Trade for Growth: Revaluating the Argument for Free Trade and Exploring Unorthodox Trade Pathways for Growth.

Trade for Growth: Revaluating the Argument for Free Trade and

Exploring Unorthodox Trade Pathways for Growth. 

The current international trade regime is characterised by the advocacy of free trade. The arguments of free trade date back to Adam Smith (1776) in which he argues that

“It is the maxim of every master of a family never to attempt to make at home what it will cost him more to make than to buy…if a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it off them with some part of the produce of our own industry, in which we have some advantage”.

 Mankiw (2004) claims the free trade argument is conventional wisdom and that “few propositions command as much consensus among professional economists as that open world trade increases economic growth and raises living standards”. However, such a surface view ignores the “ladder-kicking” (Chang, 2002) of the international trade regime as all major developed countries had used protectionism to develop and now attempt to forbid other countries from utilising the same policies that propelled them along the development pathway. This paper critically evaluates the conventional wisdom of the free trade argument and demonstrates how free trade restrains development in the global south. The paper begins by outlining how protectionism propelled Great Britain’s growth in the mercantilist era. It then offers a cost/benefit analysis of free trade before introducing Import Substitution Industrialisation (ISI) as a means of using trade for development. A contrast between the two experiments of ISI, the “East Asian Miracle” and Latin America’s own experience will be applied which shows what is needed to ensure effective execution.

How Mercantilism Propelled Britain’s Growth.

Mercantilism is a nationalist ideology that utilises state power to supress import presentation whilst systematically preventing reciprocal restrictive practises from other states. High tariffs were an “universal feature of mercantilist policy” (McCusker, 2001) and informed almost all of the theory and practise of economic policy up until 1500 (Watson, 2008). Mercantilism is therefore inextricably linked to the economic environment where large industries developed in Europe and its experiences of industrialisation (Watson, 2008). England was the first state to embed mercantilism in its economic order and an early statement in 1581 surmised its approach: “We must take heed that we buy no more than strangers than we sell them, for we impoverish ourselves and enrich them” (Hales, 1893). Mercantilism reflected “low” political priorities of nations desiring to industrialise in contrast to “high” political priorities of world affairs that characterised the 1900’ (Blaug, 1996). England’s eminent position in 17^th century trade-relations was, in Mun’s (1664/1928) treatise, due to its capacity to adapt its commercial activities to produce continual trade surpluses. By discouraging imports through protectionist measures and utilising its relative strength of state this ensured similar restrictive policies did not transpire resulting in a net inflow of precious metals. This mercantilist ideology predates Ricardian and Smithian liberalism and its influence began to decline in the late 18^th century.

The repeal of the corn laws in Britain symbolised the emergence of free trade an alternative system. This repeal was partly caused by Ricardo’s (1817) ‘Principles of Political Economy and Taxation’. Ricardo argues countries possess different factor endowments, from tropical climates for agriculture to expertise in financial services. The logic of comparative advantage is that each country should specialise in what they do best relative to other states. Ricardo’s inspiration was the continuation of the corn laws which ensured British agricultural producers guaranteed prices for foodstuffs amid the threat of French blockades of imported grain. After the Napoleonic wars the laws were not repealed as the landowning classes abused their parliamentary positions to ensure continued profit of the grain produced on their land. Ricardo described these classes as “parasites” as they impoverished others through illiberal action (Landreth and Colander, 1994). His text demonstrated that the Corn Laws were economically illogical as Britain would be better off by specialising in manufacturing and using the surplus money from its exports to import cheaper foreign foodstuffs (Watson, 2008). These ideas culminated in the Cobden-Chevalier treaty, which has been described as the first free trade agreement (Grossman, 2016), and opened up the French market to British manufactures in 1860.

