From Trade Theory to Trade Policy

1. From Trade Theory to Trade Policy • Gains from Trade: due to comparative advantage, produce surplus, convert it into export to pay for imports in case of unrestricted free trade. But the trading world is at best imperfect. • Primary commodities exports may experience a long-run decline in prices --- Prebisch-Singer theorem. Thus, an emphasis on manufacturing may be justified. But imperfect capital markets may not allow countries to follow this path. Thus, trade policy that restricts imports while a country gains comparative advantage might be an option. • Free trade gains are possible but subject to two qualifications: • The gains are usually unequally distributed ->Stolpher-Samuelson Theorem • Missing markets or incomplete markets may provide counter arguments against free trade. • Chapter 17 discusses two policies related to trade. • 1. Export Promotion – use of export subsidies, directed credit and their effects on • Welfare • 2. Import Substitution – use of tariffs and quotas to restrict imports, their effects on • exchange rates and welfare. • The practice of strict import-substitution by many countries has been reduced as • more countries switch to export promotion. Two policies, stabilization (by the IMF) • and structural adjustment (by the WB) expedited the switch to export promotion.

2. Trade Policy • Ongoing controversy on the: • Content of appropriate trade strategy • Consequences of trade openness on growth Empirical debate on the “trade and growth nexus”: Numerous papers emphasized a positive link: Dollar (1992), Sachs and Warner (1995) Growing criticism: Rodrik and Rodriguez (2000): Read “Globalization Survey” & Krugman’s “Ricardo’s Difficult Idea” in his defense of the principle of comparative advantage. • GROWING CONSENSUS • Need to improve the measurement of “trade policy” • No unconditional impact of trade policy: • depends on the context (growth or recession period) • depends on the country (specialization, institutions, accompanying measures)

3. Problems of the Dual Economy Most developing countries are characterized by economic dualism. • A high-wage, capital-intensive industrial sector coexists with a low-wage traditional sector. Dualism is associated with trade policy for two reasons: • Dualism is probably a sign of markets working poorly (market failure case for deviating from free trade). • The creation of the dual economy (an economy that is characterized by economic dualism) has been helped by import-substitution policies. Problems of the Dual Economy A. The Symptoms of Dualism Development often proceeds unevenly and results in a dual economy consisting of a modern sector and a traditional sector. The modern sector typically differs from the traditional sector in that it has: --Higher value of output per worker; -Higher wages,-Lower returns to capital,--Higher capital intensity,--Persistent unemployment (especially in urban areas)

4. Problems of the Dual Economy B. Dual Labor Markets and Trade Policy • The symptoms of dualism are clear signs of an economy that is not working well, especially in its labor markets. • Wage differentials argument • The wage differences between manufacturing and agriculture is a justification for encouraging manufacturing at agriculture’s expense. • When there is a wage differential, the manufactures wage (WM) must be higher than the food wage (WF). The Harris-Todaro model • It links rural-urban migration and unemployment that undermines the case for favoring manufacturing employment, even though manufacturing does offer higher wages. • Countries with highly dualistic economies also seem to have a great deal of urban unemployment. • An increase in the number of manufacturing jobs will lead to a rural-urban migration so large that urban unemployment actually rises. • It helps the wage differentials argument to be in disfavor with economists.

5. Value of marginal products, wages B WM A C WF PMx MPLM PFx MPLF OM OF L1 L2 Labor employed in manufactures Labor employed in food Total labor supply Problems of the Dual Economy The Effect of a Wage Differential

6. Problems of the Dual Economy & EXPORT PROMOTION C. Trade Policy as a Cause of Economic Dualism Trade policy has been accused both of: • Widening the wage differential between manufacturing and agriculture • Fostering excessive capital intensity Wage differentials are viewed as: • A natural market response • The monopoly power of unions whose industries are sheltered by import quotas from foreign competition Export-Oriented Industrialization: the East Asian Miracle From the mid-1960s onward, exports of manufactured goods, primarily to advanced nations, was another possible path to industrialization for the developing countries. High performance Asian economies (HPAEs) • A group of countries that achieved spectacular economic growth. In some cases, they achieved economic growth of more than 10% per year.

