Post War Development in Vietnam
From 1955 until the late 1980s, Vietnam employed a neo-Stalinist approach to economic development. The central government devised a plan to encourage economic growth, with the primary objectives of strengthening modern industry and capital capacity. The plan was known as the DRV Model, named after the Democratic Republic of Vietnam. The DRV Model’s goal of ‘producing the factors of production’ led to aggregated shortages, chronic fiscal deficits, and large dependency on imports to complement the established capital. (Fforde and Paine, 1987, p.75) The policy decisions made by the central government, especially with respect to state owned industries, and the ineffectiveness of the political leadership from 1955 to 1975 caused the major obstacles Vietnam has faced in its movement toward globalization, and these prevented economic growth from being maximized.
VIETNAM: 1955 – 1975
The central government’s adoption of the Soviet and Chinese models of neo-Stalinism placed heavy restrictions upon both producers and consumers in Vietnam. French rule was defeated in 1954, and by this time central authority had greatly weakened. (Fforde and Vylder, 1996, p.56) The Vietnamese were opposed to the Democratic Republic of Vietnam, which caused it to be weak from the beginning. This lack of support from the public played a large political role, but the shortcomings of the DRV Model itself resulted in unfavorable outcomes for the economy.
THE DRV MODEL
In order to understand the DRV Model, some recognition of the Socialist economy is required. (These criteria hold true for the Vietnamese economy of the time.) The Socialist central government was driven by the goal of maximizing profit (Kornai, 1980, p. 339), which encouraged firms to increase the volume of production. Producers had no control over the levels of production, as the laws of supply and demand did not hold in the imperfect Socialist economy. The central government shaped a profit plan determining output composition, which drove firms toward factor utilization. (Kornai, 1980, p. 339) Profitability was not an issue for individual firms, as the state covered any losses through subsidies.
Industry operated under a soft budget constraint, (Kornai, 1980, p. 306) which was shown in the following situations. The state controlled the prices of goods. Observed prices did not reflect the relative costs and benefits that control pricing decisions in a market economy, a direct result of the chronic shortage. (Fforde and Vylder, 1996, p.) That is,
prices and costs simply did not matter to the firms. Firms were given a variety of free grants to encourage production, which were realized as increases in capital stock. Survival of the firm did not depend on the firm’s ability to cover costs, which resulted in profits being absorbed by the state. (Kornai, 1980, p. 309) Demand for the factors of production was unlimited.
The DRV Model did not take consumers’ preferences into account when determining the output goals. A forced substitution effect resulted, where the chronic shortages forced consumers to opt for the available goods rather than those desired. (Kornai, 1980, p. 332) The government had an insatiable demand for industrial inputs, believing that complementary input supplies would not constrain output, because the inputs would be continually imported. Foreign investment in modern industry became the most important element behind economic growth, as it was the driving force behind output. The DRV Model was charged with the goal of rapid development and setting production levels high. Food supplies were essential, but were not available domestically because of the lack of attention to the deprived rural areas, a fundamental flaw in the DRV Model. Costs increased, domestic food supplies continued to decrease, and imports turned to consumption goods rather than industrial complements. (Fforde and Paine, 1987, p.50) The rural areas had lower incomes, due to the decrease in farm output, and as a result could not afford the high priced food imports. Savings and investment were decreasing, and the labor demanded by the manufacturing sector was not available, as agricultural producers were looking to horizontal markets to find incomes to feed their families. Agricultural production was not being transferred to industrial markets, resulting in decreased output in this sector. The ineffectiveness of the government’s planning decisions, and the failure to recognize these potential outcomes prevented economic growth.
Vietnam’s poverty was the main reason for foreign aid being the driving force behind growth. The DRV had to import all modern means of production. (Tables 1 and 2) Through foreign aid, capital was increasing too fast for labor to maintain market equilibrium, resulting in an initial increase in output, but only in the short run. The increases in capital required vast amounts of labor to achieve the output increases.
Jones and Samuelson’s Specific Factors Model illustrates this point. Labor is a mobile factor because it can be used in either the industrial sector or the agricultural sector, while capital is a specific factor, because it is not readily convertible into other forms. According to this model, a country with a lot of capital and limited land will produce a high ratio of manufactured goods to agricultural goods. Through foreign investment, Vietnam became a country with a lot of capital. Remembering that the central government encouraged firms to increase production of manufactured goods, the demand curve for labor in the manufacturing sector shifted to the right, causing more workers to be drawn into the manufacturing sector and out of the food sector. (Graph 1) For the centrally planned economy of Vietnam, the labor demand function was not effective, because there was no effective mechanism for the high demand to create an incentive to attract labor, meaning the incentive for increased output relied on the central planner to order labor to make the move. The government controlled the shifts in the demand curve.
