Download Policy Paper 3: Trade Policy and Economic Growth

Economics 3403
Spring, 2001
Keith Maskus
Policy Paper 3: Trade Policy and Economic Growth
There is no necessary relationship between whether an economy is protectionist (relatively closed
to trade) or liberal (relatively open to trade) in its trade policies (including policies toward foreign direct
investment (FDI) and technology imports) and economic growth. Economic growth is the result of several
factors:
1. accumulation of resources (labor, human capital, physical capital, land and natural
resources);
2. improvements in the technologies for converting those resources into goods;
3. investments in efficient public infrastructure;
4. innovation of new goods and services.
Nothing in this simple description claims that openness to trade and investment are necessary for spurring
growth. Indeed, in standard (“neoclassical”) growth models, trade barriers have no impact on the long-run
growth rate of an economy, although they can be shown to reduce the level of income available for reasons
we’ve discussed in class (deadweight losses of tariffs). For example, a protectionist economy might have a
per-capita GNP of $15,000, while an open economy has one of $20,000, but both grow at the same rate if
they have identical resource accumulation rates and innovation rates.
Therefore, for economists to claim (as most do and the World Bank and IMF believe) that open
economies tend to grow faster than closed economies, it must be because reducing trade barriers raises the
other factors that produce growth. Of course, this could go in both ways: faster growth could also provide
incentives to lower trade barriers, so one has to try to sort out the direction of causation. This paper will
review the basic arguments on both sides of the question and look at some simple evidence.
Before doing this, however, one simple point should be made. Many people (though few
economists) think that growth itself is not necessarily a good thing, for a number of reasons: it may cause
people to abandon cultural traditions, it could contribute to environmental damages, and it may contribute
to income inequality. These are all complex questions that deserve to be studied carefully. None of them is
necessarily true because whether growth has these impacts depends very much on other policies in the
economy, such as environmental protection mechanisms.
Argument One: Economies will grow faster if they protect domestic industry from import competition.
This is a general statement of the “Infant-Industry Hypothesis,” which states that manufacturing
sectors in underdeveloped economies must be sheltered from competition in order to have the incentive to
invest capital, learn how to produce goods efficiently, take advantage of scale economies through largescale production, and develop innovative or distinctive products that can be sold on world markets.
Virtually all countries at some point have justified extensive import barriers on these grounds: the U.S. in
its first 100 years or so, Japan in the post-war era, Germany and France until recently, Korea through the
late 1980s are examples. These countries experienced varying degrees of success in promoting
industrialization through trade protection, though more important factors were the large sizes of their
economies, effective educational systems, adequate investments in infrastructure, strong competition on the
domestic market among domestic firms (except for Korea, perhaps), and first-rate business management
systems.
The broadest application of the infant-industry argument for isolation from global markets
emerged in the widespread use of Import Substitution policies in developing countries. A policy of import
substitution for industrialization purposes (ISI) involves extensively controlling virtually all components of
the economy in order to direct resources into manufacturing. It is an old idea, but its modern origins come
from economists writing in the 1950s and 1960s (Arthur Lewis, Raul Prebisch, Hans Singer, Gunnar
Myrdal, others), who claimed that developing economies faced two fundamental problems. First, their
status as primary-commodity exporters left them vulnerable to world swings in commodity prices (eg, oil,
sugar, tin, copper, etc.) and also that over the long run, commodity prices would decline relative to
manufacturing prices and costs of new technologies. Second, because developing countries have high
population growth rates and abundant labor supplies, it would be difficult to absorb workers into primary
production. Rather than waiting for comparative advantage to push resources into labor-intensive
manufacturing, it would be better to force industrialization through ISI policies. Such programs became
common in the 1950s throughout Latin America, Africa, the Middle East, South Asia and Southeast Asia.
They are still much in evidence in many countries.
Policies imposed in a thorough ISI program include the following.
