International Trade and Economic Growth

Does international trade increase economic growth? In this context, what are the trade policies that have been followed by developing countries?

Standard textbook economic theory tells us that international trade benefits both parties in the trade, based on the gains from comparative advantage as laid out by David Ricardo. However, recent research into New Trade Theory suggests that trade may not always be beneficial, and there are examples when it could inhibit growth. This essay will examine when this could be the case and then relate this to the example of developing countries.

The Ricardian story goes that countries have comparative advantages in producing certain goods. This is irrelevant of their absolute advantage. Due to this comparative advantage countries can specialise in the production of these goods and then trade internationally with other countries so that both nations end up being able to consume more than they could do had they not traded. This implicitly assumes that the costs to trade – such as exchange rates and transport costs – are negligible. Whilst true in the example of transport costs, which have fallen dramatically since the 1980s as a result of container-ship advances, may not be true for exchange rates where we have seen greater fluctuation since the 1980s as most countries have decided to adopt a floating exchange rate regime in contrast to the previous fixed exchange rate policies derived from the Gold Standard and then followed by the Bretton Woods accord. Ricardo himself used the example of Portugal and England producing wine and cloth. He believed that Portugal had an absolute advantage in the production of both goods (could produce a greater total number than England), but that England had a comparative advantage in producing cloth, meaning it could do so at a lower opportunity cost than Portugal.

Streeten highlights that comparative advantage and international competitiveness might not be mutually consistent. If we consider Economy A which produces raw materials and industrial goods but has a comparative advantage over Economy B in raw materials (which produces the same but has its comparative advantage in industrial goods), then this would suggest that the removal of trade barriers would cause Economy A to export raw materials in exchange for industrial goods from Economy B. Therefore the raw material industry would expand in Economy A but this would include inefficient firms, whilst industrial goods firms will shrink, but again this would include efficient firms. Only if we were to assume (arbitrarily) that all industrial firms in Economy A were inefficient and all raw material firms were efficient would competitiveness and comparative advantage be consistent.

If we were to accept the Ricardian story we would then need to examine where comparative advantage comes from. The Heckscher–Ohlin model believes that comparative advantage comes from different countries having different factor prices. For example, Portugal may have been able to produce grapes cheaply –due to exogenous conditions such as the climate- and thus mean it has a comparative advantage in the production of wine over England. Recent studies have cast doubt on this theory, showing that a significant proportion of US imports are in capital-intensive industries, despite the US itself being a capital-intensive economy. The Heckscher-Ohlin model would instead imply that the US ought to be more likely to import labour-intensive produced goods such as raw materials or cheap manufactures.

Standard economic theory would instruct us that trade can cause economic growth because companies face international competition and must therefore eliminate Liebenstein’s X-inefficiency by cutting costs. This reduces inefficiencies and means the economy uses its resources more conservatively. Furthermore, some firms would benefit from economies of scale, by being able to sell to a larger market they can move further down their average cost curve, which if it exhibits diminishing returns to scale can result in lower costs meaning lower prices for consumers or potentially higher supernormal profits because of the natural monopoly situation that arises from diminishing returns to scale.

Stephen Redding would also argue that it is possible for a country to manufacture its comparative advantage through state intervention, citing the examples of South Korea and other Asian Tigers. Whilst this may cast aspersions on laissez-faire policy it doesn’t necessarily detract from the argument of free trade. In fact it may even support the argument, suggesting that a government should steer the economy towards a comparative advantage in a good/service which is neglected by other economies and from which it would be able to successfully trade with to increase overall consumption. Others may contend that the government is inefficient and doesn’t have the sufficient knowledge to successfully steer the economy into a comparative advantage and may instead fear that they will be influenced by pressure groups who wish to increase their economic rent.

Some development economists also worry that a developing country opening up its borders to foreign competition would be unable to compete and so is at a disadvantage and would lose out to economic growth. This comes under the infant industry protection argument which suggests that a country should maintain trade barriers until industry has sufficiently grown in its ability to compete internationally. However, there is no guarantee that an industry enjoying supernormal profits arising from the lack of competition would have an incentive to reduce X-inefficiencies and invest in new technology, and may instead maintain supernormal profits in the belief that so long as it remains inefficient (and would therefore go out of business if exposed to international competition resulting in mass unemployment) the government will not relax trade barriers. To overcome this problem the government would be well advised to impose credible promises to reduce trade barriers at a certain date to induce firms to increase efficiency and ensure they can compete on an international stage. However this faces a credibility problem. Furthermore, Rodrik proposes that any country which liberalises trade has to be seen to be doing so of its own accord, due to an internal commitment, as oppose to external pressure from debtor institutions like the World Bank. He sees this as the case, because if a government liberalised in order to access World Bank funds then private agents may not respond for fear that the government will reverse these liberalisation policies once it has overcome the debt-crisis that sent it to the World Bank in the first place. He sees this as a particular problem during the 1980s when many countries had balance of payments issues and needed support from the World Bank which was given on the conditionality of liberalisation policies being implemented. This makes it particularly difficult for governments who did indeed have a desire to implement these policies – and may have done so at the time because it is seen as easier to implement radical reforms during troubled times than it is when the economy is sound and pressure groups have a lot of influence – because private agents wouldn’t know whether this was a credible commitment. To overcome this problem, Rodrik identifies that countries like Turkey had to instead implement even more radical proposals than necessary by the World Bank – for example devaluing the currency further than necessary – in order to send an effective signal to entrepreneurs and business.

 

Dollar and Kray study what they call the Post-1980 globalisers which include developing countries such as India, China, Argentina, Mexico, Malaysia and Thailand. They come up with these countries as they had both reduced trade barriers and seen an increase in proportion trade volumes. In their study Dollar and Kray were looking to see whether trade policies increased growth or inhibited it. Therefore they were wary of countries which saw an increase in trade volumes for non-policy reasons (for example Rwanda was noticed as such an example: it had seen a large increase in trade volumes, but this was suspected to be due to the cessation of civil war rather than policy induces change) and measured it in proportional terms so as not to miss countries who were geographically disadvantaged which dispositioned them to trade less relative to other countries. They also looked at reduction in trade barriers to see which countries were inducing increased trade through policy, although they noted that this method has its drawbacks because of issues with weighting tariffs and because a country may have increased non-tariff barriers which are difficult to identify. Despite these issues within the study they found that countries who liberalised trade during the 1980s experienced higher growth relative to both other developing countries and also to developed countries, which means they experienced absolute convergence, whereas other developing countries saw lower growth than developed countries and thus saw the gap between them increase.

The Post-1980 globalisers saw economic growth per annum rise from 2.9% in the 1970s to 3.5% in the 1980s, reaching 5% in the 1990s whilst the figures for other developing countries were 3.3%, 0.8% and 1.4%. However, we must note that this increase in growth in the case of the globalisers cannot be solely attributed to trade policy and many other factors were occurring at the time, for example the introduction of property rights in China which is also likely to have led to higher growth. Furthermore, they identified that there was no increase in inequality arising from the increase in globalisation, meaning the poorest 20% didn’t see their share of income fall: if anything it rose slightly.

Based on this evidence, it is hard not to conclude that international trade leads to economic growth, however the theory behind it hasn’t been satisfactorily proven. Furthermore we must take caution in attributing all economic growth to trade liberalisation when many other factors were also in play.

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