Manufacturing output increased, as did the marginal product of labor, because there were more workers in the sector with more capital to work with. Food output decreased, relative to the increase in manufactured goods, because of the reduced labor input. (Table 3) The government assumed all industries had constant returns to scale; that is, by increasing the capital stock, a proportionate rise in output would arise (Fforde and Paine, 1987, p.38), thereby generating economic growth. This was not the result, and the assumption had devastating effects on the economy.
Labor, in a competitive market, will move to the industry that offers the higher wage, as Ricardo suggested. Had Vietnam been a competitive economy, labor would have willingly moved to the manufacturing industry. However, labor was forced to move through the plan, and the agricultural sector was all but forgotten. Increased output was realized at first, but as labor continued to move, the marginal product of labor fell. (Graph 2) Theoretically, the wage rate will decline, and labor will continue to move until the incentive to move is eliminated. In Vietnam, increased output of manufactured goods was desired, but the government controlled wage rates, so equilibrium between the two sectors was not reached.
One would suggest that Vietnam, like many less developed countries, had many idle workers due to the abundant labor supply. In 1960, the population of working age residents was 749,700, while total employment in the economy was 614,500. (Fforde and Paine, 1987, p. 143-144) The country had an excess capacity, so the capital-intensive labor requirement should have been met. It was not attained for two reasons. First, only a small amount of capital was invested in education, resulting in a labor force not adequately educated to operate the capital-intensive industries efficiently, with the outcome of diseconomies of scale. (Table 4) Second, the law of diminishing returns was evident with the capital. Capital usage was increasing, while labor basically remained fixed, so due to the capital/labor ratio, the marginal product of capital was falling. Output was not increasing proportionate to added inputs.
The DRV Model was constantly dependent upon imports and faced continuous difficulties in finding economic resources from the domestic economy for its needs. (Fforde and Vylder, 1996, p. 67) The model was oriented towards urban and modern industrial development, which resulted in this sector’s isolation from the agricultural sector. The ineffective central control, accompanied by a decrease in foreign aid at the end of the war, led to decentralization of government agencies, (Fforde and Vylder, 1996, p. 125) and the emergence of free markets.
THE SHIFT TO A MARKET ECONOMY
The end of the Vietnam War in 1975 saw the integration of the Northern centrally planned economy and the Southern foreign aid reliant economy. The North, because of the DRV Model, had become isolated from the outside world, and as a consequence was deficient in its economic development. North Vietnam did not possess such basic institutional bases as an effectively functioning legal system or an adequate statistical basis for economic planning. (Fforde and Vylder, 1996, p. 5) The DRV Model created a situation of low agricultural involvement with heavy demands on the manufacturing sector, and very little economic growth. An alternative means for development needed to emerge.
The DRV Model established the prerequisites for development. Capital deepening had occurred, resulting in high rates of capital formation. (Graph 3) The major problem with development under the DRV Model was due to the population shift out of agriculture and into the manufacturing sector. (Fforde and Vylder, 1996, p.31) Market mechanisms needed to emerge to correct the flaws brought on by the DRV Model.
State investment policies in Vietnam heavily favored modern industry. To be successful in development, the rural sector needed to be exploited and labor needed to be marketed in the agriculture sector. The DRV Model had shown that growth was not a result of capital accumulation, bringing about a realization that autonomous activities, particularly the development of markets and the agricultural sector, were essential for growth.
In the move to a market economy, agricultural development was expected to play a key role. It would provide the raw materials and food to the urban sector, and overcome the shortages experienced in the DRV Model. (Beresford, 1989, p. 134) This would stimulate the demand for industrial products and assist in growth. Economic growth would be achieved through reforms in agricultural labor productivity. Reforms were identified through the introduction of collective agriculture and the utilization of the division of labor. Marginal product of labor increased because capital formations remained fixed while labor increased. Food was now being produced using very little capital and a lot of labor. (Capital was introduced into the sector during the reforms with this objective in mind.) The policy was now in place to achieve economic growth through the agricultural sector supplying the inputs to the industrial sector.
To achieve the desired productivity gains, a market mechanism was needed to establish equilibrium levels in both industry and agriculture. Equilibrium existed only when transactions became voluntary, when economic agents had the freedom and the ability to make pricing and allocation decisions. (Fforde and Vylder, 1996, p. 35) Prices came to matter in the transitional stage, as supply and demand began to determine production patterns and utilization levels of the factors of production. The market mechanism brought continually increasing levels of rural participation in the labor force. (Table 5) The labor force was moving to areas with low capital-intensity, the agricultural sector. The state found it difficult to compete with unplanned ways of acquiring and utilizing resources, and additional food sources were hard to come by. Large-scale imports of food were necessary, (Beresford, 1989, p. 130) causing a decrease in the balance of trade. The need to achieve self-sufficiency in food production became an immediate concern.
