The WTO was established in 1995 as the successor of the General Agreement on Tariffs and Trade (GATT) which was created in 1947. Much of the GATT agreements on trade were carried over into the WTO, though there have been changes and additions in rounds of negotiations since then. Let me list the purposes that the WTO sets itself and the main principles by which it guides itself. I expand on this basic description of the WTO in later sections where I discuss the organisation’s position on trade and development relating to developing countries in particular.
The declared objective of the World Trade Organization (WTO) is to help trade flow smoothly, freely, fairly and predictably. It claims to do this neutrally, administering trade agreements, acting as a forum for trade discussions and settling disputes, reviewing national trade policy issues through technical assistance and training programs and cooperating with other international organizations (Peet 2003: 158) (WTO website).
The preamble to the Marrakesh agreement establishing the WTO in 1995 states the premise under the members come together to negotiate rules for international trade includes the following: “…relations in the field of trade and economic endeavor should be conducted with a view to raising standards of living, ensuring full employment and a large and steadily growing volume of real income and effective demand, and expanding the production of and trade in goods and services, while allowing for the optimal use of the world’s resources in accordance with the objective of sustainable development, seeking both to protect and preserve the environment and to enhance the means for doing so in a manner consistent with their respective needs and concerns at different levels of economic development…” (Marrakesh Agreement). This sets the aims of the organization into the egalitarian context of this thesis.
Members of the WTO are party to various agreements that set rules for the conduct of international trade. Part of the reason why such a set of rules is needed is this. The rules provide individuals, businesses and governments around the world with some confidence that there will be no sudden changes to policy in terms of the conditions with which they must comply in international trade. The rules thus have to be transparent and predictable (WTO website). This fosters an environment conducive to greater international trade and is in keeping with one of the aims set out in the Preamble of the Marrakesh agreement establishing the WTO.
The Preamble of the Marrakesh Agreement establishing the WTO also lists the following aims for the organisation. One: a system of trade that allows optimal use of world resources. By promoting specialisation in areas of comparative advantage, countries’ resources are put to their most productive uses. Two: to ensure that developing countries, and especially the least developed among them, secure a share in the growth in international trade commensurate with the needs of their economic development. With open access to the richer and larger markets of the developed countries, the developing countries have greater scope to increases their export revenue and thus national income.
According to the Preamble, the organisation pursues these aims by the following means. One: a system of trade that allows for reciprocal and mutually advantageous benefit. The reciprocal benefit consists of a country opening itself up to imports in return for export access to the markets of others. The mutual advantage lies in consumers in two trading countries benefiting from greater competition and lower price as their economies specialise in the direction of comparative advantage. The owners of different factors of production in the trading countries also benefit in ways we expect from the Heckscher-Ohlin model.
Two: raising standards of living, ensuring full employment and a large and steadily growing volume of real income and effective demand. These are to be considered in relation to international trade. If a country can raise national income through greater export revenues, it can improve the standard of living of its inhabitants. Access to a greater variety of commodities than are produced nationally may also contribute to this. Employment can be generated by export industries and can be reduced by import barriers erected by trade partners.
Three: a substantial reduction of tariffs and other barriers to trade and elimination of discriminatory treatment in international trade relations. Removal of barriers to trade allow countries to access larger markets through exports
According to article III (5) of the Marrakesh Agreement establishing the WTO, the organization also aims for coherence in global economic policy-making with the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD), the latter being one of the branches of the World Bank.
The members of the WTO must adopt certain agreements. The two main principles of these agreements are these.
One, the Most Favoured Nation (MFN) principle stipulates that if a WTO member country grants a trade deal, such as lower customs duties, to one trading partner, it must automatically extend that deal to all other WTO member countries. Some exceptions are permitted, but only under strict conditions. The exceptions are as follows: a group of countries may implement a Free Trade Agreement (FTA) which applies only to goods traded within the group while discriminating against goods originating from outside the group; countries can allow developing countries special access to their markets; a country can initiate barriers against products which are traded unfairly from a specific country; with respect to services, countries can discriminate in limited circumstances (Article I of GATT 1947).
Two, the National Treatment policy stipulates that imported and locally-produced goods should be treated equally, at least after the foreign goods have entered the market. The same applies to foreign and domestic services, and to foreign and local trademarks, copyrights and patents (items of intellectual property). Since this policy only applies once the good, service or item of intellectual property has entered the domestic market, customs duties on imports are permitted even without an equivalent tax on the corresponding domestically produced item (Article III of GATT 1947).
In working to reduce trade barriers, the WTO can allow countries to introduce changes slowly and usually gives developing countries longer to comply.
The agreements of the WTO apply to three main areas of trade: goods, services and intellectual property. The General Agreement on Tariffs and Trade (GATT) governs trade in goods. The core of this is the GATT agreement of 1947. The WTO is a successor to the GATT arrangement as it evolved over the decades until the 1995 replacement of GATT by WTO. The General Agreement on Trade in Services (GATS) governs trade in services. The Agreement on Trade-Related Aspects of Intellectual Property Rights (Agreement on TRIPs) governs intellectual property.
As can be expected with such wide ranging aims, they sometimes require conflicting policies. In such cases, the relative importance of the conflicting aims or means to these aims must be judged and some compromise must be reached. The provisions for Special and Differential Treatment are an instance of this.
The WTO (and GATT before it) recognises the particularly vulnerable position of developing countries and especially of the poorest among these, such as the least developed countries. With this vulnerability in mind, the organization allows some differential treatment of developing countries that does not apply to developed countries. The Special and Differential Treatment (SDT) provisions of the WTO give developing countries special rights and allow developed countries to treat developing countries more favourably than they would other WTO members. Let me briefly outline the evolution of SDT (Hoekman and Kostecki 2001: Table 12.1).
GATT 1947 Article XVIII acknowledged the special status of countries ‘which can only support a low standard of living and are in early stages of development’ by allowing them to apply some trade restrictions in order to raise standards of living. For example, it mentioned infant industry protection as an additional facility granted to these poor and developing countries (GATT 1947: Article XVIII.2a).
In 1964, the United Nations established the UNCTAD (UN Conference on Trade and Development).
In 1965, a Part IV on ‘Trade and Development’ was added to the GATT agreement. The principles and objectives of this part include the following. It recognizes that export earnings can play a vital part in development and that joint action is essential to the development of developing countries. It notes that the parties to the GATT agreement may enable the less developed members to use special measures to promote their trade and development. It describes paths which may benefit the poorer countries, such as rapid and sustained expansion of exports and diversification of their economies away from an excessive dependence on the primary sector. It notes that the developed countries party to the agreement do not expect reciprocity for commitments to reduce barriers to imports from the developing countries.
However, while Part IV pronounces on various issues of interest to developing countries and describes policies which would benefit them, it does not legally oblige the developed countries to implement the described policies for the benefit of the poorer countries. It contains no legally binding obligations other than to consult.
The Generalized System of Preferences (GSP) scheme was put into motion by the UNCTAD in 1968. It calls on developed countries to grant tariff preferences to developing countries on a non-reciprocal basis. The preferences are granted unilaterally and voluntarily. There is no legal obligation that the preferences be granted, and there are no binding specifications on the areas in which the preferences should be granted.
In 1971, the GATT grants an authorization for the GSP preferences. The waiver is made permanent by the 1979 decision of the GATT known as the Enabling Clause. The Clause enables contracting parties to accord differential treatment to developing countries as a departure from the MFN principle since it allows that the favourable treatment granted to a group of developing countries need not be extended to other contracting parties. This consolidated the concept of non-reciprocity, where trade concessions made by country X to country Y (say, lowering of tariffs on imports from Y) need not be reciprocated by similar concessions from Y.
Early years of GATT and the sidelining of developing countries
One attempt at making up for the particularly vulnerable situation of the developing countries was to exempt them from some of the obligations GATT placed on developed country members. This occurred in the early years of the GATT agreement, precursor to the existing WTO arrangement.
In the first twenty years of the GATT, developing countries were given few obligations, but at the same time, they had only a weak voice in negotiations and little power with which to assert their interests.
Article XVIII of the GATT rules allowed poor developing countries to take protective measures against imports. Developing countries could thus be members of GATT, and yet still evade some of the obligations placed on the developed countries. These rules allowed the developing countries greater freedom in determining their developmental policy. However, this advantage came with a cost. The exemptions allowed the developing countries to introduce trade protections at their own discretion. This rendered doubtful any concessions made by a developing country: it could effectively rescind the concession at its discretion. Accordingly, these countries had even less bargaining power to shape negotiations in their interests (Stiglitz and Charlton 2005: 43).
Developing countries benefited from liberalization of industrialized countries because of the MFN principle. However, the fact that they could evade many obligations to reduce trade restrictions meant that they only had a peripheral role in negotiations. This resulted in developing countries having little influence on the way that the industrialized countries liberalised. Those with a greater role in negotiations set the agenda according to their interests. They chose to discuss sectors of the economy that were of greatest concern to them, and where they had the most to gain. Liberalization in trade of goods of interest to developed countries occurred swiftly. Yet, liberalization in trade of goods of interest to the developing countries – especially labour-intensive goods – lagged behind and the developing countries ultimately suffered. Had the developing countries had greater influence in setting the agenda for negotiations, they would likely have focused on areas in which they could benefit most from reductions across the world – areas such as agriculture or labour intensive production and manufacturing.
Many developed countries were fine with the peripheral role of developing countries and with the resulting focus of negotiations. The small markets of the poor developing countries were not particularly attractive to these developed countries. Thus, the latter did not mind too much that the developing countries did not make as many concessions in removing their trade barriers. Moreover, the developed countries were glad at the peripheral role of the developing countries as it meant that they were spared the pain of removing their own trade barriers to products in which developing countries have a comparative advantage. The developed countries mostly sought to liberalize trade in those goods that were traded intensively between developed countries as these countries had the most attractive markets (Stiglitz and Charlton 2005: 93, 44).
The result was a system where the trade policies of the developed countries could be said to be discriminatory against the developing countries, even though the MFN was not generally violated. The most serious barriers to trade were erected in goods where developing countries typically had a comparative advantage (for example, agriculture and various labour-intensive goods), as these countries had little say in setting the agenda of trade negotiations and little credibility to offer in exchange for concessions they might extract from the developed (Johnson 1967: 79).
In 2004, there were once again suggestions (from the EU trade commissioner) that the developing countries might have a “Round for Free”. That is, they might have a round of trade negotiations without having to make many concessions. They could thus benefit from the reductions in MFN rates that occurred, without themselves conceding reductions.
This would be undesirable for the same reasons as the undesirability of the sidelining of the developing countries in the early years of the GATT. Whatever other effects the so called Round for Free might have, it would also reduce the developing countries’ power to influence agenda setting and the direction of trade liberalization. An alternative would be if the developing countries were involved in designing the very core of new WTO policy, so they could participate in agenda setting and steer the design in the direction of their interests. This alternative is preferable to the strategy under discussion which simply exempts developing countries from policies which have been drawn up without their interests in mind (Keck and Low 2006: 180).
Moreover, allowing minimal liberalization by poor countries affects not only their developed country trade partners, but also their fellow developing country trade partners. The volume of trade between developing countries, or South-South trade, is growing much faster than that of world trade. Developing countries often face higher tariff barriers in other developing country markets than in developed country ones. There is potentially much to be gained for developing countries if their developing country trade partners lower trade barriers to them (Stiglitz and Charlton 2005: 94).
For these reasons, the peculiar needs of developing countries cannot adequately be met through a ‘Round for Free’-type exemption (and resulting exclusion from negotiation) of developing countries from obligations imposed on other countries.