The conditions attached to the 19^th century translated Britain’s eminence in world economic affairs into British pre-eminence. This pre-eminence meant that Britain was the primary exporter within global markets and able to export its ideas of free trade (Watson, 2008). Ravenhill (2008) argues hegemonic stability theory provides an explanation of why the global liberal economic order would be sustained by a single power who is able and willing to support such a system. This system benefits the hegemon as its larger size over other economies means it has greater leverage and competitiveness over other states. In an open globalised economy this helps it to dominate the world market in trade (Goldstein, 2005). Reacting to the espouse of free trade List (1841/1977) argued free trade disadvantages less advanced countries as they lack the same level of productive capacity to compete with the hegemon. Therefore List proposed that a nationalist policy should be put in place to supress import penetration and policies like subsidies which favour domestic industry should be implemented to close the productivity gap. This argument gives a glimpse of the cost and benefits of free trade, which is explored in greater depth in the next section.

The Argument of Free Trade.

To determine whether free trade spurs development an methodology by Sachs and Warner (1995)  was created to measures openness based on five individual dummy variables for trade related policies. A state was defined as open if it did not meet any of the following criteria:

•  Average tariff rates of 40% or more.
•  Non-tariff measures covering 40% or more of trade.
• A black-market exchange rate lower by 20% or more of than the official exchange rate.
• A state monopoly on major exports.
• A centrally planned socialist economic system. 

Wacziarg and Welch (2008) analysed 140 countries using this methodology from 1960 to 2000. Their findings demonstrated that in 2000 there was a growth of 53% from 1962 of countries being defined as open. The authors correlated the timing of trade liberalisation to economic indicators which included physical-capital investment, growth in GDPpc and trade openness pre and post liberalisation. Their findings showed trade liberalisation were associated with increases in all indictors, concluding trade liberalisation is correlated to greater economic performance. Ikenberry (2011) supports this view by arguing that if China had not liberalised their trading they would have been on a much slower development path. This is because by being part of an open and rule-based system they have access to other states for trade, investment and knowledge sharing. It is argued free trade leads to an optimal allocation of resources (de Janvry and Sadoulet, 2016). Much akin to Smith’s analogy of the pin factory, specialisation can apply on a macro level for economies. Taking Ricardo’s notion of comparative advantage we can attribute this to two states, the Home economy (H) and Rest of the World (W) where both countries produce manufactured goods (M) and food (F). 

However, a problem emerges from this trade due to the redistributive effects. Both nations gain in the net surplus although consumers gain at the cost of the producers in the importer consumers lose to the benefit of the exporter. Thus, despite efficiency gains there are winners and losers from trade. For example, consider the trade in corn between the US (R) and Guatemala (H) under the Central America Free Trade Agreement (de Janvry and Sadoulet, 2016). The US is comparatively advantaged in corn and exports this to the consumers in Guatemala, resulting in consumer welfare gain, but the farmers of Guatemala could become insolvent due to the productivity gap between the two countries. Therefore, whilst urban interests viewed this deal favourably, corn producers put up resistance (de Janvry and Sadoulet, 2016). This is a limitation of free trade – countries that have more developed industries can exploit economies-of-scale to crush infant firms in developing countries which raises the consequences of further unemployment and lower tax revenues to aid development. Meanwhile, developed economies takes advantage of  wider markets and greater profits which can be passed onto the shareholders, typically residents in the developed economy. Developing economies face structural issues through higher export costs than developed economies (Waugh, 2010) which means that developing economies face a greater constrain on the amount they can export. These trade frictions are a crucial barrier to overall development in developing countries and therefore assistance should be given to overcome this constraint. Thus, free trade has been condemned as an “unequal exchange” by Stiglitz and Charlton (2005) who highlighted the necessity for “behind-the-border” support for developing countries to adapt their production structures to their comparative advantage so “fair trade for all” is achievable.

It must be considered that whilst both countries can gain from trade, these trades can be unequal. There is no rationale to assume (B+C) in the importing country H is equal to (C+D) in the exporting country R. Moreover, there is the issue of differential capacity of countries to achieve the gains from specialisation shown in Figure 1 when an agreement is between a developed and developing economy. This is partly attributed to trade frictions and the inequal capacity of the economies to adjust their production patterns to the newly agreed terms of trade and ability to specialise in order to maximise gains (Stiglitz and Charlton, 2005). 