In August of 1979, decentralization of economic decision-making began following the Sixth Plenum, (Beresford, 1989, p. 204) with the main focus on the promotion of agricultural production. The Sixth Plenum was the first viable evidence of the breakdown of the DRV Model. Reforms were also introduced for autonomous planning by local industries and direct trade between sectors. The role of the state was now “to create conditions for economic establishments to operate effectively.” (Beresford, 1989, p. 206) Business efficiency increases, as smaller consumer goods industries were given priority over large-scale heavy industry. The initial stages of a market economy were in place.
The government evaluated the agriculture sector to be equivalent to the industrial sector, (Beresford, 1989, p. 137) where an increasing one factor of production (labor) while decreasing the other (capital) would result in sustained or increased output. This had previously failed in industry, and the same outcome resulted in agriculture. Division of labor was supposed to achieve economies of scale, but the government overlooked the nature of Vietnamese agriculture. Little specialization existed in agriculture because of the crops produced, and the fact that the division was based on traditional technologies where the division of labor was not feasible. New technology was being imposed on farms to complement the divisions, and to harmonize the decreases in old capital, but it was not practical because farmers did not have the training to use it efficiently. The government’s plan was once again ineffective.
The centrally planned economy was not motivating for individuals to increase their economic activities, as there were no incentives for people to increase their contributions to the economy. The motivation to work was to achieve government set goals, which had rewards for the government at the end. The standard of living among the population was low and workers were unhappy, resulting in low labor productivity. (Fforde and Vylder, 1996, p. 44) The labor force was concentrated in rural areas with low levels of income. In 1986, total income per month was approximately 537 dong; total expenditure was 521 dong, with 80 per cent of this being spent on food. (Fforde and Vylder, 1996, p. 119) The population recognized the ineffectiveness of the government’s policies and demanded that changes be made.
During the DRV Model era, consumption was compressed, resulting in a low standard of living. The market sector provided a link between agriculture and industry, allowing for commodity exchanges to exist between the two sectors. (Beresford, 1989, p. 177) Agriculture would provide wages, raw materials, and the exports necessary to purchase capital goods. Industry would provide the manufacturing inputs and the capital equipment necessary to increase the technological level of agriculture. (Beresford, 1989, p. 179) (See Edgeworth Box) Through these transactions, the two sectors would support each other, incomes would escalate in both sectors, consumption would increase, and the standard of living would rise. The government’s allocation of the factors of production was inefficient under the DRV Model, which is why trade between the sectors was mutually beneficial and theoretically, trade would result in an efficient allocation of the factors of production. High industrial development policies were changed in favor of agricultural development, to alleviate high interest rates and to stabilize investment in order to increase consumer goods output and consumption. This change in capital formation and altering production in response to consumers’ demands are two important components in the development of Vietnam’s market economy. (Beresford, 1989, p. 188)
The state and collective sector were forced to compete with the private sector as unplanned activities increased. Financial authority was decentralized and competition to state industries emerged. The most important realization of competition was that firms previously heavily subsidized by the state must now be allowed to go bankrupt. (Beresford, 1989, p. 207) Through this, efficient allocation of capital and labor emerges. In a market economy, the firm will choose the lowest isocost line tangent to the production isoquant when subjected to a minimizing cost equation,
C = wL + rK. The firm also has to choose the highest production isoquant tangent to a given isocost line, maximizing Y = F(K,L), subject to the cost constraint wL + rK = C through these market mechanisms, a learning curve resulted, when workers gained experience in tasks, resulting in economies of scale as costs increases less proportionately with output.
The introduction of a market economy was Vietnam’s first step to sustainable economic development. The transition was not flawless, nor would the following years be.
After 1989, the Vietnamese economy can best be described as a market economy. The two-price system had been abolished along with the system of central planning based on state inputs and production targets. Vietnam had entered the ‘post-stage’ of development, (Fforde and Vylder, 1996, p. 40) where transactions were mainly voluntary, prices were established according to supply and demand, and a rise in savings as a percentage of GDP was witnessed. (Table 6 and Figure 1)
In 1990 – 1991, the state was still the dominant owner of the means of production within industry, (Fforde and Vylder, 1996, p. 254) and as was the case with the DRV Model, resources were not efficiently used. Soviet aid was lost after 1989, causing a severe shock to the political economy. The macro economy was elastic, as prices stabilized with tight monetary policy. (Fforde and Vylder, 1996, p. 282) The state sector was in shambles, as the economy destabilized through interest rate distortions and tax breaks to state industry. (Fforde and Paine, 1987, p. 131) Inflation increases with the tax breaks, leading to a reassessment of the state sector’s role in the market economy. Improvements in resource allocation were still possible because an output surplus still existed, (Fforde and Vylder, 1996, p. 285) and could be exploited, provided decentralization of state owned enterprises occurred and the incentives structure improved.