7. Trade policy in practice: Failure of Export Promotion Unfavorable demand side factors 1) Low income elasticities of demand of primary products 2) Little demand expansion with low population growth in developed countries 3) Low price elasticities of demand of primary products 4) Development of synthetic substitutes 5) Increased efficiency in industrial uses of raw materials 6) Rising tide of protectionism for agriculture in developed countries 7) Oligopolistic control of commodity markets in developed countries 8) Shift from material-intensive goods to high-technology, skill-intensive products: decline in the demand for raw materials

8. Trade policy in practice: Failure of Primary Export promotion Unfavorable supply side factors 1) Rising productivity of agriculture in developed countries 2) Increasing competitive sources of supply in developing countries 3) Lack of product differentiation 4) Failure of international commodity agreements aimed at stabilizing prices and cooperate to set output levels 5) Structural rigidity in rural production system of LDC prevents supply responses 6) Lack of incentives: taxes on exports reduce earnings and overvalued exchange rates reduce export competitiveness 7) Supply is discouraged by pernicious effects of developed countries trade (subsidies) and foreign aid policies Read “Addiction to Sugar Subsidies” Paper

9. Trade Policy in Practice: Illustration • Rich countries spend some US$300 billion a year on farm subsidies, about six times more than on development aid. • Every European Union (EU) cow gets about $2.50 a day in subsidies, a Japanese cow gets $7.50 a day! • The World Bank estimates that getting rid of farm subsidies in rich countries would cause a 17 percent rise in global agriculture production Summarizing Demand side: decline in demand for commodities and pressure for lower prices Supply side: increase in competition and discouragement of output and exports in developing world

10. Export-Oriented Industrialization: the East Asian Miracle The Facts of Asian Growth • The World Bank’s definition of HPAEs contains three groups of countries, whose “miracle” began at different times : • Japan (after World War II) • The four “tigers”: Hong Kong, Taiwan, South Korea, and Singapore (in the 1960s) • Malaysia, Thailand, Indonesia, and China (in the late 1970s and the 1980s) • The HPAEs are very open to international trade • Example: In 1999, exports as a share of gross domestic product in the case of both Hong Kong and Singapore exceeded 100% of GDP (132 and 202 respectively). Trade Policy in the HPAEs • Some economists argue that the “East Asian miracle” is the payoff to the relatively open trade regime. • The data in the below Table suggests that the HPAEs have been less protectionist than other, less developing countries, but they have by no means followed a policy of complete free trade. • Low rates of protection in the HPAEs helped them to grow, but they are only a partial explanation of the “miracle.”

11. Export-Oriented Industrialization: the East Asian Miracle Average Rates of Protection, 1985 (percent) • Industrial Policy in the HPAEs • Several of the highly successful economies have pursued industrial policies (from tariffs to government support for research and development) that favor particular industries over others. • Most economists have been skeptical about the importance of such policies because: • HPAEs have followed a wide variety of policies, but achieved similarly high growth rates. • The actual impact on industrial structure may not have been large. • There have been some notable failures of industrial policy.

12. Export-Oriented Industrialization: the East Asian Miracle Other Factors in Growth • Two factors can explain the rapid growth in East Asia: • High saving rates • Rapid improvement in public education • The East Asian experience refutes that: • Industrialization and development must be based on an inward-looking strategy of import substitution. • The world market is rigged against new entrants, preventing poor countries from becoming rich. Summary Trade policy in less-developed countries is concerned with two objectives: promoting industrialization and coping with the uneven development of the domestic economy. • Government policy to promote industrialization has often been justified by the infant industry argument. • Many less-developed countries have pursued policies of import-substituting industrialization. • These policies have fostered high-cost, inefficient production.