1. Escalating tariffs, or tariff rates that rise with the stage of processing. Thus, low tariffs on primary
goods, medium tariffs on industrial inputs and machinery, and high tariffs on final goods, particularly
consumer goods such as food products, clothing, cosmetics, automobiles, and so on. Such tariff
structures establish very high Effective Rates of Protection for final goods, meaning that auto factories
and so on were strongly protected. For example, estimates in the 1970s for Argentina suggest that the
ERP for some foods were over 1,000%.
2. Considerable taxes on production of primary commodities in order to push labor out of the countryside
and into the cities for developing manufacturing. Such taxes include tariffs on imported fertilizers,
price ceilings at very low rates for crops, export taxes on farm goods, and so on. For these reasons,
ERPs in agriculture were often strongly negative, vastly reducing output and productivity in farming.
3. Fixing exchange rates at expensive levels (ie, “overvaluing” the domestic currency), again in order to
discourage primary exports and production and also to reduce the cost of imported inputs for
manufacturing sectors. Such exchange rates tended to generate large trade deficits, forcing
governments to borrow from abroad and build up debt. It also required setting and controlling multiple
exchange rates, so that capital and input transactions could take place at cheaper rates than goods
imports in order to protect domestic industry.
4. Extensive systems of quotas and licensing for imports and production.
5. Rigorous controls on FDI coming into the country, requiring foreign firms to meet certain performance
requirements. Also controls on imported technologies, with governments placing restrictions on costs
of technology and under what terms it would be transferred to local firms.
6. Extensive nationalization of industry to establish state-owned enterprises (SOEs) in key sectors, such
as petroleum, steel, chemicals, construction, banking, and airlines. These “industry champions”
received government subsidies and were favored in the process of capital allocation, typically being
allowed to borrow at very low rates from state banks (usually at negative real interest rates).
This is a reasonable description of what we mean by a “closed economy.” It is not much different
from the centrally planned systems in the former Soviet Union and China (the Chinese are undergoing
serious reform now; Russian reform is chaotic and confused), except that firms were allowed to make
profits. In this context, it is not difficult to see how such a system encourages corruption and rent-seeking.
Estimates of the extent of rent-seeking in many heavily regulated economies (India, Indonesia, Pakistan,
Philippines, Brazil, etc.) are remarkable. For example, it may be that up to 30% of India’s potential real
GDP was sacrificed to redistributive rent-seeking in the 1970s. Stories of how cronyism have operated in
Philippines, Indonesia, and elsewhere are well-known.
To some degree these policies successfully pushed industrialization, but rarely of an efficient kind.
Developing countries are full of large manufacturing operations that operate at inefficiently low scales
because market sizes are small and product quality is not good enough to penetrate export markets, which
is a costly activity. These operations are partly supported by government subsidies, generating vested
interests in keeping them going and opposing liberalization. Relative prices of goods are heavily distorted
by the various subsidies, trade restrictions, and licenses. Other (unintended) effects include massive shifts
of workers into the cities and worsened sanitation and health problems.
However, our question is whether such policies have limited growth. It is difficult to make any
definitive empirical statements because some insulated economies grew rapidly (Indonesia, China after
some domestic reforms) and others did not (India, Pakistan). Evidently many other factors are at work.
What seems clear is that such countries have not performed well in terms of acquiring and improving
technologies, have lagged significantly behind in product innovation and adaptation, have inefficient and
distorted agricultural and manufacturing sectors, and have not performed well in building human capital,
physical capital, and infrastructure. Some relevant figures are given later. Thus, these sources of growth
have likely been limited in countries pursuing ISI programs.
Argument Two: Countries will grow faster if they are open to international competition
This is the basic hope underlying trade-reform programs that involve extensive liberalization of
trade and investment barriers, reduction of controls on technology transfers, unification of tariff rates and
domestic tax rates, removal of consumption and production subsidies, and deregulation of industry and
privatization of SOEs. It is the essential philosophy behind World Bank loans to facilitate restructuring and
IMF lending packages that require microeconomic structural reforms. It is also a very old idea (going back
to Adam Smith and David Ricardo at least) but its modern translation into trade liberalization largely began
with the reforms in Chile in the 1970s advocated by the “Chicago School” of economists (Milton Friedman,
George Stigler). There was considerable resentment of these economists for working with the dictatorial
Pinochet regime, but the trade liberalization, combined with macroeconomic and monetary stability,
worked to establish Chile as a high-growth economy in the 1980s and helped pave the way for instituting
democratic reforms. Hong Kong is the world’s most liberal economy in this context and certainly has had
high growth rates until recently (see below).
