International Political Economy
th o m as
OATLEY
.5
N
n
ito
d
E
International Political
Econom y
Fifth Edition
THOMAS
OATLEY
University o f North Carolina Chape! Hill
Longman
Columbm
Ainwidim
Delhi
U ptfow n
M u ricoT ity
Imti .in .i p..ili s. New Y firf
Uubii London m j J mJ
S ie P m b
Sfrincj
San Francisco Ufcpei Saddle R itcot
Miliri Munwh tilts Montiral focmco
Hnn^ Ktint
Seoul
Sing-ripon* Taipr-i
Tuli^o
Oatley, Thomas FL,
International political economy / Thomas Oatley. —5th
ed.
p. cm.
Includes bibliographical references and index.
ISBN-13: 978-0-205-06063-4(38*;. paper)
ISBN-10: 0-205-06063-3 (aIk. paper)
1. International economic relations. 2. International
finance. 3. Globalization. I. Title.
HF1359.G248 2012
337—dc22
2011000588
Copyright © 2012, 2010, 2008, 2006 by Pearson
Education, Inc.
All rights reserved. No part of this publication may be
reproduced, stored in a retrieval system, or transmitted, in
a n y form or by a n y means, electronic, mechanical,
photocopying, recording, or otherwise, without the prior
written permission of the publisher. Printed in the United
States. To obtain permission to use material from this
work, please submit a written request to Pearson
Education, Inc., Permissions Department, 1900 E. Lake
Ave., Glenview, IL 60025 or fax to (847) 486-3938 or e­
mail glenview.permissions@pearsoned.com. For
information regarding permissions, call (847) 486-2635.
BRIEF CONTENTS
P re fa c e
ix
CHAPTER 1
International P o litic a l E co n o m y
CHAPTER 2
T h e W o rld T ra d e O rganization and the W o rld T ra d e
System
CHAPTER 3
1
21
Th e P o litic a l E co n o m y o f In tern a tio n al T ra d e
C o o p era tio n
45
CHAPTER 4
A S o ciety-C e n te re d A p p ro a ch to T r a d e P o litic s
CHAPTER 5
A S ta te -C e n te re d A p p ro a ch to T r a d e P o litic s
CHAPTER 6
T ra d e and D evelopm ent I: Im port Sub stitu tion
Indu strialization
69
89
111
CHAPTER 7
T ra d e and D evelopm ent II: E c o n o m ic R e fo rm
CHAPTER 8
M ultinational Corporations in the G lobal Econom y
CHAPTER 9
T h e P o litic s of M u ltin atio n a l C o rp o ra tio n s
C H A P T E R 10
T h e International M o n e ta ry System
C H A P T E R 11
C o o p era tio n , C o n flict, and C ris is in the C o n te m p o ra ry
International M o n e ta ry System
C H A P T E R 12
G lo ssa ry
273
298
D eveloping C o u n tries and Intern ation al F in a n ce II:
323
G lo b a liza tio n : Consequences and C o n tro v e rsie s
346
370
R eferen ces
Index
225
D eveloping C o u n tries and In tern atio n al F in a n c e I:
A D ecade o f C rise s
C H A P T E R 16
202
249
T h e La tin A m e ric a n D ebt C ris is
C H A P T E R 15
180
A S ta te -C e n te re d A p p ro a ch to M o n e ta ry
and E x ch a n g e -R a te P o lic ie s
C H A P T E R 14
158
A S o ciety-C e n te re d A p p ro a ch to M o n e ta ry
and E x ch a n g e -R a te P o lic ie s
C H A P T E R 13
133
388
401
ili
DETAI LED CONT E NT S
Preface
ix
CHAPTER 1
International Political Economy
1
What Is International Political Economy?
2
Studying International Political Economy 7
Traditional Schools of International Political Economy 8
Interests and Institutions in International Political Economy
The Global Economy in Historical Context
13
15
CHAPTER 2
The World Trade Organization and the World Trade System
What Is the World Trade Organization?
21
22
Hegemons, Public Goods, and the World Trade System
28
The Evolving World Trade Organization: New Directions, New
Challenges 32
The Greatest Challenge? Regional Trade Arrangements and the World Trade
Organization 36
CHAPTER 3
The Political Economy of International Trade Cooperation
The Economic Case for Trade
Trade Bargaining
45
46
53
Enforcing Agreements
58
CHAPTER 4
A Society-Centered Approach to Trade Politics
69
Trade Policy Preferences 70
Factor Incomes and Class Conflict 70
Sector Incomes and Industry Conflict 73
Organizing Interests: The Collective Action Problem and Trade Policy
Demands 79
Political Institutions and the Supply of Trade Policy
IV
81
Detailed Contents
CHAPTER 5
A State-Centered Approach to Trade Politics
States and Industrial Policy 90
The Infant-Industry Case for Protection
89
91
State Strength: The Political Foundation of Industrial Policy
Industrial Policy in High-Technology Industries
Strategic-Trade Theory 100
95
99
Strategic Rivalry in Semiconductors and Commercial Aircraft
103
CHAPTER 6
Trade and Development I: Import Substitution
Industrialization 111
Domestic Interests, International Pressures, and Protectionist
Coalitions 112
The Structuralist Critique: Markets, Trade, and Economic
Development 118
Market Imperfections in Developing Countries 118
Market Imperfections in the International Economy 120
Domestic and International Elements of Trade and Development
Strategies 121
Import Substitution Industrialization 121
Reforming the International Trade System 128
CHAPTER 7
Trade and Development II: Economic Reform
133
Emerging Problems with Import Substitution Industrialization
The East Asian Model
134
137
Structural Adjustment and the Politics of Reform
145
Developing Countries and the World Trade Organization
154
CHAPTER 8
Multinational Corporations in the Global Economy
Multinational Corporations in the Global Economy
158
159
Economic Explanations for Multinational Corporations 165
Locational Advantages 165
Market Imperfections 168
Locational Advantages, Market Imperfections, and Multinational Corporations
Multinational Corporations and Host Countries 173
171
V
VI
Detailed Contents
CHAPTER 9
The Politics of Multinational Corporations
180
Regulating Multinational Corporations 181
Regulating Multinational Corporations in the Developing World 181
Regulating Multinational Corporations in the Advanced Industrialized Countries
Bargaining with Multinational Corporations 188
The International Regulation of Multinational Corporations
185
194
CHAPTER 10
The International Monetary System
202
The Economics of the International Monetary System
Exchange-Rate Systems 203
The Balance of Payments 205
Balance-of-Payments Adjustment 208
203
The Rise and Fall of the Bretton Woods System 212
Creating the Bretton Woods System 212
Implementing Bretton Woods: From Dollar Shortage to Dollar Glut
The End of Bretton Woods: Crises and Collapse 219
215
CHAPTER 11
Cooperation, Conflict, and Crisis in the Contemporary
International Monetary System 225
From the Plaza to the Louvre: Conflict and Cooperation during
the 1980s 226
Global Imbalances and the Great Financial Crisis of 2007-2009
Exchange-Rate Cooperation in the European Union
234
241
CHAPTER 12
A Society-Centered Approach to Monetary and Exchange-Rate
Policies 249
Electoral Politics, the Keynesian Revolution,
and the Trade-Off between Domestic Autonomy
and Exchange-Rate Stability 250
Society-Based Models of Monetary and Exchange-Rate
The Electoral Model of Monetary and Exchange-Rate Politics
The Partisan Model of Monetary and Exchange-Rate Politics
The Sectoral Model of Monetary and Exchange-Rate Politics
Politics
257
260
264
255
Detailed Contents
vii
CHAPTER 13
A State-Centered Approach to Monetary and Exchange-Rate Policies
Monetary Policy and Unemployment
The Time-Consistency Problem
Commitment Mechanisms
273
274
281
283
Independent Central Banks and Exchange Rates
293
CHAPTER 14
Developing Countries and International Finance I:The Latin American
Debt Crisis 298
Foreign Capital and Economic Development
299
Commercial Bank Lending and the Latin American Debt Crisis
Managing the Debt Crisis
304
309
The Domestic Politics of Economic Reform
317
CHAPTER 15
Developing Countries and International Finance II: A Decade
of Crises 323
The Asian Financial Crisis
Bretton Woods II
324
332
The Heavily Indebted Poor Countries
338
CHAPTER 16
Globalization: Consequences and Controversies
Globalization and Global Poverty
Globalization and "Sweatshops"
Trade and the Environment
Glossary
370
References
Index
401
388
358
347
351
346
Preface
xi
■ Chapter 10 includes a “ Closer L o o k ” that exam ines how the gap
between savings and investment shapes current account im balances and
relates this to the contem porary U.S.-China trade im balance.
■ Chapter 11 includes a “ Policy Analysis and D ebate” that asks students to
consider whether governments should pursue additional fiscal stimulus
to prom ote global economic recovery.
■ Chapter 12 includes a “ Policy Analysis and D ebate” that asks students
to discuss the merits and demerits o f the O bam a adm inistration’s
effort to double exports in five years in part by devaluing the dollar.
■ Chapter 13 includes a “ Closer L o o k ” that strives to explain why the
European Central Bank and the Federal Reserve have adopted such
different policies in response to current economic conditions.
■ Chapter 15 includes a “ Policy Analysis and D ebate” that asks students to
discuss whether China’s status as a m ajor creditor country in the global
economy confers political power.
■ Chapter 16 includes a “ Closer L o o k ” that exam ines how politics have
created a distributive conflict that forces governments to choose between
a global climate change regime or compliance with W TO obligations.
FEATURES
T his textbook im parts a unique perspective. First, this b o o k show s students
how dom estic p o litics shape the objectives governm ents p u rsu e and how
interaction between governm ents shapes the outcom es they achieve. In fact,
I dedicate more than one-quarter o f the book to the dom estic politics o f trade
and exchange-rate policies. Second, the book show s how the objectives that
governm ents pursue are in turn sh aped by interest gro u p s and individuals
responding to the im pact o f the global econom y on their incom es. T hus, the
book highlights how political processes shape the econom ic system and how
transactions within the global economy in turn shape political dynamics.
The book im parts this perspective by relying on four pedagogical tools.
First, each chapter elaborates the logic o f the econom ic m odels relevant to
each issue area in lan guage accessible to the n on specialist. Second, each
chapter highlights h ow the d istrib u tio n al con sequen ces o f cross-border
economic activity shape politics— domestic or international— within that issue
area. Third, each chapter uses the m odels of political com petition to explain
im portant historical events. M any chapters contain “ C loser L o o k ” boxes to
provide in-depth case studies. Finally, each chapter contains a “ Policy Analysis
and D ebate” b o x to encourage students to relate the theoretical m odels—
political and economic— to contem porary policy debates.
The book applies this approach to the m ajor issue areas in international
political economy. The first h alf o f the book is devoted to international trade
and production. C h apters 2 and 3 exam ine the p o litical logic driving the
creation and evolution o f the international trade system . C h apter 2 traces
the historical evolution of the General Agreement on T ariffs and Trade/W orld
xii
Preface
T rad e O rganization. C h apter 3 exam ines the system through the lens o f
neoliberal theories of cooperation. Chapters 4 and 5 exam ine how domestic
politics shape governm ent trad e policies. C h apter 4 presents a p lu ralist
perspective, while Chapter 5 introduces a statist approach. Chapters 6 and 7
focus on the orientation o f developing countries tow ard the international
trade system. Chapter 6 explains why so many governments sought to insulate
themselves from the system in the early postw ar period. Chapter 7 examines
and explains the shift in developm ent strategies from inw ard to exportoriented. This section concludes with a thorough exam ination o f the political
economy o f m ultinational corporations in Chapters 8 and 9.
The second h alf o f the book exam ines the international m onetary and
financial systems. Chapters 10 and 11 trace the evolution o f the international
monetary system. Chapter 10 focuses on core issues o f exchange rate systems
and balance-of-paym ents adjustm ent and traces the creation and collapse
o f the Bretton W oods system . C h apter 11 focu ses on the con tem porary
floating exchange-rate system, focusing on efforts to m anage the system via
coordination or to stabilize exchange rates via m onetary union. Chapters 12
and 13 exam ine the domestic politics of m onetary and exchange-rate policies.
Chapter 12 exam ines the partisan and sectoral m odels o f m acroeconom ic and
exchange-rate policy; Chapter 13 em ploys a state-centered approach to explore
the im pact of central banks as agents independent o f governments. Chapters
14 and 15 focus on developing countries’ relationships with the international
financial system. Chapter 14 exam ines the emergence and resolution o f the
Latin American debt crisis. Chapter 15 focuses on the A sian financial crisis
and subsequent efforts to m anage capital flow s to developing countries and to
reform the International M onetary Fund. Chapter 16 concludes by draw ing on
what we have learned to explore som e o f the m ajor policy debates that have
emerged surrounding the global economy.
SUPPLEMENTS
L o n gm an is p lea se d to o ffer sev eral re so u rc e s to q u a lifie d a d o p te rs o f
International P olitical E conom y and their students that will m ake teaching
and learning from this bo ok even m ore effective and enjoyable. Several o f
the supplements for this book are available at the Instructor Resource Center
(IRC), an online hub that allow s instructors to quickly dow nload book-specific
supplem ents. Please visit the IR C w elcom e p age at w w w .pearsonh ighered
.com /irc to register for access.
Passport for International Relations
With Passport, choose the resources you want from M yPoliSciKit and put links
to them into your course-management system. If there is assessm ent associated
with those resources, it also can be uploaded, allowing the results to feed directly
Preface
xiii
into your course-management system’s gradebook. With over 150 MyPoliSciKit
a sse ts like video case stu d ies, m ap p in g exercises, co m p a ra tiv e exercises,
simulations, podcasts, Financial Times newsfeeds, current events quizzes, politics
blogs, and much m ore, Passport is available for any Pearson introductory or
upper-level political science book. Use ISBN 0-205-09290-X to order Passport
with this book. T o learn more, please contact your Pearson representative.
M ySearchLab
N eed help with a paper? M ySearch Lab saves time and im proves results by
offering start-to-finish guidance on the research/writing process and full-text
access to academic journals and periodicals. Use ISBN 0-205-09271-3 to order
M ySearchLab with this book. T o learn more, please visit www.mysearchlab.com
or contact your Pearson representative.
Test Bank
T his resource includes m ultiple-choice question s, true/false question s, and
essay questions for each chapter. Available exclusively on the IR C .
The Economist
Every week, The E co n om ist analyzes the im portant happenings around the
globe. From business to politics, to the arts and science, its coverage connects
seemingly unrelated events in unexpected ways. Use ISB N 0-205-00262-5 to
order a 15-week subscription with this book for a sm all add ition al charge.
T o learn more, please contact your Pearson representative.
The Financial Times
Featu rin g in tern ation al new s an d an alysis from jo u rn a lists in m ore than
50 countries, The Financial Times provides insights and perspectives on political
and economic developm ents around the w orld. Use ISB N 0 -2 0 5-00248-X to
order a 15-week subscription with this book fo r a sm all addition al charge.
T o learn more, please contact your Pearson representative.
*
Longman Atlas of World Issues (0-205-78020-2)
From p o p u latio n and p o litical system s to energy use an d w om en’s rights,
the L ongm an A tlas o f W orld Issu es features full-color them atic m aps that
exam ine the forces shaping the w orld. Featuring m aps from the latest edition
of The Penguin State o f the World Atlas, this excerpt includes critical-thinking
exercises to prom ote a deeper understanding o f how geography affects many
global issues. Available at no additional charge when packaged with this book.
XIV
Preface
Goode's World Atlas (0-321-65200-2)
First pu blish ed by R an d M cN a lly in 1 9 2 3 , G o o d e ’s W orld A tla s has set
the stan dard for college reference atlases. It features hundreds o f physical,
political, and them atic m aps as well as grap h s, tables, and a pronunciation
index. Available at a discount when packaged with this book.
The Penguin Dictionary of International Relations (0-140-51397-3)
This indispensable reference by G raham Evans and Jeffrey New nham includes
hundreds o f cross-referenced entries on the enduring and em erging theories,
concepts, and events that are shaping the academ ic discipline o f international
relations and to d ay ’s w orld politics. A vailable at a discount when packaged
with this book.
Research and Writing in International Relations (0-205-06065-X)
With current and detailed coverage on how to start research in the discipline’s
m ajor subfields, this brief and affordable guide offers the step-by-step guidance
and the essential resources needed to com pose political science papers that go
beyond description and into system atic and sophisticated inquiry. T his text
focuses on areas where students often need help: finding a topic, developing
a question, reviewing the literature, designing research, and last, w riting the
paper. Available at a discount when packaged with this book.
ACKNOWLEDGMENTS
N o b o o k such as th is is the w o rk o f a sin gle p e rso n . I have b en efited
immensely from the advice and support of many people. A few deserve special
mention. Eric Stano o f Longm an publishers supported this project from its
initial conceptualization. Vik M ukhija has been terrifically supportive through
m ost of the subsequent editions. R olan d Stephen went well beyond the call
of duty as friend and colleague in entertaining my m any questions, providing
suggestions ab ou t how to im prove the text and using early versions o f the
book in his class at N orth Carolina State University. Eric Reinhardt at Em ory
University and Jeffry Frieden at H arvard University each offered com m ents
based on their experience with using this text in their courses.
N um erous reviewers provided detailed com m ents that vastly im proved
the book in so many w ays. It is no light burden to write a thoughtful and
constructive review o f a book, and I thank them all for taking the time to do
so. M y thanks, therefore, go to Ali R . A bootalebi, University o f W isconsinE au C laire; Frances A d am s, O ld D om in ion U niversity; M on ica A rrud a
de A lm eida, U niversity o f C a lifo r n ia -L o s A ngeles; K ath erine B arb ieri,
University of South C arolin a; Charles H . Blake, Jam e s M ad ison University;
C harles Boehm er, University of T e x a s- E l P a so ; Terry D . C lark , C reighton
Preface
XV
University; Linda Cornett, University of N orth C arolin a-A shville; Charles R.
D annehl, Bradley University; R obert A. D aley, A lbertson C ollege o f Idaho;
M ark Elder, M ichigan State University; M atthew D iG iuseppe, Bingham ton
University; R ichard Ganzel, Sierra N ev ad a College; Y o ram H aftel, D ePaul
University; Steven H all, Boise State University; Cullen H endrix, University
o f N o rth T e x a s; M ich ael H u elsh o ff, U niversity o f N e w O rle an s; A lan
K essler, U niversity o f T e x a s-A u stin ; D o u g la s Lem ke, Pennsylvania State
University; Andrew Long, University o f M ississippi; M ichael M astan dun o,
D artm o u th C ollege; Sean M . M cD o n ald , Bentley C o llege; Phillip M eeks,
C reighton University; Jeffrey S. M orton , Florida A tlantic U niversity; Layna
M o sley , U niversity o f N o rth C a ro lin a -C h a p e l H ill; G ene M u m y , O hio
State University; Clint Peinhardt, University o f T e x a s-D a lla s; Jim Peltcher,
D e n iso n U n iversity; H erm an Sch w artz, U n iversity o f V irg in ia ; R o ger
Schoenm an, U niversity o f C aliforn ia a t Santa C ruz; C liff Staten , Indiana
U n iversity S o u th e a st; an d C h ristian n e H a rd y W o h lfo rth , D artm o u th
College.
Finally, I owe a large debt o f gratitude to all o f those sch olars whose
research m ade this book possible. Y ou have taught me much, and I only hope
that in writing the book I have treated your w ork accurately and fairly. O f
course, in spite of all this support, I alone am responsible for any errors of fact
or interpretation.
T homas O atley
PREFACE
L
o cal eco n o m ic d ev e lo p m e n ts re fle c t g lo b a l fo rc e s. C o n sid e r the
sovereign debt crisis th at stru ck G reece in the sprin g o f 2 0 1 0 . The
Greek government borrowed heavily between 2006 and 20 0 9 . Greece’s
ability to borrow so much w as m ade possible by tw o global developm ents:
high savings rates in China created a large pool to draw from ; the creation
o f the euro seem ed to m ake G reece a lo w -risk borrow er. G erm an ban ks
interm ediated much o f the funds that flow ed to Greece in this period. When
the G reek governm ent’s fin an cial p o sitio n deteriorated sh arply in the fall
o f 2 0 0 9 , financial m arkets began to d o u b t G reek solvency and sold G reek
debt in m assive quantities. Because G erm an banks held such large am ounts
o f G reek debt, a possible G reek default w o u ld possibly precipitate a severe
banking crisis in G erm any that could ripple acro ss the EU and potentially
undermine the euro itself. T o stave o ff this possibility, EU governments agreed
(reluctantly) to provide fin an cial a ssista n ce to G reece in order to restore
stability. H ence, global forces enabled Greece to get into financial difficulty,
and once Greece encountered problem s, its difficulties threatened econom ic
stability throughout the EU. And had the crisis brought euro down, the global
economy w ould have suffered a terrible blow . In this “ era o f globalization ,”
the factors that shape our economic lives are as likely to originate in far aw ay
places as they are to stem from local events.
Understanding the global economy requires knowledge o f politics as well
as economics. For globalization is not a spontaneous economic process; it is
built on a political foundation. Governments share a broad consensus on core
principles; core principles inform the elaboration o f specific rules. Specific
rules establish international institutions— the W orld T rade O rganization,
the W orld Bank, and the International M onetary Fund. These international
institutions in turn facilitate a political process through which governments
reduce barriers to global exchange and create com m on rules to regulate other
elements o f the global economy. T his political system— the foundation and
the process— has enabled businesses to construct the network o f international
econom ic linkages that constitute the econom ic dimension o f globalization.
U nderstanding the global econom y, therefore, requires a political econom y
approach: We must study its political as well as its economic dimensions.
Studying the political and econom ic dim ensions o f the global econom y
requires us to develop theory that simplifies an inherently com plex world. This
book develops a theoretical fram ework in which politics in the global economy
revolve around enduring com petition betw een the winners and the losers
generated by global economic exchange. As econom ists since Adam Smith have
told us, global exchange raises aggregate social welfare. Yet, global exchange
ix
X
Preface
also creates winners and losers. For som e, glo b al exchange brings greater
wealth and rising incom es; for others, however, the international econom y
brings job losses and low er incom es. T hese winners and losers com pete
to influence governm ent policy. T h ose w ho profit from glo b al exchange
encourage governm ents to a d o p t policies that facilitate such exchange;
those harmed by globalization encourage governments to adopt policies that
restrict it. This com petition is played out through dom estic politics, where
it is mediated by domestic political institutions, and it is played out through
international politics, often within the m ajor international institutions such as
the G roup o f 20 and the World Trade Organization.
NEW TO THIS EDITION
A lthough this edition m aintains the basic structure o f previous edition s, I
have adjusted the bo ok’s discussion o f substantive issues to provide extended
treatm ent of the causes and consequences o f the recent financial turm oil. I
have given particular attention in this revision to a few theoretical topics and
one m ajo r substan tive topic. F irst, I have added a few new dim ensions to
the theoretical perspective. Chapter 2 structures the discussion o f hegemonic
stability theory around the concepts o f public goods and free riding. Chapter
3 introduces spatial theory to analyze bargaining in the W T O and discusses
the sources of bargaining power. The chapters on dom estic politics introduce
the concept o f Veto Player and dem onstrate how it shapes outcom es in trade
and monetary policy m aking. Second, I have included substantial new content
regardin g the 2 0 0 7 - 2 0 0 9 fin an cial crisis and the sovereign debt crisis in
Greece. T his includes a substan tial rew orking o f C hapter 11 to focus on the
global im balances and d istributional issues at the center o f the crisis and a
sm aller reorientation o f C h apter 15 to incorporate Bretton W oods II m ore
fully into the d iscussion . A s alw ays, I have u p dated the figures and tables
where appropriate to incorporate the m ost recent data available.
I have changed many of the “ Closer L o o k ” and “ Policy Analysis and D ebate”
boxes. In addition to updating recurring features, I added many new topics.
■ Chapter 5 includes a “ Policy Analysis and D ebate” that asks students to
consider the merits and demerits o f the O bam a adm inistration’s desire to
use industrial policy to prom ote green technology.
■ Chapter 6 includes a “ Policy Analysis and D ebate” focused on the debate
between Jeffrey Sachs and W illiam Easterly over foreign aid and the
Millennium Development G oals.
■ Chapter 7 includes a “ Policy Analysis and D ebate” focused on whether
development strategies should transition from the W ashington Consensus
to the Beijing Consensus.
■ Chapter 8 includes a “ Closer L o o k ” that focuses on H u go Chavez’ s
nationalization o f the oil sector in Venezuela.
■ Chapter 9 includes a “ Closer L o o k ” that exam ines Sovereign Wealth
Funds.
CHAPTER
1
International Political
Economy
e live in a glo b al econom y. H o w m any tim es have you heard or
read that short sentence in the last m onth? If you w atch the cable
news networks or read the m ajor new spapers, probably more than
a couple o f tim es. W hat does it m ean? T o p a rap h ra se the fam o u s British
economist John M aynard Keynes, I think it means in p art that, from my home
in N orth C arolina, I can order an iPod designed by an Am erican com pany, but
m anufactured by an E ast A sian com pany, order som e po lo shirts produced
in Bangladesh, and buy and sell stocks in British and French com panies all
before I have finished my m orning coffee (which, by the w ay, w as grow n in
Sum atra). In p art, therefore, living in a global econom y m eans the products
I regularly consum e are as likely to com e from a distant country as from the
United States.
Living in a global economy also means that global econom ic forces play a
large role in determining many o f our career opportunities. Forty years ago, for
exam ple, people in my hom e state could find reasonably w ell-paying jobs in
local textile mills. T oday, m ost o f these mills and the jo b s they once provided
are gone, and few young N orth Carolinians seek, much less find, employment
in this industry. D uring the sam e p eriod , how ever, high-technology firm s
moved to N orth Carolina. IBM , Lockheed, GlaxoSm ithKline, and many other
high-technology firm s all operate within a few miles o f m y hom e. Charlotte,
the state’s largest city, has em erged as one o f the country’s largest financial
centers, hom e to one o f the nation ’s largest banks, Bank o f A m erica. Hightechnology com panies and financial institutions today provide thousands o f
jo b s for N o rth C arolin ians. T hus, the opportunities available to the typical
N orth Carolinian are far different today than they were only 30 years ago. I’m
sure that the state you live in has seen sim ilar changes. The global econom y
has played a central role in bringing ab o u t these changes, shaped by global,
rather than national (much less local), economic forces.
In te rn a tio n a l p o litic a l eco n o m y (IPE) stu d ie s h o w p o litic s sh a p e
developm ents in the g lo b al econom y and how the g lo b a l econom y sh apes
politics. It focuses m ost heavily on the enduring political battle between the
winners and losers from glo b al econom ic exchange. A lthough all societies
ben efit fro m p a r tic ip a tio n in the g lo b a l e co n o m y , th ese g a in s are not
W
1
2
CHAPTER 1
International Political Economy
distributed evenly am ong individuals. G lob al econom ic exchange raises the
incom e o f som e people and low ers the incom e o f others. The distributive
consequences o f glo b al econom ic exchange generate p o litical com petition
in nation al and in tern ation al aren as. The w inners seek deeper links with
the global econom y in order to extend and consolidate their gain s, whereas
the losers try to erect barriers between the global and national econom ies in
order to minimize or even reverse their losses. International political economy
studies how the enduring political battle between the winners and losers from
global economic exchange shapes the evolution o f the global economy.
This chapter introduces IPE as a field o f study. It begins by providing a
broad overview o f the substantive issues that IPE exam ines and the kinds o f
questions scholars ask when studying these issues. The chapter then briefly
surveys a few o f the theoretical fram ew orks that scholars have developed in
order to answ er the questions they pose. The chapter concludes by looking
at the emergence o f a global econom y in the late nineteenth century in order
to provide a broader context for our subsequent focus on the contem porary
global economy.
WHAT IS INTERNATIONAL POLITICAL ECONOMY?
International political econom y studies the political battle between the w in­
ners and losers o f global econom ic exchange. Consider, for exam ple, the deci­
sion by the Bush adm inistration to raise tariffs on im ported steel in the spring
o f 2 0 0 2 . The decision to raise the steel ta riff w as prom pted by lobbying by
the owners of American steel firms and the United Steel W orkers o f America.
The steel industry lobbied for higher tariffs because they were losing from
trade. Imported steel w as capturing a large share o f the American m arket, re­
sulting in a large number of plant closings and layoffs. Thirty-four Am erican
steel mills filed for bankruptcy between 1997 and 2 0 0 2 , forcing about 18,000
w orkers from their job s. Steel producers and steel w orkers recognized that
higher tariffs would protect them from this com petition, thereby reducing the
number of American steel mills in distress and slow ing the rate at which steel
workers were losing their jobs.
The higher steel tariff had negative consequences for other grou ps in so ­
ciety, however. The tariff hurt Am erican industries that use steel to produce
good s, such as auto m anufacturers, because these firm s had to pay m ore for
steel. The tariff also harm ed foreign steel producers, who could sell less steel
in the American m arket than before the tariff w as raised. G roups that suffered
from the tariff turned to the p o litical system to try to reverse the Bush a d ­
m inistration’s decision. In the United States, the Consum ing Industries T rade
Action Coalition (or C IT A C ), a business association that represents firms that
use steel (and other im ported inputs) to produce other go o d s, pressured the
Bush adm inistration and Congress to low er the steel tariff. Foreign steel p ro ­
ducers lobbied their governm ents to pressure the United States to reverse the
decision. In response, the E uropean U nion and Ja p a n threatened to retaliate
by raising tariffs on go od s that the United States exports to their m arkets and
initiated an investigation within the W orld T rad e O rganization (W TO )— the
What Is International Political Economy?
3
international organization with responsibility for such disputes. The story of
the steel tariff thus nicely illustrates the central focus o f international political
economy as a field o f study: how the political battle between the winners and
losers o f global economic exchange shapes the economic policies that govern­
ments adopt.
The steel ta riff a lso high lights the m any distin ct elem ents th at in ter­
n ation al p o litical econom y m u st in co rporate to m ake sense o f the g lo b al
econom y. T o fully understand the steel tariff, we need to know som ething
about the economic interests o f the businesses and w orkers who produce and
consum e steel. U nderstanding these interests requires us to know econom ic
theory. M oreover, we need to know something about how political processes
in the United States transform these economic interests into trade policy. This
requires know ledge o f the Am erican political system and the Am erican trade
policy process. In addition, we need to know som ething ab ou t how a policy
decision m ade by the United States affects businesses and w orkers based in
other countries (more econom ic theory for this), and we need to know how
the governments in those countries are likely to respond to these consequences
(which requires know ledge ab o u t the political system s in the various coun­
tries). Finally, we need to know som ething about the role that international
economic organizations like the W TO play in regulating the foreign economic
policies that governm ents ad o p t. T hus, understanding developm ents in the
global econom y requires us to draw on econom ic theory, explore dom estic
politics, exam ine the dynamics of political interactions between governments,
and fam iliarize ourselves with international econom ic o rgan ization s. Even
though such an undertaking m ay seem daunting, this book introduces you to
each o f these elements and teaches you how to use them to deepen your un­
derstanding o f the global economy.
One w ay scholars sim plify the study o f the global econom y is to divide
the substantive aspects o f glo b al econom ic activity into distinct issue areas.
