the expense of undeveloped countries.

GATT and then the WTO prevailed as the international institutional model that grew economies and democracies. The members of these trade groups shunned Import Substitution and high tariffs. This “international institutional” system includes the International Monetary Fund and the World Bank as well. Countries that borrowed through the International System usually must promise to open their economies up to get access to these funds. And less developed countries must agree to the international system rules if loans are forgiven.

New Economic Models

Newer developmental growth models are focused on some different solutions. The late 1980s, the end of communism lead to the idea of “The Big Bang”. Promoted at the time by Jeffrey Sachs, the Big Bang school of development was adopted in the ex-communist countries of Eastern Europe. This involved extremely quick conversion of national properties and businesses into private hands. Either through selling them to foreign businesses or creating ownerships co-ops from the population. This method was very successful in specific cases, but a country must have an honest and law-biding government. For example, the Big Bang worked well in Czechoslovakia and Hungary. The Big Bang method ultimately failed in Russia as key pieces of the economy were sold at very little costs to friends of the leadership group.

The other new development model occurs in countries where a centralized government authority directs the growth of a country. The leaders of the economy pick and choose what sectors to invest in and focus on those. The western hope that a better economy leads to a freer world as people are rewarded with more goods and freedoms as the economy grows. Countries like Singapore, Malaysia and China are used as examples of this model.

This model works well - with caveats. It is extremely hard to transition from an economically smart autocrat to a democratic system. We have seen the political struggles in Singapore, Malaysia and South Korea where a booming economy gives rise to a populations’ expectations for more political freedom. And if the transition does not occur, often the economy will stall after a leadership change. Singapore in particular has been able to avoid this situation with a full governmental dedication to economic growth, universal prosperity and civic responsibility - regardless of the country’s leader.

To date, China has been able to avoid an economic crash despite a change in the economic philosophy of leadership. A possible solution, popular in China, is that their economic directions have been better. A more likely explanation is that China is large enough to have a domestic economy that is not reliant on the world as much.

Is Import Substitution use anymore?

Import Substitution is still widely used, albeit with changes in motivation and nomenclature. The WTO allows tariffs in those critical industries which countries determine are necessary for their protection. The United States under President Trump placed the Steel Industry under this exception. Under President Biden, computer chips have been placed under this exception.

Other countries often do the same thing for certain periods. For example, for decades after World War II, the Japanese government oversaw the car manufacturing sector. They priced foreign suppliers out of the market, in order to develop seven carmakers picked as national champions. But Japan also allowed other companies to compete, Honda being one the successful internal competitors. And while Honda did not flourish because it was selected as a growth company by Japan, it did benefit from the excessive import tariffs of foreign autos.

As a development model, Import Substitution is a flawed system. It may bring some larger countries short term gains, a country needs to abandon IS in order to fully participate in the world economy.