Puerto Rico in the Post War Liberalized Development Banking and the Fall of the Fifth Tige

Puerto Rico in the Post War: Liberalized Development

Banking and the Fall of the Fifth Tiger

JOSE A. PADIN *Portland State University, Oregon, USA

Summary. This paper analyzes the long-term effects of a liberalized regime of developmentbanking on the growth and investment trajectory of a newly industrializing country using PuertoRico as a case study. The paper analyzes conflicts between domestic business and the state over theform of state involvement in development during the critical juncture of the 1940s; the leading roleof domestic business in the push to liberalize the developmental state project; and the effects thisliberalization had on development banking, and on Puerto Ricos long-term growth trajectory. 2003 Elsevier Science Ltd. All rights reserved.

Key words Puerto Rico, Latin America, newly industrializing countries, developmental states,

development finance, political economy

1. INTRODUCTION

Puerto Ricos development experience hasbeen a matter of controversy over the decades.In the early postwar it was optimistically con-sidered a model for the modernization of un-derdeveloped regions (Annals, 1953). With theonset of protracted economic woes, startingwith the early 1970s, and arguably continuinginto the present, assessments of the islandsdevelopment experience became markedly crit-ical and pessimistic. Some studies brought at-tention to the dominance of ideology oversubstance in the workings of the governmentsdevelopment program (Pantojas-Garca, 1990;Santana Rabell, 1989), while others found in-dications that the Puerto Rican experiment wasthwarted by the larger forces of dependency(Villamil, 1979) and imperialism (Dietz, 1979).Although the Puerto Rican case received theattention of development scholars some de-cades back, partly because it appeared to con-firm all the promise of W. Arthur Lewisinfluential model of development with unlim-ited supplies of labor (Lewis, 1954, 1958), it israre to find a reference to this case in the pro-digious literature analyzing newly industrial-ized countries (NICs). A recent exception tothis neglect is Baumol and Wolff (1996), whohighlight the impressive achievements of thePuerto Rican economy in the last four decades.One of Baumol and Wolffs most interestingfindings is that Puerto Ricos unique political

ties to the United States had a negligible effecton the islands postwar growth trajectory.Having dispelled this notion, Baumol andWolff ask rhetorically, should Puerto Rico thennot be considered the fifth tiger of the post-war era? The answer, as I will argue, is that itdepends. Be that as it may, however, PuertoRico resurfaces as a case of legitimate interestto comparative scholarship on the long-termdynamics of development in NICs.

Puerto Ricos growth and productivity figuresover the course of 40 years are indeed tiger-like, as Baumol and Wolff show. But, if we aresensitive to qualitative shifts in the postwartrajectory of the Puerto Rican economy, itseems necessary to qualify this characterization.Though Baumol and Wolff emphasize four-de-cade averages, their own data show two verydistinct phases, a pre-1970 trajectory, and apost-1970 trajectory. During 195070 PuertoRicos real per capita GDP growth averaged5.84% per annum, but in 197090 it droppedconsiderably, to 2.49%. Even this last figureunderestimates the degree to which the PuertoRican economy was faltering after 1970. Bau-mol and Wolff find that the combined effect ofPuerto Rico-US links on growth was negligibleduring the golden agefrom 195070 Puerto

World Development Vol. 31, No. 2, pp. 281301, 2003 2003 Elsevier Science Ltd. All rights reserved

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*The author wishes to acknowledge the valuable feed-back of the anonymous reviewers Final revision accep-

ted: 13 October 2002.

281

Rico was indeed pulling itself up by the boot-straps. For 197090, however, institutionallinks to the United States had a positive andvery considerable effect on growth. In the ab-sence of this US bailout effect, growth wouldprobably have been a whole percentage pointlower during the low-growth years of 197990.With this in mind, Puerto Ricos proper place ina typology of late developing regions seems tobe among former tigers, or stunted NICs. Thisactually makes the case even more interestingto comparative-historical scholars.

This paper analyzes the relationship betweenthe nature of a developmental state programand the long-term fate of export-led late in-dustrialization. When Puerto Ricos industrial-ization program was still in its infancy, Mason(1958) observed that Puerto Ricos institutionalframework of development represented theliberal end in a spectrum of state-market ar-ticulations. Nearly four decades later, we are ina position to assess some of the long-term ef-fects of a liberal development program. Thefindings should yield some valuable lessons ofpertinence to the critical reassessment of indis-criminate liberalization currently under way.

Puerto Ricos developmental state projectchanged substantially over the course of the1940s, a decade of intense conflict between thestate and the local business class. The liberalstate-market articulation that Mason observedin the 1950s was a result of this conflict, and itneeds to be understood as the product of agradual accommodation between state plannersand the domestic business class. This accom-modation was made necessary by stern businessopposition to an ambitious developmental stateproject. Over the course of the 1940s stateplanners were forced to reach a compromisewith the business opposition, and finally, toabandon most of the key components of thedevelopmental state project. Of all the com-promises made, to anticipate an importantfinding of the analysis that follows, the mostfateful was probably the liberalization of theframework for financing development. The ex-tensive pruning of the Government Develop-ment Bank in response to pressures fromdomestic business left the state ill-prepared toconfront predictable problems at the end of theeasy stage of export-industrialization. This isan important and neglected part of the storybehind fall of the fifth tiger of the postwarera.

The paper is organized as follows. First,Puerto Ricos development trajectory needs to

be analyzed keeping in mind the role of states inlate development. Therefore, I begin with adiscussion of the relevant literature in devel-opment economics and developmental states.Next, I offer a brief historical background toPuerto Ricos early industrial transition. Fi-nally, the core of the paper is devoted to ananalysis of the evolving state-business rela-tionship that shaped the institutional featurethat proved to be a fundamental weakness ofPuerto Ricos development project over thelong run.

2. THE STATE IN THE PROCESS OFECONOMIC DEVELOPMENT

East Asian industrialization and the crisis ofLatin American development in the 1970s and1980s initiated a productive debate aboutprospects for economic development in poorcountries and the conditions under which thismight occur. The contrast in regional modelsand performance offered a rich field for em-pirical adjudication between competing theo-retical claims. Careful studies of the unique roleof the state in East Asian development havediscredited facile and misguided portraits ofthese states as paragons of free-market virtue. 1

Comparative evidence has borne out a long-standing proposition in heterodox developmenteconomics: economic development is a discon-tinuous process, thus, initiating and sustaininga successful take-off requires state interven-tions with the ability to coordinate a well-timedsequence of changes in the orientation ofindustrialization (Fei & Ranis, 1964; Gers-chenkron, 1962; Nurske, 1958; Rosenstein-Rodan, 1958). Sequencing successive phasesof import-substitution and export-orientation,for example, depends on the leadership of anactor with unusual foresight, a strategic com-mitment to the health of the national economy,and a capacity to hold private industry to per-formance benchmarks. States in developingregions potentially have the incentive, the le-gitimacy, and the organizational scale andscope to lead the development process (Gers-chenkron, 1962; Rueschemeyer & Evans, 1985),although there is no guarantee they will displaythe capacity and the interest (Evans, 1995;Lewis, 1957), or even the necessary credibility(Huff, Dewit, & Oughton, 2001).

A burgeoning comparative historical litera-ture makes a strong case that East Asian de-velopment successes are in some important

WORLD DEVELOPMENT282

measure explained by the particular role playedby developmental states (Amsden, 1989; Evans,1987, 1995; Hart-Ladsberg, 1993; Johnson,1982; Wade, 1990; Woo, 1991). Even skepticshave conceded, albeit timidly, that the stateplayed an important role in the developmentsuccesses of East Asian miracles (cf. Dollar &Sokoloff, 1994; World Bank, 1993). Thus, wefind a convergence between classic work indevelopment economics and the comparativehistorical scholarship of East Asian NICs: aview of development as a discontinuous process.The economic development of national econo-mies comes with no long-term guarantees;phases are punctuated by uncertain junctureswhere established formulas fail and the field ofpossibilities is again opened. Because of theuncertainty, at these junctures market actorswill run for the exits rather than bear the costsof a socially optimal transition. Sustaining so-cially optimal development requires foresightand coordination, in short, something like avirtuous developmental state. 2

A predictable discontinuity in the process ofeconomic development occurs some time aftertake-off. It can be identified precisely in thecontext of W. Arthur Lewis well-known modelof industrialization with unlimited supplies oflabor (a model particularly pertinent to thepresent study). The predicament of poor re-gions is typically an abundance of poor people,a dearth of capital, and a weak internal market.W. Arthur Lewis modeled one way out of thispredicament: matching the boundless domesticsupply of cheap labor with foreign capital, andexporting much of the output. (States withlarger internal markets have other well-knownalternatives, but they rely too exclusively on animport-substitution strategy at their own peril.)In the Lewis model, unemployed or underuti-lized labor in the traditional sector can betransferred to infant industries without dis-rupting, and arguably improving agriculturalproductivity, while industry benefits from avirtually unlimited supply of labor at very low,fixed, real wages (Lewis, 1954, 1958). The stateacts as facilitator in this take-off scenario: itpeddles the low-cost labor site; reduces infor-mation costs to foreign investors; shores upbusiness confidence, and prepares the laborforce for industrial work.

