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This volume addresses highly topical issues at a crucial time in international economic relations. The world has never been closer to dismantling the liberal multilateral trading system which has been painstakingly established and successfully operated since the Second World War. In this volume many of the world's most distinguished economists examine the movement toward protectionism, bilateralism, and regionalism, and its causes, effects, and possible solutions. The contributors are theorists, researchers, and advisors to governments and international organizations who are at the forefront of trade theory, policy, and practice, and whose analyses have a real impact on international trade. By collecting together these analyses in a single volume, this book provides a unique survey for students and scholars of economics, and all those concerned with trade theory and policy in business and government.
Protectionism and world welfare
Protectionism and world welfare edited by
DOMINICK
SALVATORE
CAMBRIDGE
UNIVERSITY PRESS
Published by the Press Syndicate of the University of Cambridge The Pitt Building, Trumpington Street, Cambridge CB2 IRP 40 West 20th Street, New York, NY 10011-4211, USA 10 Stamford Road, Oakleigh, Melbourne 3166, Australia © Cambridge University Press 1993 First published 1993 A catalogue record for this book is available from the British
Library
Library of Congress cataloguing in publication data
Protectionism and world welfare / edited by Dominick Salvatore. p. cm. Includes indexes. ISBN 0 521 41455 5. - ISBN 0 521 42489 5 (pbk.)
1. Protectionism. HF1713.P77
382'.73-dc20
2. International trade.
1993
92-34450 CIP
ISBN 0 521 41455 5 hardback ISBN 0 521 42489 5 paperback
Transferred to digital printing 2004
I. Salvatore, Dominick.
To Luci/Ie
Contents
List of contributors Preface I
page xi xiii
Protectionism and world welfare: introduction
1
DOMINICK SALVATORE
1 The new protectionism: an overview 2
Fair trade, reciprocity, and harmonization: the novel challenge to the theory and policy of free trade
15 17
JAGDISH N. BHAGWATI
3
The revival of protectionism in developed countries
54
W. MAX CORDEN
4
Changes in the global trading system: a response to shifts in national economic power
80
ROBERT E. BALDWIN
5
"Fortress Europe" and retaliatory economic warfare
99
LAWRENCE R. KLEIN AND PINGFAN HONG
II 6
Trade theory, industrial policies, and protectionism
129
US response to foreign industrial policies
131
RICHARD N. COOPER
7
The current case for industrial policy PAUL R. KRUGMAN
IX
160
Contents 8
The case for bilateralism
180
RUDIGER W. DORNBUSCH
9
Restrictions to foreign investment: a new form of protectionism?
200
VITO TANZI AND ISAIAS COELHO
III
Exchange rates and protectionism
219
10
Floating exchange rates and the new interbloc protectionism: tariffs versus quotas
221
RONALD I. McKINNON AND K.C. FUNG
11 The theory of tariffs and monetary policies
244
ROBERT MUNDELL
12 The economics of content protection
266
MICHAEL MUSSA
13 The relationship between exchange-rate variability and protection
290
JOSEPH A S C H H E I M , GEORGE S. TAVLAS, AND MICHAEL ULAN
IV
The new protectionism in the world economy
309
14 Trade protectionism and welfare in the United States
311
DOMINICK SALVATORE
15 Protectionism and growth of Japanese competitiveness
336
RYU2O SATO, RAMA RAM AC H ANDRAN, AND S H U N I C H I TSUTSUI
16 Protectionism in Western Europe
371
NORMAN SCOTT
17 Protectionism and the developing countries
396
G.K. HELLEINER
18 Trade liberalization — the new Eastern Europe in the global economy
419
JOZEF M. VAN BRABANT
Author index
441
Subject index
445
Contributors
JOSEPH ASCHHEIM
George Washington University, Washington, DC ROBERT E. BALDWIN
University of Wisconsin, Madison, Wisconsin JAGDISH N. BHAGWATI
Columbia University, New York, New York ISAIAS COELHO
International Monetary Fund, Washington, DC RICHARD N. COOPER
Harvard University, Cambridge, Massachusetts W.
MAX CORDEN
Johns Hopkins University, Washington, DC RUDIGER W. DORNBUSCH
Massachusetts Institute of Technology, Cambridge, Massachusetts K.C.
FUNG
University of California at Santa Cru%, Santa Cru%, California G.K. HELLEINER
University of Toronto, Toronto, Canada PINGFAN HONG
United Nations, New York, New York LAWRENCE R. KLEIN
University of Pennsylvania, Philadelphia, Pennsylvania
XI
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Contributors
PAUL R. KRUGMAN
Massachusetts Institute of Technology, Cambridge, Massachusetts RONALD I. McKINNON
Stanford University, Stanford, California ROBERT MUNDELL
Columbia University, New York, New York MICHAEL MUSSA
International Monetary Fund, Washington, DC RAMA RAMACHANDRAN
New York University, New York, New York DOMINICK SALVATORE
Fordham University, New York, New York RYUZO SATO
New York University, New York, New York NORMAN SCOTT
Economic Commission for Europe, Geneva, Switzerland VITO TANZI
International Monetary Fund, Washington, DC GEORGE S. TAVLAS
International Monetary Fund, Washington, DC SHUNICHI TSUTSUI
Tulane University, New Orleans, Louisiana MICHAEL ULAN
US Department of State, Washington, DC JOZEF M. VAN BRABANT
United Nations, New York, New York
Preface
This volume comes at a very crucial time in international economic relations. Never before has the world been closer to dismantling the liberal multilateral trading system that has been so painstakingly put together since the end of the Second World War and served the world so well since then. Support for a liberal trading system in the United States has weakened considerably during the past decade and has given way to aggressive unilateralism. Japan's export successes and industrial targeting, in the face of serious Japanese institutional barriers against imports from the rest of the world, have resulted in serious frictions with the United States and Europe. European agricultural and industrial protectionism has put serious strains on the system. The breaking up of the world into three major trading blocs can potentially have ominous consequences for the world trading system and can lead straight down the path of managed trade. Even the time-honoured theory that a free-trading system maximizes world welfare and the welfare of each trading nation has recently come under attack by strategic trade theory and policy. All of these problems and trends are leading the world toward a trading system that is much less liberal, multilateral, and global than the one to which we have grown accustomed - to the detriment of all. The stalling of the Uruguay Round also means that a crucial opportunity to reverse or at least to contain these dangerous trends and set the world back on a liberalizing track has been missed. In this volume, many of the world's most distinguished economists address, with original articles, the issue of the recent deterioration of xm
xiv
Preface
international economic relations and movement toward protectionism, bilateralism, and regionalism, as to causes, effects, and possible solutions. These are the theorists, researchers, and advisors to governments and international organizations who are at the forefront of trade theory, policy, and practice and whose analyses, recommendations, and opinions can, and do, make a difference in matters of international economic relations in general and international trade in particular. Having all of these analyses, thoughts, and beliefs in a single volume can prove extremely useful to theorists, practitioners, students, and the enlightened public, especially now that trade theory and policy have left the ivory towers and specialized government offices and become part of general economics and reached the general public through newspapers and news programs. I take this opportunity to thank all participants in this volume and Patrick McCartan, the economics editor at Cambridge, without whose encouragement and support this volume would never have been undertaken or completed. Dominick Salvatore New York, June 1993 Fordham University
CHAPTER
Protectionism and world welfare: introduction DOMINICK SALVATORE
1
Introduction
Trade relations among the world's major industrial nations have taken a turn for the worse during the past two decades and are now threatened by new and more dangerous forms of trade restrictions, collectively known as the "new protectionism." This phrase, coined in the mid 1970s, refers to the revival of "mercantilism" whereby nations, particularly the industrial nations, attempt to solve or alleviate their problems of unemployment, lagging growth, and declining industries by imposing restrictions on imports and subsidizing exports. The instruments by which imports are restricted are also somewhat different from and less transparent than traditional import tariffs, and are called non-tariff barriers (NTBs). These refer to "voluntary" export restraints, orderly marketing arrangements, anti-dumping measures, countervailing duties, safeguard codes, and so on. Thus, at the time when tariffs were being reduced as part of the successive rounds of trade liberalization sponsored by the GATT (General Agreement on Tariff and Trade) and they are presently very low on most industrial goods, the number and importance of NTBs have grown rapidly since the mid 1970s and they have now become more important than tariffs as obstructions to international trade. As much as 50 percent of world trade is now affected by this new protectionism. This new protectionism now represents the greatest threat to the fairly liberal world trading system that has been so painstakingly put together over the past half a century and which has served the world so well since the end of the Second World War. As Corden points out in his chapter in this volume, this new protectionism arose as nations sought to protect industry
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after industry from the adjustments required by international specialization and trade in a climate of slow domestic growth and rising unemployment. While not exactly "beggar-thy-neighbor" policies, the rise in NTBs leads to a shrinkage in the volume of world trade and to a reduction in the static and dynamic gains from trade that threatens the well-being of the entire world economy. This new protectionism is also closely related to other crucial policy controversies that the United States and other industrial countries are facing and are likely to continue to face in the foreseeable future. These include calls to adopt strategic trade and domestic industrial policies, to restrict excessive exchange volatility and misalignments and to promote greater international macroeconomic policy coordination; to form or to belong to a regional trading group and to deal with the problems that may arise from the resulting breaking up of the world into three major trading blocs; to reform the world trading system so as to stem the tide of protectionism and reverse the trend toward managed trade. All of these topics are examined in this volume and summarized in the rest of this introduction. 2
Post-war trade liberalization and the new protectionism
The 1950s and the 1960s saw unprecedented growth in the volume of international trade and in the economies of most countries of the world, particularly the industrial countries. The merchandise trade of the industrial countries grew at an average rate of 8 percent per year, and this fueled a growth in real gross domestic product of over 4 percent per year. This period can truly be regarded as a golden age of growth and stability. The growth of international trade was made possible by successive rounds of trade liberalization achieved under the Dillon Round (1960-1), the Kennedy Round (1964-7), and the Tokyo Round (1974-7). Tariffs were cut until today they are less than 5 percent on most industrial products. Effective tariffs (that is, tariffs on value added) are somewhat higher than nominal tariffs but are still very low both in absolute terms and by historical standards. Generally resisting the trend toward trade liberalization was trade in agricultural products and in services. As is well known, most nations have very elaborate domestic agricultural support programs and generally shield their agriculture and service sectors from outside competition by a powerful array of subsidies, tariffs, quotas, health regulations, and so on. The general trend toward trade liberalization was soon reversed, however, starting in 1975, when the world faced the deepest worldwide recession since the Great Depression of the 1930s. This gave rise to what has come to be known as the new protectionism, characterized by the imposition of many new non-tariff barriers. This fact did not go unnoticed
Protectionism and world welfare during the Tokyo Round of trade negotiations, and indeed codes were negotiated to restrict and regulate the use of NTBs. These codes, however, were unsuccessful in stemming the tide of new NTBs, to the point where today they represent the most serious threat to the post-war trading system and world welfare. From 1975 to 1979, world trade grew at about 5 percent per year (as opposed to an average of 8 percent during the previous two-and-a-half decades) and fell to a yearly average growth of 3 percent from 1980 to 1985. Clearly this trend of increased protectionism and declining growth in world trade had to be reversed. Thus, the Uruguay Round was initiated in 1986 and scheduled to be concluded at the end of 1990. The aim of the Uruguay Round was to establish rules for checking the proliferation of the new protectionism and reverse its trend; bring services, agriculture, and foreign investments into the negotiations; negotiate international rules for the protection of intellectual property rights; and improve the dispute settlement mechanism by ensuring more timely decisions and compliance with GATT rulings. The successful completion of the Uruguay Round would go a long way toward resolving the serious problems that face the present international trading system and restoring international confidence in the system. Negotiating rules of conduct to reverse the spread of the new protectionism proved extremely difficult, however, since issues of national sovereignty and desire on the part of most industrial nations to protect mature industries and stimulate high-tech ones are involved. In agriculture, the European Community and Japan objected to the US proposal to remove or phase out by the turn of the century all farm aid programs that interfere with international specialization and trade. In December 1990, the Uruguay Round stalled after the European Community (EC) rejected demands made by the United States and other large food exporters (among which Canada, Argentina, and Australia) for substantial cuts in EC agricultural subsidies. All attempts to revive and successfully conclude the negotiations had failed by December 1992. Thus, the world lost a crucial opportunity to reverse or even to check the slide toward a much less liberal and much more protectionistic world. 3
Strategic trade and industrial policies, and the new protectionism
The superiority of an international trading system characterized by greater multilateralism and international specialization over a trading system based on protectionism, bilateralism, and a division of the world into major trading blocs is by no means as clear cut today as it was a decade
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DOMINICK SALVATORE
ago. There are two reasons for this. One is that many of the new non-tariff trade barriers are considered part of the arsenal of policies that a nation believes to be necessary in order to achieve some important domestic objectives. The second is that in recent years the very theoretical foundation of the modern theory of international trade, which for nearly two centuries has been consistently based on the alleged superiority of free trade over a system based on trade restrictions, is being questioned. Today all the leading industrial countries impose some restrictions on the importation of automobiles, steel, textiles, consumer electronics, and agricultural products. Practically all also provide direct and indirect subsidies to their computer and data processing, aircraft, and most other high-tech industries. Industrial nations regard these trade restrictions and subsidies to be crucial either to protect employment in their large and mature industries or to promote the growth of the high-tech industries deemed essential for the international competitiveness and future technological capability of the nation. These goals are promoted by tax benefits and subsidies for research, education and investments - and most nations regard these as purely internal matters. Japan is often given as the classic example of a nation using strategic trade and industrial policies. According to this, Japan provides protection from foreign competition and a maze of direct and indirect subsidies to an industry targeted for growth. After the industry has grown and is capable of meeting foreign competition, the industry, with the tacit approval and indirect support of the government, begins to dump the product (i.e., to sell the product at below domestic production cost) on the world market on a massive scale until it has driven foreign competitors out of business or rendered them impotent. Then the industry raises prices and proclaims full support for the principle of free trade, pointing to its then unprotected industry as a model of efficiency. According to this view, Japan has successfully and systematically applied this policy to steel, automobiles, computer memory chips, and is now doing this in computers and financial services. Understandably, Japan would not readily abandon an industrial strategy that proved so successful and instrumental in turning it into a first class economic power in just a few decades. While somewhat less aggressively and generally less successfully, the leading European countries have also used some of these same policies to create and stimulate the growth of Airbus and the Arianne space program, among others, and, to some extent, so did the United States (through the commercial applications of the technological discoveries arising from its military and space research programs) to promote its commercial aircraft industry. Thus, while the leaders of the major industrial countries pay lip service to the great benefits of and preference for a free multilateral trading
Protectionism and world welfare system, they have often violated those principles and have become much more protectionistic during the past two decades. Charging interference with national sovereignty, the leading industrial nations are even objecting to providing information to GATT on these new indirect forms of trade protection. As pointed out earlier, the attempt at the Tokyo Round (1974-7) to negotiate rules of behavior to limit the use of these new forms of protectionism and make them more transparent (for example, by replacing them with equivalent open tariffs) has, in general, not been successful - and the more recent Uruguay Round has stalled. Protectionism and bilateralism are also indirectly being encouraged by the recent questioning of the superiority of the time-honored free-trade model of international economics. Ricardo's theory of comparative advantage is attacked as being entirely static in nature and not very relevant to international trade in a world characterized by imperfect competition, technological breakthroughs, product cycles, intra-industry trade, multinational corporations, and integrated capital markets. Some of these criticisms are not new but they seem to have acquired new force and legitimacy from the fact that some leading theoreticians are joining in the criticism of traditional comparative advantage (see, for example, Krugman, 1986). It is now believed that most of today's international trade is based on comparative advantage that is created by industrial policies (which give rise to new technologies and new industries) rather than by traditional comparative advantage based on inherited international differences in factor endowments across nations. Strategic trade and industrial policies are also advocated to overcome market imperfections resulting from the existence of economies of scale and externalities and to combat foreign targeting. As discussed in the paper by Tanzi and Coelho, strategic trade and industrial policies also affect foreign direct investments. Opponents of strategic trade and industrial policies point out, however, that the theory of comparative advantage can be extended to incorporate dynamic changes in the form of new products and new technologies and that, in any event, it is often very difficult for the government to pick winners in the technological race. Furthermore, as Bhagwati (1971) clearly pointed out more than twenty years ago and repeats in his chapter in this volume, market imperfections should be corrected with taxes and subsidies in the markets where these imperfections occur rather than with trade restrictions. Most economists also believe that two wrongs simply do make a right in economics. There are, then, the many real-world examples of clear targeting failures, such as the abandoned Synfuel in the United States, the huge economic losses of the Anglo-French Concorde, and the still higher costs of electricity from atomic power than from conventional methods. To this, supporters of strategic trade and industrial policies reply that
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comparative advantage can indeed be created by targeting, as has occurred, for example, in the case of synthetic rubber, jetliners, and lunar landers and in the new advanced technology that sprang from them. They also point out that Lockheed, Chrysler, and Continental Illinois were all saved by large government loans. Indeed, Krugman, in his chapter included in this volume, states that industrial policy and targeting does have its practical uses and applications in the presence of substantial and clearly demonstrable externalities. Cooper holds similar views. Dornbusch's support for bilateralism is directed primarily at forcing Japan to open its markets much more widely to imports and his support for regionalism is aimed at speeding up the process of integration of Latin America and Eastern Europe into the world trading system. Bhagwati, on the other hand, remains the most uncompromising opponent to strategic trade and industrial policies and the stronger champion of a free multilateral trading system. 4
The new protectionism and fluctuating exchange rates
Excessive fluctuations in exchange rates in general and exchange rate misalignments in particular can also lead to protectionism. Indeed, McKinnon and Fung, in their chapter included in this volume, strongly support the view that exchange-rate volatility, or frequent and large fluctuations of exchange rates about equilibrium levels, by increasing uncertainty in international trade and payments, was an important reason for the spread of the new protectionism since the advent of flexible exchange rates in 1973. They also advance the view that currency instability encouraged the formation of trading blocs and this, by undermining the most favored nation principle, led to the spread of interbloc protectionism. The empirical results that Tavlas, Aschheim, and Ulan present in this volume, on the other hand, seem to show that the exchange fluctuations of the dollar did not appear to have reduced the volume of US trade in the period from 1975 to 1990 and, therefore, could not have provided grounds for protectionism. More important in giving rise to protectionist pressures are exchange rates that remain overvalued or undervalued for relatively long periods of time. The overvaluation of a nation's currency is equivalent to an import subsidy and an export tax by the nation. Many goods and services that would normally be exported with equilibrium exchange rates would be imported with an overvalued currency. Thus, potential exporters join import-competing producers in demanding protection. These demands are greatly strengthened by displaced workers and their labor unions and are difficult to resist, especially in periods of large unemployment and sluggish growth. Another result (discussed by Mussa) is content protection (i.e., the
Protectionism and world welfare requirement that final goods assembled for foreign-owned firms in the country use a minimum amount of domestic inputs). Ironically, demands for protection arise even in nations with undervalued currencies. An undervalued currency has an effect similar to an import tax, or tariff, and to an export subsidy. Thus, a persistent currency undervaluation leads to excessive expansion in the domestic production of import-competing and export industries. A subsequent realignment of exchange rates toward equilibrium levels and the elimination of the currency undervaluation then leads to increased competition and loss of production and jobs in import-competing as well as in export industries. Having become more or less entrenched during the period of currency undervaluation, these industries and their workers are likely to demand and frequently succeed in receiving protection when the currency appreciates toward the equilibrium level. The relationship between tariffs, money price levels, and exchange rates under a fixed and a flexible exchange rate regime is examined by Mundell in his chapter included in this volume. Bergsten and Cline (Cline, 1983, chapter 3) point out that the three periods of greatest protectionist pressures in the United States since the late 1960s coincided with periods of large dollar overvaluations. These were: (1) the period from the late 1960s to 1971, when the dollar overvaluation of about 20 percent (corrected when the Bretton Woods system collapsed and was replaced by flexible exchange rates) led to increased trade restrictions on imports of textiles and steel, and to widespread support for strongly protectionist measures. (2) The period 1975-6, when a dollar overvaluation of about 15 percent (corrected during 1977—8) coincided with the adoption of the trigger price mechanism (TPM) for steel and other protectionist measures. (3) The dollar overvaluation from 1981 to 1985, which led to new trade protection for automobiles, textiles, and steel. Conversely, periods of near exchange-equilibrium in the United States have led to trade liberalizations, such as the passage of the Trade Act of 1974 and the Trade Act of 1979. There is, however, the danger of a ratchet effect, whereby trade restrictions imposed during periods of exchange-rate misalignments are not removed when exchange rates return to near equilibrium levels. For example, the extension of trade restrictions to synthetic fibers in the early 1970s (at a time when the United States had a trade deficit in that account) were not removed afterwards when the United States achieved a trade surplus in synthetic fibers. 5
Protectionism around the world
During the past two decades, the new protectionism has spread to most industrial countries. In his chapter Salvatore points out that while the
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United States has generally adhered to the principle of free trade during the past thirty years, it has made an increasing number of compromises or exceptions to protect textiles, steel, automobiles, and other industries in exchange for the political support for the general principle of free trade, in the general context of increased global competition, unemployment, and lagging growth. Furthermore, concern over "fairness" and the desire to provide a "level playing field" in international trade in recent years has led to the revision of US trade laws and their interpretation away from non-discriminatory multilateralism toward aggressive bilateralism (i.e., requiring retaliation against countries that do not provide market access to US products equal to that which foreign countries and products enjoy in the United States). As Baldwin points out in his chapter, US support for a liberal multilateral trading system has wavered during the past two decades as a result of its loss of hegemonic power. This also moved the United States more and more toward regionalism, as the recent pursuit of a North American Free Trade Association indicates. In their chapter, Sato, Ramachandran, and Tsutsui conclude that the Japanese government did play a successful interventionist role through the Ministry of International Trade and Industry (MITI) in improving the competitiveness of home industries in international trade. The government (MITI) did this by selecting a small number of powerful companies to be initially protected from domestic and foreign competition. These companies received tax credits and subsidies to encourage them to develop technology through a cooperative research program. Once technology was developed, the government then strongly encouraged domestic competition in order to increase efficiency. A school system that emphasized science and high national savings and low interest rates made this possible. The authors also point out that much of the debate on Japan centers in the West on whether MITI has superior signaling abilities in encouraging the development of new technologies by firms and whether this requires a response from Western nations. The authors conclude, however, that the channels by which Japan and MITI oversee and direct the technology transfer and the methods of stimulating new technologies differ in degree from what takes place in other countries. As pointed out by Scott in his chapter, protectionism in the European Community (EC) has increased during the past two decades and generally paralleled the US increase in both strength and form. As in the case of the United States, the EC now protects its textile, steel, automobile, machine tools, and consumer electronic industries against the export of Japan, the newly industrializing countries (NICs), and other industrial countries. The tools that it uses are also similar; i.e., safeguard mechanisms, surveillance, anti-dumping duties, and voluntary export restraints. In deciding if
Protectionism and world welfare clumping has occurred, the EC sometimes adds as much as a 30 percent profit margin to the foreign cost of production. The foreign firm is then accused of dumping if it sells the product in the EC at below such a constructed price. Particularly troublesome is the EC's common agricultural policy (CAP). According to this, the EC first determines common farm prices and then imposes tariffs so as always to make the price of imported agricultural products equal to the high established EC prices. This not only severely restricts agricultural imports but also leads to huge agricultural surpluses within the EC and subsidized exports. The unwillingness on the part of the EC to reduce agricultural protectionism sharply was the primary cause for the stalling of the Uruguay Round in December 1990. A great deal of the new protectionism has been directed by the developed countries against the manufactured exports of the NICs. These nations (Brazil, Hong Kong, Korea, Mexico, Singapore, Taiwan) are characterized by rapid growth in gross domestic product (GDP), in industrial production, and in manufactured exports to industrial nations. The NICs have gained a comparative advantage vis-a-vis developed nations (including Japan) in textiles, shoes, television sets, consumer electronic products, steel, and shipbuilding. These are the very industries in which sharp cuts in employment have occurred, and are continuing to occur in developed countries. This, combined with the fact that these newly industrializing countries have little political power and are not in a position to threaten effective retaliation, has led developed countries to raise many new forms of protection against the manufactured exports of these newcomers. This has occurred in spite of the Generalized System of Preferences (GSP), negotiated by Western European countries and Japan in 1971—2 and by the United States in 1976, which grants preferential access for the exports of developing countries into developed countries' markets. Exception after exception to GSP has been "voluntarily" negotiated by the United States and other developed countries in many products, such as textiles, which are of great importance to developing countries. As Michaely (1987) pointed out, the NICs have simply been unlucky to be rapidly growing and to have increased their manufactured exports to developed countries at a time when the latter were facing large unemployment and slow growth. Had developed countries and international trade been growing in the second half of the 1970s and in the 1980s as rapidly as they did during the 1950s and 1960s, the growth in the manufactured exports of the NICs to developed countries would probably have been absorbed much more smoothly and without as much of a rise in protectionism on the part of developed countries. Having emerged in the wake of Japan's great industrial and export success, the NICs have been drawn inevitably into the trade disputes between industrialized nations and
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Japan and have been, to some extent, victimized by the ire of the former nations against the latter. It must be pointed out, however, that while the NICs were bitterly complaining about the new protectionism directed by developed countries against their manufactured exports, they were themselves heavily protecting their market against the exports from both developed and other developing countries. As pointed out by Helleiner in his chapter in this volume, it is essential to reassert and enforce the GATT principle of non-discrimination in trade matters and allow developing countries to increase their exports to developed countries, thereby helping to solve the former's foreign-debt problem and stimulate their development. If this does not happen very soon, we may witness a revival (and justification) of export pessimism and a return to inward-looking policies in developing countries. Trade problems in the West and developing countries have recently been compounded by the political and economic collapse in the East. Until a few years ago, trade among Eastern European countries and the Soviet Union was generally conducted on the basis of bilateral agreements and bulk purchasing, with market forces playing little if any role. Since the collapse of communism, Eastern European countries and the former Soviet Republics have been struggling to restructure their economies and foreign trade along market lines. This is a monumental task after many decades of central planning and gross inefficiencies. These countries are now facing increasing unemployment, high inflation, huge budget deficits, unsustainable international debts, and disrupted trade relations. Eastern European nations are having serious difficulties in expanding trade with the West sufficiently to make up for the collapse in trade among themselves and the former Soviet Republics because of the generally low quality of their manufactured products and protectionism in the EC and in other industrial countries against agricultural, steel, and textile products in which Eastern European countries seem to have a comparative advantage. These countries also need huge amounts of foreign capital and technology in order to restructure their economies and establish market economies. As van Brabant points out in his chapter, the ultimate goal of Eastern European countries is to become members of the EC, but this can only occur after these nations have accomplished the arduous task of restructuring their economies along market lines. 6
Protectionism and the future of the international trading system
The world has already and probably irreversibly moved into an international trade order characterized by three major trading blocs. The
Protectionism and world welfare
11
EC is already a political and economic reality, the United StatesCanada-Mexico free-trade area seems to be more or less already agreed upon and its implementation seems to proceeding rapidly. Least developed is the Asian trade bloc around Japan, but the dynamics of the situation is such that its formation is all but inevitable if the other two trading blocs continue to keep to their timetable for implementation. One could argue along the lines of customs union theory that such free-trade areas are second-best trade arrangements if a true worldwide free-trade system cannot be achieved under present conditions. The formation of these trade blocs, it is argued, will lead to increased specialization in production and raise world welfare if the net effect is to stimulate trade within each bloc without reducing trade among the blocs. The latter expectation, however, may not materialize and the formation of trading blocs may in fact have a net trade-diverting effect and lead to more generalized and, thus, more dangerous commercial disputes. As pointed out by Klein and Hong in the chapter included in this volume, this will impose efficiency and welfare costs on the world similar to those resulting from the oligopolization of previously near-perfect competitive markets. The best opportunity to prevent a drift toward greater protectionism and trade disputes among the major trading blocs into which the world is breaking up is to revive and successfully bring to conclusion the Uruguay Round. If this does not occur, commercial relations among the blocs would be seriously restricted and trade frictions would be the order of the day. The total volume of world trade may then fail to rise and may even decline, international specialization in production will be limited mostly by the extent of the market within each trade bloc, and the stimulating force that trade can play in the world economy will be seriously constrained. Even if the Uruguay Round is revived and brought to a successful conclusion, however, it is most unlikely that it would succeed in fully reversing the trend toward protectionism. What is possible is to negotiate for a reduction of traditional trade barriers and explicit non-tariff trade barriers and accept as inevitable the existence of some implicit non-tariff trade barriers (such as government aid to sunset and sunrise industries that the nation might be unwilling to give up or insists on having). Nations could counteract with appropriate domestic policies the most disturbing effects of implicit foreign non-tariff trade barriers in a manner that minimizes the resulting trade controversies. Success in these negotiations is made more difficult by the loss of the hegemonic position that the United States enjoyed during the 1950s and 1960s. The most that can reasonably be expected from a successfully completed Uruguay Round is that it would: (1) reassert the principle of an open multilateral trading system, (2) strengthen the dispute-settlement procedure
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of G ATT and raise its status to that of the International Monetary Fund and the World Bank, (3) set up the framework and establish the principle for subsequent liberalization in trade in services and agriculture. This would be no small accomplishment and would preserve a world trading system that served the world so well for nearly half a century. References Bhagwati, Jagdish N. (1971), "The Generalized Theory of Distortions and Welfare," in Jagdish N. Bhagwati (ed.), International Trade: Selected Readings,
Cambridge, Mass.: The MIT Press, pp. 171-89. (1990), Protectionism. Cambridge, Mass.: The MIT Press. (1991), The World Trading System at Risk, Princeton, New Jersey: Princeton University Press. Cline, William R. (1983), Trade Policies in the 1980s, Washington, DC: Institute for International Economics. Corden, Max W. (1987), "Protectionism and Liberalization: A Review of Analytical Issues." Occasional Paper 54, International Monetary Fund, Washington, DC. Council of Economic Advisors (1992), Economic Report of the President, Washington, DC: US Government Printing Office. Hathaway, Dale E. (1987), Agriculture andGATT: Rewriting the Rules, Washington,
DC: Institute for International Economics. International Monetary Fund (1984), Exchange Rate Volatility and World Trade,
Washington, DC: International Monetary Fund. (1992), World Economic Outlook, Washington, DC: International Monetary Fund, May. (1992), International Financial Statistics, Washington, DC: International Monetary Fund. Jones, Ronald W. and Peter B. Kenen (eds.) (1984 and 1985), Handbook of International Economics, Vols. 1, 2, Amsterdam: North-Holland. Krugman, Paul R. (1987), "Is Free Trade Passe?" The Journal of Economic Perspectives, 1(1), Fall, 131-44. Krugman, Paul R. (ed.) (1986), Strategic Trade Policy and the New International
Economics, Cambridge, Mass.: The MIT Press. McKinnon, Ronald R. (1984), An International Standard for Monetary Stabilisation.