T y p ically , the g lo b a l econ om y is brok en into fo u r such issue a re a s: the
international trade system, the international m onetary system , m ultinational
corporations (or M N C s), and econom ic developm ent. R ather than studying
the global economy as a whole, scholars will focus on one issue area in relative
isolation from the others. O f course, it is som ewhat m isleading to study each
issue area independently. M N C s, for exam ple, are im portan t actors in the
international trade system. The international m onetary system exists solely to
enable people living in different countries to engage in economic transactions
w ith each o th e r. It h a s no p u r p o s e , th e re fo re , o u tsid e c o n sid e r a tio n
o f in te rn a tio n a l trad e an d in v estm en t. M o re o v e r, p ro b le m s a risin g in
the international m onetary system are intrinsically connected to developments
in international trade and investm ent. T rad e, M N C s, and the international
m onetary system in turn all play im portant roles in econom ic developm ent.
Thus, each issue area is deeply connected to the others. In spite o f these deep
connections, the central characteristics o f each area are sufficiently distinctive
that one can study each in relative isolation from the others, as long as one
rem ains sensitive to the connections am ong them when necessary. We will
adopt the sam e approach here.
4
CHAPTER
1
International Political Economy
The international trade system is centered upon the W TO , to which some
153 countries belong and through which they have created a nondiscrim inatory international trade system. In the international trade system, each country
gains access to all other W TO m em bers’ m arkets on equal terms. In addition,
the W TO and its predecessor, the General Agreem ents on T ariffs and T rade
(G ATT), have enabled governments to progressively eliminate tariffs and other
barriers to the cross-border flow of goods and services. As these barriers have
been dism antled, world trade has grow n steadily. T od ay , good s and services
worth about $7.6 trillion flow across national borders each year. D uring the
last 10 years, however, regional trading arrangem ents have arisen to pose a
potential challenge to the W TO -centered trade system . These regional trade
arrangem ents, such as the N orth Am erican Free T rade Agreement (N A FTA ),
are trading blocs com posed of sm all number of countries who offer each other
preferential access to their markets. Scholars who study the international trade
system investigate how the political battle between the winners and losers of
global econom ic exchange shapes the creation, operation, and consequences
of the W TO-centered system and the emerging regional trading fram eworks.
The in tern ation al m on etary system en ables peo ple living in d ifferent
countries to conduct econom ic transactions with each other. People living in
the United States w ho w ant to buy g o o d s produced in Ja p a n m ust be able
to price these Jap an ese goods in dollars. In addition, A m ericans earn dollars,
but Jap an ese spend yen, so som ehow dollars m ust be converted into yen for
such purchases to occur. The international m onetary system facilitates in­
ternational exchange by perform ing these functions. When it perform s these
functions well, international econom ic exchange flourishes. When it doesn’t,
the global econom y can slow or even collapse. Scholars who study the inter­
national monetary system focus on how political battles between the winners
and losers o f glo b al econom ic exchange shape the creation, operation , and
consequences of this system.
M ultinational corporation s occupy a prom inent and often controversial
role in the global economy. A m ultinational corporation is a firm that controls
production facilities in at least tw o countries. The largest o f these firm s are
fam iliar names such as Ford M otor C om pany, General Electric, and General
M otors. The United N ation s estimates that there are more than 82,000 M N C s
operating in the contem porary global economy. These firm s collectively con­
trol ab ou t 8 1 0 ,0 0 0 production p lan ts and em ploy ab o u t 77 m illion people
across the globe. Together, they account for about one-quarter of the w orld’s
economic production and about one-third o f the w orld’s trade. M N C s shape
politics because they extend m anagerial control across national borders. Corporate m anagers based in the United States, for exam ple, m ake decisions that
affect economic conditions in M exico and other Latin American countries, in
W estern Europe, and in A sia. Scholars who study M N C s focus on a variety
o f econom ic issues, such as why these large firm s exist and w hat econom ic
im pact they have on the countries that host their o peration s. Sch olars also
study how the political battle between the winners and losers o f M N C activity
shapes government efforts to attract and regulate M N C activities.
^
What Is International Political Economy?
5
Finally, a large body o f literature studies economic development. Through­
out the postw ar period, developing country governments have adopted explicit
developm ent strategies that they believed w ould raise incomes by prom oting
industrialization. The success o f these strategies has varied. Som e countries,
such as the N ew ly Industrializing C ountries (N IC s) o f E ast A sia (T aiw an,
South K orea, Singapore, and H ong Kong) have been so successful in prom ot­
ing industrialization and raising per capita incomes that they no longer can be
considered developing countries. Other countries, particularly in sub-Saharan
Africa and in parts o f Latin Am erica, have been less successful. Governments
in these countries ado pted different developm ent strategies than the N IC s
throughout much o f the postw ar period and realized much sm aller increases
in per capita incomes. Students o f the politics o f economic development focus
on the specific strategies that developing countries’ governments ado pt and at­
tem pt to explain why different governm ents ad o p t different strategies. In ad ­
dition, these students are concerned about which development strategies have
been relatively more successful than others (and why) and about whether par­
ticipation in the international econom y facilitates or frustrates development.
In trying to m ake sense o f these aspects o f development, IPE scholars empha­
size how the political battle generated by the distributive consequences o f the
global economy shapes the development strategies that governments adopt.
T h ose w ho study the global econom y through the lens o f IPE are typi­
cally interested in doing more than simply describing government policies and
contem porary developm ents in these fou r issue areas. M o st sch olars aspire
to m ake m ore general statem ents ab ou t how politics shape the policies that
governments adopt in each o f these issue areas. M oreover, m ost scholars want
to draw m ore general conclusions about the consequences o f these policies. As
a result, tw o abstract and considerably broader questions typically shape IPE
scholarship. First, how exactly does politics shape the decisions that societies
m ake about how to use the resources that are available to them? Second, what
are the consequences o f these decisions? Because these tw o overarching ques­
tions are central to what we cover in this book, it is w orth taking a closer look
at each o f them now.
H ow does politics shape societal decisions ab o u t how to allocate avail­
able reso u rces? F o r exam p le, how d o e s a so ciety d ecide w hether to use
available labor and capital to produce sem iconductors or clothing? Although
this question m ight appear quite rem ote from the issue areas ju st discussed,
the connections are actually quite close. The foreign econom ic policies that
a governm ent a d o p ts— its trade policies, its exchange rate policies, and its
policies tow ard M N C s— affect how that society’s resources are used. A deci­
sion to raise tariffs, for exam ple, w ill encourage business ow ners to invest
and w orkers to seek employment in the industry that is protected by the ta r­
iff. A decision to low er tariffs will encourage business ow ners and w orkers
currently em ployed in the newly liberalized industry to seek em ploym ent in
other industries. D ecisions ab o u t tariffs, therefore, affect how society’s re­
sources are used. Foreign economic policies are, in turn, a product o f politics,
the process through which societies m ake collective decisions. Thus, the study
6
CHAPTER 1
International Political Economy
o f international political econom y is in m any respects the study o f how the
political battle between the winners and losers o f global econom ic exchange
shapes the decisions that societies m ake about how to allocate the resources
they have available to them.
These decisions are com plicated by two considerations. On the one hand,
all resources are finite. A s a result, choices ab ou t how to allocate resources
will always be made against a backdrop o f scarcity. Any choice in favor o f one
use therefore necessarily im plies a choice to forgo another possible use. On
the other hand, in every society, groups will disagree about how available re­
sources should be used. Some groups will w ant to use the available resources
to produce cars and sem iconductors, for exam ple, whereas others will prefer
to use these resources to produce clothing and agricultural products. Societ­
ies consequently will alw ays confront com peting dem ands for finite resources.
One o f the im portant goals o f IPE as a field o f study is to investigate how such
com peting dem ands are aggregated, reconciled, and transform ed into foreign
economic policies.
The second abstract question asks w hat are the consequences of the choices
that societies m ake about resource allocation? These decisions have tw o very
different consequences. D ecision s a b o u t resource a llo catio n have w elfare
consequences— that is, they determine the level o f societal well-being. Some
choices will m axim ize so cial w elfare— th at is, they w ill m ake society as a
whole as well-off as possible given existing resources. Other choices will cause
social welfare to fall below its potential, in which case different choices about
how to use resources would m ake society better off. Decisions about resource
allocation also have distributional consequences— that is, they influence how
income is distributed between groups within countries and between nations in
the international system.
Welfare and distributional consequences are both evident in the American
steel tariff. Because the tariff m akes it m ore profitable to produce steel in the
United States than it w ould be otherwise, som e investment capital and w ork­
ers, who might otherwise be employed in highly efficient American industries
such as inform ation technology or biotechnology, will be used in the less ef­
ficient American steel industry. The tariff thus causes the United States to use
too many of its resources in econom ic activities that it does less well and too
few resources in activities that it does better. As a consequence, the United
States is poorer with a high tariff on steel than it w ould be without it.
The steel tariff also redistributes income. Because the tariff raises the price
o f steel in the United States, it redistributes income from the consumers o f steel,
such as American firms that use steel in the products they manufacture and the
American consum ers who purchase goods m ade out o f steel, to the steel pro ­
ducers. In addition, because the tariff m akes it m ore difficult for foreign steel
firms to sell in the American m arket, it redistributes income from foreign steel
producers to American steel producers. The steel tariff, like m any econom ic
policies, affects both the level and the distribution of income within a society.
These two abstract questions give rise to tw o very different research tra­
ditions within IPE. One tradition focuses on explanation, and the second fo ­
cuses on evaluation. Explanatory studies, which relate m ost closely to our first
Studying International Political Economy
7
abstract question, are oriented tow ard explaining the foreign economic policy
choices that governm ents m ake. Such studies m ost often attem pt to answer
“ why” questions. For exam ple, why does one government choose to lower tar­
iffs and open its economy to trade, whereas another governm ent continues to
protect the dom estic m arket from im ports? Why did governm ents create the
W TO? Why do som e governments maintain fixed exchange rates whereas oth­
ers allow their currencies to float? Why do some governments allow M N C s to
operate in their econom ies with few restrictions, whereas other governments
attempt to regulate M N C activity? Each o f these questions asks us to explain a
specific economic policy choice m ade by a government or to explain a pattern
of choices within a group o f governments. In answering such questions, we are
m ost concerned with explaining the policy choices that governments make and
pay less attention to the welfare consequences o f these policy choices.
Evaluative studies, which are related m ost closely to our second abstract
question, are oriented tow ard assessing policy outcom es, m aking judgm ents
about them, and proposing alternatives when the judgm ent m ade about a par­
ticular policy is a negative one. A welfare evaluation is interested primarily in
whether a particular policy choice raises or lowers social welfare. For example,
does a decision to liberalize trade raise or lower national economic welfare? Does
a decision to turn to the International M onetary Fund (IMF) and accept a pack­
age o f economic reforms promote or retard economic growth? M ore broadly, do
current policies encourage society to use available resources in w ays that m axi­
mize economic welfare, or would alternative policies that encouraged a differ­
ent allocation result in higher economic welfare? Because such evaluations are
concerned with the economic welfare consequences of policy outcomes, they are
typically based on economic criteria and rely heavily upon economic theories.
Scholars also som etim es evaluate outcom es in term s that extend beyond
narrow considerations o f economic welfare. In som e instances, scholars evalu­
ate outcomes in terms o f their distributional consequences. For example, many
nongovernm ental organizations are highly critical o f international trade be­
cause they believe that workers lose and business gains from trade liberaliza­
tion. Implicit in this criticism is an evaluation o f how global trade distributes
income across groups within countries. Evaluations m ay also extend the frame
o f reference within which outcomes are evaluated beyond purely economic effi­
ciency. For exam ple, even those who agree that international trade raises world
economic w elfare might rem ain critical o f globalization because they believe
that it degrades the environment, disrupts traditional m ethods o f production,
or has other negative social consequences that outw eigh the econom ic gains.
E xplanation and evaluation both play an im portant role in international p o ­
litical economy. This book, however, focuses primarily upon explanation and,
secondarily, upon evaluating the welfare consequences o f government policies.
STUDYING INTERNATIONAL POLITICAL ECONOMY
Scholars w orking within the field o f IPE have developed a large num ber of
theories to answ er the tw o questions posed earlier. Three traditional schools
o f political econom y— the m ercantilist sch o o l, the liberal sch ool, and the
8
CHAPTER
l
International Political Economy
M arxist school— have shaped the development o f these theories over the last
100 years. Each of these three traditional schools offers distinctive answers to
the two questions, and these differences have structured much o f the scholarly
and public debate about IPE.
Although the three traditional schools rem ain influential, m ore and more
often students of IPE are developing theories to answ er our tw o question s
from outside the explicit confines o f these traditional schools. One prominent
approach, and the approach that is developed throughout this book, suggests
that the foreign economic policies that governments adopt emerge from the in­
teraction between societal actors’ interests and political institutions. We begin
our exam ination o f how people study IPE with a broad overview o f these al­
ternative approaches. We look first at the three traditional schools, highlight­
ing the answers they provide to our two questions and pointing to som e o f the
weaknesses o f these schools that have led students to move aw ay from them.
We then exam ine the logic o f an approach based on interests and institutions
in order to provide the background necessary for the m ore detailed theories
that we develop throughout the book.
Traditional Schools of International Political Economy
H istorically, theories of IPE have been developed in three broad schools o f
thought: m ercantilism (or n ation alism ), liberalism , and M arxism . M ercan ­
tilism is roo ted in seventeenth- and eighteenth-century theories a b o u t the
relationship between econom ic activity and state power. The m ercantilist lit­
erature is large and varied, yet m ercantilists generally do adhere to three cen­
tral propositions. (See, e.g., Viner 1960; H eckscher 1935.) First, the classical
m ercantilists argued that nation al pow er and w ealth are tightly connected.
N ation al power in the international state system is derived in large part from
wealth. W ealth, in turn, is required to accum ulate pow er. Second, the classi­
cal m ercantilists argued that trade provided one w ay for countries to acquire
wealth from abroad. W ealth could be acquired through trade, however, only
if the country ran a positive balance of trade, that is, if the country sold more
g o o d s to foreigners than it purchased from foreigners. T h ird, the classical
m ercantilists argued that som e types o f econom ic activity are m ore valuable
than others. In particular, m ercantilists argued that m anufacturing activities
should be prom oted, whereas agriculture and other nonm anufacturing activi­
ties should be discouraged.
“ M odern” mercantilism applies these three propositions to contem porary
international economic policy:
1. Economic strength is a critical com ponent o f national power.
2. Trade is to be valued for exports, but governments should discourage
im ports whenever possible.
3. Some form s of economic activity are more valuable than others.
M anufacturing is preferred to the production o f agricultural and other
primary com m odities, and high-technology m anufacturing industries such as
Studying International Political Economy
9
com puters and telecom m unications are preferable to m ature m anufacturing
industries such as steel or textiles and apparel.
The em phasis on wealth as a critical com ponent o f n ation al pow er, the
insistence on m aintaining a positive balance of trade, and the conviction that
some types o f economic activity are more valuable than others leads mercantil­
ists to argue that the state should play a large role in determining how society’s
resources are allocated. Econom ic activity is too im portant to allow decisions
about resource allocation to be m ade through an uncoordinated process such
as the market. Uncoordinated decisions can result in an “ inappropriate” eco­
nom ic structure. Industries and technologies that m ay be desirable from the
perspective o f national pow er might be neglected, w hereas industries that do
little to strengthen the nation in the international state system m ay flourish.
In addition, the country could develop an unfavorable balan ce o f trade and
become dependent on foreign countries for critical technologies. The only way
to ensure that society’s resources are used appropriately is to have the state
play a large role in the econom y. E conom ic policy can be u sed to channel
resources to those econom ic activities that prom ote and protect the national
interest and aw ay from those that fail to do so.
Liberalism , the second tradition al school, em erged in Britain during the
eighteenth century to challenge the dominance of m ercantilism in government
circles. A dam Smith and other liberal w riters, such a s D av id R icardo (who
first stated the m odern concept o f com parative ad v an tage), w ere sch olars
who were attem pting to alter governm ent econom ic policy. T he theory they
developed to do so, liberalism , challenged all three central p ro p o sitio n s o f
mercantilism. First, liberalism attem pted to draw a strong line between politics
and econom ics. In doing so, liberalism argued that the pu rp ose o f economic
activity w as to enrich individuals, not to enhance the state’s pow er. Second,
liberalism argued that countries do not enrich them selves by running trade
surpluses. Instead, countries gain from trade regardless o f whether the balance
o f trade is positive or negative. Finally, countries are not necessarily m ade
wealthier by producing m anufactured goods rather than prim ary commodities.
Instead, liberalism argued, countries are m ade wealthier by m aking products
that they can produce at a relatively low co st at home and trad in g them for
g o o d s that can be produced a t hom e only at a relatively high co st. T h us,
according to liberalism, governments should make little effort to influence the
country’s trade balance or to shape the types of go od s the country produces.
Government efforts to allocate resources will only reduce national welfare.
In addition to arguing against substantial state intervention as advocated
by the m ercantilists, liberalism argued in favor o f a m arket-based system of
resource allocation. Giving priority to the w elfare o f individuals, liberalism
argues that social w elfare will be highest when people are free to m ake their
own decisions about how to use the resources they possess. T hus, rather than
accepting the mercantilist argum ent that the state should guide the allocation
o f resources, liberals argue that resources should be allocated through volun­
tary market-based transactions between individuals. Such an exchange is mutu­
ally beneficial— as long as it is voluntary, both parties to any transaction will
10
CHAPTER
1
International Political Economy
benefit. M oreover, in a perfectly functioning m arket, individuals will continue
to buy and sell resources until the resulting allocation offers no further oppor­
tunities for mutually beneficial exchange. The state plays an im portant, though
limited, role in this process. The state m ust establish clear rights concerning
ownership o f property and resources. The judicial system m ust enforce these
rights and the contracts that transfer ownership from one individual to another.
M ost liberals also recognize that governments can, and should, resolve m arket
failures, which are instances in which voluntary m arket-based transactions be­
tween individuals fail to allocate resources to socially desirable activities.
M arx ism , the third trad itio n al sch o ol, origin ated in the w ork o f K arl
M arx as a critique of capitalism . It is im possible to characterize briefly the
huge literature that has expanded on or been influenced by M a rx ’s ideas. A c­
cording to M arx , capitalism is characterized by tw o central conditions: the
private ow nership o f the m eans o f production (or capital) and w age labor.
M arx argued that the value o f m anufactured g o o d s w as determ ined by the
am ount of labor used to produce them. H ow ever, capitalists did not pay labor
the full am ount o f the value they im parted to the g o o d s they produced. In­
stead, the capitalists who owned the factories paid w orkers only a subsistence
w age and retained the rest as profits with which to finance additional invest­
ment. M arx predicted that the dynam ics o f capitalism w ould lead eventually
to a revolution that w ould do aw ay with private property and with the capi­
talist system that private property supported.
Three dynamics would interact to drive this revolution. First, M arx argued
that there is a natural tendency tow ard the concentration o f capital. Econom ic
competition would force capitalists to increase their efficiency and increase their
capital stock. As a consequence, capital would become increasingly concentrated
in the hands of a sm all, wealthy elite. Second, M arx argued that capitalism is
associated with a falling rate of profit. Investment leads to a growing abundance
o f productive capital, which in turn reduces the return to capital. As profits
shrink, capitalists are forced to further reduce w ages, worsening the plight of
the already impoverished masses. Finally, capitalism is plagued by an imbalance
between the ability to produce goods and the ability to purchase goods. Large
capital investments continually augment the economy’s ability to produce goods,
whereas falling wages continually reduce the ability of consumers to purchase the
goods being produced. As the three dynamics interact over time, society becomes
increasingly characterized by grow ing inequality betw een a sm all w ealthy
capitalist elite and a grow ing num ber o f im poverished w orkers. These social
conditions eventually cause workers (the proletariat, in M arxist terminology) to
rise up, overthrow the capitalist system, and replace it with socialism.
In contrast to liberalism ’s em phasis on the m arket as the principal mech­
anism of resource allocation, M arxists argue that capitalists m ake decisions
about how society’s resources are used. M oreover, because capitalist systems
prom ote the concentration o f capital, investm ent decisions are not typically
driven by m arket-based com petition, at least not in the classical liberal sense of
this term. Instead, decisions about w hat to produce are m ade by the few firms
that control the necessary investment capital. The state plays no autonom ous
Studying International Political Economy
11
role in the capitalist system. Instead, M arxists argue that the state operates as
an agent of the capitalist class. The state enacts policies that reinforce capital­
ism and therefore the capitalists’ control o f resource allocation. T hus, in con­
trast to the mercantilists who focus on the state and the liberals w ho focus on
the m arket, M arxists focus on large corporations as the key actor determining
how resources are used.
In the international econom y, the concentration o f cap ital an d c a p ita l­
ists’ control o f the state are transform ed into the system atic exp lo itatio n o f
the developing w orld by the large capitalist nations. In som e instances, this
exploitation takes the form o f explicit colonial structures, as it did p rio r to
W orld W ar II. In other instances, especially since W orld W ar II, exploitation
is achieved through less intrusive structures o f dom inance and control. In all
instances, however, exploitation is carried out by large firms based in the capi­
talist countries that operate, in part, in the developing w orld. T his system atic
exploitation o f the poor by the rich implies that the global econom y does not
provide benefits to all countries; all gains accrue to the capitalist countries at
the top o f the international hierarchy.
The three traditional schools o f political economy thus offer three distinc­
tive answ ers to our question o f how politics shapes the allocation o f society’s
resources. M ercantilists argue that the state guides resource allocation in line
with objectives shaped by the quest for national pow er. L ib erals argue that
politics ought to play little role in the process, extolling instead the role of
m arket-based transaction s am ong auton om ous individuals. M a rx ists argue
that the m ost important decisions are m ade by large capitalist enterprises sup­
ported by a political system controlled by the capitalist class.
Each traditional school also offers a distinctive fram ew ork to evaluate the
consequences o f resource allocation. M ercantilists focus on the consequences
o f resource allocation for national pow er. The central question a m ercantil­
ist will ask is “ Is there som e alternative allocation o f resources that w ould
enhance the nation’s power in the international system ?” Liberals rely heavily
upon econom ic theory to focus principally upon the w elfare consequences of
resource allocation. The central question a liberal will ask is “ Is there som e
alternative allocation o f resources that w ould enable the society to im prove
its standard o f living?” M arxists rely heavily upon theories o f class conflict to
focus on the distributional consequences o f resource allocation. The central
question a M arx ist will ask is “ Is there an alternative political and econom ic
system that will promote a more equitable distribution o f incom e?” T hus, lib­
eralism em phasizes the welfare consequences o f resource allocation, whereas
m ercantilism and M arxism each em phasize a different aspect o f the distribu­
tional consequences of these decisions.
These very different allocation mechanisms and unique evaluative fram e­
w orks generate three very different im ages o f the central dynamic of IPE. (See
T able 1.1.) M ercantilists argue that the IPE is characterized by distributional
conflict when governments compete to attract and m aintain desired industries.
Liberals argue that international economic interactions are essentially harm o­
nious. Because all countries benefit from international trade, pow er has little
12
CHAPTER
1
International Political Economy
T A B L E 1.1
Three Traditional Schools of International Political Economy
Most
Important
Actor
Role of the
State
Mercantilism
Liberalism
Marxism
The State
Individuals
Classes, particularly
the capitalist class
Intervene in
the economy
Establish and enforce
property rights to
facilitate marketbased exchange
Instrument of
the capitalist
class uses state
power to sustain
capitalist system
Exploitative:
Capitalists exploit
labor withm
countries; rich
to allocate
resources
Image of the
International
Economic
System
Proper
Objective of
Economic
Policy
Conflictual:
Countries
compete for
desirable
industries
and engage
in trade
conflicts as a
result of this
competition
Enhance power
of the nation­
state in
international
state system
Harmonious: The
international
economy offers
benefits to all
countries. The
challenge is to
create a political
framework that
enables countries
to realize these
benefits.
Enhance aggregate
social welfare
countries exploit
poor countries in
the international
economy
Promote an
equitable
distribution of
wealth and income
im pact on nation al w elfare, and international econom ic conflicts are rare.
The central problem , from a liberal perspective, is creating the international
institutional fram ew ork th at will enable governm ents to enter into agree­
ments through which they can create an international system o f free trade.
M arxists argue that the international political econom y is characterized by
the distribution al con flict between la b o r and cap ital within countries and
by the distributional conflict between the advanced industrialized countries
and developing countries within the international arena.
These three traditional schools have structured studies o f and debate about
the international political economy for a very long time. And although the pres­
ence o f all three will be felt in many w ays throughout the pages o f this book,
we will spend little more time exam ining them directly. In their place, we will
emphasize an analytical fram ew ork developed during the last 15 years or so,
which focuses on how the interaction between societal interests and political
institutions determines the foreign economic policies that governments adopt.
Studying International Political Economy
13
Interests and Institutions in International Political Economy
^
T o explain the policy choices m ade by governm ents, this book concentrates
on the interaction between societal interests and political institutions. Such
an approach suggests that to understand the foreign econom ic policy choices
that governments m ake, we need to understand tw o aspects o f politics. First,
we need to understand where the interests, or econom ic policy preferences,
of groups in society com e from . Second, we need to exam ine how political
institutions aggregate, reconcile, and ultimately transform com peting interests
into foreign economic policies and a particular international economic system.
Interests are the go als or policy objectives that the central actors in the
political system and in the economy— individuals, firm s, labor unions, other
interest grou p s, and governm ents— w ant to use foreign econom ic policy to
achieve. In focusing on interests, we will assum e that individuals and the in­
terest groups that represent them prefer foreign econom ic policies that raise
their incomes to policies that reduce their incomes. T h us, whenever a group
confronts a choice between one policy that raises its income and another that
lowers its incom e, it will alw ays prefer the policy that raises its income. We
focus on tw o mechanisms to explain the form ation o f these policy interests.
First, people have m aterial interests that arise from their position in the
global economy. The essence o f this approach can be sum m arized in a simple
statement: Tell me w hat you do for w ork, and I’ll tell you w hat your foreign
econom ic policy preferences are. C o n sid er once again the A m erican steel
tariff. Whether a particular individual supports or opposes this tariff depends
on where he or she w orks. If you are an American steelworker, you favor the
tariff because it reduces the likelihood that you will lose your job. If you own
an Am erican steel mill, you also will favor the tariff, because it helps ensure
a m arket and a relatively high price for the steel you produce. If you are an
A m erican au tow ork er or you ow n a su b stan tial share o f G eneral M o to rs
(G M ), however, you will oppose the steel tariff. Higher steel prices mean that
it costs more to produce cars. As cars become more expensive, fewer are sold
and, consequently, fewer are produced. The tariff thus increases the chances
that autow orkers will be laid o ff and it causes G M to earn sm aller profits.
These are com pelling reasons for autow orkers and their employers to oppose
the higher steel tariff. In sh ort, o n e’s po sition in the econom y pow erfully
shapes one’s preferences regarding foreign econom ic policy. As we shall see,
econom ic theory enables us to m ake som e pow erful statem ents a b o u t the
foreign economic policy preferences o f different groups in the economy.
Second, interests are often based on ideas. Ideas are m ental m odels that
provide a coherent set o f beliefs about cause-and-effect relationships. In the
context o f econom ic policy, these m ental m odels typically focus on the rela­
tionship between governm ent policies and economic outcom es. N o t surpris­
ingly, therefore, econom ic theory is a very im portant sou rce o f ideas that
influence how actors perceive and form ulate their interests. By providing clear
statem ents about cause-and-effect econom ic relationships, econom ic theories
can create an interest in a particular economic policy. The theory of com para­
tive advantage, for exam ple, claims that reducing tariffs raises aggregate social
14
CHAPTER 1
International Political Economy
welfare. A government that believes this theory might be inclined to lower tar­
iffs to realize these welfare gains. Alternatively, a government might adopt high
tariffs because a different economic theory (the infant industry argum ent, for
example) suggests that under the right conditions, tariffs can raise national in­
come. What matters, therefore, is not whether a particular idea is true or not,
but whether people in power, or people with influence over people with power,
believe the idea to be true. Thus, ideas about how the economy operates can be
a source of the preferences that groups have for particular economic policies.
Understanding where interests come from will enable us to specify with some
precision the competing demands that politicians confront when making foreign
economic policy decisions. It does not tell us anything about how these compet­
ing interests are transformed into foreign economic policies. T o understand how
interests are transformed into policies, we need to examine political institutions.
Political institutions establish the rules governing the political process. By estab­
lishing rules, they enable groups within countries, and groups o f countries in the
international state system, to reach and enforce collective decisions.
Political institutions determ ine which g ro u p s are em pow ered to m ake
choices and establish the rules these “ ch o o sers” will use when doing so. In
dom estic po litical system s, for exam p le, d em ocratic in stitu tio n s prom ote
m ass participation in collective choices, whereas authoritarian systems restrict
participation to a narrow set o f individuals. In international economic affairs,
governments from the advanced industrialized countries often m ake decisions
with little participation by developing countries.
Political institutions also provide the rules that these grou ps use to m ake
decisions. In dem ocratic system s, the usual choice rule is m ajority rule, and
policies are su p p osed to reflect the preferen ces o f a m ajo rity o f v oters or
legislators. In international econom ic organizations, the choice rule is often
relative bargaining pow er, and decisions typically reflect the preferences of
the more pow erful nations. Political institutions thus allow grou ps to m ake
collective d ecisio n s an d , in d o in g so , determ ine w ho gets to m ake these
decisions and how they are to be m ade.
Political institutions also help enforce these collective decisions. In many
instances, individuals, groups, and governments have little incentive to comply
with the decisions that are produced by the political process. T his is particu­
larly the case for those groups whose preferences diverge from those em bodied
in the collective choice. And even in cases where a grou p or a country a s a
whole does benefit from a particular decision, it may believe it could do even
better if it cheated a little bit. If such instances o f noncom pliance are w ide­
spread, then the political process is substantially weakened.
This problem is particularly acute in the international state system. In d o ­
m estic political system s, the police and the judicial system are charged with
enforcing individual compliance with collective decisions. The international sys­
tem has neither a police force nor a judicial system through which to enforce
com pliance, however. Consequently, it can be very tem pting for governments
to attem pt to “ cheat” on the International economic agreements they conclude
with other governments. International institutions like th e^T T O and the IM S
can help governments enforce the international agreements that they conclude.
The Global Economy in Historical Context
15
A focus on interests and institutions will allow us to develop a set o f reason­
ably comprehensive answers to our first question: H ow does politics shape so­
cietal decisions about how to allocate resources? The explanations we construct
alm ost always will begin by investigating the source o f com peting societal de­
mands for income and then explore how political institutions aggregate, recon­
cile, and ultimately transform these competing demands into foreign economic
policies and a particular international economic system. This approach may not
always provide a full explanation o f the interactions we observe in the interna­
tional political economy, but it does provide a solid point o f departure.
THE GLOBAL ECONOMY IN HISTORICAL CONTEXT
Although we will focus on how the interaction between interests and institu­
tions shapes government behavior in the post-W orld W ar II global economy,
the contemporary global economy embodies a deeper historical continuity. Even
though the contemporary global economy is distinctive in many ways, this system
continues a trend tow ard deeper international economic integration that began
in the nineteenth century. Because the contemporary system has deep roots in the
nineteenth century, it is useful to examine the rise, fall, and reconstruction of the
global economy in the years before World War II.
People have conducted long-distance trade for hundreds o f y ears, but
the first true “ glo b al” econom y emerged only in the nineteenth century. This
“ first w ave” o f globalization w as driven by the interaction between techno­
logical change and politics. Technological innovation, in particular the inven­
tion o f the steam engine and the telegraph, m ade it profitable to trade heavy
com m odities acro ss long distances. Steam engines dram atically reduced the
cost and tim e involved in long-distance trade. The railroad m ade it possible
to ship large volum es o f heavy com m odities acro ss long d istan ces— grain
from the A m erican plains states to the Atlantic co ast, for exam ple— quickly
and at low cost. In 1830, it co st m ore than $30 to ship a ton o f grain (or any
other com m odity) 300 m iles; by 1900 the cost had fallen to ab ou t $5 (Frieden 2 0 0 6 , 5). The use o f steam to pow er ocean-going vessels further reduced
the co st o f long-distance trade. W hereas in the early nineteenth century it
to ok a m onth and cost $10 to ship a ton o f grain from the United States to
Europe, by 1900 the Atlantic crossing to ok only a week and co st ab ou t $3.