13. Trade policy in practice: Failure of Primary Export promotion IMPLICATIONS • Not only, impediments to export expansion are numerous, but also export expansion results in lower export prices (thus a transfer of income from poor to rich nations) • Thus, prospects of deterioration of terms of trade and thus of current account deficits Prospects: • grim as inevitability of further synthetic substitution & the unlikelihood of protection reduction in developed world • Static comparative advantages have dynamic disadvantages • Motivation for import substitution industrialization strategy • Thus prospects of deterioration of terms of trade and thus of current account deficits

14. Summary Most developing countries are characterized by economic dualism. • Dual economies have a serious problem of urban unemployment. The difference in wages between the modern and traditional sectors have sometimes been used as a case for tariff protection of the industrial sector. The HPAEs have industrialized not via import substitution but via exports of manufactured goods.

15. Import-Substituting Industrialization There is a great diversity among the developing countries in terms of their income per capita. Why are some countries so much poorer than others? • For about 30 years after World War II trade policies in many developing countries were strongly influenced by the belief that the key to economic development was creation of a strong manufacturing sector. The best way to create a strong manufacturing sector was by protecting domestic manufacturers from international competition. Import-Substituting Industrialization • From World War II until the 1970s many developing countries attempted to accelerate their development by limiting imports of manufactured goods to foster a manufacturing sector serving the domestic market. • The most important economic argument for protecting manufacturing industries is the infant industry argument.

16. Import-Substituting Industrialization The Infant Industry Argument • It states that developing countries have a potential comparative advantage in manufacturing and they can realize that potential through an initial period of protection. • It implies that it is a good idea to use tariffs or import quotas as temporary measures to get industrialization started. Example: The U.S. and Germany had high tariff rates on manufacturing in the 19th century, while Japan had extensive import controls until the 1970s. Problems with the Infant Industry Argument • It is not always good to try to move today into the industries that will have a comparative advantage in the future. Example: In the 1980s South Korea became an exporter of automobiles, whereas in the 1960s its capital and skilled labor were still very scarce. • Protecting manufacturing does no good unless the protection itself helps make industry competitive. • Example: Pakistan and India have protected their heavy manufacturing sectors for decades and have recently begun to develop significant exports of light manufactures like textiles

17. Import-Substituting Industrialization Market Failure Justifications for Infant Industry Protection -Two market failures are identified as reasons why infant industry protection may be a good idea: Imperfect capital markets justification • If a developing country does not have a set of financial institutions that would allow savings from traditional sectors (such as agriculture) to be used to finance investment in new sectors (such as manufacturing), then growth of new industries will be restricted. Appropriability argument • Firms in a new industry generate social benefits for which they are not compensated (e.g. start-up costs of adapting technology). Promoting Manufacturing Through Protection Import-substituting industrialization--The strategy of encouraging domestic industry by limiting imports of manufactured goods • Many less-developed countries have pursued this strategy. • Has import-substituting industrialization promoted economic development? • Many economists are now harshly critical of the results of import substitution, arguing that it has fostered high-cost, inefficient production.

18. Import-Substituting Industrialization Promoting Manufacturing Through Protection • Import-substituting industrialization The strategy of encouraging domestic industry by limiting imports of manufactured goods • Many less-developed countries have pursued this strategy. • Has import-substituting industrialization promoted economic development? • Many economists are now harshly critical of the results of import substitution, arguing that it has fostered high-cost, inefficient production. • Why not encourage both import substitution and exports? • A tariff that reduces imports also necessarily reduces exports. • Until the 1970s many developing countries were skeptical about the possibility of exporting manufactured goods. • In many cases, import-substituting industrialization policies dovetailed naturally with existing political biases.

