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Trade
and development: Some reflections on the linkages I. Introduction In the post-colonial era, which began soon after the end of the second world war, most underdeveloped countries adopted strategies of development that provided a sharp contrast with their past during the first half of the twentieth century. For one, there was a conscious attempt to limit the degree of openness and of integration with the world economy, in pursuit of a more autonomous, if not self-reliant, development. For another, the State was assigned a strategic role in development because the market, by itself, was not perceived as sufficient to meet the aspirations of latecomers to industrialization. Both represented points of departure from the colonial era which was characterized by open economies and unregulated markets. But this approach also represented a consensus in thinking about the most appropriate strategy for industrialization. It was, in fact, the development consensus at the time. It is almost fifty years since then. And it would seem that, in terms of perceptions about development, we have arrived at the polar opposite. Most countries in the developing world, as also in the erstwhile socialist bloc, are reshaping their domestic economic policies so as to integrate much more with the world economy and to enlarge the role of the market vis-a-vis the State. This is partly a consequence of internal crisis situations in economy, polity or society. It is also significantly influenced by the profound transformation in the world economic and political situation. The widespread acceptance of this approach represents a new consensus in thinking about development. It has come to be known as the Washington Consensus. In spite of the shift in paradigm from the development consensus of the 1950s to the Washington Consensus of the 1990s, the degree of openness vis-a-vis the world economy and the degree of intervention by the State in the market have remained the critical issues in the debate on development. The past fifty years have, of course, witnessed a complete swing of the pendulum in thinking about these issues. But the complexity of the reality is not captured by either consensus: old or new. II. Economic theory and the free trade doctrine The belief in free trade is almost a sacred tenet in the world of orthodox economics. Yet, from time to time, the profession of economics has recognized that there are reasons - orthodox and unorthodox - which may justify departures from free trade. Economic theory has analyzed these exceptions to the rule, mostly in response to developments in the real world which have questioned the free trade doctrine. In the era of classical political economy, even before the doctrine gained widespread acceptance, it was recognized that there are two critical assumptions underlying the strong prescription of free trade: first, that market prices reflect social costs and, second, that a country's trade in a good is not large enough to influence world prices. If these assumptions do not hold, free trade cannot ensure an efficient outcome. Market failure provides the basis of the infant industry argument, recognizing that free trade may prevent an economy from realizing its comparative advantage in manufacturing activities. Monopoly power provides the basis of the optimum-tariff argument recognizing that restricting the volume of trade may enable an economy to increase its real income at the expense of the rest of the world. These arguments were accepted as valid exceptions to the rule by Mill, thus providing the analytical foundation for legitimate departures from free trade. It must be rcognized that this thinking was prompted largely by the concerns of late industrializers such as the United States and Germany who wished to follow in the footsteps of England and France. It was also motivated by the pursuit of economic interests rather than economic efficiency on the part of nation states. More than a century later, at the beginning of the post- colonial era, the aspirations of underdeveloped countries were similar for they were latecomers to industrialization and wanted to accelerate the catching-up process. In the realm of politics, of course, the strong sentiment against free trade stemmed from the perceived association between openness and underdevelopment during the colonial era. In the sphere of economics, however, the argument against free trade was based on market failure. It had two dimensions. First, it was argued that there were significant positive externalities in any process of industrialization which were difficult to identify, let alone capture. Second, it was argued that imperfections in factor markets, both labour and capital, would pre-empt the realization of potential comparative advantage in manufacturing. The infant industry argument was, thus, generalized into the infant manufacturing sector argument. The industrial sector was protected from foreign competition and the pursuit of industrialization in most developing countries came to be based on the strategy of import substitution. Recent developments in the theory of international trade which have relaxed the assumptions of constant returns to scale and perfect competition, to model scale economies and market structures, have, once again, questioned the free trade argument. This literature on strategic trade policy, which surfaced in the industrialized countries during the 1980s, developed a theoretical case for government intervention in trade on the basis of assumptions which are different from those in orthodox theory but conform more to observed reality. In terms of positive economics, the new theories suggest that trade flows are driven by increasing returns rather than comparative advantage in international markets which are characterized by imperfect competition. This has led to the formulation of two arguments against free trade in the sphere of normative economics. The first is the strategic trade policy argument which states that appropriate forms of government intervention can deter entry by foreign firms into lucrative markets and thus manipulate the terms of oligopolistic competition to ensure that excess returns are captured by domestic firms. The idea is that, in a market which has a small number of competitors, strategic support for domestic firms in international competition can raise national welfare at the expense of other countries. The second is an old argument in a new incarnation which states that government should encourage activities that yield positive externalities. In a world of increasing returns and imperfect competition, such externalities are easier to identify in industries where R&D expenditures are large and firms cannot entirely appropriate the benefits from investment in technology and learning. Economic