C onsequently, w hereas throughout history high shipping costs discouraged
trade o f all but the lightest an d highest-value com m odities, technology had
reduced shipping co sts so sh arply by the late nineteenth century that such
trade becam e very profitable.
A lthough new technologies m ade long-distance trade po ssib le, political
structures m ade it a reality. C apitalizing on the new possibilities required gov­
ernments to establish an infrastructure that facilitated global exchange. This
infrastructure w as based on a netw ork o f bilateral trade agreem ents an d a
stable international m onetary system. Governments began to reduce barriers
to trade in the mid-nineteenth century. Britain w as the first to ad o p t a freetrade policy in the 1840s when it repealed its “ C orn L a w s” and opened its
m arket to im ported grain. The shift to free trade gained m om entum in 1860,
16
CHAPTER 1
International Political Economy
when Britain and France eliminated m ost tariffs on trade between them with
the C obd en -C h evalier T reaty. T he treaty triggered a w ave o f negotiation s
that quickly established a netw ork o f bilateral treaties that substan tially re­
duced trade barriers throu ghou t E urope and the still-colonized developing
world (see Irwin 1993, 97). The United States rem ained an im portant excep­
tion to nineteenth-century trade liberalization, rem aining staunchly protec­
tionist until the 1930s.
M ost governments also adopted gold-backed currencies. In this gold stan­
dard, each government pledged to exchange its national currency for gold at
a permanently fixed rate o f exchange. From the late nineteenth century until
19 3 3 , for exam ple, the U .S. governm ent exchanged d ollars for gold at the
fixed price o f $ 2 0 .6 7 per ounce. G reat Britain w as the first to adopt the gold
stan dard , shifting from a bim etallic system in which the pound w as backed
by silver and gold to a pure gold stan dard in the eighteenth century. Other
nations em braced the gold stan d ard during the 1 8 7 0 s. G erm any shifted to
gold in 1 8 72, and m any other governm ents follow ed. By the end o f the de­
cade m ost industrialized countries, and quite a few developing countries, had
adopted the gold standard. By stabilizing international price relationships, the
gold standard encouraged international trade and investment.
Technological innovation and the creation o f an international political in­
frastructure combined to produce a dram atic expansion o f global economic ex­
change in the nineteenth century. T rade grew at an average rate of 3.5 percent
per year between 1815 and 1914, three and a half times more rapidly than the
previous 300 years. People crossed borders in historic num bers as well. Each
year between 1880 and 1 9 00, 6 0 0 ,0 0 0 people left Europe to find new lives
in the United States, C an ad a, A ustralia, and A rgentina; the num ber o f such
m igrants continued to rise, reaching one m illion per year in the first decade
of the twentieth century (Chiswick and H atton 2 0 0 3 ). In all, close to 14 m il­
lion people left Western Europe in this period (M addison 2001). Although the
absolute numbers are large, one gains a deeper appreciation o f the scale o f late
nineteenth-century m igration by recognizing that these m igrants represented 2
to 5 percent of the total population of the home countries (Baldwin and M artin
1999, 19). Financial capital also poured across borders. In the late nineteenth
century British residents invested alm ost 10 percent o f their incomes in foreign
m arkets, and the French, G erm an, and D utch invested only slightly sm aller
shares of their incomes. These capital flow s constructed railro ad s and other
infrastructure in the lands of recent settlement (Bordo 20 0 2 , 23).
By the late nineteenth century, therefore, it w as no exaggeration to talk of
a global economy. In the passage I paraphrased at the beginning o f this chap­
ter, John M aynard Keynes rem arked on the extraordinary nature o f the global
economy in the early twentieth century. “ The inhabitant o f London could or­
der by telephone, sipping his m orning tea in bed, the various products o f the
whole earth, in such quantity as he might see fit, and reasonably expect their
early delivery on his doorstep; he could at the sam e m om ent and by the sam e
means adventure his wealth in the natural resources and new enterprise o f any
quarter of the w orld. H e could secure forthw ith, if he w ished it, cheap and
The Global Economy in Historical Context
17
com fortable means of transport to any country or climate without passport or
other form ality. . . . H e regarded this state of affairs as norm al, certain, and
perm anent” (Keynes 1919, 9 -10).
G lobalization w as not perm anent, however. In the first h alf o f the twen­
tieth century governm ents dism antled the dense international econom ic net­
w orks they had created and retreated into sheltered national econom ies. The
First W orld W ar triggered the retreat. European governments abandoned the
gold stan dard in order to finance the w ar. They tightly controlled trade and
financial flow s in order to m arshal resources for the war. Follow ing the war,
governments tried to reconstruct the global economy, but were not successful.
This failure w as a consequence o f m any factors, a full accounting o f which
w ould require more space than we can dedicate here. One o f the m ost critical
factors, however, lay in dram atic changes in the global political structure that
supported the global economy.
T h ro u gh o u t the nineteenth century Britain sto o d a t the center o f the
world econom y. British m anufacturing dom inated w orld trade, and London
served as the w o rld ’s financial center. A s the dom inant econom ic pow er—
w hat many political econom ists call the hegemon— Britain provided much of
the infrastructure o f the global econom y. By the turn o f the century Britain
w as ceding gro u n d to the U nited States and G erm any. T h ese tw o risin g
nations industrialized rapidly in the late nineteenth century, taking advantage
of science and new form s of corporate organization. By the end o f the century
both countries were challenging Britain’s dominance. W orld W ar I accelerated
this trend. A m erican m anufacturing o utput expanded during the w ar as the
United States supplied the European nations. American financial pow er grew
as the belligerents turned to the United States to finance their w ar expenditures.
In co n tra st, 5 y ears o f figh tin g w eaken ed the British in d u strial capacity .
Britain borrow ed heavily and so ld m any o f its foreign assets to finance its
w ar expenditures, and thus exited the w ar saddled with a heavy foreign debt.
At the w ar’s end, the United States stoo d as the w orld’s dom inant econom ic
power— the w orld’s largest m anufacturing economy and its largest creditor.
T his pow er shift m eant th at p o stw a r glo b al econom ic reconstruction
hinged on A m erican leadership. Y et, the United States refused to accept the
responsibilities that hegemonic status carried, preferring instead to retreat into
a traditional policy of isolationism . Now here w as the lack o f American leader­
ship more evident than on the w ar debt question. France and Britain (along
with sm aller European nations fighting against the Triple Alliance) had bor­
row ed from the United States to finance p art o f their w ar expenditures. At
the w ar’s end, they asked the United States to forgive these debts. Britain and
France had paid a heavy price, m easured in terms o f hum an suffering and eco­
nomic dam age, in the w ar. W as it not reasonable, they argued, for the United
States to forgive the w ar debt as p art o f its contribution to the com m on ef­
fort? The United States refused, insisting that E uropean governm ents repay
the debt. T o further com pound the problem , the United States raised tariffs in
1922, m aking it difficult for Europe to sell products in the Am erican m arket
in order to earn dollars needed to repay the debt.
18
CHAPTER
1
International Political Economy
American war-debt policy held the key to the pace of European economic
recovery, and thus had real consequences for the interwar global economy. W ar
debt w as linked (at least in the eyes o f European governments) to German repa­
rations payments. France insisted that Germany pay for w ar dam ages by paying
reparations to the Allied powers. The am ount o f reparations the French sought
w as, in part, a function of the total demands on French financial resources. The
American refusal to forgive French debt, therefore, encouraged France to de­
mand more from Germany. Larger reparations paym ents in turn delayed eco­
nomic recovery in Germany. And the delay in German recovery in turn delayed
recovery throughout E urope. H ad the United States forgiven the w ar debt,
France might have demanded less from Germany. A smaller reparations burden
w ould in turn have enabled Germ any to recover m ore quickly, and Germ an
economic recovery w ould have driven European recovery. N o less im portant,
an early settlement w ould have enabled European governm ents to move past
wartime animosities. Instead, the w ar debt-reparations mess dom inated diplo­
macy and soured inter-European relations throughout the 1920s.
The failure to resolve these financial issues m eant that governments never
placed the international econom y on a firm foun dation . A lthough govern ­
ments had reestablished a gold stan dard and had revived international trade
by the m id -1920s, lingering w ar debts and rep aration s problem s rendered
the system quite fragile and unable to withstand the shock o f the crash of the
American stock m arket in October 1929. The financial collapse depressed eco­
nomic activity. Consum er dem and fell sharply, and as people stopped buying
goods, factories stopped production and released their workers. O utput fell and
unemployment rose. The resulting G reat Depression represented the largest col­
lapse of production and employment the industrial world had ever experienced.
American production fell by 30 percent between 1929 and 1933; unemployment
rose to 25 percent in the United States and as high as 44 percent in Germany.
Governments responded to collapsing output and rising unemployment by
raising tariffs in a desperate attem pt to protect the home m arket. The United
States led the w ay, sharply raising tariffs in the 1930 Sm oot-H aw ley T a riff
Act. Countries with colonial po ssession s created trade blocs that linked the
colonial power and its possessions. G reat Britain established the Imperial Pref­
erence System in 1933 to insulate its trade and investment relationships with
its colonies from the rest of the w orld. France established similar arrangements
with its colonial possessions. Powerful countries that lacked colonies began us­
ing force to acquire them. Ja p a n invaded M anchuria in the early 1930s and
sought to bring much of E ast Asia into a Japan-dom inated Asian Co-prosperity
Sphere. Germany exploited its pow er and position in Central Europe to estab­
lish a network o f bilateral trade relations with the region. By the m id-1930s,
the world economy had disintegrated into relatively insulated regional trading
blocs, and governments were moving tow ard the Second W orld War.
The failure to reconstruct the global economy after W orld W ar I and the
subsequent depression and w ar had a dram atic im pact on A m erican policy.
American, policym akers drew tw o lessons from tire Interwar period. F irst, they
oAAW atW w a s causeA 'm patO oy Are VaAute to reco n stru ct a
stable global economy after the First W orld W ar. As a result, the construction
The Global Economy in Historical Context
19
o f a stable and liberal international economy w ould have to be a centerpiece
o f post-W orld W ar II planning in order to establish a lasting peace. Second,
American policym akers concluded that the United States alone controlled suf­
ficient pow er to establish a stable global economy. Am erica’s European allies
had been further w eakened by W orld W ar II, and the Jap an ese and Germ an
econom ies had been destroyed. The United States, in contrast, em erged in a
stronger position. These conclusions encouraged the United States to embrace
an in tern atio n alist o rien tatio n . W orkin g alo n g sid e B ritish po licy m ak ers
in the early 1 9 4 0 s, the U nited States designed international institutions to
provide the infrastructure for the postw ar global economy.
The resulting Bretton W oods system— so named because many o f its final
details were negotiated at an intergovernm ental conference held in Bretton
W oods, N ew H am pshire, in late sum m er o f 1944— continues to provide the
institutional structure at the center o f the global economy. The W TO , the IM F,
and the W orld Bank all have their origins in this concerted period o f postw ar
planning. The contem porary global economy, therefore, w as established as an
explicit attem pt to return to the “ golden years” o f the late nineteenth century
to prevent a recurrence of the economic and political disasters o f the interwar
period. The po st-W orld W ar II glo b al econom y differed from the classical
liberal system o f the nineteenth century in im portant w ays. At the broadest
level, the difference reflected changed public attitudes about the government’s
proper econom ic role. In the nineteenth-century liberal system, governm ents
eliminated trade barriers and m ade little effort to m anage domestic economic
activity. The G reat D epression encouraged governments to play a more active
role in the econom y. G overnm ents used m acroeconom ic policy to prom ote
grow th and limit unem ploym ent, and they established safety nets to protect
society’s m ost vulnerable from the full force o f the m arket. T his m ore active
governm ent role in turn required som e insulation between the dom estic and
the international econom ies. The rules em bodied in the Bretton W oods sys­
tem provided this insulation. This im portant difference notw ithstanding, the
postw ar global economy w as, in effect, a restoration o f the nineteenth-century
global economy.
In short, the contem porary global econom y continues a global trend to ­
w ard deeper international econom ic integration that first emerged in the nine­
teenth century. So, although we are often inclined to view our contem porary
system as fundam entally new , it is not so unique. The first w ave o f g lo b al­
ization also highlights another lesson. O ne often hears that globalization is
inevitable, but the first wave o f globalization suggests that it is not. Econom ic
globalization is not a disem bodied spirit; it is the product o f multiple decisions
m ade by governments throughout the world. Sometimes these decisions result
in policies that encourage globalization, and som etim es they result in policies
that discourage cross-border exchange. These decisions, in turn, are shaped by
politics; that is, they are shaped by the pressures brought to bear by those who
gain and those who lose in the process o f international econom ic integration.
In the rem ainder o f this book we will explore how this political dynamic has
shaped the evolution o f the global econom y after W orld W ar II an d how it
continues to shape the contem porary global economy.
20
CHAPTER
1
International Political Economy
CONCLUSION
IPE studies the political battle between the winners and losers o f global eco­
nomic exchange. It examines how this political competition shapes the evolution
o f the international trade and m onetary system s, affects the ability o f M N C s
to conduct their operations, and influences the development strategies govern­
ments adopt. Thus, IPE suggests that it is hard to understand anything about the
global economy without understanding how political competition unfolds.
IPE scholars tradition ally have studied the global econom y through the
lens o f three sch ools o f thought. E ach sch ool o ffers a distinctive w indow
on the global econom y, and each em phasizes one aspect o f global econom ic
exchange— cooperation, com petition between governm ents, and com petition
between labor and capital— as the central defining element o f politics in the
global economy.
This book relies on an approach that em phasizes the interaction between
societal interests and political institutions. Such an approach will enable us to
develop m odels that provide insights into how the global econom y generates
winners and losers, how these groups com pete to influence the policies that
governm ents adopt, and how the policies that governm ents ad o p t affect the
evolution o f the global economy.
KEY TERMS
Distributional
Consequences
Evaluative Studies
Explanatory Studies
Ideas
Interests
Liberalism
Market Failures
Marxism
Material Interests
Mercantilism
Political Institutions
Welfare Consequences
Welfare Evaluation
SUGGESTIONS FOR FURTHER READING
For an excellent discussion of the historical development of the global economy since
the late nineteenth century, see Jeffry A. Frieden’s Global Capitalism: Its Rise and
Fall in the Twentieth Century (New York: W.W. Norton 8i Company, 2006). The
two best treatments of mercantilism can be found in Jacob Viner’s Studies in the
Theory o f International Trade (London: Allen & Unwin, 1960) and Eli Heckscher’s
Mercantilism (London: Allen & Unwin, 1935). Adam Smith’s The Wealth o f N a­
tions (New York: Bantam Classics, 2003) remains the most authoritative statement
of liberalism. Vladimir Il’ich Lenin’s Imperialism: The Highest Stage o f Capitalism
(New York: International Publishers, 1933) provides the seminal Marxist approach
to international political economy. For a more general treatment of the three tra­
ditional schools, see Robert Gilpin’s The Political Economy o f International Rela­
tions (Princeton, NJ: Princeton University Press, 1987).
CHAPTER
2
The World Trade
Organization and the
World Trade System
ational economies are becoming deeply connected. You probably no­
tice these connections most as a consumer, since many of the goods
you buy are produced, either in whole or in part, in a foreign country.
This is certainly the case for me. Most of my clothes are manufactured in Ban­
gladesh and other developing countries. My computer was assembled in the
Philippines from components that were designed and manufactured in at least
five other countries. Thus, my consumption (and yours) has become interna­
tionalized. And what is true about our consumption is obviously also true about
production. Although we once thought in terms of national firms, it makes
less and less sense to do so. Is the iPhone, for example, an American product?
Apple designs the phone in Cupertino, California. It manufactures the phone in
a plant in China. The components that go into the phone are in turn produced
across the Pacific basin. Production, too, has become internationalized.
Internationalization has been brought about by the rapid growth of world
trade. Global trade has grown during the last 60 years at an average rate of
about 6 percent per year. As a result, annual world merchandise trade has risen
from $84 billion in 1953 to $15.7 trillion in 2008 (World Trade Organization
2009). Never before in history has international trade grown so rapidly for
such a long period. Even more importantly, trade has consistently grown more
rapidly than the world’s economic output. Consequently, each year a greater
proportion of the goods and services produced in the world are created in one
country and consumed in another. Indeed, globalization is a consequence of
these differential growth rates.
None of this has occurred spontaneously. Even though one could argue
that the growth of trade reflects the operation of global markets, all mar­
kets rest on political structures. This is certainly the case with international
trade. World trade has grown so rapidly over the last 60 years because an
international political structure, the World Trade Organization (WTO), and
its predecessor, the General Agreement on Tariffs and Trade (GATT), has
supported and encouraged such growth. Most political scientists who study
N
21
22
CHAPTER 2
The World Trade Organization and the World Trade System
the global economy believe that, had governments never created this institu­
tional framework after World War II, or had they created a different one,
world trade would not have grown so rapidly. Internationalization, therefore,
has been brought about by the decisions governments have made about the
rules and institutions that govern world trade.
Because trade plays so important a role in our lives, and because trade is
made possible by the political institution that structures trade relationships,
understanding the political dynamics of the world trade system is vital. This
chapter begins developing that knowledge. It provides a broad overview of
the WTO’s core components. It then examines how the global distribution of
power shapes the creation and evolution of international trade systems. It then
explores some contemporary challenges to the WTO, focusing on the rise of
developing countries as a powerful bloc within the organization and the rise
of civil society groups as powerful critics of the organization from the outside.
The chapter concludes by examining regional trade arrangements, considered
by many the greatest current challenge to the WTO.
WHAT IS THE WORLD TRADE ORGANIZATION?
The WTO (located on the shore of the beautiful Lac Leman in Geneva,
Switzerland) is the hub of an international political system under which
governments negotiate, enforce, and revise rules to govern their trade policies.
Between 1947 and 1994 the GATT fulfilled the role now played by the WTO.
In 1995, governments folded the GATT into the newly established WTO where
it continues to provide many of the rules governing international trade relations.
The rules at the center of the world trade system were thus established initially
in 1947 and have been gradually revised, amended, and extended ever since.
The WTO is small compared with other international organizations.
Although 153 countries belong to the WTO, it has a staff of only about
635 people and a budget of roughly $170 million. The World Bank, by
contrast, has a staff of about 9,300 people and an operating budget of close to
$1 billion. As the center of the world trade system, the WTO provides a forum
for trade negotiations, administers the trade agreements that governments
conclude, and provides a mechanism through which governments can resolve
trade disputes. As a political system, the WTO can be broken down into
three distinct components: a set of principles and rules, an intergovernmental
bargaining process, and a dispute settlement mechanism.
Two core principles stand at the base of the WTO: market liberalism and
nondiscrimination. Market liberalism provides the economic rationale for the
trade system. Market liberalism asserts that an open, or liberal, international
trade system raises the world’s standard of living. Every country—no matter
how poor or how rich—enjoys a higher standard of living with trade than it can
achieve without trade. Moreover, the gains from trade are greatest—for each
country and for the world as a whole—when goods can flow freely across na­
tional borders unimpeded by government-imposed barriers. The claim that trade
provides such gains to all countries is based on economic theory we examine in
What Is the World Trade Organization?
23
detail in Chapter 3. For our purposes here, it is sufficient to recognize that this
claim provides the economic logic upon which the WTO is based.
Nondiscrimination is the second core principle of the multilateral trade
system. Nondiscrimination ensures that each WTO member faces identical
opportunities to trade with other WTO members. This principle takes two
specific forms within the WTO. The first form, called Most-Favored Nation
(MFN), prohibits governments from using trade policies to provide special
advantages to some countries and not to others. M FN is found in Article I
of GATT. It states, “ any advantage, favour, privilege, or immunity granted
by any contracting party to any product originating in or destined for any
other country shall be accorded immediately and unconditionally to the like
product originating in or destined for the territories of all other contracting
parties.” Stripped of this legal terminology, MFN simply requires each WTO
member to treat all WTO members the same. For example, the United States
cannot apply lower tariffs to goods imported from Brazil (a WTO member)
than it applies to goods imported from other WTO member countries. If the
United States reduces tariffs on goods imported from Brazil, it must extend
these same tariff rates to all other WTO members. MFN thus assures that all
countries have access to foreign markets on equal terms.
WTO rules do allow some exceptions to MFN. The most important ex­
ception concerns regional trade arrangements. Governments are allowed to
depart from MFN if they join a free-trade area or customs union. In the North
American Free Trade Agreement (NAFTA), for example, goods produced in
Mexico enter the United States duty free, whereas the United States imposes
tariffs on the same goods imported from other countries. In the European
Union, goods produced in France enter Germany with a lower tariff than
goods produced in the United States. A second exception is provided by the
Generalized System of Preferences (GSP), enacted in the late 1960s. The GSP
allows the advanced industrialized countries to apply lower tariffs to imports
from developing countries than they apply to the same goods coming from
other advanced industrialized countries. These exceptions aside, MFN ensures
that all countries trade on equal terms.
National treatment is the second form of nondiscrimination found in the
WTO. National treatment prohibits governments from using taxes, regulations,
and other domestic policies to provide an advantage to domestic firms at the ex­
pense of foreign firms. National treatment is found in Article III of the GATT,
which states that “the products of the territory of any contracting party imported
into the territory of any other contracting party shall be accorded treatment no less
favourable than that accorded to like products of national origin in respect of all
laws, regulations and requirements affecting their internal sale, offering for sale,
purchase, transportation, distribution or use.”
In plainer English, national treatment requires governments to treat domestic
and foreign versions of the same product (“like products” in GATT terminology)
identically once they enter the domestic market. For example, the U.S. govern­
ment cannot establish one fuel efficiency standard for foreign cars and another
for domestic cars. If the U.S. government wants to advance this environmental
24
CHAPTER 2
The World Trade Organization and the World Trade System
goal, it must apply the same requirement to domestic and foreign auto produc­
ers. Together, MFN and national treatment ensure that firms in every country
face the same market opportunities and barriers in the global economy.
These two core principles are accompanied by hundreds of other rules.
Since 1947, governments have concluded about 60 distinct agreements that
together fill about 30,000 pages. These rules jointly provide the central legal
structure for international trade. As a group, these rules constrain the policies
that governments can use to control the flow of goods, services, and technology
into and out of their national economies. Some of these rules are proscriptive,
such as prohibition against government discrimination. Others are prescriptive,
such as requirements for governments to protect intellectual property. Many
of these rules state instances in which governments are allowed to protect a
domestic industry temporarily and then delineate the conditions under which
governments can and cannot invoke this safeguard. All rules entail obligations
to other WTO members that constrain the ability of governments to regulate
the interaction between the national and the global economies.
All WTO rules are created by governments through intergovernmental
bargaining. Intergovernmental bargaining is the WTO’s primary decision-making
process, and it involves negotiating agreements that directly liberalize trade and
indirectly support that goal. To liberalize trade, governments must alter policies
that restrict the cross-border flow of goods and services. Such policies include
tariffs, which are taxes that governments impose on foreign goods entering the
country. They also include a wide range of nontariff barriers such as health and
safety regulations, government purchasing practices, and many other government
regulations. Intergovernmental bargaining focuses on negotiating agreements that
reduce and eliminate these government-imposed barriers to market access.
Rather than bargain continuously, governments organize their negotia­
tions in bargaining rounds, each with a definite starting date and a target date
for conclusion. At the beginning of each round, governments meet as the WTO
Ministerial Conference, the highest level of WTO decision making. Meeting
for three or four days, governments establish an agenda detailing the issues
that will be the focus of negotiation and set a target date for the conclusion
of the round. Once the Ministerial Conference has ended, lower-level national
officials conduct detailed negotiations on the topics embodied in the agenda.
Periodic stock takings are held to reach interim agreements. Once negotiations
have produced the outlines of a complete agreement, trade ministers meet at
a final Ministerial Conference to conclude the round. National governments
then ratify the agreement and implement it according to an agreed timetable.
To date, eight of these bargaining rounds have been concluded, and a
ninth, the Doha Round, began in 2001. (See Table 2.1.) These bargaining
rounds are usually extended affairs. Although the earlier rounds were typi­
cally concluded relatively quickly, the trend over the last 30 years has been for
multiyear rounds. Governments launched the Uruguay Round, for example,
in 1986 (though they began discussing a new round in 1982) and concluded
negotiations in December 1993. Governments launched the Doha Round in
2001 with plans to conclude the round by late 2005. Yet, in mid-2010, gov­
ernments remain unable to reach agreement. The growing length of bargaining
What Is the World Trade Organization?
25
T A B L E 2.1
Trade Negotiations within the General Agreement on Tariffs
and Trade (GATT)/World Trade Organization (WTO), 1947-2010
Name and Year of Round
Subjects Covered
1947 Geneva
1949 Annecy
1951 Torquay
1956 Geneva
1960-1961 Dillon Round
1964-1967 Kennedy Round
1973-1979 Tokyo Round
Tariffs
Tariffs
Tariffs
Tariffs
Tariffs
Tariffs and Antidumping
Tariffs
Nontariff Measures
Framework Agreements
Tariffs
Nontariff Measures
Rules
Services
Intellectual Property
Rights
Textiles and Clothing
Agriculture
Dispute Settlement
Establishment of WTO
Tariffs
Agriculture
Services
Intellectual Property
Rights
Government
Procurement
Rules
Dispute Settlement
Trade and the
Environment
Competition Policy
Electronic Commerce
Other Issues
1986-1993 Uruguay Round
2002-? The Doha Round
Participating Countries
23
13
28
26
26
62
1 02
1 23
147
Source: W o rld Trade O rganization 1 99 5, 9 and W TO website.
rounds reflects the complexity of the issues at the center of negotiations and
the growing diversity of interests among WTO member governments.
The rules established by intergovernmental bargaining provide a frame­
work of law for international trade relations. Participation in the WTO,
therefore, requires governments to accept common rules that constrain their
26
CHAPTER 2
The World Trade Organization and the World Trade System
actions. By accepting these constraints, governments shift international trade
relations from the anarchic international environment in which “ might makes
right” into a rule-based system in which governments have common rights
and responsibilities. In this way, the multilateral trade system brings the rule
of law into international trade relations.
A C L O S E R LOOK
The Doha Round
We can gain a better understanding of the WTO bargaining process by examining
the evolution of negotiations in the current round. The Doha Round was launched
at the WTO's Fourth Ministerial Conference held in Doha, Qatar, in November
2001. In Doha, governments reached agreement on the agenda for the round.
What issues would they address and which would they ignore? Governments agreed
to (1) negotiate additional tariff reductions (with a specific focus on developing
countries' exports), (2) incorporate existing negotiations in services into the Doha
Round, and (3) pursue meaningful liberalization of trade in agricultural products.
In agriculture, they agreed to reduce barriers to market access, to eliminate
agricultural export subsidies, and to reduce domestic production subsidies. The
agenda also called for negotiations on trade-related intellectual property rights,
on modifications of existing WTO rules regarding antidumping and subsidies
investigations, and on the rules pertaining to regional trade agreements and review
of the operation of the dispute-settlement mechanism. Moreover, governments
agreed to explore aspects of the relationship between trade and the environment.
Finally, members agreed to defer negotiations on trade and investment, competition
policy, government procurement, and trade facilitation (four issues known
collectively as "The Singapore Issues"). They agreed to treat the agenda as a
"single undertaking," meaning that everything must be agreed or nothing is agreed.
Governments would conclude the round by January 1, 2005.
The Doha Agenda was just that— an agenda for negotiations. It contained
no details about the form an eventual final agreement would take. Negotiations
between governments aimed at elaborating these details began at WTO headquarters
in Geneva in early 2002. These initial negotiations (conducted for the most part
by national delegations staffed by career civil servants or foreign service officers)
were not oriented toward making final decisions, but instead explored areas of
agreement and disagreement. These negotiations would set the stage for a stock­
taking exercise scheduled for the WTO's Fifth Ministerial Conference in Cancun,
Mexico, in September of 2003. Even though much of the work proceeded smoothly,
it quickly became evident that two issues presented the largest obstacles. First,
developing countries were demanding deeper liberalization of agriculture than the
United States and the European Union (EU) were willing to accept. Second, the
EU was insisting that negotiations on the Singapore issues be initiated in 2004,
but developing countries were unwilling to negotiate on new issues until they had
What Is the World Trade Organization?
27
achieved substantial gains in agriculture. In the late summer of 2003, negotiations
in Geneva paused as governments prepared for the Cancun Ministerial Conference.
As trade ministers gathered in Cancun in September 2003, they hoped to
achieve two broad goals that would push the Doha Round into the home stretch.
The first was to bridge the gap concerning agriculture and the Singapore issues. It
was hoped that this would be possible in Cancun because trade ministers had the
political authority that lower-level officials lacked to make substantial concessions.
A simple compromise appeared possible: The United States and the EU would
accept substantial liberalization in agriculture, and the developing countries would
allow negotiations on some of the Singapore issues. Second, once they had removed
this major obstacle, governments would agree on a broad framework for the final
agreement. The Geneva-based delegations would then work out the precise details
during the following year, and the final agreement would be concluded at the next
Ministerial Conference scheduled for Hong Kong in December 2005. Neither goal
was achieved. The EU and the United States were unwilling to meet the developing
countries' demands regarding agriculture, and the developing countries refused to
allow negotiations on the Singapore issues. Unable to reach agreement, the Cancun
Ministerial Conference adjourned with negotiations in complete disarray.
It took almost a year to put the negotiations back on track. Finally, on August
1, 2004, governments reached the agreement that had eluded them in Cancun. The
EU and the United States accepted broad principles concerning the liberalization of
trade in agriculture. In exchange, developing countries agreed to negotiating one of
the Singapore issues: trade facilitation. Members hoped that this agreement would
allow them to finish negotiations in time to complete the round at the Hong Kong
Ministerial in December 2005. Negotiations progressed slowly during the following
year and a half, however, as it proved difficult to translate these broad principles
into meaningful tariff and subsidy reductions. As a consequence, when governments
arrived in Hong Kong in December 2005 there was little chance they would
conclude the round. Instead, governments reached a few specific agreements at the
Hong Kong Ministerial (the EU agreed to eliminate agricultural export subsidies
by 2013; the advanced industrialized countries agreed to eliminate 97 percent of
the tariffs on exports of the least developed countries), and they accepted a work
program intended to conclude the round by the end of 2006.
Presently, governments remain unwilling to reach agreement on the core issues
necessary to conclude the round. American and European governments remain
unwilling to liberalize their farm sectors enough to satisfy India, Brazil, and other
Group of Twenty (G20) governments. For their part, G20 governments refuse
to make the large concessions in the N A M A talks required to satisfy the United
States and EU. Consequently, a "m ini-M inisterial" held in Geneva in July 2008
collapsed in mutual recrimination. Many prominent commentators argued that the
collapse in Geneva indicates that governments cannot reach a mutually beneficial
agreement. Although it is easy to see the basis for such pessimism, more optimistic
interpretations are possible. We will look at one such alternative, based in the logic
of bargaining power, in Chapter 3. ■
28
CHAPTER 2
The World Trade Organization and the World Trade System
The WTO’s dispute settlement mechanism ensures that governments com­
ply with the rules they establish. Individual compliance with established rules
is not guaranteed. Even though most governments comply with most of their
WTO obligations most of the time, there are times when some don’t. More­
over, if all governments believed they could disregard WTO rules with impu­
nity, they would comply less often. The dispute settlement mechanism ensures
compliance by helping governments resolve disputes and by authorizing pun­
ishment in the event of noncompliance.