States pursuing the Lewis strategy inevitablyreach a critical transition where the sustain-ability of a development momentum becomesuncertain. This occurs when relative labor sur-pluses are exhausted (and they are always rel-

ative in a world where the solution ofinformation and incentive problems elsewhereimmediately open new labor surplus frontiersfor investors). Investors cannot be expected tocontinue pouring in while their principal sourceof advantage starts to disappear, and theeasy stage of export-industrialization withforeign capital comes to an end. This is thereason why an export-processing zone strategyis so often viewed with skepticism by develop-ment scholars (Deere et al., 1990), and recentevidence shows that the payoffs of export pro-cessing zones are real but quite limited (Mor-timore, 2000; Buitelaar & Padilla Peerez, 2000).

At the end of the easy stage of export in-dustrialization with capital imports a develop-ing country faces the challenge of finding a newformula to maintain the investment and growthmomentum. Foreign investors are market ac-tors who react to changing market opportuni-ties and will not solve this problem for the hostsociety. The burden of a solution falls back tothe host state, although it is another matterwhether it is up to the challenge, or even ac-knowledges the problem. In short, it is evidentthat states that pursue a Lewis-type take-offstrategy need, simultaneously, to prepare for atransition from an economy driven by low-costlabor to an economy with higher order sourcesof competitive advantage. This implies thatsuch states have to undergo a transformation inthe processfrom promotional states to whatwe know as a developmental states. East Asiantigers showed a unique ability to undergothis transformation and to move beyond anexport processing zone stage.

Finance is a central problem tackled by de-velopmental states. States seeking to initiateand sustain a development take-off have toaddress the problem of channeling economicsurpluses into new investment. Because thehorizons of developmental states and privateeconomic agents are different, and, becausepoor regions tend to have underdeveloped fi-nancial systems, a push for national develop-ment has typically required state intervention inthe process of financing this development(Cameron, 1967; Gerschenkron, 1962; Haggard& Cheng, 1987; Stallings, 1990). States maydirectly manage the flow of credit, regulate theprivate banking sector, or do a combination ofboth. The optimal type of state interventionin structuring the financial system will varyfrom one stage of development to another;tighter state control and bank dominationin early stages, nimbler systems later on

PUERTO RICO IN THE POST WAR 283

(Choe & Moosa, 1999). Systems with tightbank and state control are not as good at cross-sectional risk sharing, but are better at inter-temporal risk sharing and making long-termcommitments (Allen & Gale, 1995). In spite ofthe considerable allocation inefficiencies thatcan be created by state control of finance, evenin extreme cases these can be outweighed bypositive accumulation and investment gains, asthe case of India shows (Bell & Rousseau,2001). Indeed, standard economic theory, Sti-glitz (2000) forcefully argues, has placed undueemphasis on cross-sectional efficiencies andneglects the positive externalities associatedwith retaining investment tied to domestic ac-tivities (this has not always or everywhere beenthe standard argument; cf. Chaudhry, 1993).State control and direction of the financialsystem was central to the postwar growth ofJapan (Aoki & Hughes, 1994; Johnson, 1987;Mabuchi, 1995), and critical to the develop-ment of South Korea and Taiwan beyond anexport processing stage (Chang, 1999; Cho,1989; Woo, 1991). In contrast, evidence onsecond-tier NICs seems to show that financialliberalization has made it difficult to mount atransition from the easy stage of export-ledindustrization (Akyuuz, 1998). Even in first-tierNICs, the relaxation of state controls throughhasty and indiscriminate liberalization has ar-guably had an adverse effect on development,as Chang (1998) argues for South Korea.

It follows from the preceding discussion thatthe trajectories of NICs will tend to divergeafter the critical juncture where effective laborsurpluses are exhausted: (a) some make thetransition to an upgrading NIC trajectory,characterized by continued high growth andemployment; (b) others do not, and insteadfollow a stunted NIC trajectory, characterizedby low growth and growing unemployment.The ability of states to maintain the momentumwill depend critically on their capacity to har-ness the financial system towards domestic de-velopment ends (this is one among otherfactors, of course, including the ability to en-sure that the accumulation thus promoted be-comes internationally competitive).

Puerto Ricos transition in the early 1970s fitsthe second profilea rapid late developer at anearly stage nonetheless detours into a slowgrowth, stunted NIC, trajectory. Growth ratesdropped to less than half what they were be-tween 195070 (even with the substantialbailout effect on growth noted above), andunemployment, after reaching a low of 10% in

1970, doubled and has stayed in the vicinity of20% since. A reasonable hypothesis for the fateof the Puerto Rican miracle follows from thereview of the comparative literature: PuertoRicos stunted NIC trajectory was caused(among other factors) by the states inability toset the groundwork for a transition from thelabor surplus stage. This paper analyzes struc-tural limits on the apparatus of the promotionalstate that thwarted its capacity to begin per-forming as a developmental state, specifically inthe critical area of financing development. 3

3. BACKGROUND: PUERTO RICOSINDUSTRIAL TRANSFORMATION

The 1940s were a transitional decade inPuerto Rico. A nationalist movement chal-lenging US imperialism crested, then subsided,its thrust stopped to a large extent by the re-pressive measures of the US colonial adminis-tration. A new political party emerged fromthis context to capitalize on widespread popu-lar discontent with US colonialism and UScorporations that seemed to dominate themonocrop sugar economy. The Partido PopularDemocraatico (PPD), founded in 1938, rosequite unexpectedly and defeated establishedpolitical parties and coalitions in the 1940 leg-islative and municipal elections (at the time, thegovernor was still a colonial appointee). Withthe campaign slogan Pan, Tierra, Libertad(Bread, Land, Liberty) the PPD popularized ananti-imperialist platform that made a plea fornational sovereignty on economic and politicalfronts, economic reconstruction, and re-dis-tributive justice (Anderson, 1965).

Over the course of the 1940s the PPD es-tablished an electoral dominance that extendedfor 28 years. By the mid-1940s, the party star-ted to focus more tightly on electoral ends, andbitter internal conflict flared up between the topleadership and a majority of party cadre overcommitment to the original anti-imperialistplatform. After months of deft maneuvering,and successive party purges, the charismaticleader Luis Mu~nnoz Marn forced the party toleave behind its anti-imperialist platform (An-derson, 1965).

Economic reconstruction and social justicewere also central to the original PPD platform.Proposals on this front included land redistri-bution and breaking the overwhelming powerof landed interests tied to sugar; agriculturalrestructuring to foster diversification and in-


ternal linkages; and, finally, a program of in-dustrialization hinging on limited import-sub-stitution, strategic but limited participation ofstate enterprises in areas where private capitalproved too risk-averse, and promotion of adomestic capitalist class. Public powers of thestate were prevailed upon to plan, direct, exe-cute, and coordinate economic reconstruction.Without question, in the early 1940s the PPDwas a party at the helm of a developmentalstate project (Anderson, 1965, pp. 6872; Dietz,1989; Moscoso, 1985; Perloff, 1950).

The PPDs developmental state project wentthrough two distinct phases: first, a statecapitalist phase lasting from 194146; andthen, without making any major strategicpronouncements, the PPD shifted to a liberaldevelopment strategy some time between 194647. One by one, the state administered by thePPD started to abandon most projects fromthestate capitalist phase: the limited programof import substitution and state enterprises,land reform, and state-directed agriculturaldiversification efforts. As this occurred, thefoundations were laid for an industrialization-by-invitation program modeled after the Lewistake-off strategy (Dietz, 1989; Edel, 1962).

In light of the earlier theoretical discussion,one can appreciate how, knowingly or not, thistransition could seal the long-term fate ofPuerto Rican postwar development. On the onehand, the state embarked on the path outlinedby Lewis model of industrialization with un-limited labor surpluses; on the other, it did so ina context where state instruments for economicintervention were being radically scaled back.Over the long run, did this impair the ability ofthe Puerto Rican government to contend withthe predictable problems toward end of thelabor surplus stage?

There are two prevalent types of analysis ofthe 194647 transition and of subsequent de-velopment, but neither is of much help in ex-plaining the problems that eventually boggeddown the Puerto Rican economy. According toone set of accounts, the course of developmentduring and after the critical transition of 1947was determined almost exclusively by the ra-tional choices of autonomous state managersmaking pragmatic decisions under changingeconomic constraints. This is the typical anal-ysis offered by executives and former executivesof key development agencies (e.g., Moscoso,1985; Picoo, 1962). These argue, quite plausibly,that a number of factors forced pragmatic statemanagers to reconsider the feasibility of earlier

plans involving significant state direction,regulation, and participation. State financialresources were too meager to lead an industri-alization drive with state enterprises; resourcesto complete land reform were lacking; the statelacked managerial resources to run its enter-prises; the states dual interest in developmentand legitimacy undermined its ability to runstate enterprises effectively, etc. Deliberately ornot, these analyses reduce all pragmatic con-straints on state managers to a matter of re-sources, as if their choices did not havedistributive consequences, and ignoring theextent to which they generated a considerabledomestic opposition, especially from the PuertoRican business class.

