Globalization, Growth, and Trade

1. Globalization, Growth, and Trade Lectures 15-16: More on Specific Factors Model (SFM) & Dutch Disease 0

2. Review of SFM Model • M uT • uA MA pA • MT p* • • • • XA Lm 0 XT X L • Lx LA • LT L

3. Changes in Factor Earnings (A->T) (w/pM)T M pA slope = (w/pM)A pT 0 YA YT X L LA LT 45o L

4. Gains and losses from trade in SFM • Nominal factor returns: w, rX, rM • Real factor incomes: relative to index of all consumer prices, such as CPI = pxapm1-a , a = budget share of X

5. Growth and policy experiments • Growth: What happens when the labor force grows? When either sector’s capital stock expands? • Related questions: • Productivity improvement: What happens when producers adopt new, improved technologies? • Policies: What happens when integration with world market is conditioned, e.g. by a tariff? • Effects on production, resource allocation, aggregate income, income distribution?

6. Endowment growth - prod’n fn What happens when the labor force grows? When either sector’s capital stock expands? Y Y0 Y Y0 Y1 Y1 L1 0 L0L 0 L0L Labor force growth Sectoral capital growth

7. Labor Force Growth and the PPF M • u2 • u1 q2• q1 • p = –px/pm X • Labor force growth increases maximum achievable production in each sector (PPF shift need not be symmetric) •  As drawn here, which sector is relatively labor-intensive? Why? • At constant p, what happens to real factor returns?

8. Labor Force Growth and Income M uT uT MT pT XT X L LT L

9. Labor force growth and income distribution • When the labor force grows but capital remains fixed in each sector, what happens to wages? • What happens to returns to specific factors?

10. Specific Factor Growth (FDI) and PPF M • u2 • u1 q1• q1 q2• p = –px/pm X • Growth of endowment of sp. factor in exportables increases maximum achievable production in that sector only. •  Rybczinski effect: output of M sector must decline (why?) • At constant p, what happens to real factor returns?

11. SE Asia: growth & dev. in open economies • Thailand’s trade and FDI-driven economic boom • Indonesia’s oil wealth and “Dutch Disease”

12. Manufactured exports - developing countries • Which countries industrialize, and why? • Endowments: cheap labor, infrastructure, resource-scarce (?) • Relatively stable macroeconomic & political conditions • Lower barriers to investment and importation of inputs • Early industrializers: Japan, Taiwan, Korea… • Size of domestic market prohibited closed-economy growth  export orientation • Capital raised from domestic savings • Later industrializers: Thailand, Malaysia, VN • Same export orientation, but using foreign capital

14. Thailand: growth & poverty decline • In Thailand, growth was really fast in 1985-97 • During this decade, trade/GDP rose and so did FDI/GDP, especially from E. Asia • Poverty also declined very fast • Inequality did not increase much • Can we use SFM to understand these trends?

16. What factors contribute to poverty decline? • Overall economic growth • Direct anti-poverty policies • Indirect effects of international integration • Job creation, esp. low-skilled labor • Internal migration • Wage effects • Remittances

17. Thailand: direct anti-poverty policies • Policies addressing opportunity, security, and community • Opportunity: increasing labor productivity through education and training • Security: stabilizing incomes against shocks (e.g. economic recessions) • Community: building local capacity for economic development and protection for poor • These direct policies had only mixed success

18. Indirect policies: globalization as anti-poverty measure • Globalization after about 1984: • FDI inflows • Trade liberalization • Other pro-trade measures • Job creation through FDI and specialization in L-intensive tradables sectors • Change in structure of exports and employment: gr of L-intensive mfg • Transmission of gains: wage growth in non-ag and in ag/rural areas • These structural changes associated with globalization appear to account for the largest share of poverty alleviation progress in Thailand

20. Economy-wide spread of wage growth

21. Conclusions: Thailand • Labor-intensive growth, e.g. of manufacturing, has direct and immediate effects on poverty • FDI was mostly efficiency-seeking: E. Asian manufacturers looking for cheap labor • FDI increased stock of manufacturing sector capital • This raised total labor demand and encouraged rural-urban migration (spread of gains) • With prices mostly stable, real wages increased steadily through early 1990s

22. Break time!

23. Resource Curse: Overview(http://en.wikipedia.org/wiki/Resource_curse) • Countries with rich natural resource bases have worse growth and development outcomes. Why? • One reason: “Dutch Disease”: • 1960s: Oil/gas discoveries by Holland • Huge export “boom” from oil/gas sales, but… • Severe domestic inflation • Loss of manufacturing jobs and investment • Same phenomenon seen in other oil-rich countries • Are these changes all linked? • Specific factors model: increase in natural resource capital… effects on economy?

24. Nontraded goods and “real exchange rate” • SFM can explain structural change but not inflation • Need a 3rd sector – nontraded goods, with prices endogenous • Examples of NT goods; characteristics of markets • Goods may be non-traded (or effectively so) for intrinsic reasons, or because of policy interventions • D=S in domestic market; price must adjust to clear market • Demand for NT goods is usually elastic w.r.t. income growth • Therefore, rise in income means rise in pN/pX and pN/pM • Why do we care? 23

25. Non-Tradable Sector Tradable sector Demand and Supply in T and NT Sectors D’ P P D S D’ D p’ S p* Q q* q’ Q S is flat because p in T sector is set in world markets. S slopes up and p NT rises w/ increase in demand.