Another aspect of free trade being an “unequal exchange” can be understood through the lens of comparative advantage. The Hechsher-Ohlin theory of trade builds on the concept of comparative advantage as the theory believes the basis of what a country should specialise in is a statically determined on the economy’s factor endowments (de Janvry and Sadoulet, 2016). Therefore, a “capital-abundant country will export the capital-intensive good while the labour-abundant country will export the labour-intensive good” (Appleyard et al, 2006). However such a strategy has a number of critical limitations. Consider a developing country which has a comparative advantage in agricultural due to high labour availability, an ideal climate and an abundance of natural resources. First, an abundance of natural resources is correlated to the resource curse. This is essentially the thesis that countries with an abundance of natural resources tend to have worst development outcomes than countries with fewer natural resources. Sachs and Warner (1995) found a strong correlation between natural resource abundance and poor economic growth. Pomeranz (2000) argued that the great divergence between the West and the rest of the world occurred primarily because a scarcity of wood in the West forced an innovation into using coal which gave heed to the industrial revolution. China, which had an abundance of wood did not begin to use coal until around 1900 which gave Europe an advantage in energy production and technology (Pomeranz, 2000) . Second, a comparative advantage in a primary goods has troubling implications. The Prebisch-Singer hypothesis argues that over time the price of primary commodities declines relative to manufactured goods which results in a deteriorating terms of trade (Harvey et al, 2010). This is because manufactured goods have a larger income elasticity of demand than primary goods. Therefore, as income rises so does the demand for manufactured goods causing the total demand for manufactured goods to rise more rapidly than the demand for primary goods. In turn, as an economy matures it needs to export more of its primary good to afford the same level of imports as before, assuming ceteris paribus. This theory implies that the embedding of free trade within the structure of international trade regime is therefore responsible for perpetuating inequality within the world system.

Thus, the free trade argument means a country with a comparative advantage in primary goods should specialise in this area which has constrained potential for economic growth. This would provide no guidance for a long-term industrialisation strategy which would be crucial to avert declining terms of trade. This led Porter (1985) to develop the concept of competitive advantage. Porter argues a countries development is not statically determined on resource endowment but is dynamic through factors that can all be established independently of resource endowments. This concept has significant implications for development policy in allowing strategic planning to achieve industrialisation based on endogenous advantages that can be invested in and acquired.

Using Trade for Development: Import Substitution Industrialisation.

Trade is significant in potential economic growth, domestic income distribution and it is therefore unsurprising that trade policy is a major instrument for development. Trade provides important opportunities for growth, technology transfers, public revenues and soft skill development (De Janvry and Sadoulet, 2016). Because states hold sovereignty over national borders governments exert significant influence on trade. Advocates as early as List (1841/1977) and Alexander Hamilton (Northup et al, 2003) argued that if states have a productivity gap with a more advanced economy they should enact a nationalist agenda to close this gap and advance their own infant industries. This section explores this vein of thought through import-substitution-industrialisation (ISI). Before a formal analysis takes place it must be considered that ISI is the antithesis of what forms the conventional wisdom of the Washington Consensus as it goes against trade liberalisation (Williamson, 2004). The strategy was gradually abandoned in the 1980s due to the structural adjustment programs of the IMF and World Bank (Hauss, 2014). This is crucial to consider as Rodrik (1997) argues “It is impossible to understand the East Asian growth miracle without appreciating the role that government policy had in stimulating investment” and therefore is still applicable to other developing states today.