The dispute-settlement mechanism ensures compliance by providing an
independent quasi-judicial tribunal. This tribunal investigates the facts and the
relevant WTO rules whenever a dispute is initiated and then reaches a finding.
A government found to be in violation is required to alter the offending policy
or to compensate the country or countries that are harmed. We will examine
the dispute settlement mechanism in greater detail in Chapter 3.
The WTO, therefore, is an international political system that regulates
national trade policies. It is based on rules that constrain what governments
can do to restrict the flow of goods into their countries and to encourage the
export of domestic goods to foreign markets. All of these rules have been cre­
ated (and can be amended) through intergovernmental bargaining. Because
compliance with the rules cannot be taken for granted, governments have es­
tablished a dispute-settlement mechanism to help ensure that members com­
ply. By creating rules, establishing a decision-making process to extend and
revise them, and enforcing compliance, governments have brought the rule of
law into international trade relations.
HEGEMONS, PUBLIC GOODS, AND THE WORLD
TRADE SYSTEM
The stability of the WTO, and of international trade systems more broadly, is
a function of the distribution of power in the international system. In particu­
lar, hegemonic stability theory is often advanced to explain why the system
shifts between periods in which it is open and liberal and periods in which it is
closed and discriminatory.
Hegemonic stability theory rests on the logic of public goods provision.
A public good is defined by two characteristics: non-excludability and non­
rivalry. Non-excludability means that once the good has been supplied, no
one can be prevented from enjoying its benefits. A lighthouse, for example,
warns captains away from a nearby coast. Once that beacon is lit, no captain
can be prevented from observing the light and avoiding the coast. Non-rivalry
means that consumption by one individual does not diminish the quantity of
the good available to others. No matter how many captains have already con­
sumed the light, it remains just as visible to the next captain.
Public goods tend to be undersupplied relative to the value society places
upon them. Undersupply is a result of a phenomenon called free riding. Free
riding describes situations in which individuals rely on others to pay for a
Hegemons, Public Goods, and the World Trade System
29
public good (Sandler 1992, 17). My experience with public radio illustrates
the logic. My local public radio station uses voluntary contributions from
its listeners and businesses to finance 87 percent of its budget. Without these
voluntary contributions, the station would go off the air. As a regular lis­
tener, I benefit immensely from the station’s existence, and my life would be
greatly diminished were the station shut down. Yet, I have never contributed
to the station. Instead, I rely upon others to pay for the station’s operations.
In other words, I free ride on other listeners’ contributions. Because every­
one faces the same incentive structure, contributions to the station are lower
than they would be if non-contributors could be denied access to public radio.
More broadly, goods that are non-excludable and non-rivalrous tend to be
undersupplied.
The severity of the free-riding problem is partly a function of the size of
the group. In large groups, each individual contribution is very small relative
to the total contribution, and as a result each individual has only a small im­
pact on the ability of the group to achieve its objective. Consequently, each
individual readily concludes that the group can succeed without his contribu­
tion. In large groups, therefore, the incentive to free ride is very strong. In
small groups, sometimes called “ privileged groups,” each individual contribu­
tion is large relative to the total contribution, and therefore each contribution
has a greater impact on the group’s ability to achieve its common goal. It
becomes more difficult for any individual to conclude that the group can suc­
ceed without his contribution. As a result, the incentive to free ride is weaker
(though not altogether absent) in small groups.
International institutions such as the WTO have public good character­
istics. International rules and procedures benefit all governments (though not
necessarily all benefit equally). Moreover, it is difficult (though not impos­
sible) to deny a government these benefits once an institution has been estab­
lished. Moreover, these benefits do not decrease as a function of the number
of governments that belong to the institution. Because international institu­
tions have these public good characteristics, their provision can be frustrated
by free riding. All governments want global trade rules, but each wants some­
one else to bear the cost of providing such rules.
Hegemonic stability theory argues that hegemons act like privileged
groups and thus overcome the free-riding problem. A hegemon is a country
that produces a disproportionately large share of the world’s total output and
that leads in the development of new technologies. Because it is so large and
technologically advanced, the benefits that the hegemon gains from trade are
so large that it is willing to bear the full cost of creating international trade
rules. Moreover, the hegemon recognizes that the public good will not be pro­
vided in the absence of its contribution. Hence, the free-riding problem largely
disappears, and stable regimes are established, during periods of hegemonic
leadership. As a hegemon declines in power, it becomes less willing to bear the
cost of maintaining trade rules, and world trade becomes less open.
Historical evidence provides some support for hegemonic stability the­
ory, as world trade has flourished during periods of hegemonic leadership
30
CHAPTER 2
The World Trade Organization and the World Trade System
and floundered during periods without it. The two periods of rapid growth
of world trade occurred under periods of clear hegemony. Great Britain was
by far the world’s largest and most innovative economy throughout the nine­
teenth century. Trade within Europe and between Europe and the rest of the
world grew at what were then unprecedented rates. British hegemony, there­
fore, created and sustained an open, liberal, and highly stable global economy
in which goods, capital, and labor flowed freely across borders. The same re­
lationship is evident in the twentieth century. The United States exited World
War II as an undisputed hegemon. It played the leading role in creating the
GATT, and it led the push for negotiations that progressively eliminated bar­
riers to trade. The result was the most rapid increase in world trade in history.
Hence, the two hegemonic eras are characterized by stable trade regimes and
the rapid growth of international trade.
The one instance of hegemonic transition is associated with the collapse
of the world trade system. The transition from British to American hegemony
occurred in the early twentieth century. In 1820, the American economy
was only one-third the size of Great Britain’s. By 1870, the two economies
were roughly the same size. On the eve of the First World War, the American
economy was more than twice as large as Great Britain’s (Maddison 2001,
261). By the end of World War II, the United States produced almost half of
the world’s manufactured goods. (See Table 2.2.) During this transition, each
looked to the other to bear the cost of reconstructing the global economy after
World War I. The British tried to reconstruct the world economy in the 1920s,
but lacked the resources to do so (Kindleberger 1974). The United States had
the ability to reestablish a liberal world economy, but wasn’t willing to ex­
pend the necessary resources. Consequently, the Great Depression sparked the
profusion of discriminatory and protectionist trade blocs. As protectionism
rose, world trade fell sharply. (See Table 2.3.) Hence, hegemonic transition
has been associated with considerable instability of international trade.
Although these episodes are suggestive, they are too few in number to
support strong conclusions about the relationship between hegemony and
international trade. This empirical limitation is of more than pure academic
interest, given the emergence of China and India as powerful forces in the
global economy. China’s emergence in particular raises questions about
T A B L E 2.2
Shares of World Manufacturing Production (Percent)
United States
Great Britain
Germany
France
Source: Kennedy 1988, 259.
1880
1900
1913
1928
14.7
22.9
8.5
7.8
23.6
18.5
13.2
6.8
32.0
13.6
14.8
6.1
39.3
9.9
11.6
6.0
Hegemons, Public Goods, and the World Trade System
31
T A B L E 2.3
Collapse of World Trade
(Average Monthly World Trade, $US millions)
1929
1930
1931
1932
Source: K indleberger
2,858
2,327
1,668
1,122
1 97 4, 140.
whether we are witnessing a hegemonic transition. Goldman Sachs estimates
that China will overtake the United States in total economic production by
2027. Christopher Layne asserts that “ economically, it is already doubtful
that the United States is still a hegemon” (Layne 2009, 170).
These contemporary developments find parallels in the recent past. Dur­
ing the 1960s, the Japanese economy grew at average annual rates of more
than 10 percent, compared with average growth rates of less than 4 percent
for the United States. Although Japanese growth slowed during the 1970s and
1980s, Japan continued to grow more rapidly than the United States. Faster
growth allowed Japan to catch up to the United States. In the early 1960s,
the United States produced 40 percent of the world’s manufactured goods,
whereas Japan produced only 5.5 percent. By 1987, the United States’ share
of world manufacturing production had fallen to 24 percent, whereas Japan’s
share had increased to 19.4 percent (Dicken 1998, 28). In less than 30 years,
therefore, Japan transformed itself from a vanquished nation into a powerful
force in the world economy.
Many commentators viewed Japan’s ascent as a harbinger of hegemonic
decline. The United States began running trade deficits in the 1970s, and these
deficits continued to grow during the 1980s. American policymakers inter­
preted these deficits as evidence of declining competitiveness, particularly in
high-technology industries. Measures of the United States’ comparative ad­
vantage in high-technology industries suggested that it was losing ground in
critical sectors such as mechanical equipment, electronics, scientific instru­
ments, and commercial aircraft. And what the United States appeared to be
losing, Japan appeared to be gaining. Statistics suggested that as the American
share of global high-technology markets fell (from 30 percent to 21 percent
between 1970 and 1989), Japan’s share of this market rose (from 7 percent to
16 percent in the same period) (Tyson 1995, 19). Thus, the trade deficit and
the apparent decline in American high-technology industries both pointed to
the same conclusion: The United States was losing ground to Japan.
The United States responded to these developments by adopting a more
aggressive and protectionist trade policy. The United States increasingly re­
lied on bilateral initiatives and threatened to protect the American market to
force changes in other countries’ trade policies (Krueger 1995). Japan was the
32
CHAPTER 2
The World Trade Organization and the World Trade System
principal (though not the sole) target of American assertiveness. Many ana­
lysts argued that this assertiveness reflected “ the syndrome of hegemonic de­
cline.” Some argued that the protectionist tendencies generated by hegemonic
decline would be reinforced by the end of the Cold War, which deprived the
United States of a broader purpose provided by the alliance against the Soviet
threat. Robert Gilpin, a political economist at Princeton University, summa­
rized this pessimistic outlook, arguing that “ at the opening of the twenty-first
century, all the elements that have supported an open global economy have
weakened” (Gilpin 2000, 347).
Assertions of hegemonic decline proved premature, however. American
unilateralism subsided in the m id-1990s as the United States entered a
period of sustained robust growth and Japan struggled to recover from a
financial and banking crisis. In this decade, governments strengthened and
extended the multilateral trade system. They established the WTO, which
enjoyed greater support and attracted a larger membership than the GATT
did at the height of American hegemony. As one analyst concluded in look­
ing back on the predictions of hegemonic decline, “ the institutions that
took hold after World War II continue to provide governance now, and the
economic interests and political consensus that lie behind them are more,
not less, supportive of an open world economy today than during the Cold
War” (Ikenberry 2000, 151).
The open question, therefore, is whether China’s emergence today is a he­
gemonic transition like that which occurred during the early twentieth century
or a false alarm like that prompted by Japan during the 1980s. That is, is the
global system transitioning from the American century to the Asian century,
or will Asia’s ascent level off? Moreover, if we are experiencing hegemonic
transition, must the global trade system weaken and collapse as it did dur­
ing the 1920s and 1930s? Might the institutional structures constructed under
American leadership help governments transition to a new global power struc­
ture without suffering another economic “ dark age” ?
THE EVOLVING WORLD TRADE ORGANIZATION:
NEW DIRECTIONS, NEW CHALLENGES
Although the trade system’s core principles and procedures have been sta­
ble for 60 years, the past few years have brought substantial change. These
changes will probably shape the evolution of the system over the next decade.
Two such changes are most important: the emergence of developing coun­
tries as a powerful bloc within the organization, and the emergence of NGOs
as a powerful force outside the organization. Together these developments
have complicated decision making within the WTO and raised fundamental
questions about the ability of governments to continue to achieve their goals
through the system.
The first substantial change in the WTO arises from the growing power of
developing countries within the organization. WTO membership has expanded
The Evolving World Trade Organization: New Directions, New Challenges
33
T A B L E 2.4
New Members of the General Agreement on Tariffs and Trade/World
Trade Organization, 1985-2010
Albania
Angola
Antigua and Barbuda
Armenia
Bahrain
Botswana
Brunei Darussalam
Bulgaria
Cambodia
Cape Verde
China
Chinese Taipei
Costa Rica
Croatia
Djibouti
Dominica
Ecuador
El Salvador
Estonia
Fiji
Former Yugoslavia Republic
of Macedonia
Georgia
Grenada
Guatemala
Guinea
Guinea Bissau
Honduras
Hong Kong
Jordan
Kyrgyz Republic
2000
1994
1987
2003
1993
1987
1993
1996
2004
2008
2001
2002
1990
2000
1994
1993
1996
1991
1999
1993
2003
2000
1994
1991
1994
1994
1994
1986
2000
1998
Latvia
Lesotho
1999
1998
Liechtenstein
Lithuania
Macao
M a li
Mexico
Moldova
Mongolia
Morocco
Mozambique
Namibia
Nepal
Oman
Panama
Papua New Guinea
Paraguay
Qatar
Saint Kitts and Nevis
Saint Lucia
Saint Vincent and the Grenadines
Saudi Arabia
Slovak Republic
Slovenia
Solomon Islands
Swaziland
Tonga
Ukraine
United Arab Emirates
Venezuela
Vietnam
1994
1 001
1991
1993
1986
1 001
1997
1987
1992
1992
2 004
2 000
1997
1994
1994
1994
1994
1993
1993
1 005
1993
1994
1994
1993
1 007
1 008
1994
1990
1 007
Source: W o rld Trade O rganization (w to.org).
dramatically since 1985. (See Table 2.4.) More than 60 countries have joined,
increasing total membership to 153 countries (as of June 2010). Thirty more
countries have applied for membership and are currently engaged in accession
negotiations. Assuming all of these negotiations are successfully completed,
WTO membership will surpass 180 countries during the next few years. Even if
all governments have similar interests, more members would make the decision
making harder—it is very difficult to gain consensus among 153 countries.
34
CHAPTER 2
The World Trade Organization and the World Trade System
Membership growth reflects the dramatic reorientation of emerging mar­
ket countries toward international trade. For reasons we explore in greater
detail in Chapter 6, governments in most developing countries were skeptical
about the ability to foster development through trade. Consequently, most
governments participated little in the GATT system. And to the extent that
developing countries belonged to the GATT, the industrialized countries ac­
corded them special treatment rather than demanding strict reciprocity. The
GATT became, as a result, a rich-country club in which negotiations focused
on the areas of interest to the United States, the EU, and Japan, and neglected
liberalization in areas of interest to developing countries. Since the mid-1980s,
emerging market countries have emphasized development through exports
and, as a result, have placed substantially greater importance on the market
access that participation in the WTO provides.
Under the leadership of the three largest emerging economies, Brazil,
China, and India, developing-country members have constructed a powerful
bloc within the WTO. This power is evident in the past decade. Developing
countries stymied the first effort to launch the current round of negotiations
in Seattle in 1999 because the proposed agenda dedicated too much attention
to issues of interest to the United States and the EU and insufficient atten­
tion to the issues developing countries believed important. The current round
launched once developing countries were satisfied that the agenda focused suf­
ficient attention on the topics of importance to them, especially liberalization
of agriculture and maintaining sufficient policy space to promote develop­
ment. Since 2003, cooperation among developing countries within the WTO
has been institutionalized in the Group of 20.
The emergence of the developing countries as a powerful bloc in the WTO
has transformed bargaining. In previous rounds countries with similar eco­
nomic structures exchanged roughly equivalent concessions. With developing
countries on the sidelines, the United States, the EU, and Japan defined the ne­
gotiating agenda. As a result, governments liberalized industries in which they
all enjoyed relative competitiveness, generally capital-intensive manufactured
goods, and continued to protect industries in which they were uncompetitive.
Labor-intensive industries and farming thus remained protected in most indus­
trialized countries. In essence, the United States, the EU, and Japan agreed to
allow GM, Toyota, and Volkswagen to compete against each other in all three
markets. Reducing these barriers challenged national producers in each country
by exposing them to global competition, but because all countries were roughly
similar in structure, liberalization did not impose substantial adjustment costs.
Current WTO bargaining brings together governments representing coun­
tries with very different economic structures. Industrialized countries who are
competitive in high-technology products and services bargain with developing
countries who are competitive in labor-intensive manufactured goods, in stan­
dardized capital-intensive goods such as steel, and in agriculture. For negotia­
tions to succeed, governments in each group must liberalize industries that will
not survive full exposure to international competition. As a result, the agree­
ment that will conclude the Doha Round will impose hefty adjustment costs,
The Evolving World Trade Organization: New Directions, New Challenges
35
in agriculture for many European Union countries, Japan, the United States,
and other developed countries, and in services and manufactured goods for
most developing countries.
Changes inside the organization are compounded by changes outside.
Of particular importance here is the growing number of non-governmental
organizations (NGOs) striving to influence the organization. Few interest
groups (other than businesses) paid much attention to the GATT when nego­
tiations focused solely on tariffs. Since the late 1990s, however, hundreds of
groups have mobilized in opposition to what they view as the unwelcome con­
straints imposed by new WTO rules. In many instances, NGOs worry about
how WTO rules affect the ability of governments to safeguard consumer and
environmental interests.
WTO rules do not prevent governments from protecting consumers from
unsafe foods or protecting the environment from clear hazards. For example,
when cattle stricken by mad cow disease were discovered in the United States,
nothing in the WTO prohibited other governments from banning the import
of American beef. Similarly, when U.S. inspectors found toxic chemicals in
toothpaste manufactured in China, WTO rules did not prohibit the United
States from banning imports of the afflicted product. Problems arise when
governments use health or environmental concerns as an excuse to shelter
domestic producers from foreign competition. Such practices can become
common in a world in which governments cannot use tariffs to protect industry.
Suppose the United States wants to protect American avocado growers from
competition against cheaper Mexican avocados, they assert that Mexican
avocados contain pests that harm American plants (even though they don’t)
and on this basis ban Mexican avocados from the American market. This is
disguised protectionism—an effort to protect a local producer against foreign
competition, hidden as an attempt to protect plant health in the United States.
WTO agreements, such as the Agreement on Sanitary and Phytosani­
tary Standards, attempt to strike a balance between allowing governments to
protect against legitimate health risks and preventing governments from us­
ing such regulations to protect domestic producers. This is a difficult balance
to strike. It is not easy to determine the real motives behind a government’s
decision to ban imports of a particular product. Did the EU ban the import
of hormone-treated beef because of a sincere concern about potential health
consequences or to protect European beef producers from American competi­
tion? As a consequence, WTO rules require governments to accept current
scientific conclusions about the risks to humans, animals, and plants that such
products pose. Governments cannot ban imports of a product on health or
safety grounds unless a preponderance of scientific evidence indicates that the
product is in fact harmful. Such rules extend deeply into an aspect of national
authority: the ability to determine what risks society should be exposed to and
protected from.
Civil society groups argue that the balance struck by current WTO rules
is too favorable to business and insufficiently protective of consumer and en­
vironmental interests. Moreover, they argue that the bias toward producer
36
CHAPTER 2
The World Trade Organization and the World Trade System
interests is a consequence of the nature of the WTO decision making, a pro­
cess in which producer interests are heavily represented and consumer in­
terests are almost entirely excluded. The mobilization of NGOs around the
WTO has thus sought to bring greater attention to consumer interests in order
to redress this perceived imbalance.
The growing power of developing countries within the WTO and the
greater pressure by NGOs on the outside of the organization have combined
to generate questions about whether the WTO can remain relevant under its
current decision-making procedures. One dimension of this question concerns
effectiveness: Can 153 governments at different stages of economic develop­
ment reach agreements that provide meaningful trade liberalization? A second
dimension concerns legitimacy: Should rules that constrain national regula­
tions be negotiated without the full participation of civil society?
Both dimensions matter, but they point to contradictory conclusions.
Concerns about the effectiveness of WTO negotiations highlight the need for
reform that limits the number of governments actively participating in nego­
tiations. One such proposal advocates the creation of a steering committee,
a WTO equivalent of the United Nations Security Council, with authority to
develop consensus on trade issues. (See Schott and Watal 2000.) Such reform
would make it easier to reach agreement, but only by making negotiations
less inclusive. Concerns about legitimacy highlight the need for reform that
opens the WTO process to NGOs. Opening the WTO in this manner, NGOs
argue, would ensure that business interests are balanced against other social
concerns. Although such reforms might make WTO decision making more in­
clusive, they would also make it even more difficult to reach agreement within
the organization.
Dissatisfaction with current decision-making procedures has yet to pro­
duce a consensus about whether and how to change current procedures. The
most important consequence of the current impasse, therefore, may be that
governments find the WTO increasingly less useful as a forum within which
to pursue their trade objectives. If governments come to that conclusion, they
will begin to seek alternatives.
THE GREATEST CHALLENGE? REGIONAL TRADE
ARRANGEMENTS AND THE WORLD TRADE
ORGANIZATION
Regionalism is one alternative that may gain particular appeal. Indeed, many
observers believe that regional trade arrangements pose the single greatest
challenge to the multilateral trade system. Regional trade arrangements pose a
challenge to the WTO because they offer an alternative, and more discrimina­
tory, way to organize world trade.
A regional trade arrangement (RTA) is a trade agreement between two
or more countries, usually located in the same region of the world, in which
each country offers preferential market access to the other. RTAs come in
The Greatest Challenge? Regional Trade Arrangements and the World Trade Organization
37
two basic forms: free-trade areas and customs unions. In a free-trade area,
like the North American Free Trade Agreement, governments eliminate tar­
iffs on other members’ goods, but each member retains independent tariffs
on goods entering their market from nonmembers. In a customs union, like
the EU, member governments eliminate all tariffs on trade between customs
union members and impose a common tariff on goods entering the union
from nonmembers.
Because RTAs provide tariff-free market access to some countries, but
not to others, they are inherently discriminatory. Though such discrimination
is inconsistent with the GATT’s core principle, GATT’s Article XXIV allows
countries to form RTAs as long as the level of protection imposed against
nonmembers is no higher than the level of protection applied by the countries
prior to forming the arrangement. Nevertheless, the discriminatory aspect of
RTAs makes many worry about the impact they will have on the nondiscrimi­
natory trade encouraged by the WTO.
Such worries arise because of the rapid proliferation of RTAs. According
to the WTO, there are currently between 190 and 250 RTAs in operation.
If all RTAs now planned are created, there may be as many as 400 RTAs in
effect by the end of 2010. Free-trade agreements constitute the vast majority
of these RTAs, for 86 percent of existing RTAs and for 99 percent of ar­
rangements currently being negotiated. (See Figure 2.1.) More than half of all
RTAs are bilateral agreements. The others are “ plurilateral” agreements that
include at least three countries. RTAs are densely concentrated in Europe and
the Mediterranean region. (See Figure 2.2.) Agreements between countries in
Western, Eastern, and Central Europe, and in the Mediterranean account for
almost 70 percent of RTAs in operation. North and South America take sec­
ond place, accounting for about 12 percent. The rest of the world seems less
Customs Unions,
24
Free-Trade Areas,
148
FIGURE 2.1
Regional Trade
Arrangements, 2000.
Source: The World Trade
Organization 2000
38
CHAPTER 2
The World Trade Organization and the World Trade System
Central Asia
FIGURE 2.2
Geographic Location of Regional Trade Arrangements
Source: The World Trade Organization 2000
enthusiastic about RTAs, as countries in sub-Saharan Africa and Asia-Pacific
participate in very few.
The rapid growth of RTAs reflects a number of distinct factors. The col­
lapse of the Soviet bloc and the subsequent disintegration of the Soviet Union
resulted in the rapid proliferation of RTAs. Governments sought new ways
to organize their trade, and they sought access to Western European markets.
Consequently, a large number of agreements were reached between coun­
tries within the region and between these countries and the EU (WTO 2000).
M oldova, for example, entered RTAs with eight other newly independent
countries formed from the former Soviet Union between 1992 and 1996.
Russia entered at least nine RTAs with this same set of countries. Ten Eastern
and Central European countries reached bilateral RTAs with the European
Union between 1991 and 1997. There were also substantial changes in devel­
oping country trade policies in the late 1980s and early 1990s, which led to a
greater willingness to enter RTAs (WTO 2000). Mexico, for example, negoti­
ated RTAs not only with the United States and Canada (NAFTA), but also
with Chile, Costa Rica, and Nicaragua. Chile negotiated RTAs with Colom­
bia, Ecuador, and Peru, in addition to completing the agreement it reached
with Mexico.
Although these changes help us understand why a larger number of states
were willing to undertake trade liberalization, they do not fully explain why so
many of these countries opted for RTAs rather than to liberalize trade solely
The Greatest Challenge? Regional Trade Arrangements and the World Trade Organization
39
within the WTO. Idiosyncratic factors played an important role. Countries
created out of the disintegrating Soviet Union had to find new ways to regu­
late their trade relatively quickly. An RTA probably offered the quickest solu­
tion. Central and Eastern European governments sought RTAs with the EU in
part because they wanted better access to the EU market and in part because
each planned to seek full EU membership. The EU responded by establishing
free-trade agreements as the first step in the accession process. In all of these
cases, RTAs emerged as expedient solutions to pressing trade problems in a
rapidly changing economic environment.
Scholars have also advanced more general ideas to account for the pro­
liferation of RTAs. Some emphasize a country’s desire to gain more secure
access to the market of a particularly important trading partner. In the U.S.Canada Free Trade Agreement concluded in the late 1980s, for example,
Canada sought secure access to the U.S. market—the most important destina­
tion for Canada’s exports. During much of the 1980s, the United States made
frequent use of antidumping and countervailing duty investigations to protect
American producers from Canadian imports. Such measures clearly interfered
with the ability of Canadian producers to export to the American market.
The Canadian government hoped that the U.S.-Canada Free Trade Agree­
ment would give Canada “ some degree of exemption” from these measures
(Whalley 1998, 72-73).
Other scholars emphasize a government’s need to signal a strong commit­
ment to economic reform. Governments use RTAs to convince foreign part­
ners that they will maintain open markets and investor-friendly policies. This
argument has been applied most commonly to M exico’s decision to seek a
free-trade agreement with the United States. Mexico shifted from a highly pro­
tectionist to a more liberal trade policy in the mid-1980s. The success of that
strategy hinged in part on Mexico’s ability to attract foreign investment from
the United States. The Mexican government feared, however, that American
investors would not believe that the Mexican government was committed to
its new strategy. What would prevent Mexico from shifting back to protec­
tionism and nationalizing foreign investments? If American businesses didn’t
believe the Mexican government was committed to this liberal strategy, they
would be reluctant to invest in Mexico. Absent American investment, Mexico
would be deprived of foreign capital that was critical to the success of its
strategy.
A free-trade agreement with the United States allowed Mexico to signal
to American investors the depth of its commitment to market liberalization.
It did so in part because NAFTA contained very clear and enforceable rules
concerning the treatment of foreign investment located in Mexico. A similar
argument might be used to understand at least part of the interest that Eastern
and Central European governments had in signing free-trade agreements with
the EU. These governments were also reorienting their economic policies
and were trying to attract foreign investment. Like Mexico, they might have
needed an external institution, such as an agreement with the EU, to signal
to foreign investors their commitment to market reforms. Notice that these
40
CHAPTER 2
The World Trade Organization and the World Trade System
arguments actually place less emphasis on the trade benefits that might result
from an RTA and focus more on the need to attract foreign investment.
Other scholars argue that countries enter RTAs to increase their bargain­
ing power in multilateral trade negotiations. A small country bargaining indi­
vidually in the WTO lacks power because it does not have a large market to
offer. By pooling a group of small countries, the market that can be offered
to trade partners in WTO negotiations increases substantially. Consequently,
each member might gain larger tariff concessions in WTO negotiations. Cur­
rent American enthusiasm for RTAs might also be seen as an attempt to gain
bargaining power in the WTO. As it has become more difficult to reach deci­
sions within the WTO, the United States has explicitly threatened to rely more
on free-trade agreements. By doing so, the United States denies its market to
countries unwilling to make concessions in the WTO. The fear of losing access
to the U.S. market could induce governments to make concessions in the WTO
that they would not otherwise make. The threat to rely more on RTAs and
less on the WTO, therefore, enhances American power in the organization.
Regardless of the specific motivation behind the creation of RTAs, their
rapid growth raises questions about whether they challenge or complement
the WTO. This is not an easy question to answer. On the one hand, RTAs
liberalize trade, a mission they share with the WTO. In this regard, RTAs
complement the WTO. On the other hand, RTAs institutionalize discrimina­
tion within world trade. In this regard, RTAs challenge the WTO.
Economists conceptualize these competing consequences of RTAs as trade
creation and trade diversion. Consider an RTA between France and Germany.
Because the RTA eliminates tariffs on trade between France and Germany,
more Franco-German trade takes place. This is trade creation. Because the
RTA does not eliminate tariffs on trade between France and Germany on the
one hand, and the United States on the other, some trade between the United
States and Germany is replaced by trade between France and Germany. This
is trade diversion. An RTA’s net impact on trade is the difference between the
trade it creates and the trade it diverts. If more trade is created than diverted,
the RTA has liberalized trade. If more trade is diverted than created, the RTA
has pushed the world toward protectionism.
Which of these effects predominates in existing RTAs? Nobody really
knows, in large part because it is difficult to evaluate trade creation and trade
diversion empirically. It is especially difficult once we begin to think about
how RTAs evolve once created. An RTA that originally diverts more trade
than it creates might over time create more trade than it diverts. Or an RTA
could evolve in the opposite direction. Consider the first case. Some schol­
ars have argued that RTAs exert a kind of gravitational force on countries
that are not currently members. Countries that do not belong to the EU, but
that engage in lots of trade with it, have a strong incentive to join. So it is
no surprise, therefore, that over the last 40 years the EU has expanded from
6 to 25 member countries. Some see a similar dynamic at work in the Western
Hemisphere. Mexico’s decision to seek a free-trade agreement with the United
States was at least partially motivated by concerns about the cost of being
The Greatest Challenge? Regional Trade Arrangements and the World Trade Organization
41
P O L I C Y A N A L Y S I S AND D E B AT E
The United States and Free-Trade
Agreements
Question
Should the United States pursue free-trade agreements?
Overview
Until the late 1980s, the United States pursued its trade objectives exclusively
through the multilateral trade system. Though American policymakers recognized
that governments had the legal right to pursue regional free-trade agreements
under the GATT Article X X IV , and encouraged other governments to create regional
trading blocs, it did not pursue regional arrangements itself. One might argue that it
believed that the hegemon should support the global trade system even at the expense
of specific bilateral agreements that it might find beneficial. The U.S.-Canada Free
Trade Agreement, which entered into force in 1989, changed this traditional policy.
Subsequently, the United States has negotiated 14 bilateral free-trade agreements
and is pursuing regional free-trade agreements in Central and South America, Asia,
and the Middle East. The change is now fully reflected in its trade policy strategy,
which the Office of the U.S. Trade Representative defines as the pursuit of "multiple
market-opening initiatives on a global, regional and bilateral basis." (www.ustr.gov)
America's embrace of regionalism has been controversial, even among
supporters of trade liberalization. Proponents of regionalism assert that freetrade agreements enable the United States to achieve more than it can achieve
within the WTO. In the 153-member WTO, governments willing to liberalize trade
effectively are prevented from doing so by governments reluctant to liberalize. The
difficulty of concluding the Doha Round illustrates the point. From this perspective,
free-trade agreements promote global trade liberalization better than the current
WTO because willing partners can make deep cuts in trade barriers. Opponents
argue that free-trade agreements threaten the multilateral trade system. Regional
agreements create a complex "spaghetti bowl" of preferential arrangements that
stifle, rather than expand, global trade. In addition, energy that governments
devote to regional agreements is energy taken from WTO negotiations. From this
perspective, free-trade agreements undermine the global trade system. Given these
alternative perspectives, what policy should the United States pursue?
