Import substitution industrialization

Based on Wikipedia: Import substitution industrialization

The Great Economic Experiment That Almost Everyone Tried

Here's a puzzle that should trouble anyone who thinks they understand how countries get rich: virtually every industrialized nation on Earth—from the United States to South Korea—got that way by doing something economists now tell developing countries not to do.

They protected their industries from foreign competition.

This approach has a name: import substitution industrialization, which economists shorten to ISI. The idea is elegantly simple. Instead of buying manufactured goods from abroad, make them at home. Instead of depending on foreign factories, build your own. Instead of sending your money overseas, keep it circulating in your domestic economy.

The logic seems almost too obvious to argue with. And yet ISI remains one of the most controversial economic strategies ever attempted, championed as the path to prosperity by some and blamed for decades of stagnation by others. Understanding why requires unpacking not just economic theory but the messy reality of what happened when dozens of countries tried this experiment simultaneously in the twentieth century.

What Import Substitution Actually Means

Let's start with what ISI isn't: it's not about eliminating imports entirely. That would be autarky—complete economic self-sufficiency—which almost no serious economist has ever advocated. Countries that industrialize actually import more, not less. They just import different things.

Before industrialization, a country might import finished consumer goods: clothing, appliances, automobiles, electronics. After pursuing import substitution, that same country imports the raw materials and machinery needed to make those products domestically. Petroleum. Chemicals. Industrial equipment. The sophisticated machine tools that manufacture other machines.

The goal is to move up what economists call the value chain. Raw cotton sells for pennies. Cotton fabric sells for dollars. A finished shirt sells for much more. A country that exports cotton and imports shirts captures far less value than one that does the whole process at home.

To make this shift happen, ISI advocates argued, governments needed to do several things simultaneously. First, impose tariffs—taxes on imported goods—making foreign products more expensive than domestic alternatives. Second, overvalue your currency, which sounds counterintuitive but actually helps manufacturers import the capital goods they need to build factories. Third, actively subsidize domestic industry, particularly in strategic sectors. Fourth, sometimes nationalize key industries or utilities outright.

The state, in other words, would lead economic development rather than leaving it to market forces alone.

The Intellectual Roots Run Deep

Though ISI is usually associated with mid-twentieth-century Latin America, the underlying ideas are much older. Alexander Hamilton, the first United States Treasury Secretary, articulated perhaps the earliest systematic case for protecting infant industries in his 1791 Report on Manufactures. Hamilton argued that the young American republic needed to develop its own manufacturing base rather than remaining dependent on British imports—even if British goods were cheaper and better in the short term.

Hamilton's logic was strategic as much as economic. A nation that couldn't manufacture its own goods was vulnerable. What happens when war cuts off your supply of imported weapons, ships, or even basic necessities? The United States needed industrial self-sufficiency for national security.

The German economist Friedrich List elaborated these ideas in the nineteenth century, arguing that free trade might benefit already-industrialized nations like Britain while trapping developing economies in permanent dependence on raw material exports. List coined the term "infant industry"—the idea that new manufacturing sectors need protection from established foreign competitors until they grow strong enough to compete on their own merits.

This is the intellectual tradition that would flower into full-blown ISI doctrine in the twentieth century.

The Latin American Laboratory

The Great Depression of the 1930s inadvertently launched the largest experiment in import substitution the world had ever seen. When global trade collapsed, Latin American countries that had been exporting coffee, beef, copper, and other commodities suddenly found themselves unable to afford the manufactured goods they had been importing.

They had no choice but to make things themselves.

This wasn't initially driven by sophisticated economic theory. It was pragmatic desperation. But it worked well enough that leaders began to see it as a deliberate strategy. In Argentina, Juan Domingo Perón promoted state-led industrialization. In Brazil, Getúlio Vargas did the same. Both were influenced by the apparent success of state-directed industrialization in Fascist Italy and, to some extent, the Soviet Union.

The theoretical framework came later, primarily from the Argentine economist Raúl Prebisch and his colleagues at the United Nations Economic Commission for Latin America and the Caribbean—known by its Spanish acronym, CEPAL. Prebisch had run Argentina's central bank and had grown skeptical of the standard free-trade prescription that economists recommended for developing countries.

His argument was both elegant and devastating to conventional economic wisdom.

The Prebisch-Singer Thesis

Prebisch observed something that classical economics couldn't easily explain: over time, the prices of primary commodities—agricultural products, minerals, raw materials—seemed to decline relative to the prices of manufactured goods. A country that exported wheat and imported tractors would find that each year it needed to export more wheat to afford the same number of tractors.

This meant that free trade wasn't a level playing field. The rules of the game systematically transferred wealth from commodity-exporting countries in the periphery to manufacturing economies in the center—primarily Britain and the United States.