19. Import-Substituting Industrialization Exports as a Percentage of National Income, 1999

20. Import-Substituting Industrialization Results of Favoring Manufacturing: Problems of Import-Substituting Industrialization • Many countries that have pursued import substitution have not shown any signs of catching up with the advanced countries. Example: In India, after 20 years of economic plans between the early 1950s and the early 1970s, its per capita income was only a few percent higher than before. Why didn’t import-substituting industrialization work the way it was supposed to? • The infant industry argument was not as universally valid as many people assumed. Import-substituting industrialization generated: • High rates of effective protection • Inefficient scale of production • Higher income inequality and unemployment

21. Import-Substituting Industrialization Promoting Manufacturing Through Protection • Import-substituting industrialization--The strategy of encouraging domestic industry by limiting imports of manufactured goods • Many less-developed countries have pursued this strategy. Has import-substituting industrialization promoted economic development? • Many economists are now harshly critical of the results of import substitution, arguing that it has fostered high-cost, inefficient production. Why not encourage both import substitution and exports? • A tariff that reduces imports also necessarily reduces exports. • Until the 1970s many developing countries were skeptical about the possibility of exporting manufactured goods. • In many cases, import-substituting industrialization policies dovetailed naturally with existing political biases.

22. Import-Substituting Industrialization Effective Protection of Manufacturing in Some Developing Countries (percent)

23. Import-Substituting Industrialization • Why didn’t import-substituting industrialization work the way it was supposed to? • The infant industry argument was not as universally valid as many people assumed. • Import-substituting industrialization generated: • High rates of effective protection • Inefficient scale of production • Higher income inequality and unemployment

24. Trade policy in practice: Limited success of import substitution Import substitution entails an attempt to replace commodities that are being imported, usually manufactured consumer goods, with domestic sources of production and supply. How? -Erect tariff barriers or quotas on imported products -Try to set up a local industry to produce these goods (buy technology or attract foreign companies through tax incentives) Rationale for bearing those costs • Industry will reap the benefits of large-scale production and lower costs (“infant industry argument for tariff protection”) • Improvement of the balance of payments: fewer imports. • Grown up infant industry will be able to compete in world markets and to generate net foreign-exchange earnings once it has lowered its average costs of production: prerequisite for export promotion

25. Trade policy in practice: Limited success of import substitution Expected benefits of protection • Protection against imports appears to be an appropriate means for fostering economies of scale, positive externalities, and industrial self-reliance as well as overcoming the pervasive state of economic dependence • Duties as major source of government revenue • Import restrictions represent an obvious response to chronic balance of payments and debt problems. • Developing countries can gain greater control over their economic destinies while encouraging foreign business interests to invest in local import-substituting industries

26. Limited success of import substitution Undesirable outcomes 1. Many IS industries protected from competition remained inefficient and costly to operate • To measure the degree of protection, we need to ask by how much these restrictions cause the domestic prices of imports to exceed what their prices would be if there were no protection. • Apparently low nominal protection can induce very high effective protection: percentage by which the value added at a particular stage of processing in a domestic industry can exceed what it would be without protection

27. Limited success of import substitution:Undesirable outcomes *2* Inflated prices of IS products increase costs for "forward" liked industries: inhibition of the industrialization process *3* Main beneficiaries of the IS process are foreign firms whose profits are remitted abroad *4* Heavy and often government-subsidized importation of capital goods resulted in minimal employment effect and worsening balance of payments situation *5* IS has often been accompanied by artificially overvalued local currency to lower the price of imports and as a result of repressed capital costs (interest rates)

28. Limited success of import substitution: Impediments to exports expansion of manufactured goods Empirically import substitution precedes export promotion/export-oriented industrial strategy (cf. East Asian economies) Example of East Asian economies is a source of inspiration: -encouraging indigenous skills, technologies, and firms -not just promoting labor-intensive manufactures but actively and systematically seeking to upgrade over time. Opportunities to replicate this process may now be reduced: -traditional starting with textile exports is “monopolized” by China’s “workshop of the world“ -new WTO rules would not permit discriminate support to industries (similar to South Korea in the 1970-80s) -strategy requires competent and politically powerful government which is often not to be found in LDCs

29. Empirical evidence on trade-growth relationship: Typical framework and Dollar and Kraay resultsRead “Globalization Survey “ Paper

30. Empirical evidence on trade-growth relationship Results:

31. Empirical evidence on trade-growth relationship: Result sensitivity to the measures (Rodrik critics) 1: Definition of globalization: based on level or evolution of tariffs Globalizers have greater decline in tariffs but have the highest tariffs!!