Alternative explanations are critical of thispragmatic state manager account. Accordingto these, the direction of Puerto Ricos eco-nomic development in the 20th century wasalways determined by overbearing externalforces. These external forces are variouslyunderstood as US imperialism (Dietz, 1979),a situation of dependency (Villamil, 1979),transformations in the hierarchical interna-tional economic order (Pantojas-Garca, 1990),or simply capitalism (Santana Rabell, 1989).These external forces were the real constraintsoperating on pragmatic state managers. Thevarious explanations stressing external deter-mination have a richer conception of the pos-sible constraints affecting Puerto Rican statemanagers, but they are also myopic. Both ac-countsthose stressing the pragmatism of statemanagers, and those that stress external deter-minationtend to ignore how the domesticpolitical economy shaped the course of PuertoRicos economic development.

Many studies that stress external determi-nants of Puerto Rican development havelargely focused on the crisis of the Puerto Ricanmodel in the 1970s. The 1940s, by omission, aresimply assumed to follow the pattern of exter-nal determination. An examination of thosestudies that have analyzed the transitional1940sDietz (1989), Santana Rabell (1989),and Pantojas-Garca (1990)however, revealsno concrete evidence to support the hypothesisthat overbearing external forcese.g., US im-perialismwere the cause behind the liberalturn of Puerto Rican state managers. More-over, what we do know about the turn to liberalindustrialization in Puerto Rico does not lendsupport to the external determination thesis.US firms attracted to Puerto Rico in the 1950swere relatively small, labor-intensive operations


in declining sectors with a grim future in theUnited States (notably, shoe and textile man-ufacturers and subcontractors). These US cap-italists did not have a political or economicpresence before 1947 that could explain thePPDs decision to abandon its statist program.In fact, Puerto Rico at the time was such adifficult sale that it took three or four years ofhard and uncertain promotional work beforethe Puerto Rican Economic DevelopmentCompany (FOMENTO) was able to attractany significant number of US companies. Theturn to private foreign private investment wasinitially so uncertain that each new plant wascelebrated with the orchestrated fanfare of adevelopment agency fearful of losing publicsupport for its efforts (Ross, 1976, pp. 9597,117122). Ironically, the most significant in-tervention by the US government in domesticeconomic affairs was on behalf of US unionsfighting so-called runaway shops, not UScapitalists (Galvin, 1979). Available evidencesimply does not reveal a collusion of US gov-ernment and segments of US capital lurkingbehind the PPDs turn away from a statist modeof development. 4

US capital was poised for an unprecedentedoverseas expansion on the wake of WWII, andthe US government was certainly at the helm ofefforts to build global framework for liberalizedtrade and investment favoring US corporations(McMichael, 1996). Had the question of PuertoRican development been put to Washingtonpolicy makers in the form of a menu of choices,it is likely they would have selected a liberalinvestment regime over a program with con-siderable state intervention. But Puerto Ricohas seldom been a central policy concern inWashington, and the responsibility for PuertoRican affairs has never been clear within thefederal structure (Lewis, 1963). It is also worthkeeping in mind that US imperialism wasquite flexible and pragmatic in accommodat-ing heterodox economic regimes during thepostwar eraeconomic nationalism in LatinAmerica and Asia, shades of social democracyin Europe. There is no a priori reason to be-lieve there was less elbow room for a creativecompromise with imperialism in a Caribbeanterritory whose residents could expect someleniency from their colonial patron, particularlyin the early 1940s, in the aftermath of a deepcrisis of legitimacy for the colonial adminis-tration.

When the United States was badly in need ofa local ally capable of rebuilding its legitimacy,

the PPD entered the historical stage, and itmade every effort to exploit this opportunity.The PPD distanced itself from anti-US na-tionalists and socialists, and was always carefulto draw a distinction between the evils ofsugar imperialism and the essentially benign,if neglectful, US government (Quintero Rivera,1985). Even when it proposed national in-dependence and unorthodox development stra-tegies, the party assiduously cultivated thesupport of the Roosevelt administration. Allthings considered, it is fair to imagine the de-velopmental state project of the PPD enjoyedsufficient autonomy from US imperial interestsduring the 1940s. With this in mind, the anal-ysis that follows turns attention to the roleplayed by the domestic business class in theprocess of dismantling the PPDs developmentalstate project, and more importantly, the long-term effects of this liberalization.

4. A TIGER OUT OF STEAM

(a) First approximation: economic causes

Nineteen seventy-four was the year whena crisis in the vaunted Puerto Rican industri-alization model became obvious, althoughproblems were evident earlier. After averaging7.7% per annum real GDP growth rates overthe previous 15 years, there was no real GDPgrowth that year. Over the decade that fol-lowed, annual growth averaged a paltry 1.9%(Curet, 1986, pp. 49, 84, 91). The first OPEC oilshock and the economic downturn in theUnited States (principal market for PuertoRican exports) had an undeniable impact, butthe economy never recuperated its previousluster, which suggests that a more complicatedarray of factors produced the crisis. Manyother countries entered a period of slow growthat this juncture, and in this sense Puerto Ricowas certainly not unique (Maddison, 1991). ButPuerto Ricos trajectory did start at this junc-ture to diverge markedly from that of the fourAsian tigers, the most relevant comparatorsin the context of the analysis at hand: in the1960s Puerto Ricos growth rates were in theballpark with the four Asian NICs; startingwith the 1970s Puerto Rico was no longer in thesame category (see Table 1).

A great number of factors are surely involvedin the crisis of any development model, someglobal and beyond the reach of any configura-tion of domestic actors, and some domestic. In


spite of the adverse global economic climate ofthe 1970s (which the other NICs weathered),economists have identified endogenous factorspointing to what seemed like an impendingcrisis. Productivity (measured as output peremployed persons) started to decline in theearly 1970s, and this coincided with a markeddecline in gross domestic investment (a pre-condition of growth in some well-knownmodels) from 31.1% of GNP in 1970 to 13.9%in 1984 (Curet, 1986, p. 50). Investment in plantand equipment a key component of investmentfor long-term growth, started a long and sharpdecline in 1970 (investment gross fixed do-mestic investment from both private and publicsources, though overwhelmingly from privateexternal sources; it excludes public infrastruc-ture spending) (Curet, pp. 57, 140141). Thisdecline in investment antedated the first OPECshock and 197475 recession by a couple ofyears, which indicates Puerto Ricos model wasexperiencing internal problems before theseexternal economic shocks had their impact.

Sources of investment shifted markedly be-tween 195070, and this had a bearing on theinvestment slowdown. External sources ofsavings increased their share from 54.9% to97.9% (54.776.3% if only private sector sav-ings are considered), with a concomitant de-cline in domestic sources (Curet, 1986, p. 138).The growing importance of foreign capital isnot surprising, since the Puerto Rican devel-opment program actively focused its efforts onpromotion of foreign investment. Without adoubt the economy benefited immensely frominfusions of foreign capital; among otherthings, this allowed the economy to sustain achronic deficit in its trade balance (Curet, 1986,p. 78). Over the longer term, however, a lop-sided dependence on foreign investment carriedits own risks. A significant slackening in the

flow of external capital would have dire con-sequences, and it did.

A set pattern of easy access to US capital,and chronically low rates of domestic savings,probably made it difficult to imagine any degreeof domestic self-sufficiency in financing growth(if that were a desirable goal). Nonetheless, alate 1960s study of growth and finance con-cluded, provided the political will, moderatesteps toward the reduction of extreme depen-dence on foreign investment were feasible(Freyre, 1969). Twenty years later, an economicreport for the Puerto Rico Economic Devel-opment Administration still identified invest-ment dependence as a critical problem. Itpoignantly underscored a serious governmentfailure and contrasted the Puerto Rican casewith Asian NICs.

In 1965, [Puerto Ricos] gross domestic investmentwas equal to 29% of gross domestic product. This levelof investment compared favorably with that in othermiddle income developing economies [Singapore 22,Hong Kong 36, Taiwan 23, South Korea 15]. Sincethe level of domestic savings in Puerto Rico was only8% of GDP, the remaining investment was being fi-nanced by transfers and investments from outsidethe island. [. . .] In 1965, domestic savings in the NICsvaried from a low of 8% in South Korea, the latest ofthe NICs to begin rapid industrialization, to a high of29% in Hong Kong. By 1983, the NICs had allachieved investment rates of between 27% and 45%and domestic savings rates had risen to levels varyingfrom 25% to 42%. Net resource inflows had declinedproportionately. But in Puerto Rico the investmentrate had fallen to slightly over 8% of GDP, domesticsaving was still only 8% and the net resource balancewas down to 0.9% (Stuart, 1987, pp. 23).