The British economist Hans Singer independently reached similar conclusions around the same time, which is why economists now call this the Prebisch-Singer thesis.

If this thesis is correct—and it remains debated—then the standard economic advice to developing countries amounts to telling them to accept permanent subordination. Specialize in what you're currently good at, the textbooks said. For Latin America, that meant agriculture and mining. But if commodity prices are doomed to fall relative to manufactured goods, then following this advice means falling further behind forever.

The only escape, Prebisch argued, was industrialization. And since local manufacturers couldn't immediately compete with established industrial powers, governments needed to protect them until they could.

The Results Were Mixed at Best

For a while, ISI seemed to work brilliantly. By the early 1960s, domestic industry supplied 95 percent of Mexico's consumer goods and 98 percent of Brazil's. Between 1950 and 1980, Latin America's industrial output increased sixfold, easily outpacing population growth. Living standards improved dramatically: infant mortality fell from 107 per 1,000 live births to 69 per 1,000, and life expectancy rose from 52 years to 64.

In the mid-1950s, Latin American economies were growing faster than those of the industrialized West.

And then it all fell apart.

The problems were multiple and reinforcing. State-owned enterprises set up to lead industrialization rarely became profitable; they became patronage machines, employing political supporters regardless of economic need. Governments ran persistent budget deficits trying to keep these enterprises afloat.

Protected industries had no incentive to become efficient. Why invest in better technology or management when tariffs guaranteed you'd face no serious competition? The manufactured goods these countries produced were often shoddy and expensive—fine for captive domestic markets but utterly uncompetitive internationally.

Meanwhile, the agricultural sector—the one thing these countries were actually good at producing—withered under policies designed to transfer resources to industry. Export earnings declined even as import needs increased. The result was chronic balance-of-payments crises.

Perhaps worst of all, the system created enormous opportunities for corruption and what economists call rent-seeking. If government officials decide which industries get protected and which companies receive subsidies, businesspeople will spend enormous resources lobbying those officials rather than improving their products. The profits from government favors can dwarf anything available from actually serving customers well.

Why Size Matters

ISI worked best—or failed least badly—in large countries. This isn't coincidental; it's almost mathematical.

Consider what it takes to manufacture automobiles efficiently. You need a certain minimum scale of production before the massive investments in factories, tooling, and skilled workers pay off. A plant that produces ten thousand cars per year will have far higher costs per vehicle than one producing five hundred thousand.

Brazil, with its enormous population and growing middle class, could plausibly support an automotive industry. The domestic market was big enough that Ford, Volkswagen, General Motors, and Mercedes-Benz all built production facilities there in the 1950s and 1960s. These weren't purely domestic companies—ISI didn't require rejecting foreign investment, just foreign imports—but they manufactured locally.

Honduras could not do this. Neither could Ecuador or the Dominican Republic. Their populations were too small and too poor to constitute markets large enough to support capital-intensive manufacturing. These countries could substitute imports of simple consumer goods—textiles, processed foods, basic household items—but the more sophisticated products remained beyond reach.

CEPAL economists recognized this problem and proposed two solutions. First, redistribute income within each country, bringing the enormous marginalized populations into the consumer economy through land reform and social programs. Second, integrate regional markets so that products made in one Latin American country could be sold in another without tariffs.

Neither solution proved politically feasible at scale.

The African Experience

Latin America wasn't the only region experimenting with ISI. As African nations gained independence in the late 1950s and 1960s, many adopted similar policies, seeing industrialization as both economically necessary and symbolically important—a rejection of the colonial role that had confined them to exporting raw materials.

The challenges were even greater than in Latin America. Colonial economic policies had deliberately structured African economies to serve metropolitan needs, promoting monocultures—economies centered on a single export crop or mineral. Ghana depended on cocoa, Nigeria on palm oil and later petroleum, Zambia on copper.

These weren't diversified economies that could be redirected toward manufacturing. They were extraction systems designed to benefit London, Paris, and Brussels. Local populations had minimal say over what was produced and retained marginal profits from their labor.

When independence came, the new governments inherited these distorted economies and limited industrial capacity. ISI policies struggled against these structural constraints, generally achieving less success than in Latin America.

The East Asian Counterexample

While Latin America and Africa experimented with ISI, a different model was emerging in East Asia. South Korea, Taiwan, Hong Kong, and Singapore—the four economies that would later be called the Asian Tigers—pursued what appeared to be a fundamentally different strategy: export-oriented industrialization.

Instead of protecting domestic markets from imports, these governments pushed their companies to compete in international markets from the start. Instead of high tariffs, they offered subsidies and support for firms that could export successfully. Instead of overvalued currencies that made imports cheap, they maintained exchange rates that made their exports competitive.