32. Empirical evidence on trade-growth relationship: Result sensitivity to the measures (Rodrik critics) 2. Selection of the country sample: Outliers “Tricks”: Globalizers include 6 additional countries (out of 18) that do not fit the stated criteria based on the argument that they joined GATT/WTO since the 1980s (in fact 42 countries did) No tricks: top 40 in terms of largest proportionate reduction in tariffs and largest proportionate increase in imports/GDP over the period 1980-84 to 1995-97, and select countries that make it to both lists.

33. Empirical evidence on trade-growth relationship: Result sensitivity to the measures (Rodrik critics) 3. Policy measure (tariff averages) versus outcome (import/GDP) measure If only tariff used: “globalizers”turn out to be the ones that suffered much greater output collapses in the early 1980s

34. Empirical evidence on trade-growth relationship: Endogeneity of the trade and growth relationship 1. Reverse causation: Numerous case studies (India) highlight that growth precedes trade liberalization

35. Empirical evidence on trade-growth relationship: Endogeneity of the trade and growth relationship 2. Omitted variables will be artificially overestimated if regression omits factor that is positively or negatively correlated with both trade & income growth Example: Positive: institutional reforms, price reforms Negative: conflict, drought… Proper estimation of β2 requires that those factors are accounted for in the regression: time fixed effects and county fixed effects (first-differencing) will not do the job β2

36. Something else .. allowed income increase (in case of China) In China price liberalization and de-collectivization (1980) greatly benefited the poor. Trade liberalization came after

37. Empirical evidence on trade-growth relationship: Endogeneity of the trade and growth relationship 2. Omitted Variables (contd) The issue of omitted variables is especially acute when outcome indicators are used (instead of policy): devoid of policy content In simple setting: no causal link between trade volume and growth but OLS regression would find a positive regression coefficient (correlation through geography and institutions): Do Instrumental Variables (IV) Dollar and Kraay rely on debatable instruments since lags of trade volume may explain growth not only though trade but also though the impact of past institutions on institutional change.

38. Conclusion;1 Growing consensus On the need to improve the measurement of “trade policy” to improve the quality of cross-country regression More and more voices to say that possibly the “average” impact of trade policy may not be positive since it is conditional : depends on the context (growth or recession period) :depends on the country: -specialization -complementary features such as institutions and accompanying measures) Greatest impediments to LDCs success in international trade markets may not only relate to trade policy: -exogenous impediments (international protection & geography) -endogenous barriers that relate to more general development problems

39. “Endogenous” impediments that limit SSA exports • labor market policies that induce rigidity and prevent labor from moving from less to more profitable activities; • rigidities in markets for land, particularly the inability of farmers to obtain full marketable title to land, which can prevent investment in both human and physical capital in agricultural export crops; • government policies that artificially raise the cost of capital; • domestic price regulation; • business regulations that impair ease of entry and exit; • government policies that establish or tolerate monopolies (other than natural monopolies) or business collusion; • failures of the rule of law, contract enforcement, property rights, which impairs all economic activity, including exports; • lack of technical capacity to meet international standards such as sanitary and phytosanitary standards; • inadequate infrastructure: lack of inland transport and inadequate port service for exports; cost of accessing information to conduct transactions • protracted domestic civil unrest, which increases risk and reduces investment.

40. Exogenous impediments that limit SSA exports A. International barriers imposed by exporting countries include: • high and uneven import tariffs, which distort the transmission of international prices to the domestic economy; • export taxes and prohibitions; • overvalued exchange rates, which systematically make exports artificially expensive and imports artificially inexpensive, and generally require foreign exchange rationing; • export marketing boards that affect relative prices; and • restrictions on foreign direct investment. B. Geographic trade-related impediments that may limit SSA exports include: • land-locked position, which can increase the cost of exporting products that can only be efficiently transported by land via neighboring countries; • regional instability or civil unrest in neighboring countries; and • recurring drought, famine, or other environmental adversities.