Washington, DC: Institute for International Economics. Michaely, M. (1987), "The Demand for Protection Against Exports of Newly Industrializing Countries," in D. Salvatore (ed.), The New Protectionist Threat to World Welfare, New York and Amsterdam: North-Holland, pp. 471-81. Organization for Economic Co-operation and Development (1985), Costs and Benefits of Protection, Paris: O E C D .
Salvatore, Dominick (1988), "The New Protectionism with NontarifF Trade Instruments," in Christopher Saunders (ed.), Macroeconomic Management and the Enterprise in East and West, London: Macmillan, pp. 155—82. (1993), International Economics, 4th edn, New York: Macmillan.
Protectionism and world welfare
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Salvatore, Dominick (ed.) (1987), The New Protectionist Threat to World Welfare, New
York and Amsterdam: North-Holland, (ed.) (1991), Handbook of National Economic Policies, Westport CT: Greenwood Press and Amsterdam: North-Holland, (ed.) (1992), Handbook of National Trade Policies, Westport CT: Greenwood Press and Amsterdam: North-Holland. World Bank (1992) World Development Report. Washington, DC: World Bank.
PART
i
The new protectionism: an overview
CHAPTER
Fair trade, reciprocity, and harmonization: the novel challenge to the theory and policy of free trade JAGDISH N. BHAGWATI
Writing in the new Journal of Economic Perspectives in 1987, my distinguished pupil and successor to my chair at M I T , Paul Krugman, declared: the case for free trade is currently more in doubt than at any time since the 1817 publication of Ricardo's Principles of Political Economy . . . In the last ten years the traditional constant returns, perfect competition models of international trade have been supplemented and to some extent supplanted by a new breed of models that emphasizes increasing returns and imperfect competition. These new models . . . open the possibility that government intervention in trade via import restrictions, export subsidies, and so on may under some circumstances be in the national interest after a l l . . . free trade is not passe, but it is an idea that has irretrievably lost its innocence. Its status has shifted from optimum to reasonable rule of thumb. There is still a case for free trade as a good policy, and as a useful target in the world of politics, but it can never again be asserted as the policy that economic theory tells us is always right.
Trade theorists of my generation, who spearheaded the modern theory of commercial policy from the 1950s through the 1970s, exploring several types of market failures and the appropriate nature of governmental interventions (including the use of trade tariffs, quotas, and subsidies) in each such instance, have found it puzzling that anyone should seriously suggest that "economic theory" was believed until the 1980s to imply that free trade was "always right." 1 The trade theorists who have used imperfectly competitive models recently and who then proceed to claim to be pioneers in thinking of possible theoretical arguments for departures from free trade, appear to us like young men who, on visiting a prostitute, boast of having robbed her of her virtue. 17
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JAGDISH N. BHAGWATI
But there are two other objections, of equal significance, and they concern what Krugman says about the case for free trade being in its greatest crisis since 1817. The assertion is not valid historically. As I argue immediately below, a backward glance shows that earlier crises, some of equal and others of greater significance, have occurred with regard to the policy presumption in favor of free trade: all reflecting different blends of current economic circumstances and theoretical reflections. Moreover, and this is a theme that I develop principally in this chapter, the true and greater crisis that we face with regard to the theory and policy of free trade today comes, not from what Krugman has in mind (i.e., the theoretical modeling of imperfect competition in product markets during the 1980s), but from the growth of demand for "level playing fields," "harmonization," "fair trade," etc., all of which are variously undermining insidiously the legitimacy and feasibility of free trade since it is virtually impossible to harmonize everything so that playing fields are truly level in every way. There will always be something that an opponent of free trade will be able to find that is different in the country of one's successful rival and hence can be argued to make free trade unfair and therefore illegitimate and unacceptable. I intend here to explore this problem, which I consider to be the truly greatest threat since the early 1930s when (as reviewed below) Keynes was driven to abandon free trade in face of massive unemployment and many followed in his footsteps. But first, I consider the different ways in which the intellectual presumption that free trade was empirically the policy to follow has been shaken repeatedly over the period since 1817. 1
Free trade: national versus cosmopolitan formulations
Unfortunately, in the popular as well as in the academic discussion of free trade, the critical distinction between the "national" and the "cosmopolitan" formulations of free trade is blurred. They share common foundations, but they also have different implications for matters that have become contentious from time to time. The national formulation The national formulation of the case for free trade is the one that predominantly shapes the policy debate. It posits national welfare as the objective of policy and proceeds to demonstrate that free trade will maximize national welfare. In essence, the case depends of course on the set of assumptions that ensure that market prices reflect social costs, to use the old and apt Pigovian
Fair trade, reciprocity, and harmonization
19
way of saying things. While the case, if we must make it rigorously, requires the usual theoretical armor, the simplest and most intuitive way to state it is to say that, if there are any domestic or foreign market "distortions," free trade ceases to be optimal (and indeed even its superiority over autarky no longer follows as a necessity). Of course, these distortions imply market failures, including (in the cases where external prices of goods and services can be influenced by firms or governments, requiring us therefore to distinguish between average market prices and marginal revenues in trade) the failure of the market prices in trade to reflect the true social costs and benefits of trade. The post-war analytical developments in the theory of commercial policy, especially during the 1950s through the 1970s, have set out the basic principles, building an impressive edifice. They also constitute a substantial body of scientific analysis of several market failures, typically in the shape of factor market imperfections such as monopsony, generalized sticky wages, sector-specific sticky wages, and different varieties of wage differentials among sectors. The 1980s witnessed the extension of the theoretical analysis to product market imperfections, of both the large-group and the smallgroup varieties, completing the architecture of this theory. An important component of this theory, developed mainly during the 1960s, has also been the analysis of the implications for commercial policy when the conventional objective function that the economist maximizes becomes inappropriate. When "non-economic" objectives (such as the valuation in themselves of specific outputs such as manufactures or high-tech industry so that a dollar worth of output is valued at four, for instance) are admitted into the analysis, free trade will generally cease to be the optimal solution.2 Trade theorists have then analyzed, for such diverse non-economic objectives (which are abundantly in evidence and ceaselessly impose themselves on the political and policy scene), the optimal first-best and second-best ways of departing from free trade.
The cosmopolitan formulation While the study of commercial policy by economists has focused on national advantage and hence on the national formulation of the case for free trade, there is also the cosmopolitan formulation of the case for free trade. Premised again on the assumption that prices reflect social costs, the cosmopolitan argument simply elevates to the world level what the national argument did at the nation-state level. World efficiency follows free trade. But there is one overriding difference that follows for policy. If the case for national free trade holds as stated (i.e., the premises underlying it are
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JAGDISH N. BHAGWATI
broadly reflected in the reality that the nation in question faces), then it really is irrelevant whether other nations follow free trade or not. "Fair trade" and "reciprocity," defined as the requirement that others follow free trade if one's own free trade is to make economic sense, are incompatible with this "essential" case for free trade. The prescription that emerges then is for unilateral free trade.3 Not so, however, under the cosmopolitan case. World efficiency requires that everyone follow free trade. It is simply not enough that one or more do so. The prescription now is: universal free trade. The question of reciprocity The contrast between the two cases for free trade, one implying that reciprocity does not matter and the other giving it central place, has however been less stark in practice. Unilateral free trade, as the ideal trade policy by one nation state, has been argued to be possibly deficient on theoretical grounds since Adam Smith. It has also been the subject of considerable debate among eminent economists, including at the end of the nineteenth century. Since free trade has not been widely practiced at most times, the demands for reciprocity have also implied threats to the pursuit of free trade for oneself, transmuting the issue therefore into one of free trade versus protection. At the same time, the appeal of reciprocity is such that it has spilled over in recent years into parallel demands for reciprocity and "level playing fields" in a variety of other ways, taking the form of objections to diversity among trading nations in their myriad governmental policies and national institutions, as preconditions for adopting free trade. It is necessary therefore to probe the issue of reciprocity further, prior to considering the old and the new challenges to free trade in sections 2 and 3 respectively. Reciprocity and the national case for free trade
Foreign barriers subject to change At the outset, it should be obvious that if the trade barriers of others can be regarded as changeable by the closure of one's markets, then a case can be made for departing from unilateral free trade in pursuit of national advantage.4 In fact, this was evident even to Adam Smith (1776, pp. 434-5): The case in which it may sometimes be a matter of deliberation how far it is proper to continue the free importation of certain foreign goods, is, when some foreign nation restrains by high duties or prohibitions the importation of some of our manufactures into their country. Revenge in
Fair trade, reciprocity, and harmonization
21
this case naturally dictates retaliation, and that we should impose the like duties and prohibitions upon the importation of some or all of their manufactures into ours. Nations accordingly seldom fail to retaliate in the manner. There may be good policy in retaliations of this kind, when there is a probability that they will procure the repeal of the high duties or prohibitions complained of. The recovery of a great foreign market will generally more than compensate the transitory inconveniency of paying dearer during a short time of some sorts of goods. To judge whether such retaliations are likely to produce such an effect, does not, perhaps belong so much to the science of a legislator, whose deliberations ought to be governed by general principles which are always the same, as to the skill of that insidious and crafty animal, vulgarly called a statesman or politician, whose councils are directed by the momentary fluctuations of affairs. When there is no probability that any such repeal can be procured, it seems a bad method of compensating the injury done to certain classes of our people, to do another injury ourselves, not only to those classes, but to almost all the other classes of them.
The case for the use of one's trade barriers to remove those of others raises, of course, several questions that have recurred in the debates on reciprocity through the last century: (i) Does one really have the power to effectively pry open others' markets; could this power not be overestimated, partly because of the self-interest-induced optimism of the lobbies that provide the political drive for such aggressive policies, leading to confrontational situations that create an ethos of mutual recriminations within which protectionist interests thrive? (ii) Will not the use of trade barriers for this purpose be "captured" by one's own protectionists for their purpose, leaving one saddled with tariffs? (iii) Could the power of example, rather than sanction, not suffice to induce others to follow free trade since one's own free trade should lead to prosperity at home whereas others' reliance on protection should undermine it abroad, making unilateral free trade a more efficacious and less dangerous path to reciprocity in free trade? As argued in section 2, the answers to these questions in end of nineteenth-century Britain and in end of twentieth-century United States have tended to be altogether different. In the former case, unilateralism survived the discord and debate. In the latter case, the use of muscle via threats to close markets in absence of concessions on unilateral demands made under the section 301 provisions of the 1988 Omnibus Trade and Competitiveness Act has emerged as US trade policy. 5
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JAGDISH N. BHAGWATI
But while the questions posed above were predicated on the narrow question as to whether national advantage can be enhanced by the renunciation of unilateral free trade, the key questions (raised by the use of threats and actions to close one's markets to pry open others') take one inevitably into the cosmopolitan arena, i.e., one must ask questions such as: (i) Will not the use of power to extract unilateral concessions threaten the rule of law under which a trading regime should function, by legitimating the use of force and spreading such methods to other trading nations that can rise above impotence? (ii) Would it not also lead to concessions being granted to the powerful, diverting trade from the less powerful, replacing economic competitiveness by political clout as the guiding force behind trade, thus undermining world efficiency? (iii) Would not such use of power deteriorate also into unilateral (and therefore self-serving and biased) determination of the closedness of others' markets - a danger that is manifestly great when one is dealing with allegations of "invisible and inscrutable" trade barriers that can be flung freely at all and sundry but be forced to stick only for the benefit of the strong? (iv) Should we not regret the impact on world efficiency that would follow if the strong could fully indulge their own interest and browbeat the weak into removing protection or promotion (i.e., production subsidies) when in fact these could be correcting market failure rather than creating it?6 In fact, one could argue that if these adverse systemic (and hence cosmopolitan-efficiency-focused) implications of the pursuit of national advantage through the use of muscle to extract trade concessions are indeed likely to transpire, then the immediate gain in national welfare could well yield (in a reverse-J-curve outcome) to ultimate loss of welfare as the world trading system gets impaired. Foreign barriers unchangeable But what if the prospect of getting others to reduce their trade barriers is negligible? Then, the case for unilateral free trade stands intact, quite unambiguously. To recall Joan Robinson's famous observation, "you don't throw rocks into your own harbor just because others have done so in theirs." Of course, if there are any distortions to contend with, free trade ceases to be the optimal policy. And this applies equally to all market failures whether, for instance, in factor markets or in product markets. But there is an important implication for the question of reciprocity in trade which must be grasped since it is precisely the opposite of what is
23
Fair trade, reciprocity, and harmonization
Table 2.1. Reciprocity of free trade under alternative regimes: no-distortions and oligopoly Policy choices by home country / No distortions Unilateral FT (free trade) Reciprocity in FT
Foreign country
Utility of home country
Trade barriers given FT imposed or induced
II Oligopoly
Unilateral FT
Trade barriers given
Reciprocity in FT Appropriate intervention: departure from FT and/or domestic instruments*
FT imposed or induced
UFT{R) ^ UpT{U)
Trade barriers given
UINT > U
Source: *Eaton and Grossman (1986).
generally believed to be the theoretical consequence of market failures in the shape of imperfect competition and therefore provides ammunition to the interests that seek reciprocity. This implication is that when trade occurs with market failures (uncorrected by appropriate intervention), it is no longer possible to assert with Adam Smith that the successful removal of others' tariffs (and indeed other barriers and interventions) adds to the benefits from one's own free trade. In short, in the presence of market failure, it no longer follows that my free trade in the absence of yours necessarily makes me worse off than if we both had free trade (because, say, my insistence on reciprocity had led to the embrace of free trade by you as well). But reciprocity does offer added benefits to unilateral free trade when there are no distortions. But the popular belief, certainly in policy circles, is that the recent theoretical analyses of product-market imperfections imply that, because there are imperfect markets everywhere, we must insist on reciprocity in free trade: i.e., that the presence of oligopoly, for example, strengthens, instead of weakens, the case for reciprocity! Table 2.1 summarizes what we can say about this question, for the two contrasting cases: no distortions (and therefore also perfect competition)
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JAGDISH N. BHAGWATI
and oligopoly (drawing on the recent analysis by the economists Brander, Spencer, Eaton and Grossman). It states that, in the former case, one can safely share Adam Smith's presumption that reciprocal free trade supplements the national gains from unilateral free trade. In the case of oliogopoly, however, this is no longer so. That, in some specific parametric cases one can show that reciprocal free trade is welfare-improving over unilateral free trade is, of course, compatible with the general proposition that it is not always or necessarily the case.7 Fairness and prudence The arguments so far presumed that the question of unilateral free trade versus reciprocity for national advantage could be assessed without reference to the role of emotions. But the policy question cannot be decided altogether in this fashion. Adam Smith, in the quote above, spoke of revenge as motivating the demand for reciprocity and compromising the ability to pursue a policy of unilateral free trade. But the sense that reciprocity is required by "fairness" is more pertinent today. Lack of reciprocity in free trade is generally considered, regardless of its impact on national welfare, as simply unfair. In consequence, there can follow a prudential argument for seeking reciprocity in free trade. The option of unilateral free trade may be impractical and attempts at keeping markets open unilaterally without attempting to extend free trade to one's trading partners and rivals may turn out in pluralistic countries to be a recipe for politically losing one's own free trade.8 Reciprocity and the cosmopolitan case for free trade
But the demands for reciprocity come perfectly naturally, as I have already indicated, if one approaches the question from the detached position of a "custodian" of world efficiency or, somewhat distinctly, from a "systemic" viewpoint. Cosmopolitan efficiency World efficient allocation of resources requires that no members of the world economy depart from free trade: the sin of one visits on all by compromising world efficiency (just as a monopolist is known to affect the Pareto-optimality of the economic equilibrium for all). It is necessary then to insist on all adhering to free trade: i.e., reciprocal embrace of free trade follows. To return to Joan Robinson's telling example, if any nation insists on throwing rocks in its harbor, we must throw rocks at it until it dredges them up. Systemic rationale But there is also the distinct argument that, if one is creating a trading regime, such as the GATT, to establish a rules-based
Fair trade, reciprocity, and harmonization
25
system, it is inevitable that it will impose symmetric or uniform rights and obligations on members. This is, of course, compatible with differences in obligations defined by accepted functional categories: e.g., developed and developing countries, the latter enjoying an asymmetry of obligations (i.e., Special and Differential Treatment in GATT language). But, outside of such functionally sanctioned discrimination, it is hard to imagine a regime that will tolerate asymmetries of free trade obligations. Reciprocity then belongs with the regime approach: it thus finds itself "naturally" embedded in the GATT. In fact, the GATT also generally embodies what I have called (Bhagwati, 1988) first difference reciprocity, i.e., matching reductions in trade barriers, as distinct from "zero option," or full reciprocity.9 2
The threats to free trade: from then to now
Now that I have distinguished among the alternative formulations, national and cosmopolitan, of the free trade doctrine, and analyzed the question of unilateralism versus reciprocity, it is possible to review with analytical clarity the manifold challenges to free trade since 1776 when Adam Smith invented both economics and international economics, grounding them in the principle of the division of labor. Several "episodes" of challenges to free trade can be distinguished over these two centuries and more. Of these, six (ending in the 1980s) fall broadly into one common pattern: they relate, in one way or another, to market failure. The seventh, now emerging, is radically different in nature and poses an altogether novel, and more complex, type of threat. The six market-failure related threats are now considered; the seventh, the principal subject*of this chapter, is addressed in Section 3. All are summarized and listed in table 2.2. EPISODE I Free trade with some theoretical exceptions: nineteenth century The repeal of the Corn Laws in 1846 ushered in free trade. It followed the shift from mercantilist thinking of Adam Smith and David Ricardo. The division of labor, and the gains from free trade, were in an essential way flip sides of the same coin. The relative importance of the roles played by the new economic doctrines and the industrial interests that would profit from cheap imports of corn have been the object of extensive debate; and the precise nature of the conversion by Prime Minister Sir Robert Peel has been analyzed with acute insight by Irwin (1987). For the rest of the nineteenth century, until near the end, unilateral free
Table 2.2. The threats to free trade since Adam Smith and David Ricardo" Episode
Economic circumstance
Economic theory
I 19th century
British dominance during prosperous century: no serious threat to British competitiveness since the repeal of the Corn Laws in 1846.
The case for free trade was qualified in three ways: 1 Infant industry argument in John Stuart Mill; 2 Monopoly power in trade argument in Robert Torrens and John Stuart Mill; 3 Possible use of tariffs to pry open others' tariffs; argument in Adam Smith.
Free trade with some theoretical exceptions
II End of 19th century Reciprocity and fair trade Infant industry protection
1 Britain's relative decline as No major theoretical developments transpired. Germany and the United States rose: the diminished giant syndrome (Bhagwati and Irwin, 1987) gripped Britain. "Fairness" and "Reciprocity" became fashionable demands. The belief in unilateral free trade was seriously challenged.
Threat level The conjunction of happy economic circumstance and the perceived inapplicability of the theoretical exceptions (to free trade) to British circumstance meant that these theoretical exceptions, of great potency in later periods, had very little impact on the embrace of unilateral free trade by Britain. •••
The threat to free trade was very real in the case of Britain, though it finally receded. The "latecomers," Germany and United States, practiced protection.
2 The flip side of the coin was that both Germany and United States were "coming from behind" and willing to use protection to industrialize, making the "infant industry" argument finally most potent. Ill
1930s
Macroeconomic failure
The onset of the Great Depression and the massive macroeconomic distress during and thereafter in the 1930s provided a compelling economic environment for protectionist demands to arise and flourish.
Keynes's change of mind away from free trade in the early 1930s foreshadowed the macroeconomic revolution that would effectively introduce the notion that tariffs could switch expenditure from foreign to domestic goods and thereby increase employment and national income. Later developments would include Joan Robinson's classic caveat about beggar-my-neighbor policies and, later still, the analysis of policies to maintain both external and internal balance under the adjustable peg system.
••••
The threat to free trade was not merely acute, reflecting both economic circumstance and new economic doctrine, but it also translated into reality through the 1930s.
Table 2.2. (cont.) Episode
Economic circumstance
Economic theory
IV 1930s and thereafter
The economic circumstance propelling protectionist forces was the Depression and its aftermath: it occupied center stage, to the exclusion of other forces. Nothing in the economic situation lent itself to demands for protection on grounds related to imperfect competition, in any event.
The pathbreaking developments in the theory of imperfect competition, by Edward Chamberlin and Joan Robinson, undermined the basic premise of the theory of free trade that prices would reflect social costs. However, unlike in the 1980s, this was not accompanied by significant developments in the trade-theoretic applications of imperfect competition. This reduced the overall forcefulness of this threat to free trade.
The demand for protection came, during this period, essentially from the developing countries. The presence of market imperfections, especially in their factor (rather than product) markets, was
Economic theory also developed, in tandem, to explore alternative factor market imperfections and to rank-order different trade and domestic policy interventions to improve welfare. Equally, the economic theory
Imperfect competition
V 1950s through 1970s Imperfect competition in factor markets and non-economic rtives
Threat level The lack of correspondence between economic circumstance and the new theory of imperfect competition, and the competing presence of the more powerful macroeconomic threat to free trade made the force of this threat to free trade pretty limited.
The developing countries did resort to protectionism generally. They successfully sought Special and Differential treatment at the GATT in order to do so. At the theoretical level,
considered a legitimate reason for protecting their nascent industrialization. Equally, "non-economic" objectives such as industrialization for modernization were considered to be valid reasons for departing from free trade. By contrast, the developed countries were committed to trade liberalization under GATT auspices. They enjoyed economic prosperity which reinforced, in a virtuous circle, the pro-trade policies.
of policy was extended to rank-order policy interventions, not to fix market failure, but to accommodate "non-economic" objectives. By granting legitimacy to such objectives, trade theorists developed new arguments for policy interventions, including departures from free trade. Both for factor market imperfections and for non-economic objectives, trade theory made gigantic strides in developing theoretical arguments for the first-best and second-best uses of tariffs, export duties and trade subsidies to improve on free trade.
however, the developments in the theory of commercial policy could be, and were, interpreted as narrowing down the scope for departures from free trade by showing that the first-best case for trade interventions was limited to cases where the market failures arose in the external markets whereas the best way to deal with other ("domestic") market failures ("distortions") was through domestic policy interventions instead. Equally, the use of trade instruments was optimal only when the non-economic objective was in the external sector.
Table 2.2. (cont.) Episode
Economic circumstance
Economic theory
VI Renewed imperfect competition in product markets
The economic situation was precisely the opposite of that in the 1950s through 1970s. The developing countries turned increasingly to trade liberalization (having seen the success of the Far East); whereas the developed countries started flirting actively with protectionism; the diminished giant syndrome that characterized Britain in Episode II returned to center stage, now in the United States, driving again both protectionist demands and arguments for "fair trade" and for "reciprocity."
The demands for protection and for fair trade and reciprocity coincided with theoretical advances in the theoretical analysis of imperfect competition in product markets, and the resulting application thereof to international trade theory in significant ways. These developments underlined sharply the message of the 1930s, in Episode IV, which had dealt with imperfect competition (in both product and factor markets), by specifically working out the economics of welfare-improving intervention through trade instruments under imperfect competition (of both the large and the small group variety) in product markets.
Kenewed diminished giant syndrome Return of fair trade and reciprocity
Threat level The coincidence of the demand for protection and reciprocity (resulting from the diminished giant syndrome) with the theoretical developments that could produce renewed demonstrations of the possibly beneficial effects of indulging these demands (in specific parametric situations) led to a significant threat to free trade, greater than during Episode IV and closer to that under Episode II.
Increased competitiveness due to several structural changes Fair trade in the world economy has led Harmonization and level playing to enhanced sensitivity to any fields foreign governmental policies and institutions (whose continuation in existing forms is itself taken as implying policy tolerance and therefore by implication as an act of policy) that may confer competitive advantage on one's rivals. This leads to impossible demands for harmonization, failing which there follow demands for managed trade, protection from unfair trade and absence of level playing fields, etc. VII Late 1980s and 1990s
Economic analysis of these new threats to free trade is only just beginning; it is entirely novel, different from all earlier threats (which reflected market failures). It should dominate theoretical international economics during the 1990s. It will intersect, in turn, with the major new developments in the theory of political economy and international trade during the 1980s.
The threat to free trade from the rising tide of demands for "level playing fields" and the ensuing demands for managed trade has gathered strength. It has the potential to become far more serious than most of the earlier, market-failure-variety threats.