ISI has been termed as a policy gamble (De Janvry and Sadoulet, 2016) as it is a dynamic movement that offers either a high development payoff or failure. For this reason it has critics such as Justin Lin (2009) and advocates such as Rodrik (2004). For example, most adherents started ISI post WWII including the Asian tigers and Latin America. However, it was more successful for the Asian tigers than Latin America. The strategy was applied by states that wanted to protect themselves from the economics-of-scale of foreign industries in order to industrialise. The key idea is to industrialise areas of imports as there is clearly demand for these goods. By placing a tariffs on imports and enacting other protectionist policies the citizens of such a state would substitute the foreign good for the cheaper domestically produced good assuming rational behaviour. The sequence of steps taken to industrialise can be demonstrated:

Before ISI the terms of trade between industry and agriculture for the country is dependent on the ratio of border prices.  

With the notion of a policy gamble established one can now apply this theory to the cases of Latin America and the Asian Tigers. Whilst the Asian Tigers enjoyed the “East Asian Economic Miracle” Latin America enjoyed no economic miracle. The causes of this disparity is explored below. 

Case Study: A Contrast Between Latin America and the Asian Tigers.

Japan’s economic miracle inspired East Asia’s own miracle. Japan’s miracle was attributed to utilisation of industrial policy and protectionist measures which shielded and grew Japan's sapling industries (Page, 1994). This provided the grounding for the Asian Tiger’s own policies.

Korea provides an excellent example of a successful execution of ISI. It had excellent characteristics to enter the textile industry: production experience, a well-educated workforce, cheap labour costs, strong marital law to repress trade unions and good physical infrastructure (Amsden, 2007). However, Korea could not compete against Japan’s textile industry at market prices due to a productivity gap resulting in relative higher costs of production for Korea. This catalysed Korea’s experiment with industrial policy and government intervention to artificially force the law of comparative advantage into modern times and boost productivity. To begin with, a tariff was imposed to protect Korean firms from Japanese competition.

Key players in raising productivity included foreign machinery vendors who instructed workers on how to improve efficiency and slow the deterioration rate of machinery. Foreign consultants helped improve the mixing of cotton into the yarns and fabrics which came into fashion (Amsden, 2007). At the Seoul National University a textile department was established to aid R&D. This all contributed to leaps in productivity. By the mid-1960s subsides were used to further competitiveness. However, the subsidies were tied to achieving export goals. The greater the company’s exports the greater the propensity to receive a cheap, long term loan. These conditions triggered fierce competition when the emergence of larger firms was depressing competition at an industrial level. If a firm failed to reach its export goal it’s subsidisation ceased, as evidenced by the turnover among Korea’s largest companies between 1965-1985 (Kim, 1997). By 1984, heavy industry had become Korea’s leading export sector. The success of ISI catalysed virtually all of Korea’s heavy industries development (Amsden, 1989). However, such success did not apply to Latin America’s experience with ISI. This is because industrial policy is optimised when a fair but strict balance between carrots and sticks is applied. When it came to Latin America there was too much carrot and not enough stick. This meant that the firms growing under ISI in Latin America grew sluggish and did not achieve the needed level of productivity to compete on the international market. The first issue is the use of tariffs.

Tariffs is the first step of ISI which protects the infant industries from larger foreign firms who exploit economies-of-scale to crush smaller firms. However tariffs needs to be relatively set to the international market price as a high level of protection removes incentives for productivity and makes it difficult to bring the firm into the international arena. Unfortunately, this was the case with Latin America which created an obstacle to achieving international competitiveness from the start (Baer, 1972). Tariffs can create powerful lobbies who protect their vested interests in the tariffs – much akin to the “parasites” in Ricardian Britain. Rodrik (2004) therefore argues a “sunset clause” must be entrenched which ensures firms are aware this is a temporary protection only, allowing for efficient planning and execution. A good example of this was South Korea and its five year plan as its sunset clause. However in Latin America there was fierce opposition to the removal of the tariffs embodied by Peronism in Argentina which was supported by the general confederation of workers and employers as they were wary of international competition crushing their own firms (Amsden, 2007). This led to tariffs being extended for longer than what ISI theory encapsulates and led to the firms becoming sluggish in productivity. Hurd’s belief of interest groups being “serpents that strangle efficient government” is crucial in this context (Watts, 2008). This is a key distinction between the Asian Economic Miracle and Latin America’s failure. Whilst the Asian tigers focused their development outward by the 1950’s and 60’s Latin America continued to focus their development inward due to domestic political pressure making it exceptionally difficult to bring these firms into the global trading arena.

