2008 11:25:33 AM] - hawaii.edulchung/KOREAandTransition Economies[OECD].pdf*Professor of Economics, ... current transition economies in East and Central Europe. First, ... Second,

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ECONOMIC TRANSFORMATION OF SOUTH KOREA AND

LESSONS FOR THE TRANSITION ECONOMIES

Chung H. Lee*

July 1994



*Professor of Economics, University of Hawaii at Manoa and Senior Fellow, the Program on International Economics & Politics, East-West Center, Honolulu, Hawaii.



I. Introduction

The problems faced by transition economies--those economies attempting to make the transition from a centrally planned to a market economy--are inter alia the absence of well-functioning markets and the institutions necessary for such markets. Many of the "supply-side failures" which result from the absence of the preconditions necessary for efficient markets are, however, also the problems that are endemic to developing countries since they too lack many of these preconditions. Thus many of the problems associated with economic transition are, in a fundamental sense, not different from those relating to economic development. Because of this commonality, development experiences of some of the most successful Asian economies may provide lessons for those countries now undergoing the transition process. Of these, South Korea (henceforth Korea) is selected here as an example since (1) it has successfully transformed a war-torn, primarily agricultural economy into a modern industrial powerhouse in a short span of less than thirty years and (2) there are some striking similarities between the Korea of the immediate post-World War II period and many of the current transition economies in East and Central Europe.

First, between 1910 and 1945 the Korean peninsula was a Japanese colony with its economy developed to serve the Japanese empire. It was primarily an agricultural economy, supplying rice and raw materials to Japan but also serving as a market for Japanese manufactured goods. Beginning in 1930, however, some industries were established on the peninsula with heavy and chemical industries located mostly in the north and light manufacturing industries in the south. The liberation of the Korean peninsula from the Japanese colonial rule in 1945 thus meant that, overnight, its economy lost the export market for rice and raw materials and the source of manufactured consumer and intermediate goods. The situation worsened as the peninsula was soon divided into two parts along the 38th parallel with North Korea keeping most of the heavy and chemical industries and South Korea inheriting agriculture and some light manufacturing industries. This abrupt structural change is very similar to that experienced by some of the countries in East and Central Europe upon the dissolution of the Council for Mutual Economic Assistance (CMEA).



Second, at the time of liberation 94 percent of manufacturing capital and 63.4 percent of the cultivated land in South Korea were owned by the Japanese (Kyung-Je Pyung-Ron Sa 1982). Korea was thus faced with the task of transferring the ownership of these properties to the Koreans, a situation very similar to the privatization problem faced by the transition economies.

A third similarity is that, at the time of liberation there were few Korean entrepreneurs as, with the exception of small enterprises, most factories on the Korean peninsula were managed as well as owned by the Japanese. Thus the Koreans lacked technical and managerial expertise to run these factories, and for that reason as well as for lack of funds, raw materials and intermediate inputs, there was, in South Korea, a significant contraction in output and employment soon after liberation. According to one estimate, the contraction in output and employment was 44 and 59



percent, respectively (Kyung-Je Pyung-Ron Sa 1982).1

These similarities do suggest that there are some useful lessons that the present transition economies may draw from the experience of Korea's successful economic transformation. But, of course, what these lessons might be clearly depends on what we understand to be the causes of that transformation. According to a widely held view, Korea has been able to transform its economy successfully because of its adoption of sensible macroeconomic policies. These policies are supposed to have created a stable and unbiased incentive structure, which in turn brought about rapid export expansion and economic growth (e.g., Balassa 1980, 1981, and 1988, Lau 1990). Implicit in this view are two assumptions which are basic in neoclassical economics: First, in an efficiently functioning economy the role of the state is limited only to that of establishing a stable and neutral incentive structure and, second, the private sector is capable of promptly responding to price incentives.

There is currently, however, growing skepticism about this neoclassical interpretation as we have learned more about the role of the state in Korea. The weight of the evidence is that the Korean government has played a far more active and direct role in managing the economy than merely adopting sensible macroeconomic policies (e.g., Alam 1989, Amsden 1989 and 1992, Bradford 1987 and 1992, Choi and Lee 1990, Dornbusch and Park 1987, Ho 1981, Hong 1990, Johnson 1985, Lee 1992, Roh 1990, Wade 1985 and 1990, Westphal 1990, Whang 1987, and World Bank 1993).2 This is not to suggest, however, that there were no earlier challenges to the neoclassical interpretation. In fact, in a 1980 report summarizing a series of joint studies on Korean development by the Harvard Institute for International Development and the Korea Development Institute, Mason, et al. (1980, p.2) state that:

"This literature [on Korea's "success" story and the supposed reasons for success] in the main stresses changes in macroeconomic magnitudes and the macroeconomic policies to which these changes are attributed. Indeed, according to certain interpretations, rapid economic growth of Korea is to be principally accounted for by these macroeconomic policies,



the implication being that if other less-developed countries want to accelerate development all they need do is adopt similar measures. We do not believe this is so. There is much more to Korean economic development than sensible monetary, fiscal, and foreign exchange policies." (Emphasis added.)

Another issue relating to the sufficiency of sensible macroeconomic policies for the successful transformation of the Korean economy is whether or not it would have been possible had the government adopted the same set of policies prior to the 1960s. The neoclassical answer would be, obviously, affirmative given its implication that all that the developing countries need to do for rapid economic development is to adopt sensible macroeconomic policies. If differences between countries do not matter to the



successful outcome of sensible macroeconomic policies, it would follow that the timing of their adoption in a particular country would not matter either. In fact, most of the studies on rapid industrialization and economic growth in Korea give that impression by focusing only on periods beginning in the early 1960s and neglecting the 1950s when some crucial developments for later success took place (e.g., Dornbusch and Park 1987, World Bank 1993).

A more careful examination of the Korean experience tells, however, a much more complex story. According to Kuznets (1977), rapid growth was possible after the early 1960s only because certain institutional or historical constraints were loosened by then. In other words, loosening these constraints or, alternatively speaking, building a platform for takeoff, was a necessary condition for the macroeconomic policies to be effective in bringing about rapid economic development. What is also clear is that such a platform could not have been established overnight.

Some of these constraints were a part of Korea's colonial legacy. For instance, in 1945, when the Korean peninsula was liberated from the Japanese colonial rule, the country was left with widespread illiteracy and a ill-trained labor force. Furthermore, the "Yen Bloc" specialization which had made the peninsula a supplier of rice and raw materials for Japan and a market for Japanese manufactures, the partitioning of the peninsula which deprived South Korea of most of the heavy and chemical industries established during the colonial rule, and the Korean War which destroyed much of the infrastructure and manufacturing capital that Korea inherited from the Japanese colonial rule all made it necessary to rebuild as well as restructure the economy before rapid industrial development could take place. This period of rebuilding and restructuring was needed to prepare a platform for the subsequent takeoff. In the words of Kuznets (1977, pp.91-2.),

Economic performance may have been unimpressive during the years immediately after the Korean War..., but during this time a number of Korea's inherited constraints were loosened. Reconstruction and import substitution restored and added new



industry so that the country had a reasonably coherent economic structure by the early 1960s. Land reform and the disruption of output that tends to follow reform were completed by 1958. Also, the new generation entering the labor force had more education and better job training than its predecessors.

There are thus at least two important lessons that the contemporary transition economies may learn from the Korean experience.3 The first is that there are certain preconditions that are necessary if sensible macroeconomic policies are to be effective in bringing about their intended results. The second lesson is that the transition from a centrally planned socialist economy to a market economy where the role of government is limited largely to a regulatory function may require a transition through a



phase during which the government may have to play a more active role in resource allocation than envisioned in neoclassical economics.