Note: Seven threats to free trade since Adam Smith and David Ricardo are tabulated here. They are tabulated chronologically, with stars awarded under the column, Threat level, to rank-order them in terms of their efficacy in affecting free trade as the preferred policy.
a
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JAGDISH N. BHAGWATI
trade was Britain's policy. There was no serious threat to British dominance as a producer of manufactures during this period. The economic circumstance was therefore propitious for the continued embrace of free trade: strength makes it easier for politicians and industry to believe that the Darwinian process of survival of the fittest will serve one's interests well in competition. The economic theory of free trade, however, was not left unchanged and unqualified during this period. It is only a mild caricature to say that, ever since Adam Smith invented the case for the Invisible Hand (and hence also for free trade),10 economists have made their reputation by inventing reasons why the Invisible Hand fails. John Stuart Mill, in that respect no exception, produced the "infant industry" argument (1848, p. 922): n The only case in which, on mere principles of political economy, protecting duties can be defensible, is when they are imposed temporarily (especially in a young and rising nation) in hopes of naturalizing a foreign industry, in itself perfectly suitable to the circumstances of the country. The superiority of one country over another in a branch of production often arises only from having begun it sooner. There may be no inherent advantage on one part, or disadvantage on the other, but only a present superiority of acquired skill and experience. A country which has this skill and experience yet to acquire, may in other respects be better adapted to the production than those which were earlier in thefield. . . A protecting duty, continued for a reasonable time, will sometimes be the least inconvenient mode in which the nation can tax itself for the support of such an experiment. But the protection should be confined to cases in which there is good ground of assurance that the industry which it fosters will after a time be able to dispense with it; nor should the domestic producers ever be allowed to expect that it will be continued to them beyond the time necessary for a fair trial of what they were accomplishing. Mill started an argument whose theoretical formulation underwent considerable refinement during the last century. And while it proved to be of great influence in subsequent periods and in the latecoming nations, with the British free traders forecasting accurately its potency in practice - John Bright, Cobden's great ally in the movement to repeal the Corn Laws, remarked that Mill's one paragraph justifying infant industry protection "would cause hereafter more injury to the world than all his writings would do good" 12 - it did little to influence British policy, of course, and remained a theoretical curiosum there. So did the argument for the use of tariffs to extract greater gains from trade by improving the terms of trade, originally produced by Robert Torrens in 1844. Widely debated, by Mill, Bickerdike, Marshall, and
Fair tradey reciprocityy and harmonization
33
Edgeworth, it has now become the celebrated argument for an optimal tariff. But again, it found no place in British policy, a policy judgment supported by most of the eminent economists of the time but a folly according to the historian McCloskey (1980).13 I would also be remiss not to recall that the case for free trade was debated almost exclusively from the viewpoint of national advantage. And that it took a unilateral form, though it was seen from the time of Adam Smith himself that the unilateralism assumed that the trade barriers of others were immutable. All in all, therefore, the period until the rise of United States and Germany by the last quarter of the nineteenth century was characterized by the dominance of (unilateral) free trade in Britain, by the development of two remarkable theoretical exceptions to the case for free trade, and by lively academic debate over the policy merits of these exceptions and over the further issue raised by Britain's embrace of unilateral free trade and concerning the efficacy and the wisdom of British attempts at turning instead to reciprocity in free trade. Since Britain remained wedded to unilateral free trade throughout this period, and there was little sentiment among the leading economists of the time to change this policy despite the theoretical debates outlined here, the threat to free trade during this period can be dismissed as negligible. It was indeed the heyday of this doctrine. EPISODE II Reciprocity and fair trade: infant industry protection, last quarter of the nineteenth century By the end of the nineteenth century, however, the relative decline of Britain and the rise of the United States and Germany in the world economy had produced in Britain the "diminished giant" syndrome (that would recur in the United States a century later as it confronted the rise of Japan and the Far East).14 The consensus in Britain over her policy of unilateral free trade was now to be shaken. "Fair trade" and "reciprocity" became the common words of discourse. They also became the focus of organized lobbying: during the 1870s and 1880s, fair trade organizations such as the National Fair Trade League, the National Society for the Defense of British Industry, and the Reciprocity Free Trade Association arose on the British scene. The Conservative party was deeply split on the issue. Academic opinion, however, remained united behind the doctrine of unilateral free trade and the wisdom of continuing adherence to it by Britain despite manifest protection by her new and successful rivals.15 Indeed, if unilateral free trade survived in Britain into the twentieth century, protection was embraced by the new economic powers, Germany and the United States. The appeal of the doctrine of free trade was less
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JAGDISH N. BHAGWATI
compelling for the latecomers. Instead, the argument for infant industry protection, propounded ably by John Stuart Mill, had a greater resonance in these countries, just as it would after the Second World War in the newly independent developing countries. Thus, this episode during the last quarter of the nineteenth century, was marked by a serious, if eventually unsuccessful, challenge to the doctrine of (unilateral) free trade in the country that had embraced it in 1846 in a pioneering departure from the protectionism of the past, and by the explicit practice of protection by the newly emerging industrial powers. Both in terms of threat, to itself, and actual breach of its tenets, free trade must then be regarded as having been subjected to a serious challenge during this period. EPISODE III
Macroeconomic failure, 1930s
The most dramatic episode in the life of the (national) free trade doctrine, however, was to come with the onset of the Great Depression. The massive macroeconomic distress during and thereafter in the 1930s provided a compelling economic environment for protectionist demands to arise and to flourish. Writing in 1951, Hicks recounted how the unemployment of these years had seriously undermined the belief in the doctrine of free trade:16 The main thing which caused so much liberal opinion in England to lose its faith in free trade was the helplessness of the older liberalism in the face of massive unemployment, and the possibility of using import restriction as an element in an active programme fighting unemployment. One is, of course, obliged to associate this line of thought with the name of Keynes. It was this, almost alone, which led Keynes to abandon his early belief in free trade. (1959, p. 48) Keynes's apostasy on free trade had been suggested in A Treatise on Money (1930) and in his evidence before the MacMillan Committee in February 1930 where he offered the view that tariffs, while unwise as a long-term policy, could immediately alleviate the slump.17 This viewpoint however becomes more pronounced in Keynes's thinking and writings through 1931, resulting in a celebrated controversy with Lionel Robbins and the Beveridge-led (1931) riposte by Robbins, Hicks et al. to Keynes in Tariffs: The Case Hxamined (Beveridge, 1931). Interestingly, Keynes seems to have anticipated the later objection that the superior intervention to achieve full employment was domestic reflation rather than expenditure-switching protection: If nations can learn to provide themselves with full employment by their domestic policy . . . there would no longer be a pressing motive why one
Fair trade, reciprocity, and harmonization
35
country need force its wares on another or repulse the offerings of its neighbours. International trade would cease to be what it is, namely, a desperate expedient to maintain employment at home by forcing sales on foreign markets and restricting purchases, which, if successful, will rarely shift the pattern of unemployment to the neighbour which is wasted in the struggle.18
Later theoretical analysis would then show how, under fixed exchange rates, the reflation would cause external imbalance and therefore the two policies, reflation and devaluation, would be generally necessary to attain the two targets of external and internal balance. Tariffs would then appear to be inferior to both devaluation and to the optimal combination of devaluation and reflation as the policy solution to unemployment. But these insights came later. During the 1930s, Keynes's renunciation of the doctrine of free trade remained a potent source of disbelief in the doctrine. Combined with the massive unemployment unleashed by the Great Depression and the lingering aftermath of its distress, this apostasy turned the 1930s into the most deadly episode among the challenges to the (national) doctrine of free trade. EPISODE IV
Imperfect competition, 1930s and thereafter
The 1930s also witnessed the emergence of a threat to free trade from an altogether different direction. It came, not from economic circumstance as the earlier threats had partly or wholly done, but entirely from theoretical progress — and that too in a curiously tangential way. In the early 1930s, Edward Chamberlin (1933) and Joan Robinson (1933) independently came up with important theoretical analyses of imperfect competition, opening up to systematic exploration the middle ground between perfect competition and pure monopoly.19 The result was to undermine seriously the notion that market prices reflected social costs, calling into question, more widely, the virtue of laisse^ faire, and, more narrowly with it, the merit of free trade as well. The economists of the Chicago School correctly saw this as a threat that would legitimate interventionism. Therefore, they proceeded to counter the threat by taking to econometrics to demonstrate that, although markets seemed imperfect to the naked eye, in reality there was "as i f or "working" competition and that the imperfections did not amount to a hill of beans.20 Today, we talk, not of "as if" competition but of "contestable markets": but, by and large, the key thought is the same. Despite Chicago's riposte, however, the skepticism about prices not reflecting social costs due to imperfect competition remained a potent source of erosion of the belief that free trade was a desirable policy. In his
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JAGDISH N. BHAGWATI
earlier-cited essay of 1951, analyzing the different reasons why the doctrine of free trade had lost "much of its strength" and "been called into question," 21 John Hicks captured this reality well:22 the Monopoly-Competition argument . . . is of much less practical importance than the others, but it deserves at least a passing mention, because of the undoubted influence which it undoubtedly exercises - in a negative sort of way - upon the minds of economics students . . . If apparent costs only equal true costs under conditions of perfect competition, and competition hardly ever is perfect, the bottom seems to drop out of the Free Trade argument. This is in fact a fair description of the state of mind which quite a number of economics students seem to have reached. (1959, p. 46)
But the damage that the theory of imperfect competition did to the policy of free trade cannot be argued, as Hicks also suggests, to have been serious. There were two reasons. First, there was nothing in economic circumstance that led to the demand for protection; citing this kind of theory the attack on free trade was of the nihilistic variety and hard to tap by specific interest groups. Besides, free trade was already imperilled far more seriously by Keynes's desertion, by the economic circumstance of massive unemployment, and by the new macroeconomic ideas that I discussed as Episode III. When economists returned to imperfect competition in the 1980s, the threat would become more serious: economic circumstance would have changed, with more compelling craving for protection, and the idiom and substance of the new work on imperfect competition would be more readily accessible for capture by the protectionist interests. Episodes V and VI are more recent and familiar and require no elaboration. 3
Fair trade, reciprocity and harmonization, the 1990s
Until now, therefore, the challenges to the doctrine of free trade were concentrated on its national version. In turn, they reflected varying combinations of economic circumstance (fuelling the demand for protection) and economic theory (fuelling the supply of protection). 23 The latter again reflected different varieties of market failure that undermined the basic premise of the free-trade doctrine: that market prices should reflect social costs. But, even if there was no evident market failure, the question raised by Adam Smith had to be addressed: would one renounce free trade for oneself if others did not embrace it too? This issue of unilateralism versus reciprocity was never wholly dormant; but it turned to center stage during the two episodes (II and VI), a century apart, when Great Britain and the United States, both free traders in actual policy and
Fair trade, reciprocity, and harmonization
37
Table 2.3. Theoretical arrangements against free trade for oneself Episodes
Free trade: essential case
Unilateralism versus reciprocity
Episode I
Doctrine was accepted but with theoretical exceptions for two types (1) infant industry and (2) variable terms of trade^ by, for example, John Stuart Mill, Robert Torrens. Same as in Episode I
Unilateralism was accepted but a theoretical case was made for tariffs to pry open foreign markets, and hence for reciprocity, by Adam Smith. No new theoretical case of substance was developed for reciprocity, but several arrangements for unilateralism emerged in the great debate over fair trade and reciprocity that marked the British scene as Britain was afflicted by the diminished giant syndrome. Unilateralism was not an issue.
Episode II
Episode III
Episode IV
Episode V
Episode VI
Doctrine was frontally rejected by Keynes: macro unemployment was the source of market failure now. Doctrine was undermined because of the new theories of imperfect and monopolistic competition: (1) Imperfect competition in product markets: monopoly, oligopoly, and the large-group case; and (2) Imperfect competition in factor markets: monopsony (Joan Robinson). During this period, there was focus on two sets of market failure: (1) Imperfect competition in factor markets: monopsony, wage differentials between sectors, sticky or minimum wages, etc., and (2) Non-economic objectives-, the failure of markets to reflect non-economic objectives. The market failure focused now was that arising from imperfect competition in product markets: oligopoly; and the large-group case.
Unilateralism was not an issue.
Unilateralism again became an issue, reflecting both the renewal of the diminished giant syndrome (now in the US) and demonstration that lack of reciprocity may produce loss, rather than gains, vis-a-vis autarky.
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JAGDISH N. BHAGWATI
self-perception, confronted the rise of new and successful trading rivals, either avowedly protectionist or accused of being deviously so, and were engulfed in demands for reciprocity in trade. "Free trade by oneself" would have to confront "free trade for all or free trade for none." Indeed the emphasis on reciprocity and its kin, fair trade, is a natural outgrowth of economic weakness or, more accurately, of perceivedeconomic weakness. The shifted focus on to what others are doing that may aid their producers vis-a-vis ours is an inevitable consequence of the "competitiveness" concerns that attend the rise of new and fiercely successful rivals abroad. In the earlier episode relating to the affliction of many in Britain by the diminished giant syndrome and for much of the 1980s in the parallel case of American affliction, the concerns were focused largely on whether others had trade barriers as well. Doubtless, tariffs by others reduced one's gains from trade: a matter that strong countries with commensurate faith in their strength would not elevate to a policy concern. But not so, when the strong, feeling weak, faced the weak. The giants, diminished relative to erstwhile Lilliputians, were still giants. So the academic (and policy) debate that ensued was mainly about the empirical relevance, and the wider systemic consequences, of Adam Smith's old "strategic" argument. In Randolph Churchill's classic phrase, the question became: should free trade be renounced in favor of protection as an instrument for opening foreign markets, the way one pried open oysters with a clasp knife?24 But, in the recent replay, the reciprocitarians and fair traders have gone considerably further than seeking a mutuality of trade barrier levels and reductions therein, raising an altogether different and more dangerous kind of threat to free trade. Let me explain. The fair trade notion now extends to any foreign governmental policy or institution that is different from one's own. Such differences, myriad in principle, are assumed to create an unfair advantage of one kind or another in favor of foreign producers, implying the absence of "level playing fields." This results in demands for getting these policies harmonized (in practice, to what the diminished giant prefers, reflecting of course its own political and ideological constraints and objectives), or (failing harmonization) for getting the alleged trade consequences of these different policies neutralized through countervailing duties, subsidies, etc. The latter set of policies, of course, amounts to protectionist intervention on behalf of one's industries. The proponents of managed trade, i.e., a fix-quantity as against a fix-rule regime, also draw comfort from the widespread notion that, if level playing fields are absent, free trade does not make sense. The delegitimation of free trade makes the case for managing trade through bureaucratically set
Fair trade, reciprocity, and harmonization
39
market shares and allocations of production and trade targets seem like the solution that is both natural and desirable when trading countries have different policies and institutions. Reasons for the rise of fair trade The demands for fair trade are not altogether novel. They have been more or less confined traditionally to foreign subsidies and predatory dumping, both of which have long been countervailed, both before the GATT arrived on the world stage and certainly under GATT auspices. But today the demands have grown out of hand.25 They have been extended, in the case of the Structural Impediments Initiative with Japan by the United States, to nearly 240 items including Japan's savings rate, her working hours, her retail distribution system, her keiretsus, etc. The 1988 Omnibus and Competitiveness Act now defines as unreasonable, and hence actionable, a variety of foreign policies and institutions such as labor standards and export targeting. Differences in environmental policies have also come under the fair trade rubric: Senators Baucus and Danforth have recently introduced legislation in Congress to countervail differentially smaller pollution abatement costs of production in foreign countries. Believe it or not, there have even been proposals to equalize similarly, through countervailing duties, the differentially higher legal costs imposed on domestic producers by the "extortionary" tort system that American lawyers have gifted to their nation 1 Many of my examples come from the United States where the diminished giant syndrome has prompted an acute search for unfair trade by others. The payments deficit and the special chord that fairness plays in the American political psyche have further fueled this search. But I suspect that there are also broader forces at work which will make this a continuing phenomenon that should further diffuse internationally: Since it is easier to get protection if one alleges unfair trade by others than if one simply pleads for assistance citing the difficulty of one's situation, once the unfair trade route is discovered it will be well traveled. Given the decline of transparent tariffs and the rise of nontariff barriers, of varying degrees of transparency, it is somewhat easier to charge others with unfair trade. Thus, for instance, the tendency has become manifest to "construct" what imports "should" be and are not, just as in anti-dumping actions it has become customary to "construct" fair value (and win through exploiting the scope for chicanery that this procedure opens up).
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JAGDISH N. BHAGWATI
The slide to unfair trade allegations has also been facilitated by the fact that the main newly-emergent trading nation has been Japan with its manifest differences of culture and economic organization, and with its long history of being regarded since the 1930s by its fearful rivals as an unfair trader. The continuing globalization of the world economy, with its spider's web of criss-crossing investments and rising shares of trade to GNP, has increasingly made the force of international* competition more palpable to many, making producers ever more sensitive to whether, in one way or another, their rivals gain an unjustified, unreasonable, unfair advantage in the lethal struggle for markets and survival. The volatility of exchange rates, a fact of life despite "managed floats" since 1971, may have contributed to this sensitivity, though there is little econometric support for the thesis that trade volumes have been adversely affected in any significant fashion by the arrival of flexible exchange rates. For these powerful reasons, the concern over whether others are fairly trading, whether in our markets or in theirs or in third markets, has intensified. It will grow, rather than diminish. It can overwhelm the fix-rule, open trading system unless it is confronted; for, in principle and in revealed practice, the scope for unfair trade allegations is open-ended. A Pandora's box is open. Confronting fair trade How does one cope with the serious consequences of fair trade, ever looming larger, for the doctrine and regime of free trade? A pragmatic response would simply be to get nations to agree to a set of constraints beyond which the absence of level playing fields cannot be a ground for suspending free trade. This certainly should help; but it does not get to grips with the underlying theoretical problem that the issue of fair trade creates and which requires us to reconsider the way we think of free trade. This theoretical question arises because for over two centuries we have deduced free trade essentially as a mutual-gain trade arrangement among nations with private agents differentially endowed with tastes, technology, and resources, but with governments that exist only to implement our recommendations on trade policy. Free trade, and letting market-determined comparative advantage work, are thus two sides of the same coin: for, in our basic models of commercial policy where free trade and the gains
Fair trade, reciprocity, and harmonization
41
from trade are analyzed, governments simply play no independent role. But as soon as you let governments in, with their own myriad policies, they will wittingly or unwittingly affect comparative advantage: i.e., few policies are "neutral" in their impact on resource allocation. Thus, as soon as governmental policies are taken from the backburner and put on to the table, as the fair traders are now doing, there is simply no way that we can pretend that there is a (wholly) market-determined comparative advantage. Comparative advantage is inevitably "distorted," "created," in fact "shaped" by myriad governmental policies, wittingly or unwittingly. Therefore, if fair traders are to be confronted, we need a revolution in the way we think about the theory of commercial policy and gains from trade, divorcing it altogether from (untenable) notions of "market-determined" comparative advantage. In short, having discarded this baggage of marketdetermined comparative advantage, we need to ask questions such as: Can free trade produce mutual gains from trade even if two nations have different policies on, say, retail distribution or minimum wages or working hours or abatement of pollution entirely affecting one's own citizens? Or do such differences cause predation by one at the expense of the others under free trade (relative to autarky or other forms of intervention)? Would different types of harmonization in one's image, or the others', or in an altogether different fashion produce more overall gains from trade? If so, how would it affect the distribution of the gains from trade? When can one expect that non-harmonization will imply greater gains from trade for each nation, just as greater differences in private tastes between countries generally would increase trade gains? But before I consider these novel ways of getting at the way we must now address the question of free trade, putting governments and their actions squarely into our models, let me turn to the pragmatic agenda for containing the fallout from the growing flood of fair trade. Pragmatic solutions Slight reflection, if not familiarity with the way in which the traditional fair trade mechanisms in the shape of CVD and AD processes have evolved, shows at least four pragmatic forms of containment: Principle of proportionality For any specific policy where the absence of level playing fields becomes contentious, the principle of proportionality
42
JAGDISH N. BHAGWATI
can be applied: i.e., we can accept procedures which eliminate complaints that do not amount to a hill of beans. In essence, the application of an injury test is precisely a test of proportionality. Whereas it deals with proportionality of consequences, proportionality could equally be applied to the gradient on the level playing field: e.g., an anti-dumping margin of less than 20 percent may be declared inadmissible as a ground for action.26 Principle of intentionality Yet another way to contain the fair traders would be to ask whether any particular playing field is intentionallyfixedin favor of the home team or whether one is dealing with unwitting consequences. Thus, a nation subsidizing its higher education is shifting the endowment of skilled labor and therefore indirectly favoring those activities that used skilled labor. But the specific trade effect is unintended. So this range of governmental policies should be excluded from the fair traders' grasp. Principle of selectivity Again, one may agree to exclude policies that are not selectively designed in their impact. Thus, a general R&D credit, not confined to a specific industry or set of (say high-tech) industries, may be accepted as admissible even though it may have non-neutral effects on resource allocation. Equally, accelerated credit for investment amounts to an interest-free loan that can affect the choice of technique and also differentially impact on different sectors with different capital intensities. Yet, because it is applied non-selectively, it may be accepted as a policy that should be exempt from free trader's attention. Principle of proximity Finally, one may delimit fair trade concerns to include only policies that proximately, rather than indirectly, affect comparative advantage. Thus, agricultural export subsidies are offensive but not income support payments that keep farmers alive and may indirectly therefore lead to more production and exports. Principled solution: redoing the theory of free trade But these ways of containment of the fair traders, while helpful, do not get at the basic problem that fair traders find with free trade: that, in the absence of level playing fields, free trade is illegitimate since it distorts in one way or another the market-determined comparative advantage. Since governments will not self-destruct to oblige either Bakunin or Friedman, since politicians get elected or seize power to do myriad things, and since harmonizing everything is generally impossible, a theory of free trade and the gains from trade that does not squarely put governmental
Fair trade, reciprocity, and harmonization
43
policies (other than the trade policies which we seek to rank-order for benign governments to consider) into the specification of the model and its analysis will simply fail to address the concern that agitates the fair traders and undermines free trade. It is no longer enough, as in the classic welfare-theoretic analysis of Samuelson (1939, 1962), Kemp (1962), Kenen (1959), and others to argue that, in conventional economic models that postulate absent governments, we can prove well-known theorems such as that free trade dominates no trade (FT> NT) for national welfare and for world welfare, and that free trade is a mutual-gain policy for trading nations. We need to rewrite our models to allow for governments explicitly to have other policies, harmonized or otherwise, and to ask questions such as whether FT> NT in the presence of such policy differences or similarities. In particular, we need at minimum to investigate, for any particular such policy pursued by different governments in different ways so that level playing fields are absent, whether FT still dominates ATT and that F T leads to mutual gain for the trading nations. But this, and related questions which I suggest for theoretical analysis below, imply that governments must be explicitly modeled: i.e., we must build the theory of free trade on the foundations of the theory of political economy that has been developing through the 1980s, but with altogether different sets of questions. Equally, since these other policies may be driven (as in the case of environmental and labor-standards policies) by considerations which suggest that they define "non-economic objectives" (a la Corden, 1957; Johnson, 1965; Bhagwati and Srinivasan, 1969), it may be necessary in the case of some of these policies to augment the social objective function to include considerations such as: despite gains from trade, will FT not lead to more pollution or harm to child labor abroad? Thus, in the analysis required to address the concerns of fair traders and nonetheless argue for free trade, it would sometimes be necessary to combine two great traditions in the theory of commercial policy: the incorporation of non-economic objectives into the analysis, which is part of the early post-war development of the theory of commercial policy, and the explicit treatment of government, which is part of the recent (politicaleconomy) developments in the theory of commercial policy. Again, while the analysis so sketched would treat these other policies as exogenous to the choice of trade policy, so that comparisons such as F T versus NT are carried out subject to these policies pre-set in the analysis, we must also allow for the fact that some of these policies are endogenous to the choice of trade policy itself, e.g., if my labor standards are more stringent than yours, or my pollution abatement requirements are more drastic than yours, the competitive pressures that this builds on my industry in free trade may
44
JAGDISH N. BHAGWATI
lead to political lobbying to reduce environmental and labor standards at my end, in which case those of us who value environmental and labor standards would have good reason to object to free trade if harmonization of these standards to our own preference is not obtained. Thus, we need in the following analysis of fair-trade-prompted refashioning of the theory of commercial policy to distinguish among three classes of possibilities: (i) other policies exogenous; conventional objective function; (ii) other policies exogenous; non-economic objectives considered; and (iii) other policies endogenous; non-economic objectives considered. Let me indicate each type of analysis in turn, setting out the way we need to develop the theory rather than taking any particular policy and undertaking the theoretical analysis I argue to be necessary. Exogenous other policies; conventional objective function
This is the most "natural" case to consider, for a variety of policies where demands for harmonization (i.e., for level playing fields) have been raised. What questions should we ask here? Where we traditionally derive theorems that state that, for two countries I and II, F 7 > N T such that t/fT ^ U?7 and UFJ ^ 1/J7, we must now ask the following questions for the cases where there is harmonization (H) and non-harmonization (NH) and the countries then go from NT to FT. Where harmonization occurs with country Ts policy, denote it by H(I); at country IPs level, it is denoted by H(II). Question 1 The most important question which we must ask then, and which is the natural counterpart of the earlier free-trade doctrine in the absence of governments, is: will free trade, without harmonization, still lead to mutual gain* — i.e. can we still find that TTNH,FT^TTNH,NT
Uj
^Uj
,
TTNH,FT^
; and Un
TJNH,NT
^ Un
This is the key question since most fair traders seem to imply that predation, rather than mutual gains, will follow from free trade in the absence of harmonization. I would suspect that, in most cases, differential policies, left unharmonized, will be compatible with mutual gains from free trade; but this analysis is part of the agenda that awaits the theorists of commercial policy in the 1990s. Question 2 Harmonization: them like us - But the fair traders may well be interested in a different question as well, i.e., willfree trade with harmonization
Fair trade, reciprocity, and harmonization
45
imposed on the other country in one's image produce more gains than free trade without
harmonization? \ suspect that, in the case of the US's SII policy toward Japan where attempts are being made to remold Japan's retail distribution system, her keiretsusy etc. so that Japan gets closer on these policies to the US, the motivation is as much the fear that otherwise there will be predation (i.e., question 1 will be answered in the negative for the US) as the chagrin that the gains from trade are being diminished for the US by Japan's differential policies. This then leads to the comparison and question whether
Question 3 Harmonization: us like them - The question can then be turned around to ask if one's welfare would increase, relative to non-harmonization, if one changed one's policies in the image of the other. This has been suggested, for instance, by Japan-fixated writers such as Prestowitz, and by other admirers of the Japanese system as imagined by them, with regard to institutions and policies such as the keiretsus and industrial policy. In this case, the assumption to be examined, for any policy in question is, whether UH(II),FT>UNH,FT
An extremely important observation to make here is that there is no presumption at all that these harmonization versus non-harmonization comparisons will have the former win. If anything, policy differences between countries may act like private taste differences and lead to greater, rather than less, gains from trade. But this is precisely the issue that awaits formal analysis for different kinds of policies. Question 4 In case of both forms of harmonization, we should also ask the world-welfare or cosmopolitan-efficiency questions as to whether harmonization with one or other policy improves world efficiency over the case where non-harmonization prevails, and how each harmonization compares against the other, i.e., we should ask to compare27
{U?W'FT,
U%U)'FT} versus {U™-FT, U™-FT}
(2)
and
Exogenous other policies; non-economic objectives considered
As with the usual analysis of non-economic objectives, if the policies in question are treated as furthering desired social objectives, there
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JAGDISH N. BHAGWATI
may be a problem and a necessity to incorporate these into the welfare analysis at hand. Take, for instance, labor standards. If child labor is prohibited in the EC, but not in South Korea or Mexico (whether de jure or de facto), then comparative advantage may indeed shift in favor of South Korea or Mexico for labor-intensive industries that rely on child labor. But this creates no particular social-objective problem within the US where child labor laws continue to be enforced. But suppose that non-governmental organizations claim jurisdiction over what happens in South Korea or Mexico, saying that, as planetary citizens, they have a stake in what happens to children abroad as well. Then, the expansion of child labor-using industries in South Korea or Mexico, thanks to free trade, creates a non-economic disutility which must be taken into account. The EC will have to incorporate into its utility function, if this non-economic objective is held to be significant within the EC, the fact that more child labor in employment abroad means less utility at home, i.e., as done in the formal analysis of non-economic objectives (Bhagwati and Srinivasan, 1969), the EC utility function must be rewritten as ,Cn;LFc)
where Cv . .. Cn are consumption levels of goods and services 1 .. . n in the EC as in conventional analysis, and Lc is the child-labor employment in foreign countries and is a source of disutility. While this is the formal way to rework the gains-from-trade analysis in this instance, I might add that the question of asserting one's preferences over what is conventionally regarded as a matter within the domestic jurisdiction of other countries by way of social policy, and then proceeding to suspend other nations' trading rights as defined by their GATT membership, has become a major issue today. Increasingly, of course, matters which were regarded as within purely domestic jurisdiction have been internationalized: human rights is the most striking example. The question has arisen now in an acute way with environmental issues, as I noted earlier, even with regard to issues such as differences in pollution abatement policies where no physical international spillovers on to other nations are involved and where instead the environmental impact is entirely domestic and therefore the environmental policy chosen by any nation should be a matter of its own choice, reflecting factors such as its intertemporal preferences over income and environment, resources, and technology (including the current and anticipated technology of pollution prevention now and pollution cleanup later). From the viewpoint of the world trading system, the tendency to so assert jurisdiction over what others do or do not do is dangerous because it
Fair trade, reciprocity, and harmonization
47
has prompted a tendency to enact national legislations and actions by governments to unilaterally suspend other nations' trading rights when they do not have policies that conform to one's own preferences. If each nation proceeds to act unilaterally in this fashion, we face a prospect where righteousness, instead of protectionism, will reproduce the trading chaos of the 1930s! Unilateralism in these matters is therefore a lethal development. But it is well in conformity with the short-sighted mentality that has produced the unilateralism embodied in the 301 policy in the US and which is applauded inside the beltway by those who want "results" and are unable, or do not bother, to see the systemic implications of such policies.28 Endogenous other policies: non-economic objectives considered
The theoretical analysis changes further when, in matters such as environment and labor standards, the policies designed to ensure a targeted fulfillment of such objectives become endogenous to the trade policy chosen. There is, in political-economy-theoretic modeling of these questions, an interesting interplay between trade policy and, say, environmental policy. The environmentalists fear free trade will, by putting competitive pressure on their industries that bear differentially higher abatement costs, trigger demands to reduce the environmental standards; so they ask for harmonization by others up to their own domestic standards or else they oppose free trade. The industry interests seek harmonization, given the stringent domestic standards, on competitiveness grounds. The two groups then unite in their demands for fair trade and harmonization by others to the more stringent standards at home, failing which free trade is to be rejected. Where such harmonization is rejected by others, either as incompatible with their optimal choice given their own constraints and objectives or as impossible to enforce effectively (as with, say, child labor laws), this becomes a surefire recipe for protectionism. By asking for harmonization that is impossible to get, one can then get the protection that is otherwise beyond reach. In fact, there is also the possibility then that protectionist lobbies may "strategically" set socially sub-optimal higher domestic environmental standards, joining with environmental groups equally to make demands for harmonization up to these higher standards which are then calculated to be impossible to meet by foreign rivals, and then ensuring the grant of protection because of lack of level playing fields. This observation also suggests that the theoretical analysis must also allow for the fact that these other policies, such as the environmental policy, may have been set at "distorted" levels and indeed in a sub-optimal fashion.