Current Special and Differential Treatment (SDT)
Developing countries currently have a greater role in negotiations relative to the sidelining in the early GATT years. The following are the main types of current SDT measures:
· provisions aimed at increasing trade opportunities through market access (for example, there are exemptions from the MFN principle so that developed countries are enabled to allow greater market access to exports of developing countries);
· provisions requiring WTO members to safeguard the interests of developing countries (these are not legally binding obligations on developed countries, but rather clauses to the effect that ‘developed countries will endeavour to be considerate of poor country interest. Here is an example. “The developed contracting parties shall to the fullest extent possible … give effect to the following provisions: (a) accord high priority to the reduction and elimination of barriers to products currently or potentially of particular export interest to less-developed contracting parties…” (GATT 1947: Article XXXVII.1));
· provisions allowing flexibility to developing countries in rules and disciplines governing trade measures (this can occur in the form of allowing them some choice in whether to implement agreements requiring regulatory or administrative reform);
· provisions allowing longer transitional periods to developing countries; and
· provisions for technical assistance.
Some examples of SDT from WTO agreements are footnoted below.
The types of SDT that I will mostly focus on are efforts to increase market access for developing countries and provisions requiring developed countries to safeguard developing country interests. This is not to mark these provisions as more important than other SDT provisions, many of which are very valuable. The focus simply reflects my chosen circumscription of the discussion. Greater market access for developing economies is encouraged via differential obligations on removing subsidies or tariffs and via exemptions from the MFN principle. In some cases developing country governments are allowed to maintain domestic support for certain producers even though developed country governments are enjoined to reduce these.
Exemption from the MFN principle enables developed countries to lower tariffs on imports from developing countries without also offering the same reduction to like imports from other countries.
The idea is that even if a developed country is unwilling to lower its trade restrictions on imports of some product across the board, it may be willing to lower those restrictions on imports of that product from developing countries. The preference margin is the difference between the tariffs set on imports from the selected developing countries and that set for other countries (which can be referred to as the MFN rate). The longer term aim is the reduction of MFN tariff rates towards zero (as per para 3(b) of the Enabling Clause). The preferential treatment is intended as temporary and lasts as long as MFN rates are above zero.
Reasons for Special and Differential Treatment of developing countries and especially of Least Developed Countries (LDCs)
Let me list four different sorts of reasons presented in support of special and differential treatment or SDT (Page and Kleen 2005: 6-8).
First, consider the original justification, which was informed by Prebisch 1950 and Singer 1950, and which lies at the foundation of the United Nations Conference on Trade and Development (UNCTAD) and in the adoption of Part IV of GATT. The justification is that developing countries are different in ways that policies best for developed countries are not necessarily best for the developing. These latter countries need to transform the structure of their economies rather than merely expanding the existing structure. The sort of structural transformation involves, for example, promoting particular sectors of the economy in order to develop fluency in more technology-intensive industries. This can require planning and intervention by the government, as well as some temporary loss in efficiency while the intervention in the market bears fruit. Further, developing economies often differ in sectoral composition and in the size and competitiveness of firms. As a result, the argument goes; policies may have different effects to what would be expected in developed countries. There may be lower gains from trade than would be expected for a developed country. Or there may be lower efficiency cost of subsidies (the loss in efficiency caused by the introduction of a subsidy). The idea that developing countries need to intervene more than developed countries need to is the basic argument behind SDT designed to allow developing countries to follow different policies.
Two, trade liberalization can require costly economic and institutional adjustments. For example, developing countries often need to expand production in an export sector or need to enter new foreign markets and there can be substantial costs to making these economic adjustments. To help developing countries make these adjustments and to make the costs more bearable, rules can be modified or transitional rules can be implemented. Ensuring that countries are subject to lower tariffs in a transitional period can make the cost more bearable. The idea is that this will put them on par with (rather than give them an advantage over) domestic producers in the importing developed countries. Even if they do have an advantage over the import competing firms in the developed country, the exporting developing country firms are often too small to make much of a difference to the competitors.
Other substantial costs can be in terms of development of the requisite infrastructure of laws, regulations and policies. Developing countries will probably need to make the biggest changes to comply with the so-called ‘Singapore Issues’. The Singapore Issues refer to a group of topics discussed during the 1996 WTO Ministerial Conference at Singapore. The topics include investment protection, competition policy, transparency in government procurement, and trade facilitation. There are heavy costs attached to the creation and enforcement of new competition policy, investment regulations, and trade and customs procedures. Generally, developing countries have the furthest to go to meet these regulation and procedural standards, and often face a shortage of the requisite legal, administrative, bureaucratic and other expertise to design and implement the changes.
Three, many believe that developed countries have benefited disproportionately from past GATT rounds as well as from present WTO arrangements, and that they do so at the expense of developing countries. SDT is seen as a way of redressing the balance. There is evidence that developing countries, particularly the LDCs, had few economic gains and suffered some losses from the Uruguay Agreement (the round of negotiations ending in 1994) of the WTO (see, for example, Page and Davenport 1994). This is due in part to some distortions in the existing WTO system. For example, there is greater protection in sectors like agriculture and textiles – where developing countries have the comparative advantage – than there is in sectors where the developed countries have the comparative advantage. Even some of those who think greater and freer trade is beneficial to all, might think that such existing distortions need to be offset by preferential treatment for developing countries. These measures can be supported either as a second best economic solution or as a confidence-building measure to include the developing countries despite perceptions of an unfair distribution of advantages from previous rounds of negotiations. Supporters of this view can retain free trade as the ultimate objective, whilst acknowledging that if the protectionism of developed countries prevents us from getting there in the immediate future, then we can at least encourage lower trade restrictions for those most in need of the benefits of trade and those too small to raise protectionist fears (namely, developing countries, especially LDCs and small countries).
Four, some reject the basic premise of GATT, which is that all countries can gain from trade, and argue that some types of countries need different policies. The view is that some countries need permanent special treatment because of peculiar features such as their size or geography. The view holds that many of the poorest countries, or countries that gain least from trade, are not just less developed, but are unable to follow the same path as other developing countries. Such countries may be too small to diversify away from dependence on one or two export commodities, making them more vulnerable to world price changes in that single commodity. They may also have greater import dependence, as their economy may not be of sufficient size to produce a great diversity of products. Regarding matters of geography, many small economies happen to face greater costs due to greater distance from large markets and from suppliers and many happen to be particularly vulnerable to natural disasters. They still have a comparative advantage in some products, but the absolute disadvantage means they can never secure a high income (Winters and Martins 2004: 348).
All this means that these small countries in free trade would possibly find that they cannot establish a commanding position in any export. They have relatively high costs due to inability to match the economies of scale of larger economies and the cost of importing inputs from distant regions as well as high transport costs in shipping their goods to large markets, which are also distant. Their unusually high reliance on imports for many essentials may make inhabitants particularly vulnerable to fluctuations in world prices and in export revenue (with which to pay for imports) in the absence of interventions to stabilise the effects of these on the economy.
Both debate internal to the WTO and academic literature external to it contain various criticisms of existing SDT measures. The criticisms are used to different ends by different authors, and there are many proposals for improving the system: for example, fine-tuning the SDT provisions; changing the sorts of industries in which SDT provisions have had most impact; reducing the role of some sorts of SDT in trade negotiations; and alternative systems of preferential or progressive trade regulations. I will use the criticisms as basis for a particular alternative, namely, the Market Access Proposal discussed below. For the time being, let me list some of the criticisms in the literature. For ease of presentation, I group the criticisms under three loose sub-headings: costs imposed by the SDT scheme on developing countries; bias against the areas of greatest interest to developing countries; and unnecessarily moving trade further from efficient specialisation.
Costs imposed by the SDT scheme on developing countries
Rules of origin are regulations determining a product’s country of origin. An importing country can sometimes impose different tariffs or duties on imports from different countries, perhaps because of differential treatment of particular groups of developing countries or because of bilateral trade agreements. Determination of country of origin affects the tariff or duty that is imposed. There are currently many bilateral trade agreements and preferential treatment arrangements. Rules for determining country of origin and tariff rates vary from country to country. Often products contain components or inputs from many different countries. All of this combines to make determination of country of origin a complex matter which imposes transaction costs on exporters. The cost lies in researching and assessing the likely duties one must pay to export to a given country and in keeping up with the countries of origin of all components. This is particularly costly for small corporations and traders, and for developing countries (Sutherland et al 2005: 22).
Policy makers and advisors have finite resources and must make trade offs. Keeping up with the complex negotiations on SDT at the WTO and on GSP with particular developed countries can require a lot of resources. Yet, greater of preferential market access in international trade is only one aspect of poverty alleviation and accordingly, there is an opportunity cost to this use of resources. For, there are other critical areas in poverty alleviation such as macro-economic policy, basic health provision, infrastructure provision, education, effective governance and property rights. There is the danger that the Doha Development Agenda of the WTO (part of the most recent round of WTO talks) and, more generally, negotiations regarding preferential market access through GSP and SDT, can absorb all trade-policy making resources and much bureaucratic and analytical capacity in many developing countries, at the expense of other development areas (Winters 2002: 1-2). If preferential treatment is desired, an arrangement which avoided the complexity of the existing arrangements would be preferable insofar as it would free up more scarce resources for other urgent needs in developing countries.
The utilization rate is the ratio between imports covered by a GSP scheme that actually receive preferences and imports covered by a GSP scheme. There are many reasons why, even though a product is covered by the GSP scheme of a country, its developing world trade partners do not export that product to it in large quantities. For example, there may be high compliance costs, restrictive rules of origin and a lack of understanding of technicalities. The low level of industrialization and diversification in many developing countries may mean that they are unable to initiate or expand production of many of the commodities covered by a GSP scheme (Page and Kleen 2005: 14-5). It may also be because of ongoing uncertainty about tariffs in the future. To function as an incentive to traders in developing countries, preferences must be predictable and stable enough to allow traders to rely on them in planning exports and increases in production. For various such reasons, the utilization rates for developing countries are generally quite low, especially for LDCs (UNCTAD 1999: para 56-7).
Bias against the areas of greatest interest to developing countries
There is a lower preference margin on agricultural goods than on industrial goods. (Recall that the preference margin is the difference between the tariffs set on imports from the preferred developing countries and the MFN rate (the tariffs set for other, non-preferred, countries)). It is generally granted that the poorer developing countries depend more substantially on agriculture and the primary sector more broadly. The comparative advantage of developing countries generally lies in the primary sector. The fact that preference margins in this area are nonetheless lower, may reflect the fact that grantor and not grantee interests determine the preferences (UNCTAD 1999: para 53).
The Enabling Clause does not place formal obligations on developed countries. The exemptions from MFN, for example, are entirely voluntary on the part of the grantor developed countries. The grantors are not obliged to give tariff preferences at all, and in cases where they do choose to provide tariffs, they decide unilaterally which products and countries will be covered.
Once preferences are granted, they are not binding on the grantor countries and can be altered to exclude certain products, or even withdrawn entirely at the grantor’s discretion. Without binding obligations, preference providers face pressure from their own import-competing domestic lobbies to minimise the scope of their preferential schemes. The result is that interests in the preference grantor country, rather than the interests of the grantee country, determine the products covered and the types of preference offered.
In the case of the EU’s GSP (Generalized System of Preferences), once the scheme led to successful exports, the EU began setting annual quotas that considerably restricted the advantage that the exporting countries could extract from the preferences. Or again, in 1992 US withdrew $60 million worth of pharmaceutical imports from their preference scheme because the US Trade Representative determined that India had weak patent protection that adversely affected US companies (Sutherland et al. 2005: 25).
Unnecessarily moving trade further from efficient specialisation
I have mentioned that differential treatment in terms of tariff rates creates a ‘preference margin’: the difference between the rate imposed on all other countries (the MFN rate) and the rate imposed on the preferred country. The margin allows the preferred country a competitive edge over other exporters. The preferred country develops an interest in stalling negotiations to reduce MFN rates, because such a reduction would narrow the preference margin and thus its competitive edge (Sutherland et al 2005: 23). Since some developing countries face the MFN rate while others face the preferred rate, the latter countries’ stalling of negotiations to reduce MFN rates hurts the former developing countries.