These lessons are especially important now for there seems to be an over-reaction to the failure of planned socialist economies and thus a denial of any active role for the state in economic transition. In fact, a correct lesson from the Korean experience could be an effective antidote to the over-reaction observed by Bruno (1992, p.775) in several East European countries where:

..., capitalism is viewed simplistically by those who would like to embrace it as a well-oiled system consisting only of private property ownership and pure laissez-faire and self-adjusting market mechanisms, requiring no government interference. However, market failures often occur in the most laissez-faire economies (for example, in financial markets), and governments have to intervene in the microeconomy.

Thus, a hands-off policy during the transition from a centrally planned to a market economy would be most inappropriate. The temptation to resort to the old mistakes under central planning may be strong--for example, in the process of restructuring--but that possibility should not be used as an argument against any government intervention during the transition period.

The remaining part of this paper provides empirical and theoretical rationale for the above two lessons from the Korean experience by examining (1) certain crucial developments that took place in the 1950s and (2) the role that the Korean government has played since the early 1960s to promote rapid industrialization. The following section thus examines three developments that took place during the 1953-1960 period--a period from the end of the Korean War until the collapse of the Rhee regime4--which, we believe, laid a foundation for rapid industrialization in the subsequent period. Section III then follows with the discussion of the role of government in rapid industrialization since the early 1960s. Some concluding remarks are offered in section IV.

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II. Building a Platform for Rapid Industrial Development

In 1953, when the Korea War ended, Korean GDP and per capita income were, in 1975 prices, $4,547 million and $224, respectively. The economy consisted mostly of agriculture, fishery and forestry, which accounted for 47 percent of its GDP. The few light manufacturing industries that Korea inherited from the Japanese colonial period were mostly destroyed during the Korean War of 1950-53, and industry accounted for only 9 percent of GDP.

The economy nevertheless began its growth, with foreign aid financing approximately 90 percent of the fixed capital formation in 1953-1960. During that period the country received approximately $2,083 million in foreign aid, of which $120 million came from United Nations Korea Reconstruction Agency and $1,963 million from various aid agencies, including food grains donated



under PL 480 (Lee 1987). Trade policy was inward-oriented with imports subject to control with high tariffs, various quantitative restrictions, a complex system of multiple exchange rates, and an overvalued exchange rate. Under these protective measures, however, mining and manufacturing output grew at about 15 percent per year between 1953 and 1957 while more rapid growth taking place in construction, textiles, milling, and light consumer goods.5 Growth in mining and manufacturing slowed down, however, to 9 percent by the late 1950s when the limits of domestic markets were reached and strong stabilization programs were carried out to control inflation. Although the stabilization programs succeeded in bringing down inflation from almost 40 percent per year between 1953-57 to virtually zero rate in 1957-59, they had the effect of reducing private investment and slowing down the rate of economic growth (Frank, Jr., Kim, and Westphal 1975).

By all indications, the performance of the Korean economy during this period was poor in comparison with what it has achieved since then. But, as pointed out by Kuznets, there were certain changes taking place during this period that, whether intentional or not, laid the foundation for the subsequent rapid economic growth. For instance, entrepreneurial experience was accumulating with the establishment of a number of new enterprises, education at all levels was expanding rapidly, and the Korean army became, in effect, a training center for labor by producing a disciplined work force capable of handling mechanized equipment and organizing teamwork. Thus by the early 1960s sufficient changes had occurred in Korea to make it ready for subsequent industrial development. Of these, changes in land ownership, education, and entrepreneurial capability were especially important.

1. Land Reform

Land reform in Korea was first initiated in 1945 by the U.S. Military Government which distributed over 240,000 hectares of farmland, formerly owned by the Japanese, to their former tenant-cultivators. Under the new Land Reform Act of 21 June 1949, further land reform was carried out by the new government of the Republic of Korea, redistributing formerly Japanese-owned land as well as large Korean-owned farms (in excess of 7.5 acres). This



redistribution involved some 23 percent of the total arable land, and by the end of 1952 the government managed to redistribute nearly 330,000 hectares of farmland. The Land Reform Act, which was finalized on 10 March 1950, also provided a powerful incentive to landlords and their tenants to make private arrangements and caused more than 500,000 hectares of farm land to be voluntarily transferred to tenant-cultivators. An effect of these official redistribution and private sales was thus to reduce the average size of the farm to less than 2.2 acres by 1959, with 42 percent of all farms no larger than 1.2 acres and only 0.3 percent larger than 7 acres. In other words, by 1959 a relatively equal distribution of agricultural land was achieved in Korea (Ban, et al. 1980).

Land reform itself does not redistribute wealth from landlords to tenant farmers if it is accompanied with full compensation. In



the case of Korea, however, a redistribution of wealth actually took place as the compensation amounted to perhaps only one-sixth to one-fourth of former land values. In fact, it was estimated that, on average, the income of the bottom 80 percent of the total farm households increased by 20 to 30 percent while the top 4 percent suffered an 80 percent or so decline in income.6

Another effect of land reform in Korea, perhaps more important in the long run than the redistribution of land and wealth, was the elimination of the class structure. In traditional Korea, before the Japanese occupation, social mobility was restricted to some degree by the existence of a rigid class structure where the upper class of a hereditary elite called yangban constituted perhaps 10 percent of the total population. Their position was weakened, however, during the Japanese occupation as the Japanese as colonial masters replaced them as the social elite. The post-liberation land reform became the coup de grace for the yangban class and had the effect of widening the opportunities for advancement for Korean farmers who then constituted more than 60 percent of the total population.

Land reform in Korea helped bring about the equality of opportunities and the possibility of economic and social upward mobility for the masses of Koreans, thus contributing to the "shared growth" in the subsequent period. It also had the effect of removing potential agrarian unrest from the political agenda, and subsequent industrialization could, therefore, proceed in the context of a politically pacified countryside (Wade and Kim 1978). A perhaps unexpected effect of land reform in Korea was to promote the growth of import-substitute industries during the 1950s by destroying the landlord class. If it had remained a powerful interest group, the landlord class could have opposed the shift from primary commodity exports to import substitution in consumer goods industries (Cheng 1990).

2. Education

In 1945, 78 percent of the adult population was estimated to be illiterate, but by 1960 the illiteracy rate went down to 28 percent largely as a result of a massive increase in school enrollment. In



1953, for instance, 60 percent of the elementary school-age group (ages 6-11), 31 percent of the middle school-age group (ages 12-14), and 18 percent of the high school age-group (ages 16-17) were enrolled in school. The corresponding figures for these respective age groups increased to 86 percent, 33 percent, and 20 percent by 1960, and by 1964 virtually universal elementary education was achieved in a population that had been overwhelmingly illiterate less than two decades before (McGinn, et al. 1980).

An immediate effect of such a rapid increase in school enrollment was to increase unemployment and shorten working hours in the beginning of the 1960s as other productive resources did not catch up with educational development. Its long-term effect was, however, to create a pool of educated manpower for the subsequent rapid economic growth. This pool became the source of labor capable of short-term on-the-job training that was being carried



out at factories as demands for semi-skilled labor increased with the rapid pace of industrialization that began in the 1960s. Choo (1990) in fact regards this role of education, that is, creating a pool of educated and readily trainable labor force, as the most important of all the possible contributions that education could have made to the subsequent rapid industrialization in Korea.7 How education may have contributed to Korea's economic development still remains, however, controversial. No direct empirical relationship between school enrollment and the rate of economic growth has been confirmed, and the role of education may in fact have been only that of "screening," "credentialism," and "socialization" (McGinn, et al. 1980). As a matter of fact, McGinn, et al., who carried out a study of the role of education in Korea's economic development, conclude that "...education did play a critical role in the modernization of Korea; it did this primarily by assisting a strong government with `modernizing' policies to impose its will upon the nation" (p.241). It is, however, possible that, given that there is a strong parallel between the development experiences of Japan and Korea (Blumenthal and Lee 1985), education has played a role in Korea's economic development in a way similar to its contribution to Japan's economic development.