theory has, from time to time, thrown up serious questions about free trade. The response of orthodoxy has been predictable. It has endeavoured to reduce the validity of the widely accepted arguments for protection to a set of stringent conditions. It has attempted to dilute the arguments against free trade, in the context of industrialization and development, by arguing that domestic economic policies provide the first-best corrective. It has coaxed the new trade theorists into an acceptance of free trade as the best policy by invoking the real world of politics. The exceptions, it would seem, have been explored to establish the rule. Yet, these exceptions have provided the rationale for departures from free trade in the real world of policy choices. The infant industry argument, sometimes generalized into the infant manufacturing sector argument, has shaped the strategies of most countries that were, or are, latecomers to industrialization, at least in the earlier stages of their development. It has, therefore, been the focus of an extensive literature and an intensive debate on trade and industrialization, particularly with reference to the experience of the developing world during the second half of the twentieth century. In recent years, the new trade theories have revived the same issues and similar concerns by exploring the linkages between trade, industrialization and growth in a dynamic context. For one, these theories have emphasized, once again, the importance of externalities, scale or learning, and recognized, for the first time, the significance of market structures. For another, these theories have pointed to the inequalizing effects of trade, given the importance of initial conditions, so that even if trade is good more trade is not always better. Thus, unmindful of the conclusions reached by orthodoxy, economic theory has lent new dimensions to the discussion on trade and development or openness and industrialization. III. Openness, intervention and industrialization The actual industrialization experience of economies in Asia, Africa and Latin America, during the quarter century which followed the second world war, led to questions about the development consensus. Research on the subject which attempted to describe, analyze and evaluate this experience suggested that industrialization in developing countries was characterized by success stories in a few, muddling-through in some and near-failure in others. Such uneven development, over time and across space, should not have come as a surprise. For those who questioned conventional wisdom, however, the post- mortem of failures led to a diagnosis while the analysis of successes led to prescriptions. These lessons drawn from the experience of particular countries were sought to be generalized and transplanted elsewhere. Such an approach tended to ignore not only the complexities of the growth process but also the characteristics of economies which are specific in time and space. Yet, this approach came to exercise a profound influence on thinking about development. The bottom line was clear. Industrialization policies, which protected domestic industries from foreign competition and led to excessive or inappropriate State intervention in the market, were responsible for the high cost and the low growth in these economies. Inward-looking policies, particularly in the sphere of trade, were seen as the prime culprit. The prescription followed from the critique. More openness and less intervention would impart both efficiency and dynamism to the growth process. And outward- looking policies, particularly in the sphere of trade, were seen as the prime saviour. Thus, trade policies were perceived as critical in the process of industrialization and development. It needs to be said that this approach to trade and development was narrow in its focus. For it was not recognized that there is more to trade policies than the distinction between import substitution and export promotion or inward and outward orientation, just as there is much more to industrialization and development than simply trade policies. Even more important, perhaps, this approach was selective in its use of theory and history. For one, there was a striking asymmetry between the unqualified enthusiasm of policy prescriptions advocating free(r) trade, unmindful of the distinction between statics and dynamics or irrespective of time and place, and the formal exposition of the free trade argument in economic theory with its careful assumptions, proofs and exceptions. For another, the characterization of the success stories as economies which approximated to free trade and laissez faire was partial if not caricature history for their export orientation was not the equivalent of free trade just as the visible hand of the State was more in evidence than the invisible hand of the market. In spite of these limitations, however, the neo-classical critique continued to gather momentum through the 1980s. The policy prescriptions derived from it became increasingly influential as these were adopted by the World Bank, to begin with in its research agenda and subsequently in its policy menu. The process was reinforced by the reality that unfolded. The earlier success stories - Korea, Hong Kong, Taiwan and Singapore - turned into the East Asian miracle which spread to China, Malaysia, Thailand and even Indonesia. The debt crisis which surfaced in Latin America moved to sub-Saharan Africa and ultimately caught up with South Asia. The collapse of the political system in East Europe, particularly in the former Soviet Union, represented the failure of planned economies. The disillusionment with the development consensus was complete. And, by the early 1990s, the Washington Consensus acquired a near-hegemonic status in thinking about development. It would mean too much of a digression to enter into a detailed discussion on the industrialization experience, its neo-classical critique and the neo-liberal prescription. There is an extensive literature on the subject, which is characterized by a diversity of views that range from the orthodox through the heterodox to the unorthodox. Elsewhere, I provide a criticl assessment of the neo-classical analysis and the neo-liberal prescription in terms of theory and experience. It would serve little purpose to do the same here. Instead, I would simply like to highlight some of the analytical limitations of the new orthodoxy on trade and industrialization. First, it is a simple fallacy in logic to claim that if something (State intervention or protection) does not work, its opposite (the free market or free trade) must work. This is true only in a dichotomous world of two alternatives. In the world of economic policies, where there are always more than two alternatives, such a view is obviously false. Thus, if A is wrong, it