Policy Options
• The United States should continue to negotiate free-trade agreements as the
best approach to achieving its trade objectives.
• The united states should cease negotiating new free-trade agreements, consider
abrogating those currently in force, and advance its trade objectives exclusively
through the WTO.
(Continued)
42
CHAPTER 2
The World Trade Organization and the World Trade System
Policy Analysis
• Does the United States derive benefits from free-trade agreements that it cannot
derive from WTO agreements?
• Are there costs associated with creating a large network of free-trade
agreements?
Take a Position
• Which option do you prefer? Justify your choice.
• What criticisms of your position should you anticipate? How would you defend
your recommendation against these criticisms?
Resources
Online: Search online for "Free Trade Areas." You might also visit the U.S.Trade
Representative website (www.ustr.gov) for timely information about current
negotiations. The WTO maintains an excellent web page dedicated to regional
trade agreements and their impact on the multilateral trade system (www.wto
.org and follow the links under "Trade Topics").
In Print: For contrasting views see Jeffrey J. Schott, ed., Free Trade Agreements: U.S.
Strategies and Priorities (Washington, DC: Institute for International Economics,
2004); Jagdish Bhagwati, Termites in the Trading System: How Preferential Agreements
Undermine Free Trade (New York: Oxford University Press, 2008.)
outside a U.S.-Canada Free Trade Area that had been negotiated in the late
1980s (Gruber 2000). The interest of many Latin American countries in a
Free Trade Area of the Americas (FTAA) is at least partially a consequence
of Mexico’s entry into NAFTA (Baldwin 1995). Over time, this gravitational
pull attracts so many additional members that a regional RTA evolves into
a global free-trade area. In this optimistic scenario, RTAs lead eventually to
global free trade in which trade creation outweighs trade diversion and RTAs
complement the WTO.
By contrast, the creation of a large RTA in one region could encourage the
formation of rival and more protectionist RTAs in other regions. In this sce­
nario, NAFTA as well as FTAA could be seen as an American response to the
EU. An emerging free-trade area in Pacific Asia could be seen as a response to
regionalism in Europe and the Western Hemisphere. In this view, world trade
is becoming increasingly organized into three regional and rival trade blocs.
Once regional trading blocs have formed, each bloc might raise tariffs to re­
strict trade with other regions. A tariff increase by one RTA could provoke re­
taliation by the others, leading to a rising spiral of protection that undermines
global trade liberalization (Frankel 1997, 210). In this case, trade diversion
outweighs trade creation and RTAs pose an obvious challenge to the WTO.
It is impossible to predict which of these two scenarios is the more likely.
The world does seem to be moving toward three RTAs: one in Europe, one
Conclusion
43
in the Western Hemisphere, and one in Asia. At the same time, governments
appear to be aware of the challenges RTAs pose to the WTO, as they have
created a WTO committee on RTAs that is exploring the relationship between
these arrangements and the multilateral system. Only time will tell, however,
whether RTAs will develop into discriminatory trade blocs that engage in tar­
iff wars or if instead they will pave the way for global free trade.
CONCLUSION
The multilateral trade system is an international political system. It provides
rules that regulate how governments can use policies to influence the cross­
border flow of goods and services. It provides a decision-making process
through which governments revise existing rules and create new ones. And
it provides a dispute-settlement mechanism that allows governments to en­
force common rules. By promoting nondiscriminatory international trade, by
establishing a formal process for making and revising rules, and by allowing
governments to enforce the rules they create, the WTO reduces impact of raw
power on international trade relationships. In short, the WTO brings the rule
of law to bear in international trade relations.
Like all political systems, the WTO reflects the interests of the powerful.
Its creation reflected the interests of a hegemonic United States; its strengthen­
ing during the Cold War era reflected the growing interest of European and
Japanese governments that trade liberalization promised real gains. Although
one can argue that the WTO reflects only the interests of the advanced indus­
trialized countries, the trends over the last 20 years suggest otherwise. The
rapid growth in the number of countries joining the WTO during that period
suggests that most of the world’s governments believe that they are better off
with the WTO than without it. This doesn’t mean that the system is perfect. It
does suggest, however, that in the contemporary global economy, the major­
ity of the world’s governments believe that they do better when world trade is
organized by a system based on nondiscrimination and market liberalism than
they do in a discriminatory, protectionist, and rule-free environment. The
WTO will weaken, and perhaps even crumble, when governments no longer
believe this is true.
The largest contemporary challenges to the WTO emerge from the ability
of its decision-making process to continue to produce outcomes in a changing
world. On the one hand, the growth of WTO membership and the emergence
of the G-20 as a powerful bloc within the organization has raised the stakes
of trade negotiations and made it more difficult to find packages acceptable
to the full membership. On the other hand, the emergence of a vocal NGO
movement critical of the WTO’s apparent tendency to place business interests
before consumer interests has made it even more difficult to reach agreements
within the organization. The full consequences of these two challenges remain
uncertain. Can governments reform decision making in the system in a way
that simultaneously enhances the legitimacy and the efficiency? Or will con­
tinued decision-making paralysis impart additional impetus to regionalism?
44
CHAPTER 2
The World Trade Organization and the World Trade System
KEY TERMS
Customs Union
Dispute Settlement
Mechanism
The Doha Round
Free Riding
Free-Trade Area
Generalized System of
Preferences
Hegemon
Hegemonic Stability
Theory
Intergovernmental
Bargaining
Market Liberalism
Ministerial Conference
Most-Favored Nation
National Treatment
Nondiscrimination
Nontariff Barriers
Public Good
Regional Trade
Arrangement (RTA)
Tariffs
Trade Creation
Trade Diversion
World Trade
Organization (WTO)
SUGGESTIONS FOR FURTHER READING
For a detailed discussion of the origins and development of the rules governing
international trade, see John H. Jackson,The World Trading System: Law and
Policy of International Economic Relations (Cambridge, MA: MIT Press, 1997).
A recent and thorough investigation of WTO procedures is available in Kent Jones,
The Doha Blues: Institutional Crisis and Reform in the WTO (New York: Oxford
University Press, 2009)
Unfortunately, there is no single book that provides a good overview of bargaining
rounds. Detailed treatments of the political dynamics of the last three rounds of
negotiations can be found in Ernest H. Preeg, Traders and Diplomats: An Analysis
of the Kennedy Round of Negotiations under the General Agreement on Tariffs and
Trade (Washington, DC: The Brookings Institution, 1995); Gilbert R. Winham,
International Trade and the Tokyo Round Negotiation (Princeton, NJ: Princeton
University Press, 1986); and Ernest H. Preeg, Traders in a Brave New World: The
Uruguay Round and the Future o f the International Trading System (Chicago:
University of Chicago Press, 1995). See Bernard Hoekman and Michel M. Kostecki,
The Political Economy o f the World Trading System: The WTO and Beyond, 2nd
ed. (New York: Oxford University Press, 2001) for an extended analytical account
of the politics of the world trade system.
CHAPTER
3
The Political
Economy of
International Trade
Cooperation
hy does the W orld T rade O rganization (W TO) exist? There are two
ways to answer this question. One approach emphasizes the partic­
ular historical process that led to the W T O ’s creation. A s we saw in
Chapter 2, the United States had an econom ic interest in creating the General
Agreement on T ariffs and T rade (G A TT) after W orld W ar II, and it had the
power required to do so. The world trade system w as thus shaped by the spe­
cific configuration o f pow er and interests in place following the Second W orld
W ar. An alternative approach em phasizes a more abstract logic. In this more
abstract logic, the W TO exists because it helps governments w ork together in
pursuit o f mutual gain. In this approach, the world trade system is treated as a
specific instance o f the more general problem o f cooperation.
C oo peration is not alw ays easily achieved, even when everybody recog­
nizes that they all could gain from cooperation. Cooperation is often difficult
because people often have strong incentives not to cooperate. T hese incen­
tives are driven in part by a desire to take advantage o f others and in part by
a desire to avoid being taken advantage of. But regardless o f whether people
are trying to gain advantage, or whether they are sim ply trying to avoid be­
ing exploited, the behavior yields the sam e result— cooperation is stym ied and
people are w orse o ff than they could be. A pplied to w orld trad e, this logic
suggests that countries can gain substantially from cooperation aim ed at lib­
eralizing w orld trade. Yet, because som e governments w ant to take advantage
o f others, and all governments w ant to avoid being exploited in this fashion,
no governm ent is w illing to liberalize trade. Consequently, societies are de­
prived o f the benefits that trade confers. In order for cooperation to emerge in
any society, therefore, people m ust be assured that cooperation on their part
will be met by cooperation from others.
W
45
46
CHAPTER
3
The Political Economy of International Trade Cooperation
Individuals cannot easily provide these assuran ces to each other. If you
think som eone w ants to take advantage o f you, you will probably disregard
his or her request that you trust him or her. The necessary trust can emerge
gradually over time. But if you can’t cooperate with each other w ithout trust,
and if building trust requires cooperation, then you are stuck. Societies often
solve this problem by creating institutions. Institutions provide the necessary
assurances by punishing people who try to take advantage o f others. For ex­
am ple, every time you enter into a contract with som eone, the pow er o f the
state ensures that you and the party you contract with com ply with the agree­
ment. Applied to w orld trade, this logic suggests that trade liberalization is
possible only if an international institution like the W TO can ensure that all
governm ents com ply with the agreem ents they m ake. It does so by creating
conditions that help governm ents enforce the agreem ents they conclude. The
W TO exists, therefore, because it enables societies to cooperate and capture
the welfare gains that trade offers.
This chapter develops this abstract logic o f cooperation in three essential
steps. First, we exam ine trade theory to gain a firm understandin g o f why
trade offers welfare gains to all countries. T his exam in ation is im portant in
its own right, but it also highlights the gains available from international co ­
operation aim ed at liberalizing trade. Second, we exam ine why cooperation
to capture the welfare gains available from trade is difficult using a standard
m odel o f coop eration , the priso n ers’ dilem m a. T h ird, we exam ine how the
W TO helps governments enforce the agreements they reach.
THE ECONOMIC CASE FOR TRADE
Why should countries trade? The stan dard answ er is that countries should
trade because trade m akes them better off. G rasping why, exactly, trade m akes
societies better off, however, can be tricky. A s the prom inent econom ist Paul
Krugm an has argued, even many scholars and journalists who spend their lives
writing about the global economy don’t fully understand why trade m akes soci­
eties better o ff (Krugman 1997, 117-125). Because understanding the rationale
for trade is central to understanding the global economy but can be difficult to
grasp, we develop the logic o f com parative advantage in some detail.
We begin by establishing a few core concepts. The first is the production
possibility frontier (PPF). Countries are endowed with factors o f production in
finite am ou n ts. C on sequen tly, any d ecision to use facto rs to pro du ce one
good necessarily m eans that these factors are not available to produce other
good s. A decision to allocate capital and labor to the production o f com pu t­
ers, for exam ple, necessarily requires the country to forgo the production o f
som e number o f shirts. These forgone shirts are w hat econom ists call o p p o r­
tunity costs, and the production possibility frontier allow s us to measure these
opportunity costs quite precisely.
C o n sid e r
U nited
to p ro d u c e
a llo t
'(tsil.
The Economic Case for Trade
/ 47
10 O million com puters (point A in Figure 3.1) and if it allocates all labor and
capital to shirts, it can produce 300 million shirts (point B in Figure 3.1). If we
connect A and B with a line, we have defined a production possibility frontier
for the United States. Along it lie all combinations o f shirts and computers that
the United States can produce using all o f its factors o f production. As we move
from A to B, capital and labor are reallocated away from computer production
to shirt production. The slope o f the line, called the m arginal rate o f transfor­
mation, tells us exactly how many shirts the United States forgoes for each com­
puter it produces. In this exam ple, every com puter the United States produces
costs three shirts. Because an autarkic country cannot consum e more than it
produces, the PPF also defines the limits of possible consumption.
We can draw the PPF either as a straight line, as in our exam ple, or as a
curved line. W hich we select depends upon the assu m p tion we m ake about
the nature o f the opportunity costs that the United States faces. A straight PPF
em bodies the assum ption that the United States faces con stan t opportunity
costs. Every additional com puter alw ays costs 3 shirts. If we assum e constant
opportunity costs, we also implicitly assum e that the United States enjoys con­
stant returns to scale in production. T h is m eans that w henever the factors
employed in shirt production are increased by som e facto r, we will increase
the amount o f shirts produced by the sam e factor. D ouble the am ount o f labor
and capital employed in shirt production and double the number o f shirts pro­
duced. Alternatively, we could assum e that the United States faces increasing
opportunity costs and connect points A and B with a curved line that bends
out away from the origin. The shift from producing 4 9 ,9 9 9 ,9 9 9 computers to
50 million com puters costs 3 shirts. Yet, when the United States m oves from
producing 89,9 9 9 ,9 9 9 to 90 million com puters, it costs 7 shirts. Thus, the op­
portunity cost o f producing each go o d rises as the United States dedicates a
larger share o f its factors to the production o f a single good. If we assume the
United States faces increasing opportunity costs, we are also implicitly assum ­
ing that factors yield diminishing m arginal returns. This m eans that the num­
ber o f additional com puters the United States can produce for each additional
w orker employed in com puter production will fall as the num ber o f workers
employed in com puter production rises. M o st contem porary m odels assume
that factors yield diminishing m arginal returns. T o keep things simple, we will
assume constant m arginal returns.
O ur second core concept, consum ption indifference curves, helps us under­
stand the specific com bination o f com puters and shirts Am erican consumers
will purchase. Consum ers will acquire shirts and com puters in the com bina­
tion that m axim izes their collective utility. Econom ists conceptualize consumer
utility with indifference curves. We assum e that consum ers prefer more to less,
and therefore consum er utility increases as we m ove aw ay from the origin.
Some com binations o f shirts and com puters, such a s those at points a , b, and
c on Figure 3.1, yield the sam e am ount o f utility. If asked to choose between
these three, our consumer will say, “ I like them all the sam e.” If we connect ev­
ery com bination o f shirts and com puters that provides our consumer with the
same amount o f utility with a curved line such as Ua, we have drawn an indif­
ference curve. Our consumer enjoys identical utility from every combination o f
48
1
chapter
3
The Political Economy of International Trade Cooperate
shirts and computers that falls on Ua. We can draw a second indifference curve
that links the com binations d, e, and f. Each o f these com binations yield more
utility than a, b, or c, and are thus said to lie on a higher indifference curve.
But, our consum er is indifferent between d, e, and f. We can connect these
three com binations with a second indifference curve, Ub. Were we to repeat
this exercise for every possible com bination of shirts and consum ers within this
two-dimensional space, we would have a complete indifference m ap.
Three additional characteristics o f indifference curves are im portant. First,
indifference curves typically slope dow nw ards. This slope, called the m arginal
rate o f substitution, tells us how much o f one good the consum er is willing to
give up to acquire an additional unit o f the second good. Second, indifference
curves typically bend in tow ard the origin. This reflects the assum ption o f di­
minishing m arginal utility. The first com puter provides a large im provem ent
in utility. Each successive com puter, however, provides a sm aller increase of
utility. Consequently, even though the consum er m ight be w illing to give up
a large num ber o f shirts to acquire her first com puter, she will be w illing to
give up fewer shirts to acquire her sixth com puter. Finally, when we focus on
production and consum ption for an entire country, we construct com m unity
indifference curves rather than individual indifference curves. Com m unity in­
difference curves aggregate utility for all consum ers in that society. In this
exam ple, then, our com m unity indifference curves em body the aggregated
preferences of all American consum ers.
T ogeth er, the PPF an d indifference curves allo w us to define eq u ilib ­
rium production and consum ption o f shirts and com puters in this autarkic
A m erican econom y. P roduction and co n su m p tio n will occur at the po in t
where the m arginal rate o f transform ation (the slope o f the PPF) is equal to
the m arginal rate o f substitution (the slope of the indifference curve). T h at is,
production and consum ption will occur where the PPF and the indifference
curve are tangent. This is point e on Figure 3.1.
Why m ust production and consum ption occur only at this poin t? Su p ­
pose the United States initially produced and consum ed at G . Society can gain
greater utility than at G (consum ers can shift to a higher indifference curve)
by consum ing fewer shirts and more com puters. We w ould therefore expect
consum ers to dem and few er shirts and m ore com puters and we w ould e x ­
pect production to shift in response, producin g m ore com puters and fewer
shirts. Beyond e, consum ing additional com puters and fewer shirts decreases
consumer utility. Consequently, consum ers will begin to dem and m ore shirts
and fewer com puters. Only at e is it im possible to achieve higher utility from
a different com bin ation o f shirts and com puters. C on sum er utility is thus
maximized by producing and consum ing at e. Under autarky, therefore, equi­
librium production and consum ption in the United States equals 60 m illion
com puters and 120 million shirts.
T o see how trade changes this equilibrium , we m ust introduce a country
for the United States to trade with. We will assum e that the only other country
in the world is China. We construct China’s PPF just as we did for the United
States (see Figure 3.2). L e t’s suppose that if China dedicates all o f its labor
"
Shirts (millions)
The Economic Case for Trade
FIGURE 3.1
Shirts (millions)
U.S. Production Possibility Frontier
FIGURE 3.2
China's Production Possibility Frontier
49
50
CHAPTER 3
The Political Economy of International Trade Cooperation
and capital to com puters, it can produce 20 million com puters. If it dedicates
all o f its lab or and cap ital to shirt p ro d u ctio n , it can produce 4 0 0 m illion
shirts. Connecting these tw o poin ts yields C h in a’s PPF. Given our assu m p ­
tions, C h ina’s m arginal rate o f transform ation is 20: Every com puter China
produces carries o pportu n ity co sts o f 2 0 shirts. We then find the poin t o f
tangency between C hina’s consum er indifference curves and the PPF to iden­
tify equilibrium production and consum ption in an autarkic China. Based on
our assum ptions, equilibrium production and consum ption in autarkic China
yields 13 million com puters and 140 million shirts under autarky.
We can now see how trade between the United States and China affects
equilibrium production and consum ption in both countries (see Figure 3.3).
Trade changes equilibrium production by causing each country to specialize in
the production o f one good. The United States specializes in computer produc­
tion and stops producing shirts. China specializes in shirt production and stops
producing com puters. Specialization arises from the conclusions each draw s
from a simple price com parison. The United States acquires m ore shirts per
computer when it buys them from China than when it produces them at home.
A computer buys 20 shirts in China whereas at home it buys only 3 shirts. Why
should the United States produce shirts at home when it can acquire them for
substantially less in China? The United States thus stops producing shirts, p ro ­
duces only computers, and acquires the shirts it wants from China.
Sim ilarly, China acquires m ore com puters per shirt when it buys them
from the United States than when it produces them at hom e. China can ac­
quire a com puter from the United States for only 3 shirts whereas if it produces
com puters at home each com puter costs 20 shirts. Why should China produce
com puters when it can acquire them much less expensively from the United
States? China therefore stops producing com puters, specializes in shirts, and
acquires the com puters it w ants through trade with the United States. T rade
thus changes equilibrium production in both countries: the United States spe­
cializes in com puter production and China specializes in shirt production.
T o see how trade affects equilibrium consum ption in both countries, we
need to know the price at which the United States and China will exchange
shirts for com puters. We know that this price m ust fall som ewhere between
3 and 20 shirts per com puter. We could solve for the exact price th at will
arise, but w e’ll simply assum e that the two agree to trade at 6 shirts per com ­
puter. T his new price is depicted in Figure 3.3 as the dashed line labeled p t.
N ow we m ust find the com bination o f shirts and com puters that m axim izes
consum er w elfare in each country at this new price. T o do so , we find the
point of tangency between the new price line and our consum er indifference
curves. These points are labeled Cus and C c, respectively.
E quilibrium consum ption in both countries has thus expan ded beyond
w h at w as po ssib le under au tark y . A m erican co n su m p tio n e x p an d s from
60 million com puters and 120 million shirts under autarky to 75 million com ­
puters and 150 million shirts. Chinese consum ption expands from 13 million
com puters and 140 million shirts under autarky to 25 m illion com puters and
2 5 0 m illion shirts. At this new equilibrium , b o th countries consum e m ore
The Economic Case for Trade
51
I FIGURE 3.3
I
Equilibrium with Free Trade and Complete Specialization
shirts and com puters than they could under autarky. Consequently, consum ­
ers achieve greater utility, which is reflected in the move to higher indifference
curves (U 'vs and U 'c , respectively). T his add ition al consum er utility is the
gain from trade. Trade between the United States and China is thus beneficial
for both countries.
52
CHAPTER 3
The Political Economy of International Trade Cooperation
T his specific exam ple illu strates the b road er claim that every country
gains by specializing in g o o d s it produces relatively well and trad in g them
for the goods it produces relatively less well. This is the principle o f co m para­
tive advantage. These gains are not dependent upon having an absolute cost
advantage in a particular industry. The United States does not gain because it
produces com puters more cheaply than China. It gains because it can acquire
more shirts per com puter in China than it can at home. And these gains exist
even if shirts cost m ore to produce in China than in the United States. Thus,
even countries that produce every go od at a higher cost than all other coun­
tries gain from trade by specializing in the good s they produce best. This is the
logic of com parative advantage.
W hat determines which goods a particular country will produce relatively
well and which it will produce relatively less well? The H ecksher-O hlin (or
H-O) m odel, (named after the two Swedish econom ists, Eli Hecksher and Bertil Ohlin who developed it) provides the stan dard answ er. The H -O m odel
argues that com parative advantage arises from differences in factor endow ­
ments. Factors are the basic tools of production. When firm s produce good s,
they em ploy lab or and capital in order to transform raw m aterials into fin­
ished go o d s. L a b o r obviously refers to w orkers. C a p ita l en co m p asses the
entire physical plant that is used in production, including the buildings that
house factories and the machines on the assem bly lines inside these factories.
Countries possess these factors o f production in different am ounts. Some
countries, like the United States, have a lot o f capital but relatively little labor.
Other countries, such as China, have a lot o f labor but relatively little capital.
These different factor endow m ents in turn shape the co st o f production . A
country’s abundant factor will be cheaper to employ than its scarce factor. In
the United States and other advanced industrialized countries, capital is rela­
tively cheap and labor is relatively expensive. In developing countries, labor is
relatively cheap and capital is relatively expensive.
Because countries have different facto r endow m ents and face different
factor prices, countries will hold a com parative advantage in different goods.
A country will have a com parative advantage in goods produced using a lot of
their abundant factor and a com parative disadvantage in go od s produced us­
ing a lot of their scarce factor. In the auto industry, for exam ple, paym ents to
labor account for between 25 and 30 percent o f the total cost o f production.
The much larger share o f the costs o f production arise from capital expendi­
tures, that is, expenditures on the m achines, assem bly lines, and buildings re­
quired to build cars (Dicken 1998). In contrast, in the apparel industry wages
paid to w orkers account for the largest share o f production co sts, w hereas
capital expenditures account for a much sm aller share o f the costs o f produc­
tion. It follow s that countries like the United States and Ja p a n with a lot o f
capital and little labor will have a com parative advantage in producing cars
and a com parative d isad van tage in produ cin g clothing. By the sam e logic,
developing countries with a lot o f lab or and little cap ital will have a co m ­
parative advantage in producing clothing and a com parative disadvantage in
producing cars.
Trade Bargaining
53
T hus, in our exam ple, the United States has a com parative advantage in
com puters and not in shirts because the United States is abundantly endowed
with physical and hum an cap ital and poorly endow ed w ith low -skill labor.
China has a com parative advantage in shirts and not in com puters because
China is abundantly endow ed with lab or and poorly endow ed with hum an
and physical capital. Com parative advantage tells us, therefore, that all coun­
tries gain from trade by specializing in the goods that rely heavily on the fac­
tors o f production th at they hold in abundance and exch an gin g them for
good s that m ake intensive use o f the factors o f production that are scarce in
their economy.
TRADE BARGAINING
Although trade liberalization raises the standard o f living, governm ents don’t
often liberalize trade unilaterally. Instead, governments strive to open foreign
m arkets to the exports o f competitive domestic industries and continue to pro­
tect less competitive industries from im ports. As a result, trade liberalization
generally occurs through trade bargaining in which governm ents exchange
m arket access commitments.
We can model trade bargaining using basic spatial theory. T o keep things
concrete, we will m odel the central bargaining problem in the D oh a R ound.
We begin by defining the bargaining space. The tw o issues at the center of the
D oha Round are the reduction o f barriers to trade in agriculture products that
governm ents in the advanced industrialized countries im pose and the reduc­
tion o f barriers to trade in m anufactured good s that governm ents in devel­
oping countries im pose. We can depict each o f these as a policy dim ension
(see Figure 3.4a). The horizontal axis depicts all possible levels o f agriculture
protection in the advanced industrialized countries. Protection o f agriculture
is zero at the origin and barriers to trade rise as we move out tow ard the right.
The vertical axis captures all possible levels o f protection o f m anufactured
good s in developing countries. Again, protection is zero at the origin and in­
creases as we move up from the origin. Each point within the two-dimensional
bargaining space represents a com bination o f trade barriers in industrialized
country agriculture and developing country manufactured goods.
We can locate the current levels o f protection, the status quo, in this bar­
gaining space. The status quo is characterized by a fairly high level o f protec­
tion in both sectors. The United States, the EU, and Jap an excluded agriculture
from m ultilateral trade negotiations until quite recently. Consequently, trade
barriers in this sector remain quite high. Similarly, developing country govern­
m ents did not participate m uch in bargaining roun ds p rio r to the U ruguay
R ound. As a result, they retain high tariffs on manufactured goods. Hence, the
status quo, labeled SQ in Figure 3.4a, falls in the northeast q u ad ran t o f the
bargaining space.
In o ur n ext step we lo cate governm ent ideal poin ts in the bargain in g
space. An actor’s ideal point is its best possible outcom e, in this instance the
Group of 20
SQ
0
j* .
◄ -------------------------------•
Unilateral US/EU
Agriculture Liberalization
>
<0
TJ
O
O
a
o
C\]
6
US/EU
US/EU Market for Agriculture
(a)
(b)
FIG UR E 3.4
Tariff Bargaining in
the Doha Round
Trade Bargaining
55
specific com bin ation o f barriers to trade in agriculture an d m anufactured
good s that each actor prefers to all other com binations. R ather than depict
ideal points for each o f the 153 W TO m em bers, we focus on tw o coalitions
at the center o f bargaining, the United States/EU an d the G roup o f 20. We
locate these ideal poin ts using a sim ple rule— governm ents liberalize com ­
paratively advantaged sectors and protect disadvantaged sectors. The United
States/EU is relatively poorly endow ed with land and relatively abundantly
endow ed with capital. The ideal outcom e from their perspective is a sharp
reduction o f tariffs on G -20 go od s m arkets and continued protection o f their
agriculture sector. Their ideal point therefore lies in the sou th east quadrant
o f the b argain in g sp ace. G overnm ents in the G ro u p o f 2 0 are abundantly
endowed with land and poorly endow ed with capital. The ideal outcom e for
these governm ents com bines low barriers on agricultural m arkets in the EU
and the United States with high barriers on their g o o d s m arkets. The ideal
point for the G roup o f 20 thus lies in the northwest quadrant o f the bargain­
ing space.
N otice that given these ideal points and the status quo, neither group can
improve its utility relative to the status quo from unilateral liberalization. A s­
sume that utility for each actor is a linear function o f distance; that is, utility
decreases a s we move aw ay from the ideal points in any direction. Unilateral
reduction o f protectionist barriers on United States/EU agriculture shifts the
outcom e from SQ tow ard the left along a line parallel to the horizontal axis.
Every point on this line is further from the United States/EU ideal point than
SQ and thus offers less utility than the SQ . Similarly, any unilateral reduction
o f tariffs on m anufactured g o o d s shifts the SQ dow n along a line parallel to
the vertical axis (not drawn). Every point on this line is further from the G-20
ideal point than SQ . Hence, neither group can realize higher utility by engag­
ing in unilateral liberalization.
W hat neither is willing to do unilaterally, both are w illing to do through
international bargaining. T o see why, we m ust first identify all outcom es that
each group prefers to the status quo. We can see these outcom es by draw ing
circular indifference curves centered upon each g ro u p ’s ideal poin t w ith a
radius equal to the distance between this ideal point and the status quo (see
Figure 3 .4 b ). Each gro u p prefers all outcom es interior to this indifference
curve to the statu s quo. The com binations within the “ len s” created by the
intersection o f the two indifference curves are thus outcom es that the G -20
and the United States/EU both prefer to the status quo. And in the v ast m a­
jority o f these outcom es, each grou p h as liberalized the sector it w ishes to
protect quite substantially. International bargaining, therefore, enables gov­
ernments to liberalize dom estic sectors that they are unw illing to liberalize
unilaterally.
The selection o f one outcom e from all o f those that offer joint gains car­
ries distributional consequences. Som e agreements benefit the United States/
EU more than the G -20, and som e agreements benefit the G -20 more than the
United States/EU . We can see this by draw ing a series o f indifference curves
for each group (see Figure 3.4c). We then connect all o f the points a t which
56
CHAPTER 3
The Political Economy of International Trade Cooperation
the United States/EU and G roup o f 20 indifference curves are tangent to one
another. The result is a contract curve— the set o f m utually-beneficial agree­
ments that exh aust available join t gains. We assum e that governm ents will
select an agreem ent from th at set. N o w , each agreem ent on this co n tract
curve carries a different distribution of the joint gains. If the G roup o f 20 and
the United States/EU select the outcom e represented by m they divide avail­
able joint gains evenly. If they select an outcom e between m and e the United
States/EU realizes larger gain s than the G roup o f 2 0 . If instead they choose
an outcom e between m and g the G roup o f 20 realizes larger gains than the
United States/EU. Hence, governm ents are not just realizing joint gains, they
are also deciding how to distribute these gains between them.
Bargaining pow er determines which distribution of gains governments ul­
timately select. Although we often think o f pow er as brute force, bargaining
power derives from an array o f much subtler characteristics such as patience
and outside options. Patience refers to the fact that both parties to the nego­
tiation w ould prefer to settle today rather than tom orrow . Because each side
gains from agreem ent, delaying agreem ent sacrifices utility for both. But if
one government is more patient than another, it can use its willingness to w ait
to insist on an outcom e closer to its ideal point, and thereby capture m ore o f
the joint gains for itself. A governm ent m ay be less patient, and thus willing
to concede som e o f the surplus to other governm ent in exchange for a quick
deal, if it is relatively poor (since economic gains have greater m arginal utility
for poorer states), or if it has a low tolerance for risking a breakdow n in ne­
gotiations. Patience seems to be an im portant element o f bargaining pow er in
the D oha Round (see A Closer Look: Distributive Bargaining and the Geneva
Mini-Ministerial).
A CLOSER LOOK
Distributive Bargaining and the Geneva
Mini-Ministerial
Doha Round negotiations collapsed (again) at the end of July, 2008. After reaching
agreement on multiple issues during a "mini-Ministerial" in Geneva, India, China,
and the United States failed to bridge their differences on a rather obscure special
safeguard mechanism (SSM). The SSM would allow developing countries to
raise tariffs (temporarily) to protect local farmers from import surges. India and
China demanded SSM rules that would make it relatively easy to protect farmers,
whereas the United States insisted on rules that made it more difficult to do so.
Unable to find rules that satisfied both, trade ministers abandoned the negotiations.
Major media outlets across the world pronounced the Doha Round dead, while
some even speculated that the WTO itself was doomed.