The modern development of the Japanese economy was a process of catching up with the West in terms of its technological capability (Ohkawa and Kohama 1989). This catching-up was possible because of a sustained process of upgrading Japan's "social capability" for absorbing advanced technology from industrially more developed economies of the West. But it took time for this social capability to increase as it was through education, training, and learning-by-doing that the capability expanded gradually. Given that Korea's industrial development is also a "process of acquiring technological capability in the course of continual technological change" (Pack and Westphal 1986, p.106), it must be concluded that by creating a readily trainable labor force the spread of mass education through the 1950s contributed to Korea's ability to begin its rapid industrial transformation in the early 1960s.

3. Large Private Enterprises



When an economy exports traditional, agricultural products and imports manufactured nondurable consumer goods, the commercial institutions that are engaged in expanding commerce and diverting agricultural products from domestic to international markets serve the economy well. As the economy makes the transition from exporting agricultural products to manufacturing nondurable consumer goods at home, these commercial institutions will be replaced by manufacturing institutions. Whether or not the country makes the successful transition will thus depend on how successful the manufacturing institutions are in replacing the commercial institutions and in growing in strength.

In the early 1960s, when the process of rapid industrialization began in Korea, the private enterprises that



possessed entrepreneurial talents, organizational structure, personnel, facilities, and capital resources were, by and large, the large enterprises that had grown during the 1950s (Kim 1976). These large enterprises called the chaebol8 became a powerful instrument in the strategy of rapid industrial development as they provided the necessary organizational base as well as entrepreneurial skill.9 As will be discussed in the following section, it is through a unique relationship with the chaebol that the Korean government has played a leading role in economic development. Given that they have been used effectively by the state in achieving its developmental objectives, how they came about to exist in the early 1960s is an important story to be told in understanding economic development in Korea.

Some of today's successful chaebol were established during the Japanese colonial period, but their numbers were few, given that the dominance of the zaibatsu (the Japanese equivalent to the chaebol) precluded the development of strong, indigenous commercial interests or industrial capitalists (Cheng 1990). For the majority of the 30 largest chaebol (as of 1988) their origin goes back only to 1945-60 with 16 starting during the Rhee government (1948-1960), 8 during the Park government, and 6 during the Japanese rule. It is thus during the period preceding the rapid industrialization that the majority of the chaebol were created and nurtured.

The years from 1953 to 1960 were a period during which Korea had a low rate of saving equal to 0.3 percent of GNP and a poor underdeveloped financial system. In such a situation, several policies undertaken by the government had a critical effect on the birth and growth of the chaebol by creating the source of their capital. The first and most important source of capital was their acquisition of vested properties at favorable prices (Cheng 1990, Kang 1993). At the time of liberation, there were 166,301 properties that had formerly belonged to the Japanese. These vested properties—which included 3,551 operating plants and firms, land, infrastructure, and inventories, and which accounted for approximately 30 percent of the entire Korea's total wealth—were first entrusted to the American Office of the Property Custodian (AOPC). Some of the vested properties were distributed by the AOPC itself, but the rest were transferred to the Rhee government in August 1948 and their distribution was completed in 1957.



In distributing the vested properties, the price was set at the pre-1945 book values which were substantially lower than market prices, and many of the properties were distributed at even lower prices than the book values. Furthermore, they were sold in exchange for a cash payment equal to only 10 percent of the sales price and install payments stretched over a fifteen year period.10 A high rate of inflation that followed the privatization further reduced the real burden of paying for the vested properties, and in many cases loan repayments were not even enforced. In fact, as of 1958 when the sales of vested properties were completed, 37.7 percent of the outstanding loans were not repaid. Significant windfall gains were thus realized by those who had acquired vested properties although many of these assets were destroyed during the



Korean War, and these gains became an important source of capital for a number of enterprises that later grew into such large conglomerates as Samsung, Lucky, and Hyundai (Cho, D.S. 1990).

The second source of capital for the chaebol was the preferential allocation of import licenses and foreign exchange at an overvalued exchange rate. Overvaluation of the domestic currency and import restrictions obviously meant that the acquisition of foreign exchange at the official rate was extremely profitable. Thus import trading became an important source of revenue for many of the chaebol and contributed to their capital accumulation.

The third source of capital was the allocation of aid funds and materials. Acquisition of foreign aid, whether in the form of aid dollars or raw materials, was an important factor in building a industrial base and becoming a chaebol. Furthermore, as recipients of foreign aid they could obtain government-arranged, long-term, low-interest bank loans similar to those associated with the sales of the vested properties. In fact, with foreign aid and preferential credit the chaebol could build a plant with its own equity equal to only 15–25 percent of total required capital. This process of capital accumulation was further abetted by their being allowed a monopoly position by the government.

The chaebol's preferential access to bank loans was the fourth source of capital especially because of a high rate of inflation during that period and the implied negative real interest rate. It should be noted, however, that the access to bank loans was interconnected with other factors such as the acquisition of vested properties and the allocation of aid funds and materials.

What the allocation of vested properties and preferential treatments accomplished is subject to disagreement. It may have created what Woo (1991) calls "political capitalists" in a country where "..., politics, and not innovative drive, has always been the umbilical cord nurturing big business...." Evidence clearly shows that many rent-seeking activities were involved in the allocation of the scarce resources and opportunities and some of the rents went toward political ends,11 but what is also clear is that rents were not all squandered on political payoffs, luxury consumption or capital flight as evidenced in the actual growth of the chaebol.



To give a few examples, Yi Pyong-chol of Samsung turned one or two vested properties into a huge chaebol; Chong Chu-yong of Hyundai built up his business by procuring noncompetitive contracts from the government and the U.S. military; and Cho Chung-hun of Hanjin, who heads the Korean Air Group, began his transportation business with one used truck (Woo 1991). One might argue that if vested properties and other valuable opportunities had been allocated in a non-political way Korea would have gained more innovative entrepreneurs. But it is hard to question the innovative entrepreneurship of those who established a chaebol on the basis of a couple of vested properties, some noncompetitive contracts, or one used truck. These were the people who could have spent their wealth on luxury consumption or taken it abroad, but obviously they did not and instead saw to it that their enterprises grew and



expanded. Thus by the early 1960s there were several large private enterprises in place which could be used as instruments of economic development by a new government committed to developmental objectives.

III. Industrial Development in Korea

The early 1960s saw a Korea with a number of large private enterprises and a cheap but well-educated, motivated labor force. Given these, the Korean economy might perhaps have developed as rapidly as it has only with sensible macroeconomic policies. What actually has happened is, however, quite a different story: The economy has been led by a hard state which, in addition to macroeconomic policies, utilized some direct intervention in order to achieve developmental objectives. How such a state was established, how and what policies it has implemented to achieve developmental objectives, and how such policies could have achieved rapid economic development are the subject matter of this section.

1. Hard State and Efficient Administration

The adoption of what Mason, et al. call sensible macroeconomic measures began with the devaluation of the Korean won in May 1964, which was followed by the implementation of a floating unitary exchange rate in March 1965. In return for a credit of $9.3 million from the International Monetary Fund, Korea undertook a further series of reforms. These included a tight monetary policy, increases in taxation, higher import duties on nonessential items, limits on international borrowing, and greater export efforts. These were followed by an interest-rate reform in the fall of 1965 (Haggard 1990). In the words of Balassa (1980, 1981), these measures had the effect of improving allocative efficiency by providing unbiased incentives to both exports and import substitutes and by minimizing uncertainty over the structure of incentives.