Exploitation of rural economies needed to progress, with emphasis on the application of the spillover effects from the Asian Tigers. Asia’s growth was in response to high saving, strong commitment to education and openness to trade. (The Asian Miracle, 1997) Vietnam needed to mold itself after these economies.
Economic growth models have been developed in attempts to explain why some economies grow faster than others. The Romer model of economic growth demonstrates the flaws Vietnam has in its route to development
THE ROMER MODEL
Capital is accumulated according to the equation k = sy – (n+d) K, where sy is gross investment, dK is the depreciation in capital, and nK is the population growth of capital per person. As graph 3 shows, capital was accumulated during the DRV Model, but as it accumulated, it also depreciated. The capital saved demonstrates diminishing returns; the future marginal product of capital is less than its present value. Vietnam had experienced capital deepening resulting in increases in the capital stock. (Graph 6) The simple Solow model explains that countries with high investment rates will have higher output per worker, provided the population growth is low. Through foreign aid, Vietnam’s investment levels continued to be high, but population growth was also high. Due to this, a balanced growth path could not be reached; output, population growth, and capital accumulation would not be equal.
Economic growth was to be achieved exogenously. Rather than heavily funding research sectors, technology was imported. This was beneficial, as output increased in the early 1990’s, and the cost was minimal. (Table 7) However, exogenous growth resulted in temporary growth rates, as there were no long run growth effects. The increase in investment had a long run effect on the level of output per worker, but did not affect the long run growth rate per worker. (Graph 7) At the time of the policy change, output per worker increased rapidly, which continued until the output-technology ratio reached its new steady state, where growth returned to its long run level. (Graph 8 and Table 7) For these reasons, the only plausible way of increasing economic growth was through worker education.
A country can achieve long run economic growth by investing in human capital. Human capital is accumulated as individuals devote time to learning new skills rather than working. The economy recognizes the availability of the educated labor, and exploits it according to the production function Y = K (AH), where Y is total output, A is the amount of available technology, and H is the amount of skilled labor accessible. Labor accumulates education according to L = (1 – u) P, where u is the fraction of time an individual spends learning the skill, L is the total amount of unskilled labor, and P is the population of the economy. Thus, L is equivalent to H in the production function, proving that if Vietnam had invested more capital and time into educating the workforce output would have increased, because labor would have been able to the technology more efficiently, allowing total factor productivity to increase, and converge with the economies of the Asian Tigers. Vietnam was engrossed with neo-Stalinist ideals, resulting in a shortage of workers possessing skills suited to the developing economy.
Vietnam’s current population is approximately 77.3 million, with a growth rate of 1.37 per cent. (The U.S. State Department, 1999) The high population growth rate, according to the neoclassical model, is detrimental to the economy, because more capital is required to keep the capital-labor ration constant. Investment needed to increase to keep this ratio constant. For the 1996 – 2000 period, Vietnam’s government set a goal of $42 billion in investment, to maintain growth rates of 9 – 10 per cent, (The U.S. State Department, 1999) with $21 billion coming from domestic sources. To achieve these goals, Vietnam will have to boost domestic savings, which will be difficult because of the underdeveloped financial system and because of the low faith in local banks. High population growth, along with the disappearance of the DRV Model’s allocation of labor to state owned enterprises, led to high levels of unemployment, at approximately 25 per cent in 1995. (The World Factbook, 1999) With unemployment high, these investment levels may be unrealistic. To attract capital and investment in Vietnamese business, focus is needed on the institutional aspects of the economy, mainly on better markets and better education.
The economy of Vietnam has a great deal of unused potential for economic development. The decision to decentralize state owned enterprises was a good one, yet it has not been fully implemented. Since 1993, only 29 of 5800 state owned enterprises have been partially sold off. (The Ho Chi Min Trial, 1998) Privatization of these enterprises would result in greater profits for the private sector, as the state monopoly would weaken, and competition would increase. The incentive to be creative and innovative would arise. Vietnam also needs to open up its economic markets. A stronger statistical base is needed for the growing markets. Knowledge is required to supply the growing markets with demanded information. The rural economy needs to be given more priority, as it is the supplier for the inputs of growth. An emphasis on internal strengths needs to be taken, and foreign aid must be used efficiently. The Vietnamese have to accept the market economy as a parallel to the centrally planned economy, and allow the market forces to take their course.
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