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Thus, in the theoretical analysis I suggested earlier, comparing FT with NT subject to harmonized and non-harmonized such policies, the answers will vary, for my specific policy problem, depending on how these other policies are defined and set. 4
Concluding remarks
I have only been able to sketch here the kinds of questions that must now be explored by the theorists of commercial policy during the 1990s. Only if we rework the theory in these altogether new ways can we hope to contain the slide toward fair trade and its ill consequences: else, we will simply not be equipped to respond to the growing demands for level playing fields. I should add, in conclusion, that I have touched only tangentially on the unfair capture of the conventional fair trade mechanisms: the CVD and AD procedures. We are all in great debt to the economists such as Michael Finger, Brian Hindley, and Patrick Messerlin, and to the lawyers such as David Palmeter, John Jackson, and Michael Trebilcock, for illuminating analyses of the capture of the AD mechanism, in particular, by protectionist interests in the US and, even more so, in the EC. In turn, these findings raise yet another powerful agenda for complementary research to what I have suggested so far: how do we design these mechanisms so that we minimize the risk of such capture? We have to make sure that those who allege the lack of level playing fields are not really seeking the higher ground! The analysis of these questions takes us directly into the new microeconomics of information and incentives. It must take center stage as well in the agenda of research for the 1990s.29 In short, the agenda for fundamental thinking on the theory of commercial policy, or what James Meade beautifully entitled trade and welfare, in the 1990s will have to build squarely on foundations laid in the 1980s and earlier, not in the theory of market structure and related market failures, but in the theory of optimal intervention in the presence of non-economic objectives, in the theory of political economy in open societies that explicitly treats governments in the formal analysis, and in the theory of the design of institutions. Notes This paper is the culmination of a line of thinking which I had begun, in a somewhat primitive and preliminary fashion, in several writings from the mid-1980s, especially in the 1987 Bertil Ohlin Lectures (Bhagwati, 1988) and more notably in the 1989 Harry Johnson Lecture (Bhagwati, 1990). I have profited from conversations with Douglas Irwin who is currently engaged on a major historical
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review of the vicissitudes of the free trade doctrine since 1776, tentatively titled Economic Thought and Free Trade. The views expressed here are strictly personal. A version of this paper will appear in a volume by R. Stern and A. DeordorfT forthcoming from the Michigan University Press. 1. Nearly one hundred and fifty years ago, even John Stuart Mill and Robert Torrens had developed the two celebrated theoretical exceptions to the case for free trade: the infant-industry and the monopoly-power-in-trade arguments, so that no student of international economics or informed policy-maker could possibly have believed that economic theory could not generate arguments for departure from free trade. Given however the susceptibility of many economists unfamiliar with the field of trade theory to such claims, and the eagerness of protectionists to embrace them, some of us have been moved to write against such claims even though they are trivially easy to refute and we have more interesting things to do (see, for instance, Bhagwati, 1989). 2. Strictly speaking, market failure will arise now in the sense that the true social costs, reflecting the costs and benefits as redefined by the inclusion of the non-economic objectives, will not equal the market prices. 3. I qualify this below to argue that this case for unilateral free trade has been modified, since Adam Smith himself, to allow theoretically for departures from free trade when free trade does not obtain elsewhere. 4. Strictly speaking, one would need to distinguish between the cases where the threat to close one's markets suffices to pry open others' markets and where the threat must be made credible by actually implementing it. In the latter case, one must at least set off the current or "first-period" losses from one's protection against the "later-periods" gains from reduced barriers abroad. The optimal policy choice should then reflect the usual considerations such as the intertemporal objective function of the nation. 5. For an extended analysis, see Bhagwati and Irwin (1987) and Bhagwati and Patrick (1990). The relevant Sections of the 1988 Act are 30O-310 but are popularly subsumed under the rubric of "301." 6. Alfred Marshall's objection to the use of British protection to remove the protection of latecoming nations was based in part on the notion that these foreign nations were justified in using "infant industry" tariffs (cf. Bhagwati and Irwin, 1987). 7. The effect of the demonstration of such a possibility of welfare-improvement in Paul Krugman's (1984) classic article on import restrictions leading to export promotion appears to have been precisely to mislead many into deducing erroneously that imperfect competition in product markets implies a strengthening, rather than weakening, of the case for reciprocal free trade. 8. Under imperfect competition, as noted in the table for the case of oligopoly, reciprocal free trade need not be a desirable policy (for national advantage) compared to imposing appropriate intervention in the presence of exogenously specified foreign trade barriers. 9. I have discussed several economic rationales tot first difference reciprocity in my 1990 Harry Johnson Lecture (Bhagwati, 1991). 10. One can correctly say that Economics and International Economics were born simultaneously in Adam Smith's The Wealth of Nations.
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11. Quoted by Irwin (1991a). 12. Cf. Irwin (1991a, p. 203). 13. Also see Irwin (1987) who argues, based on econometric estimates of the relevant elasticities, that the optimal tariff could not have been large and that the maximal estimate of the loss from adopting free trade may have been of the order of 0.5 percent of GNP. 14. Bhagwati and Irwin (1987) compare the two historical phenomena, drawing both parallels and contrasts. 15. The academic defense of unilateral free trade by the best economists of the time, including the celebrated Alfred Marshall of Cambridge and F.Y. Edgeworth of Oxford, was richly textured and nuanced. It is reviewed in Bhagwati and Irwin (1987) and Bhagwati (1988). 16. Hicks' (1959) essay on free trade and modern economics was read to the Manchester Statistical Society in March 1951. 17. I am indebted to Barry Eichengreen (1984), Bernard Wolf and Nicholas Smook (1988), and Douglas Irwin (1991b), who offer a richly textured analysis of Keynes's views on free trade. 18. Cited in Irwin (1991b). Joan Robinson (1937) and Nicholas Kaldor (1950-1) analyzed further the argument that expenditure-switching policies to deflect expenditures on to oneself were "beggar-thy-neighbour" policies. 19. There were differences between the two pioneers. In particular, Chamberlin's analysis was deeper on product differentiation whereas Mrs Robinson's analysis of monopsony and price discrimination would prove seminal. Chamberlin insisted on differentiating his analysis of "imperfect" competition. Among those innocent of the resulting acrimony was D.H. Henderson (the Drummond Professor of Political Economy at Oxford at the time). Presiding over Chamberlin's lecture at All Souls' College, Henderson introduced him, with unintended double entendre, "as the father of the theory of imperfect competition." 20. I have discussed this response by Chicago at length in my obituary (1978) of Harry Johnson whose views, on migrating to Chicago from England, had progressively changed toward those of the Chicago school. An alternative response to the assertion that markets are imperfect and therefore, say, free trade must yield to welfare-improving intervention, would be to argue along with the Public Choice school that intervention will, in practice, make things worse rather than better. 21. Hicks writes: "Free Trade is no longer accepted by economists, even as an ideal, in the way it used to be. Economics has not lost authority, but the preponderance of economic opinion is no longer so certainly as it was on the Free Trade side." (1959, pp. 41-2). Doubtless, the reader will want to juxtapose Hicks' forthright statements on the challenges to free trade, as indeed his masterly analysis thereof, with Krugman's quote I started with in this chapter. 22. Interestingly, Hicks' does not explicitly cite the theory of imperfect competition or Mrs Robinson, preferring to talk of the Monopoly-Competition argument instead. Was this due to the lack of sentiment between the two great
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24.
25.
26.
27. 28.
29.
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English economists? Or did Hicks harbor theoretical reservations about the foundation of the new theory, sensing the kinds of problems that later developments in the theory of industrial organization would begin to address meaningfully only in the latter 1970s and 1980s? In table 2.3,1 divide the theoretical arguments into two broad classes: those that pertain to free trade per se, reflecting market failures of one kind or another, and those that pertain to unilateralism versus reciprocity. This would not be the way the policy issue of reciprocity would arise for a weak country. Whereas the strong who feel weak can try to force others to reciprocate, the weak can only force reciprocity on themselves. I do not go into the theoretical and policy analysis of 301 actions of the US administration here, referring the reader instead to Bhagwati and Patrick (1990). A proper history would trace the beginning of this breakout to the early 1970s, in the US, in the wake of the dollar crisis that forced the US off gold convertibility, and on to the 1974 Trade Act. In practice, however, there are documented instances of apparently minuscule margins being countervailed. Proportionality of cause is distinctly less evident in practice as against proportionality of consequences. These would be "situation" comparisons of utility possibilities, of course, under each policy set. These issues are explored systematically, the GATT laws and rulings on the subject spelled out and their rationale explained, and alternatives to unilateralism are suggested in the forthcoming Annual Report of the GATT secretariat on environment and the trading system. The recent theoretical research of Robert Feenstra, John McMillan, Dan Coates, Tracy Lewis and others is already addressing this range of issues, while there is also a more institutional literature growing of the design of institutions that govern trade.
References Beveridge, William (ed.) (1931), Tariffs: The Case Examined, London, Parker & Co. Bhagwati, Jagdish (1977), "Harry G. Johnson," Journal of International Economics, 7(3), 221-30. (1988), Protectionism, Cambridge, Mass.: The MIT Press. (1989), "Is Free Trade Passe After All?" Weltwirtschaftliches Archiv, 125 (1), 17—44; reprinted in J. Bhagwati, Political Economy and International Economics, edited by Douglas Irwin, Cambridge, Mass.: The MIT Press (1991), chapter 1. (1991), The World Trading System at Risk, Princeton, New Jersey: Princeton University Press. Bhagwati, Jagdish and Douglas Irwin (1987), "The Return of the Reciprocitarians: US Trade Policy Today," The World Economy, 10(2), 109-30; reprinted in J. Bhagwati, Political Economy and International Economics, edited by Douglas Irwin, Cambridge, Mass.: The MIT Press (1991), chapter 3.
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Bhagwati, Jagdish and Hugh Patrick (eds.) (1990), Aggressive Unilateralism: America's 301 Trade Policy and the World Trading System, Ann Arbor: Michigan University Press and Harvester Wheatsheaf. (1991), Aggressive Unilateralism, Ann Arbor: Michigan University Press. Bhagwati, Jagdish and T.N. Srinivasan (1969), "Optimal Intervention to Achieve Non-economic Objectives," Review of Economic Studies, 16, 27-38. Chamberlin, Edward (1933), The Theory of Monopolistic Competition, Cambridge, Mass.: Harvard University Press. Corden, W.M. (1957), "The Calculation of the Cost of Protection," Economic Record, 33, April. Eaton, Jonathan and Gene Grossman (1986), "Optimal Trade and Industrial Policy under Oligopoly," Quarterly Journal of Economics, 2, 383-406. Eichengreen, Barry, 1984, "Keynes and Protection," Journal of Economic Theory, 44, 363-73. Hicks, John R. (1959), "Free Trade and Modern Economics," in J.R. Hicks, Essays in World Economics, Oxford: Clarendon Press, reprinted in Hicks (1959). (1959), Essays in World Economics, Oxford: Clarendon Press. Irwin, Douglas (1987), "Welfare effects of British Free Trade: Debate and Evidence from the 1840s," presented to Mid-West International Economics Meetings, Ann Arbor. (1991a), "Challenges to Free Trade," Journal of Economic Perspectives, 5(2), 201-8. (1991b), "Keynes and the Macroeconomics of Protection," mimeo, Chicago University Business School. Johnson, H.G. (1965), "Optimal Trade Intervention in the Presence of Domestic Distortions," in R.E. Caves, P.B. Kenen, and H.G. Johnson (eds.), Trade, Growth and the Balance of Payments, North Holland, pp. 3-34. Kaldor, Nicholas (1950-1), "Employment Policies and the Problem of International Imbalance," Review of Economic Studies, 19, 42-9. Kemp, M.C. (1962), "The Gain from International Trade," Economic Journal, 72(288), December, 303-19. Krugman, Paul (1984), "Import Protection as Export Promotion," in H. Kierzkowski (ed.), Monopolistic Competition and International Trade, Oxford: Basil Blackwell. Krugman, Paul (ed.) (1986), Strategic Trade Policy and the New International Economics, Cambridge, Mass.: The MIT Press. McCloskey, Donald N. (1980), "Magnanimous Albion: Free Trade and British National Income, 1841—1881," Explorations in Economic History, 17, 303—20. Mill, John Stuart (1848), Principles of Political Economy, London, Parker & Co. Robinson, Joan (1931), The Economics of Imperfect Competition, London: MacMillan. (1937), "Beggar-my-Neighbour Remedies for Unemployment," in Essays in the Theory of Unemployment, New York: MacMillan. Samuelson, P. A. (1939), "The Gains from International Trade," Canadian Journal of Economics and Political Science, 5, 195—205.
(1962), "The Gains from International Trade Once Again," Economic Journal, 72, 820-9.
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Smith, Adam (1776), The Wealth of Nations, New York: Cannan Edition, Modern Library, 1937. Wolf, Bernard and Nicholas Smook (1988), "Keynes and the Question of Tariffs/' in O.F. Hamouda and J.N. Smithin (eds.), Keynes and Public Policy After Fifty Years, Vol. II, New York: New York University Press.
CHAPTER
3
The revival of protectionism in developed countries W.
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There is evidence of the revival of protectionist attitudes in developed countries, notably the United States and Western Europe. This chapter reviews some aspects of this protectionist renaissance, focusing particularly on the relationship between protection and macroeconomic events and policies. Protection and macroeconomic policies Recessions bring protection From 1980 to 1982 the developed world passed through a major recession created essentially by tight monetary policies designed to squeeze inflation out of the system. During this period protectionist pressures increased, and there were also some increases in actual protection. The issue arose again in the United States in 1991; as a result of the recession of that year, there was a powerful revival of protectionist attitudes directed particularly against Japan. This experience raises the important issue of the connection between two sets of government policies - protection policies and macroeconomic policies. One has to consider the case where macroeconomic policies may have induced a recession or may have failed to prevent a recession caused by other factors and where the recession in turn has induced pressures to increase protection. Policies of monetary tightness squeeze profitability and reduce employment, one aim - perhaps the primary one - being to moderate wage increases. If the moderation in wages anticipated the monetary squeeze, or 54
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at least followed it very closely, then profitability and employment would not need to fall, and the desired decline in the rate of inflation could be brought about without cost. But we know that profits do get squeezed and employment does fall. The declines in the rates of inflation in the United States, Japan, Germany, and Britain were brought about at considerable cost, especially in Britain. Additionally, if a country's monetary contraction is significantly greater than that of other countries (so that its real interest rate rises relatively), its real exchange rate is likely to appreciate and the decline in profitability and employment will be greater, the adverse effects being focused on the export and import-competing sectors of the economy. In 1981 and 1982, this was the experience both in the United States and in Britain. Pressures for protection, direct and indirect, are then inevitable. The protection may take the form not of tariffs, quotas, or voluntary export restraints (VERs), but of subsidization of private industries or the covering of losses of publicly owned industries. Recessions, whether policy-induced or not, always give rise to increased pressures for protection. This experience suggests that contradictions in government policy can arise here. The central bank and Ministry of Finance bring about a profitability squeeze which the Ministry of Industry - pushing for protection - seeks vainly to reverse. If the latter were successful, one would have to ask whether the original macroeconomic policy was justified: the profitability squeeze was meant to moderate wage increases, and these will not be moderated if the squeeze is avoided by protection. But in fact, in an overall sense, protection cannot undo what macroeconomic policy has created. It can only reshuffle the consequences. For example, with given fiscal and monetary policies, subsidies to particular industries must be balanced by fewer funds elsewhere. If taxes are raised, this may lead to increased wage demands, again offsetting the initial effects. Furthermore, protection to help some import-competing industries which have suffered from appreciation will lead to greater appreciation than otherwise, and so increase the adverse effects on other import-competing as well as export industries. These considerations do not rule out a role for microeconomic policy, including specific subsidies or even tariffs, but they do raise a question about protectionist policies designed to negate or soften the effects of macroeconomic policies. A recession - whether policy-induced or otherwise - may lead to increases in protection in spite of the implicit contradiction just discussed. The danger is then that protection will not be reduced once the economy recovers, since reducing protection may require a much more prolonged period of prosperity. Long-term costs are then imposed in the form of
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adverse effects on resource allocation and on the degree of competition. If protectionist pressures at a time of recession cannot be resisted, such adverse long-term effects must be taken into account when framing short-term macroeconomic policies. A temporary recession has, then, adverse long-term effects not only through the fall in investment that it brings about and through the loss of work experience of the temporarily unemployed but also through the recession-protection ratchet effect: a recession increases protection, but the following boom does not lower it to* the same extent. The association of increased protection with recessions or depression has also led some people to believe that protection can actually cause recessions. The association of the two in the 1930s helps to explain the free-trade movement in developed countries in the 1950s and 1960s. Others again think that protection can moderate a recession because of the favorable effects on employment in particular industries. In fact, it is not obvious that protection can either contribute to or moderate a recession. It can, of course, raise the inducement to invest in particular industries, but one must balance against this the indirect opposite effects in other industries. Protection and growth While the relationship between protection and recession goes only one way — recessions tending to increase protection but protection not necessarily moderating or intensifying recessions - the relationship between low long-term growth and protection is clearly two way. Widespread protection is likely to lower the long-term growth rate, especially if it is designed to protect losers from change rather than just consisting of a system of fixed tariffs or subsidies. If an industry that is having difficulty in coping with foreign competition can expect to obtain higher protection as a result, the incentive to improve its efficiency, or to transfer resources elsewhere, will be reduced. Protection reduces the flexibility of the economy, and hence the productivity of capital and labor. At the same time, low growth - and especially a shift of gear to a lower growth rate - means that adjustment between industries is difficult: relative losers may also have to be absolute losers, since fewer alternative job opportunities become available and since fewer resources are available to compensate losers. People become more security-minded, protection being part of an implicit "industry insurance system." Hence, it has been much easier to reduce protection at times of high growth. The relationship between the degree of protection and the rate of growth is not always clear-cut, one reason being that the degree of overall protection is difficult to measure satisfactorily. A very large economy which
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is in itself a free-trade area will lose less from some protection against imports from outside than a small economy. There is little doubt that the great economic success of the United States over a long period can be partially explained by the fact that it has been a very large area of free trade. The trend of its protection against trade with the outside world is probably less relevant in explaining its growth. For the same reason, some part of the high post-war growth in Europe can surely be explained by the freeing of intra-European trade and, especially, the establishment of the common market. The great economic success stories of the post-war period - Japan, Korea and Taiwan - have not been free-trade countries, and at some stage all practiced infant industry protection. But they have been outward-looking countries, developing during their crucial high-growth stages by export expansion. There has been little, if any, bias against exports in favor of import-competing industries, apart from agriculture. In this respect these countries have differed greatly from India and Latin American countries. It is also worth noting that Brazil's highest growth period, 1968-73, was the period when protection was reduced (though, by no means, eliminated), and when exports were fostered. In developing countries shortages of imports needed as inputs into domestic production have, at times of balance-of-payments difficulties, been an important explanation of low growth. Export expansion fostered growth by making it less necessary to restrict imports that were essential for domestic production. Protection and the exchange rate In the days of fixed exchange rates it was often said that a move to floating rates would obviate the need for tariffs and quotas to deal with balance-of-payments deficits. In the immediate aftermath of the first oil shock, it was usual to congratulate OECD countries for having avoided a revival of protectionism, the credit being given (at least to some extent) to exchange-rate flexibility. If one thinks of devaluation as a policy instrument that switches demand from foreign to home goods and, within the latter, from tradables to non-tradables, and switches output from supplying the domestic market to exports, then tariffs, tighter import quotas, export subsidies, and so on, are substitutes for devaluation. The standard argument is that they are inferior substitutes because they create distortions within the tradable goods (import-competing plus exporting) sector. Tariffs and quotas favor only import substitution relative to non-tradables, while devaluation or depreciation makes both import substitution and exporting more profitable relative to non-tradables, so that they are not anti-trade biased. Further-
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more, devaluation (or depreciation in a floating rate regime) has a uniform effect on the import side - being like a uniform ad valorem tariff - and so avoids the distortions between different import-substituting activities which result from differential tariffs or from any system of import quotas. It is thus an important argument in favor of exchange-rate flexibility that it is likely to reduce or eliminate the need to use tariffs, quotas, and similar devices for balance-of-payments reasons. Comparing two ways of improving the balance of payments (while simultaneously maintaining the level of demand for domestically produced goods and services in total) - the way of devaluation and the way of tariffs or quotas - the former has a more favorable resource allocation effect. The connection between protection, trade liberalization, and the exchange rate has been crucial for developing countries. In the 1960s and 1970s, many developing countries were very reluctant to devalue at a time of balance-of-payments crisis. The normal response was to tighten up imports restrictions - and these were not always relaxed when the crisis came to an end, so that, in many cases, a legacy of high import restrictions remained. Familiar distortions resulted. Not only did such policies introduce or strengthen a bias in favor of import-replacement against exporting, but they also distorted the pattern of imports and domestic import-competing production and, through the use of licensing as the main method of import restriction, led to rent-seeking and corruption. In the 1980s devaluations or frequent exchange-rate adjustments (crawling peg exchange rates) were more widely used, thus avoiding the tightening up of restrictions. This was partly the result of pressure from the International Monetary Fund and the World Bank. Even more important, several developing countries (notably Turkey, Morocco, and Mexico) liberalized imports, a process that had to be associated with devaluations of the exchange rates. It would certainly have been more difficult to engage in trade liberalization if the countries had been committed to fixed exchange rates or had been reluctant to devalue. It must be stressed that, for a given level of utilization of domestic labor and capacity, any improvement in the current account of the balance of payments requires a fall in aggregate expenditure, since the initial excess of expenditure over output has to be reduced if the current account is to improve. It is widely understood that this is so in the case of devaluation, but it is also true if tariffs or import quotas were, instead, to be used. Thus, trade restrictions are not painless ways of improving the balance of payments. We have considered here the case where a country has to improve its competitiveness because the balance of payments needs to improve. The argument also applies to the case where a change in the balance of payments
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is not needed but where a country is losing competitiveness owing to its inflation rate exceeding that of its trading partners. Exchange-rate depreciation can then restore competitiveness. If such exchange-rate adjustment were not possible, the resultant losses in profitability and employment in the export and import-competing industries would inevitably generate protectionist pressures. Adverse effects of exchange-rate fluctuations This standard approach views the exchange rate as a policy instrument. It implies that the exchange rate is neither fixed nor freely floating, but rather is managed so as to attain desired competitiveness or balance-of-payments outcomes. The rate could be pegged in the short run, with occasional or frequent policy decisions that alter the peg. A system of managed floating, with frequent interventions in the foreign exchange market by central banks, could also have the same result. But we must now consider a somewhat different situation, one where the exchange rate floats - possibly with some "leaning against the wind" intervention - and fluctuates over the medium term because of varying pressures originating in the capital market. There will then be changes, possibly very large ones, in competitiveness. This might be called the US problem - on which a number of economists, notably Bergsten and Williamson (1983), have focused. Whenever the United States loses competitiveness, pressures for US protectionism appear to intensify. The yen-dollar rate is particularly important in this respect. There have been three periods when the dollar was overvalued relative to the yen in terms of purchasing power parity (meaning some average longer-term real exchange rate). The overvaluation in the late 1960s and early 1970s gave rise to the Mills and Burke-Hartke bills, import controls on steel, and finally, in 1971, the import surcharge. The Burke-Hartke bill, if enacted, would have imposed strict quantitative limits on the levels and rates of growth of all imports into the United States. The overvaluation of the 1976-7 period led to major trade conflict between the United States and Japan. Finally, the overvaluation of 1981-5 led to voluntary export restraints on Japanese cars and numerous protectionist proposals in Congress. It is implied in this view that fluctuations in exchange rates originating in the capital market, especially in the yen-dollar rate, always generate pressures for increased protection in the United States when the dollar is in its real appreciation phase - when US competitiveness has declined - but that this is not offset by reductions in protection when the dollar is in its real depreciation phase. Thus, an asymmetry or ratchet effect is implied. When times are bad for US import-competing industries, they succeed in getting
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more protection, but when times become good, protection is not dismantled. There is possibly some tendency toward such a ratchet effect, though it has to be borne in mind that "protectionist pressures" do not always lead to actual increases in protection. Furthermore, one must also look at the Japanese side of the coin. In the 1980s there have been some reductions of protection in Japan (how much being hard to assess), and it seems very plausible that this has been caused not only by political pressure from the United States but also by the improved competitiveness of Japanese industries owing to yen depreciation. Medium-term fluctuations in exchange rates in response to forces originating in the capital market are not necessarily inappropriate. A country's exchange rate may appreciate because there is a transfer of long-term capital into the country based on correct expectations of favorable investment opportunities relative to other countries. Thus, for a time, the United States was seen by investors as a "safe haven." The exchange rate may also appreciate because of short-term capital inflows (or incipient inflows) that reflect particular expectations of prospective monetary and fiscal policies, expectations that may be perfectly rational, given available information. If the resultant loss in competitiveness leads to protectionist pressures, the question arises to what extent the exchange rate itself should be altered through exchange market intervention - which may be difficult, in any case, if market expectations are very firm - and to what extent effort should be put, rather, into resisting the protectionist pressures, while allowing the exchange rate to fluctuate. If the market expectations turn out to be justified, some reallocation of resources induced by the exchange-rate signals will also be justified. But this does not rule out an argument in favor of the monetary authorities forming a medium-term view about an exchange rate and, if this view differs from the market, sometimes cautiously acting on it. The US budget deficit and the decline in US competitiveness In the case of the United States there has been a connection between the budget deficit, the current-account deficit and the real exchange rate - and hence between the budget deficit and the apparent decline for some years in US competitiveness. The basic relationships are as follows. The budget deficit is financed by borrowing on the open capital market, and this tends to raise interest rates, draw capital into the United States and, thus, bring about appreciation of the exchange rate. The domestic expansionary effect of the budget would have an opposite effect on the exchange rate: it would lead to higher imports which, in itself, would tend to depreciate the exchange rate. But it is clear
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that in the US case the capital market effect on the exchange rate was stronger than the effect of the current-account deterioration. The net result was that indirectly the budget deficit was financed by foreign savings. The budget deficit led to the current-account deficit, which was financed by foreign capital inflow. Of course, the dollar also appreciated for other reasons, notably US monetary contraction which, for some time, was greater than that of the other major OECD countries. The private sector net financial surplus (excess of savings over investment) of the United States was insufficient to finance the large budget deficit. If there had been no international capital mobility, this surplus would have had to finance the budget deficit. This would have been brought about by real interest rates in the United States rising until sufficient investment was crowded out for the private surplus to reach the level of the budget deficit. There would have been no current-account deficit and hence no need for real appreciation. With an open capital market it was inevitable - and desirable from the US point of view - that the higher interest rates drew in capital from abroad. Inevitably the United States had to finance some of its budget deficit from foreign savings. If it had not done so and the structural budget deficit had attained the sorts of levels which it did, a significant decline in private investment relative to its normal recovery level in the United States would have been required. The United States had to run a current-account deficit, this being the way in which foreign savings became absorbed into the United States.1 Real appreciation is part of the mechanism by which a current-account deficit is brought about. The United States had to lose competitiveness if it was to generate the current-account deficit which was the counterpart of the capital inflow. There had to be some shift of resources, at least at the margin, away from export and import-competing industries toward non-tradables. Clearly there were gainers in the United States - above all, the industries stimulated by the extra defense spending and those benefiting from the extra consumer spending resulting from the tax cuts - but there were also losers, namely, employees and the owners of capital in the tradable goods industries, especially the more marginal ones. In addition, of course, there were gainers and losers from higher interest rates. Inevitably losers sought protection, irrespective of gainers elsewhere. It was never widely understood that the decline in US competitiveness was a by-product of expansionary fiscal policy - an inevitable one - and did not reflect any particular inadequacies of US industries. Such inadequacies surely existed, although they did not have to lead to a general loss of competitiveness, but only to a loss of competitiveness on the part of particular industries, offset - through the mechanism of exchange-rate
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adjustment - by a gain in competitiveness of other industries. The politicians whose taxation and spending policies generated the deficit should have gone to some trouble to explain that an overall loss of US competitiveness was necessary. In doing so, they might have been able to moderate some of the protectionist pressures. The following generalization might be added. If some increase in protection is a predictable by-product of real appreciation, while real appreciation in turn is a by-product of an increased fiscal deficit, then there is a reason to reduce the fiscal deficit additional to the usual reasons. It is usually argued that a large deficit would tend to crowd out private investment, might lead to the incurring of large interest commitments eventually payable by the US taxpayer, and would have adverse effects on developing-country debtors and new borrowers. To this is now added the resource misallocation cost resulting from extra protection. An increase in US protection could not alter the average effect on US import-competing and export industries of the fiscal deficit. It could only shelter particular industries or sectors at the expense of others. If an increase in particular imports is prevented by protection, other imports will have to increase even more, and so other import-competing industries will be even more adversely affected and the decline in exports will have to be greater. The key point is that the higher the level of protection for particular sectors, the greater the real appreciation of the dollar has to be to yield the required current-account deficit. The cost of protection to the United States results from the distortions set up within the US tradables sector and in distorting relative tradables prices facing US purchasers. Foreign suppliers of protected products will certainly lose, but foreign suppliers of other products will actually gain, benefiting from an even higher real appreciation. The continual real appreciation of the dollar actually came to an end in 1985. The dollar started depreciating relative to the major currencies, notably the yen and the DM, from 1985 on, and by 1990 it was (as measured by the International Monetary Fund) actually below 1980. Thus, one would expect the pressure for protection in the United States to have eased, and it did a little . . . though it revived again in the 1991 recession. The Federal budget deficit as a proportion of GNP remained high during 1984-6 (averaging 4.8 percent) but declined from 1987, and by 1989 was 3 percent. The current-account deficit clearly responded - though with a lag to the depreciation of the real exchange rate. In addition, the decline in the budget deficit played a part. The depreciation itself can be explained both by a shift in expectations and, later, by the decline in the budget deficit. Of course, relative monetary policies of the United States and the other major economies also played a role. The current-account deficit as a proportion of GNP reached its peak in
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1987, at 3.5 percent, and by 1989 was down to 2 percent. What is particularly striking is the growth in the volume of US exports that had taken place. In 1987 it was 14.5 percent and in 1988 22.5 percent, and over the whole period 1987—90, average annual export volume growth was 14 percent (compared with 4 percent for Japan). Thus, US competitiveness has certainly improved, whether measured by the movement in the real exchange rate or the actual trend in export volume. OECD protection and the developing countries Protection and the debt problem The effects of OECD protection on the developing countries are crucial. To start with, the relationship between OECD protection and the developing countries' debt will be discussed. It seems obvious that if the indebted developing countries are to meet their interest obligations and eventually to repay at least some of their debt, they must be allowed to increase their exports. It also seems obvious that it is in the interests of the developed countries, and especially their financial system, that the debt issue be resolved without open or implicit default. It might be argued that improvements in a current account can be brought about as much by reductions in imports as in increases in exports. Clearly the indebted developing countries must operate on both fronts. But if OECD countries were unwilling to accept substantial extra imports of manufactures from developing countries, then the latter would be forced to bring about the necessary balance-of-payments improvements mainly by reducing their own imports from OECD countries. This would mean that the necessary improvements would be brought about at greater cost to the developing countries. They would be deprived of the potential benefits of further exploiting their comparative advantage in labor-intensive products. More specifically, there tends to be some minimum requirement of imported components and raw materials for domestic manufacturing production (at least in the short run), so cutting imports beyond a point is likely to lead to increased unemployment. Furthermore, reduced imports would raise the cost of living, so tend to raise nominal wages to compensate, and hence lead to reduced employment in the manufacturing industry owing to higher wage costs. It follows that the indebted countries have to increase their exports - and to be allowed to do so by OECD countries - if they are to bring about the necessary balance-of-payments improvements at tolerable cost. How important has this issue been for the principal debtors? In the case of a number of products exported by them, OECD protection must have