A somewhat different version of this approach is (to contrast it with ISI) called Export Promotion,
which is the policy followed largely by East Asian economies in recent decades, including Japan from the
1960s through the 1980s, South Korea, Taiwan, and Singapore beginning in the 1970s, and Malaysia,
Thailand, and Indonesia more recently. These approaches are not necessarily liberal in the sense of free
competition. There are many examples of sheltered and subsidized domestic firms or industrial groupings
(such as the Keiretsu in Japan, the Chaebol in Korea, and family-owned businesses in Malaysia and
Indonesia); much of this protection was designed to encourage infant industries to mature and export.
However, the key component of export promotion programs is not to discourage exports, as is done under
ISI programs. The basic policies under export promotion include the following.
1. Properly valued exchange rates, meaning exchange rates that do not discriminate between
imports and exports. This is accomplished either through flexible rates (Japan, Korea) or
pegged exchange rates that are allowed to move gradually to account for inflation differences
between the country in question and major export markets like the U.S. In this sense, the
exchange rate did not impose any tax on exports.
2. Remove taxes on export production and, indeed, make the tax and tariff system as neutral as
possible across sectors of production. Thus, while in most of these nations agricultural
production was protected from import competition, in manufacturing there was relatively little
discrimination across types of goods. This meant that ERPs were not very high in comparison
to nominal tariffs and resource pulls were largely caused by relative price changes rather than
by bureaucratic decisions. In the economics development literature, this is called “getting
prices right”. It is for this reason that export-promotion policies are far closer to open trade
policies than are ISI policies. There were certainly major exceptions to this rule in many
export-promotion countries, however.
3. Rather than rely largely on import protection to promote infant industries, some active forms
of export promotion in manufacturing and high-tech sectors were taken, including favorable
allocation (based on industries rather than particular firms) of loans and subsidies and rebates
of import tariffs paid on imported industrial inputs.
4. Recognizing that exporting is harder than cutting off imports because exports require
improving levels of quality and considerable foreign marketing costs, East Asian firms have
emphasized quality control and access to foreign technologies on favorable terms.
Governments have supported this by ensuring strong public educational efforts, investments
in infrastructure for exports, and technology transfer policies that attempted to force inward
technology flows at cheap prices.
(For more information on all this, the now-classic reference is World Bank, The East Asian Miracle,
Oxford U Press, 1993, though there are many others.)
Recent problems in Asia indicate that while export-promotion strategies may have contributed to
growth (see below), they ultimately cause serious problems of overproduction (excess capacity) relative to
the economy’s ability to consume commodities. Japan is now discovering how painful it is to unwind years
of directed loans and subsidies that had the effect of discouraging consumption in favor of output and
exports.
How do we know that East Asian economies following EP policies in fact are more open to trade than
the ISI countries in Africa and Latin America? One decent measure of how open an economy is to foreign
competition is the premium on the black-market exchange rate, meaning the ratio of the black-market rate to
the bank rate. Here are some relevant figures for 1984 (1.0 means no difference): Singapore 1.01; Korea 1.09;
Indonesia 1.03; Malaysia 1.02; Thailand 1.03; Hong Kong 1.00; India 1.19; Pakistan 1.22; Egypt 1.79;
Zimbabwe 2.56; Nigeria 1.78; Uganda 6.53; Ghana 8.32; Argentina 1.80; Brazil 1.29; Mexico 1.15; Bolivia
2.78; Turkey 1.13; all developed countries are 1.00. The higher is this ratio, the more distorted is the exchange
rate (and, by extension, interest rates, wages, and commodity prices) in an effort to protect some favored groups
in the economy, typically large and inefficient manufacturing concerns. Needless to say, the difference
between East Asian and African exchange-rate policies is massive, with the former group choosing to allow
international competition to enter their markets to a far greater extent. In turn, this means that relative prices for
goods and services in those economies are much closer to being determined by markets than by government
edict. Another (very imperfect) measure is the average tariff rate, or tariff revenues divided by total imports.
