1. Slides prepared by Thomas Bishop Lecture 9 Political Economy of Trade Contd. Trade Policy in Developing Countries

2. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-2 Organizational stuff Missing paper drafts Missing Assignment 3 Feedback Check Reserves List Page on website for Advanced Readings if you are interested… Assignment 4 due Thu, posted later today on the website

3. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-3 Preview International Trade Negotiations, WTO Preferential Trade Agreements China and WTO: What Price Membership Import substituting industrialization Trade liberalization since 1985 Export oriented industrialization Discussion about ch. 5 and 6 in Irwin Development Giants: Yunus, Sachs, Easterly

4. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-4 International Negotiations of Trade Policy The average US tariff rate on dutiable imports has decreased substantially from 1920–1993. Since 1944, much of the reduction in tariffs and other trade restrictions came about through international negotiations.  The General Agreement of Tariffs and Trade was begun in 1947 as a provisional international agreement and was replaced by a more formal international institution called the World Trade Organization in 1995.

5. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-5 US Tariff Rate Declines After GATT Talks

6. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-6 The Advantages of Negotiation 1.Easier to mobilize support for free trade (exporters can lobby for it) 2.Possibility to avoid trade wars

7. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-7 Exporters can lobby for free trade to counteract lobby of import-competing groups Multilateral negotiation mobilize exporters to support free trade if they believe export markets will expand (because the foreign country will open up to trade as well.)  This support would be lacking in a unilateral push for free trade.  This support counteracts the support for restricted trade by import-competing groups.

8. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-8 Multilateral negotiations prevent trade war Multilateral negotiations also help avoid a trade war between countries, where each country enacts trade restrictions. If each country has a political interest (due to political pressure) to protect domestic producers, regardless of what other countries do,  then all countries could enact trade restrictions, even if it is in the interest of all countries to have free trade. Let’s use a simple example to illustrate this point.

9. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-9 Game theory and Trade Wars

10. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-10 Temptation of Protection: In our example, you fare better with it whatever others do In this simple example, each country acting individually would be better off with protection, but both would be better off if both chose free trade. If Japan and the US can establish a binding agreement to maintain free trade, both can avoid the temptation of protection and both can be made better off.

11. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-11 World Trade Organization The WTO negotiations addresses trade restrictions in at least 3 ways: 1.Reduction of tariff rates through multilateral negotiations. 2.Binding: a tariff is “bound” by having the imposing country agree not to raise it in the future (this was very effective in the past).

12. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-12 WTO: Non-tariff barriers and exceptions… 3.Prevention of non-tariff barriers: quotas and export subsidies are changed to tariffs because the costs of tariff protection are more apparent.  Subsidies for agricultural exports are an exception.  Exceptions are also allowed for “market disruptions” caused by a surge in imports.

13. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-13 WTO Agreements The World Trade Organization was founded in 1995 on a number of agreements  General Agreement on Tariffs and Trade: covers trade in goods  General Agreement on Tariffs and Services: covers trade in services (e.g., insurance, consulting, legal services, banking).  Agreement on Trade-Related Aspects of Intellectual Property (TRIPs): covers international property rights (e.g., patents and copyrights).

14. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-14 World Trade Organization Disputes  The dispute settlement procedure: a formal procedure where countries in a trade dispute can bring their case to a panel of WTO experts to rule upon.  The cases are settled fairly quickly: even with appeals the procedure is not supposed to last more than 15 months.  The panel uses previous agreements by member countries to decide which ones are breaking their agreements.

15. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-15 WTO Enforcement Mechanisms  A country that refuses to adhere to the panel’s decision may be punished by allowing other countries to impose trade restrictions on its exports.

16. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-16 WTO and GATT WTO has a much stronger dispute settlement procedure If a complaint by a country is upheld by a WTO panel, retaliation is authorized if the offending country does not correct its policy

17. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-17 Trade Talks Rounds Geneva 1947 Annecy 1949 Torquay 1950-51 Geneva 1956 Dillon 1960-62 Kennedy 1964-67 Tokyo 1973-79 Uruguay 1986-93 Doha 2001-

18. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-18 Preferential Trading Agreements and WTO’s Most Favored Nation Principle Preferential trading agreements are trade agreements between countries in which they lower tariffs for each other but not for the rest of the world. Under the WTO, such discriminatory trade policies are generally not allowed:  Each country in the WTO promises that all countries will pay tariffs no higher than the nation that pays the lowest: called the “most favored nation” (MFN) principle.  An exception to this principle is allowed only if the lowest tariff rate is set at zero.

19. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-19 Free Trade Area There are two types of preferential trading agreements in which tariff rates are set at or near zero: 1.A free trade area: an agreement that allows free trade among members, but each member can have its own trade policy towards non-member countries  An example is the North America Free Trade Agreement (NAFTA).

20. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-20 Customs Union 2.A customs union: an agreement that allows free trade among members and requires a common external trade policy towards non-member countries.  An example is the European Union.

21. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-21 Preferential Trading Agreements: They May Decrease Economic Welfare Are preferential trading agreements necessarily good for national welfare? No, it is possible that national welfare decreases under a preferential trading agreement. How? Rather than gaining tariff revenue from inexpensive imports from world markets, a country may import expensive products from member countries but not gain any tariff revenue.

22. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-22 Trade creation and diversion Preferential trading agreements increase national welfare when new trade is created, but not when existing trade from the outside world is diverted to trade with member countries. Trade creation  occurs when high cost domestic production is replaced by low cost imports from other members. Trade diversion  occurs when low cost imports from non-members are diverted to high cost imports from member nations.

23. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-23 Theory of trade blocs: other gains Other possible sources of gains to members of a trade bloc include: 1.Increased competition that lowers prices or costs 2.Enhanced ability to achieve scale economies 3. Attracting more direct investment by foreign companies

24. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-24 Overall effects of a trade bloc Whether a trade bloc is good or bad overall depends on the difference between its - gains from trade creation (and any other positive effects) - and its losses from trade diversion.

25. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-25 Other types of economic blocs 1.Free trade area (NAFTA ‘94) 2.Customs union (MERCOSUR ’91) 3.Common market (EU ’92) 4.Economic union (Belgium/Luxembourg)

26. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-26 Features of Bloc Type of BlocFree trade among members Common external tariffs Free movement of factors Harmonization of all econ policies Free-trade areaYes Customs unionYes Common marketYes Economic unionYes

27. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-27 Trade blocs—facts By mid-2000s, nearly half of world trade occurred within functioning trade blocs Today, almost every country is a member of some trade bloc (Mongolia and Taiwan were the exceptions in 2005)

28. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-28 World Trade Blocks

29. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-29 China and WTO 3 major types of reforms: WTO commitments and implementation Impact of WTO membership on China: What was the price of the membership? Tensions with the West. Impact of China’s WTO membership on world?

30. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-30 China’s Stock Market Soaring Recently

31. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-31 Trade and Development Import substituting industrialization Trade liberalization since 1985 Export oriented industrialization Discussion about ch. 5 and 6 in Irwin Faces of Development: Easterly, Yunus, Sachs

32. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-32 Introduction Which countries are “developing countries”? The term “developing countries” does not have a precise definition, but it is a name given to many low and middle income countries.

33. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-33 Other names Less Developed Countries Emerging Markets

34. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-34 Introduction

35. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-35 GDP GDP per capita GDP Growth 2003 2003 2003 2003 (bn US$) (PPP bn US$) US$ PPP US$ ’75-’03 ’90-’03

36. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-36 UN Human Development Index Three components 1. A long and healthy life (life expectancy at birth etc) 2. Knowledge (adult literacy and gross school enrollment ratio) 3. Standard of living (GDP per capita in purchasing power parity terms: takes into account prices of goods, $1,000 will buy you more in a country with lower prices than in US)

37. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-37 Implications Richest nations don’t have to be the ones with the highest human development US higher income per person than Australia, but Australia no. 3 on HDI, US no. 10

38. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-38 HDI Winners & Losers Top countries 1. Norway 2. Iceland 3. Australia 10. USA Bottom 2 countries Sierra Leone Niger

39. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-39 Import Substituting Industrialization Import substituting industrialization was a trade policy adopted by many low and middle income countries before the 1980s. The policy aimed to encourage domestic industries by limiting competing imports. It was often accompanied with the belief that poor countries would be exploited by rich countries through international financial markets and trade.

40. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-40 Some industries protected by regulations equivalent to tariffs rates of 200% or more

41. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-41 Infant Industry Argument The principal justification of this policy was/is the infant industry argument:  Countries may have a potential comparative advantage in some industries, but these industries can not initially compete with well-established industries in other countries.  To allow these industries to establish themselves, governments should temporarily support them until they have grown strong enough to compete internationally.

42. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-42 Problems With the Infant Industry Argument 1.It may be wasteful to support industries now that will have a comparative advantage in the future. 2.With protection, infant industries may never “grow up” or become competitive. 3.There is no justification for government intervention unless there is a market failure that prevents the private sector from investing in the infant industry.

43. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-43 Infant Industries and Market Failures Two arguments for how market failures prevent infant industries from becoming competitive: 1.Imperfect (financial) capital markets  Because of poorly working financial laws and markets, new industries are not allowed to borrow as much as they need, which results in restricted economic growth.  If creating better functioning laws and markets is not feasible, then high tariffs would be a second-best policy to increase profits for new industries, leading to more rapid growth.

44. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-44 2. The problem of appropriability (of positive spillovers/externalities)  Firms may not be able to privately appropriate the benefits of their investment in new industries because those benefits are public goods.  The knowledge created when starting an industry may be not appropriable (may be a public good) because of a lack of property rights.  If establishing a system of property rights is not feasible, then high tariffs would be a second- best policy to encourage growth in new industries.

45. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-45 Import Substituting Industrialization Worked In Encouraging Manufacturing As a strategy to encourage manufacturing industries, import substituting industrialization in Latin American countries worked in the 1950s and 1960s.

46. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-46 Success in development of manufacturing, but not in development… But economic development, not encouraging manufacturing per se, was the ultimate goal of the policy. Did import substituting industrialization promote economic development?  No, countries adopting these policies grew more slowly than rich countries and other countries not adopting them.

47. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-47 New industries didn’t become competitive, ISI involved costs and waste of resources It appeared that the infant industry argument was not as valid as some had initially believed. New industries did not become competitive despite or because of trade restrictions. Import substitution industrialization involved costs and promoted wasteful use of resources:  They involved complex, time-consuming regulations.  They set high tariff rates for consumers, including firms that needed to buy imported inputs for their products.  They promoted inefficiently small industries.

48. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-48 Examples Taiwan, South Korea practiced ISI, then switched to export-promotion and started growing 10% a year Ghana encouraged ISI and subsequently experienced a 42% decline in living standards in 1974-84

49. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-49 Is trade liberalization bringing growth to developing economies? Evidence is mixed

50. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-50 Study supporting the view that openness promotes growth World Bank Study The newly globalizing developing economies grew 5% p.a. in 1990s and 3.5% p.a. in 1980s Other, not so open developing countries grew by 0.8% and 1.4% p.a. respectively Developed countries grew at about 2.2%

51. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-51

52. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-52 Tariffs fell everywhere but not all regions grew fast as we saw in the table earlier

53. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-53 Opening up is not always good… Trade liberalization does not stimulate growth in economies with excessive regulation, and may even retard it, data from a World Bank study of more than 100 countries show. Excessive regulations restrict growth because resources are prevented from moving into the most productive sectors and to the most efficient firms within sectors.

54. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-54 …if it’s not preceded by deregulation Regulation=bureaucracy, permits, taxes and licenses that make business more difficult Chile's low regulatory barriers allowed resources to be reshuffled to the most efficient producers and largely contributed to the growth spurt following trade liberalization.

55. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-55 Heavily regulated economies don’t benefit much from free trade By contrast, in highly regulated economies, increased trade liberalization is more likely to occur in the "wrong" goods – where comparative advantage does not lie. The results imply that regulatory reform enhances the benefits from trade liberalization.

56. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-56 Trade Liberalization By the mid-1980s many governments had lost faith in import substituting industrialization and began to liberalize trade.

57. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-57 India and Brazil liberalized trade

58. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-58 Trade Liberalization Lead To Higher Share of Trade on GDP in Developing Countries

59. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-59 Mixed evidence on growth effect of trade liberalization Has trade liberalization promoted development?  The evidence is mixed.  Growth rates in Brazil and other Latin American countries have been slower since trade liberalization than the were during import substituting industrialization.

60. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-60 Non-trade factors that affect growth  But unstable macroeconomic policies and financial crises contributed to slower growth since the 1980s.  Other countries like India have grown faster since liberalizing trade in the 1980s, but it is unclear to what degree liberalized trade contributed to growth.  Some economists also argue that trade liberalization has contributed to income inequality, as the Hechscher-Ohlin model predicts.

61. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-61 Export Oriented Industrialization: High Performance Asian Economies Instead of import substituting industrialization, several countries in East Asia adopted trade policies that promoted exports in targeted industries.  Japan, Hong Kong, Taiwan, South Korea, Singapore, Malaysia, Thailand, Indonesia and China are countries that have experienced rapid growth in various export sectors and rapid economic growth in general.  These economies or a subset of them are sometimes called “high performance Asian economies”.

62. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-62 Open Economies, sure… But Are they also “Free Traders”? These high performance Asian economies have generated a high volume of exports and imports relative to total production.  By this standard, these economies are “open economies”. But it is debatable to what degree these economies established “free trade”.  Although evidence suggests that these economies did have less restricted trade than other low and middle income countries, some trade restrictions were still in effect during different times.

63. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-63 Asian Tigers Had Lower Tariffs, But Not That Much Lower…

64. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-64 Trade and Growth: Causation or Correlation? It is also unclear if the high volume of exports and imports caused rapid economic growth or was merely correlated with rapid economic growth.  Some economists argue that the cause of rapid economic growth was high saving and investment rates, leading to both rapid economic growth in general and rapid economic growth in export sectors.  In addition, almost of the high performance Asian economies have experienced rapid growth in education, leading to high literacy and numeracy rates important for a productive labor force.

65. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-65 Industrial Policies in East Asia Some East Asian economies have implemented industrial policies: policies intended to promote certain industries.  Examples of industrial policies include not only tariffs, import restrictions, and export subsidies for import-competing industries and export industries,  but also policies like subsidized loans for industries and subsidized research and development. But not all high performance Asian economies implemented these policies, and the ones that did had a wide variety of policies.

66. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-66 Industrial Policies and Growth There is little evidence that countries with industrial policies had more rapid growth in the targeted industries than those that did not. There is some evidence that industrial policies failed: chemicals, steel, automobiles were promoted by the South Korean government in the 1970s,  but the polices were later abandoned because they were too expensive and did not produce desired growth.

67. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-67 Irwin, Free Trade Under Fire, Chapter 6, pp. 160-188 China and India Success and failure of trade reform Government’s role and East Asia Developed world’s barriers

68. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-68 China and India Poverty rate down from 28% in ’78 to 9% in ’98 in China In India, poverty down from 45% in ’83 tp 26% in 2000 Economic Growth…

69. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-69 Success and failure South Korea Vietnam Chile Mexico Latin America Africa: Kenya, West Africa Former Soviet Union

70. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-70 Government’s Role Industrial policy Business environment, infrastructure East Asia  Japan (MITI)  South Korea Applicable elsewhere in Asia/world?

71. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-71 Developed Countries Protectionism Agriculture 1/3 of every $1 of farmer’s income in OECD comes from government policies In poor countries agriculture 60% of workforce, 25% of GDP Reduction in tariffs would help more than subsidies But cotton and textiles/apparel subsidies still cost poor countries dearly

72. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-72 Faces of Development: Yunus, Sachs, Easterly Muhammad Yunus, Grameen Micro- Credit Bank, 2006 Nobel Peace Prize Jeffrey Sachs, Columbia Earth Institute Only academic consistently ranked as one of world’s most influential people William Easterly, left the World Bank, NYU’s Development Research Center

73. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-73 Prof. Muhammad Yusuf: Microcredit Econ. Prof. in Tennessee Founder of Grameen Microcredit Development Bank in Banghladesh Small loans can make huge difference for poor Model now emulated in over 20 countries, including USA

74. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-74 Prof. Jeffrey Sachs: Foreign Aid Advisor to UN Secretary General Ban Ki-moon The End of Poverty book Poverty kills 20K people a day Focus on disease control— HIV/AIDS, malaria Foreign aid needed to escape poverty trap

75. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-75 Prof. William Easterly: Incentives White Man’s Burden Rebuttal of Sachs Skeptic about Sachs’s Big Plan to end World Poverty by 2025 Utopian social engineering vs piecemeal democratic reform

76. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-76 Summary 1.Import substituting industrialization aimed to promote economic growth by restricting imports that competed with domestic products in low and middle income countries. 2.The infant industry argument says that new industries (e.g., in poor countries) need temporary trade protection because of market failures:  imperfect capital markets that restrict borrowing  problems of appropriating gains from private investment

77. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-77 Summary (cont.) 3.Import substituting industrialization was tried in the 1950s and 1960s but by the mid-1980s it was abandoned for trade liberalization. 4.The precise effect of liberalized trade on national welfare is still being debated.  Trade helped growth in some sectors, but saying that trade caused higher overall economic growth has attracted some skepticism.  Some argue that trade has caused increased income inequality.

78. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-78 Summary (cont.) 5.Several East Asian economies adopted export oriented industrialization instead of import substituting industrialization.  High export and import volumes and relatively low trade restrictions were characteristics of this policy.  But it is unclear to what degree this policy contributed to overall economic growth. 6.Some East Asian economies used more general industrial policies as well.  But it is unclear to what degree this policy contributed to or hindered overall economic growth.

79. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 10-79 Reading assignment for next class Irwin pp. 189-202: Trade and Labor Standards Irwin pp. 231-249: Trade and the Environment