Although it is tempting to conclude from the collapse that the Doha Round is in
peril, one might also suggest, less obviously, that the collapse brings governments
57
Trade Bargaining
one step closer to agreement. To understand this apparent paradox we need
to think about bargaining strategy. The best deal for each government is the
, ,, . .
one that combines maximum concessions Trom other members In exchangejfqr,,_
minimal concessions. Group of Twenty (G2Q) governments want large reductions, in American and European agricultural protection in exchange for minimal --. - j
liberalization of their manufacturing and service sectors. American and European
governments seek the opposite— maximum 620 cuts in manufacturing and services
in exchange for minimal cuts in farm tariffs and subsidies. In bargaining, therefore/
governments are tussling over the distribution of the availabie jqjM^gains,and the .
agreement best for a G20 government is necessary less g o p ^ r. the jolted; States
and the European Union (EU).
-
*v* *
''sf4'
,
,■
Each government's ability to negotiatethe best possibledeal fqfita;ff js5 A*./*'
complicated by private information. -.620;governmentsifenot^kft^lhaw^nSyi' r
American and European governments are willing to reduce farm tariffs and
subsidies. Nor do they know how much they must after jfi.excftlnge^tor,such,* j.
liberalization. Each government holds thesttcritfcqf^feeqsof
„
its negotiating position privately, and Has no Incentive fq reveal them t6”ettejhs.*tf
American negotiators tdl the 620 the maximum cuts in farm tariffsjm^Sul^idleS
the United States wilt make, then 620 governments will accept noting"lesi'ff th e >
United States tells 620 governments thefnlhlmaf amotint'flf
liberalization it expects, G20 governments will offer only this minimal amount.
Revealing private information about their negotiating positions thus co n d em n s:
governments to their worst possible deal— minimal gains and maximal concessions.
Negotiating the best deal possible thus requires governments to force eagh V other to reveal Information they do not wish to reveal. This is exactly thq situation.
governments faced in Geneva in July, 2008. Trade'ministers head negotiated-for,'1 nine days. By Tuesday, they had reached.the point at which eact) government,had
decide whether the resulting package was the best deal it couW.ggt, Cf)in|t
Irufia .
had to decide whether the United States and ,the Ell had-macfe' ^elr.maximqm,';\lf, . :
concessions. Yet, they knew that asking for additional concessions was pointless^,
they had been asking for nine days, and asking for more now wbuld .simply el|pt a
quick "no, this is my best offer." China and India could learn If, in fact, tije fffejr- r
on the table was the best offer only by walking away from the negotiations.
Walking away from the table served a strategic purpose. Walking away cqnstitpted
a "costly signal": it transformed cheap talk (can we tave additional concessions) into
costly action (we'll forgo this agreement now to get additional concessions). This.
costly action, which demonstrates that India and China are not impatient, makes "
American policymakers more likely to believe that additional concessions are - ’
necessary to get a deal. Walking away also
the t
A
i
t
' ~
~
e
d
.*
denying it an agreement it wants. By walking away, therefore, India and Chjn^are. . trying to gain information about the U .S. bargaining position. If the United States'
..
offers additional concessions, India and China get a better deal and their^ airj^ ji^ ';,,
paid off. But even if the United States fails to offer additional concessions, China.gqd .
58
CHAPTER 3
The Political Economy of International Trade Cooperation
India stiil gain valuable information that the United States has offered all that it will
offer. They can then accept the deal On the table.
The collapse of negotiations thus might bring governments one step closer to
agreement by revealing information about each government's negotiating position.
The better information enables governments to believe they have achieved the best
deal possible. Of course, the collapse might also indicate that the Doha Round is
dead. The problem, of course, is that we cannot know which of these is correct. To
know which is correct we need private information about government negotiating
positions that we cannot get. Thus, although we cannot know whether the collapse
does, in fact, bring governments closer to agreement, we should not be surprised if
governments conclude a deal not fundamentally different from the one India and
China walked away from in July of 2008. ■
If governments are equally patient, one government m ay gain bargaining
power if it has an attractive outside option. An outside option is a government’s
next-best alternative to agreement. For exam ple, if the EU can strike a sim ilar
bargain with the United States, then it has little need to m ake large concessions
to the G roup of 20; it can leverage its potential deal with the United States to
extract concessions from the Groups of 20. If the Group of 20 knows this, it will
be willing to allow the EU to capture a larger share of the gains than it would if
the outside option o f a deal with the United States did not exist. Somewhat para­
doxically, therefore, giving one side a good reason to not reach agreement often
enables governments to find com m on ground. The U.S. strategy o f negotiating
regional trade agreements, for exam ple, might be an attem pt to demonstrate an
outside option in order to gain greater power within W TO negotiations.
In short, governm ents liberalize trade via trade agreem ents because they
are unwilling to liberalize unilaterally. Given their focus on export expansion,
trade negotiations enable governm ents to exchange m arket access com m it­
ments. A lthough the resulting trade agreem ents yield benefits to all parties,
they also carry d istributional consequences. Som e governm ents will realize
sm aller gains in m arket access opportunities in exchange for larger conces­
sions o f their ow n. T hese d istribution al consequences reflect differences in
bargaining power. Governments that are m ost willing to w ait, that are willing
to risk a breakdow n of negotiations, and that have outside options are likely
to capture a larger share of the available gains from agreement.
ENFORCING AGREEMENTS
The ability of governments to conclude trade agreements is additionally frus­
trated by the second intervention o f politics: the enforcem ent problem . The
enforcem ent problem refers to the fact that governm ents cannot be certain
that other governments will com ply with the trade agreem ents that they con­
clude (Conybeare 1984; Keohane 1984; Oye 1986). As a result, governments
will be reluctant to enter into trade agreements, even when they recognize that
>_
Enforcing Agreements
59
United States
Liberalize
Protect
Liberalize
L,L
1
L,P
II
Protect
P,L
IV
P,P
III
China
Preference Orders:
China: P,L > L,L > P,P > L,P
United States: L,P > L,L > P,P > P,L
I FIGURE 3.5
I
The Prisoner's Dilemma and Trade Liberalization
they w ould benefit from doing so. Even though this m ight seem counterintui­
tive, we can use a simple gam e theory m odel, called the prisoners’ dilemma, to
see how the enforcement problem can frustrate the efforts o f governments to
conclude mutually beneficial trade agreements.
Suppose that the G roup o f 20 and the EU m anage to identify an outcome
that each prefer to the status quo. In the absence o f a m echanism to enforce
the agreement, w ould they be able to conclude the agreement? The prisoners’
dilemma tells us that they will be unable to do so. In the prisoners’ dilemma,
the G roup o f 20 and the EU each have tw o strategy choices: Each can open
its m arket to the other’s exports, which we will call liberalize, or each can use
tariffs to keep the other’s products out o f its dom estic m arket, which we will
call protect. T w o governm ents with two strategy choices each generates the
two-by-two m atrix depicted in Figure 3.5.
Each cell in this m atrix corresponds to a strategy com bination, and these
strategy com binations produce outcom es. We can describe these outcom es
starting in the top left cell and m oving clockw ise. O ne w ord about the n o ta­
tion we use before we proceed. It is conventional to list the strategy choice o f
the row player (the player who selects its strategy from the row s of the matrix)
first and the strategy choice o f the colum n player (the player who selects its
strategy from the columns o f the m atrix) second. T hus, the strategy com bina­
tion referred to a s “ liberalizefprotect” m eans th at the row player, which in
this case is G roup o f 2 0 , has played the strategy liberalize and the colum n
player, which is the EU, has played the strategy protect.
We can now describe the four outcom es.
■ Liberalize/Liberalize: Both eliminate tariffs. G roup o f 20 exports agri­
cultural products to the EU, and the EU exports m anufactured goods to
G roup o f 20 countries.
■ Liberalize/Protect: The G roup o f 20 eliminates tariffs, but the EU does
not. The EU thus exports goods to the G roup o f 20 , but the G roup of 20
cannot export farm goods to the EU.
60
CHAPTER 3
The Political Economy of International Trade Cooperation
■ Protect/Protect: Both retain their tariffs. N o trade takes place.
■ Protect/Liberalize: The EU eliminates tariffs, and the G roup o f 20 does
not. The G roup of 20 exports farm goods to the EU, but the EU cannot
export manufactured goods to the G roup o f 20.
N o w we m ust determ ine how each governm ent ran k s these fou r o u t­
com es. H ow much utility do they realize from each outcom e? The G roup o f
20 ranks them in the following order:
protect/liberalize > liberalize/liberalize > protect/protect > liberalize/protect
where the “ greater than” sign means “ is preferred to .” It is not hard to justify
this ranking.
■ The G roup o f 20 gains the m ost utility from protect/liberalize. Here
the G roup of 20 exports to the EU and protects its producers from
EU competition.
■ The G roup o f 20 gains less utility from liberalize/liberalize than from
protect/liberalize. Here the G roup o f 20 can export to the EU, but m ust
open its m arket to EU imports.
■ The G roup of 20 gains still less utility from protect/protect than from
liberalize/liberalize. Here the G roup o f 20 protects its dom estic m arket,
but cannot export to the EU.
■ The G roup o f 20 gains less utility from liberalize/protect than from
protect/protect. Here the G roup o f 20 opens its m arket to the EU but
does not get access to the EU market.
In other w ords, the G roup o f 2 0 ’s m ost preferred outcom e is unrecipro­
cated access to the EU m arket. Its second-best outcom e is reciprocal tariff re­
ductions, which is in turn better than reciprocal protection. The G roup o f 2 0 ’s
w orst outcome is a unilateral tariff reduction.
The prisoners’ dilemma is a symmetric gam e. T his m eans that the EU faces
the exact sam e situation as the G roup o f 2 0 . Consequently, the E U ’s p ay o ff
order is identical to the G roup of 2 0 ’s payoff order. The only difference arises
from the notation we use. Like the G roup o f 2 0 , the EU ’s m ost preferred out­
come is unreciprocated access to the other’s m arket, but for the EU this is the
outcom e liberalize/protect. A lso like the G roup o f 2 0 , the EU ’s least preferred
outcom e is granting the other unreciprocated access to its m arket, which for
the EU is the outcom e protect/liberalize. T hus, the EU ’s payoff order is identi­
cal to the the G roup o f 2 0 ’s p a y o ff order, but the po sition o f the m ost and
least preferred outcom es are reversed:
liberalize/protect > liberalize/liberalize > protect/protect > protect/liberalize
We can now see how the G roup o f 20 and the EU will play this gam e and
what outcome will result. The G roup o f 20 and the EU both have a dom inant
strategy— a single strategy that alw ays returns a higher p ay o ff than all other
strategy choices. Protect is this dom inant strategy. Protect dom inates liberal­
ize as a strategy choice because each governm ent will alw ays realize higher
utility by playing protect than by playing liberalize.
Enforcing Agreements
61
We can see why protect is a dom inant strategy by w o rk in g through the
G roup o f 2 0 ’s best responses to the EU ’s strategy choices. Sup pose the EU
plays the strategy liberalize. If the G roup o f 20 plays liberalize in response, the
G roup o f 20 receives its second m ost preferred outcom e (liberalize/liberalize).
If the G roup o f 20 plays protect in response, the G ro u p o f 2 0 receives its
m ost preferred outcom e (protect/liberalize). T hus, if the EU plays liberalize,
the G roup o f 2 0 ’s best response— the strategy that returns the highest utility—
is protect.
N ow suppose the EU plays protect. If the G roup o f 2 0 responds with lib­
eralize, it receives its least preferred outcom e (liberalize/protect). If the Group
o f 20 responds with protect, how ever, it receives its secon d least preferred
outcom e (protect/protect). T hus, if the EU plays p rotect, the G roup o f 2 0 ’s
best response is to play protect.
Protect, therefore, “ d om in ates” liberalize as a strategy choice— that is,
protect yields m ore utility for the G roup o f 20 than liberalize regardless of
the strategy that the EU plays. Because the prison ers’ dilem m a is symmetric,
protect is also the E U ’s dom inant strategy. Because both governm ents have
dom inant strategies to p lay protect, the gam e alw ays yields the sam e o u t­
come: The G roup o f 2 0 and the EU both play p rotect an d the gam e ends at
the protect/protect outcom e. Governm ents in both grou ps retain tariffs and
no trade occurs.
This outcom e has tw o im portan t characteristics. F irst, it is Pareto suboptim al. Pareto optim ality is a w ay to conceptualize social w elfare. An out­
come is Pareto optim al when no single actor can be m ade better o ff without
at the same time m aking another actor w orse off. Pareto suboptim al refers to
outcom es in which it is possible for at least one actor to im prove its position
without any other actor being m ade worse off. In the prison ers’ dilemma the
protect/protect outcome is Pareto suboptim al because both governments real­
ize higher payoffs at liberalize/liberalize than at protect/protect. Thus, rational
behavior on the part o f each individual government, each playing its dominant
strategy protect, produces a suboptim al collective outcom e. The G roup o f 20
and the EU are both poorer than they would be if they liberalized trade.
Second, the protect/protect outcome is a N ash equilibrium . A N ash equi­
librium is an outcom e a t w hich neither player h a s an incentive to change
strategies unilaterally. If the G roup o f 20 changes its strategy from protect
to liberalize, the outcom e shifts to liberalize/protect, the G roup o f 2 0 ’s least
preferred outcome. Thus, the Group o f 20 has no incentive to change its strat­
egy unilaterally. If the EU changes its strategy from p rotect to liberalize, the
outcom e moves to protect/liberalize, the E U ’s least preferred outcom e. Thus,
the EU has no incentive to change its strategy u n ilaterally either. Putting
these two points together reveals the prisoners’ dilem m a’s central conclusion:
Even though the G roup o f 20 and the EU w ould both gain from reciprocal
ta riff reductions, neither has an incentive to reduce ta riffs. M ore broadly,
the prison ers’ dilem m a suggests that even when all countries w ould clearly
benefit from trade liberalization , political dynam ics trap governm ents in a
protectionist world.
62
CHAPTER 3
The Political Economy of International Trade Cooperation
Governments are unable to conclude agreem ents that m ake them all bet­
ter o ff because each fears getting the “ sucker p a y o ff.” If the G ro u p o f 20
and the EU agree to liberalize trade and then the G roup o f 20 com plies with
this agreem ent but the EU does not, the EU has exploited the G roup o f 2 0 .
The G roup o f 20 su ffers the “ c o sts” o f risin g im p orts w ith out getting the
“ benefit” o f increased exports. The gains from trade liberalization could be
achieved, o f course, if governm ents could enforce international trade agree­
m ents. G overnm ents could agree in advance to play strategies if they were
confident that cheating w ould be caught and punished. M oreover, because
cheating w ould be punished, both w ould com ply with the agreement. The in­
ternational system provides no enforcem ent m echanism , however. D om estic
political systems rely upon the police and the judicial system to enforce law s,
but the international system does not have an authoritative and effective judi­
cial system. Instead, the international system is anarchic; that is, it is a politi­
cal system without an overarching political authority capable o f enforcing the
rules o f the game.
A lthough the p riso n ers’ dilem m a is pessim istic a b o u t the p ro sp ect for
international trade coop eration , coop eration in a p rison ers’ dilem m a is not
im possible. Cooperation can emerge if three specific conditions are met. First,
cooperation can emerge in an iterated prison ers’ dilem m a, that is, in a gam e
played repeatedly by the sam e governm ents (see T ay lor 1976; A xelrod 1984;
Keohane 1984; Oye 1986). Iteration changes the nature o f the rew ard struc­
ture that governm ents face. In a one-shot play o f the p riso n ers’ dilem m a,
countries m ake a one-time choice and receive a one-tim e p ay off. In an iter­
ated gam e, however, governments m ake repeated choices and receive a stream
o f pay offs over time. A ssum ing that the tw o other necessary conditions are
met, governments will prefer the stream o f paym ents they receive from co o p ­
erating over time to the p ay o ff they receive from cheating on an agreem ent.
Iterating the gam e can therefore m ake it rational for a governm ent to play the
liberalize strategy.
Seco n d , go vern m en ts m u st use rec ip ro city stra te g ie s to en force the
liberalize/liberalize outcom e. A lthough m any reciprocity strategies exist, the
m ost well known is called tit-for-tat (A xelrod 1984). In tit-for-tat, each gov­
ernm ent plays the strategy that its partner played in the previous roun d o f
the game. T rade liberalization by one government in one round o f play is met
by trade liberalization from the other governm ent in the next round. Should
one government play protect in one round (that is, cheat on an existing trade
agreement), the other government m ust play protect in the next round o f play.
Playing such tit-for-tat strategies allow s governments to rew ard each other for
cooperation and punish each other for cheating.
Finally, governments must care about the payoffs they will receive in future
rounds o f the gam e. If governments fully discount future payoffs, the iterated
game essentially reverts back to a single play o f the prisoners’ dilemma; when it
does, the threat of punishment in the next round o f play can hardly be expected
to prom ote cooperation in this round. But if governments care about the future
and if they use a reciprocity strategy such as tit-for-tat, then cooperation in an
>
y
Enforcing Agreements
63
iterated prisoners’ dilemma becom es rational; each governm ent can realize a
larger stream o f payoffs by cooperating than it can realize by defecting.
T he W TO provides the first two o f these three necessary conditions. The
W TO helps iterate the gam e by creating expectations o f repeated interaction.
M em bership in the W TO has been relatively stable. The num ber o f countries
that belong to the W TO has increased over time, and very few countries have
left the organization after joining. As a consequence, W T O m em bers know
that the governments with which they negotiate today will be the governments
with which they negotiate tom orrow , next year, and on into the future. In
addition, W TO members interact regularly within the organization. G overn­
m ents have already concluded eight form al bargaining roun ds and are now
engaged in the ninth such round. In addition to these form al rounds o f nego­
tiation s, the W T O draw s governm ents together fo r annual and sem iannual
reviews o f national trade policies. By bringing the sam e set o f governm ents
together in a regularized pattern o f interaction, the W TO iterates intergovern­
mental trade interactions.
The W TO also provides the inform ation that governm ents need in order
to use reciprocity strategies. In order to use a tit-for-tat strategy effectively,
governments m ust know when their partners are com plying with trade agree­
m ents and when they are cheating. The W TO m akes this easier by collect­
ing and dissem inating inform ation on its m em bers’ trade policies. M oreover,
W TO rules provide clear standards against which governm ents’ trade policies
can be evaluated. The W T O ’s m ost-favored nation clause, for exam ple, p ro ­
hibits discrim inatory practices except under a set o f well-defined exceptions.
T o give another exam ple, the W T O ’s rules governing dom estic safeguards de­
fine the conditions that m ust be met in order for governm ents to tem porarily
opt out o f commitments. These detailed rules increase transparency. T ra n s­
parency m eans that it is easier for governm ents to determine whether a sp e­
cific trade measure adopted by a particular government is or is not consistent
with W TO rules. The high-quality inform ation and the transparency provided
by the W TO allow governments to m onitor the behavior o f other W TO m em ­
bers. T his in turn makes it easier for governments to use reciprocity strategies
to enforce trade agreements.
The ability o f governments to use the W TO to enforce trade agreem ents is
m ost clearly evident in the W T O ’s dispute settlement mechanism. The dispute
settlement mechanism follow s a standard procedure that w as agreed to by all
m embers o f the W TO during the U ruguay Round. (See Figure 3.6.) A dispute
is initiated when a governm ent brings an alleged violation o f W T O rules to
the W T O D ispute Settlement Body (D SB, consisting o f all W T O m em bers).
The D SB initially encourages the governm ents involved in the dispute to try
to resolve the conflict through direct consultations. If such consultations are
unsuccessful, the DSB creates a form al panel to investigate the com plaint.
T h is panel is typically com posed of three experts in trade law who are
selected by the DSB in consultation with the governments involved in the dis­
pute. T he panel reviews the evidence in the case, m eets w ith the parties to
the dispute and outside experts if necessary, and prepares a final report that
Consultations'
(Aft. 4 )--------
60 days
During all stages
by 2nd DSB
meeting
good offices, conciliation,
Of mecHationt(Art.'5) v I
Panel established
by Dispute Settlem ent Body (DSB)(Art. 6)
Terms of. reference (A |t7) , ., ,
Compo8ltlon(Art, 8)
0-20 days
20 days
(+10 if
DirectorGeneral
asked to
pick panel)
Panel examination
' Expert review
--g ro u p >
-
1 meeting with third parties (A rt ,1 0 ),
T
(A it 13; Appendix 4)
'
Interim review s t a j^ ; * .'^ ’';
NOTE: a panel
can be
"composed”
(i.e., panelists
chosen) up to
about 30 days
after its
"establishment”
(i.e., after
DSB’s
decision to
have a
panel)
-With panel
parties for comment (Art. 15.1)
Interim report sent to parties for comment
(Art. 15.2)
6 months
from panel’s
composition,
3 months
if urgent
►... 30 days for
appellate report
Panel report issued to parties;
(Art. 12.8; Appendix 3 p a r.1 2 (j))
up to 9 months
from panel’s
establishment
upon request
(Art. 15.2)
Panel report issued to DSS • ' '
(Art. 12.9; Appendix 3 par. 12(k)) ■ •
Appellate review
(Art. 16.4 and 17)
60 days for DSB adopts panel/appellste report(s)j,
panel report
including any changed te fjahsi report
unless
made by ap pellate report‘(Art. 16:1)18.4,
appealed ...
and 17.14)
~
~
“REASONABLE
PERIOD
OF TIME” :
*
♦
Im plem entationi->- *
Report by losing party of proposed
determined by: implementation within ‘ reasonable period of
time" (Art; 21.3)
member
proposes,
DSB agrees;
or parties
in dispute
agree; or
arbitrator
(approx. 15
months if by
arbitrator)
In cases of nonlmplementatlon,
. Dispute over
implementation
; Retaliation
r ~ f.
30 days
after
Cross retaliation:
“reasonable
period” same sector, other sectors, other, agreements
(A rt!2 2 .3) ' ‘ ' ** * • ”
expires
FIGURE 3.6
The Dispute Settlement Mechanism
Usually up to
9 months (no
appeal) or 12
months (with
appeal) from
establishment
of panel to
adoption of
report (Art. 20)
Proceedings possible,
’ including referral
to initial panel on
implementation
'(A rt.t 2 f.5 )‘ ' ' * 90 days
parties negotiate cornpensatloopending
full implementation (Art. 2 2 .2 )'' * '
if no agreement on compensation, DSB
authonzes retaliation pending full
implementation (Art. 22)
max. 90 days
TOTAL FOR
REPORT
ADOPTION:
- Possibility of
■ .arbitration
on level of suspension,
’ ’ procedures, and
principles of
refutation
(A rt 22.6 and 22.7)
Enforcing Agreements
65
it subm its to the D SB. The D SB m ust accept the pan el’s final report unless
all W TO m em bers, including the governm ent that initially brought the com ­
plaint, vote against its adoption.
Both governm ents can ap p eal the p an e l’s decision . If an ap p eal is re­
quested, the D SB creates an appellate body com posed o f three to five people
draw n from a list o f seven permanent members. The appellate body can up­
hold, reverse, or m odify the panel’s findings, conclusions, and recom m enda­
tions. The appellate report is given to the D SB for approval, and as with the
panel report, the D SB can reject the report only with the consent o f all m em ­
ber governments. If at the end o f this process it is determined that the disputed
trade m easure is inconsistent with W TO rules, the governm ent m ust alter its
policy to conform to the rule in question or com pensate the injured parties.
The entire dispute settlem ent process, from initiation to appellate report, is
supposed to take no longer than 15 months.
An ongoing dispute involving Am erican cotton subsidies illustrates how
governm ents use the dispute-settlem ent m echanism to enforce com pliance
with trade agreem ents (see Schnepf 2 010). The cotton subsidy case began in
2 0 02. The Brazilian government com plained to the W T O that subsidies paid
by the U .S. government to American cotton farm ers provided an advantage in
global m arkets that harm ed Brazil’s cotton grow ers and violated W TO rules.
The Bush adm inistration defended the m easures on the grounds that the sub­
sidies represented a “ safety net” that protected American cotton grow ers from
volatile global com m odity m arkets. Because the tw o governm ents could not
settle the dispute through initial discussions, the W TO established a panel in
early 2003.
The panel found that Am erican subsidies violated several W T O rules. In
particular, the panel ruled that the American cotton policy constituted an ex­
port subsidy and dom estic production support that harm ed Brazilian cotton
grow ers. A lthough the United States appealed the ruling, the appellate panel
upheld the original ruling. As a result, the United States m odified its policy in
an attem pt to bring it in line with its W TO obligations. These changes failed
to satisfy the B razilian governm ent, however. They requested that a W TO
compliance panel evaluate whether the American adjustm ent brought the sub­
sidies regime in line with W TO rules. The com pliance panel sided with Brazil;
it found that the U .S. policy change w as insufficient, a finding upheld by the
appellate panel. A s a consequence, the W TO authorized Brazil to retaliate
again st the United States by im posing tariffs on im ports o f U .S. good s into
Brazil up to as m uch as $823 million per year, the am ount the American cot­
ton policy cost Brazil.
Brazil’s threatened im position o f these retaliatory tariffs induced the U.S.
government to negotiate a less-costly solution to the dispute. In April 2010 the
tw o governm ents announced the results o f these negotiations. A rguing that
cotton subsidies form p art o f its larger agricultural policy, the United States
agreed to reform its cotton subsidies regim e only as p art o f the 2 0 1 2 Farm
Bill. Second, until the subsidies regime is reform ed, the United States agreed
to pay to Brazil $ 1 4 7 m illion per year for capacity-buildin g and technical
66
CHAPTER 3
The Political Economy of International Trade Cooperation
improvement in Brazilian agribusiness. In exchange, Brazil agreed to not im ­
pose retaliatory tariffs against U .S. good s, services, or intellectual property. In
other w ords, Brazil accepted current Am erican policy, even though it violates
W TO rules, and the United States agreed to com pensate Brazil for doing so.
The cotton case illu strates how governm ents can use tit-for-tat strate­
gies to enforce trade agreem ents. An alleged defection by the U nited States
prom pted a W TO investigation. T his investigation indicated that U .S. policy
violated W TO rules, and when the U nited States failed to bring its policies
into line with its o b ligation s, Brazil w as allow ed to retaliate by w ith d raw ­
ing concessions it had m ade previously to the A m ericans. In the lan guage
o f the iterated p riso n ers’ dilem m a, the U nited States defected an d B razil,
playin g a tit-fo r-ta t stra te g y , d efected in re sp o n se . M o re o v e r, B razilian
retaliation cam e only after the W T O h ad determ ined th at it w as ju stified
and the scale o f the re taliatio n w as p ro p o rtio n ate to the in jury su ffered .
A lthough the W T O ’s d isp u te reso lu tio n m echanism fo cu se s o ur atten tion
on a legalistic version o f tit-for-tat, it also allow s us to see in a very detailed
way how the W TO can prom ote trade cooperation by helping governm ents
enforce trade agreem ents.
The W TO thus helps governments gain the assurances they need in order
to conclude the trade agreem ents required to capture the gain s from trade.
The W T O p ro v id es th is assu ran ce by allo w in g govern m en ts to m o n ito r
the behavior o f their trade partners and to enforce the trade agreem ents they
reach. By doing so, the W TO enables societies to capture the welfare gains the
trade provides. In the absence o f the W T O , or an institution that perform ed
sim ilar functions, it is unlikely that governm ents w ould be able to reach the
agreements required to liberalize trade. Each society, and thus the w orld as a
whole, would be poorer as a result.
CONCLUSION
The W TO exists, therefore, because it facilitates international cooperation ,
thereby enabling societies to capture the w elfare gains available from trade.
T rade raises social w elfare by enabling consum ers to enjoy a higher level of
utility than if they could consume only goods produced at home. The principle
of com parative advan tage tells us that these w elfare gains do not require a
country to have an absolute advan tage in anything. As long as a country is
better at doing som e things than others, it gains by specializing in w hat it does
relatively well and trading for everything else.
Politics, how ever, m akes it d ifficult for societies to realize these gain s
from trade. For reasons we exam ine in greater detail in the next chapter, gov­
ernments often neglect consumer interests in favor o f producer interests. C on­
sequently, governments can capture the gains from trade only by negotiating
agreements in which they exchange m arket access commitments. In such bar­
gaining, governments strive to gain access to foreign m arkets for their com par­
atively advantaged industries in exchange for granting access to their m arkets
in their com paratively disadvantaged industries. Consequently, governm ents
Suggestions for Further Reading
67
employ bargaining pow er in an attem pt to gain m axim um access in exchange
for minimal concessions. By providing a forum for bargaining, the W TO en­
ables governm ents to liberalize trade m ore than they w ould be willing to do
unilaterally.
Yet, concluding trade agreem ents is also com plicated by the enforcement
problem . Governments m ust believe that cooperation on their part will be re­
ciprocated by cooperation from their partners. They m ust believe that their
partners will not try to take advantage o f them. And as the prisoners’ dilemma
highlights, unless such assuran ces are provided, governm ents have little in­
centive to cooperate. The international trade system lacks the equivalent of a
state to enforce agreem ents, and thus governm ents face a pervasive enforce­
ment problem when they try to cooperate for m utual gain. Consequently, it is
difficult for governments to conclude mutually beneficial agreements, and as a
result, societies have lower stan dards of living.
The W T O helps governm ents solve this enforcem ent pro b lem . By en­
abling governm ents to feel reason ably secure that their partners will com ply
with the agreem ents they enter, the W TO provides the assuran ces necessary
to achieve coop eration . Strictly speakin g, the W TO is not an international
equivalent o f a state because the W TO does not have the au th ority or the
capacity to punish governm ents th at fail to com ply w ith trade agreem ents.
In stead , the W T O fa c ilita te s in te rn atio n al c o o p e ra tio n by p ro v id in g an
in frastructure that allo w s governm ents to enforce agreem ents them selves.
By p ro v id in g a set o f m u tu ally agreed on rules, by h elpin g governm ents
m onitor the extent to w hich their partners com ply with these rules, and by
providin g a dispute-settlem ent m echanism that helps governm ents resolve
th ose issu es o f co m plian ce th at d o a rise , the WCTO en ab les governm ents
to enforce effectively the trad e agreem ents that they reach. The W T O thus
pro vid es enough assu ran ce th at all governm ents w ill live up to the agree­
m ents th a t they enter into an d th at no governm ent w ill be ab le to take
advantage o f the others. By providing this infrastructure, the W T O enables
governm ents to conclude the trade agreem ents necessary to capture the w el­
fare gains from trade.
KEY TERMS
Bargaining
Contract Curve
Dispute Settlement
Mechanism
Enforcement Problem
Factor Endowments
Hecksher-Ohlin Model
Nash Equilibrium
Outside Option
Pareto Suboptimal
Patience
Reciprocity
SUGGESTIONS FOR FURTHER READING
For an approach that emphasizes the intuition of the theory of comparative advantage
and downplays explicit theory, see Russell D. Roberts, The Choice: A Fable o f Free
Trade and Protectionism (Upper Saddle River, N J: Prentice Hall, 1994). For an
68
CHAPTER 3
The Political Economy of International Trade Cooperation
excellent account of the historical development of the theory of comparative advan­
tage and of those theories that have challenged the central claim of this theory, see
Douglas Irwin, Against the Tide: An Intellectual History o f Free Trade (Princeton,
NJ: Princeton University Press, 1996).
To delve more deeply into the logic of international cooperation and the role inter­
national institutions play in facilitating such cooperation, see Robert O. Keohane,
After Hegemony: Cooperation and Discord in the Global Economy (Princeton,
N J: Princeton University Press, 1984) and Robert Axelrod, The Evolution o f
Cooperation (New York: Basic Books, 1984).