Some figures for 1990: Argentina 9.1%; Brazil 10.5; Chile 9.0; China 6.4; Colombia 16.7; Ecuador 12.5; Egypt
11.5; Hong Kong 0.0; India 50.5; Indonesia 6.2; Korea 7.5; Malaysia 4.3; Mexico 5.1; Nigeria 14.3; Philippines
13.6; Singapore 0.3; Turkey 5.8; Venezuela 10.0. Generally the fast-growing East Asian economies have the
lowest average tariff rates.
What about Growth?
It is no surprise to learn that until 1997 the so-called East Asian "Tigers" (Hong Kong, Singapore,
Korea, and Taiwan) grew extremely rapidly in recent decades, following in Japan's footsteps. Less appreciated
is that other Southeast Asian nations (Malaysia, Thailand, perhaps Indonesia and the Philippines) are now on
similar growth paths and China stands a good chance of doing so also. At the same time, Latin American
countries have grown more slowly while most sub-Saharan African nations have stagnated.
First, some figures of interest are in order. Consider these data,taken from The World Bank, World
Development Report, various issues.
PPP Income Growth
Gr.Earn.
Gr.Inv.
Mfg.in Exp.
Gr.Exp.
1992 (1999)
80-92
80-92
80s(70s) 1992
90s(80s)(70s)
Singapore
$16720(27024) 5.3%
5.0%
5.0(7.8)% 78%
na(9.9)(4.2)%
Hong Kong
20050(20939) 5.5
4.9
4.8(12.1)
95
8.4(5.0)(9.7)
South Korea
8950(14637) 8.5
7.9
12.7(14.2)
93
15.6(11.9)(23.5)
Malaysia
8050(7963)
3.2
2.4
5.5(10.8)
61
11.0(11.3)(4.8)
Thailand
5890(5999) 6.0
6.5
12.4(7.2)
67
9.4(14.7)(10.3)
Indonesia
2970(2439) 4.0
4.4
6.6(14.1)
48
9.2(5.6)(7.2)
China
1910(3291) 7.6
na
na
79
13.0(11.9)(8.7)
Argentina
6080(11324) -0.9
-1.3
-2.6(3.1)
27
8.7(2.2)(7.1)
Mexico
7490(7719) -0.2
-3.0
-0.8(10.7)
52
14.3(1.6)(13.5)
Brazil
5250(6317) 0.4
-2.4
1.8(8.0)
58
4.9(5.0)(8.5)
Chile
8090(8370) 3.7
-1.0
9.2(-2.1)
15
9.7(5.5)(10.4)
India
1210(2149) 3.1
3.4
5.3(4.5)
71
11.3(5.9)(4.3)
Egypt
3670(3303) 1.8
-2.3
-0.6(18.7)
35
3.1(3.1)(-2.6)
Ivory Coast
1640(1546) -4.7
na
-8.4(10.1)
11
4.7(7.6)(4.7)
Nigeria
1440(744) -0.4
na
-6.6(11.4)
1
2.5(1.7)(0.4)
Tanzania
630(478) 0.0
na
5.6(3.1)
16
9.5(-1.2)(-7.5)
Spain
13170(16730) 2.9
1.0
5.9(1.5)
78
10.9(8.2)(9.1)
Turkey
5170(6126) 2.9
0.8
2.5(6.9)
72
11.9(9.0)(4.3)
Japan
20160(24041) 3.6
2.0
2.3(4.9)
97
5.1(4.6)(9.0)
USA
23120(30600) 1.7
0.5
2.3(2.8)
80
9.3(3.8)(6.5)
Germany
20610(22404) 2.4
1.9
2.7(0.5)
90
4.1(4.6)(5.0)
Notes: Column 1 is per-capita GNP in purchasing-power-parity (PPP) terms; Column 2 is annual average
growth in per-capita GNP; Column 3 is average annual growth in manufacturing earnings per worker; Column
4 is average annual growth in fixed investment; Column 5 is share of manufacturing in exports; Column 6 is
average annual growth in merchandise exports.
