profitable. Such capacity would probably be scrapped, rather than converted
for other purposes. Private entrepreneurs might not believe in the lasting power
of a liberalization-devaluation strategy for many reasons. Trade liberalization
might not be credible if accompanied by an import surge and a resulting large
balance of payments deficit, if the tariff cuts generate an unsustainable govern-
ment budget deficit, if liberalization causes redistribution of income in the
domestic economy (see below) that is not politically sustainable, or if govern-
ment is not truly committed to the liberalization (perhaps because it has been
imposed by foreign donors in return for aid). Rational entrepreneurs would
then withhold investment until any uncertainty regarding the success/sustain-
ability of reforms is eliminated (Rodrik, 1990). Yet without that investment
reforms will fail to generate exports and economic growth. The failure of
reforms will become a self-fulfilling vicious circle.
It is almost impossible to quantify the credibility beliefs of private investors,
but there are good reasons to consider that much of the 1980s liberalization in
developing countries was not ‘credible’. Because liberalization was often
imposed by the IMF at moments of crisis, investors doubted that the domestic
government had any real commitment to it. Liberalization (particularly cuts in
subsidies and import tariffs) generated enormous political opposition; from
farmers who benefited from fertilizer subsidies, from manufacturing firms that
depended on protection from imports and from urban workers who enjoyed the
cheap imported consumer goods provided by an overvalued exchange rate.
Investors rightly concluded that this would pressurize governments into
reversing many aspects of liberalization.
Liberalization was in many cases accompanied by stabilization. Through
unsustainable budget and trade deficits in the 1970s, countries had run into debt
crises in the 1980s. Higher world interest rates in the early 1980s added to their
burden of debt and higher oil prices after 1979 added to import costs.
Governments in developing countries responded by strenuous efforts to reduce
budget deficits,by cutting spending and raising tax revenue. Much of the world
lurched into recession in the early 1980s, and across the developing world real
wages fell sharply. The 1980s were thus not conducive to private sector indus-
try investment,even though savings were becoming more easily available
through liberalized and privatized financial systems. The work of Keynes dating
back to the global depression of the 1930s, discussed in Box 3.2 explains why.
Regarding the work of Keynes it is evident that the animal spirits of entre-
preneurs in the 1980s were depressed by stagnant global markets and falling
profit expectations. The liberal model wrongly assumed that private firms
would compete to borrow all available resources to invest. The Keynesian
model rightly assumed that banks would be left with surplus liquidity if private
firms lacked the motivation to borrow and invest. The contemporary world
economy offers another such example. The top one hundred firms, as listed on
the UK Stock Market,were by 2013 sitting on a cash pile (surplus cash hold-
ings in banks) of almost $270 billion, up by $70 billion since 2008. Firms had
the resources but were simply not investing.
Domestic and Foreign Direct Investment 71