The next step of ISI taken by the Asian Tiger states was to identify the “winning” firms that arose out of the sunset clause. The winners were subsidised to boost productivity to achieve further international competitiveness. As noted, South Korea followed this procedure but it was also applied successfully to the Steel industry within Japan in the 1950-60s. For effective execution of subsidy allocation there must be effective political leadership at the top – for example in South Korea President Park and his personal impact on the “Miracle on the Han River.” This enables the profile of industrial policies to the highest level of governance which provides optimal coordination, oversight and monitoring for the allocation of subsidies. This entrusts the senior figure to be held accountable to the policies and therefore provides a deterrence against corruption and nepotism. East Asia thus possessed strict discipline of capital and the more the subsidy allocation is monitored and disciplined the faster the growth of the targeted industries (Amsden, 1991). However Latin America, had a more corrupt political environment. In the case of Argentina, Peron’s corrupt banks and nepotistic public agencies crowded out the financial funding available for effective subsidies for the winners of ISI as was practised in East Asia (Amsden, 2008). By 1950 Frondizi had adopted tied foreign investment which contributed to the failure of ISI. In other Latin countries subsidies were allocated on a “free-for-all basis” and were not allocated according to East Asia’s principle of reciprocity, that is in exchange for excellent output, productivity and eventually R&D (Amsden, 1991). This reduced the scope of subsidies acting competition boosters when key players emerged which dampened competition.

Therefore it is crucial to note the difference of characterisation in how ISI was executed in Latin America and the Asian Tigers. Latin America suffered from a less coherent industrialisation pathway as there was no inbuilt sunset clause. Instead powerful interest groups prevented the movement towards export orientated industrialisation which did not occur in the case of South Korea due to its marital law. Moreover, South Korea allocated subsidies to the wining firms which encouraged competition between the big industries when competition was dampened which did not occur in Latin America. In Argentina’s case this was due to corruption crowding out financial funding available for this path of industrialisation and ultimate culminated in reduced innovation, efficiency and quality of goods which kept protectionist policies high (Franko, 2007). Thus whilst Asian states moved their development outwards, Latin America’s development remained inward and resulted in a failure of ISI as a development pathway. This is because when Latin America liberalised its trade the firms that were slowly growing did not grow at a fast enough rate to compete with larger foreign firms.

Conclusion.

It is therefore clear that free trade is not an optimal catalyst for development for a number of reasons. This paper explored why free trade is an unequal exchange and how advanced states such as the U.K. has advanced their own economies through protectionist measures and only liberalised trade once they were able to reap the benefits. The current international trading regiment is focused on liberalising trade – one of the pillars of the Washington Consensus (Williamson, 2004). By forcing trade liberalisation through structural adjustment programmes this effectively kicks away the ladder (Chang, 2002) that developed states had used to achieve their economic development. This paper has therefore critically assessed how to deploy protectionist policies for economic development. The East Asian Economic Miracle had been attributed to ISI. However, the paper has highlighted how ISI operates as a policy gamble and does not ensure mass gains. This was done through a analysis of Latin America’s failure to achieve the same “miracle” as East Asia. In doing so, key obstacles to successful ISI implementation as a development pathway has been identified. This means that a strict but fair balance between stick and carrot incentives must be achieved. Within Latin America, the issues of  ineffective tariffs, powerful political interest groups, corrupt governance caused an inefficient allocation of resources.  ISI in Latin America operated as an inward development pathway culminating in a failure to achieve the competitiveness needed in the global markets. Contrastingly, Korea’s sunset clause, effective political leadership at the top, utilisation of subsidisation to winners of the ISI period and outward development path from ISI culminated in its Economic Miracle. Thus it is crucial that were ISI to be utilised by another state to create export-led growth an optimal strategy must be created and executed.