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reduced their income substantially. The Community's Common Agricultural Policy has had an adverse effect on Argentinean agricultural exports. Some of the debtor countries are substantial exporters of textiles and clothing. The Republic of Korea is a debtor country (which has been repaying its debt) and obstacles have been placed by the United States on its exports of textiles, clothing, and color television sets. In addition to these products, Community countries have restricted imports from Korea of steel products and (in the case of France at least) many other goods. Its footwear exports generally meet trade obstacles in the Community on a whole range of primary product exports. Japan has quotas on footwear imports. These are just examples. Perhaps more important in the case of several of the countries are the actual and expected obstacles against products which would form the basis of a feasible export expansion program. The potential for expanding exports of labor-intensive goods of various kinds would seem to be very large. I shall return to this point below. The effects of OECD protection on the developing countries Until the 1980s one could say clearly that OECD protection in the manufacturing sector grossly discriminated against developing countries, especially the more successful exporters among them. This was in spite of the Generalized System of Preferences, which had a modest effect compared with the various and complex restrictions imposed under the umbrella of the Multi-Fibre Arrangement (MFA). It really seems outrageous that over a long period of time severe limits have been placed on imports of textiles and clothing from developing countries. It appears that these restrictions, if anything, have been strengthened since the renewal of the MFA in 1981. This arrangement provides a framework for bilateral agreements (utterly contrary to the most-favored-nation GATT principle) and is the basis for numerous VERs. At the end of 1982 the United States had bilateral agreements with twenty-two developing countries, mostly embracing all textiles and textile products (clothing), and with the Community, twenty-nine. The 1981 MFA renewal endorsed continued quantitative restrictions arranged bilaterally, especially against the most successful suppliers. Furthermore, the complexities of the arrangements are likely to inhibit exporters, especially the less experienced ones. Textiles and clothing are by no means the only products from developing countries that have suffered from restrictions, but it is here that the comparative advantage of developing countries (as well as some of the ex-socialist countries of Eastern Europe) is particularly strong. The Common
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Agricultural Policy also has an adverse effect on many developing countries which are exporters of wheat, beef, rice, and sugar; Poland's exports are held back by this policy. It is worth noting that some developing countries which are importers of products the Europeans export at heavily subsidized prices are gainers. This would include particularly major grain importers. It cannot be said that the Common Agricultural Policy clearly discriminates against developing countries since it has a significant adverse effect on temperatezone exporters such as Australia, Canada, and New Zealand (though Argentina is also in that group). In addition, because of restrictions imposed primarily on Japanese exports in recent years, one cannot say for sure that overall protection by the United States and the Community discriminates against developing countries. But it does discriminate against particular labor-intensive products, and, in any case, in some fields at least, it puts a severe limit on export expansion by developing countries. The importance of these protectionist policies directed against exports from developing countries can perhaps be overstated.2 After all, manufactured exports from developing countries to OECD countries have continued to increase and rose steadily, even relative to world trade, over the whole post-war period. It is worth noting that in 1970 the share of developing-country imports in the total (apparent) consumption of manufactured goods in industrial countries was 1.7 percent, and by 1980 it had risen to 3.4 percent. In the United States it rose from 1.3 percent to 2.9 percent. Over the period 1983 to 1989, the volume of exports from all those developing countries that were predominantly exporters of manufactures rose by 8.5 percent per annum, a very impressive result. The growth rates of exports from Korea, Turkey, Malaysia, Thailand, and the People's Republic of China were particularly high. So protection may have slowed the growth of exports somewhat but did not halt it. Even exports of textiles and clothing have steadily increased. Taking a broad view, the severest restrictions have clearly been applied in the field of clothing and textiles. Even here some suppliers have managed to cope with the restrictions by upgrading their products: when restrictions are on a quantitative basis it pays to export higher-value products. This, of course, is not necessarily an economically sound adjustment for a country that may have a comparative advantage in low-value, low-quality products. In addition many developing countries have widely diversified their exports, moving into areas where there have been rather fewer or looser restrictions: machinery and non-metallic mineral products (including china and glassware), and miscellaneous goods such as sports equipment, toys, and musical instruments. Furthermore, extensive import controls have been imposed on products from the Far Eastern exporters; nevertheless, they have increased their shares of the OECD market. Restrictions on
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footwear imports into most OECD countries have not been as tight as for clothing and textiles, although Japan has strict quotas, the Community has negotiated VERs with Korea and Taiwan, and tariffs are still moderately high (averaging 13 percent in the major developed countries). On the other hand, the possibilities of export expansion are very great. There are widespread restrictions on imports of consumer electronics from developing countries, notably Korea, and yet these must be regarded as having a major potential for growth. Developing countries clearly have a comparative advantage in textiles, clothing, and footwear and yet still have only a small part of the market of OECD countries. (In 1976 the developing countries had about 2 percent of the total US market for textiles and 10 percent of the market for clothing, though, of course, they had a much larger share of imports. In 1980 the share in the market of a group of eleven industrial countries as a whole - including the main ones - was 5.4 percent for textiles and just over 16 percent both for clothing and for footwear.) Not only are there possibilities of further expansion from the major existing exporters but there are also many potential exporters around the world who could, after an initial infant-industry period, become suppliers of such goods to the industrial countries without subsidization. But there is always the danger that they will be discouraged by the prospects of restrictions as soon as they manage to break into a market. Protection by developing countries Perhaps the worst aspect of the continuance of such protection and the revival of protectionist sentiments in the developed countries is that it could lead to a revival of export pessimism in developing countries, leading again to inward-looking policies. In the 1950s export pessimism was fashionable, especially in India and Latin America, and, arguably, led to severely growth-inhibiting importsubstitution policies. For a long time it was widely believed that there was little hope of breaking into the markets for manufactured goods of the developed countries so that, if developing countries were to build up their manufacturing industries, they would have to do so by replacing imports. On the basis of such beliefs some highly uneconomic industries were built up in many countries, for example India and Brazil. Partly as a result of the successes of the new industrial countries, as well as of academic and World Bank research and writing, there has been a gradual shift of opinion, leading to significant moves to trade liberalization in many developing countries, the outstanding example being Mexico. Through hard experience the disadvantages of import-substitution policies have been realized. The experiences of Korea and Taiwan seemed to justify export optimism. In fact, in major
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countries, notably India and Brazil, the shift of policies has not been so great. But there is always a danger that this tendency will be reversed. There are really two separate issues here. One is whether protection in developed countries justifies protection by developing countries. It might be noted here that most developing countries have much more all-embracing systems of protection — and, on the average, at much higher rates — than OECD countries have. If the OECD rates of protection were given, there would be no case for developing countries keeping their protection just because of OECD protection. This is a well-known proposition of trade theory: one country's protection does not justify another's. Protection by a trading partner lowers the real income both of the partner and at home, and protection at home would add to the income loss both at home and in the partner country. The matter would be different if OECD protection consisted of fixing the quantity of (rather than rates of protection on) imports from developing countries. It would then pay the latter to restrict their exports so as to obtain the highest possible prices, given the fixed quantity they can export. An indirect form of export restriction is through quotas and tariffs on imports (with the exchange rate adjusting to bring exports down to the reduced level of imports). But, of course, such an extreme situation does not really exist. Thus there is still a case for these countries in general to reduce their trade restrictions. The second issue is crucial. In practice, it has been quite difficult to persuade policy-makers and the general public in developing countries to liberalize their trading arrangements. The protectionist arguments used have been prevalent in developed countries as well, and are very similar. They are the types of arguments that have been analyzed by economists for over two hundred years and generally have been found wanting. If there is a revival of protectionist attitudes in developed countries, if it seems that OECD protection has greatly increased (though it may not actually have done so), and if it is possible to obtain ready-made arguments from intellectuals and policy-makers in developed countries in favor of protection, then it is quite possible that the liberalization trend in the developing world would be reversed. Increased protection by developing countries themselves - or even a failure to continue liberalization trends - may do them more harm than have the possibly modest increases in protection in Europe and the United States, but the latter may encourage the former. Some arguments for protection It is worth looking briefly at some arguments for protection currently popular in the United States and Europe. 3 The main argument
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from the point of view of politicians is presumably that protection may raise the incomes of particular groups in their countries or - more important may avoid falls in incomes that might otherwise take place, and that these groups have political influence. But a variety of arguments is used to show that either fairness or the national interest justifies such protection. With regard to the national interest, the implication is that there is some national gain - either that there will be no significant losers from protection but only gainers or that over time losers could be compensated and a net gain would remain. In fact, no new arguments for protection have been developed in recent years. Indeed, some of the currently popular arguments were advanced in the nineteenth century in the United States, notably the "pauper labor" argument. One of the more acceptable arguments in current conditions is for the imposition of temporary restrictions to modify a sudden import surge that might impose serious and unexpected injury on some domestic industry. This will be referred to later in connection with a possible safeguard code and GATT Article XIX. Here let us look briefly at the employment argument, the pauper labor argument, the fairness argument, and the dumping argument. Subsequently I shall consider the supposed "problem" of Japan. The employment argument Protection of an industry may contribute to preserving employment in that industry. At the same time there is evidence that the actual declines in employment in particular industries (such as textiles, clothing, automobiles, and steel) that have taken place in the United States and Western Europe have not been primarily caused by increases in import shares. In the United States in particular, declines in rates of change in overall demand for various industries' products as well as labor productivity growth have been quantitatively much larger in their impact on employment (as shown in Krueger, 1980). Nevertheless, if import competition is significant and the volume of imports is large, common sense suggests sufficient protection could offset the adverse employment effects of these other factors. The weakness of the employment argument is that it is narrowly partial equilibrium, focusing only on particular industries. One should note the adverse effects, for example, of protection of steel on steel-using industries. Higher steel costs reduce effective protection (protection related to value added) for the automobile industry and will tend to reduce employment there, and this could more than offset the gains in employment in the steel industry. More important are the general equilibrium effects operating
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through effects on wage levels and the exchange rate. Here let us note the oft neglected exchange-rate aspect. If protection of some industries is increased and yet the balance of payments is not to change, then - given the average level of nominal wages as well as foreign costs - the exchange rate has to appreciate. And this will have an adverse effect on employment in those tradable-goods industries where protection has not increased. To consider the case where the general level of protection for import-competing industries is reduced, such reduction would have to be associated with depreciation of the exchange rate and thus would have beneficial effects on employment in export industries. The possibility of transitional unemployment effects cannot be denied: the demand for labor in one set of industries may fall while that in others increases, but labor may not readily move, and in the short run the former industries may shed labor before the latter absorb extra labor. But such a problem suggests simply the need for temporary measures to foster adjustment, not protection designed to prevent change. In addition there may be some general real wage rigidity. If initially there is unemployment because real wages are too high, then, if protected industries are labor-intensive relative to non-protected industries, an increase in protection would raise overall employment. The gain in employment in the protected industries would more than offset the losses in the non-protected industries. But here it must be noted that United States exports, not import-competing industries, tend to be relatively laborintensive (though there are measurement problems which require this to be stated with caution) so that, given the real-wage rigidity assumption, a general rise in tariffs or imposition of quotas, as proposed for example in the famous Burke-Hartke bill, would actually lower US employment overall. In any case, the real-wage rigidity model is too simple. If the nation as a whole gains from a particular measure (that is, non-labor and labor incomes combined rise), there is scope through the tax system for maintaining after-tax real wages while lowering pre-tax real wages to the levels required for full employment. The pauper labor argument The pauper labor argument is that protection should be imposed on goods originating from countries where wages are low. In fact, in many developing countries labor costs per unit of output are not relatively low, since the benefits of low wage costs are offset by low labor productivity. But let us suppose that labor costs per unit are low for particular products, presumably labor-intensive ones. This simply means that these countries have a comparative advantage in such products. There must be other
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products where costs are relatively high, for otherwise they would be only exporting, not importing. If they were only exporting, then presumably they would need to alter their exchange rates unless they were primarily interested in importing bonds - that is, lending money - rather than importing goods and services. Another version of this argument is that it is "immoral" to buy goods produced by cheap or "sweated" labor. On the basis of such an argument some labor unions have advocated restricting imports from Hong Kong, for example. Yet if the demand by the United States for Hong Kong products fell, Hong Kong producers would either have to lower their prices - and hence in due course the wages they paid - in order to unload more exports on other markets or unemployment in Hong Kong would increase. Fairness argument To industrialists faced with competition from imports produced in more favorable conditions than at home, such competition seems "unfair." Thus one gets the view that conditions - wages and other factors affecting the cost of labor - should be equalized around the world. In the extreme this could be interpreted to mean that protection should offset all comparative advantage differences, so that all trade would cease. More plausibly it may be meant that the flow of trade should depend purely on differences in managerial efficiency and entrepreneurial skill, all other factors being offset by protection. In any case, the appropriate analysis is the same as in the case of the pauper labor argument. But there is one complication. Suppose foreign governments subsidize certain industries or the exports of certain products. They may provide indirect assistance, as Britain used to do when it covered the losses of publicly owned industries, or the United States does through its defense spending or its space program. One country may pump funds into research and development, another into its educational system, a third into its agricultural sector, and a fourth into reviving its steel industry. Does this mean that it is in other countries' interests to engage in countervailing protection? If a country is concerned only with maximizing its national income and neither with sectional interest nor with fairness, such protection is not to its advantage. The various interventions by country A should be taken as given by country B when the latter formulates its optimal policy, at least unless it can induce country A to change its policies in more favorable directions. But some intervention policies by country A may actually be favorable for A's trading partners, for example, policies that lower the prices of A's exports relative to its imports. In the case of unfavorable
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policies, such as tariffs that restrict the flow of trade, if B responds by imposing tariffs of its own, the cost of protection will be increased. All this must be qualified for the case where the foreign interventions are expected to be temporary, in which case they can either be ignored or some temporary offsetting measure might be applied to avoid short-term dislocations. Dumping In the 1980s, anti-dumping measures have become very common instruments of protection. The principal users are the United States, the European Community, Canada, and Australia. These measures are subject to the GATT Anti-Dumping Code, which was amended in 1980 and which is actually quite permissive about such selective, discriminatory measures (Stegemann, 1991). Dumping generally means that a country exports its products at prices lower than it sells them at home. Naturally the competing industries abroad will seek to get the country to raise its export prices or will try to persuade their own governments to impose countervailing duties. Yet, there is no logical argument for such reactions. It should not really be of interest to either the import-competing producers of a country or its purchasers of imports at what prices these goods are sold to purchasers in the foreign country. In general a nation benefits when its imports become cheaper relative to its exports, even though import-competing producers may lose. If there is a sudden fall in the price or a surge of imports, there may be some argument for temporary protection, but this has little or nothing to do with whether the price charged to consumers in the supplying country is above or below the import price. The "Japan problem" There has been great concern in Europe and the United States about the growth of Japanese exports and, even more, there has been fear even paranoia - about their prospective growth. A good deal of the revival of protectionism has been directed against Japan, notably in the case of motorcars, steel, and consumer electronics. Partly this appears to be connected with trade and current-account balances. Japan has had large trade surpluses with the United States. This is reduced but not eliminated when services are allowed for; that is, when the focus is on the current rather than the trade account. But world trade is not meant to be balanced bilaterally, so clearly one must at the minimum look at Japan's overall current account.
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In the twelve years from 1970 to 1981 Japan ran current-account deficits in four years, balance in one, and surpluses in the other seven. The two big surplus periods were 1971-2 and 1977-8. But the surpluses were low as proportions of Japanese GNP - the maximum was 2.5 percent in 1971, and in 1977 and 1978 they were only 1.6 percent and 1.7 percent respectively. But in the five years 1984 to 1988, the surplus averaged 3.4 percent of GNP. In general, changes in the Japanese overall current account have been closely correlated with bilateral current-account movements with the United States, and the explanations can be largely found in the relationships between Japanese and US macroeconomic policies. Essentially there have been two explanations: divergences in overall macroeconomic demand levels or pressures (in 1977-8, the United States followed expansionary and Japan relatively contractionary policies) and divergences in the monetaryfiscal policy mix, as recently. Apart from these cyclical movements, there does appear to be some general tendency for the Japanese current account to be in surplus, a surplus substantially larger than required to maintain constant the real value of Japan's foreign financial assets. These current-account surpluses are not necessarily matters for concern. The Japanese household sector has a very large savings ratio by world standards, and even though most of these savings are absorbed by Japanese private investment and by the Japanese budget deficits, there is on average still something left over for the rest of the world, so that Japan as a nation tends to be a net buyer of financial assets in exchange for goods. This is not necessarily a bad thing. It tends to lower world interest rates. It is the obverse of the situation of most developing countries and of the United States situation. In fact, as the United States became a large net borrower on the world capital market as the result of its budget deficit, there had to be net lenders - countries that ran current-account surpluses - and Japan was the premier candidate for this role, a role in which it was practiced and which, for some time, its cautious citizens saving massively for their old age have been eager to fulfill. There are surely gains from international trade in financial assets against goods, as there are in goods-goods trade. There are, furthermore, plenty of similar examples from the history of countries that ran surpluses over long periods, notably Britain in the nineteenth century. There seem to be two problems connected with Japan's impact on the world. The first is that a large, high-growth, high-productivity country, by the very fact of its importance and of the changes it generates in the rest of the world, provokes fears. These fears were provoked by the United States in the 1950s. For those who do not understand the law of comparative advantage, there is the fear that this country is getting better at everything -
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and presumably will end up only exporting and not importing. There is also the feeling that, just because the country happens to have the world's highest productivity growth rate now, this must go on forever - even though Japan's growth rate has actually slackened dramatically since 1974. The second problem is the true problem. There are losers as well as gainers both from longer-term Japanese economic expansion (with a given current-account balance) and from periods (like 1971-2, 1977-8, and 1981-4) when there is a substantial Japanese current-account surplus. In the former, long-term growth case, the gainers are the consumers of Japan's export products and the suppliers of food and raw materials; while in the latter episodes the gainers include those consumers as well as borrowers who can draw indirectly on Japanese savings. But the focus, inevitably, is on the losers. They are the competitors with Japanese exports, above all. The problem is particularly acute when these exports expand suddenly. In Japan, unlike other countries, a deflation of domestic demand leads very quickly to a significant increase in exports, so that variations in Japanese domestic macroeconomic policy manifest themselves in variations in exports. From 1975 to 1981 the volume of Japanese exports increased 71.5 percent while import volume rose only 21.4 percent. Just to show how quickly exports can change, in 1976 export volume was 43 percent above 1973. It is no wonder that competitors in other countries were unhappy. But it is not difficult to explain these developments. Japan suffered a sharp deterioration in its terms of trade owing to the two oil price shocks, and compensated by pushing exports. A big current-account deficit in the first half of 1974 had by the second half of 1974 been turned into a surplus. Taking the whole period from 1975 to 1981, when export volume increased 71.5 percent and import volume rose only 21.4 percent, the country's terms of trade deteriorated 52 percent. The reaction to these developments has been increased protectionism outside Japan. In particular, the two oil shocks created major adjustment problems, some of which manifested themselves indirectly through increased competition from Japan in certain products, as Japan sought to avoid large current-account deficits. It has to be accepted that rapid expansion of Japanese export volume however justified by the rise in its import prices - inevitably generates protectionist pressures in other countries. So it may be advisable in such situations for Japan to moderate rapid export expansion and accept temporarily larger budget deficits (so as to reduce its current-account surpluses) even though such restraint is in the interests neither of consumers in other countries nor of borrowers. One should look rather carefully at the full implications of proposals that Japan open its own markets further to imports from the United States and
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Europe. First it must be stressed that this would have an adverse effect on third countries, such as Australia and many developing countries, if it led to discrimination in favor of the United States (and there are some signs that this is happening). Apart from that, reductions in Japanese protection would have favorable efficiency effects on the standard grounds that more of the benefits of comparative advantage differences would be reaped. But the source of current complaints has been the surge in Japanese exports. If Japan accelerated its growth rate or opened up its markets more, its imports would increase, which would inevitably lead to more exports. There is no reason why the current account would disappear or even turn into a deficit, since this depends on the aggregate savings-investment balance, which is only very indirectly affected by changes in Japanese protection levels, if at all. The tendency would be for the yen to depreciate in real terms even more, thus improving Japanese competitiveness and, no doubt, generating increased pressures from US and European industries for protection. It is doubtful that these pressures would be moderated by the knowledge that the Japanese have reduced their own protection. The industries in the United States that benefit from the extra sales to Japan need not be the same ones that would lose from a new Japanese export expansion. The current pressures in the United States designed to reduce the bilateral trade imbalance between the two countries are misguided for five reasons. First of all, the focus on bilateral balances is grossly misguided. World trade balances - insofar as it does - multilaterally. It is the inevitable nature of comparative advantage that bilateral "imbalances" will emerge. Thus, Australia has a surplus with Japan and a deficit with the United States. In a triangular relationship there is some canceling out of imbalances. Surely Australia should not impose restrictions on imports from the United States, with the aim of favoring Japan, because of its bilateral deficit with the United States, nor should Japan restrict imports from Australia for the same reason. Second, the focus on the trade balance - which does not include trade in services - is misguided (and even more, when it is focused on trade in particular categories of goods, such as automobiles). The United States actually has a surplus in trade in services with Japan. Third, even the concern with overall current-account balances is misguided. In a world of capital mobility, it can be strongly argued that the current account, in itself, does not really matter at all (see Corden, 1992). As noted earlier, it simply reflects the exchange of financial assets for goods. If capital flows into a country in order to finance a private investment boom, and a current-account deficit naturally comes about as part of the transfer process, this may well be a desirable flow. It all depends on the nature of the investment, whether private investment decisions are distorted by public
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policies, or whether they are based on unwise private investment decisions. If there is a problem, it will not be the current account as such but rather the particular investment decisions. When the current-account deficit results essentially from a budget deficit, as in the case of the United States (where, on the whole, there has not been a very significant change in private savings and investment ratios), the problem is the budget deficit - which imposes a burden on future taxpayers - and not the current account. The United States is lucky to have been able to draw on Japanese and German savers to finance its deficit, and so avoid crowding out of US borrowers. If the United States had continued running the budget deficit but, instead of increasing its foreign debt, had reduced its domestic investment, it would probably have imposed an even greater burden on future generations. Fourth, the pressure on Japan to take the initiative to reduce its surplus and hence the US deficit - was misguided because such action would be harmful to the United States. By what mechanism would an increase in the Japanese budget deficit - which would appreciate the yen and raise world interest rates - reduce the US deficit? In the absence of a change in the US budget deficit, it could only reduce the US deficit if US savings were raised or investment reduced. The rise in world interest rates - and hence US interest rates - would indeed reduce investment. Since it is doubtful that savings respond much to interest rates, it is doubtful that the savings ratio would be raised. Assuming that US monetary policy would, in any case, have assured a level of demand in the United States that yielded the "natural rate of unemployment," there would not be any scope for savings rising owing to an increase in US real income induced by the real depreciation of the dollar which would be the mirror image of the real appreciation of the yen. Thus, success in the US pressure, while benefiting tradable goods producers in the United States and increasing US competitiveness, would bring about a decline in US investment. Finally, there is the most misguided aspect of the pressure for increasing US protection and reducing Japanese protection in order to alter current accounts. There is no reason to believe that overall current accounts would be affected by changes in protection. This point has already been made above. The current-account deficit is definitionally equal to the excess of private investment over private savings plus the budget deficit. Why would US protection lower investment, raise savings, or reduce the budget deficit? Of course, an increase in tariffs might do so insofar as it brought in revenue, but in this respect it is no different from any other tax increase. An increase in US protection might well reduce US imports, but it would lead to a real appreciation of the dollar that would stimulate exports. Protection affects
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the pattern of US tradable goods industries, the protected industries expanding and the others contracting. The current-account balance depends on the net capital flows which, in turn, depend on savings and investment, private and public. At this point a qualification should be noted. If the United States discriminated against imports from Japan, it might succeed in reducing its bilateral deficit with Japan. But, given savings and investment in the United States and Japan, the dollar would appreciate and the US bilateral surplus with Australia, for example, would decline, and its deficit with Taiwan would increase further. As for Japan, when its market in the United States declines owing to the discriminatory measures directed against it, its exchange rate would have to depreciate, and this would reduce its imports from Australia, as well as from the United States. On balance, there would be a reshuffling of bilateral balances, with Japan selling less to the United States and more to other countries, and the United States buying less from Japan and more from other countries. Changes in rules and changes in attitudes Much of the current policy discussion on international trade issues is concerned with institutions and rules. Among the developed countries the post-war movement toward the freeing of trade was built around GATT, and GATT itself was built around the most-favored-nation principle - the principle that tariffs and quantitative import restrictions should not discriminate among sources of supply. Only agriculture and textiles were left out of this process. But GATT has been bypassed more and more, and a feature of the "new protectionism" is that it is discriminatory, leading to bilateral arrangements, and that it involves devices that are not subject to GATT rules and procedures. Various proposals for changes have been made. In general Americans tend to favor extending and tightening rules, ensuring that "codes" are obeyed, and so on, while the Europeans are inclined toward more pragmatism, which at the moment means letting every country be as protectionist as it wants, subject only to some limitations that can be rather easily bypassed. The GATT ministerial meeting of November 1982 came up against this conflict and no progress was made, whether to slow up the existing movement toward more protectionism, to tidy it up and make it more transparent (the latter needed especially with regard to VERs), to enforce and extend the new subsidies code agreed upon at the Tokyo Round, or to extend regulations to include trade in services (as the United States wished). The most urgent need seems to be to bring the various non-tariff
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restrictions that now exist - the VERs, the quotas, and especially the bilateral arrangements under the auspices of the MFA - within the ambit of GATT rules. This, of course, should be an outcome of the Uruguay Round negotiations. Some allowance must be made for the desire of countries to impose at least temporary restrictions on particular imports when there is a sudden inflow likely to impose substantial damage on particular domestic industries (even though such an import surge would benefit consumers or industries that use these imports as inputs). Article XIX of GATT is a famous article that provides for quotas on these grounds but sets certain conditions. Restrictions must be nondiscriminatory, must be temporary, and must be justified to GATT. Countries imposing restrictions under that article must notify the affected parties in advance and must consult with them, are expected to compensate countries against which affected action is taken, and could be subject to retaliatory action in the form of the withdrawal of equivalent concessions by adversely affected exporters. Countries have bypassed Article XIX by inducing suppliers to accept VERs or what are called "orderly marketing arrangements," of which the MFA is the main case. Suppliers have agreed reluctantly because the alternatives would probably not be Article XIX restrictions but unilaterally imposed import quotas which would be even less satisfactory from the exporters' point of view. Attempts at the Tokyo Round negotiations or later to negotiate a new "safeguards code," involving a revision of Article XIX to make it more acceptable and to bring much of the new protectionism within its ambit, failed. The main obstacle was the determination of the European Community to preserve the principle of selectivity - discrimination among countries — something that was not acceptable to most developing countries and probably also not to the United States. It is well known that the United States was the original protagonist of the principle of non-discrimination, having viewed the British preferential system of the prewar years with great disfavor. But perhaps there is a deeper reason why no agreement had been reached by January 1992 to bring the various existing unilateral or bilateral safeguard arrangements within GATT rules. The major nations simply see no reason to subject their policies to international scrutiny. But, in any case, this matter will be resolved by the outcome of the Uruguay Round negotiations. It could be argued that the central problem is one of attitudes. If attitudes became less protectionist, agreements would be readily reached and it would be found easy to strengthen GATT. If they harden - if protection becomes the new conventional wisdom - then surely in time the attitudes will be reflected not just in a maintenance of the new protectionism but in increased actual protection and thus in a substantial movement away from
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the open trading system. The greatest concern must be about protection that is designed to prevent adjustment in OECD countries to export expansion by developing countries. Essentially, protection as currently practised in developed countries involves protecting one sector of an economy at the expense of others, with the nation as a whole losing, at least in the long term. The gains from protection are usually very visible, perhaps concentrated on one industry, while the losses are more indirect and thinly spread. The understandable argument for protection is that it helps a particular sector, this being a sufficient argument for the relevant lobby. But, as noted above, it is often argued incorrectly and yet persuasively that there are national gains - in particular that, in the absence of protection, employment lost at one end of the economy as a result of an inflow of imports will not be compensated for by employment gains elsewhere. As a result, it is usually thought by non-economists that protection yields national gains at the expense of foreign suppliers, thus providing the basis for trade negotiations. The central message that economists regularly preach, but fail to convey, is that protection is likely to inflict a loss on the protecting nation itself. Yet it is a message that - if understood - should carry much weight. The question thus arises why attitudes have become more protectionist and how a shift in attitudes back to a belief in the gains from trade can be fostered. While this issue seems to arise particularly in the European Community, none of the developed countries seems immune from the revival of protectionist sentiment. It is not difficult to find protectionists in the United States Congress or in the US labor movement. If a shift back to a belief in the advantages of relatively free trade does not occur, it is at least possible that the fairly open world trading system in manufactures that we had until the early 1970s will be gradually eroded with long-term adverse effects for the world economy, and especially for the growth of many developing countries.