The GNP/GDP ratio steadily declined fromthe 1960s to the 1980s (Curet, 1986, pp. 191192), dropping to 0.70 by 1990 (Junta de Pla-nificacioon, 1993, Table A-1), reflecting a steadydenationalization of the economy. More-over, while the role of foreign capital steadilyincreased, so did the risk of depending on it. Bythe 1980s, net factor payment outflows ex-ceeded net long-term capital inflows by a ratioof 2.651 (Stuart, 1987, Table 3). The gap hasbeen filled by a massive inflow of US govern-ment transfers, but these go principally towardindividual and government consumption, notproductive investment, so the impact on growthis limited.

In sum, the crisis of the Puerto Rican modelwas caused by a conjunction of causes, butthe scissors effect created by (a) chronicallylow domestic savings, and (b) long-term

Table 1. Average annual growth rate, Puerto Rico andEast Asian countries

196070197082

GDPGNPpc GDP

Puerto Rico 5.9 7.2 1.9a

Singapore 5.5 8.8 8.5Hong Kong 8.7 10 9.9Taiwan 6.3 9.2 8.0South Korea 6.4 8.6 8.6

Source: World Bank, cited in Barrett and Chin (1987).a Puerto Rico figures are for 197584; calculated fromCuret (1986, pp. 49, 91).


dependence on foreign investment for domesticcapital formation was a key structural flaw.Chronic dissavings exacerbated a long-termhyperdependence on foreign investment, and asthe easy labor-surplus stage came to an end,rates of reinvestment became predictably ad-verse. Foreign investment can provide both thespark and the fuel for an industrial take-off,but it is uncertain over the long run. Over thelong run the solution lies in building alternativesources of competitive advantage, and stabi-lizing the continuity of investment by cultivat-ing a sturdy supplement of domestic investmentsources. It was at this juncture that East Asiandevelopmental states intervened, increased theshare of domestic investment sources anddomestic participation in exports, and success-fully made a transition from the early exportprocessing zone strategy (Amsden, 1989; Gra-bowski, 1998; Woo, 1991). Those NICs con-tinued on a high-growth path for another 20years. The government of Puerto Rico, incontrast, did not make any fundamental ad-justment to its development strategyforeigninvestment promotion on the basis of produc-tion cost advantagesand paid dearly in termsof economic performance. Why did the PuertoRican government not make similar adjust-ments to deal with the erosion of its labor-costadvantages? 5 An answer to this question re-quires an analysis of the political economy thatshaped the Puerto Rican program of economicdevelopment.

(b) The domestic political economyof stunted development

(i) The elusive class of Puerto Rican capitalists

The establishment of the pre-conditions of economicgrowth is so handicapped by existing political interestsin some underdeveloped areas as to make it unlikelythat much can be accomplished without a forcibleoverthrow of those interests. The revolutionary move-ment need not be communist . . .

(Mason, 1958).

The Puerto Rican capitalist class disappearedfrom historical accounts and sociologicalanalysis after 1940 on the unwarranted as-sumption, it seems, that the power of this classwas inconsequential. 6 Weak domestic busi-ness classes ought to be taken more seriously,even where they seem to be overshadowed byforeign corporate interests. Weak domesticcapitalists have unique resources at their dis-

posal that give them a power far in excess oftheir direct share of control over investment.Their leverage comes from the important inte-grative role they play in the economy. Domesticcapitalists set the tone for the relationship be-tween foreign investors and the state; they canfacilitate, or they can foul the relationship.Their knowledge of the local economy, andtheir business and government contacts, arevaluable to the state and foreign capitalistsalike. Their mediating role puts them in theposition to shape perceptions about the do-mestic business climate: their good word canredeem the states credibility with foreignbusiness; their vote of confidence in thegovernment is a proxy for investment risk. 7

Governments wishing to work with foreign in-vestors unavoidably need to nurture a goodrelationship with local capital; foreign investorswishing to maximize information and minimizerisk may use domestic capitalists as feelers.Thus, while weak domestic capitalist classeslack the structural power that comes withability to threaten or execute the proverbialinvestment strike, 8 they are in a good positionto precipitate such a strike. This is the structuralpower of weak domestic capitalists. 9 Domesticbusiness classes have in addition another purelypolitical source of leverage: they enter the frayof national politics and policy formation witha certain amount of legitimacy that foreignbusiness lacks.

Strategists within the PPD correctly appre-ciated the early 1940s were a propitious junc-ture for economic reconstruction. The sugareconomy was in its final throes on account ofadverse US quotas and declining prices, andthis offered an opportunity to lay the founda-tions for a new economy before a new impe-rialist combine could take form (Anderson,1965; Dietz, 1989; Navas Daavila, 1978; Quin-tero Rivera, 1985). Conditions were also morefavorable for PPD reformers in the 1940s thanthey had been earlier. In the 1930s, reformerswere in the political opposition, but with thePPDs 1940 victory they entered government.Finally, as US legitimacy reached its lowestpoint, the President for the first time appointeda colonial governor who did not cater to theinterests of privileged classes. Rexford Tugwell,a member of Roosevelts brain trust marginal-ized by the rightward turn in the New Deal,was the last US-appointed governor. He sawthe appointment as an opportunity for eco-nomic experimentation that was no longerpossible in the United States, and became a


strong supporter of the PPDs statist develop-ment program.

In spite of the unique opportunities affordedby the war years, the early PPD developmentproject threatened the interests of most sectorsof the domestic business class. First, the landreform program sought to redistribute alllandholdings exceeding 500 acres. While partyrhetoric tended to equate landed power withabsentee sugar corporations, most corporatefarms above the limit were in fact domesticallyowned. Four US corporations collectivelyowned some 98,000 acres (Curtis, 1966, p. 10,Table 2), but nearly as much land was ownedby the largest six Puerto Rican corporateholdings. Over three-quarters of all holdingsabove 1,000 acres, some 341,000 acres, werethe property of 152 Puerto Rican corporationsor owner-operators (Dietz, 1989, p. 125). Sec-ond, the PPDs developmental state projectsought to regulate the monopsonistic power ofsugar mills. While the American big fourowned 11 sugar mills in 1938, 31 belonged toPuerto Ricans. Thirty-seven of these mills werestill in business in 1947; 27 were Puerto Rican-owned, and these produced more than 60% ofthe islands sugar (Perloff, 1950, pp. 7677).Third, the government established profit-sharing farms which competed directly withprivate farms and mills, and which threatenedto raise the wage floor in rural labor markets.Fourth, plans for agricultural diversificationand substitution of imports posed a directthreat to oligopolistic food importers. Finally,state and business agendas clashed over theideologically charged subject of state enter-prises. Five state enterprises were establishedby 1946, conceived principally as demonstra-tion projects to crowd-in risk-averse do-mestic capitalists. In and of themselves, thesesmall enterprises were not real threat to theprivate sector.

The governmental enterprises of the insular regime ac-counted for only 1.2% of total net incomeproving,incidentally, that the characterization by its critics ofthe Puerto Rican economy under the New Deal asone of state socialism constituted an extravagantexample of poetic license (Lewis, 1963, p. 169).

Yet, as a piece of a broader program that had thestate meddling in areas of traditional businessprerogativeproperty ownership, management,labor markets, and price determinationstateenterprises could appear, or be made to appear,particularly threatening.

Considering the impact of the PPD devel-opmental state project on domestic capitalists,it is intriguing that their influence on thepragmatism of state managers has not beenstudied carefully. 10 Several studies have notedthat many of the 1940s economic reforms hadbeen attempted during the Great Depression,and were at that time defeated by a recalcitrantPuerto Rican elite (Mathews, 1960; NavasDaavila, 1978, p. 66; Santana Rabell, 1989, pp.5152; Tugwell, 1958, p. 79). It would be indeedsurprising if the elite that opposed economicreconstruction in the 1930s had not resistedsimilar efforts in the 1940s. This class in factbecame a considerable obstacle in the way ofthe early 1940s developmental state project.

During the 1940s the Puerto Rican businessclass led a broad offensive against the PPDsdevelopmental state project. This occurred onseveral fronts simultaneously. A press cam-paign to discredit the developmental projectviciously attacked it with charges of state so-cialism, bureaucratic excess, and incompetence.Conservative US Senators were invited to in-vestigate charges of state socialism, while do-mestic business tried to cripple state enterprisesby refusing to purchase their product (ironi-cally, these were in part established to meet theneeds of this class amidst wartime inducedshortage). Land reform was bogged down byyears of litigation and in the end abandonedaltogether. 11 Finally, the domestic businessopposition was able to redirect the orientationand priorities of the developmental state pro-ject through direct participation in the admin-istration of key agencies.

Their participation was more at the level of policy-making than political activism. Puerto Rican entre-preneurs from private banks and industries wereincorporated into the board of directors of Fomentoand of all of its subsidiaries. According to David F.Ross, they provided a measure of conservatism and re-spectability to the states industrialization program.Indeed, their participation ensured that the interestsof the local bourgeoisie were part of the developmentprogram (Pantojas-Garca, 1990, pp. 5253).