This description of macroeconomic policy changes tells, however, only a part of the changes that took place upon the



military coup of 1961. First of all, for these policy changes to take place certain institutional changes had to be carried out. Second, the industrial development that followed the policy changes was not a process carried out solely by the private sector. It was strongly influenced by direct government intervention designed to facilitate the passage of the economy through successive phases of industrial transformation.

The goals of the military coup of 16 May 1961 were (1) to "make anti-communism, which has been considered only a superficial slogan, the foremost national policy" and to "solve the people's economic plight" (Choi 1988, p.4). These twin goals became the basis for reorganizing the institutional structure of the government.

The economy of Korea in 1961 was in a state of stagnation. Its growth rate was below that of population growth, and aid from the United States, which had reached $383 million and accounted for 14 percent of Korea's GNP in 1957, was being reduced by $60 to $100



million yearly. In addition, there was the perception that North Korea, which had already established and successfully pursued a long-term economic plan, was growing faster than Korea.12 To achieve at least the second goal of the coup, the military government carried out several institutional changes.

First, the government took measures to centralize its political power. Upon the inauguration of the Third Republic on 17 December 1963, the National Assembly was dissolved and political authority centralized in the office of the president. To increase presidential political power, four agencies were created under the direct control of the president—the Central Intelligence Agency (CIA), the National Security Council, the Council for Economics and Science, and the Board of Audit and Inspection (BAI)—and given the authority to obtain information relating to national security, the economy, and general administration. Although the BAI and CIA did not have direct control in implementing economic policies they were able to collect economic information and often intervene in the implementation of economic policies.

It is important to note that all the leaders of the coup had experience during the Korean War (1950-1953) in creating and managing large organizations for goal achievement. Most of them were exposed to modern organization and management theory by having undergone military training in the United States and were familiar with, and used to, the hierarchial structure of the military organization. They were, therefore, knowledgeable about scientific management systems consisting of planning, programming, budgeting, and evaluating and were able to transfer this knowledge to reorganizing the government for achieving economic objectives.

Second, the hard, developmental state needed an effective instrument to carry out its developmental objectives. Thus, on 22 July 1961 the Economic Planning Board (EPB) was established as a strong and accountable organization for drafting and organizing economic plans. It took over planning functions from the Overall Planning Bureau and the Commodity Planning Bureau, which had belonged to the Ministry of Reconstruction. It also took over budgeting functions from the Budget Bureau of the Ministry of Finance and statistical functions from the Statistics Bureau of the Interior Ministry. The EPB's authority to control related agencies in economic planning and management was formally vested by the



Government Organization Law, and it was in fact named a board rather than a ministry in order place it at a higher level in the structure of administrative hierarchy than a ministry (Choi 1988).

The organizational alignment of the EPB was completed in December 1963 when a civilian government was formed. The EPB thereafter took strong initiatives in leading various economic agencies in the government. It consisted of five bureaus: the Economic Planning Bureau, the Budget Bureau, the Economic Cooperation Bureau, the Technology Management Bureau, and the Statistics Bureau. With these bureaus, the EPB was able to carry out budgetary and planning functions as well as supportive and regulatory functions for the economy. With this bureaucracy in place the hard state could now give a direction to a market economy



which had, until then, received little guidance from the government (Lee 1993).

2. Policies for Rapid Industrialization

(a). Drive for Labor-Intensive Export Expansion (1964-1972)

A major change in the direction of resource allocation took place when, during 1961-1963, the government introduced several measures to promote exports.13 Direct subsidies were given to certain export commodities while preferential loans were provided for all exports. Tariff exemption on imports of raw materials used for manufacturing export products and the exemption of indirect taxes on exports and intermediate inputs used in export production were introduced. A 50 percent reduction in income tax was also granted on earnings from exports and tourism (Kwang Suk Kim 1991).

After a major devaluation in 1964, the government introduced additional export-promotion measures. These included accelerated depreciation allowances for export industries and wastage allowances on raw materials imported for the manufacture of exports. Because there were neither tariffs nor indirect taxes on imported raw materials, these allowances were a source of large profits for those engaged in export production as they could be used for domestic production or sold on the market.

In addition to these financial incentives, the Korean government utilized direct, administrative measures to promote exports. For example, it created the Korea Trade Promotion Corporation (KOTRA), which, with its extensive overseas network, became an effective instrument for promoting exports.

What was perhaps unique to Korea was the Monthly Export Promotion Conference which was established in December 1962 and became to be one of the most important administrative support mechanism for exports. Regular participants included President Park Chung Hee, the Minister of the Economic Planning Board, the Minister of Trade and Industry, the Director of the Korea Trade Promotion Corporation, the Chairman of the Korea Traders Association, and other public officials and private experts



concerned with trade. The progress of exports and the performance of exporting firms were routinely reported on, and almost every month the President awarded medals and citations to successful businessmen.

At each meeting of the conference, business representatives presented their problems and opportunities, and government officials were informed, in front of the president, of the problems that businesses faced in dealing with government offices. The conference thus served not only as a forum in which the president could hector businesses to increase exports but also as a place where the president took part in frank discussions about various problems, including bureaucratic redtape, that hindered the achievement of export targets.

Another administrative measure used for export promotion was the export-targeting system adopted in early 1962. It was initially used to establish an annual target for total exports, but by the second half of the 1960s the system became more elaborate



with annual targets set for major commodity groups and destinations. Targets for major commodity groups were then assigned to related industrial associations and targets for destinations were given to the Korean embassies in respective countries or regions for implementation. A "situation room" was installed inside the Ministry of Commerce and Industry to monitor export performance and to compare it with the annual targets. The status of export performance was then reported at the Monthly Export Promotion Conference, where, as discussed above, the president was regularly in attendance.

An important aspect of the export promotion policy in the 1960s is that most of the promotion measures were basically non-discriminatory. For instance, preferential credit was given to any exporter, regardless of the product exported, as long as the exporter could present an export letter of credit at a foreign exchange bank.

This non-discriminatory export promotion policy is often cited as an indication that the government maintained incentive structures favorable to exports as a whole but neutral as to the composition of exports (Kim and Leipziger 1992, World Bank 1986). The fact is that in the 1960s Korea had a very small manufacturing base—mostly light nondurable consumer goods—and consequently there was very little to be selective about in promoting exports. Furthermore, the economy was not ready for the next phase of export promotion, i.e., the phase of secondary export substitution, which requires first going through the phase of secondary import substitution.

(b). Promotion of Heavy and Chemical Industries (1973-1983)

The promotion of heavy and chemical industries began formally in June of 1973 with the promulgation of the Heavy and Chemical Industries (HCI) Promotion Plan. According to the plan, six industries—steel, nonferrous metal, machinery (including automobiles), shipbuilding, electronics, and chemicals—were to be promoted at a total investment of US$9.6 billion between 1973 and 1981. These were targeted to become future leading industries with their share of total commodity exports expected to be more than 50



percent by 1980.14

In the early 1970s there were virtually no Korean firms possessing the technical as well as financial resources necessary for venturing into any one of the heavy and chemical industries. Furthermore, given large scale-economies and high risks inherent in such industries, not many firms, including the chaebol, were willing to undertake such projects. Thus to implement its plan, the government had to handpick suitable firms and in fact coerced them into undertaking the projects by offering various incentives.

The HCI program is a clear case of the state and the private sector co-operating closely in order to prepare the economy for changing international conditions and comparative advantage. By the late 1960s, Korea began to face import restrictions on its light manufactured exports to the United States and other developed countries. It also began to face challenges from China and the



developing countries in Southeast Asia for light manufactured goods in the world markets. These changes prompted the government to promote the heavy and chemical industries for the next phase of industrialization.