The results were spectacular. These four economies achieved growth rates that seemed almost impossible, transforming from poor agricultural societies to wealthy industrial powers in a single generation.

This contrast—ISI failure in Latin America versus export-orientation success in East Asia—became central to economic policy debates from the 1980s onward. The conclusion seemed obvious: protectionism failed, free markets worked, and developing countries should open their economies to international competition.

But the reality is considerably more complicated.

The Inconvenient Details

The Asian Tigers weren't actually practicing textbook free-market economics. Their governments intervened constantly and extensively in their economies. South Korea's industrial policy was extraordinarily dirigiste—the government picked winners, directed credit to favored sectors, and sometimes ordered companies to merge or enter new industries whether they wanted to or not.

What differed was the direction of intervention. Latin American governments protected firms from competition; East Asian governments exposed them to it while providing support. Latin American protection was unconditional; East Asian support was tied to performance. Hit your export targets and you received continued help. Fail and the support disappeared.

The South Korean economist Ha-Joon Chang, in his provocatively titled book Kicking Away the Ladder, argues that the distinction between ISI and export-orientation obscures more than it reveals. All industrializing countries, he contends, have used some form of infant-industry protection. What matters is how long protection lasts and whether it's structured to create genuine competitiveness rather than permanent dependence on government support.

Chang goes further, arguing that today's wealthy countries—including Britain, the original apostle of free trade—used exactly the protectionist policies they now tell developing countries to avoid. Having climbed the ladder of development, they're kicking it away to prevent others from following.

The Debt Crisis and the Death of ISI

Whatever ISI's theoretical merits or demerits, the strategy died as a practical matter in the 1980s. The executioner was debt.

Throughout the 1970s, Latin American governments borrowed heavily from international banks, which were flush with petrodollars—money from oil-exporting countries recycled through the global financial system. The loans funded continued industrialization and, often, corruption and waste.

When the United States Federal Reserve dramatically raised interest rates in 1979 to combat inflation, these debts became unpayable. Country after country defaulted or approached default. Mexico's crisis in 1982 triggered what became known as the lost decade of Latin American economics.

The International Monetary Fund and World Bank stepped in with rescue packages, but the price was abandoning ISI. Countries had to reduce tariffs, privatize state-owned enterprises, open their economies to foreign investment and competition, and generally adopt what critics called the Washington Consensus—a package of free-market reforms that seemed designed to help foreign creditors more than local populations.

By the late 1980s, ISI was effectively dead as policy throughout most of the developing world. Countries that had spent decades building industrial capacity behind protective walls suddenly faced international competition. Many domestic firms couldn't survive the transition.

The Uncomfortable Question

We're left with a genuine puzzle. If ISI was so clearly wrong, why did it seem to work for a while? Why did virtually all successful industrializing nations use some version of it? And why has no country successfully industrialized through pure free trade?

Part of the answer may be that ISI's failure wasn't inevitable—it was mismanaged. Protection that was meant to be temporary became permanent. Subsidies went to political supporters rather than promising industries. State enterprises became jobs programs rather than competitive businesses. The problem wasn't the core insight that infant industries need support; it was the political corruption of that insight.

Another part of the answer may be timing. ISI might have been appropriate for a particular moment in economic history—the mid-twentieth century, when manufacturing was the clear path to prosperity and international trade was far less important than it would become. By the 1980s, the global economy had changed in ways that made inward-looking development strategies less viable.

A third possibility is that the success stories—particularly in East Asia—weren't really doing something different. They were doing ISI better, with tighter discipline, less corruption, and more effective state institutions. What looked like export-orientation from outside was really a more competently executed version of state-led industrialization.

The debate continues. When economists today argue about industrial policy—whether governments should try to promote particular sectors like semiconductors or green energy—they're continuing a conversation that goes back through Prebisch and List all the way to Hamilton.

What We Know and What We Don't

Some conclusions seem reasonably solid. Permanent protection creates permanent inefficiency. Countries can't substitute imports forever; eventually they need to compete internationally or face stagnation. The political economy of protection creates powerful interests opposed to reform, making temporary measures tend to become permanent.

Other questions remain genuinely open. Can a well-governed country use infant-industry protection effectively, or will political pressures always corrupt the process? How important is manufacturing specifically, versus industrialization more broadly, versus just economic growth however achieved? What lessons from the twentieth century apply to the very different global economy of the twenty-first?

The appeal of ISI—the intuitive sense that a country should be able to make its own things—hasn't disappeared. When politicians today talk about bringing manufacturing jobs back, or reducing dependence on foreign supply chains, or achieving self-sufficiency in strategic industries, they're drawing on the same logic that motivated Prebisch and Hamilton.

Whether they can avoid the same pitfalls remains to be seen.