March 2, 2008

Trade and Development link in developing countries beyond the free trade vs protectionism debate

The link between trade and development has been discussed by centuries even before Adam Smith most famous book. What is disappointing with this debate is that it was framed as you can be only either an enlightened free trader of a short-term-looking protectionist. This debate, particularly the last two or three decades, has been very ideological. With this post, we will try to resume another way to think on trade and development linkages beyond this dichotomy.

What is needed in this highly polarized debate is to look at the historical reality with pragmatism to show, beyond oversimplifying economic theories, what we can affirm on this link. In fact, policies should be context specific. Checking theories on reality is very important. This means that neither free trade nor protectionism are always the best decision. In some case, free trade could be positive in terms of welfare and, in other cases, it can have an overall negative impact. We can say the same for protectionist policies.

Classical economic theory based on comparative advantage assumption cannot explain why many African and Latin American countries which choose free trade in the 80s have a worse development track record that, for example, South Korea that choose to be protectionist for many decades. The answer is that only experience and learning by doing strategies can tell us what the best option in a particular setting is.

Before dealing with the trade and development issue, we need to better understand what causes explain growth and development success stories of the past. There are two authors, Rodrik and Reinert, that I cite in the “interesting to read” section of this blog, that give us some interesting insight that were tested on the historical reality. The following points are very important:

  1. Not all the economic sectors provide the same input to a development process. In fact, the assumption of mainstream economics that all products are the same is not proved by a reality check. As Reinert underlines, there is two different ideal types of economic activities: Schumpeterian activities, that “create welfare and development” and Malthus activities, “that keep wage-levels close to the subsistence level” (Reinert, 2007, p. 150). Reinert characterized both ideal types (Reinert, 2007, p. 151). Schumpeterian activities, which include most of manufacturing and advanced services, are characterized by the following elements: increasing returns, dynamic imperfect completion, stable prices, generally skilled labour, creates a middle class, irreversible wages, technical change leads to higher wages for the producer and create large synergies. Malthusian activities, as most of agriculture and raw material extraction, are characterized by the following elements: diminishing returns, perfect competition, extreme price fluctuations, generally unskilled labour, creates “feudalist” structure, reversible wages, technical change tends to lower price to consumer and create few synergies [i]. Three elements are important to achieve development: increasing returns, technological change and synergies. The secret to achieve development and growth is simply to succeed to shift an economy from Malthusian to Schumpeterian activities. Industrialization and development of advanced services is the key for development.
  2. The role of states, notably through the building of institutions, is capital to give the right incentives to the private sector in order to start a real and sustainable development process. As Rodrik pointed out, “it is increasingly recognized that developing societies need to embed private initiative in a framework of public action that encourages restructuring, diversification, and technological dynamism beyond what market forces on their own would generate” (Rodrik, 2007, p. 100). Furthermore, Public and private sector can interact in different way and achieving the same results in terms of development. Institutional setting can vary among countries (Rodrik, 2007, p. 29). What is more, their effectiveness in terms of development depends on their fitness with the specific historic, cultural, economic and political situation.
  3. The driving forces of capitalism are entrepreneurship, state policies, technological change and innovation: capital, markets and labour are just auxiliary factors (Reinert, 2007, pp. 121-3). This assumption has a big impact on how we understand development.
  4. A country should use strategically the opportunities offered by the international context. What UNCTAD called policy space [ii] is crucial to adopt a successful development strategy. There is no one-size-fit-all recipe to start and sustain a development process (Rodrik, 2007).