Insofar as the state did not have the capacityto replace the private sector with a state-man-aged economy (and it was not considering thisin any event), it had to rely on private invest-ment. To sustain this private investment, thestate had to be mindful of the business cli-mate, and this, in turn, meant coming to termswith the structural power and interests of itsweak domestic business partner. Domestic


capitalists, for their part, were aware that thesugar sector that had dominated the economyfor four decades faced a dead end. Conse-quently, they had an interest in securing a placefor themselves in the new economy the statewas trying to build. The disruptive campaign ofthe Puerto Rican business class put the state ina position where it needed to placate domesticcapital but not so obviously that it wouldthreaten its populist electoral credentials. 12

The Puerto Rican business class, for its part,had every incentive to fend off the statist pro-gram of economic development and to pusheconomic liberalizationbut to do so underthe convenient cover of the PPDs populistrhetoric, or else risk a popular backlash. Inshort, domestic capital and the PPD adminis-tration faced strong incentives to find someform of mutual accommodation.

(ii) Development financeA decisivecompromise

Finance is a central problem of economicdevelopment. On the question of finance, aswith the multiple other areas where a state cancontribute to development, the success of stateefforts depends in part on the quality of itsagencies and personnel; but it also depends ona tricky balance of power, and on the qualityof relations between the state and the differ-ent domestic sectors in control of key produc-tive assetsbanks, industry, landed interests(Evans, 1998). This section examines how thedomestic political economy, and specifically,the tensions and accommodation between thegovernment and private banks, shaped theframework of development banking for PuertoRicos export-led development. The analysisthen turns to the long-term negative effects ofthis government-bank compromise.

PPD reformers during the 1940s were clearlymindful of the importance of finance, and oneof their first state-building moves was to es-tablish a government development bank tosupport the governments development pro-gram. Law 252 of May 13, 1942, established theGovernment Development Bank (GDB), aninstitution charged with facilitating long-termfinancing for the projects of the Industrial De-velopment Company, the Land Authority,other government development efforts, andwith promoting domestic manufacturing gen-erally. The law also entrusted the Bank withfiscal agency functions, which authorized andrequired it to manage Treasury deposits, andthe public debt of the state and public corpo-

rations (Dietz, 1989, p. 206; Maldonado, 1970,p. 55; Perloff, 1950, p. 39). A development bankwas an indispensable tool to support publicinvestment projects, and to overcome the aver-sion of domestic business to investments out-side areas where they traditionally enjoyedprotected rents and reduced riskimport lux-uries, land-speculation, commercial expansion,and hoarding (Perloff, 1950, p. 166). Develop-ment finance is a demanding task for any state,in no small measure because it seeks to imposesome discipline on market actors that wouldrather do without it. In the 1940s this put thePPD on a collision course with commercialbanks, the most robust segment of the PuertoRican business class.

Commercial banks were the only significantfinancial institutions in Puerto Rico on the eveof industrialization (Maldonado, 1970, p. 46).Puerto Rican banks were the strongest segmentof the domestic business classnone otherproved more resilient in the face foreign com-petition, or gained so much ground over thefirst four decades of the 20th century. WhenPuerto Rico became a US possession in 1898,commercial banks were feeble institutions witha short history; at that time the three banks thateventually survived through 1930 had total as-sets that did not reach $180,000 (Sanz, 1969,pp. 58). By 1928, there were four US andCanadian banks operating in Puerto Rico, andthe number of domestic banks had increased to14. Puerto Rican banks accounted for approx-imately 40% of commercial bank capital on theeve of the Depression, in spite of governmentdeposit polices that favored a US bank, theAmerican Colonial Bank (Sanz, 1969, pp. 89;Clark, 1930, p. 376). Puerto Rican banksprospered by working niches that US andCanadian banks could not serve as well: theyfinanced sugar and coffee producers, andextended personal loans secured against realestate, while US and Canadian banks tended toconcentrate on financing importexport activ-ity. Puerto Rican banks were favored by familyand business networks that spread into nu-merous areas of economic activity, and by abetter understanding of the local clientele.Their successful participation in New Yorkcapital markets and adaptation to US regula-tory agencies allowed them to survive foreigncompetition (Cochran, 1959).

Although Puerto Rican banks more thanheld their ground through 1940, the next twodecades were the start of their golden age.During the 1940s banking assets increased at a


yearly rate of 11.5% (up from 6.6 for 190740),and from 195067, the glory years of the PuertoRican industrialization, their annual rate ofgrowth was 12%. By 1967, eight domesticallychartered banks held 62.5% of all assets in theprivate commercial banking sector (Maldo-nado, 1970, pp. 9192). Given the importanceof bank finance in the early stages of develop-ment, state planners could not avoid the taskof seeking a mode of cooperation with thedomestic banking sector.

The new era ushered by the Partido Popularsdevelopment project clearly proved to be aboon for domestic banks, but this outcome wasnot at all certain when the party first took officein 1941. Economic development is in the in-terest of banks, insofar as it increases demandfor private financial services. Nevertheless, stateefforts to direct the financial system towarddevelopment goals are a matter to concernprivate financial institutions. Theoretically thereare long-run gains that result from state stew-ardship, but long-term development dividendsare always uncertain. In the short term, stateefforts to regulate the use of savings and debtcompete with private banks for a fixed pool ofdomestic savings and external capital. In addi-tion, when state bureaucracies become activelyinvolved in regulating a market there is theproverbial slippery slope of bureaucratic over-extension. It is not difficult to see why efforts toestablish a Development Bank in 1942 addedto the mounting tensions between the statedevelopment program and the domestic busi-ness class.

A relationship developed between the gov-ernment of Puerto Rico and private domesticbanks after 1940 that has not been examined todate, but which in retrospect had a determinanteffect on the fate of the Puerto Rican industri-alization program. Before 1940, governmentdeposits were held by US chartered banks, upto 90% by the American Colonial Bank (Sanz,1969, p. 9). After 1940, the year of the PPDsfirst electoral victory, the Treasury Departmentinitiated a new policy of favoring Puerto Ricanbanks. Interestingly, although this policy seemsquite consistent with the early nationalist pri-orities of the Partido Popular, it was never anexplicit theme in the partys platform, nor has itsurfaced as a matter for examination in studiesof the period. This change in Treasury policywas a boon for domestic banks. By the mid-1940s Treasury deposits were already evenlydivided between Puerto Rican and US banks;by 1950, two-thirds of these deposits were

placed with Puerto Rican banks. Treasury de-posits were not that critical for US-charteredbanks because these had access to statesidedeposits. For domestic banks, however, thechange in Treasury policy was a blessing, rais-ing deposits anywhere between 50100% in theearly part of the decade. Government depositsmeant a substantial increase in volume, but alsoacted as a form of insurance at a time whendomestic banks were not insured. Domesticbanks were able to parlay these new advantagesinto a decade of unprecedented growth in de-posits, assets, and market share. Between 194253 total deposits quadrupled and capital assetstripled (US banks, in contrast, increased de-posits by only 35% in the same period) (DiVenuti, 1955, pp. 4344, 46, Tables 1013).

The new Treasury policy was undoubtedly aboost to Puerto Rican banks, but relations withthe government did not end there. Governmentplans to establish a development bank were asource of consternation among bank execu-tives. In the course of an interview with a USSenator investigating allegations of state so-cialism in Puerto Rico, a member of the Roigbanking family expressed fears about the plansfor a development bank, and in particular,about the unfair extension of state prerogativeswhich this entailed (Tugwell, 1947, pp. 529530). There was a matter of unfair directcompetition for individual deposits, but moreimportantly, with the founding of the devel-opment bank, private bankers also faced therisk of losing part of their share of Treasurydeposits. These deposits offered state develop-ment planners a source of leverage, and theycould be made conditional on bank coopera-tion with development plans. Considering thefull ramifications of the proposed developmentbank, it is not difficult to appreciate why localbankers were apprehensive.

The worst fears of domestic bankers, how-ever, did not materialize. Rafael Buscaglia wasthe first Treasurer of the first PPD adminis-tration, and on his watch, the depository policystarted to favor Puerto Rican banks. Buscagliahad good relations with private sector bankers,supported them, and was held in high esteemamong bank executives (Sanz, 1969, pp. 21, 15).While Puerto Rican banks had reasons to beconcerned about the establishment of theGovernment Development Bank, in Buscagliathey had a trusted supporter; and Treasurysupport in the battle over development bank-ing was important because the Treasurerwas directly responsible for the Government


Development Bank. From the Treasury De-partment Buscaglia moved on to become thefirst President of the Government DevelopmentBank, a move that could only allay the con-cerns of private bankers. A member of thePlanning Board that later became president ofthe Development Bank, commented on how, infact, at the beginning the Bank developedslowly; it had to be brought along under thediscipline and heat of the Secretary of theTreasury (Picoo, 1962, p. 247) [my italics].