Notes This is a revised version of W.M. Corden, The Revival of Protectionismy Occasional Paper No. 14, The Group of Thirty, New York, 1984. 1 An excellent exposition of these issues, making many of the key points stressed in the present paper, appeared in Council of Economic Advisors (1983), chapter 3. 2 The following discussion draws on Hughes and Waelbroek (1981) and Hughes and Krueger (1983). 3 One argument not discussed here is the infant-industry argument. This is used currently by advocates of protection for high-technology or "sunrise" industries. This argument has slightly more to be said for it than some of the other
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arguments discussed here but is not as widely applicable as often believed. It is analyzed in Corden (1974), chapter 9. References Bergsten, C.F. and W.R. Cline (eds.) (1983), Trade Policy in the 1980s, Washington, DC: Institute for International Economics. Bergsten, C.F. and J. Williamson (1983), "Exchange Rates and Trade Policy," in C.F. Bergsten and W.R. Cline (eds.), Trade Volicy in the 1980s, Washington, DC: Institute for International Economics. Corden, W.M. (1974), Trade Volicy and Economic Welfare, Oxford: Clarendon Press. (1980), "Relationships Between Macroeconomic and Industrial Policies," The World Economy, 3, 167-84. (1992), "Does the Current Account Matter? The Old View and the New," in Jacob A. Frenkel and Morris Goldstein (eds.), International Financial Policy: Essays in Honor of Jacques J. Polak, Washington, DC: International Monetary Fund. Council of Economic Advisers (1983), Annual Report. Washington, DC: US Government Printing Office, chapter 3. Hughes, H. and A.O. Krueger (1983), "Effects of Protection in Developed Countries on Developing Countries' Exports of Manufactures," in R. Baldwin (ed.), The Structure and Evolution of Recent US Trade Policies, Chicago: University of Chicago Press. Hughes, H. and J. Waelbroek (1981), "Can Developing Country Exports Keep Growing in the 1980s?" The World Economy, 4, 127-48. Keesing, D.B. and M. Wolf (1980), "Textile Quotas Against Developing Countries," Thames Essays No. 23, London: Trade Policy Research Centre. Kelly, M., Naheed Kirmani, Miranda Xafa, Clemens Boonekamp, and Peter Winglee (1988), "Developments in International Trade Policy," Occasional Paper No. 16, Washington, DC: International Monetary Fund. Krueger, Anne (1980), "Trade Policy as an Input to Development," American Economic Review, May, 288-92. Lai, D. (1981), "Resurrection of the Pauper-Labour Argument," Thames Essays No. 28, London: Trade Policy Research Centre. Stegemann, K. (1991), "The International Regulation of Dumping: Protection Made Too Easy," The World Economy, 14, 375-405.
CHAPTER
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Changes in the global trading system: a response to shifts in national economic power ROBERT E. BALDWIN
Introduction Significant changes are taking place in the global trading system. The growing importance of regional trading arrangements is one such development, as indicated by the negotiation of the North America Free Trade Agreement, the enlargement of the European Community, and the revival of regional trading arrangements in Latin American and Africa. Another is the increased use of non-tariff measures to restrict trade, e.g., the voluntary export-restraint agreements in steel, automobiles, and machine tools, the price fixing agreement in computer chips, and the anti-dumping and countervailing duties imposed on a wide range of products, coupled with the greater difficulty of securing trade liberalization through multilateral negotiations, such as the Uruguay Round. Using the threat of closing one's own markets as a means of opening foreign markets is still another major change, as demonstrated by the more frequent use of Section 301 of the 1974 Trade Act and the inclusion of a Super 301 provision in the 1988 Trade and Competitiveness Act. This chapter relates these changes in trade policies to significant structural changes in world industrial production that have brought about a decline in the dominant economic position of the United States, a concomitant rise to international economic prominence of the European Economic Community and Japan, and the emergence of a group of newly industrializing developing countries (NICs). The first two sections describe the rise of the United States to a dominant position in international economic affairs in the immediate post-war period and indicate the types of hegemonic actions followed by this country. "Shifts in International 80
Changes in the global trading system Economic Power" explains how changes in trade, finance, and energy conditions, have led to modifications in national trade policy behavior, particularly on the part of the United States, while the following section discusses the trade policy response of countries to these shifts in economic power. We then speculate about the nature of the international trading regime that is evolving under the present distribution of economic power among nations. The chapter's final section is a summary and conclusion.
The rise in US hegemony The role of the United States in the evolution of the modern trading system has been central. Although this country became an important trader on the world scene after the First World War, it gave little indication at the time of a willingness to assume a major international leadership role. The American share of the exports of the industrial countries rose from 22.1 percent in 1913 to 27.8 percent by 1928 (Baldwin, 1958), but during this period the United States chose political and economic isolation by rejecting membership in the League of Nations and by erecting in 1930 the highest set of tariff barriers in its peacetime history. The failure of the London Economic Conference of 1933 due to the inward-looking economic position of the United States marks the low point of US internationalism in the interwar period. A major policy reorientation toward participation in international affairs began in the United States during the late 1930s and especially in the Second World War. More and more political leaders and the electorate generally began to accept the view of key policy officials in the Roosevelt Administration that continued international isolationism would bring renewed economic stagnation and unemployment to the American economy and the likely prospect of disastrous new worldwide military conflicts. Consequently, active participation in the United Nations was accepted by the American public as were the proposals to establish international economic agencies to provide for an orderly balance-of-payments adjustment mechanism for individual nations and to promote reconstruction and development. International trade had long been a much more politicized subject, however, and all that was salvaged (and then only by executive action) from the proposal for a comprehensive international trade organization was the General Agreement on Tariffs and Trade (GATT). The economic proposals initiated by the United States were not, it should be emphasized, aimed at giving this country a hegemonic role. Rather, they envisioned the United States being one of a small group of nations that would cooperate to provide the leadership necessary to avoid the disastrous nationalistic policies of the 1930s. The envisioned leadership group
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included the United Kingdom, France, China, and hopefully, the Soviet Union. Hegemony was thrust upon the United States by a set of unexpected circumstances. The failure of the United Kingdom to return to anything like her prewar position as a world economic power was unforeseen. US officials thought, for example, that the US loan of $3.75 billion to the United Kingdom in 1946 would enable the country to restore sterling convertibility and return to its earlier prominent international role. But the funds were quickly exhausted, and it was necessary to restore exchange control. The 1949 devaluation of the pound was equally disappointing in its failure to revitalize the country. Economic reconstruction in Europe also proved much more costly than envisioned. The resources of the International Bank for Reconstruction and Development (the World Bank) proved to be much too small to handle this task and massive foreign aid from the United States became necessary. The US economy also grew vigorously after the war rather than, as many expected, returning to stagnant conditions. The failure of either China or the USSR to participate in the marketoriented international economy placed an added leadership burden on the United States. But perhaps the most important factor leading to US hegemony was the effort by the Soviet Union to expand its political influence into Western Europe and elsewhere. American officials believed they had little choice from a national viewpoint but to assume an active political, economic, and military leadership role to counter this expansionist policy, an action that most non-communist countries welcomed. The significant expansion of productive facilities in the United States during the war coupled with the widespread destruction of industrial capacity in Germany and Japan gave American producers an enormous advantage in meeting the worldwide pent-up demand of the 1940s and 1950s. The US share of industrial country exports rose from 25.6 percent in 1938 to 35.2 percent in 1952 (Baldwin, 1958). (The combined share of Germany and Japan fell from 24.0 percent to 11.4 percent between these years.) Even in a traditional net import category like textiles, the United States maintained a net export position until 1958. Static trade theory suggests that a hegemonic power will take advantage of its monopolistic position by imposing trade restrictions to raise domestic welfare through an improvement in its terms of trade. However, like the United Kingdom when it was a hegemonic nation in the nineteenth century, the United States reacted by promoting trade liberalization rather than trade restrictionism. A restrictionist reaction might have been possible for a highly controlled, authoritarian economy that could redistribute income fairly readily and did not need to rely on the traded-goods sector as a major source of employment generation or growth, but the growth goals of
Changes in the global trading system free-market firms together with the nature of the political decision-making process rule out such a response in modern industrial democracies. Industrial organization theory emphasizes that firms in oligopolistically organized industries take a long-run view of profitability and strive to increase their market share. In doing so, they try to prevent both new competitors from entering the market and possibly causing losses to existing firms and old competitors from increasing their shares to the point where others might suffer progressive and irreversible market losses. US oligopolistic firms seized the post-war competitive opportunities associated with American dominance to expand overseas market shares both through increased exports and direct foreign investment. The desire of US political leaders to strengthen non-communist nations by opening up American markets and providing foreign aid complemented these goals of US business, and business leaders actively supported the government's foreign policy aims. Even most producers in more competitively organized and less high-technology sectors such as agriculture, textiles, and miscellaneous manufactures favored an outward-oriented hegemonic policy at this time, since they too were able to export abroad and were not faced with any significant import competition. The United States behaved in a hegemonic manner on many occasions in the 1950s and early 1960s. As Keohane (1984, chapter 8) emphasizes, in doing so, it did not coerce other states into accepting policies of little benefit to them. Instead, the United States usually proposed joint policy efforts in areas of mutual economic interest and provided strong incentives for hegemonic cooperation. In the trade field, for example, US officials regularly pressed for trade-liberalizing multilateral negotiations and six such negotiations were initiated between 1947 and 1962. The United States traded short-term concessions for possible long-run gains, since the concessions by most other countries were not very meaningful in trade terms due to the exchange controls they maintained until the late 1950s. The US goal was to penetrate the markets of Europe and Japan as their controls were eased and finally eliminated. One instance in which the United States did put considerable pressure on its trading partners to accept the American viewpoint was in the Kennedy Round of multilateral trade negotiations. At the initial ministerial meeting in 1963, US trade officials - with President Kennedy's approval - threatened to call off the negotiations unless the European Community accepted the American proposal for a substantial, across-the-board tariff-cutting rule. Members of the Community had regained much of their economic vitality and the United States wanted economic payment for its earlier nonreciprocated concessions and its willingness to support a customs union arrangement that discriminated against the United States.
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In the financial area the $3.75 billion loan to the United Kingdom in 1946, the large grants of foreign aid after 1948 under the Marshall Plan, and the provision of funds to help establish the European Payments Union in 1948 are examples of hegemonic leadership by the United States. American leaders envisioned a post-war international monetary regime withfixedand convertible exchange rates in which orderly adjustments of balanceof-payments problems would take place. When the International Monetary Fund (IMF) proved inadequate to cope with the magnitude of post-war payments problems, the United States provided financial aid until the affected countries were strong enough economically for the IMF to assume its intended role. A US hegemonic role was also exercised in the energy field, as American companies, with the assistance of the US government, gained control over Arab oil during the 1940s and 1950s. Shifts in international economic power Trade competitiveness
The hegemonic actions of the United States aimed at maintaining the liberal international economic framework established largely through its efforts and at turning back the expansion of the Soviet Union succeeded very well. By 1960 the export market shares of France, Germany, Italy, and Japan had either exceeded or come close to their prewar levels. Among the industrial countries only the United Kingdom failed to regain its prewar position by this time. The restoration of peacetime productive capabilities in these countries meant that the exceptionally high market shares of the United States in the early post-war years declined correspondingly. The 35.2 percent US export share of 1952 had dropped to 29.9 percent by 1960, a figure that was, however, still higher than its 1938 share of 25.6 percent (Baldwin, 1962). For manufactured products alone, the picture is much the same. The US world export share decreased sharply from 29.4 percent in 1953 to 18.7 percent in 1959, while shares of Western Europe and Japan rose from 49.0 percent to 53.7 percent and from 2.8 percent to 4.2 percent, respectively (Branson, 1980). The export market share of Western Europe remained unchanged in the 1960s, but the Japanese share continued to rise and reached 10.0 percent in 1971. At the same time the US share of world exports of manufactures fell to 13.4 percent by 1971. While aid from the US government played an important part in restoring the trade competitiveness of the European countries and Japan, the governments of these nations themselves were the prime driving force for revitalization. The French government, for example, formulated an industrial modernization plan after the war and two-thirds of all new
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investments between 1947 and 1950 were financed from public funds. Similarly, the British government under the Labour Party created an Economic Planning Board and exercised close control over the direction of post-war investment, while even the relatively free market-oriented German government channeled capital into key industries in the 1950s. Government investment aid to the steel, shipbuilding, and aircraft industries and the use of preferential government policies to promote the computer sector are other examples of the use of trade-oriented industrial policies in Europe during this period. Japan is perhaps the best-known example of the use of government policies to improve international competitiveness. During the 1950s and 1960s the Japanese government guided the country's industrial expansion by providing tax incentives and investment funds to favored industries. Funding for research and development in high technology areas also became an important part of the government's trade policy in the 1970s. Governments of newly industrializing developing countries used industryspecific investment and production subsidies to an even greater extent than any of the developed nations in their import substitution and export promotion activities. Not only had the prewar export position of the United States been restored by the late 1960s, but the absence of significant import pressures in major industries ended. Stiff competition from the Japanese in the cotton textiles industry was evident by the late 1950s, and the United States initiated the formation of a trade-restricting international cotton textile agreement in 1962. A broad group of other industries also began to face significant import competition in the late 1960s. The products affected included footwear, radios and television sets, motor vehicles and trucks, tires and inner tubes, semi-conductors, hand tools, earthenware table and kitchen articles, jewelry, and some steel items. Trade pattern changes in the 1970s and early 1980s were greatly influenced by the price-increasing actions of the Organization of Petroleum-Exporting Countries (OPEC). This group's share of world exports rose from 5.4 percent in 1970 to 13.7 percent in 1981 {Economic Report of the President, 1986). By 1985 OPEC's share had, however, fallen to 7.1 percent as the power of the cartel declined. The 1970s saw a continued decline in the US share of world exports, although at a greatly decreased rate. The US share of world exports fell from 13.8 percent in 1970 to 11.7 percent by 1981, while that of the European Community dropped from 36.2 percent to 30.7 percent. Japan managed to increase its share from 6.2 percent to 7.6 percent. The non-OPEC developing countries also performed well, increasing their share from 10.9 percent in 1970 to 12.9 percent in 1981.
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The dominant factor influencing US trade in the 1980s was the dramatic appreciation of the dollar during the first half of the decade and its depreciation during the second half. The real trade-weighted value of the US dollar increased from an index of 84.8 in 1980 (1973 = 100) to 131.9 in 1985 and then back to 86.4 by 1990. The appreciation brought about an enormous increase in the merchandise trade deficit from $25 billion in 1980 to $160 billion by 1987. Due to the lag in the adjustment process the deficit was still at $102 billion in 1990. The US share of total world exports actually increased somewhat during this period, rising from 11.1 percent in 1980 to 11.7 percent in 1989 (see International Trade, 89-90, General Agreement on Tariffs and Trade for these and the following figures). However, the US share of world exports of manufactured goods declined from 13.3 percent in 1980 to 11.4 percent in 1988. Japan continued its growth in market share with total exports rising from 6.4 percent in 1980 to 8.9 percent by 1989. For manufacturing the rise was from 11.2 percent in 1980 to 12.7 percent in 1988. However, the most impressive performers in manufacturing were the developing countries. Their share of world exports of manufactured goods rose from 9.5 percent in 1980 to 15.1 percent in 1988. An important feature of the trade-pattern shifts in industrial countries during the 1970s and 1980s was the severe import competition faced not only by labor-intensive sectors like textiles, apparel, and footwear but also by large-scale, oligopolistically organized industries such as steel, automobiles, and shipbuilding. Machine tools and consumer electronic goods also came under increasing import pressure. International financial and other economic changes As a decline in the dominant trade-competitive position of the United States became increasingly evident in the 1960s, both the United States and many other countries became dissatisfied with the US role in the international monetary system offixedexchange rates. Since the supply of gold in the world increases only slowly, the demand for additional international liquidity that accompanied the rapid growth in world trade had to be met by greater holdings of dollars, the other official form of international reserves. However, as these holdings grew, a number of countries became concerned about the freedom from monetary and fiscal discipline that such an arrangement gave the United States and resented the seigniorage privileges it granted. The US also became increasingly dissatisfied with its inability to change the exchange rate of the dollar as a means of adjusting its balance of payments. Another indication of the decline in US hegemony was the creation in 1969 of a new form of
Changes in the global trading system international liquidity in the International Monetary Fund (IMF), namely, Special Drawing Rights (SDRs), designed to reduce the dependence of the international economy on the dollar. The shift to a flexible exchange-rate system in 1971 was the clearest manifestation of the decline in US dominance in the monetary field, however. Although the results of this action have not given countries the expected degree of freedom from US financial influence, the role of the dollar as a reserve and vehicle currency has declined. Another institutional change directed at reducing the monetary influence of the United States was the formation of the European Monetary System in 1979. The severe difficulties faced by the industrial nations in the energy field as a consequence of the success of OPEC have already been mentioned. This development was an especially devastating blow to the international economic prestige of the United States. Trade policy responses to the redistribution of national economic power The non-hegemonic members of the international trading regime, i.e., countries other than the United States, responded to the inevitable industry disruptions caused by the shifts in comparative cost patterns in a manner consistent with their earlier reconstruction and development policies. With the greater post-war emphasis on the role of the state in maintaining full employment and providing basic social welfare needs, these governments intervened to prevent increased imports and export market losses from causing what they considered to be undue injury to domestic industries. Assistance to industries such as steel and shipbuilding injured by foreign competition in third markets took the form of subsidies, including loans at below-market rates, accelerated depreciation allowances and other special tax benefits, purchases of equity capital, wage subsidies, and the payment of worker social benefits. Such activities had been an integral part of the reconstruction and development efforts of the 1940s and 1950s, and the provisions of the GATT dealing with subsidies other than direct export subsidies did not rule out such measures. Because of the difficulties of modifying the tariff-reducing commitments made in the various earlier multilateral trade negotiations, import-protecting measures generally did not take the form of higher tariffs. By requiring compensating duty cuts in other products or the acceptance of retaliatory increases in foreign tariffs, increases in tariffs could have led to bitter disputes and the unraveling of the results of the previous negotiations. Therefore, to avoid such a possibility, governments negotiated discriminatory quantitative agreements outside of the GATT framework with
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suppliers who were the main source of the market disruption. For example, quantitative import restrictions were introduced by France, Italy, the United Kingdom, and West Germany on Japanese automobiles and on radios, television sets, and communications equipment from Japan, South Korea, and Taiwan (Balassa and Balassa, 1984). Flatware, motorcycles, and video-tape recorders from Japan and the NICs of Asia were also covered by such import restrictions on the part of various European countries. In the agricultural area, which had been excluded from most of the rules of the GATT, governments did not hesitate to tighten quantitative import restrictions (or restrictions like those under the European Community's Common Agricultural Policy that have the same effect) or provide export subsidies to handle surpluses produced by high domestic price-support programs. In the United States the disrupting effects of the post-war industry shifts in competitiveness throughout the world produced basic policy disputes that continue today. Except for two politically powerful industries, oil and textiles, up until the latter part of the 1960s import-injured industries were forced to follow the administrative route provided for import relief under the escape clause provisions of the GATT. Moreover, many of the industry determinations by the International Trade Commission were rejected at the presidential level on foreign policy grounds, i.e., the need for the hegemonic power to maintain an open trade policy. Industry subsidies provided by foreign governments, though subject to US countervailing duty laws, were also largely ignored by the executive branch for the same reason. The official position of the United States began to change under the strong import pressures of the late 1960s. As their constituents described the competitive problems they faced, fewer members of Congress accepted the standard argument that a liberal US trade policy was essential to strengthen the free world against communism. The intensity of congressional views on trade issues is indicated by the rejection by that body of President Lyndon Johnson's 1968 request for new trade authority and by the near approval in 1970 of protectionist legislation covering a wide variety of products. The growing unwillingness of the allies of the United States in the Cold War to accept the unquestioned US leadership in international political, military, and economic affairs also caused officials in the executive branch to question the traditional American position on trade policies. The view that gradually gained the support of the major public and private interests concerned with trade matters was that a significant part of the increased competitive pressure on the United States was due to unfair trade policies of foreign countries such as government subsidization, dumping by private and public firms, preferential government purchasing
Changes in the global trading system procedures, and discriminatory foreign administrative rules and practices relating to importation. This argument had appeal for several reasons. No new legislation was required to provide import relief; a stricter enforcement of long-existing domestic legislation seemed to be all that was necessary. After a material injury clause was introduced into the US countervailing duty law in 1979, these laws also were consistent with the provisions of the GATT dealing with unfair trade practices. Consequently, stricter enforcement of US unfair trade laws was unlikely to lead to bitter trade disputes with other countries. By placing the blame for their decline in competitiveness on unfair foreign actions, US managers and workers could avoid the implication that this decline might be due to a lack of efficiency on their part. Finally, government officials could maintain that the United States was still supporting the rules of the liberal international regime that the country had done so much to fashion. The emphasis on the greater need for fair trade was clearly evident in the Trade Act of 1974. The best-known provision of this legislation, Section 301, authorizes the president to impose new duties or other import restrictions as well as withdraw previous trade concessions unless foreign countries remove a wide variety of perceived unfair trade practices. As amended by the 1979 Trade Act, these practices include the maintenance of unjustifiable, unreasonable, or discriminatory policies that burden or restrict US commerce or deny benefits to the United States under any trade agreement. Some 70 cases have been brought under Section 301 since 1975 with a noticeable increase in the frequency of its use since 1985. The 1974 Act also authorized US participation in the Tokyo Round of multilateral negotiations. In reshaping the president's proposal, the Congress stressed that the president should seek "to harmonize, reduce, or eliminate" non-tariff trade barriers and tighten GATT rules with respect to fair trading practices. Officials in the executive branch supported these directives not only on their merits but because they deflected attention from more patently protectionist policies. The Tokyo Round codes, which were enacted into US trade law in the Trade Act of 1979, by no means fully satisfied those who strongly stressed the need for fairer trade, but their provisions and the attention that the subject received established the framework for many of US trade-policy actions that followed. There has, for example, been a marked increase in the number of anti-dumping and countervailing duty cases since the 1979 Trade Act. The number of anti-dumping investigations totaled 494 between 1980 and 1990, while the number of countervailing duty investigations amounted to 300 over the same time period. Trade legislation in the 1980s continued to broaden the scope for taking actions against import practices alleged to be unfair and against foreign
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countries that restrict access by US exporters to their domestic markets. For example, the Trade and Tariff Act of 1984 and the Trade and Competitiveness Act of 1988 make it easier to obtain anti-dumping and countervailing duties when foreign producers try to avoid such duties either by shipping components of the product subject to the duties rather than the product itself or by shipping another good containing the dumped or countervailed product as an intermediate input. However, so-called Super 301 is the most important provision of the 1988 Act dealing with unfair trade. Under this provision, particular countries targeted for their unfair trade-distorting practices must reach an acceptable agreement with the United States over the practices within a specified time or risk retaliatory action by the United States. One of the most important protectionist actions taken by the United States in the 1970s and 1980s, namely, the gradual tightening of controls over steel imports (over twenty-five countries are now covered by such controls), has also been justified mainly on the grounds of unfair trade practices by foreign producers. For example, the trigger price mechanism (TPM) introduced by the president in 1978 that in effect established minimum import prices for steel was designed to offset foreign dumping. When a series of voluntary export restraint agreements with leading steel exporting nations were concluded in late 1984, a spokesperson for the US Trade Representative stated: "We are responding to unfair trade in the US; defending yourself against unfair trade is not, in our opinion, protectionism" (New York Times, December 20, 1984). The unfair trade argument has been used in support of most other trade-restricting or trade-promoting actions taken by the United States in recent years. The textile and apparel sectors have been described by government officials as "beleaguered" by disruptive import surges, thus justifying more restrictive import controls. Similarly, when temporary orderly marketing agreements (OMAs) were negotiated in the 1970s with selected east and southeast Asian countries, the implication conveyed was that these were responses to unfair export activities of these nations. Even the Japanese voluntary export restraints on automobiles introduced in 1981 are often justified by American industry and government officials on the grounds that the industry's competitive problem was in part due to the unfair targeting practices of the Japanese government. On the exportpromoting side, it is routinely claimed that subsidized export credits through the Export-Import Bank are necessary to counter unfair foreign practices in these areas. In short, fair trade arguments using such phrases as the need for "a level playing field" or "to make foreign markets as open as US markets" have become the basic justification for the greater use of trade-distorting measures by the United States.