The selection of these industries for industrial promotion came easily to the top policy makers since they were fully aware of the fact that Japan had earlier taken the same path of industrial development with great success. Furthermore, the experience in helping light manufacturing industries become internationally competitive gave them confidence in Korea's ability to establish the heavy and chemical industries as the next group of leading export industries.

An additional factor, no less important than these economic factors, was a major change in the foreign policy of the United States toward Asia. In July 1969 the Nixon Doctrine was announced, signalling the withdrawal of direct U.S. involvement in Asia. Subsequently, in the spring of 1970 a decision was reached to withdraw U.S. troops from Korea, and March 1971 saw the completion of the first phase of troop withdrawal. In the face of this development, which clearly had serious implications for national security, President Park Chung Hee decided to establish Korea's own defense industries, which in turn required the establishment of the heavy and chemical industries. Accordingly, various measures were introduced to carry out the HCI program.

In order to provide a market for the new industries, the government re-instituted import restrictions and rolled back tax exemptions on the import of certain intermediate goods and capital equipment. It also granted higher investment tax credits to businesses which purchased domestically produced machines.

A major package of tax incentives for investment in the heavy and chemical industries was provided in the Tax Exemption and Reduction Law of 1975. It included tax holidays, investment tax credits, and accelerated depreciation for the firms investing in the designated industries. These tax incentives had the effect of lowering the tax rate on the marginal return to capital by 10 to 15 percentage points, making the tax rate about a quarter lower than otherwise (Kwack 1984).



The government also began investing heavily in the infrastructure relating to the heavy and chemical industries: large-scale industrial parks were constructed; educational and training systems were overhauled to produce engineers and skilled workers; and research institutes were established to develop necessary technology.

Separate industrial complexes were established throughout the country: Pohang for steel, Kunsan for nonferrous metal, Kumi for electronics, Changwon for machinery, Ulsan, Ok-po, and Chukdo for shipbuilding, and Ulsan and Yeochon for chemicals.

The educational system was revised to increase the supply of skilled manpower. For example, between 1973 and 1980, the enrollment capacity of science and engineering colleges expanded from 26,000 to 58,000 and the total enrollment in technical high schools doubled and that in technical junior colleges increased



more than fivefold.

Six research institutes were established for science and technology, especially for the machinery, chemistry, and electronics sectors, with a corresponding increase in research and development expenditures financed by the government.

What was perhaps most important among all these measures taken by the Korean government to implement the HCI plan was its use of financial policy. The government was directly involved in mobilizing and allocating financial resources for the targeted industries. It did so by controlling much of the credit system and giving preferential credit to these industries.

To finance the new projects the government established the National Investment Fund, a special fund contributed by the government and financial institutions. The funds thus raised were not, however, sufficient for the entire HCI program, and as an additional measure the government required a portion of commercial bank loans to be allocated to the heavy and chemical industry projects.

Because of the policy of preferential credit, the firms engaged in the HCI program received loans with a longer period for repayment and at a rate 25 percent lower than that for other industries. This difference in borrowing costs, however, disappeared during the HCI adjustment period of 1979-1981.

An effect of all these promotion measures was the creation of excess capacities in the heavy and chemical industries by 1979. The severe world recession following the second oil shock, combined with a tight monetary policy at home, worsened the problem, requiring subsequent restructuring of the industries by the government. It can be said, however, that it was this excess capacity in human as well as nonhuman capital that laid a foundation for the export boom in the heavy and chemical industries that began in 1983.

(c). Beginning of Economic Liberalization (1984- )



The double-digit economic growth in the middle of the 1980s was led by the exports from and further investments in the heavy and chemical industries and coincided with the beginning of the secondary export substitution phase. The successful establishment of most of the heavy and chemical industries now allowed the substitution of domestic supply for hitherto imported industrial intermediate inputs. As a result, the users of petrochemical products could now rely on the domestic producers for a stable supply of intermediate inputs even in the midst of worldwide shortage and thus continue to expand their exports. Likewise, the steel industry played a key role in sustaining the competitiveness of Korea's manufactured exports by serving domestic industrial activities even during a worldwide shortage in steel.

An important change in the role of government took place during this phase of industrial development. State intervention became less selective but more functionally based, and its position vis-a-vis private enterprises became relatively weaker. The development of the Korean semi-conductor industry is illustrative



of this change.

The government has always played an important role in the development of the semi-conductor industry. For example, it established the Korea Institute of Electronics Technology, the Electronic Technology Research Institute, and the Korea Advanced Institute of Science and Technology to bring about technological advances in the electronics industry. But since 1986, when the government began seriously promoting the "high-tech" industries, its relationship with private firms has changed into that of equal partnership. One of the reasons for this change is the recognition that some of the Korean firms such as Samsung, Hyundai, and Goldstar are large enough to possess excellent organizational and R&D capabilities and are thus able to undertake semi-conductor projects without substantial support from the government (Hong 1992).15

IV. The State, Finance, and the Chaebol in Industrial Development

As discussed in the preceding section, the Korean government intervened extensively in economic affairs in order to achieve its developmental objectives. For effective government intervention President Park created and relied on a strong and centralized bureaucracy although relying on the private sector as the primary engine of growth. The government thus maintained a cooperative but leading relationship with the private sector, especially with the chaebol. It monitored and closely controlled their activities to ensure that the resources and opportunities they received would be used productively to contribute to export expansion and economic growth. In controlling the private sector the government used both discretionary power and incentives, but of all these instruments the most important was its control over the financial system and credit allocation.

Immediately after the military coup of 1961 the commercial banks were nationalized through the confiscation of wealth allegedly accumulated illicitly during the previous regime. The annual budgets of the commercial banks and appointments to top management then became subject to the approval of the finance minister. Special banks such as the Korea Development Bank and the



Small and Medium Industry Bank were also established but they were wholly government-owned and -controlled.

Under government direction the commercial banks channeled an increasing amount of credit to the manufacturing sector for the explicit purpose of promoting exports. Then, in the 1970s when the government began its push for heavy and chemical industries, the allocation of credit became more selective. The share of bank loans allocated to these industries increased from less than 20 percent in 1970-1974 to over 29 percent by 1980. A majority of foreign loans was also channeled into these industries (Park 1991, pp. 59-60).

A financial system such as the one that has existed in Korea has been a topic of much research ever since the contribution by McKinnon (1973) and Shaw (1973) to the literature on finance and development. It is argued that in such a system, where the



government maintains artificially low interest rates and carries out selective credit allocation, resources would be misallocated and the economy would thus stagnate.

First, in such a system allocative decisions are in the hands of government bureaucrats, who often lack both the information and incentives to allocate credit efficiently. Second, government actors are likely to be influenced by rent-seeking pressures and considerations other than rates of return. Third, since subsidized credit lowers the cost of capital, it leads to the adoption of overly capital-intensive techniques.

What is, therefore, puzzling in the light of the Korean experience is how a country with what Dornbusch and Park (1987) call "activist" government policy has been able to achieve successful industrialization. An answer to this question may be found by accepting a fundamental shift in the way we regard the relationship between the state and the market.

1. Need for an Alternative Theoretical Framework

Recent developments in the theoretical literature on finance point out that financial markets do not operate in the manner of "textbook models" and that "credit-rationing" and "equity-rationing" are, instead, inherent characteristics of these markets (Stiglitz 1989).

Credit rationing by banks occurs because they have less information about the credit-worthiness of prospective borrowers than the borrowers themselves and because they are risk averse (Stiglitz and Weiss 1981). Thus, even without government intervention, banks would set interest rates below a market-clearing rate and ration credit among prospective borrowers. Such credit rationing can lead to an inefficient allocation of credit especially in the absence of well-functioning equity markets (Y.J. Cho 1986). But even where there is an equity market, equity rationing takes place because of problems of adverse selection. In the absence of perfect information, equity markets may be unable to differentiate between good and bad issues, and may thus discount the prices of even good issues. Unwilling to see its net worth



decrease, "good" firms will be reluctant to issue new shares and will rely more on internal financing for capacity expansion. This can result in an inefficient allocation of resources.