26. The ‘real’ exchange rate • Real exchange rate = price of N goods in terms of all T goods (= pN/pT) • RER is endogenous, even if prices of all T goods set in world mkts (‘small country assumption’) • It conveys effects of changes in one sector, or in aggregate income, to other sectors • Directly, through relative price changes • Indirectly, through changes in factor prices • RER rise: indicator of inflation relative to other countries --> changes in relative production costs 25

27. Salter-Swann diagram T RER = -pN/pT (yT, yN) = (cT, cN) N Note: All tradable goods in one index, on vertical axis 26

28. 2. Resource wealth Many dev. econs have relatively large resource sectors (minerals, agric., forestry) producing commodities for export to world mkts These sectors & their global markets have special characteristics-- incl. volatility What happens to the structure and performance of the economy when a resource sector experiences a “boom” (price rise, new reserve discovery, tech change)? What are the contradictions/risks of rapidly rising income from a single booming sector? 27

29. What do you think? • ‘Income effect’: new income raises spending across the board • Rise in N prices: domestic inflation, wage rises • Loss in profitability and jobs in T goods other than the ‘booming’ sector • Boom in gov’t revenues and spending • G. consumption or investment? • What about changes in factor returns? • Labor, ‘capital’ in booming sector, etc. • income distribution? 28

30. Dutch Disease • Could a natural resource boom lead to “deindustrialization” (or “deagriculturalization”)? • Why would a country like Venezuela export only oil products and import basic goods like eggs? • Why did Nigeria’s export agriculture sectors collapse in the 1980s, and what were the consequences for incomes, welfare and poverty? • Why is Indonesia’s manufacturing sector now failing to grow? 29

31. 3. Resource Boom Model • 3 Sectors: 1. Resource sector (oil, natural gas) - X 2. Tradable (Ag, Manuf) – M 3. All tradables together: T, so LT = LM + LX 4. Non-tradable (services, land) - NT Example (NT): Haircuts, restaurants, health, educ. • Small open economy, one mobile factor – labor • X production uses a specific factor (oil reserves, mineral reserves), M and N both use specific capital. 30

32. Economy-wide labor allocation before energy export boom 1. LNTL0 is labor in NT production 2. LTL0 is total labor in T prod’n 3. LTa is labor in manuf production 4. aL0 is labor in energy sector 5. w0 is econ-wide wage rate W W LT LNT LM WO LNT L0 a  LT 31

33. Labor allocation after the boom: resource movement effect LT' 1. LNTL1 is labor in NT production 2. LTL1 is total labor in T prod’n 3. LTb is labor in manuf production 4. bL1 is labor in energy sector W W LT LNT LM W1 w0 L1 L0 LNT a b LT 32

34. Labor allocation after the boom: incomes spending effect LT' LNT’ 1. New spending raises pNT 2. Lab demand in NT rises to LNT’ 3. Higher wages & labor costs for all industries 4. Manuf sector costs rise, output falls W W LT LNT LM W2 W1 w0 L1 L0 LNT a b c LT 33

35. Implications of Dutch Disease • Increased Dependence on Boom and Non-Tradable (NT) Sectors • Increased vulnerability to price shocks • World commodity markets are very volatile • NT sector adjusts through prices more than quantities • Higher risks of macro instability • Rising NT prices means inflation and speculation (property booms, unproductive investments) • Decline of tradable sector • Loss of comparative advantage is traditional industries (Nigeria palm oil) • May reduce potential for dynamic growth in manuf industries

36. Resource Curse:Lack of Diversification • Basic logic of why? • Dutch Disease model explains • Expectations of easy wealth • Incentives for entrepreneurs and innovators shifted to wealth-grabbing • Evidence of lack of diversification (boom sectors dominating exports, Boom and non-tradables sector dominating GDP)

37. Empirical Evidence on Lack of Diversification • Nigeria • Petroleum, 95% exports, 20% GDP, once a food exporter now importer, • 70% labor in agriculture, 17% of GDP. • Ecuador • Petroleum, 56% of exports, Bananas 12% • Oil-mining, 24% of GDP • Ag 6% GDP, 8% of labor • Services 60% of GDP, 68% of Labor • Iran • Petroleum, 80% of exports, • Ag 11% of GDP 30% of labor • Unemployment 20%

38. Resource Curse: Rent-Seeking Behavior • Huge incentives to capture the “rents” (excess profits of resources). Foreign exploitation potential is high. • Ex: $80/bbl of oil versus $8/bbl prod costs. • Rents = Super-normal profits • Political economy of country dominated by efforts to control & capture rents. • Crowds out other kinds of political and economic initiatives. • Conflict becomes central (as does potential for dictators or authoritarian regimes).

39. Resource Curse:Feeble Taxation Systems • State control of resources (nationalization or taxation) reduces need for development of other tax systems. • Oil-rich countries get almost all of their government revenues from state oil company or taxes. • Lack of public commitment to taxation system makes government vulnerable to volatile prices of oil or other leading resource. • Also undercuts commitment to public expenditures. • Low investment in public education common in resource rich countries (competitiveness of workers lower priority when resource rents are main source of wealth). • Low commitment to democracy as well if public sector not viewed as carrying out allocation of people’s tax revenues.

40. Resource Riches Not Always a Curse • Empirical examples • U.S., Canada, Australia • Chile (copper, fruits, lumber) • Norway and Sweden • Botswana • Malaysia • Brazil • Vietnam? • Why? • Types of resource riches (ag/ind. Links) • Types of institutions in place • Size of economy/diversity of production sectors • Timing of booms • Policy choices

41. Summing up • Growth and globalization have a complex relationship • Understanding these requires careful analysis • Simple models – heuristic devices (road maps) • Heckscher-Ohlin – ‘benchmark’ model • SFM: Extends H-O to take account of realities (natural resources, limited adjustment capacity) • Dutch Disease model: introduces macroeconomic dimension with endogenous prices and many more development/political economy stories

42. Looking forward • Tomorrow – quiz only • Next week – one meeting (return hwks and quizzes; discuss as needed)