An accommodation between the Treasury andthe private banking sector was consistent with alarger pattern of accommodation taking placebetween the state and the private sector on manyfronts. It is against this backdrop that theTreasurys slow and cautious stewardship overthe Development Bank should be understood.On the agrarian front, the Land Authoritystopped pursuing land reform in 1944, and mostof the land acquired after that date either per-tained to consent decrees signed by 1944, or wassimply purchased in the open market (Edel,1962). In FOMENTO, the industrial develop-ment agency, Teodoro Moscoso was active be-hind the scenes, at least as early as 1945, layingthe groundwork for a shift from a statist to aliberal industrialization program founded onforeign investment promotion (Ross, 1976,Chapter 5). FOMENTO managed five state en-terprises, and was so central to the state devel-opment program, that Moscosos efforts couldnot have been a mystery to his colleagues in theDevelopment Bank and the Treasury. Finally,Luis Mu~nnoz Marn, the charismatic PPD leaderwho led the charge against sugar imperialism,distanced himself from programmatic commit-ments to state-led development and nationalindependencegingerly at first, and in an openand acrimonious public fight with other partymembers in 1946 (Anderson, 1965). With each ofthese shifts, the PPD drifted further from theinitial commitment to a developmental stateproject. In this context, the Planning Boardfound itself under attack by officials formerlycommitted to the state development program(Descartes, 1946, pp. 1213), and its role ineconomic planning was reduced to planningfor public infrastructure. By 1946, GovernorTugwell was the only ranking member of theadministration still committed to strong statestewardship in the development process, butended up resigning the post, fully aware of hisgrowing political isolation.

Ultimately it was the Government Devel-opment Bank that was starved of Treasury

support during much of the 1940s, not privatebanksin spite of bankers fears. Treasurydeposits with the Government DevelopmentBank were very limited for the greater partof the decade, until about 1947. After thatyear, the Treasury literally, and figuratively,started to deposit more trust in the Bank (seeTable 2). Treasury deposits with the Govern-ment Development Bank only reached a stableplateau after 1949. The Development Bankwas virtually on a short leash until the originaldevelopment program that so upset the do-mestic business class had been effectivelydismantledland reform halted, state enter-prises privatized, and the activities of thePlanning Board narrowed to infrastructuredevelopment.

The Government Development Bank itselfwent through some transformation before itstarted to receive Treasury support. Two leg-islative acts, Law 272 of 1945, and Law 15 of1948, reorganized the development bank andnarrowed its functions. The Bank ceased ser-vicing private savings accounts (and hencecompeting with private banks), and its workwas focused more narrowly on fiscal agencyfunctions that are by nature conservative. By1948, articles defining the Banks charter madeno reference to development functions that hadbeen part of the Banks original chargefinancing industrialization, nurturing domesticcapital, etc. Only a vague rhetorical commit-ment to development remained in the 1948charter:

To aid the Commonwealth Government in the perfor-mance of its fiscal duties and more effectively to carryout its government responsibility to develop the econ-omy of Puerto Rico, particularly with respect to its in-dustrialization . . . (Act 17 of 1948, Section 1).

The obligations specifically mentioned in therevised charter were narrow, and symptomaticof the broader liberalization of the develop-

Table 2. Development bank treasury deposits as a % oftotal treasury deposits

1943 01944 2.91945 91946 6.71947 13.2194953 2025%

Source: Calculated from Di Venuti (1955, p. 44, Table

14).


ment program under way. The Bank was in-structed to

invest its funds in direct obligations of the UnitedStates or obligations guaranteed as to both principaland interest by the United States. [. . .] or obligationsof Puerto Rico, or guaranteed as to both principaland interest, by Puerto Rico [. . .] The Bank may alsoinvest its funds in bank acceptances or other obliga-tions or certificates of deposit endorsed or issued, asthe case may be, by banks organized or authorizedto do business under the laws of the Commonwealthof Puerto Rico, the United States, or any State ofthe Union (Act 17, 1948, Charter, (E), as amendedby Act 3, 1957, Act 55, 1965, Act 1, 1986).

By law, the only obligation of the re-re-structured development bank was to maintain avery conservative portfolio, and within thatconservative mandate, it was instructed to keepa portfolio that stabilized the domestic bankingsector as a whole. The Bank was reorganized tobecome a judicious fiscal agent for the state,and an effective banking sector stabilizer, but inthe process it was stripped of all but rhetoricalcommitments to development banking with along view.

Angel Sanz, president of the Banco Creedito yAhorro Ponce~nno in the 1940s, took some pridein observing that an esteemed colleague, andhis successor, Esteban Bird, actively partici-pated in drafting the charter and restructuringthe Government Development Bank (Sanz,1969, pp. 8, 21). Bird later went on to becomepresident of the Government DevelopmentBank. Bird succinctly described the qualitativetransformation in the relations between theGovernment Development Bank and privatebankers.

When the [development] program started in 1942Esteban Bird was with a private bank, and like nearlyall the businessmen and bankers he knew, opposed theprogram. Six years later he was working for it as ahigh executive of the Governments DevelopmentBank. I interviewed him there. Today, he said,these men [bankers] have become convinced of theintegrity of the administration and the soundness ofthe Fomento idea. Ive been here two years now,and no political pressure of any kind has ever beenput on this office (Chase, 1951, p. 33).

The establishment of Government Develop-ment Bank was of clear concern to privatebankers; to placate banker opposition the statechanged its own priorities, and representativesof the domestic banking sector participateddirectly in the process of restructuring the

Government Development Bank and liberaliz-ing the framework of development banking.

(iii) The long-term effects of the compromise ondevelopment finance

Having the Government Development Bank of PuertoRico set the terms of our developmentand it doesis analogous to having a goat look after your cabbagepatch. Government planner, 1990s.

As a fiscal agent, the Development Bank hasbuilt a strong track record over the years. Ex-cept for a brief period in the mid-1970s, PuertoRican debt instruments that financed publicinfrastructure maintained high ratings throughthe late 1970s (US Department of Commerce,1979). Every significant economic study since1950 concurs, however: the Government De-velopment Bank never became an effectivemechanism for industrial development (Comiteepara el Estudio de las Finanzas, 1976, pp. 8283;Consejo Asesor, 1989, pp. 7072; Di Venuti,1955; Maldonado, 1970, p. 57; Perloff, 1950, p.106; Puchi-Acu~nna, 1984). In the late 1940sPerloff observed, in a seminal study of PuertoRican development,

[D]evelopment Bank . . . loans for industrial purposeshave been quite limited in scope and amount. Duringthe fiscal year 1947 direct industrial loans of 2,065,000were made. As of June 30, 1948, total legislative ap-propriations for the bank amounted to $20,500,000.The bank has the power to issue its own bonds, butno bond issue has yet been floated (Perloff, 1950,p. 107).

In the mid-1950s a study of the Puerto Ricanfinancial sector again noted about the Bank:structurally it still is not organized to carry onan intensive lending operation of the kind es-sential to the promotion of economic develop-ment (Di Venuti, 1955, p. 88; see also Comiteepara el Estudio de las Finanzas, 1976, p. 82). In1962, a former executive of the DevelopmentBank lamented: We still need mechanisms andsources for the creation of investment with along-time-view (Picoo, 1962, p. 239, my trans-lation). Decade after decade, studies havepointed to the institutional deficiency of theGovernment Development Bank. We have seenthat faulty institutional design was only theproximate cause of the Development Bankspoor performanceultimately this institutionalweakness was the result of a compromise be-tween the government and private bankers.


Between 195067 the Government Develop-ment Bank played a key role in financing publicinfrastructure, but, notwithstanding its nameand rhetoric, its role as a development bankwas marginal at best. During these years, 75%of all long-term investment in Puerto Rico wentinto housing, with mortgage bankers the prin-cipal source of long-term investment (54%),followed by the US government (17%), and thePuerto Rican government (16%). Only 25% oflong-term finance went into areas other thanhousing, including investment in productiveassets (Maldonado, 1970, p. 49). Here thecontribution made by the Development Bankwas negligible until the late 1960s; during thecrucial years of industrial take-off, the Bankcontribution to financing nonhousing develop-ment (1951 0%) (see Table 3).