Changes in the global trading system Although the United States became more aggressive in the 1970s and 1980s in unilaterally restricting access to its own markets when it believed foreigners were adopting either export-promoting or import-restricting unfair trading policies, US officials continued to press for multilateral negotiations as a means of dealing with such practices. For example, the United States proposed a new multilateral negotiation round at a meeting of trade ministers in 1982. However, both the European Community and the developing countries rejected the US initiative, although they eventually agreed to new negotiations in 1986 (the Uruguay Round). This rejection had a major effect in causing the United States to negotiate a series of regional agreements as a means of securing some of its trading objectives. These include the Caribbean Basin Initiative, the US-Israel Free Trade Agreement, the US-Canada Free Trade Agreement, and the North American Free Trade Agreement. The future of the international trading regime The US fared well economically in its hegemonic role: American exporters and investors established substantial foreign market positions from which they are still benefiting greatly. The open trade policy that US officials were able to maintain for so long also promoted growth and resource-use efficiency and thus extended the period of US economic dominance. But the post-war recovery of Europe and Japan and the emergence of a number of developing countries as industrial economies brought an inevitable relative decline in US economic and political power. The comparative economic position of Western Europe also receded from its post-war recovery level as Japan and the industrializing developing countries grew more rapidly. The outcome in the area of commercial relations has been a relative decline in the multilateral approach to trade policy and increased emphasis on such approaches as non-tariff protection, regionalism, and market opening measures. No country or country group is likely to assume a dominant role in the world economy during the rest of the century and first part of the next. Japan would seem to be the most likely candidate for this leadership role with its highly competitive industrial sector, but this country appears to be too small economically to be a hegemonic power. Moreover, like the United States in the 1920s, Japan is still quite isolationist. Government and business leaders are conditioned by the disastrous outcome of the country's expansionist efforts in the 1930s and 1940s and by its past history of inwardness. Furthermore, when a potential hegemonic nation first demonstrates its competitive strengths over a wide range of products, certain traditional sectors, for instance, agriculture, that are faced with difficult adjustment problems tend to be able to prevent the national commitment to
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trade openness required by a dominant economic power. This occurred in the early stages of both the British and American rise to economic dominance and is now hampering Japan from assuming a commitment to openness commensurate with its competitive abilities. In addition, Japanese consumers have not yet developed the taste for product variety needed to make Japan an important market for foreign manufactured goods. The European Community possesses the size and resources to be the dominant economic power, but the very diverse economic nature of its members and the severe structural adjustment problems faced by almost all of them preclude a hegemonic role for this economic bloc. The developing countries of East Asia are becoming major players in world markets for manufactured goods, but they are not sufficiently united politically to act as a dominant power. The United States remains the country most able to identify its trading interests with the collective interests of all. However, a number of the industries that were among the most competitive internationally during the rise of US hegemony have become victims of their success. The relatively high profits these oligopolistically organized industries were able to maintain provided the investment funds needed to take advantage of the expanding market opportunities at home and abroad. But their economic structures were also favorable to the development of powerful labor unions that wished to share these profits through higher wages. The outcome was wage increases in these industries that far exceeded wage increases in manufacturing in general. Consequently, as other countries developed their productive capabilities, these American industries found themselves penalized by above average labor costs and an institutional framework that made it very difficult to adjust to the new realities of international competition. Management in some of these industries also failed to keep up with the most advanced practices. Another very important feature of these industries is their ability to obtain protection by exerting political pressure at the congressional and presidential levels, if they fail to gain it through administrative routes involving the import-injury, anti-dumping, and countervailing duty laws. The consequence of these developments is that protectionism has gradually spread in the United States as such industries as steel, automobiles, computer chip, and machine tools have come under severe international competitive pressure. European governments are faced with even stronger protectionist pressures for similar reasons and have also moved toward more restrictive import policies. As Mancur Olson (1983) has argued, organized common interest groups such as these industries tend to delay innovations and the reallocation of resources needed for rapid growth.
Changes in the global trading system There seems to be no reason why the recent trend toward increased non-tariff protectionism, more regionalism and greater unilateral efforts to open export markets will not continue in the world economy. But one should not conclude from this that the present international trading regime will turn into one where protectionism is rampant and multilateralism is abandoned. There are - and will continue to be - dynamic, export-oriented industries in the older industrial countries that will seek access to foreign markets and see the relation between this goal and open markets in their own country. Moreover, such industries will have considerable political influence, as US high technology and export-oriented service industries have demonstrated. These sectors will continue to provide the United States, Western Europe, and Japan with the economic power that makes international openness a desirable trade-policy objective. Moreover, the GATT is likely to continue to prove to be a mutually beneficial institution in which to resolve trade disputes and reach agreements on matters affecting the trade of most countries. Consequently, none of these trading blocs is likely to adopt a policy of general protection or cease to support the multilateral trading system. But will not creeping protection at the industry level eventually bring a de facto state of general protection? And will not increased unilateralism and regionalism, in effect, destroy the multilateral system? These are, of course, real possibilities. However, one reason this conclusion need not follow is that protection usually does not completely stop decreases in employment in declining industries. Even politically powerful industries usually only have sufficient political clout to slow down the absolute fall in employment. Furthermore, while employment tends to increase due to the fall in imports from the countries against which the controls are directed, offsetting forces are also set in motion. These include a decrease in expenditures on the product as its domestic price tends to rise; a shift in expenditures to non-controlled varieties of the product, to either less or more processed forms of the good, and to substitute products; a redirection of exports by foreign suppliers to more expensive forms of the item; and, if the import controls are country-specific, an increase in exports by non-controlled suppliers. The larger industry profits associated with the increased protection are also likely to be used to introduce labor-saving equipment at a more rapid pace than previously. The continued decline in employment after increased protection is well documented from histories of protection in particular industries (e.g., United States International Trade Commission, 1982). In the European Community and the United States even such politically powerful industries as textiles and apparel and steel have been unable to prevent employment from falling despite increased import protection.
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While there are many factors that determine an industry's effectiveness in protection seeking, its size in employment terms is one important factor. With declining employment, an industry is likely to face diminishing political power not only because of a fall in its voting strength but because of a decrease in its ability to raise funds for lobbying purposes. The decline in the political power of the US agricultural sector as the farm population has declined is an example that supports this hypothesis. It seems likely, therefore, that highly protected industries such as textiles and apparel will gradually lose their ability to maintain a high degree of import protection. Consequently, in older industrial nations the spread of protection to sectors in which newly industrializing countries gradually acquire international competitiveness may be offset by a decrease in protection in currently protected sectors. Counter-protectionist pressures also build up as industry-specific protection spreads. The stagnating effect of this policy becomes more obvious as do the budgetary and economic efficiency costs. A state of affairs may thus be reached in which protectionism will not increase on balance in the current group of industrial countries or only at a very slow rate. Meanwhile, export-oriented high technology and service sectors will encourage continued international cooperation to maintain an open trading regime. The formation of regional groupings also in itself lowers trade barriers, although on a discriminatory basis. The enlargement of the European Community (EC) and the development of special free-trade relationships between the EC and other countries in Europe represent a major liberalization of trade as does the North American Free Trade Agreement. Furthermore, after such regional agreements are negotiated, strong pressures are usually exerted on these groups by non-member countries to undertake protection-reducing multilateral trade negotiations so that the discriminatory impact on non-members will be reduced. One can make a case that regional groupings may lead to a faster pace of overall liberalization. Even if this sanguine scenario takes place, the international trading regime is likely to operate quite differently than it did in the years of US dominance. Industrial countries will seek short-run economic reciprocity in their dealings with each other. In particular, the United States seems no longer willing to trade access to the American market for acquiescence to US international political goals and the prospects of long-term penetration of foreign economic markets. The developing countries and nations with special political relationships with particular major trading powers will probably continue to be waived from the full reciprocity requirement but their trade benefits from this waiver will be closely controlled. Greater emphasis will be placed on bilateral negotiations in reducing non-tariff trade distortions, though these negotiations may still take place at general meetings of GATT members. The articles and codes of the GATT will
Changes in the global trading system provide the broad framework for such negotiations, but the variety and discriminatory nature of non-tariff measures make true multilateral negotiations too cumbersome. Bilateral negotiations will also be used to a greater extent in handling trade disputes. The GATT dispute-resolution mechanism will be utilized by smaller countries in their dealings with the larger trading nations and by the larger nations to call attention to actions by one of their members that are outside of generally accepted standards of good behavior. These means of settling disputes will not differ essentially from the practices followed throughout the history of the GATT. Greater discrimination among countries in the granting of trade benefits and the imposition of restrictions is another feature of the emerging international trading regime. This is an inevitable outcome of the increased number of regional trading arrangements. In addition, the increased use by countries of countervailing and anti-dumping duties and the greater willingness to adopt 301-type actions reinforce this trend. More state assistance for the development and maintenance of high-technology and basic industries is likely to be another characteristic of the international trading order. The governments of industrial countries and developing nations will continue to insist on the use of subsidies to develop a certain minimum set of high-technology industries and to maintain a number of basic industries domestically on the grounds that these are needed for a country to become or remain a significant economic power. The international trading regime described above is quite different than the ideal global trading system favored by economists. It will not yield the degree of static economic efficiency and economic growth that economists believe are achievable in an open, non-discriminatory trading order. But this is an essay on the most likely nature of the future international trading order and not on the regime economists would most like to see evolve. Free trade is not a politically stable policy in an economic world of continuing significant structural shifts involving severe adjustment problems for some politically important sectors and demands by infant industries for special treatment. But neither is general import protection a politically stable state of affairs in modern industrial democracies with dynamic export sectors. Politically stable conditions in this type of world economy involve a mix of openness, discrimination, and protection/subsidization across countries and industries. The particular mix will vary depending on such factors as the country distribution of national economic power and the pace of structural change. Summary and conclusions The changing global trade system is related to significant structural changes in world production that have brought about a decline in the
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dominant economic position of the United States, a concomitant rise of the European Community and Japan to international economic prominence, and the emergence of a highly competitive group of newly industrializing countries. The trading regime expected to develop after the Second World War involved a shared responsibility on the part of the major economic powers for maintaining open and stable trading conditions. However, the unexpected magnitude of the immediate post-war economic and political problems thrust the United States into a hegemonic role. US economic dominance manifested itself in the trade, finance, and energy fields and enabled American producers to establish strong export and investment positions abroad. Yet, by facilitating the reconstruction and development of Western Europe and Japan as well as the industrialization of certain developing countries, US hegemonic activities led eventually to a marked decline in the American share of world exports and a significant rise of import competition in both labor-intensive sectors and certain oligopolistically organized industries. These developments also significantly diminished the leadership authority of the United States. Most industrial countries responded to the inevitable market disruptions associated with these shifts in comparative advantage by providing extensive government assistance to injured industries in the form of subsidies and higher import barriers. Such behavior was consistent with the extensive role the governments of these countries played in promoting reconstruction and development. For the hegemonic power, the United States, the policy adjustment has been more difficult. Government and business leaders gradually adopted the view that unfair foreign trading practices were a major cause of the country's competitive problems. Therefore, the United States has more vigorously enforced US laws and GATT rules covering alleged unfair trade practices and has also enacted new legislation making it easier to take unilateral actions designed to open foreign markets. Furthermore, in response to their perception that US trade-policy objectives could not be successfully attained through multilateral trade negotiations, US trade officials have attempted to gain some of these goals by negotiating special regional agreements with certain countries. No trading bloc seems able or prepared to become a hegemonic power. However, free trade is not a politically stable policy in a dynamic economic world in the absence of such leadership. Without the foreign policy concerns of the dominant power, domestic sectors injured by import competition and the loss of export markets are able to secure protection or other forms of government assistance through the political processes of industrial democracies. Nevertheless, these industries are unlikely to be able
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to prevent market forces from halting a decline in employment and thus an erosion of their political influence. General protectionism is also not a politically stable policy in a rapidly changing economic environment. Politically important export industries that are able to compete successfully abroad will press for the opening of foreign markets and realize the need to open domestic markets to achieve this result. While it is possible that the spread of trade-distorting measures for particular industries, the increased numbers of regional agreements, and the greater emphasis on aggressive bilateral policies will essentially destroy the multilateral trading system that has operated quite successfully for the last fifty years, a more sanguine outcome seems more likely. It involves establishing a reasonably stable trading regime characterized by more trade-distorting government interventions and greater regionalism than at the height of American hegemonic influence. However, while new industries will be added to the list of protected or subsidized sectors over time, others will be withdrawn as they lose political influence so that, on balance, the list does not change much over time. The rate of increase in regional arrangements is also likely to slow down over time and their discriminatory effects on other nations reduced through multilateral pressures. Furthermore, the growing importance of trading problems shared by all nations, as economic and environmental interdependence increases, will continue to require the existence of a multilateral organization such as the GATT for solving these problems. Such a regime may not yield the growth and efficiency benefits of an open trading system, but at least it will not lead to the disastrous economic and political consequences brought about by the type of trading order prevailing in the 1930s. References Baldwin, R.E. (1958), "The Commodity Composition of Trade: Selected Industrial Countries, 1900-1954," The Review of Economics and Statistics, 40, 50-68. (1962), "Implications of Structural Changes in Commodity Trade," in Factors Affecting the United States Balance of Payments, Part 1, Washington, DC: Joint Economic Committee, 87th Congress, 2nd Session. Balassa, B. and C. Balassa (1984), "Industrial Protection in the Developed Countries," The World Economy, 7, 179-96. Branson, W. (1979), "Trends in US International Trade and Investment Since WW II," Princeton University, Princeton, NJ: Department of Economics. Economic Report of the President (1986), Washington, DC: US Government Printing Office. General Agreement on Tariffs and Trade (1990), International Trade 89-90, Vol. II. Geneva, Switzerland. Keohane, R.O. (1984), After Hegemony: Cooperation and Discord in the World Political Economy, Princeton, NJ: Princeton University Press.
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New York Times, December 20, 1984. Olson, M. (1983), "The Political Economy of Comparative Growth Rates," in D.C. Mueller (ed.), The Political Economy of Comparative Growth Rates, New Haven: Yale University Press. United States Department of Commerce (1985), United States Trade: Performance in 1984 and Outlook, Washington, DC: US Department of Commerce, International Trade Administration. United States International Trade Commission (1982), The Effectiveness of Escape Clause Relief in Promoting Adjustment to Import Competition, USITC Publication 1229, Washington, DC: United States International Trade Commission.
CHAPTER
^
"Fortress Europe" and retaliatory economic warfare L.R. KLEIN a n d PINGFAN HONG
Ever since protectionist tendencies began to appear on an increasing scale during the 1970s, Project LINK has tried to estimate the effects on the world economy. At first, there was general consideration of the effects of the increased tariffs (see Klein and Su, 1979). Not surprisingly, the system validated the arguments in favor of free trade, in the sense that protectionism generated overall economic loss in the form of reduced global production and trade volume. The microeconomic effects of trade barriers are argued to be welfare losses and departures from (Pareto) optimality. It was, however, the objective of LINK to examine the macroeconomic effects. Trade barriers extend far beyond the imposition of tariffs, but, for understandable reasons of quantification and also ease of computation, tariff changes served as the instrument of protectionism. In principle, non-tariff barriers to international trade can be approximated by a corresponding tariff rate, but we did not undertake the extensive analysis that would be necessary to pair non-tariff and tariff barriers. For the present exercise, tariffs are imposed on total imports of given groups of countries, specifically, the EEC (Common Market) and the ROW (Rest of the World). On occasion, within the context of LINK simulations we have further examined tariff influences on classes of imports, manufactures, e.g., crude oil, or combinations excluding some primary products (see Klein, Pauly, and Petersen, 1987). The impacts of more specific forms of protectionism are localized, but, generally speaking, LINK results at the macrolevel are consistently in support of free trade. 99
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External fears of the single market in Europe The European Economic Community (EEC) has been a practical success. It has expanded over the years and become an accepted institution. While the economist's ideal might be one of unrestricted multilateral free trade, in the framework of welfare economics, most people admire the achievements of the EEC in giving a sense of economic unity to Europe and in providing a framework into which peripheral and emerging countries in Europe will fit. Some or all the countries in the European Free Trade Association (EFT A) and the countries of the former Conference on Mutual Economic Assistance (CMEA) seem to want to join the enhanced EEC, after 1992. It is easy to understand how the EEC might improve trading conditions within the European territory that is directly involved. It can, however, fall short of optimality in the strict economic welfare sense if the gains from liberalization accrue only to member countries and divert trade or other possible economic benefit from countries outside the system. In particular, countries of North America and the Asia-Pacific community, admire, from the outside, what the European countries are doing for themselves, but they are apprehensive about the new step toward more complete economic unification in Europe. They fear that a "Fortress Europe" could be erected to promote as much internal trade within the EEC as possible, to the exclusion of trade with outsiders. Experience with the attempts to remove barriers to agricultural trade under the Uruguay Round has left outsiders pessimistic that European countries will liberalize trade with outsiders and raises the possibility of the imposition of new barriers against trade with non-Europeans. We have accordingly made new trade scenario calculations with the Project LINK system to examine the effects of tariffs imposed on imports generally by EEC countries against ROW, followed by retaliation on the part of ROW against EEC countries in a virtual trade war. Of course, these calculations are only expository. The barriers, as in the case of agricultural trade, would not be entirely, if at all, in the form of tariffs. Also the entire ROW or the entire merchandise trade volume will not be treated uniformly. Nevertheless, the calculations do look interesting and reveal the folly of economic warfare. Some conceptual and computational issues The import flow from country j to / can be specified as
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Xji = real merchandise imports of / fromy, GDPt = real GDP of/, Pf = domestic price index for /, PXjt = price of imports of / fromy (countryy's export price converted to /'s currency units including CIFO adjustment), Tji = tariff rate imposed by / on goods fromy, PX.t = weighted average of price of imports of / from all countries except y. The first argument has a positive effect on xjh while the next two have negative effects. If country / should increase its tariff rate on goods fromy, the cost of imports fromy relative to its domestic goods will rise, and imports fromy will be expected to fall. Also the cost of imports fromy relative to the price from other countries will rise, and this, too, will cause imports fromy to fall. Country j's exports will show a fall in the "mirror" statistics. Other countries will gain an advantage, relative toy in exporting to /. Depending on the strength of the relative price effects, the reduced demand for imports in / could lead to an improved current-account balance. Domestic spending might fall in country /, but /'s treasury collections of import duties will tend to improve the budget balance and there could be some secondary effects in financial markets. If countryy retaliates by raising its duty on goods imported from /, then the same chain of reasoning applies to variables associated withy's imports. The final outcome for both countries, worked out by the LINK system, depends on the strengths of several elasticities or effects. If the EEC, as a whole, raises their duties on goods from ROW (but not against EEC trade partners) and if ROW does likewise against EEC, then trade between the two regions will fall, but trade within each of the two regions might increase. There are some practical difficulties in implementing these changes in the LINK system in precisely the way that was outlined above because bilateral import functions in LINK are not all specified as above. Import functions are not directly estimated from bilateral flows between / andy, but as a country's total imports, which are then allocated among trading partners according to calculations from a trade-share matrix. The overall import equation for country / is
m^ = real merchandise imports of /, GDPi = real GDP of/,
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PMi = average import price of / (calculated as a weighted average of partners' export prices), Tt = weighted average of all tariff rates for /, Pi = domestic price index for /. When country / increases the tariff rate on imports fromy, the average rate, Tf, will increase just enough to reflect the contribution of j to the average rate. This will lead to a decrease in m{ because the second argument in the function above will increase, and its effect on m{ is negative. The decline in mi would be allocated to all trade partners of/ and not toy, as in the previous analysis. We must, therefore, modify the LINK calculation based on a given trade-share matrix. We have, in the protectionist scenario, increased tariff rates by 10 percent for all EEC countries and in a preliminary LINK solution obtained an increase in exports by the EEC countries, as a whole (by summation). In the LINK algorithm, a country's exports are expressed as a weighted sum of partner's imports,
VXL(= £ oiijVMj+CAi, ieEEC VXLt = value of/'s exports computed by linkage, OLij = ij element of trade-share matrix, VM( = value of/'s imports, CAt = adjustment term to /'s exports (for world as a whole
t
i=l
We then reallocate VXLh
/'GEEC,
A jeROW
£
ieEEC
to ROW by the formula
VXL
,M)-I=0 L(px,py,M) = 0
It may be seen now that there are five equations in six unknowns, px,py,E,I, Mand e. Under flexible exchange rates, M is given and the exchange rate is determined by the equations; under fixed exchange rates, e is given and Mis determined by the equations. Back now to figure 11.1. The exchange rate, the price of foreign currency in terms of A's domestic currency, is given by OV/OW; it can also be related to the home and foreign prices of either of the commodities, since . In general,
Note that this exchange-rate equation does not imply a relationship between the exchange rate and the terms of trade. The terms of trade (tot) equals
= pjpy = ep*lep * which cannot be derived from the exchange-rate equation. The exchange rate is a monetary variable and the terms of trade is a real variable; the exchange rate and money supply cannot therefore affect the equilibrium terms of trade. 2
The effect of a tariff
Let us now consider the effect of a tariff on imports in country A. Since country A imports commodity Y, the price of Y rises, at constant foreign prices, by the full amount of the tariff; our assumption that country A is small relative to the rest of the world means that the tariff has no effect on the terms of trade. It is useful now to take into account the assets backing the money supply. It is convenient to divide the assets backing the money supply, M, into a domestic component, D, and a foreign component, R, for international reserves, along the lines of the monetary approach, so that M = D - f eR. Another equation specifies the relation between foreign reserves and the money supply, R = aM, where a is the target ratio of
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international reserves to the money supply. The equation system now becomes
Y(pX9py,M)~I=0
y
M= where T is the rate of the tariff on imports in country A. The conditions of the new equilibrium can now be determined by specifying the exchangerate/monetary system. Consider first a tariff under flexible exchange rates. Under the assumption that the central bank does not intervene in the foreign exchange market to change the level of reserves or supply new domestic credit, the money supply is constant. The tariff increases the price of import goods, initially by the full amount of the tariff, creating an excess demand for money, a reduction of domestic expenditure below income and an incipient export surplus; the exchange rate appreciates. But because the prices of export goods at home and abroad must be identical (when translated into different currencies), the appreciation of the currency means that the price of exports must fall in terms of country A's currency. In figure 11.2, the price of export goods, initially at OG, falls to OS, and the price of import goods becomes SU exclusive of the tariff and ST inclusive of the tariff. The equilibrium is determined at the point where the money requirements line LL is above the terms of trade line OW by the rate of the tariff UT/ST. The currency appreciates from OV/OW to OU/OW. The extent of the appreciation of the currency and the changes in domestic prices depends on how the demand for money is related to expenditures on the two goods. The exchange rate will be greater, the more the money is held for command over import goods. If the demand for money depends on the two prices in proportion to expenditure on the two goods, the change in the exchange rate will be greater the larger is the share of imports in total expenditure, i.e., the more open the country is. There are two extreme cases. In one case, the demand for money depends only on exportable goods and the LL curve is vertical; in this case the price of exports is unaffected by the tariff, the price of imports rises by the full amount of the tariff, and the exchange rate is unchanged. In the other extreme case, the demand for money depends only on importable goods and the LL curve is horizontal; in this case the price of imports inclusive of the
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Figure 11.2 Tariff equilibrium under flexible exchange rates
tariff remains constant and the price of exports and the exchange rate falls by the full extent of the rate of the tariff. Let us now consider the effect of a tariff when the exchange rate is fixed. In the absence of autonomous credit operations (changes in D), the money supply is determined by the balance of payments, surpluses causing an increase and deficits causing a decrease. We can assume, however, that domestic credit expansion takes place to the extent consistent with preserving a given ratio, a, of international reserves to domestic money, in conformity with the equation R = aM. In figure 11.3, the curve RR, denoting the equilibrium level of reserves, is drawn in a proportion to LL such that OC/OV = a. The imposition of a tariff by country A raises the price of the import good by the full amount of the tariff, creating an excess demand for money, a reduction of income below domestic expenditure and a surplus in the balance of trade and balance of payments. Pressure for the currency to appreciate is now offset by central bank purchases of foreign exchange or gold in foreign-exchange markets in exchange for new supplies of domestic currency. The excess demand for money is thus eliminated by an increase in the supply of money. In figure 11.3, the balance-of-payments surplus shifts the RR curve to R'R' and the increase in the money supply shifts the LL curve to L'L' where the domestic price of imports at the new equilibrium is higher than at the old by the full amount of the tariff; export prices remain unchanged.
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"R
0
G
Px
Figure 11.3 Tariff equilibrium under fixed exchange rates The situations under flexible and fixed exchange rates are similar but not the same, even in real terms. In both cases, the relative price of imports and exports is the same, but there is a difference in the composition of wealth. In the case of flexible exchange rates, the money supply remained constant and there was no change in the balance of trade. In the case of fixed exchange rates, with accommodating monetary policy, there was an increase in international reserves that had to be financed by a temporary reduction of expenditure below income and a balance-of-trade surplus; this means that private-sector wealth has been reduced and public-sector wealth has been increased. The two systems could be made identical in real terms, however, if the central bank expanded domestic credit by enough to satisfy the excess demand for money without an increase in reserves; this would imply a reduction in a, the reserve ratio. 3
The symmetry of import and export taxes
The proposition, first advanced by Alfred Marshall in 1879, and developed by Abba Lerner in 1936, that export and import taxes have symmetrical effects, applies for the barter model of trade theory. The question is whether it also applies, or in what sense it applies, to the general equilibrium theory of trade incorporating money. To answer this question it will be convenient to write down the system allowing for both export taxes (e) and import taxes in the home country:
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Figure 11.4 Export tax and flexible exchange rates
X(px,py,M) + E = 0 Y(px,py,M)-I=0 L(px,py,M) = 0 M=D + eR It may be seen at once that the domestic price ratio is affected in the same way by export and import taxes. Both taxes drive a wedge between the domestic and international price ratios, raising the relative price of the import good relative to the export good. The monetary general equilibrium model does not alter that conclusion. There is, however, a substantial difference in the monetary effects. Whereas a tariff, under flexible exchange-rates, led to a currency appreciation with a deflationary effect on the prices of export goods, an export tax leads to a currency depreciation with an inflationary effect on the prices of import goods. Because international prices are fixed, the export tax forces down the domestic price of exportables, leading to an excess supply of money and a depreciation of the currency, raising the price of import goods. This case is illustrated in figure 11.4, where it is assumed that the initial equilibrium at V is disturbed by an export tax.
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The tax, equal to TZ/HT, creates a wedge between the international and domestic prices of exports and results in a new, higher, equilibrium tax-inclusive price of export goods of HZ, and a fall in the home price to HT. The currency depreciates from an exchange rate of OV/OW to an exchange rate of OZ/OW. Consider now fixed exchange-rates. Whereas a tariff, under fixed exchange rates, leads to a balance-of-payments surplus and an increase in the price level, an export tax leads to a balance-of-payments deficit, an outflow of reserves and a decrease in the price level; the price of export goods at home falls by the full amount of the export tax. This case is illustrated in figure 11.5, where it is assumed that the initial fixed exchange-rate equilibrium is disturbed by an export tax. The tax, equal to DV/BD, lowers the home price of exports, and creates a balance-of-payments deficit and a reduction in the money supply until the equilibrium quantity of money, indicated by the L'L' curve, is reached. We can also consider the combined effects of tariffs and export taxes. In the classical barter theory of trade, export and import taxes, because of their symmetrical effects, can be compounded, so that the total protective effect of a tariff is the sum of export and import taxes. In this case, it would appear to make little difference whether relative prices were changed by export or import taxes. However, as we have seen, it becomes clear that export and import taxes have different monetary effects whether the exchange rate is fixed or flexible. Under flexible rates, for example, a tariff would result in the appreciation of the currency whereas an export tax would result in its depreciation. It is therefore normally possible to achieve a given protective effect, with no change in the exchange rate, by a suitable combination of export and import taxes. "Protective effect" is measured by the change in relative price of import and export goods. In figure 11.6, the combined protective effect of import and export taxes is measured by the change in relative prices in the home country, given by the difference between the slopes of OV and OS. To achieve the protective effect with no change in the exchange rate or the quantity of money requires establishment of the home price equilibrium at the point where the LL schedule intersects OS extended, i.e., at the point S itself. The establishment of such a point requires a tariff equal to SF/FE combined with an export tax equal to FV/DF, yielding a combined protective effect of SG/GE. 4
Effect of foreign tariffs and export taxes
A tariff or export tax abroad has the effect of turning the terms of trade against country A, reducing the opportunities for gains from trade.