Insofar as the preferences apply to one group of developing countries and not to other developing countries, they often simply divert trade from some poor countries to others, at the whim of the country granting them. That is, while a country may have been importing from developing country X before preferences, after preferences, it finds it cheaper to import from developing country Y. In terms of efficiency, trade diversion can switch demand away from an efficient (but not-preferred) producer to a less efficient (but preferred) producer.
The EU’s ‘Everything But Arms’ (EBA) agreement granted duty free and quota free access for all LDC (Least Developed Countries) exports except for arms and for three sensitive agricultural products. To put this preference into context however, note that the LDCs produce almost nothing that is directly competitive with EU production. The countries produce such small amounts that the removal of duties on their exports will rarely reduce prices sufficiently in the EU to expand demand from EU consumers. Instead, the EBA diverts EU purchases from other countries to LDCs. Generally the countries which compete most closely with the LDCs are countries whose incomes fall just outside the ‘least developed’ limit. These countries, very nearly as poor as the LDCs, see their demand diverted to LDCs (Winters 2002: 25).
This does not benefit the developing world as a whole, but only shifts the same amount of export revenue from one needy country to another. Moreover, since the choice of preference recipient is up to the grantor country, this leaves some potential for political favouritism and punishment in extending or withdrawing preferences to developing countries (Stiglitz and Charlton 2005: 100).
A preferable system would institute a rule-based and principled mechanism for differentiating between rich and poor, and strong and vulnerable economies. Many possible systems can be designed with this aim in mind. I will investigate one proposal in the literature.
Keck, A. and P. Low (2006). “Special and differential treatment in the WTO: why, when, and how?” Economic development and multilateral trade cooperation. S. Evenett and B. M. Hoekman (eds). Washington DC, Palgrave Macmillan and the World Bank.
Page, S. and M. Davenport (1994). World trade reform: do developing countries gain or lose? London, Overseas Development Institute.
Page, S. and P. Kleen (2005). Special and differential treatment of developing countries in the World Trade Organization, Ministry of Foreign Affairs, Sweden. <http://www.odi.org.uk/Africa_Portal/pdf/S&DTofDevCosinWTO.pdf > Accessed on 31-07-2008.
Peet, R. (2003). Unholy trinity : the IMF, World Bank, and the WTO. London ; New York, Zed Books.
Stiglitz, J. E. and A. Charlton (2005). Fair Trade For All. New York, OUP.
Sutherland, P., J. Bhagwati, et al. (2005). “The Future of the WTO: Addressing Institutional Challenges in the New Millennium.” Report by the WTO Consultative Board to the Director-General. Geneva, WTO.
Winters, L. A. (2002). Doha and the World Poverty Targets. Annual Conference on Development Economics, Washington DC, World Bank.
Winters, L. A. and P. M. G. Martins (2004). “When comparative advantage is not enough: business costs in small remote economies.” World Trade Review 3(3): 347-83.
Tags: Posts by Bumbu
In New Zealand, lawyers are theoretically obliged to be available to clients on a first-come first-served basis, like a taxi waiting in a taxi stand. This obligation is known colloquially as the ‘cab-rank rule’, and similar formulations can be found in the rules of the legal profession in other countries also.
In its detailed & official formulation[1], the rule specifies limited circumstances for which you can refuse a client. These circumstances include your workload, the presenting legal issue being outside your area of expertise, and the client not being able to afford your fees. (Elsewhere in the professional rules governing lawyers is a requirement that fees be “reasonable” - an obligation I will examine on another occasion if I have the time.)
The rule also specifies grounds under which refusal is impermissible. These disallowed grounds are any of the listed prohibitions under the Human Rights Act 1992 (e.g. discrimination on the basis of sex, gender, political opinion, disability, ethnicity, etc), any personal characteristics of the prospective client, and the merits of the case.
Justification
The reasons for the cab-rank rule are well-established.[2] Perhaps the most basis justification of the cab-rank rule flows from the acknowledgement that access to legal representation is a crucial right of individuals, and in fact is necessary for our adversarial system of justice to work. In a society in which there are legal frameworks & implications regarding almost every action, individuals often need expertise (their own, or more commonly that of a specialist advocate) to navigate the jargon of the jungle that is ‘the law’.
Access to legal assistance thus should not be fettered by the morality or aesthetic preferences of the professionals (i.e. lawyers). If a lawyer could refuse a client based on their political views or their social group, then those espousing unpopular views or from a disliked minority may be denied legal assistance. In many cases, these marginalised groups would need legal assistance the most in terms of asserting their rights vis-a-vis the majority community.
The perceived short-comings
In practice, the cab-rank rule is difficult to enforce. It is understood, if not tacitly condoned, that workload is used as a convenient and tactful excuse for turning away unsavoury clients. There are few, if any, complaints from individuals that lawyers have breached the cab-rank rule to their detriment.
Issues of proof are also cited as a problem with the rule, as many of the grounds for refusal are impossible for the prospective client to evaluate.
Another difficulty with the cab-rank rule that is discussed academically is the associated requirement on the lawyer to be morally neutral. This notion of a lawyer is sometimes described as a “hired gun”. As long as the prospective client is not asking for something illegal, or an abuse of the court process, the lawyer is not allowed to impose her moral judgment on the client. The client is autonomous, and the lawyer is not, but rather is merely an agent, or ‘learned friend’. For a price, of course.
The real problem
In my view, the cab-rank rule ignores the financial difficulties that most people have with accessing a lawyer. This hurdle - not political views or being part of a minority - is the real barrier that most people face when they need legal help. Coupled with the fact that pro-bono or community service work is not required of lawyers in NZ (as it is in the States), individuals seeking representation must rely on state services or NGOs to fulfil their requirements. For any equal access to the law, then, these state and NGO services must be available & functioning to all who can’t afford a lawyer from the taxi stand.
The two main ways people get legal representation (apart from paying the ‘reasonable fees’ of a regular lawyer) are through Legal Aid, and community law centres.
Legal Aid is a government-managed scheme to provide legal assistance to those who cannot afford a lawyer. It is granted based on income and assets, and in most cases individuals granted Legal Aid will be required to pay back a contribution on a weekly basis. This equates to a government-subsidised lawyer, or (more specifically, for those assessed for repayments) a government loan on more lenient terms for a cheaper lawyer[3]. Not all lawyers make themselves available for Legal Aid work[4], and there is some feeling in the community that Legal Aid lawyers are ’second-rate’. This may be true of some lawyers undertaking Legal Aid work, but a broad critical brush is unfair to many skilled, caring & passionate lawyers who do Legal Aid.
Community law centres are recognised under law to be organisations which meet “unmet legal need”. Their existence around NZ (26 around the country) provides a safety net for people who can’t get help anywhere else. Their main funding is not from the government, but through the interest on solicitor’s trust accounts. The government however benefits from community law centres as their work dulls somewhat the imperative on the state to ensure true universal access to justice.
Many people can’t afford lawyers at market rates, so the cab-rank rule is irrelevant to them. As long as lawyers are relatively free as a group to set their own “reasonable fees”, and are not compelled to undertake pro-bono work, there will be incredible pressure on back-up providers such as the Legal Aid system or community law centres to address the inequalities.
This needs to be clearly acknowledged both within the legal profession and by the relevant decision-makers.
[1] My commentary in the post is based on the Rules of Professional Conduct & Client Care which are coming into force in NZ on 1 Aug 08 (currently in draft format). The current version (7th edition) simply states in Rule 1.02: “A practitioner as a professional person must be available to the public and must not, without good cause, refuse to accept instructions for services within the practitioner’s fields of practice from any particular client or prospective client.” The requirements will be more specific after 1 Aug as an entire section (Chapter 4: Availablility to the Public and Retainers) comprising over two pages of rules will itemise the rules under this aspect. See the latest legal professional regulation documents from the NZ Law Society’s website.
[2] A leading academic commentator in this field is Duncan Webb whose text book ‘Ethics, professional responsibility & the lawyer’ outlines many of the justifications for (and short-comings of) the cab-rank rule. See the latest edition (currently 2nd edition, 2006, but will be regularly updated).
[3] For example, there is a cap on repayments that is set based on income and assets. Weekly repayment installments are likewise set at a level proportionate to means. There is no interest charged on these ‘loans’ unless the recipient is in default. In those cases, the interest is lower than market rate, and applies only to the amount in default.
[4] For a list of Legal Aid providers, see the Legal Service Agency website. The LSA is the government agency that administers Legal Aid, and they also administer the funding pool to community law centres (although the funds are from a non-governmental source.)
Tags: Posts by Kimchi
By Bumbu
In this post, I summarise the basic economic background surrounding international trade and how this can affect developing countries. It covers the basic economic attractions of international trade for developing countries, some sorts of government intervention in such trade and reasons for and against these.
The place to begin is with the important concepts of comparative advantage and the Heckscher-Ohlin model. These outline the basic reasons for free international trade and present the basic mechanism by which such trade can benefit developing countries.
We then turn to complicating features of economies which can mean that the results of international trade without government intervention are less than ideal. In particular, we consider some market failures which require corrective government intervention in the economy. These include imperfections in market conditions within an economy, apparent even when an economy is considered in isolation from others, as well as sub-optimal results which occur because of competition from foreign producers. These market failures suggest ways in which the cause of development in poor countries might be furthered by specific government interventions. These interventions may be macro-economic, involving tax and public expenditure in the domestic economy, or they may be in trade policy, involving such tools as tariffs and subsidies.
We discuss the patterns of specialisation and the distribution of gains and losses likely from trade between different sorts of economies. This suggests reasons that developing countries might want to shape the direction of their economy, again using macro-economic and trade policy.
The theory of comparative advantage
The theory holds that when two countries X and Y trade in two goods G and H, both can benefit by specialising in the good in which they have comparative advantage and then trading the goods. Country X may have an absolute advantage in both goods. That is, it may be more efficient than country Y in producing both goods. Nonetheless, country Y will have a comparative advantage at producing one of the goods. The scarce resources which are used in the production of both G and H will be more productively employed in the production of one than in the production of the other. When country X commits its scarce resources to producing good G, there is an opportunity cost of not committing them to producing H. Country Y will have a comparative advantage in producing the good whose production incurs the larger opportunity cost for country X.
To consider a simple example, begin with a situation of no trade and suppose there is a single input of production. Suppose it takes country X 10 and 15 units of input to produce a unit of G and of H respectively. Suppose it takes country Y 40 and 20 units respectively. Country X has an absolute advantage in both goods. However, consider the relative of the goods. In X, a unit of G costs 2/3 of an H (10/15). In Y, a unit of G costs 2 units of H (40/20). Even though X has lower absolute prices for both goods, than does country Y, the latter has a lower relative price of H. It thus has a comparative advantage in producing H. In this model, each country will always have a comparative advantage in one and only one of the goods except in the case where the two countries have the same relative price in a situation of no trade.
Country X has a lower absolute cost for producing both goods. Yet, if it specialises in G and imports H, the units of input freed up from abandoning production of H will produce more units of G than they produced of H. Likewise in Y. If it specialises in H and imports G, the units of input freed up from abandoning production of G will produce more units of H than they produced of G. With specialisation in one’s area of comparative advantage, the combined production by both countries of each good G and H rises when compared to the combined production of each in a situation of no specialisation. If the countries trade, as well as specialising, they can share the benefits of this greater pool of goods.
Countries can have a comparative advantage for reasons such as differences in technology or in endowments of factors of production such as arable land.
Heckscher-Ohlin model and distribution of gains and losses from trade
Let me briefly introduce the Heckscher-Ohlin model of the gains and losses from international trade. While it is not clear that empirical evidence confirms the model, it is nonetheless useful for reasoning about trade. I will present the conclusion of the model, but will not run through the argument for these conclusions. I begin by explaining the concepts of intensity and abundance.