A cautious look at Table 3 might suggest thatthe Development Bank simply took some timeto get on with the business of financing long-term investment, but the Banks asset portfolioin the late 1960s shows this continued to be avery marginal part of its business. Over half ofthe Banks assets were in low-risk governmentsecurities, much of this contributing to capitalformation outside Puerto Rico (US securitiesplus an undisclosed proportion of municipalbonds that were not Puerto Rican governmentissues). Even the modest loan activity, 33% ofits portfolio, shows no clear commitment toindustrializationa mere 16% of bank assetswere in the form of industrial development fi-nance, the purported priority of the govern-ments development program (see Table 4). 13

Almost as early as the industrialization-by-invitation program got underway the Gov-

ernment Development Bank of Puerto Ricohad become something other than a develop-ment bank and this deficiency continued intothe 1990s. Chronic domestic dissavings coupledwith a weakening foreign investment were ear-lier identified as underlying causes of theslowdown in Puerto Ricos export-led indus-trialization. A state intent on sustaining a de-velopment momentum might use its financiallevers to counteract the weak investment func-tion underlying slowdown; the GovernmentDevelopment Bank, however, instead added tothe problem. Figure 1 is a simplified chart offinancial flows between government, the devel-opment bank, private banks, and the domesticand external sectors. The magnitude of differentflows, by origin, and by destination, gives arough sense of the role and priorities of thedevelopment bank through the early 1990s.Flows originate in two types of financial inter-mediariesthe development bank and privatecommercial banks, and they reach several des-tinations: US government securities, PuertoRico government bonds, commercial banks,consumer loans, real estate, industrial andcommercial enterprises. Total flows, brokendown by destination, are as follows (in billionsof dollars): US government securities, 3.8 bil-lion; Puerto Rico government bonds, eightbillion; commercial banks, 3.6 billion; con-sumer loans, 3.5 billion; real estate, 3.8 billion;and industrial and commercial loans, 5.387billion, for a total of 28.47 billion. Of the creditmade available by all banking intermediaries,about 18.92% reaches industrial and commer-cial enterprises. Whether this figure is high orlow by comparative standards is a matter Ileave aside here. Instead, what I wish to high-light is the meager contribution of the Devel-opment Bank. While 25.6% of outflows fromcommercial banks go to industry and commerce(5.2/20.3), only a paltry 2.4% of DevelopmentBank outflows reach commerce and industry

Table 3. Supply of long-term finance, excluding housing,195167

Distribution % oftotal

1951 1957 1967

Commonwealth Government 12.3 77.8 43.3Government DevelopmentBank

0 5.3 19.7

Industrial Development Co. 12.3 72.5 17.6Other 0 0 5.9

Commercial Banks 58.9 7.4 1.5

Private Nonbank 0 0 37.7Insurance Companies 0 0 30.9Other 0 0 6.8

Source: Maldonado (1970, p. 53, Table 4.3).

Table 4. Government development bank asset profile,1967

Government Securities 50.8US Government (32.4)Municipal Bonds (incl. Common-wealth Bonds)

(18.4)

Loans 33Industrial (16)Commercial (10)Misc. (5)

Source: Maldonado (1970, p. 57).


(the figure for industry alone, which is notshown in Figure 1, is around 1%). The publicinstitution that purports to finance develop-ment, and, one expects, ought to place a goodportion of its bets on industry and commerce(not to mention riskier industrial and com-mercial bets), turns out to be far more conser-vative than even private sector commercialbanks (all figures, Junta de Planificacioon, 1993).

By the early 1990s, the share of GovernmentDevelopment Bank assets in low-risk govern-ment securities and bank deposits reached97.6%. Almost half of these assets were actuallyinvested outside Puerto Rico in the form of USGovernment securities. Government Develop-ment Bank investments outside Puerto Ricoexceeded loans to industry and commerce by afactor of 20 (and exceeded loans to manufac-turing by a factor of 45). Domestically, Devel-opment Bank deposits with commercial banksexceeded loans to industry and commerce by afactor of 11, and loans to industry by a factorof 25 (all figures are from Junta de Planifi-cacioon, 1993, Chapter 6). Meanwhile, Bankpolicies bolstered profits in the commercialbanking sector, as it injected liquidity into thefinancial system (in the early 1990s it accountedfor 42% of all certificates of deposit in domesticcommercial banks), and considerably reducedthe cost of money to domestic banks (Junta,1993, Chapter 6). Banking sector growth aver-

aged 15% per year from the early 1980s to theearly 1990s (Junta, 1993, Chapter 6); in con-trast, real GDP scarcely averaged 2% growthper annum, and the share of domestic firms inoverall profits dropped below 2% (Stuart,1987).

5. DISCUSSION

An investment bottleneck, resulting from acombination of weak internal savings and aslowdown of external inflows caused by the endrelative labor surpluses seems to underliePuerto Ricos transition from a stage of highgrowth and declining unemployment to a stageof low growth and high unemploymentfrommiracle to debacle. The problem of chro-nic domestic dissavings was well known in thelate 1960s (Freyre, 1969), and the slowdown offoreign investment with declining labor costcompetitiveness was predictable. In spite ofthis, the government had no effective mecha-nism or plan to counteract this structuralweakness in the investment function. Given thispredicament, it is surprising that through theearly 1970s, and for an additional two decades,the Government Development Bank contrib-uted only marginally to long-term financing ofindustry. This was neither coincidental nor asimple flaw of vision or leadership.

consumer loans

real estate

industrial & commercial loans

U.S. Govt Securities

U.S. municipal bond market

Banks

Dev Bank

Govt. of Puerto Rico

Bonds

Revenue

External Capital Markets

3.5

3.8

0.187

3.4

1.09

6.3

2.1

1.7

1.5

3.8

3.5

5.2

Commercial

Figure 1. Financial flows of the Puerto Rican banking system, 1992.


The Government Development Bank func-tioned efficiently within the parameters of itscharter. But that charter was gradually nar-rowed in the course of the 1940s in a way thatruled out a leading role for the Bank in fi-nancing any type of industrial transition. TheBanks contribution to the development processwas circumscribed in response to domesticbusiness opposition, and specifically, the op-position of domestic bankers. During theeasy stage of export industrialization thispresented no problems; orderly government fi-nances and infrastructure development wereenough to abet the growth momentum. But atthe end of the easy stage the government ofPuerto Rico found itself bereft of a mechanismto counterbalance the chronic shortfall in in-vestment and domestic savings that startedweighing the economy down; it lacked amechanism to lead the process of industrialrestructuring away from dependence on laborcost advantages.

Bound as it was by a conservative charter tostabilize domestic banking and government fi-nances, the Government Development Bank insome ways exacerbated the problem: its con-tribution to industrial and commercial capitalformation in the island was negligible andmuch of the asset portfolio was outside theeconomy. It should not come as a surprise ifprivate investors, foreign or domestic, decidenot to reinvest vigorously in an economytheyhave unique priorities and a world of choices. Itis striking, however, to discover that, as thisoccurred, there was no visible change in De-velopment Bank policy to counteract thesetrendsthe proportion of Bank assets placedoutside the Puerto Rican economy actuallycontinued to rise through the early 1990s.State- and bank-dominated financial systemsplay a critical role in financing early stages ofindustrialization, but in Puerto Rico, we haveseen, the state gave up any means to redirectsome sizable pool of domestic and externalsavings into accumulation. Over the long term,the liberalization of development bankingturned out to be a serious institutional inca-pacity for a state committed to development.Notwithstanding its name, the GovernmentDevelopment Bank was clearly designed not tobecome directly involved in financing industri-alization. Its principal role was of fiscal agentand stabilizer for the domestic banking sector.Both are critical functions, but in this instancestabilizing private banking has come at a highcost: an institutionalized long-term pattern of

bets against domestic capital formation.Here the divergence between private and socialoptimality has been indeed wide.

The precise nature of the causal argumentmade in this paper should be clearly restated toavoid confusion. Strictly speaking, was theDevelopment Bank one of the causes of crisis inthe Puerto Rican model? Strictly speaking, no,but in fact yes. Development Bank practicesor portfolio management preferences werenot the immediate cause behind the weakeningin external capital inflows and re-investmentratesthis was the endogenous product of alabor-surplus strategy whose time horizon isinherently limited. Neither were DevelopmentBank practices the direct cause of other factorsassociated with the crisis of the Puerto Ricanmodel, to wit: a negative marginal propensityto save, one of the lowest ratios of productiveinvestment in the world (measured as a ratioof investment in plant and equipment to hous-ing investment), and an excess concentration ofexternal capital financing short-term consumerdebt (Gutierrez, Saanchez, & Caldari, 1979). Allthese problems point to deficiencies in the fi-nancial system as a whole. The DevelopmentBanks was a sin of omission. When the privatefinancial sector can or will not solve problemsof socially suboptimal financing of develop-ment, the responsibility falls back on state en-tities representing the public trust in thatsphere. But the Government Developmentsimply continued the established pattern ofstabilizing domestic commercial banking as itexistedin fact, as we have seen, over time itspractices became even more conservative thatthose of the private sector. There are neverguarantees that a state promoting developmentwill succeed when it tackles problems that standin its way; but when the problems are known,and a response is not forthcoming, the stateshares in the responsibility for the outcomes.The fact that some or even most of the prob-lems were not created by the DevelopmentBank in the first place makes little difference.Little credence would go to a top managementteam in a corporation facing bankruptcy thatabsolves itself by arguing we were not thecause of bankruptcy, it was the changing envi-ronment in our industry. Some organizationsare charged with reaching goals within achanging environment; states with strong rhe-torical commitments to development areamong them. It is in this sense that the devel-opment banking practices of the Puerto Ricangovernment are implicated as a cause in the fall


of the fifth tiger. The remote historical causesof this complicity were the accommodationbetween state and private sector on the eve ofthe export industrialization program.