CHAPTER
4
A Society-Centered
Approach to Trade
Politics
O
ur focus on the international politics o f trade has bracketed an im por­
tant question— what determines the specific trade objectives that gov­
ernments pursue when bargaining within the W TO, when negotiating
regional trade arrangements, or when m aking unilateral trade-policy decisions?
We take up this question in this chapter and the next by exam ining tw o ap ­
proaches to trade politics rooted in domestic politics. This chapter exam ines a
society-centered approach to trade politics. A society-centered approach argues
that a government’s trade policy objectives are shaped by politicians’ responses
to interest grou ps’ demands. The European Union’s (EU) reluctance to liberal­
ize European agriculture reflects EU policym akers’ responses to the dem ands
of European farm ers. The Japan ese governm ent’s commitment to high tariffs
on imported rice reflects the Japanese government’s need to respond to the de­
m ands o f Japanese rice grow ers. The American effort to open foreign m arkets
to American high technology and service exports while continuing to protect
the Am erican textile, apparel, and steel industries reflects the influence that
industry-based interest groups exert on American trade policy.
T o understand the p o litical dynam ics o f this com petition, the societycentered approach em phasizes the interplay between organized interests and
political institutions. The approach is based on the recognition that trade has
distributional consequences. In my home state, people employed in the textile
and apparel industry— traditionally a large employer in N orth Carolina— have
been hit hard by trade liberalization. Between 2000 and 2 0 04, 2 0 7 textile and
apparel factories closed, and about 4 4 ,0 0 0 people lost their jobs. In contrast,
N orth Carolinians employed in the pharm aceutical industry or in finance have
benefited from trade liberalization. The average w age earned by people em ­
ployed in these industries rose in the first h alf o f this decade, as did the to ­
tal number o f jobs available in these industries. In N orth C arolina, therefore,
some people have gained from trade, whereas others have lost.
These distributional consequences generate political com petition as the
w inners and losers from trad e turn to the p o litical arena to advance and
69
70
CHAPTER 4
A Society-Centered Approach to Trade Politics
defend their econom ic interests. The A m erican T extile M an u facturers Insti­
tute and the N ation al Council o f Textile O rganizations, business associations
representing textile and apparel firms, pressure American politicians for more
stringent controls on textile and apparel im ports. They are joined by other
business associations representing businesses harm ed by trade liberalization.
A protectionist coalition gradually begins to form . The C oalition o f Service
Industries, a business association that represents Am erican financial-services
firms (and many other service industry firm s), pressures the U .S. government
to conclude W TO negotiations aimed at liberalizing w orld trade in services. As
other groups that benefit from expanded trade join them, a pro-liberalization
co alitio n begins to form . E x a ctly how th is co m p e titio n u n fo ld s— w hich
groups organize to lobby, w hat coalitions arise, how politicians respond to
interest-group dem ands, which g ro u p s’ interests are reflected in trade policy
and which g ro u p s’ interests are not— is shaped by the po litical institutions
within which it takes place.
This chapter develops the analytical to o ls central to a society-centered
approach. We focus first on interest-group preferences— which groups prefer
protectionism, which groups prefer liberalization, and why? We use trade the­
ory to develop som e system atic expectations ab ou t trade policy preferences,
and we use collective action theory to understand which groups will organize
to pursue their interests. We then turn our attention to political institutions,
looking at how different institutional fram ew orks create different kinds o f in­
terest representation. We conclude by discussing som e o f the w eaknesses o f
this approach.
TRADE POLICY PREFERENCES
Because a society-centered approach argues that trade policy reflects interestgrou p d em an d s, it d evotes co n sid erab le atten tion to the so u rce, content,
and organization o f these dem ands. Here we exam ine tw o stan dard m odels
o f trade policy preferences: the factor m odel and the sector m odel. The two
m odels agree th at raisin g and low erin g ta riffs red istrib u tes incom e, and
they agree that these incom e con sequen ces are the sou rce o f trad e policy
preferences. The tw o m odels offer distin ctive con ceptio n s o f how tra d e ’s
income consequences divide society. We exam ine both m odels and then turn
our attention to the collective action problem that shapes the ability o f groups
with common interests to organize in order to lobby the government on behalf
of their desired policies.
Factor Incomes and Class Conflict
The factor model argues that trade politics are driven by com petition between
factors o f production— that is, by com petition between labor and capital, be­
tween w orkers and capitalists. L ab o r and capital have distinct trade policy
preference because trad e ’s incom e effects divide society alon g facto r lines.
Whenever tariffs are lowered and trade expanded (or tariffs raised and trade
Trade Policy Preferences
71
restricted), one factor will experience rising incom e, w hereas the other will
see its income fall. T rade, therefore, places labor and capital in direct com pe­
tition with each other over the distribution o f nation al incom e. T o fully un­
derstand the reason for this com petition, we need to look at how trade affects
factor incomes.
T o do so, we are going to m ake som e assum ptions. First, we will assum e
that there are only two countries in the w orld: the United States and China.
Second, we will assum e that both countries produce tw o go o d s: shirts and
computers. T hird, we will assum e that each country uses tw o factors o f pro­
duction, labor and capital, to produce both goods. Fourth, we will assum e that
shirt production relies heavily on labor and less heavily on capital, whereas
computer production requires a lot of capital and little labor. Finally, we will
assum e that the United States is endowed with a lot o f capital and little labor,
whereas China is endowed with a lot o f labor and little capital. These assum p­
tions merely restate the standard trade model that we learned in Chapter 3.
T hese assu m p tion s establish w ho produces w hat. F irst, cap ital w ill be
relatively cheap and lab or will be relatively expensive in the United States,
w hereas the o ppo site will be the case in China. C on sequ en tly , the United
States will exp ort the capital-intensive good (com puters) and will im port the
labor-intensive good (shirts). China will export the labor-intensive good and
im port the capital-intensive good.
We can now see w hat happens to factor incomes in the United States and
China as they engage in trade. We look first at the U nited States. When the
United States begins to im port shirts from China, dem and for American-made
shirts falls. A s dem and for American shirts falls, Am erican firm s manufacture
fewer o f them. A s shirt production falls, apparel firm s liquidate the capital
they had invested in shirt factories, and they lay o ff their em ployees. At the
sam e time, Am erican com puter firm s are expanding production in response
to the grow ing Chinese dem and for Am erican com puters. A s American com ­
puter production expan ds, com puter firm s dem and m ore capital and labor,
and they begin to employ capital and labor released by the shirt industry.
There is an im balance, however, between the am ount o f labor and capital
being released by the shirt industry and the am ount being absorbed into the
computer industry. The imbalance arises because the tw o industries use labor
and capital in different proportions. The labor-intensive shirt industry uses a
lot of labor and little capital, and so as it shrinks, it releases a lot of labor and
less capital. The capital-intensive com puter industry em ploys lots o f capital
and less labor, and so as it exp an d s it dem ands m ore cap ital and less labor
than the shirt industry is releasing.
C onsequently, the price o f capital and labor w ill change. M ore capital
is being dem anded than is being released, causing the price o f capital to rise.
People who ow n capital, therefore, now earn a higher return than they did
prior to trade with China. Less labor is being dem anded than is being released,
causing the price of labor to fall. W orkers, therefore, now earn less than they
did prior to trade with China. Fo r the United States, then, trade with China
causes the return to capital to rise and w ages to fall.
72
CHAPTER 4
A Society-Centered Approach to Trade Politics
The same dynamic is taking place in China, but in the opposite direction.
As dem and for Chinese com puters falls, Chinese firm s m an ufactu re few er
com puters. As com puter production falls, Chinese com puter m anufacturers
liquidate the capital they have invested in com puter factories and they lay o ff
their employees. Chinese shirt firms are expanding in response to the grow ing
dem and in the United States and they dem and m ore cap ital and labor. The
Chinese shirt industry thus absorbs capital and labor released from the com ­
puter industry.
Again, however, there is an im balance between the factors being released
and those being dem anded. The com puter industry uses lots o f capital and lit­
tle labor, and so as it shrinks, it releases lots o f capital and only a little labor.
Yet, the shirt industry em ploys a lot o f lab or and relatively little capital. So
as it expands, it is dem anding m ore labor and less capital than the com puter
industry is releasing.
Consequently, the relative prices of capital and labor change. M ore labor
is being dem anded than is being released, causing the price o f lab or to rise.
Less capital is dem anded than is being released, causing the price o f capital
to fall. T rade with the United States has caused the w ages earned by Chinese
workers to rise and the return to Chinese capital to fall.
T rade between the United States and China has thus caused changes in
the incom es earned by w orkers and capitalists in both countries. A bundant
American capital and abundant Chinese labor both gained from trade. Scarce
American labor and scarce Chinese capital both lost. M ore generally, therefore,
trade raises the income o f society’s abundant factor and reduces the income of
society’s scarce factor. If we allow this trade to continue uninterrupted, then
over time, factor incom es in the United States and China will equalize. T h at
is, w ages for American w orkers will fall and w ages for Chinese w orkers will
rise until w ages in the two countries are the sam e. The return to capital in the
two countries will also equalize. The return to Chinese capital will fall and the
return to American capital will rise until the return to capital in the tw o coun­
tries is the sam e. The tendency for trade to cause factor prices to converge is
known as factor-price equalization (or the Stolper-Samuelson Theorem ).
T rade policy preferences follow directly from these incom e effects. Be­
cause trade causes the scarce facto r’s incom e to fall, scarce facto rs w ant to
minimize trade. Scarce factors thus dem and high tariffs in order to keep fo r­
eign products out o f the hom e m arket. B ecause trade causes the abun d an t
factor’s income to rise, abundant factors w ant to m axim ize trade. A bundant
factors thus prefer low tariffs in order to capture the gains from trade. In the
United States and other capital abundant countries, the factor m odel predicts
that owners o f capital (the abundant factor) will prefer liberal trade policies,
whereas workers (the scarce factor) will prefer protectionist trade policies. In
developing countries, the factor m odel predicts that labor w ill prefer liberal
trade policies, whereas owners o f capital will prefer protection. T rade politics
are thus driven by conflict between lab or and business (or capital). Because
this com petition pits w orkers again st cap italists, the facto r m odel is often
called a class-based model o f trade politics.
Trade Policy Preferences
73
The factor m odel suggests that the debate over trade policy is a conflict
o ver the d istrib u tio n o f n a tio n a l in co m e betw een A m erican la b o r and
Am erican business. Because trade reduces the incom e of A m erican w orkers,
these w orkers, and the organizations that represent them, have an incentive to
oppose further liberalization and to advocate more protectionist policies. And
indeed, Am erican labor unions have been very critical o f globalization . The
A FL-C IO , a federation o f 64 labor unions representing 13 m illion Am erican
w o rk e rs, h a s been a m o n g the m o st p ro m in en t critics o f g lo b a liz a tio n .
A lthough the A FL-C IO does not consider itself protection ist, it h as fought
consistently to prevent p assage o f fast-track authority. It is also highly criti­
cal o f the N orth American Free Trade Agreement (NAFTA) and the proposed
Free T rade Area o f the Am ericas (FTAA).
Conversely, because trade raises the return to American capital, American
businesses should be strong supporters o f globalization. And A m erican busi­
ness has been very supportive o f globalization. The Business R oun dtable, a
business association com posed o f the chief executives o f the largest American
corporation s, strongly supports globalization. It has been an active lobbyist
for fast-track authority, it su pp orts N A FT A and the FT A A , and it strongly
supported C hina’s entry into the W TO . The N ation al A ssociation o f M an u ­
facturers, which represents about 14,000 American m anufacturing firms, also
supports the W TO and regional trade arrangem ents. T rade policy dem ands
from A m erican labor and capital thus reflect the incom e consequences that
the factor model highlights. American trade politics does seem to be shaped by
com petition over national income between workers and capitalists.
We conclude with an im portant qualification. The emergence o f conflict
between w orkers and capitalists is based on the assum ption, em bodied in our
sim ple tw o-factor m odel, that Am erican labor is hom ogeneous— all w orkers
are identical. W orkers are not hom ogeneous, however, an d at a m inim um ,
we need to divide labor into distinct skill categories, such as low- and highskill, and treat each category as a d istin ct facto r o f p ro d u ctio n . A m odel
that allow s for different skill categories am ong workers yields different con­
clusions a b o u t trad e’s im pact on the incom es o f A m erican w orkers. T rad e
still reduces the incom e o f low -skill A m erican w orkers; high-skill w orkers,
however, which are an abundant factor in the United States, w ould see their
incom es rise.
Sector Incomes and Industry Conflict
The sector m odel argu es that trade po litics are driven by com petition be­
tween industries. Industries have distinct preferences because trad e’s income
effects divide society alon g industry lines. W henever ta riffs are raised or
low ered, w ages and the return to capital em ployed in som e industries both
rise, whereas wages and the return to capital employed in other industries both
fall. Trade, therefore, pits the workers and capitalists employed in one industry
against the workers and capitalists employed in another industry in the conflict
over the distribution o f national income.
74
CHAPTER 4
A Society-Centered Approach to Trade Politics
PO LICY A N A LY S IS AND D EBAT E
Trade Adjustment
Question
How should governments respond to the economic dislocation caused by trade?
Overview
Most economists believe that trade does not change the n um ber of jobs in the
local economy. Instead, trade changes the kinds of jobs that are available. Jobs in
import-competing industries disappear as firms shut down or move offshore. In the
meantime, jobs are created in export-oriented industries. The jobs created offset
the jobs lost. The jobs being created are quite different from the ones that are
eliminated. In North Carolina, for example, trade has eliminated low-skilled jobs in
the apparel industry while creating high-skilled jobs in high-technology industries.
Society as a whole is much better off over the long run with these high-paying jobs
than it is with low-paying jobs.
In the short run, however, the inevitable adjustment creates some real policy
dilemmas. It is difficult for workers to move from low-skilled to high-skilled jobs.
Typically, low-skilled workers have a high school education at best and in many
instances are 40 years old or older. This segment of the population finds it very
difficult to become employed in high-technology industries. Moreover, even if it
weren't so difficult, many would find it necessary to abandon the communities in
which they were born and raised to take a job in a new town. What policies should
governments use to manage this trade adjustment problem?
Policy Options
• Protectionism : Governments should raise tariffs or use other means to protect
industries threatened by import competition. By protecting industries from
import competition, this policy would protect the most vulnerable from the
forces of economic dislocation.
• A djustm ent Assistance: Governments should establish programs to retrain workers,
by offering such programs, this policy would help workers move from declining
to expanding industries with less difficulty.
Policy Analysis
• What are the costs and the benefits of each policy?
• Who pays the costs for each policy?
• Is one policy more feasible politically than the other? If so, why?
What Do You Think?
• Which policy do you advocate? Justify your choice.
• What criticisms of your position would you anticipate? How would you defend
your recommendation against those criticisms?
Trade Policy Preferences
75
Resources
Online: Do an online search forU.S. government trade adjustment policy. Compare
the U.S. approach with that of another country. (Sweden provides a strong con­
trast.) Search for the terms trade adjustment assistance Smien and labor market policy
Sweden.
In Print: Alan V. Deardorff and Robert Stern, The Social Dimensions of U.S. Trade Policy
(Ann Arbor: University of Michigan Press, 2000); Kenneth F. Scheve and Mat­
thew J. Slaughter, "A New Deal for Globalization,"Foreign Affairs 86 (July/August 2007); Howard F. Rosen, "Designing a National Strategy for Responding to
Economic Dislocation," testimony before the Subcommittee bn Investigation
and Oversight House Science and Technology Committee, June 24,2008. www
.petersonlnstitute.org/publications/papersfprint.cfm?doc=puf>&ResearchID=967. “ - •
'
The sector m odel argues that trade divides society across industry rather
than factor lines because the assum ptions it m akes about factor m obility are
different from the assum ptions embodied in the factor m odel. Factor mobility
refers to the ease with which labor and capital can move from one industry to
another. The factor m odel assum es that factors are highly m obile; labor and
capital can move easily from one industry to another. T hus, capital currently
em ployed in the apparel industry can be quickly shifted to the com puter in­
dustry. Sim ilarly, workers currently engaged in apparel production can easily
shift to com puter production. When factors are m obile, people’s econom ic
interests are determined by their factor ownership. W orkers care about w hat
happens to labor, whereas capitalists care about the return to capital.
The sector m odel assum es that factors are not easily m oved from one in­
dustry to another. Instead, factors are tied, or specific, to the sector in which
they are currently em ployed. C apital currently em ployed in apparel produc­
tion cannot easily move to the com puter industry. W hat use does a loom or
a spinning m achine have in the com puter industry? W orkers also often have
industry-specific skills that do not transfer easily from one sector to another.
A worker who has spent 15 years m aintaining sophisticated autom ated loom s
and spinning m achines in an apparel plant cannot easily transfer these skills
to com puter production. In addition, the geography o f industry location often
m eans that quitting a jo b in one industry to take a jo b in another requires
w orkers to ph ysically relocate. Shifting from apparel pro du ctio n to a u to ­
m obile production m ight require a w orker to m ove from N orth Carolina to
M ichigan. Logistical obstacles to physical relocation can be insurmountable.
A worker m ay not be able to sell his house because the decline of the local in­
dustry has contributed to a more general econom ic decline in his community.
C om plex social and psychological factors also intervene, as it is difficult to
aban don the netw ork o f social relations that one has developed over many
years. The com bination o f specific skills, logistical problem s, and attachments
76
CHAPTER 4
A Society-Centered Approach to Trade Politics
to an established com m unity m ean that labor cannot alw ays m ove from one
industry to another.
When factors are im m obile, trade affects the incom es o f all facto rs em ­
ployed in a given industry in the sam e w ay. We can see why by returning to
our U .S.-C h in a exam ple. C onsider the apparel industry first. Shirt im ports
from China lead to less shirt production in the United States. F actories are
closed and w orkers are laid off. A s in the factor m odel, apparel w orkers see
their incom es fall. In con trast to the facto r m odel, how ever, the ow ners o f
capital employed in apparel production also see their incom es fall. Why? Be­
cause capital is im m obile and therefore capital em ployed in apparel p ro d u c­
tion cannot move into the com puter industry. A s dem and for American shirts
falls, dem and for capital em ployed in the Am erican shirt industry m ust also
fall. As it does, the return to this capital m ust also fall. W orkers and business
owners in the apparel sector thus both suffer from trade.
The opposite consequences are evident in the com puter industry. T rad e ’s
im pact on the return to capital em ployed in the com puter industry is sim ilar
to the factor model. As com puter production expands, increasing dem and for
capital raises the return to capital employed in the com puter industry. T rad e’s
impact on the incomes of w orkers employed in the com puter industry is quite
different from the facto r m odel’s prediction. The facto r m odel tells us that
com puter w orkers see their incom es fall as they com pete again st the w o rk ­
ers released by the apparel industry. W ith m ore people chasing few er job s,
all w o rk ers’ incom es fall. The sector m odel argu es that com puter w o rk ers’
incomes rise. Because labor is im m obile, the w orkers released by the apparel
industry cannot move into the com puter industry. Greater dem and for labor in
the com puter industry increases the w ages paid to w orkers already employed
in the industry. T hus, capital and labor em ployed in the Am erican com puter
industry both gain from trade.
When factors are im m obile, it m akes little sense to speak o f the interests
o f a unified labor or capital class. The apparel w orker loses from trade; the
com puter worker gains. R oger M illiken (owner o f the w orld’s largest privately
owned textile firm, M illiken & Com pany) loses from trade while M ichael Dell
(founder of Dell C om puters) gains. Consequently, trade policy interests are
defined in term s o f the industry in which people w ork or have invested their
capital. A pparel w orkers and R oger M illiken will have a com m on interest in
trade policy. Com puter workers and M ichael Dell will have a com m on inter­
est in trade policy. T rade politics is then driven by com petition between the
w orkers and capitalists who gain from trade and the w orkers and capitalists
who lose. The result is not class conflict, but conflict between industries.
We can be very precise about which industries gain and which lose from
trade. L abor and capital employed in industries that rely intensively on society’s
abundant factor (that is, the country’s com paratively advantaged industries)
both gain from trade. In the advanced industrialized countries, this m eans
that labor and capital em ployed in capital-intensive and high-technology in­
dustries, such as com puters, pharm aceuticals, and biotechnology, gain from
trade. As a group, these industries are referred to as the export-oriented sector.
Trade Policy Preferences
77
Conversely, labor and capital employed in industries that rely intensively on
society’s scarce factor (that is, the country’s com paratively disadvantaged in­
dustries) lose from trade. In the advanced industrialized countries, this means
that the incomes o f owners o f capital and workers employed in labor-intensive
sectors such as apparel and footw ear will fall as a result of trade. A s a group,
these industries are com m only referred to as the im port-com peting sector.
Thus, the sector m odel argues that trade politics is driven by com petition be­
tween the im port-com peting and export-oriented sectors.
The sector m odel ad d s nuance to our understanding o f the political de­
bate over globalization. The factor m odel suggests that the debate over glo ­
balization pits lab or again st capital, and the sector m odel suggests that this
political debate often pits capital and lab or in im port-com peting industries
against capital and labor in export-oriented industries. We might expect there­
fore that U N IT E (the Union o f N eedletrades, Industrial and Textile Em ploy­
ees), the principal union in the American apparel industry, and the American
Textile M anufacturers Institute (A TM I), a business association representing
American textile firm s, w ould both oppose globalization. Indeed, this is what
we find. U N IT E has been a vocal opponent o f N A FT A , of the FTA A , and o f
fast-track authority. For its part, the A T M I has not been critical o f all trade
agreem ents, but it has opposed free-trade agreem ents with South K orea and
Singapore, has been very critical of the American decision to grant China per­
manent norm al trade status, and does not support further opening o f the U.S.
m arket to foreign textiles through m ultilateral trade negotiations (Am erican
Textile M anufactures Institute 2 001). In general, labor and capital employed
in textile and apparel are both skeptical of globalization.
Conversely, the sector m odel predicts that capital and labor employed in
export-oriented industries will both support globalization. It is relatively easy
to document such support am ong American export-oriented firms. A coalition
o f business associations representing American high-tech firms— including the
Consum er Electronics A ssociation, Electronic Industries Alliance, Inform ation
Technology Industry Council, M ultiM edia Telecom m unications A ssociation,
and The Sem iconductor Industry A ssociation— has supported fast-track au ­
thority, the approval o f norm al trade relations with China, N A FT A , and the
FTAA. It is more difficult to docum ent attitudes o f workers employed in these
industries, in large part because w orkers in high-technology sectors are not
unionized to the sam e extent as w orkers in m any m anufacturing industries.
However, w orkers in high-tech industries are predominantly high skilled, and
on average, high-skilled w orkers are more supportive o f trade liberalization
than low-skilled w orkers (Scheve and Slaughter 2 0 01). Although this is indi­
rect evidence, it is consistent with the prediction that both labor and capital
employed in American high-technology industries will support globalization.
The facto r and sector m odels thus both argue that trade policy prefer­
ences are determ ined by the incom e consequences o f trade. T rade raises the
incom es o f som e grou ps and low ers the incom es o f others. T hose who gain
from trade prefer trad e liberalization , w hereas those who lose prefer p ro ­
tectionism . Each m odel offers a distinct pattern o f trade policy preferences,
78
CHAPTER 4
A Society-Centered Approach to Trade Politics
TABLE 4.1
Two Models of Interest-Group Competition over Trade Policy
The principal actors
How mobile are factors of
production?
Who wins and who loses
from international trade?
The Factor Model
The Sector Model
Factors of production
or classes
Perfectly mobile across
sectors of the economy
W inner: abundant
factor—capital in the
Industries or sectors
advanced industrialized
countries
Loser: scarce factor—
labor in the advanced
industrialized countries
Central dimension of
competition over trade
policy
Protectionist labor
versus liberalizing
capital
Immobile across sectors
of the economy
W inner: labor and capital
employed in exportoriented industries
Loser: labor and capital
employed in importcompeting sectors
Protectionist importcompeting industries
versus liberalizing exportoriented industries
however, based on distinct conceptions o f how the income effects o f trade di­
vide society (see T able 4.1). The factor model states that trade divides society
across factor lines and that, consequently, trade politics is driven by conflict
between labor and capital. The sector m odel states that trade divides society
along sector lines and that, consequently trade politics is driven by conflict
between import-competing and export-oriented industries. These distinct p at­
terns are based on the assum ptions each m odel m akes ab ou t factor mobility.
The factor model assum es that factors are highly m obile, and therefore people
define their interests in term s o f factor ownership. The sector m odel assum es
that factors are im m obile, and thus people define their interests in term s of
the industry in which they earn their living. Recent research challenges the
assum ption that trade policy preferences are based on the im pact o f trade on
individual incomes (M ansfield and M utz 2 009). Rather than base their trade
policy preferences on their factor ow nership or on the sector in which they
are employed, this research suggests that people base their trade policy prefer­
ences on perceptions or beliefs about w hat is good for the country as a whole.
Such “ so ciotrop ic” concerns m ight focus on or revolve around attitudes to ­
w ard out-groups (e.g., foreigners), foreign policy (i.e., isolationism or inter­
ventionism ), or beliefs ab o u t the im pact o f trade on the n ation al econom y
rather than specific sectors. As a consequence, people might hold com plicated
trade policy preferences that change over time. For instance, a person might
support trade during economic boom s but oppose trade during recessions. If
citizens believe that trade enriches their country as a whole, they will be more
Organizing Interests: The Collective Action Problem and Trade Policy Demands
79
likely to support open trade. Conversely, if citizens believe that trade causes
a loss of jobs to other countries they will be more likely to oppose open trade
policies.
ORGANIZING INTERESTS: THE COLLECTIVE ACTION
PROBLEM AND TRADE POLICY DEMANDS
Individuals’ preferences are not transform ed autom atically into political pres­
sure for specific trade policies. T ransform ing individual preferences into p o ­
litical dem ands requires that the individuals who share a com m on preference
organize in order to exert influence on the policy-making process. Organizing
can be so difficult that individuals with com m on interests m ay not organize at
all. This m ight seem counterintuitive. If trade affects incom es in predictable
w ays, and if people are rational, then why w ouldn’t people with com m on in­
terests join forces to lobby for their desired policy?
G roups often can ’t organize because they confront a public go od s p ro b ­
lem or collective action problem (O lson 1965). C ollective action problem s
are sim ilar to the problem o f pu blic g o o d s provision . C on sid er consum ers
and trade policy. A s a grou p, the 2 0 0 m illion or so consum ers w ho live in
the United States w ould all gain from free trade. T hese 2 0 0 m illion people
thus have a com m on interest in unilateral trade liberalization. T o achieve this
goal, however, consum ers will have to lobby the government. Such lobbying
is costly— m oney is required to create an o rgan ization , to p ay for a lobby ­
ist, and to contribute to politician s’ cam paign s, and tim e m ust be dedicated
to fundraising and organization. Consequently, m ost consum ers will perform
the follow ing very simple calculation: M y contribution to this cam paign will
m ake no perceptible difference to the g ro u p ’s ability to achieve free trade.
M oreover, I will benefit from free trade if the group is successful regardless of
whether I have contributed or not. Therefore, I will let other consum ers spend
their money and time; that is, I w ill free ride. Because all consum ers have an
incentive to free ride, no one contributes time and money, no one lobbies, and
consum er interests fail to influence trade policy. Thus, even though consum ­
ers share a com m on goal, the collective action problem prevents them from
exerting pressure on politicians to achieve this goal. The incentive to free ride
m akes collective action in pursuit o f a com m on goal very difficult.
The logic o f collective action helps us understand three im portant char­
acteristics o f trade politics. First, it helps us understand why producers rather
than consum ers dom inate trade politics. Consum ers are a large and hom oge­
neous grou p, and each individual consum er faces a strong incentive to free
ride. Consequently, contributions to a “ Consum ers for Free T ra d e ” interest
group are substantially less than the underlying common interest in free trade
would seem to dictate. In contrast, m ost industries are m ade up o f a relatively
sm all num ber o f firm s. Producer gro u p s can thus m ore readily organize to
lobby the governm ent in pu rsuit o f their desired trade policy. The logic o f
collective action helps us understand why producers’ interests dom inate trade
politics, whereas consumer interests are often neglected.
80
CHAPTER 4
A Society-Centered Approach to Trade Politics
Second, the logic o f collective action su gge sts th at trad e p o litics will
exh ib it a b ias to w ard p ro tectio n ism . A ta r iff p ro v id e s larg e b en efits to
the few firm s p ro d u cin g in the p ro tected in d u stry . T he c o sts o f a ta riff,
however, are distributed acro ss a large num ber o f individuals and firm s. A
higher ta riff on steel, for exam ple, provid es large benefits to the relatively
sm all num ber o f Am erican steel producers and their w orkers. The co sts o f a
steel tariff fall on everyone who consum es steel, a grou p th at includes m ost
A m erican consum ers as well as all firm s that use steel as an input in their
production processes. The sm all group o f steel producers that benefits from
the higher ta riff can fairly easily overcom e the collective action p ro b lem
to lobby for protection. The large and heterogeneous grou p th at bears the
costs o f the tariff finds it much m ore difficult to organize for collective a c ­
tion. Consequently, trade politics is dom inated by im port-com peting indus­
tries dem anding protection.
Finally, the logic o f collective action helps us understand why govern ­
m ents rarely liberalize trad e u n ilaterally , but have been w illing to do so
through negotiated agreem ents. R eciprocal trade agreem ents m ake it easier
for export-oriented industries to overcom e the collective action problem (see
Bailey, Goldstein, and W eingast 1997; G illigan 1997; M ilner 1988). R ecipro­
cal trade agreem ents provide large benefits in the form o f access to foreign
m arkets to sm all groups of export-oriented firms. Reducing foreign tariffs on
m icroprocessors for personal com puters, for exam ple, provides su bstan tial
gains to the three American firms that dom inate this industry (Intel, Advanced
M icro Devices [A M D ], and M o to ro la). These three firm s will solve the co l­
lective action problem they face and lobby for trade liberalization at home in
exchange for the rem oval o f foreign barriers to their exports.
M any scholars argue that exactly this effect lies behind postw ar trade lib­
eralization in the United States. The R oosevelt adm inistration proposed and
Congress passed the R eciprocal T rad e Agreements Act (RTAA) o f 1934. This
legislation has continued to structure U .S. trade policy ever since. Under its
term s, C ongress delegates to the president the authority to reduce tariffs in
exchange for equivalent concessions from foreign governments. By linking re­
ductions o f Am erican tariffs to the opening o f foreign m arkets to Am erican
exporters, the RTA A transform ed the large and heterogeneous group favoring
liberalization into sm all groups o f export-oriented industries that could more
easily organize to pursue com m on goals. T his in turn altered the balance o f
interest-group pressure that politicians faced. M ore balanced political pres­
sure made politicians more willing to liberalize trade.
In a society-centered ap p ro ach , therefore, trad e po litics are sh aped by
com petition between organized interest groups. This com petition som etim es
revolves around class conflict that pits w orkers again st business ow ners and
at other tim es revolves around industry conflict that pits im port-com peting
industries again st export-oriented industries. In all cases, how ever, the core
conflict in, and the ultim ate stakes of, this com petition rem ain the sam e: the
distribution of national income. The winners of this political com petition are
rewarded with rising incomes. The losers become poorer.
Political Institutions and the Supply of Trade Policy
81
POLITICAL INSTITUTIONS AND THE
SUPPLY OF TRADE POLICY
While scholars have devoted considerable attention to developing conceptual
models o f the dem and side o f trade politics, they have focused less on the sup­
ply side of trade politics. Supply-side m odels strive to say something systematic
about who wins the competition over trade policy. Here we find considerable
agreement that political institutions play an im portant role in transform ing
interest-group dem ands into actual policies, but substantially less agreem ent
about how exactly they do so.