Suppose both goods G and H use two inputs of production, K and L (capital and labour). At given prices for K and L, production of a unit of a good will likely use the inputs in a different ratio. Suppose that at any given input prices, G always uses a higher ratio of K to L than does H. This makes the production of that good K-intensive. Note that intensity is a relative concept to do with the ratio of inputs used. In this model, if G is K-intensive, this must mean that H is L-intensive.
If country X’s endowment of inputs of production is composed of a higher ratio of K to L than country Y’s, then X is K-abundant and Y is L-abundant. Again, this is a relative concept. Country X may have a larger absolute quantity of both inputs K and L than does country Y, but, obviously, it cannot have a larger ratio of both K to L and of L to K than country Y.
Comparative advantage is often due to technological advantage. If country X is technologically advanced and country Y is not, it is likely that the former has a comparative advantage in the production of a technologically intensive good.
However, the Heckscher-Ohlin model makes a prediction about comparative advantage and the direction of trade flow even in cases where technology is assumed to be the same in the two countries in the model. The model makes the following predictions.
A country will tend to export products which are intensive in factors that are possessed by the country in abundance. So, for example, a developing country - which is labor-abundant - will tend to export products which are labour intensive. Country Y, which is L-abundant, will tend to export the labour intensive good H.
As it does so, the relative price of the abundant factor in that country will rise. To continue with our example, the developing country will see the price of labour rise relative to the price of capital - wages will rise relative to the rent. Suppose w is the factor price for L and r is the factor price for K. Country Y will see the ratio w/r rise. Real wages will rise and real rents will fall for both the labour intensive good and the capital intensive good.
Moreover, the purchasing power of owners of labour will rise and the purchasing power of owners of capital will fall. In the initial discussion of comparative advantage, international trade turned out to raise the aggregate product. With this latest prediction of the Heckscher-Ohlin model, we see reasons for thinking that the distribution of gains from international trade will be uneven. There will be some gainers and some losers from trade. According to the model, owners of labour will gain in country Y and owners of capital will lose. Its trade partner, which we might think of as a developed country, is capital abundant and tends to export the capital intensive good G. In X, owners of capital will gain and owners of labour will lose.
Finally, international trade will tend to equalise the relative prices of the two factors in the two countries. That is, the ratio w/r in country X and the ration w/r in country Y will tend to equalise.
The theory of comparative advantage suggests that with specialisation and international trade, aggregate global product will increase given constant amounts of factors of production and technology. For each country, there is an increase in average efficiency. Even if some industries unable to compete with imports are destroyed, the human and capital resources thus freed up can be absorbed into production in some other industry where the country has comparative advantage and where it now specialises. Since the country has comparative advantage in this latter industry, the resources have moved from low productivity protected sectors to high productivity export sectors.
Trade can potentially open up a foreign market, boosting demand for domestic products. Domestic producers can expand their production to satisfy this larger demand and even achieve economies of scale in the process. Trade liberalization can mean that imported inputs used in the production of domestically produced goods are cheaper, thus reducing domestic cost of production. Liberalization can result in greater competition from foreign firms in the domestic economy. This can lower prices and force improvements in efficiency in the local production. Liberalization can also affect the rate of economic growth by, for example, leading to greater production to meet the greater demand generated by access to foreign markets.
There are both winners and losers in this model. The model predicts that the gains from trade will outweigh the losses. Consequently, the gainers would gain from trade more than enough to compensate the losers for their loss from trade. If the losers could be adequately compensated by the gainers, then everyone would be better off as a result of trade. However, there may be many reasons why the losers from trade are not adequately compensated. Some of these reasons will be discussed in a section below on political aspects of development.
The case for government intervention: the role of history and expectations
From the above, it might seem that under free international trade between developed countries and developing ones, the wages of various factors of production will gradually converge (as per the Heckscher-Ohlin model). However, there are reasons that different economies might experience persistently different rates of investment and why similar rates of savings in two economies might lead to different rates of economic growth. Among the reasons are issues of coordination failure.
An economy may have multiple equilibriums. The market is capable of reaching each of these equilibriums and once it reaches one, it would tend to stay there, unless some force moved it away. The equilibriums may not be equally desirable from society’s point of view.
One particular instance of multiple equilibriums is one where the economy finds itself stuck in a relatively low level equilibrium because of a coordination failure. If a relevant set of agents could coordinate their actions, the economy would move to higher level equilibrium which is better for the economy and the agents concerned. However, in the normal course of things, the agents fail to coordinate and the market remains in the lower level equilibrium. This is one type of obstacle faced by developing countries wanting to develop. It also highlights the role of history a particular economy in the amount and type of investment it receives today.
Consider a developing country which is largely reliant on its primary sector. It would like to develop an export sector for manufactured goods. There is abundant labour who could be employed in manufacturing and there are entrepreneurs with sufficient resources in terms of finance and know-how to set up the industry. Nonetheless, there may be other obstacles to a move to the ‘manufacturing-export-equilibrium’ and the economy may remain at the lower level primary sector equilibrium. For, various complementary developments which make a manufacturing export sector viable may be absent. The machinery required for the manufacturing industry might require a steel industry which in turn requires iron, mining and coal industries. Yet, these latter industries may not exist, as there is insufficient demand for their products. If the manufacturing sector existed, there would be sufficient demand for steel and thus a reason for an entrepreneur to set up a steel industry. In the absence of a manufacturing industry, there is no reason for an entrepreneur to establish a steel industry, as there is demand for the product. Similarly, if the steel industry existed, there would be sufficient demand for iron to warrant establishment of an iron industry. A similar story can be told for the coal and mining industries which create inputs for iron production. At this end, the entrepreneur who contemplates setting up a manufacturing industry sees an absence of inputs of production in the economy.
Meanwhile, at the other end, the entrepreneur sees insufficient demand for the product. The incomes and preferences of workers in the developing country may not be sufficient to generate adequate demand for the manufactured goods to warrant the initial setup costs. The entrepreneur would have to sell the products overseas. Yet, in order to do so, the economy must have adequate railways to transport the goods to a port and a shipping industry to ship the goods from the port to foreign markets. The railway and shipping industries, in turn, do not exist because there is insufficient demand for their services and insufficient inputs for their production. Demand for their shipping services would come from an export sector (like manufacturing) and demand for railways would come from industries like manufacturing or iron (to transport coal to iron producers). Inputs for railways and shipping would include steel and coal. These sorts of forward and backward linkages abound in developing economies (Hirschman 1958). The steel industry facilitates development of railway industry by increasing availability or lowering price of steel. This is a forward linkage, affecting the ease of supply of another product. The steel industry has a backward linkage to the coal industry, as expansion of the former raises demand for the latter.
Note that any one entrepreneur is unwilling to invest in establishing a mining, coal, iron, steel, manufacturing, railway of shipping industry because she is uncertain that there will be demand for her product and/or that inputs of production will be available cheaply. None of these industries is viable on its own. Yet, they are collectively viable, if only the entrepreneurs contemplating investment in each industry could coordinate and rely on the others to invest. Unless this coordination failure is resolved, the economy will remain at the lower level equilibrium.
Note this link to the section on dynamic comparative advantage. Static comparative advantage might move a country into specialising in a product given the existing low level equilibrium. Yet the country’s dynamic comparative advantage may be in some other specialisation that is not reached by the market because of coordination failure.
History plays a part in explaining why different economies might experience persistently different rates of investment and why similar rates of savings in two economies might lead to different rates of economic growth. A country with a well established industrial sector, with a variety of industries, will attract investment for establishment of new industries. The existence of complementary industries makes it profitable for entrepreneurs to invest in this economy to set up new industries. Many developed countries are like this. On the other hand, a developing country which has very little industry and, in particular, lacks various key industries, will be unattractive to investors. This is the case not only for foreign investors, but also for domestic savers. A similar rate of savings to the developed country may still yield different rates of economic growth of the two economies. Domestic savers in the developing country will be unwilling to invest in their economy for the reasons above and this will affect the rate of economic growth. Meanwhile, domestic savers in the developed country will be eager to invest in their economy because complementary industries exist and their investment is more likely to be profitable.
Remedial policies for coordination failure
In cases of coordination failure, each potential investor bases her decision on her expectation of whether other investors will invest on complementary industries in a given time period. No investor wants to be the first to make the move, because the first will face losses for at least the short run while other investors set up other industries which have linkages to the pioneering investment. The first investor’s action would have positive externalities – making it profitable for others to set up complementary industries – but brings poor returns to the investor herself (at least in the short run).
One way to deal with this is government action. The state can be the first actor, willing to bear some losses for the sake of the positive externalities. The state seeks out the key sectors - call them leading sectors - whose development would spur the development of complementary sectors through forward and backward linkages. Backward linkages usually have direct consequences by raising demand for inputs. Forward linkages generally have more diffuse effects. They increase supply of something which is an input in many things, so that investment in any one of them rather than in others is not assured. Moreover, the input will be only one input among others for the other product and if prices of other inputs stay the same, the effect of lower price of one input may be small. Sectors which have been thought to be leading sectors in this sense include heavy industry, exports, tourism, transportation and agriculture.
If the government invests in a leading sector, preferably a very low profitability sector (in which private entrepreneurs would therefore be unlikely to invest), they can change the expectation of entrepreneurs. Without government action, each entrepreneur expected that no private investor would make the first move (as this would not be profitable in the short run for any investor). Accordingly, no entrepreneur was prepared to make a move in the future. With government action, entrepreneurs expect that, in the future, there will be some complementary industry necessary for the profitability of their own enterprise and so, will be willing to undertake the investment.
Capital markets
Opponents of government action grant that the government action could resolve the coordination failure, but argue that it is not the only - nor the best - way to do this. The problem is that the first mover would face losses in the near future. However, it may well be profitable in the longer run as complementary industries set up to take advantage of the linkages created by the first mover. Accordingly, first movers should be able to borrow against their longer-run expected profitability to tide them through their short run losses.
In many developing countries, credit markets may be poor and so first movers may be unable to find a willing lender. This is indeed a market failure and could justify remedial government intervention. However, many would argue that the appropriate role of the government would be to fix the credit market and not to set up the leading sector as a public enterprise. This is in keeping with the rule of thumb that it is best to deal with a market failure as directly as possible, as less direct policy tends to lead to unintended distortions of incentives elsewhere in the economy (Krugman and Obstfeld 2003: 227).
This does not seem to be the end of the matter, however. Research in the implications of asymmetric information suggests that in many cases it may be best to see capital market imperfections as inherent and not simply something that governments can fix (see Stiglitz and Weiss 1981). Banks would have to be willing to lend to a firm that sells below cost in the hope that it will eventually increase productivity enough to become a viable competitor. This would be highly risky for a bank, which is at an information disadvantage in judging the credibility of the firm’s pronouncements about its own future profitability despite current losses. This situation of asymmetric information is an inherent feature of the operation of economies. Once we take seriously the intractability of these capital market imperfections – rather than supposing them to be easily remedied by government intervention – government protection may be optimal(Stiglitz and Charlton 2005: 32).
The case for protectionism
Increasing returns to scale
Expansion in the scale of production often reduces the average unit cost of a product. These lead to increasing returns to scale. To realise gains from increasing returns there must be a sufficiently large market for the product. If the market is small, a profitable product may never make it onto the market. It may be that if increasing returns to scale are not realised, then the cost (and thus price) of the product will remain too high for potential consumers.
For instance, there may be a close substitute which is of inferior quality but which has complete market share. Given the market share, its producer can realise increasing returns to scale and thus sell the product at a relatively low price. The innovative producer of a substitute which is of higher quality may be unable to break into the market because potential consumers will not immediately shift from the inferior to the superior product. Consumers need time to find out about a product, to build trust in it from seeing others buy it, to be convinced out of brand loyalty or habit or to wait for the inferior product to wear out before they buy a new one. In the short run, the superior product will have only a very small market share and the inferior product will retain its dominant position. This means the superior product sees insufficient demand to warrant increased scale of production. Accordingly, it does not experience increased returns to scale and cannot reduce its price to come close to the cheaper inferior product. This higher price further disadvantages the superior product.