Though these problems are inherent in all financial markets, there are reasons why they are particularly serious for developing countries. Capital markets are generally less developed and the economy is subject to greater uncertainty, particularly where the political system is unstable. The problems of weak social infrastructure for communications, transportation and contract enforcement in the developing countries are well-known (Diaz-Alejandro 1985). Finally, the small scale of business enterprises in most of the developing countries implies a lack of capability for collecting, evaluating, and disseminating information, and the absence of internal capital markets capable of allocating funds among diverse subunits.

The existence of credit and equity rationing does not



necessarily justify government intervention since private institutions such as internal capital markets develop to cope with imperfect financial markets. Moreover, even with imperfect markets, free financial markets may still be superior to government intervention. So the critical issue centers on the conditions under which various policy regimes are likely to yield better results.

The new theoretical literature on financial markets raises several issues which are germane to our discussion of the Korean case. In addition to emphasizing the potential for important inefficiencies in all financial markets regardless of the policy regime, this work also draws greater attention to the institutional setting in which credit is allocated.

The "financial system" is usually taken to mean the collection of financial markets in a given economy, be they formal credit markets, stock markets, or curb markets. We need to recognize that the mobilization and allocation of financial resources, even in highly developed countries, are not limited to these market institutions. Non-financial institutions, be they households or manufacturing firms, also carry out the mobilization and allocation of financial resources. These internal capital markets are not necessarily primitive institutions preceding the development of a market, but rather an institutional development that has evolved in response to market imperfections. Since the mobilization and allocation of financial resources clearly take place within organizations as well as in markets, a study of the financial system as that consisting solely of financial markets presents only a partial and incomplete picture of the mobilization and allocation of financial resources that take place in any market economy. We, therefore, need a theoretical framework which encompasses the role of organizations, including the government, in credit allocation.

2. Markets and Hierarchy

The theoretical foundation for such a framework exists in the new institutional economics (Williamson 1975, 1985). The core insight of this literature is the pervasiveness of transactions costs, and the role of organizations and organizational innovation in reducing



them. In a capitalist market economy, organizations, including the firm, emerge because they are more efficient in carrying out certain economic transactions than markets.

The advantages of internal transactions relative to that of market transactions include the ability of internal organizations to better handle informational imperfections. Firstly, because of its hierarchical structure which allows the specialization of decision making and economizes on communication costs, the internal organization is able to extend the bounds of rationality. Secondly, the internal organization is able to reduce uncertainty by coordinating the decisions of interdependent units to adapt to unforeseen contingencies. Since financial transactions are especially subject to moral hazard and costly contract enforcement, we would expect that organizations are particularly likely to develop, functioning as an internal capital market for allocating



financial resources.

Clearly, not every internal capital market is efficient due to limited size and scope. For such a market to be efficient, it would ideally be large enough to have diversified investment opportunities. Such an internal capital market can, however, clearly exist in the M-form (multi-divisional) structure of a large modern enterprise (Chandler, Jr. 1977). Economic transactions that take place within such an internal market are not price-mediated but are nevertheless less costly than price-mediated market transactions.

With its strategic planning capacity, ability to allocate resources, and monitoring and control apparatus, the M-form structure can effectively reallocate cash flows among its subunits to high-yield uses. The advantages of the M-form structure are clearly spelled out by Williamson (1985, pp. 283–84) and are worth citing at length:

The M-form structure removes the general office executives from partisan involvement in the functional parts and assigns operating responsibilities to the divisions. The general office, moreover, is supported by an elite staff that has the capacity to evaluate divisional performance. Not only, therefore, is the goal structure altered in favor of enterprise-wide considerations, but an improved information base permits rewards and penalties to be assigned to division on a more discriminating basis, and resources can be reallocated within the firm from less to more productive uses. A concept of the firm as an internal capital market thus emerges. (Emphasis added.)

Effective multidivisionalization thus involves the general office in the following set of activities: (1) the identification of separable economic activities within the firm; (2) according quasi-autonomous standing (usually of a profit center nature) to each; (3) monitoring the efficiency performance of each division; (4) awarding incentives; (5) allocating cash flows to



high-yield uses; and (6) performing strategic planning (diversification, acquisition, divestiture, and related activities) in other respects. The M-form structure is thus one that combines the divisionalization concept with an internal control and strategic decision-making capability.

The M-form structure is hierarchical, and its internal capital market is therefore hierarchical as well. The point to be noted here is that what is commonly called "financial repression" can also be modeled as a hierarchical system consisting of government and business, with the former performing the role of the general office and the enterprises receiving credit being analogous to divisional subunits. To analyze the efficiency or inefficiency of financial repression, it is therefore fruitful to compare this financial system with the M-form structure.



The efficiency of internal organizations, relative to markets, has been extensively analyzed by Williamson (1975) in terms of transactions costs. There are, however, a number of reasons why private internal organizations, which have evolved over time to economize transactions costs in a capitalist market economy, would function differently from an institution created by the government or the government itself. A particularly critical issue in this regard concerns the possibility of rent-seeking behavior. Neoclassical political economy emphasizes that a major source of inefficiency is the ability of business and government to effectively collude through the provision of rents which advance the interests of politicians, bureaucrats, and their private sector clients at the expense of the welfare of the entire society. Yet it is important to underscore that opportunism is a characteristic of market transactions as well; indeed, the transactions cost literature assumes what Williamson has called "self-interest with guile." Moreover, rent-seeking relations are also visible within firms, and though the existence of hierarchy does not eliminate them, it can mitigate them through effective monitoring and sanctioning.

A major point to be made here, however, is that by regarding a financial system in which the government plays an active role as an internal capital market, we admit the possibility that it can be more efficient than the market system of credit allocation; this alone is a significant departure from the conventional treatment of such a financial system which takes nonprice-mediated transactions as ipso facto inefficient. The crucial question then centers on the conditions under which a quasi-internal organization will be in fact more efficient.

3. The State and Large Business--A Quasi-Internal Organization

Patrick (1990) correctly points out that for a "highly-competitive, market-based financial system" to work efficiently, there must be an adequate institutional infrastructure including: a system of laws, regulations, and courts; an efficient information system which minimizes uncertainties and costs of financial intermediation; prudential regulation ensuring the stability of the financial system and protecting depositors; and government



supervision minimizing moral hazard. Patrick does not, however, discuss how this institutional infrastructure comes about; nor does he discuss the choices that governments confront between developing these institutions for the purpose of supporting market transactions and substituting for them through alternative organizational means.

For reasons outlined above, it is possible for an internal organization with an internal capital market to perform the tasks required of this institutional infrastructure more efficiently. Thus, the question facing a developing country is whether it should invest in building the institutional infrastructure to support markets or devise an alternative system bypassing the imperfect financial market. That is, the issue is whether or not investing in making the imperfect market less imperfect is necessarily the



best policy for a developing country.

The financial system even of an advanced developed country consists of both market and non-market institutions, and as pointed out, private internal capital markets develop because of market imperfections and transactions costs. In developing countries, however, private internal capital markets may not be efficient because of the limited size of their enterprises or they may not serve the developmental objectives of the state. In either case, the government may create an internal capital market of its own in an attempt to improve the efficiency of credit allocation. If a government-created internal capital market is to succeed as an efficient institution, however, it is likely to share features that are typical of those private institutions which have evolved and withstood the test of time in market economies.