That's a large volume of numbers to consider and I'll let you do so on your own. But here are a few
general observations about them. First, by any measure the East Asian countries had the best growth
performances in the 1980s. This is especially true in exports; look at the phenomenal growth rates over the
1970s and 1980s two decades for Korea, Taiwan, Malaysia, Indonesia, and China. Japan, Spain, and (maybe)
Turkey and Chile are the only other nations in that class. Export growth rates fell somewhat in the 1990s but
remained high in East Asia. Mexico's high export growth in the 1990s reflects NAFTA and Mexico's proximity
to the US. Second, Chile is unique among Latin American nations in not having stagnated in the 1980s. Note
an interesting phenomenon in Chile. It reduced most of its trade and investment barriers in the late 1970s,
resulting in high growth rates but lower earnings in manufacturing. What does this tell you about Chilean
comparative advantage (hint: consider the Heckscher-Ohlin theorem)? Third, the 1980s were truly a lost
decade for the sub-Saharan African nations. Per-capita incomes (in nominal terms, therefore even more so in
real terms) are lower now in much of Africa than they were in 1975. Fourth, the 1980s generally were a period
of slower trade growth in the rich countries than were the 1970s. In terms of income growth, the USA did not
do so well, especially in manufacturing earnings. This was the result of the famous "productivity slowdown"
and other factors in North America and Western Europe. Recently US manufacturing wages rose sharply due
to higher productivity growth in the 1990s. Finally, the Asian crisis reduced PPP incomes in a number of Asian
nations.
So much for the data; how do international economists explain this excellent performance in Asia and
the poor performance in Latin America and Africa? I will focus first on major economic explanations. Without
question a part of the story is that East Asian nations have been more open to trade and exports. But consider
other factors first.
1. Human Capital Formation. Between 1970 and 1991 the percentage of Koreans age 18-23 enrolled
in college education rose from 16 to 40, a very high figure. Other countries: Singapore 8 to 25; Hong Kong 11
to 18; Malaysia 4 to 7; Thailand 13 to 16; Indonesia 4 to 10. On average these enrollments in our East Asian
sample more than doubled, while high school enrollments nearly doubled. You might also be interested to hear
that proportional female enrollments in these nations are the same as male enrollments. Compare to: Argentina
22 to 43 (that's good); Mexico 14 to 15 (not good); Brazil 12 to 12 (bad); Chile 13 to 23; Egypt 18 to 19; Ivory
Coast 3 to 3; Nigeria 2 to 4; Tanzania 0 to 0; Spain 24 to 36; Turkey 6 to 15 (excellent); Japan 31 to 31 (not
good, and a potential future problem); USA 56 to 76 (excellent). The point is that, among the developing
economies, there is a close relationship between improvements in educational attainment and economic growth.
Also, health and nutrition (other inputs into effective human capital) are excellent in East Asia. Basic theory:
acquisition of basic skills (literacy, simple numerical abilities) is critical for development, but technical skills
(math, engineering, critical thinking) is required for sustained and dynamic development.
2. High Savings and Investment Rates. It is harder to come by reliable comparative data on savings
behavior but it is clear that the fast-growing Asian economies have the highest savings rates. If we take the
World Bank's figures, here (excluding small oil exporters) are the 10 highest national savings rates (gross
domestic savings -- by households, businesses, and government -- divided by GDP) in 1992: Singapore 47%;
Korea 42; Indonesia 37; Malaysia 35; Thailand 35; Japan 34; Hong Kong 30; Ireland 28; Germany 28;
Switzerland 27. The ten lowest are all in sub-Saharan Africa. In fact, many have negative savings rates,
meaning consumption exceeds GDP. The US rate is 15%, placing it next to last among 19 industrial nations
(UK's rate is 14%). To a first approximation, these high savings rates imply high rates of investment. The
Asian countries on this list also
have the world's highest investment rates. Basic Theory: savings are used to finance investment in physical
capital, human capital, and technological innovation.