Increasing returns to scale in an industry might mean that an infant industry in a developing country cannot compete against import from established foreign producers. Government protection from such imports can allow the infant industry to become more competitive.
Learning by doing
Sometimes assimilation of new techniques of production is possible only through ongoing production at a sufficiently large scale. There may also be increased productivity merely from increased labor skills arising from accumulated experience rather than from any change in technology (sometimes referred to as the Horndal effect). The learning process may also involve innovation which improves the quality of a product or the efficiency of its production. For instance, a type of circuitry may have been designed in foreign conditions where heat and humidity are not a big problem. Use of the circuitry may be sub-optimal in the greater heat and humidity of the domestic environment. Domestic producers can innovate and modify the product to cope with the different conditions (Ray 1998: 669).
Learning by doing may not be possible for an industry if it must face import competition which already has the benefits of having learnt from experience. A government may want a domestic industry to achieve the benefits of learning by doing and thus become more competitive. It may protect the industry from imports in order to give it time to learn.
Dynamic comparative advantage
The existence of increasing returns to scale and learning by doing can mean that an industry is unable to compete against imports from established foreign producers. However, the theory of comparative advantage suggests that there will always be some industry in which the country would have comparative advantage and thus where it could competitively produce.
Why, then would a country want to develop an industry which is outside its area of comparative advantage rather than letting free trade guide the country to its area of comparative advantage? To answer this, it is useful to distinguish static and dynamic comparative advantage. There may be industries in which a country does not currently have comparative advantage, but in which it could have comparative advantage in the future. In such cases, free trade is likely to lead the country towards a specialisation which may be worthwhile in the short run, but which may be best in the long run.
One reasons attaches to the existence of positive externalities of the operation of specific industries which do not attach to the operation of other industries. Positive externalities are a sort of market failure in which the market equilibrium produces less of a good than is socially optimal. In our case, the market may fail to promote an industry even though, from a social optimum point of view, it is highly desirable. From this latter point of view, the particular industry may be judged to generate more advantages in the long run than the area of (static) comparative advantage would generate.
Here are some examples of such positive externalities. The growth of some industries prompts other developments in the country. For instance, it might spur a local industry for intermediate inputs, as we saw in the case of coordination failure. It might yield knowledge and technical expertise which can spill over into other industries within the country as employees eventually leave one industry for another. It might lead the government to improve key infrastructure necessary for the industry to prosper (such as, roads or electrification) or institutions (such as, intellectual property law or bankruptcy law) to assist the industry if it is sufficiently important to the economy. Depending on the level and type of inputs and technology involved in the industry this public expenditure can promote various sorts of specialised technical education or improve telecommunications infrastructure and so on. In these ways, the industry in which a country specialises can affect the development of the country not merely in increasing its income through the income directly generated through exports, but also through flow-on effects or positive externalities which pave the way for other industries to establish themselves. While the area of (static) comparative advantage would maximise export receipts in the short run, some other industry may turn out to be preferable in the long run.
Another reason relates to the fact that, for many developing countries, the area of comparative advantage lies in primary sector areas such as agriculture and mining. Primary products are generally those obtained directly by transforming natural resources. Agriculture, fishing and mining are examples of primary sectors of economies. This contrasts with the secondary sector of economies which involves processes such as manufacturing and construction where primary products serve as inputs.
It is an established empirical observation that as consumer budgets grow, consumers spend a decreasing proportion of their budget on primary products such as foods. A greater proportion is spent on luxuries rather than necessities and many sorts of primary products fall under the latter classification rather than the former. A greater proportion is also spent on processed goods. As income grows, the demand for primary products is likely to grow, but will do so at a decreasing rate.
There is a tendency for developing countries that export mostly primary products and import the bulk of their manufactured goods, to see their terms of trade (the price of a country’s exports divided by the price of its imports) decline. Other contentions in the literature include the claim that primary product prices tend to fluctuate widely. If this is the case, it may contribute to economic instability of countries which rely on the primary sector.
Suppose the export sector of a developing country is heavily dependent on primary products. One way for the country to increase its national income is to simply try and sell more of the primary products. However, there is a limit to how far it can grow its share of the market in these products.
Another way for it to increase its income is to move into a further step in the production chain which transforms primary product into final product. Suppose country A exports raw wool (a primary product) to country B which processes and dyes it and makes woollen clothing from it. Consider this clothing as the final product, a product which is not used as input in any further production process. If country A begins to process its raw wool rather than exporting it, it can enter a new market – that for processed wool or for dyed wool or woollen garments. Country A can increase its income in this way for the following reason. Consider the value of the final product, the woollen garment, to be an amount Z. Amount Z can be analysed into component amounts of value added at the various steps in the chain of its production. The raw wool has a value of V, the processing and dyeing of the raw wool adds a value W, making the processed wool into wool cloth adds a value X and making this cloth into clothing adds a value of Y, where V+W+X+Y=Z. If country A exports the raw wool, its income is V. If it exports at a later stage in the chain of production, its income is the increased amount V+W+… This strategy for greater economic growth and development is known as moving up the value-added chain towards higher value added production.
If a country expects that in the long run a specialisation in, say, manufacturing is more lucrative or stable than a specialisation in a primary sector, it might promote more capital- and technology-intensive industries in which the country does not currently have a comparative advantage but in which it could become competitive.
Types of activist trade policy: Import substitution and export promotion
We have seen some reasons that governments might want to actively promote particular industries through policy. Import substitution and export promotion are two sorts of policies countries can follow to promote industries. Both ways distort market outcomes and both involve significant government intervention.
Import substitution involves barriers to imports and perhaps government support for the import competing sectors. The aim is to let the import competing firms become established and become competitive. They can become more competitive by, say, acquiring organisational experience, increasing returns to scale, building relationships with suppliers of inputs in order to get these at a low cost, perhaps developing new technology or techniques particularly adapted to the domestic market and so on.
Suppose a local substitute for a currently imported product is just as good or better (more suited to local conditions). Suppose also that the product type has increasing returns to scale, such that it is difficult for the fledgling domestic import competing producer to sell at sufficiently low prices to compete with the imports. Import protection can be used to reduce the share of imports in the relevant market and thus leave more of the market for the domestic producer. This can allow the latter to increase its scale of production and also gain other advantages such as experience and may help it become more competitive. The hope is that the producer will eventually become competitive enough to survive without protection.
Export promotion involves government promotion of exports. Means of doing this include subsidies for inputs and for production, cheap access to imported inputs (perhaps through import quotas reserved for selected exporters) and preferential credit at below market rates to facilitate borrowing for investment.
Developed country consumers, generally would prefer developing countries to adopt export promotion than import substitution, as the developed country consumers would thus have access to cheap imports from these countries. Moreover, export promoting countries tend to have fewer import barriers than import substituting countries. This is attractive to developed country exporters who may want to access the markets of certain large developing countries.
For the developing countries themselves, import substitution can lead to entrenched business interests in the import competing sector who take for granted the government protection from cheaper imports. They may not believe that this period of support by the government is limited. Accordingly, they might see no reason to take advantage of the period of shelter from competition to become more competitive. They may never become sufficiently competitive as to be able to survive without government protection. Then the business interest acts simply as a drain on government money and domestic consumers face higher prices with no compensating benefit.
Note that for a protected industry to become competitive, it may need access to a large market. The industry cannot reach a sufficient scale of production to benefit from increasing returns and falling average cost of production if there is not sufficient demand for its product. For many developing countries, the domestic market may not be large enough, meaning that the industry needs to access export markets to become more competitive. This leads in the direction of export promotion policies. Some of the government protection for the fledgling domestic industry might continue, but one sort of support – namely import barriers to stop foreign competition is no longer on the cards. Exporting to a foreign market involves competing against foreign producers. Export promotion is thus preferable to import substitution for many developing countries, as it allows access to larger markets.
There are other reasons why export promotion is desirable. A developing country may need income for, say, servicing international debt. Greater export earnings are a way to do this.
Expected distributions of gains and losses in various types of international trade
Tariff barriers and export promotion
Suppose a developing country imposes a tariff on an import. This will raise the price at home. This hurts domestic consumers and benefits domestic import-competing producers. The government also receives a tariff revenue, boosting its ability to spend. There is an efficiency loss as domestic producers produce more than they would and domestic consumers consume less than they would under an efficient market equilibrium.
Assessing the overall wisdom of the tariff depends on distributional features and on the social importance placed on a dollar of cost or benefit accruing to different groups. For instance, it matters whether the producer gain accrues mostly to wealthy owners of resources or to low wage workers. It matters whether the consumer loss is borne mostly by poorer than average people or by the affluent. It also matters whether the government puts its tariff revenue to good use. These are effects in the short run. There may be other relevant effects in the longer run. We have come across these effects in previous chapters. The import competing industry may be an infant industry which needs only temporary protection and which may promise future benefits which outweigh the costs of the protection. These benefits may be in the form of externalities for the rest of the economy or in the form of a surer and more stable source of export revenue in the future.
Consider an export subsidy. The exporting country experiences a rise in price. Its producers gain, its consumers lose and the government also loses as it must foot the bill of the subsidy. There is an efficiency loss as domestic producers produce more than they would and domestic consumers consume less than they would under an efficient market equilibrium.
Again, the wisdom of the subsidy depends on things like distributional effects, externalities and potential long run effects. As we have seen in previous chapters, a well thought out export subsidy can allow an infant industry to establish itself and to become a competitive export earner in the long run. There may also be positive externalities such as rectifying coordination failures and moving to a better market equilibrium if multiple equilibriums are on offer. Moreover, if the consumers who lose at home are affluent and the producers are mostly low skill workers, then these results become more acceptable.
Let us note the effects of these measures for trade partners. The producer in the trade partner country X, facing an import barrier, experiences a fall in demand as the tariff raises prices for consumers in the importing country Y. Depending on the size of Y’s market for the relevant good relative to the size of world market, country X will also undergo a change in price of the good. If Y has a small market, then the tariff makes very little difference to price in X. If Y has a large market relative to world market, then the price in X will fall by some amount smaller than the size of the tariff. So, producers in X face a fall in revenue as demand for the product falls. Consumers in X will benefit from a fall in price if Y is a sufficiently large market, but will face no effects otherwise.
In the long term, if the import competing producer in Y ceases to be an infant industry and grows up to become competitive, then the producer in X will face grater competition in the world market and may even see its market share shrink.
In the case of an export subsidy by country Y, the importing country X undergoes a fall in price. Consumers in X benefit and the import competing producer in X finds it harder to compete and, if the subsidy is substantial enough, could be driven out of business.
Trade between a developed country and a developing one
Recall that the Heckscher-Ohlin model predicts that the relative prices of factors of production will tend to equalise across trading partners. If a developed country trades with a developing one, we expect the former country to export a capital intensive product and the latter to export a labor intensive product. The model leads us to expect that owners of capital will become wealthier in the developed country and less wealthy in the developing country. Similarly, we expect that the owners of labour will become wealthier in the developing country and less wealthy in the developed country. Conditions of production are so different in the two countries, that there should be plenty of gains. Labour in the developing country can expect a rise in wages and consumers in the developed country can expect much cheaper goods.
Yet, the large differences in conditions of production also mean that distributional effects of free trade between such countries are likely to be large. Gains to consumers from much cheaper imported products are expected to outweigh the losses to specific small groups. However, those who stand to lose, in a developed country often organise themselves to oppose free trade with a developing country. Fear of a fall in real income or of losing jobs have led to US protection of particular sectors such as the auto industry, agriculture and textiles. (Krugman and Obstfeld 2003: 228-32).