The structure of a hierarchical system of credit allocation consists of the government and enterprises receiving credit allocated by it. There may be financial institutions that function as intermediaries between government and enterprises but in this hierarchical system their role is essentially that of distributing credit as directed by the government planners. As the relationship of financial intermediaries and firms with the government is looser than that of subunits with the general office of a modern corporation, and as some transactions are clearly price-mediated, the organization consisting of the government, financial intermediaries and the recipient enterprises may be called a "quasi-internal organization."

The similarities between the quasi-internal organization and the M-form structure of a modern corporation are worth specifying. Decisions are made hierarchically, transactions between the government (general office) and select private enterprises (subunits) are internalized (or "quasi-internalized" through an organizational chain from government to financial intermediary to firm), and the activities of the subunits are monitored and coordinated by bureaucrats (salaried employees) instead of by the market mechanism. Because of direct contact between the government and selected private enterprises, both sides are able to share information which otherwise would be conveyed indirectly through prices. Decisions over the allocation of credit can thus be made before price changes can signal the direction of credit allocation



and private agents can respond to these signals.

It needs to be pointed out, however, that the fact that the quasi-internal organization can function as an internal capital market does not necessarily mean that funds will be allocated efficiently; this will depend on the objectives of the political leadership and the internal structure of the quasi-internal organization. In the literature on the firm, the commitment of management to profitability is ultimately supplied by the market. The choice of a wrong product or technique may lead a firm to fail. Market competition ensures the survival of only those that, on average, choose the right products and production techniques. Through the monitoring of performance, shareholders and boards are also capable of punishing and rewarding executives not committed to



increased profitability.

These checks may not operate to restrain governments, however. First, the quasi-internal organization does not face the competition that private firms face in the market. As it is the only such organization in the economy, it enjoys a monopoly position. Like any monopoly, the quasi-internal organization may prove "efficient" in achieving its own narrow objectives, but at the expense of the rest of the economy. Moreover, unlike the model of the firm in which shareholders and board members monitor performance, there are, typically, imperfections in the political market that prevent political leaders from being punished for bad performance. This is true of some authoritarian governments, but it may also be true in democracies where powerful lobbies are capable of capturing policy for their own benefit.

There are, however, mechanisms that can serve to constrain socially inefficient credit allocation. The first has to do with the broader policy setting in which the quasi-internal organization operates. If the government is committed to an outward-oriented strategy, the dependence of the economy on external markets can act as a check on government financial policy. Import-substitution policies, by contrast, remove this check.

For a small developing country committed to an outward-oriented development strategy, prices are parameters determined in world markets. The government cannot thus arbitrarily change prices to cover the consequences of an inefficient allocation of credit. Because of this constraint, an inefficient internal allocation of credit which supports "wrong" projects will result in financial losses for the constituent enterprises. They may be able to survive with subsidies from the government, but their losses are financial losses for the quasi-internal organization. Thus, whether subsidized or not, the quasi-internal organization will suffer financial losses, and thus face pressures to correct its pattern of credit allocation. In other words, the quasi-internal organization in a country committed to an outward-oriented development strategy faces one equivalent of a "hard" budget constraint.

In contrast, a small developing country which has adopted an inward-oriented development strategy can alter prices to cover the



consequences of misguided internal credit allocations. Potential losses of the constituent enterprises can be made to disappear by changing prices with little noticeable effect on the treasury, at least in the short run. The quasi-internal organization can avoid making losses resulting from wrong credit allocations, and there is thus little or no incentive or compulsion to correct the existing pattern of allocation. Such a quasi-internal organization operates under a "soft" budget constraint.

As market competition is necessary to ensure the survival of efficient private internal organizations, so is competition necessary to ensure that the quasi-internal organization committed to economic growth makes efficient allocation of credit. For the quasi-internal organization, such competition exists only if it is exposed to competitive forces in world markets. For this reason it



is essential that the country is committed to an outward-oriented development strategy; this commitment imposes the market discipline on the quasi-internal organization.

4. Conditions for Efficient Government Intervention

We have argued that, given the inherently imperfect nature of financial markets, financial repression in certain countries may be interpreted as an effort on the part of the government to create its own internal capital market for mobilizing and allocating financial resources for its developmental objectives. Drawing on the analogy of the emergence of internal capital markets in market economies, we have suggested several theoretical reasons why this government-created internal capital market can be relatively efficient, as well as the empirical conditions under which it is likely to be so.

First, the quasi-internal organization is likely to be more efficient where the government is committed to economic growth and to an outward-oriented growth strategy that both restrains it and provides information on the soundness of its investment choices. Second, the contracts with the private sector must be clearly specified and measurable, and the government must be politically and organizationally "strong" enough to monitor and enforce those contracts through sanctions. Third, the quasi-internal organization is likely to be more effective where the number of private sector actors is limited.

These are clearly formidable conditions for many transition economies, and only a few have the political and bureaucratic capabilities that would enable them to meet these conditions. These conditions suggest that for most transition economies, the risks of government failure probably outweigh those of market failure, and that attempts to correct the latter through government intervention may only make the situation worse. What, however, seems clear is that strengthening the political and bureaucratic capabilities is as important as improving the functioning of markets if it is to achieve a successful economic transition.



V. Conclusion

We have argued in this paper that land reform, the spread of mass education, and the growth of the chaebol that took place in Korea during the 1950s laid a foundation for rapid industrialization that began in the early 1960s and that, starting on that foundation, the government has played an active role to promote export expansion and economic growth.

Clearly, Korea adopted by and large sensible macroeconomic policies early in the 1960s, which by all accounts have contributed to the accelerated pace of industrial development. But, by focusing too often on these policies and its effect on trade and economic growth, the larger, but evolving, role played by the Korean government in economic development has, for the most part, been ignored. The fact is that at least in the early stages of industrial development the Korean government did much more than providing stable and neutral incentive structures and waiting for



latent comparative advantage to exert itself.

One of the key functions performed by the Korean government is to help create supply-side conditions necessary for exploiting world market opportunities. It has not relied solely on markets to reveal latent comparative advantage; it has helped them in realizing comparative advantage by directing and encouraging resources into the areas of latent comparative advantage. The import-substitution policies of the 1950s promoted the growth of labor-intensive light manufacturing industries, and with a pool of entrepreneurial talents thus created and with a change in trade policy Korea was able to shift its gear to exporting labor-intensive manufactured goods in the early 1960s. Then, in the mid-1970s the Korean government decided on a policy promoting heavy and chemical industries against the objections based on the argument that Korea did not have a comparative advantage in those industries. It carried out its policy inter alia by protecting these industries from foreign competition and providing them with preferential credit.

Such a role by the state is conceptually inadmissible in the standard neoclassical economics. A point made in this study is that such a role is, however, perfectly admissible once the government and large enterprises in Korea are viewed as a quasi-internal organization. Viewed in this way, direct government intervention is an internal transaction comparable to a transaction taking place within a private internal organization, and consequently it can be efficient (or inefficient) for the reasons that a private internal transaction can be. In other words, once the government and large enterprises are regarded as a quasi-internal organization, state intervention is not necessarily inefficient and under a certain set of conditions it can make a positive contribution to economic development.

The experience of Korea points out that for state intervention to make a positive contribution to economic development, the state needs to have developmental objectives and a bureaucracy capable of formulating and implementing policies aimed at these objectives. But the role of the state is an evolving one, supporting, and in certain cases leading, the private sector in the early stages of economic development and then diminishing in importance as the economy develops and the private sector becomes more efficient in



allocative decisions. Thus the simple dichotomy often made between the state and the market is a false one since there are many shades to state intervention and since an appropriate intervention can make a difference to how a basically private market economy may develop.

