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
  -gtStolpher-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 Krugmans
Ricardos 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 agricultures 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
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 US300 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 Banks 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 didnt 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 didnt 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 substitutionUndesirabl
e 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 Chinas 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 globalizersturn 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
ß2
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 ß2 requires that those factors are
accounted for in the regression time fixed
effects and county fixed effects
(first-differencing) will not do the job
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
Conclusion1

• 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.