Development finance and the orientation ofthe development bank have been the focus ofthis paper, but it is important to bear in mindthat they were part of a broader developmentstrategy, and that strategy itself was flawed.None of the principal government agencies fordevelopmentIndustrial Development Corpo-ration (FOMENTO), the Planning Board, orthe Bankmade a qualitative change in theircourse to either anticipate the end of the laborsurplus stage or to counteract the investmentsqueeze. Industrial development continuesto mean promotion, and planning per-tains exclusively to infrastructure development.Against reason, the entire Puerto Rican devel-opment modelshaped in the heat of battlebetween business and state developmentalistswas premised on the effectiveness, in perpetuity,of a hands-off promotion strategy. The Bankis thus not single-handedly responsible forthe socially suboptimal transition of the early1970s. Its deficiency is related to a larger prob-lem with the Puerto Rican developmental stateproject. In the present, as in the 1940s, thedesign of the development project has beendefined by the political economy.

6. CONCLUSIONS

Baumol and Wolff have called attention toPuerto Rico as possibly the fifth tiger of thepostwar era. Over the entire period PuertoRicos development has been, by many mea-sures, quite impressive. It is equally importantto note that Puerto Ricos tiger-like recordreally comes to an end in the early 1970s. Thetrajectory of any national economic develop-ment program is influenced by a complex con-figuration of factors, some domestic, someexternal. The analysis of what went wrong inPuerto Rico has neglected the critical role ofdevelopment finance. The purpose of this paperhas been to fill that void. What went wrong,Evans (1998) notes in a reassessment of the roleof the state in East Asian development, almostcertainly includes deterioration of the genera-tive institutional context and diagnosing dete-rioration requires a clear understanding of theoriginal. In the Puerto Rican case, the orig-inal institutional framework for developmentwas set during the 1940s. This paper has shown

that its contours were decisively influenced bythe domestic political economy, in particular,by conflicts between banks and the state overthe latters role in financing development.

Wade (1990) has one of the last words in theongoing state intervention vs. market liberal-ization controversy when he notes that whatreally matters are unique national state-marketarticulations. Four decades ago, Mason (1958)hinted at an interesting comparative questionregarding long-term development when heidentified Puerto Rico as a case on the liberalend of state-market articulationsthe statesupplies public goods, but almost exclusivelyon criteria agreeable to the private sector. Withthe benefit of historical hindsight, this paperrevisited Masons observation to identify someof the long-term consequences of a liberal de-velopment formula. In the specific area of de-velopment finance, the evidence is troubling.

The key finding is that a compromise be-tween domestic bankers and the state in the1940s gave bankers a stabilizing mechanismthey soughtand such a stabilizer should bethought of as a public goodbut stripped thestate of a capacity it needed but banks feared.The state was unable in this compromise toextract a development-minded quid pro quo,and was left to hope that development bankingguided by private optimality would never muchdiverge from social optimality. Although thefindings of this paper do not warrant a blanketindictment of liberalization, the analysis doesidentify a long-term development problem thatgrows out of insufficient state capacity to eitherdiscipline private financial actors, or to take thelead when social and private optima begin todiverge. Over the long-term this episode ofliberalization was too indiscriminate, and thismust be considered a critical weakness of thePuerto Rican model.

Financial liberalization can be a source ofsignificant short-term economic instability, butas the analysis presented shows, some problemsmay show up only over the long term. This begsthe question, what political economy configu-ration will allow for a design of developmentinstitutions that balance the present and thefuture? An answer to this question is beyondthe scope of this paper. Preliminarily, theanalysis does suggest a need for a clear insti-tutional division of labor, and a system ofchecks and balances, between those publicagencies with a focus on fostering short-termefficient functioning of markets and others witha view on the long term. Blanket liberalization


sacrifices the latter. But there is an additionallesson. Key problems with the Puerto Ricanmodel have their roots in the political economythat shaped state-building in the 1940s; itwould be naive to simply rethink or redesignthe institutional scaffolding of the model with-out considering how the contemporary politicaleconomy will impinge on this.

Finally, this case study has significance be-yond Puerto Rico. It adds to a growing lite-rature that cautions against indiscriminate,doctrinaire, and misguided prescriptions forliberalization that threaten the stability andgrowth of poor societies (Adelman, 2000;Chang, 1998; Stiglitz, 2000; Stretton, 2000).Puerto Ricos case stands as another cautionarytale. In this particular case, the exhaustion ofthe Puerto Rican tiger called forth a massive USbailout package in the mid-1970s: a mix ofsubstantial and weakly targeted investment in-

centives for US corporations and massive sup-port for needy persons. 14 This has de facto beenthe Puerto Rican model since. It has notworked, and, in any event, it is fair to assumethat institutions of global management and af-fluent states are neither prepared nor willing tounderwrite a bailout on this scale for thedeveloping world as a whole. All are welladvised to consider carefully the mounting evi-dence of long-term problems with indiscrimi-nate liberalization prescriptions. Poor countriesurgently need development assistance on amassive scale, but all of this would be self-defeating if institutions overseeing the extensionof global economic governance put nationaldevelopment institutions in a position wherethey have to place bets against the future oftheir own populations. On a smaller scale this ispart of the story behind Puerto Ricos crisis ofdevelopment.

NOTES

1. Whether, and to what extent, East Asian state-led

development is an asset or a liability is still a heated

debate, especially since the 1997 Asian crisis, and in the

midst of a nearly decade-long recession in Japan. One

thing is clear; nowhere in the mainstream business press

does one find an inclination to present East Asian

countries, particularly Japan and Korea, as textbooks

cases of free market development.

2. Stiglitz (2000) reiterates the importance of this

distinction between social and private optimality.

3. A structural incapacity of would explain why, by the

early 1970s, the developmental ideology of the promo-

tional state appear shopworn and hollow. Cf. Pantojas-

Garca (1990) for a critical analysis of this ideology.

4. Imperialism was an important rhetorical figure

wielded by all parties to the conflict between the

nationalist and the Mu~nnoz factions of the Partido

Popular in the 1940s. An analysis of the rhetorical uses

of the terms imperialism is, however, outside the scope

of this article.

5. We have been doing the same thing for thirty

years was the typical comment of a career staffer of the

industrial promotions office with FOMENTO inter-

viewed by the author.

6. Only three studies in the last 40 years have examined

any aspect of the Puerto Rican business class (Cochran,

1959; Gonzalez Daz, 1991; Steward, 1956). None has

examined the interests of this class, its internal organi-

zation, its relation to the state, or its influence on

development policy.

7. Stephens and Stephens (1986) analysis of the first

Manley period in Jamaica shows how even the weakest

local capitalist class can act as an effective spoiler.

8. This argument is an extension of Fred Blocks classicand succinct analysis of the relation between the state

and capitalists (Block, 1977).

9. This power is clearly a variable; it is more or less

considerable depending on the absence or existence of

more formal institutional arrangements for regulating

and assessing the risk of a foreign investment site. In the

1940s, prior to the formation of a global financial

infrastructure for risk assessment and underwriting the

mediating role and the structural power of Puerto Rican

capitalists was probably more considerable than it is

today.

10. There are only isolated references to business

opposition buried in a few of the studies of the era but

no careful study of the phenomenon. Part of the reason

for this is myopia, I suspect, has been the immense

cultural influence of the Partido Populars populistrhetoric. Quintero Rivera (1985) and Gonzalez Daz

(1980) discuss how that rhetoric effectively dissolved

classes into an amorphous national community.


11. It has already been noted that the campaigns of

Puerto Rican capitalists and their effects have not been

studied carefully. A number of known studies are

nonetheless peppered with references to this business

opposition. References to business campaigns against

the government can be found in Tugwell (1947), Edel

(1962), Lewis (1963), Picoo (1962), Ross (1976, Chapter

4), Navas Daavila (1978), Palau de Loopez (1985), Dietz

(1989) and Pantojas-Garca (1990).

12. This image of a state that compromises the

substance of its developmental state project without

abandoning the rhetoric is consistent with the analysis

of Pantojas-Garca (1990).

13. Table 4 shows that the Industrial Development

Corporation (a subsidiary of FOMENTO) was making a

significant contribution to long-term nonhousing invest-

ment. This went to land and manufacturing shells

facilitated on demand to firms promoted by FO-

MENTO. It did not directly finance industrial under-

takings.

14. Weisskoff (1985) aptly refers to the new model a

regime of factories and food stamps. Pantojas-Garca

(1990) offers a useful discussion the post-1976 incentives

scheme. After 1976, new US tax exemptions to US

corporations in Puerto Rico became the crucial promo-

tion enticement. This was not a substantial change in

development strategy: the Puerto Rican government

simply used these tax breaks to compensate foreign firms

for the deterioration of labor cost advantages. US

intervention in this case arguably allowed successive

administrators in Puerto Rico to avoid responsibility for

the consequences of development failures; it is also

symptomatic of the absolute loss of economic sover-

eignty suffered by the Puerto Rican government as a

result of the collapse of its economic program.

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Puerto Rico in the Post War Liberalized Development Banking and the Fall of the Fifth Tige

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