does not mean that the opposite of A (say B) must necessarily be right. If there are other alternatives, say C, D, E or F, one of these rather than B may be right. Second, the emphasis on trade liberalization, which assumes that international competition will force domestic firms to become more efficient, makes an elementary but commonplace error in the design of policies. It confuses comparison (of equilibrium positions) with change (from one equilibrium position to another). In the real world, economic policy must be concerned not merely with comparison but with how to direct the process of change. Thus, even if a reduction in protection can, in principle, lead to a more cost-efficient economy, the transition path is by no means clear. And the process of change should not be confused with the ultimate destination of an economy that is competitive in the world market. Third, the analytical construct is narrow. Success at industrialization is not only about resource allocation and resource utilization at a micro-level. It is as much, if not more, about resource mobilization and resource creation at a macro-level. The excessive concern with resource allocation, in terms of static allocative efficiency criteria, is perhaps misplaced, while the strong emphasis on resource utilization, in terms of competition through deregulation and openness, is important but disproportionate. Significant new developments in the neo-classical tradition, whether in industrial economics or in trade theory, are almost ignored when such analysis is applied to problems of industrialization and development. Hence this approach, which is static rather than dynamic in conception, tends to ignore intertemporal considerations and does not quite incorporate increasing returns, market structures, externalities or learning which are inherent in any process of industrialization. Fourth, there is a presumption that what is necessary is also sufficient. The management of incentives, motivated by the object of minimizing cost and maximizing efficiency at a micro- level, is based on a set of policies that are intended to increase competition between firms in the marketplace. Domestic competition is sought to be provided through deregulation in investment decisions, in the financial sector and in labour markets. Foreign competition is sought to be provided through openness in trade, investment and technology flows. It must, however, be recognized that policies may be necessary but are not sufficient, for there is nothing automatic about competition. Policy regimes can allow things to happen but cannot cause things to happen. The creation of competitive markets that enforce efficiency may, in fact, require strategic intervention through industrial policy, trade policy and financial policy. Fifth, the strong emphasis on allocative efficiency is matched by a conspicuous silence on technical efficiency. It is forgotten that low levels of productivity in most developing countries are attributable more to technical inefficiency than to allocative inefficiency. And inter-country differences, as also inter-firm differences, in technical efficiency are explained, in large part, by differences in technological (and managerial) capabilities at a micro-level. These capabilities determine not just efficiency in the short run but also competitiveness in the long run. But, given the nature of the learning process, such capabilities are both firm-specific and path-dependent. The new orthodoxy simply ignores this critical dimension on the supply side. In contrast, the heterodox literature places the acquisition and development of technological capabilities at centrestage in the story of success at industrialization. It also shows that the presumed relationship between trade liberalization and technical efficiency is dubious in terms of both theory and evidence. IV. Conclusion In my reflections on the linkages between trade and development, I set the stage by explaining the rationale of departures from free trade in economic theory and by outlining the orthodox critique of the industrialization experience in developing countries. The latter highlights the sins of import substitution and State intervention to stress the virtues of openness and markets. However, the policy prescriptions derived are strong generalizations, which do not match orthodox theory in terms of rigour and do not recognize recent theoretical developments in terms of insights. What is more, the neo- classical critique and the neo-liberal prescription are both characterized by analytical limitations. Most important, perhaps, the mainstream literature on trade and development is narrow in its focus just as it is selective in its use of theory and experience. The changed international context, attributable to globalization, has important implications for trade and industrialization in the developing world which must be recognized. An increase in the degree of openness of economies is inevitable, while the degrees of freedom for nation states are bound to be fewer. But it would be a mistake to consider this necessity a virtue. Simplified prescriptions, which emphasize more openness and less intervention to advocate a rapid integration with the world economy combined with a minimalist State that vacates space for the market, are not validated either by theory or by history. Economic theory recognizes and economic history reveals the complexities of the industrialization process. The degree of openness and the nature of intervention are strategic choices in the pursuit of industrialization, which cannot be defined (and should not be prescribed) once-and-for-all for they depend upon the stage of development and must change over time. And there can be no magic recipes in a world where economies are characterized by specificities in time and in space. The irony is that, at the present juncture, when the disillusionment with the State is so widespread, given the reality of globalization, its role in the pursuit of industrialization and development is more critical than ever before. However, this does not mean, nor should it suggest, more of the same. Correcting for mistakes and learning from experience is vital. It is, therefore, essential to redefine the economic role of the State vis-a-vis the market, so that the two institutions complement each other and adapt to one another as circumstances or times change. That is what success at industrialization and development is about. (Third World Economics No. 207/208, 16 Apr-15 May 1999) Deepak Nayyar is Professor of Economics at Jawaharlal Nehru University (New Delhi) and a former Chief Economic Adviser to the Government of India. This paper was presented at the World Trade Organization's High Level Symposium on Trade and Development in Geneva on 17-18 March 1999.
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