These crucial lessons learnt from history can be translated in the following elements that help us to explain the trade and development links:

  • If a country is pushed by its trade policy to specialize in the production of Malthusian products it will neither reduce its poverty nor start a successful growth and development path. A country should find trade (and other) policies that give incentives to the entrepreneurs to start and improve business linked to products that allow technological change. There is not a list of such products because they vary across periods (Reinert, 2007, p. 111). What is more a developing country should think strategically in terms of synergies and clusters between the industries that it chooses to incite.
  • There is a timing on changes in trade policy. Friedrich List [iii] proposes the following useful sequence, summarized by Reinert: “1) all nations first needed a period or free trade to change the patterns of consumption and thus to create a demand for industrial goods. Then followed a period 2) when small states protected and built their own industries (i.e. activities subject to increasing returns, including advanced services). Once this was done, List suggested 3) a period where even larger geographical areas would be integrated economically. […] Subsequently, when all countries had established their own competitive industrial sector, it was 4) in everyone’s mutual interest to open for global free trade” (Reinert, 2007, p. 161). This is probably the main lesson that all the countries that achieved historically important development progresses (for example, the US, Germany, South Korea, China, etc.) teach us. This with the first point simply means that a country can take advantage from trade if it conceives its international markets integration strategically.
  • Regarding exports: the main goal should be to maximize exports of diversified products with increasing returns. Diversification is a precondition for development because, notably, of increasing synergies and for selecting the best technologies, products and organizational solutions (Reinert, 2007, p. 256). Export of decreasing returns products can be useful only if is utilized for a short period in order to earn more resources to invest in the development of increasing returns sectors.
  • Regarding imports: a developing country should find a balance between the protection of the immature industry and the utilization of imports in order to improve gradually competitiveness. In fact, as Reinert rightly underlines, “production systems need time to learn to adjust” , consequently sudden open of markets can have a very negative impact (Reinert, 2007, p. 58) that tends to die out the most dynamic sector of the least advanced country (because these sectors are founded on increasing returns and are not competitive against a country that produce much more quantities) (Reinert, 2007, p. 181). The infant industry protection is crucial for development but “[…] once a country had been solidly industrialized, the very same factor that required initial protection – achieving increasing returns and acquiring new technologies – now required bigger and more international markets in order to develop and prosper. Successful industrial protection thus carries the seeds of its own destruction: when successful, the protection that was initially required becomes counterproductive” (Reinert, 2007, p. 81) [iv]. What is more, as Reinert shows empirically through the case of Peru, “[…] a country with an inefficient industrial sector is far better off than one with no industrial sector at all” (Reinert, 2007, p. 163) .
  • To have enough policy space to innovate in policy and industry is crucial. The problem is that often the international trading system is used to limit this freedom.
  • The world production in organized around the creation of value chains across countries. It is very important how the regional/global value chains are broken up among different countries. In fact, there is a link between the place that a country have in the value chains and its competitiveness or, in other words, its welfare. In fact, “the risk with globalization is that the value chains of production are broken up in such a way that the rich countries take all the high-skill jobs […] while activities [which rich countries can no longer mechanize or innovate further] are farmed out to poor countries” (Reinert, 2007, p. 39).

In conclusion, the comparative advantage assumption is not supported by a serious historical analysis. Free trade could be theoretically the best option in every case but in the reality is better for a developing country to be pragmatic and integrate strategically in the world markets by following the lesson learnt that we presented in this post. Thinking on this way at the economic issues (test theories against reality and historical experiences) will more probably allow us to have a better understanding than to use models that should oversimplify the reality. What is more, a mathematical model tends to become an ideology (as free trade shows us). On the opposite looking at the reality move us away from ideology and bring us to pragmatism and a more scientific approach.

Footnotes


[i] Reinert give even more detail on the difference between products through its “quality index of economic activities” (Reinert, 2007, p. 317).
[ii] Policy space can be defined as the opportunity that a country has to use heterodox and context specific policies that can be very different from what international expert think to be the best option.
[iii] List is often showed as a protectionist. Nevertheless, “list was both a protectionist and a free trader, depending on the stage of development of a nation” (Reinert, 2007, p. 161).
[iv] Reinert shows the key elements of “good” and “bad” protectionism (Reinert, 2007, pp. 311-2). Rodrik too acknowledged this assumption. In fact, he underlines that “import substitution, planning, and state ownership did produce some successes, but where they where entrenched and ossified over time, they led to colossal failures and crises” (Rodrik, 2007, p. 100).



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