A key lesson to be drawn from the Korean experience for the transition economies is that setting up a neutral, unbiased incentive system may not be sufficient for successful transition even with privatization firmly in place. Preconditions such as human capital including entrepreneurial talents and market-supporting institutions must be created. Doing so, however, will take both time and scarce resources, but what the Korean experience has demonstrated is that this process of transition can be



accelerated with the government taking an activist role. In Korea, this was done by the government and large private enterprises forming a quasi-internal organization and thus together achieving the goal of rapid export expansion and economic growth. This experience of Korea suggests that the failure of the centrally planned economy does not necessarily mean that the role of government in a transition economy should be limited to that of setting a stable and neutral incentive system.



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1. There are additional similarities. Korea had to establish a new government while purging collaborators with the Japanese whereas the Eastern and Central European countries had to establish new governments without former communists cadres. The South Koreans were intensely anti-communists especially after the Korean War of 1950-53 whereas Europeans were disillusioned with communism. The situation in Europe seems to be better, however, than that in Korea in 1945 or 1953 as what it lacks now is entrepreneurial, not managerial, experience and it has plenty of engineers and skilled labor.

This skepticism is further reinforced as research on the European transition economies shows that the supply and other behavioral responses in the newly created private sector are rather slow in responding to drastic changes in the economic environment and thus the state may need to do more than just establish a correct incentive system (Bruno 1992). Fischer and Gelb (1990, p.19) also argue the necessity for state intervention in certain cases: "When assessing the efforts underway to change legal and regulatory institutions in reforming socialist countries rapidly, it must be remembered that those of the market economies have evolved over centuries. Such reforms and the creation of human capital appropriate to a new system are lengthy processes which pose a constraint on the efficiency and speed of reform."

McMillan and Park (1993) also argue that there are some lessons that Eastern Europe can learn from the Korean experience. The most important of these lessons is that the state can play a strong, positive role in the transition process.

This period is ignored in most studies on the Korean economy although it was a period of both failures and



successes by the usual measures of economic performance. Woo (1991, p.43) argues that this is because "...existing [American developmental] theory grows aphasic when confronted with successes that are not supposed to happen."

Real GDP grew, however, only at about 5 percent per year due to especially poor harvests in 1955 and 1956.

Endnotes



The land reform did not have, however, much effect on agricultural output; it grew at 3.6 percent a year in 1953-1961 in contrast with 2.9 percent in the 1930s (Ban, et al. 1980).

See also Lucas (1993) on the importance of on-the-job human capital accumulation in the Korean economic growth.

The Chaebol may be defined as a large diversified business group that is owned and managed by the founder of the business group and his blood-related family members.

The importance of such an organizational base and entrepreneurial skill may be also seen in the case of Hungary. In making the transition to a market economy a major problem for Hungary was the slow pace of progress in developing public and private institutions required to support a market system. For example, in spite of a well-educated work force Hungary's educational system is not yet geared to training managers and workers for a market system. Shortages of teachers in subjects such as market economics, Western business practices, foreign languages, and marketing, have limited the capacity of the existing educational system to support private enterprise development (Rondinelli and Fellenz 1993).

A typical example is the sale of the Chosun Spinning plant in Taegu to Kyung-Dong Sul, who later became the owner of the Taihan chaebol. The market price of the plant was estimated to be in excess of 3 billion won in 1947, but the official appraised price was only 700 million won. The plant was eventually sold at 360 million won, or 51 percent of the appraised price, and the payment was arranged to be made on an installment basis over 15 years financed by low-interest bank loans. By 1962, 15 years later, the wholesale price index increased 193 times, making the sale a virtual



gift.

According to Haggard, Kim, and Moon (1993), out of 10.7 billion won preferentially released to 45 selected firms from August 1959 to March 1960, 6.2 billion won was channeled to the Liberal Party in the form of political contributions for the election held on March 10, 1960.

According to Joseph Sang-hoon Chung (1974), North



Korea's national income and its per capita income increased at 12.7 percent and 11.0 percent per year during 1947-67.

For an interesting discussion of the politics of the transition from import substitution to export promotion policy see Haggard, Kim and Moon (1990).

For a more comprehensive discussion of the Heavy and Chemical Industries Promotion Plan, see Suk-Chae Lee (1991).

According to Hong (1992), the Korean government came under strong pressure from the United States because of the aggressive exports of the Korean semi-conductor industry. It was pressured not to provide any subsidies to the industry, and since the middle of the 1980s this pressure has been a major constraint on the government's promotion policy toward the semi-conductor industry.

For more general arguments against government intervention in economic development, see Krueger (1990).

Fischer and Gelb (1990, p.33) argue that in reforming socialist economies equity markets will not play a useful role in the allocation of resources because of "valuation and information deficiencies." They believe that functioning equity markets will take years to develop and, furthermore, they should be allowed to develop after the banking system has been restructured. The same thing can be said about equity markets in many developing countries.

There are, however, some exceptions. For example, the chaebol can be viewed as possessing an efficient internal capital market.

Resource allocation in a market economy takes place in both markets and internal organizations, and allocative mechanisms used even in the market and within the firm



are often a mixture of the pure market principle and the pure organization principle. Market principles penetrate into the internal resource allocation and organization principles enter into the market allocation to remedy the failures of pure principles either in the market or in the organization (Imai and Itami 1984).

The basic idea presented in this section is more fully



discussed in Lee (1992).

A parallel between the quasi-internal organization and the M-form structure can be clearly seen in Korea. For example, the Economic Planning Board (EPB) was established on July 22, 1961 as an organization for drafting and organizing economic plans. Its functions included planning, budgeting, and statistical functions, and it was placed on a level higher than a ministry in the hierarchy of government structure. Thus with the authority to control related agencies in economic planning and management, the EPB became central to planning and implementing economic plans (Choi 1988).

Fischer and Gelb (1990, pp.34-35) also argue a similar commitment by the government in a reforming socialist economy: "A government that starts out with a clear idea of what it wants to achieve and with a popular mandate to move in that direction, and that resolutely pursues its goals, will transform the economy more successfully than a government and a society which is not sure of what it wants. For this reason, reform is more likely to succeed in those countries where there is a consensus on the necessity of moving to a normal private market economy." Chalmers Johnson may not find much difference between such a government and his developmental state in East Asia.

Clearly, Korea did have most of these conditions. According to Kim and Leipziger (1992), the Korean government had a clear vision of its industrial goals, an ability to control the economy through both direct and indirect methods, a willingness to socialize some of the business risks, and an excellent ability to create institutions such as development banks, trade promotion agencies, and general trading companies, and an ability to make pragmatic decisions. It also had an able bureaucratic and planning apparatus and a unique relationship between the government and business which helped in designing and implementing economic policies. It should be pointed out, however, that Korea had all



of these conditions only after 1961 and the situation before then was quite different (Haggard, Kim and Moon 1990).

This view of the role of import substitution in economic development in Korea follows that of Ohkawa and Kohama (1989) who present economic development as a process of moving from the phase of traditional product export to the phase of primary import substitution of nondurable consumer



proceed to intermediate goods. In other words, import substitution made a contribution to subsequent export expansion because it did not inflict too great a damage to the economy! goods, followed by the phase of primary export substitution of light manufactured goods. For Krueger (1982, p. 168), however, if there was any contribution made by import substitution towards building a foundation for subsequent export-oriented growth in Korea, it was due to the fact that import substitution did not

Amsden (1992) argues that a precondition for such a developmental state is a relatively equal distribution of income. One reason for this is that for the industrialization of a developing country the government needs to subsidize business as it lacks pioneering technology but then it must discipline subsidy recipients. A relatively equal distribution of income will prevent the state from being controlled by a few and being used for their own rent seeking. Another reason is that equality motivates managers and workers towards to improve productivity.

Datta-Chaudhuri (1990) sees the role of the state as that of promoting and supporting the right kind of market institutions. The experiences of Korea and Taiwan show that the state can also be a member of a market institution called a quasi-internal organization.