3. High Degree of Economic Mobility. A key factor in deciding whether to invest in human capital
or take economic risks through investment or business formation is how people perceive their chances for
advancement. This is a poorly measured phenomenon but one reasonable statistic is the ratio of the GNP share
earned by the richest 20% of the population to the share earned by the next richest ("fifth quintile" divided by
"fourth quintile"). This measure shows income to be more evenly distributed in Asia than in Latin America
and Africa (you are welcome to compute any measure you like and you'll reach the same conclusion):
Singapore 2.3; Korea 1.9; Indonesia 2.0; Malaysia 2.6; Thailand 2.5; Japan 1.6; China 1.7 (but rising fast as
Chinese inequality worsens). Compare to Mexico 2.8; Brazil 4.0; Chile 3.9; Peru 2.4; Guatemala 3.4;
Zimbabwe 3.6; Kenya 3.6; Tanzania 3.4. (US ratio is 1.7; Canada's is 1.6; the most evenly distributed incomes
are all in Scandinavia, eg Norway's ratio is 1.4.) By all accounts, South American nations are the most unequal
in the world, followed closely by Africa. In both of those areas there are small numbers of fabulously wealthy
people and large numbers of poor people. There is a strong relationship between income levels and income
equality, with the richest nations being the most egalitarian (you may be surprised by that but it is
indisputable). Basic theory: why bother trying to invest if there is no chance to get ahead? The basic
mechanisms of expropriating any gains you make include confiscatory taxation, government favoritism for
particular businesses, and bribery. Genuine economic and political competition, which are lacking in Latin
America and Africa, significantly reduce the power of these mechanisms.
4. Better Economic Policies. Related to the last point is that East Asian economies have been far
more responsible in their monetary policies (allowing effective independence of central banks, realistic
exchange-rate policies, relatively open financial markets at least domestically). In turn they have had lower
inflation, lower interest rates, more stability, and more rapid investment and growth. Also these countries have
liberalized their trade restrictions far more rapidly and earlier than have African and Latin American countries.
If you do some research you will find exceptions to each of these general points but, taken together, they are
persuasive as to economic differences among regions. Of course, the obvious question is why these differences
exist. Some statements that are demonstrably wrong or questionable include: "Asian savings rates are high
because of thriftiness imbued by the Confucian tradition," "The absence of property rights in Africa means that
individuals cannot function in a competitive market," and "Effective democracy is a precondition for economic
growth." But my point here is not to set up strawmen. It is simply to get you to think about economic sources
of growth and trade.
Evidence
Several economists have tried to compute the correlations between openness to trade and economic
growth, accounting for these other factors and additional factors. A typical paper is by David Dollar (really,
that’s his name) in a paper published in Economic Development and Cultural Change, 1990. He found that,
using the black market premium as measure of price distortions, open economies tend to grow faster by around
0.5-0.7 percent per year, other things equal. Many other articles have found that rapid export growth tends to
be associated with rapid income growth, though these articles do not do a good job of deciding which way the
causation runs. In a series of papers published by Robert Barro and Jong-Wha Lee recently, the linkage
between openness and higher growth seems well established. A paper by Jeffrey Frankel and David Romer in
the 1999 American Economic Review finds that, controlling for factor endowments and other policies, countries
that are more open to trade grew faster over the 1970s and 1980s by perhaps 0.3 - 0.5% per year, which is a
significant difference over a long time. A dissertation written here recently by Juan Blyde shows that open
economies have better access to technological improvements embodied in foreign direct investment of capital,
thereby raising productivity and growth.
Again, why should this be? The basic theory is that open competition at market-determined prices
improves resource allocation and generates dynamic gains in investment, quality, and innovation. These are the
basic sources of productivity gain from competition that we have discussed in class.