Harrod sets up an equation of growth for an open economy thus:1
GwCr = s — b
where Gw is the warranted rate of growth, Cr is the required capital coefficient, s the fraction of income saved and b the foreign balance. The equation says that if Cr and s remain constant, the value of Gw , varies inversely as b, or in other words, the warranted rate of growth of an economy falls as its foreign balance increases.
For an advanced economy where the saving propensity is so high that the warranted rate of growth exceeds the natural rate of growth and where a reduction in the warranted rate of growth is called for in the interest of full employment, there is justification, Harrod argues, for the maintenance of a positive foreign balance. So foreign balance is important.
Now, just the opposite happens in the case of a developing economy where the saving propensity is low and the warranted rate of growth lags behind the natural rate. Maintenance of a negative foreign balance in such an economy serves, other things remaining the same, to push up the warranted rate of growth towards the natural rate. To lower the warranted rate of growth down to the level of the natural rate, an advanced economy needs an outsider (a ‘third person’, to use Rosa Luxemburg’s famous phrase) to absorb surplus, while to raise the warranted rate growth up to the level of its natural rate, a developing economy needs an outsider to cover deficit. So foreign balance is important.
This does not mean, however, that a developing economy has necessarily to put up with a growing deficit in foreign balance; it cannot afford to for the simple reason that it is a good deal more difficult to borrow than to lend. Nor does it mean necessarily that, in the absence of adequate foreign aid, it has to continue with trade controls. Increasing marginal rate of saving, such as is associated with planned economic development, serves two purposes.
While it raises the warranted rate of growth, it also tends to reduce the rate of growth of trade deficit, even if it does not eliminate it altogether Further, in the perspective of long term growth one must also count on such adjustments in the investment pattern as would ensure that import substitutes and exports bear an increasing ratio to national output. By raising the ratio of import substitutes to national output we can reduce the foreign capital coefficient and by diversifying exports and raising the ratio of exportable to national output, we make it possible for the economy to maintain the same import coefficient without facing a growing deficit in foreign balance. As to whether one or the other should have a higher weightage in the investment pattern of a developing economy, one must keep an open mind; the question has to be answered by our old guide. The Law of Comparative Costs.
This reminder is called for particularly in the context of our own planning. For, a considerable amount of futile controversy has gone on here over this choice the parties in the dispute often forgetting that the production of import substitutes at higher cost than international price is as much a social cost as subsidy to exports. So foreign balance is most important.