The theory of tariffs and monetary policies
Figure 11.5 Export tax and fixed exchange rates
Figure 11.6 Protective policy mix at constant exchange rates
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To analyze the impact of foreign tariffs and export taxes, it is necessary to modify the arbitrage equations in the general equilibrium system as follows
X(px,py9M) + E = 0 Y(pX9py,M)-I=0 px = epx*l(l+e)(l+T*) /> y = ( M=
where T* and e* are, respectively, the tariffs and export taxes in the rest of the world. From the arbitrage equations, it can be seen that the relative price levels in the rest of the world and at home are as follows: Px*IP,*lPxlP, = (1 + 6)(1 + T*)(l + T)(l + £*) Tariffs and export taxes in the rest of the world have the same effect on relative prices as those at home, although, of course, the welfare effects are fundamentally different. An export tax in the rest of the world has the effect of raising the price of A's imports, creating an excess demand for money and, under fixed exchange rates, a balance-of-payments surplus until a higher equilibrium quantity of money is attained. In figure 11.7, an export tax equal to TV/VS would raise the price of A's imports by VT, creating an excess demand for money that generates the balance-of-payments surplus that eventually results in a new equilibrium quantity of money indicated by L'L' to support A's new price equilibrium point at T. Under flexible exchange rates, an export tax in the rest of the world would appreciate country A's currency until the export tax just equalled the gap between home and foreign prices, compatible with the equality of money demand and money supply. In figure 11.8, the export tax of JK/JL in the rest of the world results in a set of prices in A indicated by the point K. At this equilibrium, A's currency has appreciated from OV/OW to OJ/OW. Whereas under fixed exchange rates, the export tax in the rest of the world has an inflationary effect in A, under flexible exchange rates it has a deflationary or neutral effect. Now let us consider a tariff in the rest of the world. Under fixed exchange rates the tariff has a deflationary effect in country A. With prices in the rest of the world constant, a tariff worsens down the price of exports in country A by the full amount of the tariff. At lower export prices there is an excess supply of money and a balance-of-payments deficit that lowers the supply of money until it is equal to the lower demand.
255
The theory of tariffs and monetary policies
Figure 11.7 Export taxes in ROW under fixed rates
0
L
Px
Figure 11.8 Export taxes in ROW under flexible rates
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ROBERT MUNDELL
Figure 11.9 Tariffs in ROW under fixed rates In figure 11.9, the tariff in the rest of the world lowers country A's export prices by VS, where VS/NS is the rate of export tax. The new equilibrium at S will be achieved through a balance-of-payments deficit and a reduction in the money supply to that indicated by L'L'. Under flexible exchange rates, as might be expected, the result is different. The tariff in the rest of the world lowers domestic export prices, creating an excess supply of money and a depreciation of country A's currency. For a tariff in the rest of the world at the rate (see figure 11.10) KH/JK, equilibrium prices in country A are indicated by the point K. Country A's currency will have depreciated from OV/OW to OH/OW. The combination of tariffs and export taxes has a compounded effect on the rate of protection but, as we have seen, opposite effects on the exchange rate or the balance of payments. It is left as an exercise to the reader to prove that it is possible to achieve a given change in the terms of trade by means of a combination of export and import taxes in the rest of the world that will leave the balance of payments, the exchange rate, and the stock of money unchanged. Figure 11.11 illustrates the equilibrium when country A as well as the rest of the world have both tariffs and export taxes, for a case where the exchange rate and the quantity of money do not need to change. First note that there are three price ratios to take into account: relative prices in the rest of the world, the terms of trade, and the price ratio in country A. In figure 11.11, the export tax in the rest of the world is DC/DB, the tariff in the rest of
The theory of tariffs and monetary policies
257
Figure 11.10 Tariffs in ROW under flexible rates
A's price ratio
0
J
B
Px
Figure 11.11 Combination of tariffs and export taxes at home and abroad
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ROBERT MUNDELL
the world is VD/ED, the export tax in country A is FC/GF, and the tariff in country A is HF/FJ. 5
Allowance for changes in the terms of trade
Up until now the analysis has assumed that the prices in the rest of the world are constant so that tariffs and export taxes in country A, hitherto assumed to be a small country, have no effect on the terms of trade. This assumption is relaxed in the present section in order to take into account mutual interaction of country A and the rest of the world in determining the terms of trade. The first step is to modify the general equilibrium system in order to allow for the fact that country A is no longer a "price-taker" in world markets. The new equations specify that the excess demands in country A are matched, in equilibrium, by corresponding excess supplies in the rest of the world. For the money market conditions, it is again true that the excess demands for money in each country must be zero, but it is now necessary to specify the nature of the international monetary system. One possibility is to introduce one or more commodities or reserve assets into which currencies may be made convertible, as under silver, bimetallic, gold, or SDR systems. Interesting as it may be, such a characterization would carry us far afield from the scope of the present chapter. I shall instead assume that the currency of one or all of the countries of the rest of the world, ROW, produces reserves, leaving up to country A the choice of fixing exchange rates or allowing them to float. In this case, the monetary authorities would be able to follow an independent monetary policy. The equation system would be as follows X(px,py,M) + X*(px*9 py*9 M*) = 0 Y(pX9py9 M) + Y*(px*9py*9 M*) = 0 L(px,py,M) = 0; L*(px*9py*9M*) = 0 px = epx*l(l+s)(l+r*) py = (l+r)(l+e*)epy* M=D + eR
where M*° indicates that the monetary policy in the rest of the world is autonomous. In this framework, under the assumption that the money supply in the rest of the world is given, we can develop the more general analysis of tariffs and export taxes that takes into account changes in the terms of trade.
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259
L*
Figure 11.12 Determination of the terms of trade
In figure 11.12, Q and W represent the autarkic equilibria of country A and ROW, with OQ and OW reflecting the pre-trade price levels. With the opening up of trade in goods (but not money), A will export commodity X and B will export commodity Y, lowering the relative prices of Y in country A and X in ROW. The terms of trade will settle at an equilibrium terms of trade indicated by the ray OVU. The equilibrium terms of trade will lie between the autarkic price ratios; other things equal, it will lie closer to the larger of the two trading blocs. In the cases discussed in previous sections, ROW was so large relative to country A that the terms of trade lines OW and OU coincided. But the larger country A becomes relative to ROW, the closer to OQ will the international terms of trade settle. The purchasingpower-parity equilibrium will be at an exchange rate, the value of ROW's currency relative to A's, equal to OV/OU. To analyze the effects of trade taxes, it will be sufficient to consider a tariff in country A; the conclusions for other taxes will follow, mutatis mutandis. As before, a tariff creates a wedge between home and foreign price ratios. At constant foreign prices, the tariff raises the price of imports, and shifts demand in country A from imports onto exportables and money. This reduces the demand for the rest of the world's exports and the supply of its imports, turning the terms of trade in favor of country A. In figure 11.13, assuming flexible exchange rates, a tariff equal to ST/JT results in a rise in the price of imports by less than the rate of the tariff; the "foreigner pays part of the tax." The exchange rate appreciates from OV/OU to OT/ON.
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ROBERT MUNDELL
Figure 11.13 Tariffs and flexible rates
Under fixed exchange rates, a tariff also raises the price of imports in country A and shifts excess demand from commodity Y onto commodity X and A's currency, giving rise to a balance-of-payments surplus and an influx of money from the rest of the world (see figure 11.14). To determine the effect of the tariff in country A on prices in the rest of the world, it is necessary to take into account two effects, a terms-of-trade effect and a monetary effect. The terms-of-trade effect lowers the price of Y and raises the price of X in ROW. But the monetary effect involves a balanceof-payments deficit in ROW (the counterpart of country A's surplus), leading to an export of money and a fall in both prices. It is therefore clear that the money price of commodity Y falls in ROW, but the two effects work in opposite directions on the money price of commodity Y: its price might rise, fall, or remain unchanged as a result of the tariff in country A. A similar analysis applies to the effect of the expansion in money in country A. The price equilibria after the imposition of the tariff in country A are indicated by the (tariff-inclusive) point J in country A and the point F in the rest of the world (see figure 11.14). 6
Customs unions and discriminatory tariffs
Up until now we have considered ROW, the rest of the world, as a single trading entity. To consider the problem of discriminatory tariffs, we must have a model that includes at least three countries, one of which can again be taken as the rest of the world. It will be convenient first to specify
261
The theory of tariffs and monetary policies
L*1
L'
0
Px Figure 11.14 Tariffs and fixed exchange rates
the conditions of equilibrium for n countries and then to examine more interesting special cases. Commodity prices in the different countries are connected by the law of one price. The price of a good in country /is equal to the export prices of the cheapest producer, labeled countryy, after adjusting for tariffs and export taxes and multiplying the price in country^ by the exchange rate, the price of country j's currency in terms of country /. The monetary arrangements must now take into account the multiplicity of currencies, all of which, in principle, could be used for foreign exchange reserves. To avoid complications associated with private holdings of foreign, currencies, I shall assume that only central banks (or governments) hold reserves for the purpose of backing, in the case of fixed exchange rates, the domestic money supply. The equation system can be written as follows
//
(
)
(
Af' = V + Z
(>=1,2,..,») (i=\,2,..\n)
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ROBERT MUNDELL
Figure 11.15 Three-country equilibrium
The final equation specifies foreign currency preferences for each central bank; these preferences are assumed to be autonomous. The formation of a free-trade area involves the elimination of tariffs between any two or more countries. It will be convenient, however, to proceed in a reverse direction, starting from free trade and analyzing the effects of one or two countries imposing a tariff that exempts its prospective partner. It will also be convenient to analyze the situation in a three-country model, one of which can again be taken to be the rest of the world. Figure 11.15 portrays the equilibrium for three countries, A, B, and C, under conditions of free trade: country A. exports commodity X to countries B and C and imports commodity Y from one or both of those countries. The equilibrium exchange rates are as follows eAB = OJ/OH; *AC = OJ/OK; eBC = OH/OK There are two types of free-trade areas that need to be distinguished. One involves an agreement between two rivals, countries producing substitute goods, such as a free-trade agreement between B and C; the other involves an agreement between two complementary countries, such as an agreement between either A and B or A and C. In the theory of customs unions, it is generally concluded that free-trade agreements between rival countries are more likely to replace inefficient industries in a rival country and therefore involve less trade diversion and
The theory of tariffs and monetary policies
263
more trade creation than is the case of free-trade areas between complementary countries. Our interest here, however, is not with the static welfare gains but with the new equilibrium terms of trade, exchange rates, and price levels after the free-trade area is formed. Consider first the effect of a tariff in country B imposed on country A's goods. The price of country A's goods rises in country B relative to those of country A. However, since no tariff is imposed on C's products, A's goods could enter B through C unless transport costs or regulations prohibited it. Certificates of origin would, however, be of little help if C also produces commodity Y; sales of commodity Y from country C to country B could be made up by increased imports in country C from country A. The unilateral imposition of a discriminatory tariff in B fails to alter the equilibrium because of the problem of trade deflection.2 Now consider a mutual and equal increase in tariffs in countries B and C on A's products as in a customs union; the problem of trade deflection is avoided in a customs union. This raises the price of commodity X in both B and C and creates an excess demand for commodity Y and money in each country, improving the terms of trade, and appreciating the currencies (under flexible exchange rates), of both B and C. In figure 11.16, the tariffs in B and C, equal to JK/HJ and NR/LN, turn the terms of trade against A from OV to OU. It depreciates A's currency from OE/OZ to OU/OJ against currency B, and from OE/OG to OU/ON against currency C. Under fixed exchange rates, increases in the money supplies of B and C would replace currency appreciation and the same change in the terms of trade would take place, but through a rise in the prices in the customs union area of both goods. If countries B and C hold reserves in A's currency, however, part of the inflationary effects will be mitigated by a fall in the price level in country A. Consider now a customs union between two complementary countries, such as A and B. The two member countries, from an initial free-trade position, levy a tariff against imports from country C, driving a wedge between the relative prices in A and B on the one hand and C on the other. In which direction do the terms of trade and other variables change? Figure 11.17 illustrates customs union between complementary countries. Because A and B are complementary, exporting different products, any change in the terms of trade means that the terms of trade of one of the member countries improves while that of the other worsens. Which of the member countries terms of trade will improve?3 It will be that country whose trade is complementary to the trade of the rest of the world. If the rest of the world is an exporter of commodity Y, as in figure 11.17, the country that exports commodity X will experience an
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ROBERT MUNDELL
Figure 11.16 Customs union between competitive countries, B + C
0
Px Figure 11.17 Customs union between complementary countries, A + B
The theory of tariffs and monetary policies
265
improvement in its terms of trade, and the other country will suffer a worsening of its terms of trade. In figure 11.17, country B exports the same commodity as the rest of the world and will therefore experience a deterioration of its terms of trade. The terms of trade of country C deteriorate from the line OM to the line OL. Under flexible exchange rates, country A's currency appreciates from ON/OM to OK/OL, and country B's currency, from OR/OL to OJ/OL, against the currency of country C. It is not, in general possible to determine the effect of the currency union on the intraunion exchange rates; the price of A's currency in terms of the currency of country B changes from OR/ON to OJ/OK. What if the rest of the world contains many individual countries, some of which export commodity X and others, commodity Y? What matters is the //£/exports of the rest of the world. If the rest of the world, on balance, exports commodity X, the world price of X will tend to fall, and so will the terms of trade of the member of the customs union that exports commodity X. Whether the customs union is composed of complementary or competitive economies, it holds that the terms of trade of the rest of the world depreciate upon formation of the union. Those members of a union that export the same products as the rest of the world to the union will be harmed by the terms-of-trade effect, whereas those countries that are complementary to the rest of the world will be benefited by the terms-of-trade effect. Notes 1 The techniques used in this chapter were developed in Mundell (1964, 1968, and 1971); they have been applied in an intertemporal context in Mundell (1992). 2 This conclusion, of course, would not hold in the presence of transport costs or other transactions costs. 3 For general proofs of the effects of discriminatory tariff preferences in a real economy, see Mundell (1964). References Mundell, Robert A. (1964), "Tariff Preferences and the Terms of Trade," Manchester School of Economic and Social Studies, 32 (January), 1—14 (reprinted in Mundell, 1968). (1968), International Economics, New York: MacMillan. (1971), Monetary Theory: Interest, Inflation and Growth in the World Economy, Pacific Palisades: Goodyear. (1992), "Fiscal Policy in the Theory of International Trade," in Herbert Giersch (ed). Money, Trade and Competition (Essays in Memory of Egon Soh men), Heidelberg: Springer.
CHAPTER
The economics of content protection MICHAEL MUSSA
1
Introduction
This chapter analyzes economic effects of policies of content protection, such as the requirement that "domestic" automobiles sold in the United States to embody a prescribed minimum share of domestic value added. Similar policies have been implemented in a number of developing countries, as well as in Australia and Canada. Included in this broad class of policies are both requirements that final goods assembled in a country should use a minimum amount of domestic input, and requirements that final goods exported to a country should use a minimum amount of domestic input in their foreign assembly processes.1 To analyze the consequences of such policies of content protection, it is assumed that the final product is produced in accord with a neo-classical production function, specified in section 2, that employs domestic inputs and imported (or foreign) inputs. This specification allows for smooth substitution possibilities between domestic and imported inputs which, it is argued, characterize the situation of many industries that are the actual or potential subjects of content protection policies. This specification differs from that of Grossman (1981) who assumes that the imported material input is a perfect substitute for a domestically produced material input and that total material input (imported plus domestic) substitutes against domestic labor in the production of final output. 2 Using the present specification, it is shown that a domestic content requirement, specified as a required minimum share of domestic input in the value of the final product and enforced by a penalty tariff imposed against violators, raises the ratio of 266
The economics of content protection
267
domestic input to imported input and creates a production distortion by raising unit production cost above the cost-minimizing level. Because of the all-or-nothing nature of the enforcement penalty, however, content protection has the virtue of not inducing a distortion between the social cost of production (given the distortion of input choice) and the price charged to consumers of the final product. For this reason, content protection is preferable to a tariff on imported inputs or a subsidy on domestic inputs as a policy to increase the ratio of domestic to imported input in final output. Content protection has less salutory effects when account is taken, in section 3, of the effects on incentives for improvements in technical efficiency. The private and social benefit of technical improvements that save on domestic input is artificially reduced and the private and social benefit of technical improvements that save on imported inputs is artificially increased by a domestic content requirement. Taking account of the cost of finding and implementing improvements in technical efficiency, therefore, content protection will impede progress in making production processes that employ domestic inputs more efficient, and will lead to excess investment in technical improvements that will reduce required amounts of imported inputs. The effects of content protection on the equilibrium price and quantity of the domestic input are obviously of central concern to the suppliers of this input, who are frequently the most ardent advocates of content protection. In section 4, it is shown that under competitive market conditions, a small increase in the domestic content requirement above the level that firms would voluntarily choose will increase the derived demand for the domestic input and (assuming a positive but less than infinite elasticity of supply of the domestic input) will also increase the equilibrium quantity and price of the domestic input. The direct effect of further increases in the domestic content requirement above this marginally effective level are at least partially offset by reductions in demand for the final product resulting from increases in its price due to increased unit costs that are the consequence of content protection. However, provided that the price elasticity of demand for the final product is less than a critical value, the overall effect of an increase in the domestic content requirement will still be to increase the derived demand for the domestic input and, hence, the equilibrium quantity and price of that input. The condition for an increase in the content requirement to increase demand for the domestic input is modified in situations, examined in section 5, where only foreign firms (and not domestic firms) are effectively constrained by content protection. In such situations, the own price elasticity of demand for the foreign firms' product is likely to be larger than the overall price elasticity of demand for the products of the domestic and
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MICHAEL MUSSA
the foreign firms because an increase in the price of the foreign firms' product shifts demand toward the domestic firms' product. Hence, the increase in the price of the foreign firms' product due to an increased domestic content requirement will be a more powerful force in reducing demand for the domestic input. However, since a shift of demand toward the domestic product increases the domestic firms' demands for the domestic input, the overall effect of an increase in the content requirement for foreign firms is still likely to be an increase in demand for the domestic input. The implications of non-competitive behavior in the final product and domestic factor markets are examined in section 6. Content protection does not alter the usual difference between monopolistic and competitive behavior by sellers of the final product or between monopsonistic and competitive behavior by buyers of the domestic input, unless content protection creates a monopoly or monopsony situation when one would not otherwise exist. Content protection, however, does interact in an interesting way with monopoly behavior of suppliers of the domestic input since it alters the elasticity of demand for this input in a way that can always be exploited by these suppliers. The main results of this analysis of content protection are summarized in section 7, and extensions and modifications of these results are briefly discussed. 2
Effects on input choice, production cost, and output price
The technology of the industry subject to content protection is assumed to be described by a neo-classical, linear homogeneous production function X=F(I,D)
or XjI=x=f(d)
= F(l,d\ with d=D/I
(1)
where X is the quantity of final output, I is the quantity of imported (or foreign) input, and D is the quantity of domestic input. This production function applies equally well to a final product assembled at home using domestic and imported inputs, and to a final product assembled abroad using domestic and foreign inputs and then exported back to the home country. The smooth shape of the isoquants of this production function illustrated in figure 12.1 reflect the assumption that domestic input can be substituted continuously, but with increasing difficulty, for imported (or foreign) input. The idea is that as the required share of domestic content rises, production of more components and more assembly processes must employ domestic inputs, starting first with the production activities in which domestic inputs are relatively most efficient and moving progressive-
The economics of content protection
269
D I=d
Figure 12.1 The effect of content protection on input choice and the iso-cost locus
ly to activities where these inputs are less and less efficient in comparison with imported (or foreign) inputs. This description applies fairly well to the automobile industry which is a favorite subject of such requirements in many countries. Arguably, this description also applies to a wide range of manufactured goods, from apparel to televisions, that are or might become subjects of content protection.3 Domestic nominal prices of final product, domestic input, and imported input are denoted by P, U> and V> respectively. Using the domestic input as numeraire, relative prices of the final output and the imported input are denoted by^> = P/Uand v=VIUy respectively. The zero profit condition for final goods producers requires that or p =
(2)
where aD = D/X is the amount of domestic input per unit of output and aj = I/X is the amount of imported input per unit of output. Using the fact
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MICHAEL MUSSA
that aD = d\f{d) and al = \\f{d)^ it follows that the relative output price consistent with zero profits is given by p = {d+v)lf{d)
(3)
The cost-minimizing input ratio is determined by the requirement that the marginal technical rate of substitution equal the relative input price
(dFldI)l(dFldD)=f(J)-J-fy)
= (t*(J) = p
(4)
For example, if the input price ratio is v0, then as illustrated in figure 13.1, the cost-minimizing input ratio d0 is determined by the point A along the isoquant F(I, D) = \ at which the marginal technical rate of substitution is equal to v0. For any v, choice of d=(f)~\v) clearly results in the minimum relative output price, p(v) = [~\v) + v\ Iflfi ~1(v))> t n a t ls consistent with zero profits for that input price ratio. Domestic content requirements may sometimes be set in terms of physical units, but because of difficulties in comparing physical units of different inputs and outputs, it is more common for a domestic content requirement to be stated in terms of the share of domestic inputs in the value of final output. This share is given by *(#•» = (d* + v)lf(d*) = [,7(1 - 6*)M(p • 5*1(1 - 3*)) 1
(
v
tnat
(7)
is greater than the price p = [(f>~ (v) + v]lf( t> ~\ )) yields zero profits when producers minimize cost. For example, if the domestic content requirement necessitates an input ratio d1=d*(v0, d*)>do = 4>~\vo), then as illustrated in figure 12.1, production occurs at the point B along the unit isoquant, rather than at the cost-minimizing point A. The relative output price that yields zero profits with this content requirement px =P*(VQ, 5*) = (d1 +^o)//(^i)> ls indicated by the vertical intercept of the line passing through B with slope equal to — P0. This price is clearly greater than the price p0 that yields zero profits under cost minimization, as indicated by the vertical intercept of the tangent to the unit isoquant (with slope equal to — v0) at the cost-minimizing production point A.
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271
To enforce an effective domestic content requirement, there must be an incentive for compliance or a penalty for violation. When the final product is produced at home with imported inputs, it is natural for this incentive or penalty to be a tariff charged on imported inputs for producers violating the content requirement but rebated to producers complying with the requirement.4 The penalty tariff necessary to enforce the content requirement must make the minimum cost for violators at least as great as the cost for those who comply. For example, in the situation illustrated in figure 12.1, an input tariff Tl which makes the relative price of imported inputs for violators ^i = (1+^1)^0 *s sufficient to enforce the content requirement because the isocost line for violators with intercept px and slope vx passes below the unit isoquant. Producers who satisfy the content requirement, however, can produce at B and enjoy unit costs of only pv The content requirement and enforcement penalty make the isocost locus for unit cost of pi correspond to the kinked line that connects the pointsp x , B, E, and G. With this isocost locus, the optimum production point is clearly B. When the final good is produced abroad with exported domestic inputs, it is natural that the incentive for compliance be a penalty tariff (at an ad valorem rate /) in imports of the final product that do not satisfy the content requirement. Since \+t imported units of final product subject to this tariff generate the same revenue as one unit satisfying the content requirement, producers will satisfy the requirement when the cost of producing 1 + / units with a free choice of inputs is greater than the cost of producing 1 unit under the content requirement. In terms of figure 12.1, the penalty tariff rate tl9 for which the isoquant F(I, D) = \+t1 lies everywhere above the isocost line connecting pl9 B, E, and G, is sufficient to enforce the content requirement. It is an important property of content protection that the output price consistent with zero profits does not depend on the penalty used to enforce the content requirement, so long as the penalty is high enough to induce compliance. This property reflects the all-or-nothing nature of the penalty imposed for any violation of the content requirement. If the requirement is satisfied, no penalty at all must be paid and the zero profit price of a unit of output embodies only unit production cost and no penalty. Unit production cost, of course, exceeds the minimum achievable when producers are allowed free choice of inputs, but a content requirement generates no additional distortion by forcing a divergence between true social production cost (with the distorted choice of inputs) and the price producers must charge to earn zero profit.5 This property of content protection schemes accounts for their superiority over alternative policies for increasing the ratio of domestic input to imported input. Another policy that could achieve this same objective,
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is an ad valorem tariff on imported inputs, with no rebates for producers. Specifically, to achieve the same input ratio dx as the content protection policy illustrated in figure 12.1, a tariff on the imported input would have to raise the domestic relative price of this input to the level v2 determined by the slope of the unit isoquant at the point B. Since this tariff is collected, producers must charge a pricep 2 , determined by the vertical intercept of the tangent to the unit isoquant at B, in order to earn zero profit. Sincep± is the true social cost of producing a unit of output using the input combination at B, the difference p2 —p\ measures an excess of price charged to consumers over true social production cost and implies a consumption distortion loss in excess of the distortion loss from content protection.6 Alternatively, the domestic input ratio could be raised to d1 by paying a subsidy on the use of domestic inputs that raises the relative price of imported inputs to v2. Since this subsidy reduces the output price for consumers (at the expense of the government) to below true social production cost, this subsidy creates consumption distortion loss in excess of the distortion loss from content protection. Because a content requirement avoids the excess consumption distortion loss generated by a tariff on imported inputs or a subsidy on domestic inputs, it is the second-best policy for achieving a prescribed increase in the ratio of domestic input to imported input. The question remains, of course, why society should tolerate the production inefficiency that inevitably results from content protection in order to raise the ratio of domestic to imported input. 3
Incentives for improvements in technical efficiency
The conclusion concerning the second-best optimality of a content protection policy requires qualification in situations where firms incur costs to maintain and improve the efficiency of their production processes. While analysis of such situations is not fully compatible with assumptions of perfect competition and a common constant-returns-to-scale technology for all firms, we can use the model of the preceding section to indicate the distortion of incentives for improvements in technical efficiency created by content protection. To this end, consider the reduction in unit production cost resulting from improvements in technical efficiency for a firm initially operating under the content protection policy described by the point B in figure 12.1, which corresponds to the points B in figures 12.2 and 12.3. An improvement in technical efficiency that allows for a small reduction AD < 0 in the amount of domestic unit used to produce a unit of output shifts the unit isoquant downward in figure 12.2 to the isoquant passing through the point G. To satisfy the domestic content requirement with the new technology, the firm must move up the unit isoquant to the point H that lies
The economics of content protection
273
D
Figure 12.2 The effects of a reduction in domestic input necessary to produce a unit of output
along the ray where DjI = d1. Substitution of domestic for imported inputs in the move from G to H occurs at the rate v2 which is equal to the marginal technical rate of substitution at G and at B. The reduction in unit production cost made possible by the improvement in technical efficiency is measured in units of domestic input by Ap =p$ —p\, where px and^>3 are the vertical intercepts of the lines passing through B and H, respectively, with slopes of —v0. To the first order of approximation, the reduction in unit production cost per unit reduction in required domestic input is given by
This result indicates the benefit to the firm and to society from an improvement in technical efficiency that saves domestic input, given that the content protection policy is in force. However, the benefit to society from this improvement in technical efficiency in the absence of the content protection policy is greater than the amount indicated by (8) because saving
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MICHAEL MUSSA D
DII=d
Figure 12.3 The effects of a reduction in imported input necessary to produce a unit of output
one unit of domestic input in the absence of this policy would be worth exactly one unit of domestic input. Since (v2 — Vo)l( v2 + ^1) m u s t be less than 1, the distortion created by content production cannot eliminate all of the benefit from improvements in technical efficiency that save domestic input. But, if the difference between v2 and v0 is large, the distortion could substantially reduce this benefit. For improvements in technical efficiency that save imported input, the distortion created by content protection works in the opposite direction. As illustrated in figure 12.3, saving a small amount A/ of imported input shifts the unit isoquant to the left to the new isoquant passing through the point J. At J, the firm can substitute increased imported input for reduced domestic input (at a rate equal to the marginal technical rate of substitution v 2) and still satisfy the domestic content requirement by producing at the point K. To the first order of approximation, the reduction in unit production cost resulting from this increase in technical efficiency is
The economics of content protection
Vo + ^ - ^ - y j ^
+ d,)]
275
(9)
In this result, the amount v0 represents the social and private benefit of saving a unit of imported input in the absence of content protection. The additional amount (t;2~vo)' [^1/(^2 + ^1)] > 0 ls t n e distortionary effect of content protection that arises because content protection forces a differential between the marginal value of imported input in production (measured by the marginal technical rate of substitution v2) an(d)) = d-f(d)lf(
J) = y, when v = (d) (14)
Further, since in the absence of content protection d= (f) ~ \v), it follows that the proportionate change in the input ratio is given by 2=a.(0-V)
(15)
where a — (1 — y) • \f{d)\d*f"{dj\ < 0 is the elasticity of substitution between domestic and imported inputs. This result together with (11), (12), and (13) implies that D=[ti5 + (l-y)-<j]-U
(16)
D=[(l-(5).>/-(l-7).<x].F
(17)
Equation (17) reveals the condition for a tariff on the imported input, which induces a positive K, to increase demand for the domestic input: the elasticity of substitution between the domestic and the imported input must be greater in absolute value than the price elasticity of demand for the final output. Otherwise, the negative effect on the derived demand for D from the increase in the output price caused by the increased cost of the imported input will outweigh the positive substitution effect of the increase in the price of the imported input relative to the domestic input. It follows that suppliers of the domestic input will benefit from a tariff imposed on the imported input only when the elasticity of substitution between domestic and imported inputs is greater (in absolute value) than the price elasticity of demand for the final product. Under content protection, the input ratio is no longer d=(j)~1(v), but rather ^==*/*((5*,J>)==(Z>*