While specialisation according to comparative advantage can increases the aggregate income of both countries, the pattern of specialisation may nonetheless be problematic. This is for reasons familiar from our discussion of dynamic comparative advantage and of complementary industries. The developing country may experience an expansion of low-skilled labour-intensive industries as competing industries in the developed trade partner shut down and relocate, but at the same time the developing country experiences a flight of some technically intensive industry to the developed country. This may be because the latter country may have better infrastructure and easier access to high-technology inputs and other complementary industries than does the developing country. The developing country may be unhappy with this division of specialisation.
It is important to differentiate between developing countries at varying stages of development and with varying degrees of wealth as the divide between the Least Developed Countries (LDC) and the middle income developing countries can be substantial. Some developing countries will have better infrastructure than others. Suppose trade between developed and developing includes not just two countries, but three - a developed country, a middle income developing country and an LDC. The existence of better infrastructure and complementary industry in the middle income than in the LDC may mean that investors relocate some low skill labour intensive industry to the former rather than the latter. This may be despite the latter country having lower wages, as wages are only one component of cost of production.
Trade between two developed countries
We can expect that developed countries have depth of product variety and that any differences in proportions of various factors of production will be relatively small. For these reasons, distributional effects will be small and we can expect fewer impediments to trade between such countries. Indeed, the EU is an example of such trade.
Much of their trade might be in similar, but differentiated, products or in goods that do not use substantially different proportions of factors of production. Similar products can be differentiated in terms of features like branding. The main effect for such trade may be a bigger market without a drastic change in factor prices. Here trade is more likely to bring actual Pareto improvements.
Suppose one developed country produces only white wine and another produces only red. Suppose consumers in both countries want to try both kinds of wine. Free trade allows each country to keep half its domestic wine and export the other half. Consumers have more variety and producers do not have to downsize in either country. It seems that no one stands to lose from trade in this case. The only opposition might be if there is monopolistic or oligopolistic production in autarky. The monopolist will want to resist free trade as this will eat their super profits.
Trade between two developing countries
The optimistic result for free trade in the previous case required two factors: (i) similar per capita income (so that products demanded are similar and thus unlikely to vary much in terms of factor composition) and also (ii) a certain depth of consumption or input variety. Developing countries can satisfy the first criterion, but they fail the second.
Such trade can serve the need to exploit markets on a larger scale than that permitted by import substituting industrialization. Suppose two developing countries open free trade between themselves. They were import substituting before and are now jointly import substituting, This allows them a bigger market. If the industries simply located in one country each, cutting out duplications and thus reaping returns to scale from the larger market, they could be more successful.
However, there is no reason to expect such harmony where each major industry picks one country, so that each country has one major industry. If one of the countries is larger or has better infrastructure or better access to skilled workers, it would end up with both industries and the other would be left with none. The more similar the countries, the more likely that the location choices of industry will be evenly distributed. However, increasing returns mean that even a small advantage can magnify over time, through a process termed agglomeration. The process involves a chain of activities in which each additional link heightens the prospects of a fresh link to be forged.
Locational choices are like this. Recall the earlier discussion of complementary industries with regard to the problem of coordination failure. The absence or presence of complementary industries can influence an entrepreneur’s decision to invest in a region. A slightly better climate for industry can prompt the location there of one industry. This makes it more likely that fresh industries will locate there and so on (Ray 1998: 740-2).
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References
Hirschman, A. O.; 1958; The Strategy of Economic Development; Yale University Press; New Haven
Krugman, Paul and Maurice Obstfeld; 2006; International economics : theory and policy (7th ed); Addison-Wesley; Boston MA
Ray, Debraj; 1998; Development Economics; Princeton University Press; Princeton
Stiglitz, Joseph and Andrew Charlton; 2005; Fair Trade for all; Oxford University Press; New York
Stiglitz, Joseph and Andrew Weiss; 1981;” Credit rationing in markets with imperfect information”; American Economic Review; vol 71 issue 3
Tags: Posts by Bumbu
By Bumbu
A developing country’s policy to promote development rests on many factors. One factor is the economic arguments for and against the policy. This comes up often in debates about whether developing countries should be liberalising their economies and committing to free trade or not. Another important factor is the domestic political situation. Here I describe a few examples of how domestic politics can influence the desirability of a policy. Generally the political factors mentioned are to do with the distribution of costs and benefits from a policy. Even if the country expects to benefit overall from the policy in an economic sense, distributive concerns can present reasons against the policy.
A government’s decision to protect certain industries from import competition may reflect the pressure of business lobby groups representing the import competing industry. It may be that the protection concentrates benefits onto producers in the import competing industry, while diffusing much larger costs over the rest of the population, perhaps in terms of higher prices faced by all consumers.
We might suppose that the political parties in a system of representative government will act to maximise overall gains for the country, or might pursue policies which win over the ‘median voter’. However, these parties need large campaign funds if they are to have any success in elections. Special interest groups are the major sources of such funds. Political parties or individual politicians will likely be willing to trade off some overall welfare for greater campaign funds. Obviously, they cannot trade off too much of the overall welfare, lest they lose significant amounts of voters. However, some reduction in overall welfare may have little effect on the number of voters if the costs are widely diffused or are hidden. There is a tendency for protectionist trade policy to be captured by special interest groups such as import competing firms.
This is the case, for example, with respect to protectionism by developed countries in selected sectors such as agriculture and textiles. Developed country protections in these areas raise domestic prices or substantially increase fiscal expenditure without a corresponding benefit for the economy as a whole. The beneficiaries are generally very small in number. For example, farmers constitute a small proportion of most developed countries’ populations. In the US farmers constitute only about 2% of the work force, yet their well organised and politically influential lobby allows them to drag trade policy in their favour (Krugman and Obstfeld 2003: 232). Developed country protection of agriculture and textiles has been a major sticking point in recent multilateral trade negotiations with developing countries.
It is often argued that governments seeking to pursue protectionist policy for the overall benefit of the country tend to become captured by special interest groups. While certain protectionist policies would be most desirable on strictly economic grounds in a given case, some propose that this should be avoided for practical, political reasons. In practice, the position goes, the protectionist policy will end up benefiting certain special interest groups at the cost of general consumers rather than being to the overall advantage of society. As a result, it may well be to the overall detriment of society in a cost benefit analysis. Advocates of this position say that free trade should be advocated without exception (even if it is not the best option in some cases on strictly economic grounds), so as to avoid protectionism being used as a tool to benefit small groups of special interests (Krugman and Obstfeld 2003: 221).
In many cases, social movements opposed to development and growth are opposed to particular policies. Particular policies undertaken in the process of development are bound to include an element of economic reasoning about the usefulness of the project for the region or the country, as well as an element of politics in its distribution of costs and benefits. There are systematic reasons why poor and marginalised groups, especially in developing countries, will end up bearing the bulk of the cost of development projects while special interest groups - perhaps business groups or powerful voting blocs – will reap the concentrated rewards. Elements of corruption, poor news media, unequal power and resources to make one’s case to the public and to politicians are all factors in this distribution of costs and benefits. These are important factors which can serve to perpetuate oppression, marginalization and poverty of the global poor which relate to the implementation of development projects and the concrete pursuit of economic growth. The criticism in these cases need not be of the underlying economic theory. It may instead be of the political and social factors, both systematic and contingent, which inevitably accompany the implementation of the policies. Let me briefly run through some examples of these factors.
Some parts of the population may be pandered to by politicians at the expense of others. For example, an urban middle class voting bloc is likely to be relatively well courted by politicians when compared to the urban and rural poor in many developing countries. The well courted voting bloc is likely to seek government support for projects which benefit them and which happen to have few benefits or even substantial harms for the marginalised. Entire regions in a country can become left behind if their votes or other political and financial clout matters insufficiently to the rulers.
Special interest groups and business lobbies will seek to capture government policy regardless of whether it is protectionist. Firms seek concessions from the government, such as places to build factories, public funding for infrastructure, concessions for inputs, incentives to invest in this country rather than in some other, or in one region of the country rather than in another. Means by which business interests can pursue their ends include campaign contributions, political corruption and bribery, slick campaigning (to politicians and to the voting public) to ensure that their assessment and presentation of costs and benefits from a project (rather than that of affected groups) capture public or decision-makers’ minds.
The political factors can involve not only domestic agents and institutions but also foreign or global ones. Pogge, for example, highlights the role of the resource and borrowing privileges, the poor policing by developed countries of the bribery practices of their large corporations and the international arms trade (the majority of which is tied to the US and other developed countries) in encouraging corruption and partisanship in the domestic politics of developing countries (see for example Pogge 2002: 113-6 and Pogge 2005: 336). Political context in a developing country can also be affected by the political, diplomatic or military intervention of a foreign government. A foreign government may intervene on behalf of a special interest lobby which has interests in the developing country.
Marginalised groups in developing countries are particularly vulnerable when special interest groups pursue their agenda. Often, they have neither access to national news media to make their plight known, nor the wherewithal (in terms of literacy, experience, organisation, wealth, leisure) to make their case effectively to courts, politicians or bureaucrats. In India, for instance, tribal peoples (collectively referred to as Adivasi peoples), Dalits and the landless are among the most marginalised groups. Adivasis comprise roughly 8% of the country’s population, yet compose more than 40% of persons displaced as a result of development projects. Dalits and other landless people together constitute a similar proportion of displaced persons (Bandopadhyay et al 2008: 15).
Consider an example. Suppose an entrepreneur wants to open up a new car manufactory in a developing country. It will petition politicians for a favorable location - close to highways, suppliers and ports. It will petition for subsidies on inputs – including basics such as cheap electricity and water, as well as industry specific inputs form other industries. It will petition for land not merely for the factory, but perhaps also for housing and other facilities for some of its employees and guests. This is especially the case if the development is some distance from established urban centres, as a certain level of facilities is required to entice skilled workers from urban centres to the rural setting.
There are various possible benefits to the region and to the country more generally of the construction of the factory. These include the creation of exportable goods, creation of relatively high-skilled jobs, an influx of technology into the economy, a spur to complementary industries in the region (especially if the location is relatively undeveloped or rural in nature).
First, however, some land must be acquired. In many cases, the private agent will not negotiate individually with the very large numbers of inhabitants in a densely populated urban or rural region in a developing country. This may be very costly for the private agent. This may be in money terms or in terms of reputation or legal consequences if the land acquisition encounters collective resistance or turns violent. There may also be legislative restrictions on private agents buying land from certain populations in developing countries. Indigenous and tribal populations, for example, are sometimes protected in this way. This is to address the imbalance in bargaining power and familiarity with law and regulation between these groups and corporations which makes unfair deals very likely.
The land acquisition may require displacing existing inhabitants and users of the land. The gross product of the country, and perhaps also the local region, may well benefit from the building and operation of the factory as compared to a status quo use of the land. Nonetheless, the displacement may be very costly. One might think that compensating the displaced for their land might solve the issue.
However, it can be extremely difficult to arrive at a satisfactory valuation for land. In some cases, the government may want the land for uses the market will not value highly. For example, consider the ongoing controversy over the Sardar Sarovar mega-dam project in India. Many villages are expected to be submerged by the large reservoirs which result from the dams. If this expected future use of the land is known, the market price at the time is likely to be untrustworthy (Ray 1998: 157).
Even if a market price is clear, it may not reflect the cost imposed on the displaced. Costs of displacement include, but are not limited to, the following. This list of eight processes that lead to impoverishment is taken from Cernea 1995 (pp251-2).
· Landlessness is costly in that land is often the foundation for productive systems, commercial activities and livelihoods.
· Joblessness affects not only urban displaced but also rural people – landless labourers, service workers, artisans and small businesspersons. Creation of new jobs can be difficult and unemployment may last well beyond relocation.
· Homelessness may be temporary but may also be chronic. There is also a sense of cultural homelessness.
· Marginalization occurs when families lose economic power and slide downwards. It can begin well before displacement, as condemned land becomes devalued, new investments are prohibited and social services are undercut.
· Increased morbidity results from relocation-related diseases and from increased stress and trauma. Vulnerability to disease is increased and unsafe water supply and waste systems contribute to spread of infectious disease.
· The risk of food insecurity rises as sudden drops in food availability and in income are certain during relocation.
· Loss of access to common property is a substantial matter for the landless and otherwise assetless poor. Relocation can mean loss of access to forests (a source of food, medicine, construction material), water bodies, grazing lands. Since these are common property or are not thought of as property at all, these losses generally escape compensation calculations.
· Social disarticulation involves dismantling of a community’s social organization, and the dispersion of formal and informal networks, associations, local societies and so on. This can include some very tangible losses. For instance, traditions within a community may have meant that an individual could rely on the free labour of their fellows in certain projects like the construction of a house. Again, these losses generally escape accounting in compensation calculations.
Whether or not the announced compensation reflects the value of the land to the displaced, it may not even eventuate. Compensation may not be possible until after the project or reform has occurred and has had time to generate revenue. Yet, by then, the issue of compensation may have left the attention of the news media or the politician who promised the compensation may have left office. The incumbent politician may see no reason to carry through the promise if they judge that there will be no punitive public outcry as a result. Even when effected, compensation can be whittled away by corruption as it moves from politicians, bureaucrats and officials to the displaced.
Estimates in a report by the Indian government suggest that almost 75% of those displaced since 1951 (until 1996, when the estimate was released) were still awaiting rehabilitation (National Policy for Rehabilitation [Govt. of India] cited in Sainath 1996: 71). Moreover, these figures represent only those directly displaced by land acquisition. They do not include, for instance, landless laborers, fisherfolk or artisans or people outside designated ‘project affected areas’ whose livelihood depends on the resources or the economy in the affected area (Sainath 1996: 71-3). Only a third of persons displaced for the sake of development projects have been resettled (Bandopadhyay et al 2008: 15).
Another reason behind systematic bias against the marginalised and the poor lies not in their relative influence on politicians, but rather in their lack of influence on news media. Visibility in major news media and the ability to effectively voice one’s criticisms in news media can determine the issues which reach public consciousness. Whether a government can get away with helping a special interest group at substantial cost to a marginalised group depends a great deal on whether the cost will become widely known among the section of the public which is crucial to re-election. A public outcry among this section can be devastating to chances of re-election. The route to, and the effect on, wide public consciousness often depends on the amount and type of coverage given by major news media. This is especially the case where the marginalised group does not have significant interaction with the politically influential section of the population in the normal course of things. This may be because of geographical distance, or because of prejudice, or other, less pernicious, social norms.
The seriousness with which a government carries out consultation and impact assessment (of the costs of a policy) and the credibility which is properly attached to this is also important. Expecting that not all affected groups will be able to influence politicians or make their voices heard, consultation by a government can seek out the views of those affected and an impact assessment can try to objectively weigh the costs against expected benefits. As a regrettable matter of fact, governments, especially in developing countries, are not always good at doing this. Possible reasons for this include cost of adequate research, difficulty in conducting the research (geographical, security of access to conflict areas) and political corruption.
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Bandopadhyay , D. et al.; 2008; “Development Challenges in Extremist Affected Areas: report of an expert group to Planning Commission”; Rural Development Division, Government of India; http://planningcommission.nic.in/reports/publications/rep_dce.pdf
Cernea, Michael M. ; 1995; “Understanding and preventing impoverishment from displacement: reflections on the state of knowledge”; Journal of Refugee Studies; vol 8 issue 3; pp 245-64
Grossman, Gene and Elhanan Helpman; 1991; Innovation and Growth in the Global Economy; MIT Press, Cambridge MA
Kalshian, Rakesh; 2007; Caterpillar and the Mahua Flower: tremors in India’s mining fields; PANOS South Asia; New Delhi http://sanhati.com/wp-content/uploads/2007/08/caterpillar-and-the-mahua-flower.pdf
Krugman, Paul and Maurice Obstfeld; 2006; International economics : theory and policy (7th ed); Addison-Wesley; Boston MA
Sainath, Palagummi; 1996; Everybody loves a good drought: stories from India’s poorest districts; Penguin, New Delhi
Tags: Posts by Bumbu
This is a sumamry of Francisco Rodriguez and Dani Rodrik’s 1999 paper, “Trade Policy and Economic Growth: A Skeptic’s guide to Cross-National Evidence”, published by the National Bureau of Economic Research. It is available in full at http://www.nber.org/papers/w7081
Several recent studies have investigated the systematic relation between growth and trade or growth and liberalization using empirical data comparing countries with different trade regimes.
Rodriguez and Rodrik, in their 1999 paper, review four influential papers which are typical of this recent literature. The papers are Dollar 1992, Ben-David 1993, Sachs and Warner 1995 and Edwards 1998. Dollar 1992 is the most heavily cited paper on the link between growth and openness. Sachs and Warner 1995 is a close second, but it also develops an index of openness which has since been widely used in the cross national research on growth. The two other papers are also widely cited and are representative of different types fo methodologies. Ben-David 1993 considers income convergence in countries which have integrated (such as the European Community) and is representative of a strand in the literature which investigates the effect of trade on income convergence. Edwards 1998 undertakes a robustness analysis, using a wide range of trade policy indicators to see whether the relation between trade openness and growth is robust across indicators.
Rodriguez and Rodrik 1999 argue that these studies, which typify the approach of recent studies devoted to this task, have several methodological deficiencies which mean that the existing studies cannot be taken as evidence of a systematic link between trade openness and economic growth. This summary avoids most of the technical economics and econometrics details. For a fuller treatment, consult the paper itself.
Dollar 1992:
Dollar constructs two separate indices which are demonstrated to be negatively correlated with growth from 1976-85 for a sample of 95 developing countries. The indices are ‘index of real exchange rate distortion’ and ‘index of real exchange rate variability’. The indices aim to capture the notion of outward orientation. Outward orientation is discussed as a combination of two things. One, the level of protection, especially for production process inputs, is relatively low, resulting in a sustainable level of exchange rate which is favorable to exporters (the exchange rate is thus not too ‘distorted’ by the level of protection). Two, there is relatively little variability in exchange rate so that incentives are consistent over time (Dollar 1992: 524).
If the indices are a good measure of outward orientation, their correlation with growth would be potentially informative about the relation between trade openness and growth. However, Rodriguez and Rodrik criticize the indices as poor measures of outward orientation. Whatever correlation there may be between the indices and growth, if the indices are poor measures of outward orientation, then the correlation reveals little of significance about the relation between growth and free trade.
The distortion indexis sensitive to the form in which trade restrictions are applied. A country can seem more outward oriented in the index just by replacing import barriers with export taxes, even though they have the same relevant effect (of changing the domestic price ratio between import competing products and exportables) (Rodriguez and Rodrik 1999: 10). The first criticism relates to the fact that for the index to do a good job in ranking trade regimes according to restrictiveness, it is necessary that export policies play a comparatively small role. This necessary condition is not met in the world.
The adequacy of the index also depends considerably on the Law of One Price. The Law of One Price(LOP) holds that, over the long run, the price of a tradable good produced in different countries can diverge from one another when expressed in a single currency only when there exist trade restrictions or transport costs. The distortion index is based on a comparison of the price levels in various countries expressed in terms of a single currency. The assumption that LOP holds allows us to regard differences in price levels across countries as indicative of trade restrictions.
However, LOP does not hold in the world and thus the suitability of the index as a measure of trade orientation is further weakened. A recent review of empirical research on the issue suggests that tradables for which the LOP holds are the exception rather than the rule (Rogoff 1996: 650). It seems that differences in price levels between countries can be significantly affected by factors such as exchange rate policy which affects nominal exchange rate as well as by geographical factors such as proximity to sea routes and to global markets (Rodriguez and Rodrik 1999: 12).
For these reasons, the distortion index cannot be considered a good measure of outward orientation. The index is affected by factors other than trade restrictions, such as nominal exchange rate policy, geographical factors and the presence of export taxes and subsidies. Let us turn to the variability index.
The distortion index ranks countries by what it claims is the degree of outward orientation (though, we have seen reasons to question whether the index measures outward orientation). For many developing countries, this ranking more or less matches the impression created by other works which have sorted countries by trade orientation. However, there are some significant anomalies, where the distortion index judges some country X to be more outward oriented than country Y when previous works which sort countries by trade orientation have judged the relation between X and Y to be the opposite (Dollar 1992: 530). The number of anomalies falls sharply if we include the variability indicator as well as the distortion one (Dollar 1992: 531).
Thus Dollar uses a weighted average of the distortion and variability indices to create an orientation index (Dollar 1992: 532). However, as Rodriguez and Rodrik point out, the variability index has little to do with trade orientation (Rodriguez and Rodrik 1999: 12). Its inclusion in Dollar’s study appears to be somewhat ad hoc in order to match his rankings of trade orientation more closely to the rankings suggested by existing work and is not well motivated as capturing any aspect of outward orientation.
The indices used by Dollar are poor measures of outward orientation. The relation between countries ranked by the indices and their rates of growth thus shed no light on the correlation between free trade and growth.
Sachs and Warner 1995
The authors devise an index of openness which combines several aspects of trade policy. The rationale for combining the various policies into a single index is that these are different ways an economy can close itself to trade. The Sachs-Warner (SW) openness indicator (OPEN) is a zero-one dummy which takes the value of zero if the economy was closed according to any of these (Sachs and Warner 1995: 22):
1. it had average tariffs rates above 40% (TAR)
2. its non-tariff barriers covered on average more than 40% of imports (NTB)
3. it had a socialist economic system (SOC)
4. it had a state monopoly of exports (MON)
5. its black market premium exceeded 20% during either the 70s or the 80s. (BMP)
The black market premium is a measure of exchange control, and a large BMP indicates rationing of foreign exchange, which tends to be a form of import control (Sachs and Warner 1995: 25). The rationing of foreign exchange creates a black market for the currency.
The authors find that there is a difference in growth rates between economies which their variables class as open and as closed. In particular, economies classed as open by the OPEN indicator tend to have higher growth rates than ones classified as closed (Sachs and Warner 1995: 36-7).
Rodriguez and Rodrik discover that the correlation between OPEN and growth rates is largely due to the combination of BMP and MON. Little of the indicator’s statistical strength is lost if the other three policy aspects are excluded. Recall that these other three include the two most direct measures of trade policy – tariff (TAR) and non-tariff barriers (NTB), as well as SOC. An indicator constructed using only BMP and MON (let’s call this new indicator BM) very closely matches the results yielded by OPEN in classifying countries as closed or open to trade. By contrast, an indicator constructed out of TAR, NTB and SOC performs quite poorly in matching the classification yielded by OPEN (Rodriguez and Rodrik 1999: 16-9). BMP and MON do most of the work in the OPEN indicator’s classification of economies as either closed or open.
The degree of correlation between economies classed as closed by OPEN and lower rates of growth is matched to a large extent by the same correlation between economies classed as closed by BM and lower rates of growth. Rodriguez and Rodrik narrow their focus to BMP and MON and their relevance for rates of growth, since the other three components of OPEN do little work. Recall that the context is to analyze the relation between trade openness and growth via the OPEN indicator. The authors investigate whether the two variables MON and BMP correlate with other variables which have a detrimental effect on growth. If they do, and if these other variables have little to do with trade policy, then the correlation demonstrated by Sachs and Warner between OPEN and rates of growth cannot establish that differences in trade policy are the relevant factor in the differences in growth rates. For, these other variables which have little to do with trade policy (and which are yet to be discussed) could be responsible for the correlation between rates or growth and economies classed as closed by the OPEN indicator.
Their investigation reveals that, except for one country (Mauritius), the inclusion of MON in the SW dummy is indistinguishable from the use of a Sub Saharan Africa dummy for the countries studied by Sachs and Warner. The only info we can extract from this is that Sub Saharan economies have grown slower than the rest of the world in the period studied by Sachs and Warner (Rodriguez and Rodrik 1999: 20).
As for BMP, it is not a good measure of trade policy because it is also a proxy for many other variables unrelated to trade policy. Black market premia correlate highly with level of inflation, with debt/exports ratio, with wars and with institutional quality. It is reasonable to expect these latter things to affect growth (Rodriguez and Rodrik 1999: 22).
BMP and MON are overwhelmingly responsible for the effect of the SW index on growth. Yet, the two indicators are not very robust at controlling for variables which are not related to trade policy, such as an Sub Saharan Africa geographical dummy or indicators of macro-economic and political distress or poor institutions. Thus, the Sachs Warner study cannot justify inferences about the effect of trade openness on growth.
Edwards 1998:
Edwards 1998 does not construct a new indicator of openness as was the case in the previous two articles considered. Rather, Edwards considers the robustness of the openness-growth relationship to the use of different indicators. The idea behind this is that although particular indicators can be faulted, this is less of an issue if the estimated positive coefficient on openness is robust to ways in which openness is measured (Edwards 1998: 386).
Edwards carries out his analysis using nine different indicators of openness present in the literature, as well as a measure of schooling and a measure of initial income. Edwards concludes that the results suggest with tremendous consistency that there is a significantly positive relationship between openness and productivity growth (Edwards 1998: 391).
Rodriguez and Rodrik will argue that the results do not warrant such a strong conclusion. The robustness of the regression results are largely due to weighting and identification assumptions which Rodriguez and Rodrik argue are inappropriate. Edwards tests 19 specifications of the theory that openness promotes growth, spanning the nine indicators and a constructed indicator combining some of these indicators, and calculating regressions using weighted and instrumental weighted least squares.
Rodriguez and Rodrik argue against some of the assumptions in Edwards. They add that if we are to take seriously the fact that property rights are not excludable from the productivity growth regressions, (and we must do so, given the extensive literature on the protection of property rights being an important determinant of growth) we face the conclusion that of the 19 different specifications, we find a negative and statistically significant correlation between trade restrictions and productivity growth in only 3 cases (Rodriguez and Rodrik 1999: 25-7). The three cases which survive this initial scrutiny use the following indicators: the Collected Taxes Ratio (ratio of trade tax revenue to total trade), the World Development Report Index (a subjective index), and the Heritage Foundation Index (another subjective index). For these cases, Rodriguez and Rodrik criticize the data as inadequate.
In Edwards 1998, the Collected Taxes Ratio (CTR) is calculated based on raw data from the IMF (Edwards 1998: 389). Rodriguez and Rodrik are skeptical of this data, as many of its numbers for developing countries are implausible. For example, India, known to have one of the highest tariff rates in the world, is found to have an average ratio of only 2.4% according to the raw data. Rodriguez and Rodrik recalculate the CTR using the most recent data (at time of publication of their paper) from the World Bank and obtain very different, and more plausible, results. Using this new data set to perform the same regressions as Edwards and obtain quite different results which undermine Edwards’ result for the CTR indicator. The coefficient on average duties is, contrary to expectation, positive (meaning that higher CTR correlates positively with growth), albeit insignificant (meaning that the coefficient is too small to confidently establish a positive correlation). If import and export duties are considered separately, import duties yield a positive and significant coefficient and export duties are insignificant (Rodriguez and Rodrik 1999: 27).
The two other cases concern subjective indices constructed by the World Bank (the World Development Report Index) and the Heritage Foundation. Subjective indices are commonly criticised as suffering from judgment bias. It is telling, the authors emphasise, that the only indices which stand up their analyses are subjective ones.
In addition, the Heritage index rates trade policies in 1996. Yet, the period over which Edwards considers growth rates is 1980-90. Rodriguez and Rodrik recalculate the Heritage Foundation Index using its methodology but with data about trade restrictions from 1985-88, a period more fitting for Edwards’ study. When they replicate the relevant equation from Edwards using this new data, they find that the coefficient of correlation is insignificant. This suggests that the significance of the Heritage Foundation Index in Edwards’ regression is due to changes in trade policy which occurred after 1990.
The World Bank’s index exhibits several anomalies. For example, high growth Korea is ranked as more open than moderate growth Malaysia despite having higher tariffs and non-tariff barriers, higher exchange rate distortions and lower export/GDP ratio. Indeed, in another paper, Edwards himself had noted serious probems with the index (Edwards 1993: 1386-7). Further, given that the primary data for the World Bank’s index is the same as that used in some of the other work discussed earlier in the Rodriguez and Rodrik paper (where the data was not similarly telling of a connection between openness and growth), the authors conclude that it is likely that the significance of the index stems from subjective biases in the way that countries have been classified (Rodriguez and Rodrik 1999: 29).
All of this combines to leave the Edwards 1998 with little credibility in its conclusion of having demonstrated significant correlation between trade openness and productivity growth.
Ben-David 1993
Ben-David’s paper measures the effect of trade policy on income by investigating whether trade liberalization promotes income convergence. The expectation that liberalization may lead to income convergence is based in the factor price equalization theorem (FPE). The theorem holds that, under various conditions (including zero transport costs, identical technologies and equal numbers of goods and factors), free trade leads to factor price equalization. The idea is present in the common intuition that as a developed country and a developing country open to trade with one another regarding a certain product, the wage (the price of the labour factor of production) will fall in the former country and rise in the latter, and will approach equality.
Ben-David looks primarily at income convergence among countries belonging to the European Economic Community (EEC). He shows that there is a decrease in the dispersion of incomes among these countries in the post war era. Of course, this decrease in income dispersion could be due to many factors. To make the case that it as due to trade liberalization, he argues that (i) the convergence is not merely a continuation of a long term convergence trend unrelated to postwar economic integration; (ii) that the European countries which did not enter the free trade agreement did not experience the same level of convergence; and (iii) other subsets of economies in the world which were not economically integrated did not experience convergence. Rodriguez and Rodrik criticise these three arguments and thereby cast doubt on Ben-David’s conclusion.
Rodriguez and Rodrik argue that, despite what Ben-David claims, he has not shown that (i) is the case. They do this partly by including Germany in the calculations of the long term trend. Ben-David had excluded Germany because it has historically been one of the poorest of the six countries which began the EEC and yet is one of the wealthiest in Europe today. Were Germany included in Ben-David’s analysis, it might be claimed by detractors that all of the convergence among the EEC countries is due solely to Germany’s influence. Its exclusion, claims Ben–David biases the conclusion away from convergence, making his job harder (Ben-David 1993: 662).
However, Rodriguez and Rodrik point out that while Germany’s exclusion makes it harder for Ben-David to establish income convergence in post-war liberalization, it also hides Germany’s role in any potential long term trend of convergence. Its exclusion biases results in favour of the hypothesis that there is no long term convergence predating postwar liberalization. When Germany is included, it is much harder to discount the possibility that the income convergence is part of a long term trend predating post-war liberalization. It now appears that income dispersion has been on a downward trend for many decades before the war (Rodriguez and Rodrik1999: 31).
A look at the pre war history of the countries further reveals that the previous major period of trade liberalization from the 1820s until 1880 was actually accompanied by increased income dispersion (Rodriguez and Rodrik1999: 32). Moreover, the retreat from free trade beginning around 1880 was a period of income convergence which continued to the start of WWI.
The analysis of Rodriguez and Rodrik reveals that there is no long run tendency for trade liberalization to be associated with income convergence in the EEC and that there has been a trend towards income convergence beginning around the start of the 20th century and thus predating post war liberalization (Rodriguez and Rodrik1999: 33).
Ben-David then turns to the next three countries to join the EEC (after the EEC began with the initial members) and to whether their income differentials behaved just as those of the original six (Ben-David 1993: 662-3). He looks at changes in income dispersion amongthese three countries – UK, Ireland and Denmark. Rodriguez and Rodrik point out that the relevant issue is income convergence between these countries and the otherEEC members and not convergence among the three countries themselves, as the relevant policy change is that the three countries relaxed trade restrictions between themselves and the initial EEC members. Looking at this, Rodriguez and Rodrik find that the three countries do not show a marked change in their pattern of convergence with EEC levels of income after the change in their trade policy regarding the EEC in 1965.
Ben-David then compares the income convergence of subsets of world economies which, unlike the EEC group of economies, have not liberalized their trade with one another. From the groups of economies he considers, he obtains the result he desires. Rodriguez and Rodrik criticise Ben-David’s selection of groups opf economies for this comparison. They note that the groups whose incomes are converging in Ben-David’s selection are geographically close, while the diverging groups are geographically distant. The obvious confounder is that what Ben-David claims is the effect of economic integration may in part be the effect of geographical proximity. For a fair comparison, we must ask whether free trade or lack thereof among geographically adjacent economieswould lead to convergence or divergence (Rodriguez and Rodrik 1999: 34).
Looking at geographically adjacent groups of economies, Rodriguez and Rodrik find that the economies of East Asia – canonical examples of open economies – have experienced steadily divergingincomes since the 1960s. Meanwhile, the economies of Latin America – canonical examples of closed economies – have experienced a steady decrease in divergence during their period of import substitution. Moreover, dispersion jumps upwards as countries in Latin America begin to liberalize trade. The authors make the point that while there are areas of the world where convergence has been accompanied by trade liberalization, there are also regions where the opposite is true. Ben-David’s study cannot justify belief in a systematic relationship between convergence and liberalization (Rodriguez and Rodrik 1999: 34-5). The authors also cite Slaughter 1998 as a recent empirical study which shows that liberalization does not lead to convergence in the cases studied (formation or EEC, of European Free Trade Agreement, liberalization between EEC and EFTA and the Kennedy round tariff cuts under GATT).
Ben-David’s paper fails to establish that the income convergence follows trade liberalization as serious criticisms can be brought against each of (i), (ii) and (iii) which were to be established in order to settle the larger question.
This ends my discussion of the papers reviewed in Rodriguez and Rodrik. Let me summarise the sorts of criticisms they have mounted. They questioned the adequacy of openness indicators at measuring the effects of trade policies; pointed out cases where openness indicators may be reflecting factors which influence growth but which are not part of trade policy; noted cases where the data used in studies was unreliable and where the results of a study changed substantially when more plausible data was substituted; they argued that the methodology in some cases was poor and again noted the substantial change in results when better methodology was used.
Rodriguez and Rodrik rightly caution that their paper reviewing recent attempts to demonstrate a link between openness and growth is not intended to bolster support for the position that trade restrictions promote growth. The context for their paper is their belief that there has been a tendency in academic and policy discussions to greatly overstate the systematic evidence in favour of trade openness. The motivation for their paper is to provide a corrective to this, showing that the touted evidence is not convincing and to foster a stance of humility about the state of research into the connection between trade and growth (Rodriguez and Rodrik 1999: 39).
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Ben-David, Dan; 1993; “Equalizing Exchange: Trade Liberalization and Income Convergence”, Quarterly Journal of Economics; vol 108 issue 3; pp653-79
Dollar, David; 1992; “Outward Oriented Developing Economies Really Do GrowMore Rapidly:Evidence from 95 LDCs, 1976-1985″; Economic Development and Cultural Change; vol 40 issue 3; pp 523-544
Edwards, Sebastian; 1998; “Openness, Trade Liberalization, and Growth in Developing Countries”; Journal of Economic Literature; vol 31 issue 3; pp 1358-93
Rogoff, Kenneth; 1996; “The Purchasing Power Parity Puzzle”; Journal of Economic Literature; vol 34 June; pp 647-668
Sachs, Jeffrey, Andrew Warner, Anders Aslund, Stanley Fischer; 1995; “Economic Reform and the Process of Global Integration”; Brookings Papers on Economic Activity; 1995 issue 1; pp1-118
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