Political institutions shape how com petition between organized interests
unfolds. They do so by establishing rules that influence the strategies people
adopt in pursuit o f their policy objectives. These rules influence how people
organize and thus determine whether interests organize around factor or sec­
toral interests. Rules influence how organized interests exert pressure on the
political process and thus determine whether interest groups lobby the legisla­
ture or whether they exert influence through political parties. Rules influence
which interests politicians m ust respond to and thus determine which interests
gain representation and which do not. Because political institutions shape the
w ay people behave, they have an im portant im pact on who ultim ately wins
the battle over national income.
The electoral system is one institution that m ost political economists agree
has an important impact on trade politics. Electoral systems can be classified into
two broad categories: m ajoritarian and proportional. The critical dimension on
which the two types are distinguished is the number o f legislative seats selected
in each constituency. M ajoritarian electoral systems combine single member
districts and first-past-the-post elections. G reat Britain, for exam ple, is divided
into 650 constituencies, each o f which elects a single member o f parliam ent.
First-past-the-post voting means that a candidate need only attract a plurality of
the vote to win in each district. As a result, British political parties can capture
a majority in the H ouse o f Com m ons with only a plurality o f the popular vote.
In the 2005 election, for exam ple, the Labour Party received 35 percent o f the
popular vote but won 55 percent of the seats in the H ouse o f Commons. In 2010,
the Conservative Party captured 47 percent o f the seats in the H ouse with only
36 percent o f the popular vote. M ajoritarian systems also disadvantage smaller
third parties. The British Liberal Dem ocrats, for example, earned 23 percent of
the popular vote in the 2010 election, but only 9 percent o f the seats in parliament.
Proportional representation (PR) electoral systems employ multi-member
d istricts to distribute legislative rep resen tation in p ro p o rtio n to the share
o f the popular vote each party attracts. N orw ay, for exam ple, is divided into
19 constituencies, each o f which elects between 4 and 17 representatives to
the N orw egian parliament. Legislators from each district are selected from the
po litical p arties in p ro p o rtio n to the p a rty ’s share o f the p o p u lar vote in
the district. In the 2009 election, the N orw egian Labor Party gained 33 percent
o f the seats in parliam ent based on 35 percent o f the popular vote, while the
second largest party, the Progress Party, captured 22 percent o f the seats on
82
CHAPTER 4
A Society-Centered Approach to Trade Politics
23 percent o f the popular vote. In PR system s, therefore, a party’s importance
in the legislature closely tracks its share o f the popu lar vote.
Electoral systems can affect trade politics in tw o w ays. First, electoral sys­
tems m ay play an im portant role in shaping how grou ps organize to pursue
their trade policy objectives. In particular, m ajoritarian system s m ay encour­
age organization around the com m on sector-based interests while PR systems
may encourage organization around factors. C onsider the incentives created
by m ajoritarian electoral systems. T o win elections in such system s, candidates
m ust satisfy the dem ands o f their districts’ residents. Each electoral district is
relatively sm all and likely to be dom inated by one or tw o m ajo r industries.
The w ages paid in these industries will in turn play a large role in su p p o rt­
ing the rest o f the district econom y— the retail and service-sector businesses
that provide jo b s for m any other people in the com m unity. Such electoral
systems create incentives for elected officials to represent the interests o f the
owners o f and w orkers in the industries that dom inate econom ic activity in
their districts. We expect legislators from D etroit, M ichigan, to advance and
defend the interests o f the auto industry and its em ployees. Because elected
representatives have incentive to rew ard dem ands from the industries in their
districts, industries have incentive to pursue their narrow interests rather than
seek to construct b road er co alition s. C onsequently, m ajo ritarian electoral
institutions m ay create strong incentives for individuals to organize around
narrow industry-specific interests.
In contrast, PR system s do not link political representation tightly to the
interests of sm all and undiversified electoral districts. In the extreme case, for
exam ple, a PR system has a single national constituency. In such system s, elec­
toral success requires the construction o f electoral coalition s that appeal to
broad rather than narrow interests. Consequently, PR system s seem to p ro ­
duce political parties based on class or facto r interests. In N o rw ay , for e x ­
am ple, the three largest political parties in postw ar politics are closely tied to
factor-based interests. The labor party is closely linked to N orw egian labor
unions, the agrarian party evolved out o f the farm m ovem ent o f the 1 9 2 0 s,
and the conservative party has represented the business or capital interest. And
with the electoral system creating an incentive to represent factor-based inter­
ests, econom ic actors gain an incentive to pursue their trade policy go als by
organizing around factor-based interests. Thus, PR systems m ay create incen­
tives for individuals to organize for political action around factoral interests.
Electoral system s m ay also affect the level o f protection adopted by gov­
ernments in the tw o system s. In particular, we m ight expect governm ents in
countries with PR systems to m aintain lower tariffs (and other trade barriers)
than governments in countries with m ajoritarian electoral system s. The logic
behind this hypothesis asserts that the sm all gro u p s that benefit from p ro ­
tection can more easily influence policy in m ajoritarian than in proportional
system s. As one advocate o f this hypothesis explains, “ When autom akers or
dairy farm ers entirely dom inate twenty sm all constituencies and are a pow er­
ful m inority in fifty m ore, their voice will certainly be heard in the n ation ’s
Political Institutions and the Supply of Trade Policy
83
councils. Where they constitute but one or two percent o f an enorm ous dis­
trict’s electorate, represen tatives m ay defy them m ore freely ” (R ogow ski
1987, 208). Such a logic m ay help us understand why farm ers, who constitute
well less than 5 percent o f the A m erican p o p u latio n , are able to gain such
favorable legislation from C ongress. In other w o rd s, m inority interests can
construct legislative m ajorities m ore easily in m ajoritarian than in PR systems.
It has proven difficult to tease out unam biguous empirical support for this
electoral system hypothesis. The m ost recent em pirical investigation reports
substantial evidence that tariffs are higher in countries with m ajoritarian elec­
toral systems than they are in countries with proportional systems (see Evans
2009). Analyzing the experience o f as m any as 1 4 7 countries (and as few as
30) between 1981 and 2 0 04, this study finds that the average tariff in m ajori­
tarian countries stood at 17 percent, while the average tariff in countries with
PR systems reached only 12 percent. This five-percentage point difference per­
sists even when the relationship between electoral system s and tariff rates is
evaluated with m ore dem anding statistical techniques that control for a large
number o f possible alternative explanations.
Other research reaches very different conclusions. A study that focuses
on the experience o f Latin A m erican countries in the 1 980s and 1990s finds
that tariffs are higher in countries with PR systems than they are in countries
with m ajoritarian electoral systems (H atfield and H au k 2004). A study based
on v ariation in non-tariff form s o f protection in fourteen industrial coun­
tries during the 1980s also finds that protectionism w as higher in countries
with PR system s than in countries with m ajoritarian system s (M ansfield and
Busch 1995). Both o f these studies thus find exactly the opposite o f w hat the
electoral system hypothesis suggests we should observe. C onsistent evidence
about how electoral systems shape the level o f protection has thus proven dif­
ficult to find.
One final political institution, the num ber o f veto players present in the
political system, m ay also affect trade policy. A veto player is a political actor
whose agreement is necessary in order to enact policy (Tsebelis 2002). In the
U .S. context, each branch o f governm ent m ight be a veto player. W hether
each branch is a veto player in fact depends upon the preferences o f the in­
d ividuals th at con trol each branch. We m ight co u n t situ atio n s o f divided
government, where one party controls Congress and the other party controls
the White H ouse, as two-veto player system s and count unified government
as one-veto player system s. C oalition governm ents in parliam entary systems
such as G erm any, where tw o or m ore p arties alm o st alw ays m ake up the
m ajority within the legislature and hold cabinet p o sts, are m ulti-veto player
systems. Britain is perhaps the sim plest system (until quite recently). With its
m ajoritarian electoral system and parliam entary government, it has been ruled
by single-party m ajority governments for m ost the postw ar era. It is typically,
therefore, a political system with a single veto player.
The central exp ectatio n o f veto play er theory is th at the difficulty of
m oving policy from the status quo increases in line with the num ber o f veto
84
CHAPTER 4
A Society-Centered Approach to Trade Politics
A CLOSER LOOK
The Politics of American Agricultural Policy
Agricultural policy presents a compelling political economy puzzle. Congress
passed the 2007 Farm Bill, which allocated billions of dollars to fund a variety of
agriculture and related programs for 5 years. Current legislation in turn builds on a
longer history of government support for agriculture. The Environmental Working
Group documents that, as a group, American farmers received more than $177
billion from American taxpayers between 1995 and 2007 (Environmental Working
Group). Yet, the beneficiaries of these programs, farmers and farm workers
especially, constitute a small fraction of the American population. The U.S. Census
Bureau estimates that only slightly more than 2 million farms are currently in
operation, employing fewer than 3 million hired farm workers (U.S. Department
of Agriculture 2002). How does such a small minority of the population manage to
attract such large sums from the federal government?
Farmers, and their representatives in Congress, have passed legislation that
provides these payments by creating legislative coalitions with other minority
interests. Rather than handle each farm commodity through independent
legislation, the Farm Bill combines all commodities into a single piece of
legislation. As a consequence, producers of individual commodities gain a
common interest in the bundle rather than a narrow interest in commodity-specific
legislation. Wheat growers have a common interest with corn farmers, and both
in turn have incentive to support cotton farmers, sugar beet producers, soybean
growers, and so forth. Moreover, bundling farm commodities into a single bill
expands the number of states that support the farm bill. Indeed, farms in all 50
states (even Alaska) receive some financial assistance via the subsidies the Farm
Bill provides.
Legislators from farm states also link agricultural policy to other issues.
Traditionally, for example, the Farm Bill is linked to Food Stamps, a program
designed to enhance the nutritional standards of low-income individuals, and to
some school lunch programs. Linking farm subsidies to these consumer programs
helps draw in support from legislators who represent those urban districts most
harmed by higher food prices generated by a protected farm sector. The specific
link to school lunch programs, by financing fresh fruit and vegetable consumptions,
garnered support from producers of fresh produce, who are not typically supported
by direct subsidies. Legislators also linked the 2007 Farm Bill to the issue of
energy security by funding biofuel research, to environmental issues by funding
clean up of the Chesapeake Bay, as well as to water and land conservation. Linking
these issues expands the legislative coalition beyond farm interests.
This broad-based coalition in turn reflects the institutional imperatives of the
American political system. On the one hand, the Senate, which confers two votes
to each state, overrepresents rural relative to urban residents. Senators from rural
states can thus build a majority for the Farm Bill so long as they can spread the
gains across a sufficient number of states. Getting the measure through the House,
^
85
Political Institutions and the Supply of Trade Policy
however, requires that the bill provide some clear benefit to (or at least impose nq ,
obvious costs on) the more densely populated urban areas that are more^heayily
^.
represented in the House. Building a House majority, therefore, required;measures , ,
like Food Stamps to ensure that higher prices paid to the farmers represented , , - i ,
by Senators from rural states did not worsen the plight of low-income groups,,
represented by Representatives from urban districts. ;<i
,.. . .
.
.. ...
Finally, the Senate and House committees that wrote tbjc.Faj'jn B illfarf.-^
composed of legislators from the states that are the principal beneficiaries ofK
,..
the agricultural policy. Tom Harkin, a .Democrat
1.- *
Senate Committee on Agriculture, .Nutrition* pnd
two-thirds of the committee members represent s
t
a
t
e
s
.
,
sectors. Similar characteristics are evident in the House Comrryttee on^griculture.
More than four-fifths of the H o u se .Q o irra ti^ f^ w ^ rhemtets comi^fropt farm, .
states, while Collin Peterson, who represents Minnescrta's Seventh Cpngressignai,„ .
District (which attracted half of al! subsidies paid to,M »orje?pta^ pi^
1995 and 2006), chairs the committee. Legislators.frorrr^arm’stjftds fhiSs <
considerable control over agricultural trade policy by cpntrp|l^ thfecpfnr|i t t ^ j t* r
with direct responsibility for the r e le v a n j ^
A
. -
Seeing how domestic politics shape American agrl<^tural i » l ^ .baps,t^ \ ,fr understand why the Doha Round isbothan impprte^soutcf. o f ^ ^ ^ ^ g e ^ d t
yet also is limited in what it can
large part in agenda setting. In the.absence of ipfcerhat!k^t| p r ^ y j e ^ p g j ^ p a a f
committees would be unlikely to consider dramaticchanaes in ^ I ^ K y p , i i gUcy.«v
There are simply too few people on GongigMip^agri^ltijre committees who jiave
an incentive to press for such.reforms. Hence* placing
agenda also forces the issue onto the congressionalJlgftKia.
f
pressure is insufficient by itself to produce substantial pqUcy,change. Th&.Fapn Bill
enjoys widespread support within Congress (Congress voted to dyperide. President <
George W. Bush's veto afthe2Q07Farm Bill). One cannot/ea^lly, imqgi/le :the... .
construction of a majority willing tq disrnantle this program in a^ipgleqct,
i ..
Consequently, one might suspectjthat domestic politics wiil.xaqse.the jjbjralUftion,
of trade in agriculture to proceed gradually, much as tariffs pn manufactured goqds
came down slowly. ■
»
...
■i,^
.
players in the political system. Applied to trade policy, this suggests that p o ­
litical system s with m any veto players will find it difficult to alter tariffs in
response to societal pressure for change (Henisz and M ansfield 2 0 0 6 ). In con­
trast, tariffs will be relatively easy to change in political systems with few veto
players. Som e research that explores how protectionism reacts to changes in
m acroeconom ic conditions su pp orts this expectation. We m ight expect, for
exam ple, that protectionism w ould rise during recessions and fall during eco­
nom ic boom s. This is surely w hat occurred during the 1 9 3 0 s as well as to a
lesser degree in the 1970s. M ore recently, policym akers have feared that the
86
CHAPTER 4
A Society-Centered Approach to Trade Politics
recession sparked by the financial crisis w ould spark a surge o f protectionism .
H ow ever, the extent to which protectionism rises during recessions appears
strongly shaped by veto players. Protection rises sharply during recessions in
countries with few veto players but rises substan tially less in countries with
fewer veto players.
Political institutions thus shape how private sector trade policy dem ands
are transformed into trade policy outcom es. The rules governing elections can
influence whether private sector grou ps organize around facto rs or sectors.
These sam e rules can also shape the level o f protectionism . The num ber of
veto players in the political system shapes the governm ent’s ability to raise or
lower tariffs in response to changes in the relative pow er o f protectionist and
liberalizing dem ands em anating from organized groups. These features o f in­
stitutions thus play an im portant role in determining which groups prevail in
the distributive competition over trade policy.
CONCLUSION
Although a society-centered approach helps us understand how the interac­
tion between societal interests and political institutions shapes trade politics,
it does have w eakn esses. We conclude our d iscu ssio n o f this ap p ro a ch by
lookin g at the three m ost sign ifican t w eakn esses. F irst, a society-centered
approach does not explain trade policy outcom es. It tells us that trade p o li­
tics will be ch aracterized by conflict betw een the w inners an d losers from
international trad e, and it does a fine jo b telling us w ho the w inners and
losers will be. It does not help us explain which o f these groups will win the
political battle. Presum ably, a country’s trade policy will em body the prefer­
ences o f society’s m ost pow erful interests. T o explain trade policy outcom es,
therefore, we need to be able to evaluate the relative pow er o f the com peting
grou ps. The society-centered ap p ro ach provid es little guidance a b o u t how
to m easure this balance o f pow er. The tem ptation is to look at trade policy
outcom es and deduce that the m ost pow erful grou ps are those w hose prefer­
ences are reflected in this policy. Y et, lookin g at outcom es renders this a p ­
proach tautological; we assum e that the preferences o f pow erful grou ps are
em bodied in trade policy and then infer the pow er of individual grou ps from
the content o f trad e policy. T h u s, the society-centered ap p ro a ch is better
at explaining why trade po litics are characterized by com petition between
organized interests than at telling us why one group outperform s another in
this com petition for influence.
Second, the society-centered approach implicitly assum es that politicians
have no independent trade policy objectives and play no au ton om o u s role
in trade politics. This assum ption is probably m isleading. Politicians are not
simply passive recorders o f interest-group pressures. As Ikenberry, Lake, and
M astandun o (1988, 8) note, politicians and political institutions “ can play a
critical role in shaping the m anner and the extent to which social forces can
exert influence” on trade policy. Politicians do have independent trade policy
Conclusion
87
objectives, and the constellation o f interest groups that politicians confront is
not fixed. Indeed, politicians can actively attem pt to shape the configuration
of interest-group pressures that they face. They can, for exam ple, mobilize la ­
tent interest groups with a preference for liberalization or protection by help­
ing them overcom e their collective action problem . By doing so, politicians
can create coalition s o f interest grou ps th at supp ort their own trade policy
objectives. Political institutions also affect the extent to which societal groups
can influence policy. In som e countries, political institutions insulate politi­
cians from interest group pressu res, thereby allow ing politician s to pursue
their trade policy objectives independent o f interest group dem ands. We will
exam ine this in greater detail when we look at the state-centered approach in
the next chapter.
Finally, the society-centered approach does not address the m otivations
o f noneconom ic actors in trade politics. Societal interest grou ps other than
firm s, business association s, and lab or unions do attem pt to influence trade
policy. In the United States, for exam ple, environmental groups have played a
prom inent role in trade politics, shaping the specific content o f N A FT A and
attem pting to shape the negotiating agenda o f the D oha R ound. H um an rights
groups have also become active participants in Am erican trade politics. This
has been particularly im portant in A m erica’s relationship with China. H um an
rights groups have consistently sought to deny Chinese producers access to the
U .S. m arket in order to encourage the Chinese governm ent to show greater
respect for hum an rights. The assum ption that trade politics are driven by the
reactions o f interest groups to the im pact o f international trade on their in­
comes provides little insight into the m otivations o f noneconom ic groups. The
society-centered approach tells us nothing ab ou t why grou ps that focus on
the environment or on human rights spend resources attem pting to influence
trade policy. N o r does it provide any basis with which to m ake sense o f such
grou ps’ trade policy preferences. In the p ast, such a w eakness could perhaps
be neglected because noneconom ic grou ps played only a sm all role in trade
politics. The contem porary backlash again st globalization suggests, however,
that these g ro u p s m ust increasingly be in co rp orated into society-centered
models o f trade politics.
A lthough recognizing these w eaknesses of the society-centered approach
is im portan t, these w eaknesses are not reason s to reject the approach . The
appropriate m easure o f any theory or approach is not whether it incorporates
everything that m atters, nor even whether it explains every outcom e that w e
observe. All theories abstract from reality in order to focus m ore sharply on a
number o f key aspects. Consequently, the appropriate m easure o f any theory
or approach is whether it is useful— that is, does it provide us with a deeper
understanding o f the enduring features o f the phenom enon o f interest? O n
this m easure, the society-centered approach scores high. By focusing on how
trade shapes the fortunes of different grou ps in society, it forces us to recog­
nize that the enduring features o f trade politics revolve around a continual
struggle for income between the winners and losers from international trade.
88
CHAPTER 4
A Society-Centered Approach to Trade Politics
KEY TERMS
Collective Action Problem
Export-Oriented Sector
Factor Mobility
Factor Model
Factor-Price Equalization
Import-Competing Sector
Majoritarian
Proportional
Representation
Reciprocal Trade
Agreements Act
Sector Model
Specific Factors
Stolper-Samuelson
Theorem
Veto Player
SUGGESTIONS FOR FURTHER READING
For an excellent introduction to and an interesting attempt to resolve the debate
over the factor and sector models of trade policy preferences, see Michael Hiscox,
International Trade and Political Conflict: Commerce, Coalitions, and Mobility
(Princeton, NJ: Princeton University Press, 2002). For a deeper understanding of
the collective action problem, it is hard to do better than the classic by Mancur
Olson, The Logic o f Collective Action: Public Goods and the Theory o f Groups
(Cambridge, MA: Harvard University Press, 1965).
The literature on U.S. trade politics is enormous. The best available introduction is
probably I. M. Destler, American Trade Politics, 3rd ed. (Washington, DC: Insti­
tute for International Economics, 1992). Unfortunately, there has been much less
written in English on the trade policy process in the EU and Japan. For the EU, see
John P. Hayes, Making Trade Policy in the European Community (London: The
MacMillan Press, 1993). For Japan, see Chikara Higashi, Japanese Trade Policy
Formulation (New York: Praeger, 1983).
r
CHAPTER
5
A State-Centered
Approach to Trade
Politics
I
n O ctober o f 2 0 0 4 , the United States lodged a com plaint w ith the W orld
T rad e O rgan izatio n (W T O )’s dispute-settlem ent m ech an ism in which
it alleged that France, G reat Britain, G erm any, and Spain were illegally
su b sid izin g the E u ro p ean com m ercial aircraft m an u factu rer, A irbus SAS.
The Am erican m ove punctuated a decade during which A irbus successfully
challenged the Am erican firm Boeing for dom inance in the global m arket for
com m ercial aircraft. Only 20 years ago Airbus appeared to pose little threat
to Boeing; Boeing jets com m anded alm ost tw o-thirds o f g lo b al com m ercial
aircraft sales, w hereas A irbus airliners captured only slightly m ore than 15
percent. A s each year passed, however, Airbus drew closer, until early in the
current decade it finally caught up with Boeing, with each firm capturing
roughly half o f the global m arket. Within this changing m arket context, U.S.
T rade Representative R obert Zoellick argued that although there m ay once
have been justification for subsidies to Airbus, that time had long since passed.
The European Union (EU) quickly responded to the American com plaint. A s­
serting that the American move w as “ obviously an attem pt to divert attention
from Boeing’s self-inflicted decline,” the EU initiated a counter-dispute with
the W TO in which it alleged that Boeing receives “ m assive su b sid ies” o f its
own from the U .S. government (Pae 2004).
H o w do w e m ake sense o f this trad e conflict? A society-centered a p ­
proach suggests that we should look at the political influence o f the indus­
tries concerned. And indeed, there is little doubt that Boeing has substan tial
influence in A m erican politics. Form er President G eorge W. Bush explicitly
acknow ledged this influence during the 2 0 0 4 cam paign when he prom ised
Boeing workers during a cam paign stop in Seattle in August that he would end
EU subsidies to Airbus even if he had to initiate a W TO dispute to do so. Yet,
the conflict also raises issues that are not readily incorporated into the societycentered approach. In particular, this isn’t an instance o f conflict between an
American im port-com peting industry and a foreign export-oriented industry.
Instead, the conflict is between two export-oriented firms battling over global
89
90
CHAPTER 5
A State-Centered Approach to Trade Politics
m arket share. M oreover, the conflict does not revolve aroun d one govern­
ment’s use of tariffs to protect dom estic producers from foreign com petition,
but instead focuses on the use of government subsidies to support the dom es­
tic firm as it competes for global m arket share.
There is also a difference hinted at by the R obert Z oellick statem ent—
although there once m ay have been a ju stificatio n for EU subsidies to A ir­
bus, that time has now long passed. This suggests that there m ay be instances
in which governm ent intervention can raise social w elfare and m ay thus be
justified. Yet, the stan dard m odel o f trade, which provides the basis for the
society-centered approach, pretty much rules out such w elfare-im proving in­
tervention. T o fully understand the U .S.-E U trade conflict in the com m ercial
aircraft industry, therefore, we have to broaden our understanding o f the eco­
nomics, and perhaps also the politics, o f international trade.
We gain this b ro ad er u n d erstan d in g in this ch ap ter by d ev elo pin g a
state-centered ap proach to trade politics. A state-centered ap p roach argues
that national policym akers intervene in the econom y in pursuit o f objectives
that are determined independent from dom estic interest gro u p s’ narrow selfinterested concerns. M oreover, this approach suggests that such intervention
m ay (but need not necessarily) raise aggregate social w elfare. We exam ine
the state-centered approach with a specific focus on governm ent intervention
designed to prom ote the development o f specific national industries. We look
first at the broader econom ic justification for protectionism aim ed at creat­
ing internationally com petitive industries, then narrow our focus to the use
o f such m easures by the advanced industrialized countries in high-technology
industries, and then apply the logic o f this approach to the current U .S.-E U
conflict in the commercial aircraft industry. We conclude the chapter by look­
ing briefly at som e o f the weaknesses o f this approach.
STATES AND INDUSTRIAL POLICY
A state-centered approach is based on two central assum ptions, both o f which
contrast sharply with the assum ption s em bodied in the society-centered a p ­
proach. The first assum ption concerns the im pact o f protectionism on aggre­
gate social welfare. The society-centered approach argues that protectionism
reduces social w elfare by depriving society o f the gain s from trade and by
employing society’s resources in com paratively disadvantaged industries, but
the state-centered approach argues that under certain circum stances trade p ro ­
tection can raise social welfare.
The second assum ption concerns whether governments can operate inde­
pendently of interest group pressures. The society-centered approach argues
that national policy reflects the balance o f pow er am ong com peting interest
grou ps, but the state-centered ap p roach argues that under specific circum ­
stances governments are relatively unconstrained by interest-group dem ands.
As a consequence, a governm ent’s trade and econom ic policies em body the
go als o f nation al policym akers rather than the dem ands o f dom estic inter­
est groups. The state-centered approach com bines these tw o assum ption s to
States and Industrial Policy
91
suggest that under a specific set o f circumstances, governm ents will intervene
in the dom estic econom y with tariffs, production subsidies, and other policy
instruments in w ays that raise aggregate social welfare.
T o fully understand this approach, we need to understand the conditions
under which such intervention m ay raise social welfare. We then can examine
the institutional characteristics that enable national policym akers to act au ­
tonom ously from interest groups to capture these welfare gains.
The Infant-Industry Case for Protection
A
_x
The econ om ic ju stific a tio n fo r the state-cen tered a p p ro a c h rests on the
claim that targeted government intervention can increase aggregate social wel­
fare. T his claim stands in stark con trast to the conclusions draw n from the
standard m odel o f trade that we exam ined in Chapter 3 and extended in our
discussion o f the dom estic adjustm ents to trade in C h apter 4. The standard
model rules out such w elfare-increasing government intervention by assum p­
tion. In the standard m odel, society does best by rem oving all form s o f trade
protection and by specializing in its com paratively advantaged industry. M ain­
taining protection merely deprives society o f the welfare gains from trade.
M oreover, in the standard trade model, nothing m akes it difficult for factors currently em ployed in com paratively disadvantaged industries to move
into the com paratively advantaged sector. Factors o f production will move
into com paratively advantaged industries because it is profitable to do so— the
returns in these industries are higher than the returns in the com paratively
disadvantaged industries. Such movement will take time, there will be adjust­
ment costs, and there is a case to be m ade for governm ent policies that help
individuals m anage these co sts, but such policies are oriented tow ard shift­
ing w orkers and resources into sectors where they w ould go anyw ay. In this
m odel, tariffs and other form s o f protection can only m ake society w orse off
by preventing factors from m oving out o f low-return and into high-return in­
dustries. In the world depicted by the standard trade m odels, therefore, gov­
ernment intervention cannot raise social welfare.
In order to claim that a tariff and other forms o f government intervention
raise social welfare, one m ust be able to dem onstrate that som ething prevents
factors from shifting into industries that yield higher returns than are available
in other sectors o f the econom y. H istorically, this justification has been pro­
vided by the infant-industry case for protection. The infant-industry case for
protection argues that there are cases in which newly created firm s (infants, so
to speak) will not be efficient initially but could be efficient in the long run if
they are given time to m ature. Consequently, a short period o f tariff protec­
tion will enable these industries to become efficient and begin to export. Once
this point has been reached, the tariff can be rem oved. The long-run welfare
gains created by the now -established industry will be greater than the shortrun losses of social welfare im posed by the tariff.
There are tw o reasons w hy an industry may not be efficient in the short
run, but could be efficient in the long run: economies o f scale and economies
92
CHAPTER 5
A State-Centered Approach to Trade Politics
o f experience (Kenen 1994, 2 7 9 -2 8 1 ). Econom ies o f scale arise when the cost
o f production varies w ith the size o f outpu t, that is, when the unit co st of
producing falls as the number of units produced rises. For exam ple, it is quite
costly to develop a new commercial aircraft. Estim ates put the cost o f develop­
ing Boeing’s new 777 at around $3 billion. The unit cost o f production will be
very high if Boeing produces only a few o f these planes, as we m ust divide this
fixed cost by a sm all num ber o f final good s. The unit cost falls substantially,
however, if Boeing produces 1,000 o f these new planes. W hat we see, then, is
that the average cost o f each unit falls as the num ber o f units produced rises.
Firms in industries with such scale econom ies face a dilem m a, however. They
can produce efficiently and begin to export once they produce enough output
to achieve the available scale economies. In an open economy, however, these
firm s m ust com pete im m ediately again st established foreign producers that
have already achieved economies o f scale. Consequently, a new firm will have
a hard time selling its higher-average-cost output in the face o f com petition
from lower-cost firm s. Consequently, the new firm will never reach the level
of output necessary to achieve economies o f scale.
In such cases, a tariff might be w elfare im proving. By im posing a tariff,
the government could effectively deliver the dom estic m arket to the infant d o ­
mestic firm. With a guaranteed m arket, the dom estic firm could sell its early
high-cost output to dom estic consum ers and eventually produce enough to
achieve economies of scale. Once it had done so, it could then compete against
foreign producers without the need for tariff protection. The tariff w ould then
be removed.
Econom ies o f experience arise when efficient production requires specific
skills that can only be acquired through production in the industry. In many
industries, efficient production requires “ season ed m an agers, skilled w o rk ­
ers, and reliable suppliers o f equipm ent and m aterials” (Kenen 1 9 9 4 , 2 80).
Because these skills are lacking by definition in an infant industry, it will be
costly to produce the early units o f output. Over time, however, m anagem ent
skills im prove, w orkers learn how to do their task s efficiently, and reliable
suppliers are found and supported. C osts o f production fall as experience is
gained. For exam ple, when A irbus built its first jet, it took 3 4 0 ,0 0 0 personhours to assem ble the fuselage. A s A irbus gained experience, how ever, the
time required to assem ble the jets fell rapidly. By the tim e that A irbus had
produced 75 aircraft, only 8 5 ,0 0 0 person-hours were required to assem ble
the fuselage, and eventually this num ber fell to 4 3 ,0 0 0 person-hours (M c­
Intyre 1992, 36). The efficiency gain s realized as a result o f these dynam ics
are often called “ moving dow n the learning curve.” A gain, however, the new
firm faces a dilem m a. In an unprotected m arket, it w o n ’t be co st com peti­
tive in the face o f established foreign producers. Consequently, it will never
be able to produce enough output to realize these econom ies o f experience.
As with econom ies o f scale, a ta riff can allow the infant industry to realize
the cost savings available from econom ies o f experience and achieve greater
efficiency. Once it has done so , it can begin to exp ort, and the tariff can be
removed.
States and Industrial Policy
93
A CLOSER LOOK
A.
A
A
Criticism of the Infant-Industry Case
for Protection
Many economists are skeptical about the claim that government intervention is
the best response to the problems highlighted by the infant-industry argument (see
Kenen 1994, 281). First of all, a tariff is rarely the best policy response to the
central problem the infant industry confronts. Economists argue that a subsidy is
a much better approach because it is more efficient. Subsidies are a more efficient
policy than a tariff because they target the same policy goal— helping the domestic
industry cover the gap between its production costs and established foreign
producers' costs— but they don't reduce consumer welfare like tariffs do (Kenen
1994, 281). Thus, a subsidy is more efficient.
However, a government subsidy may not improve social welfare either. The
case against a subsidy arises from the fact that a firm that will be profitable in the
long run but must operate at a loss in the short run should be able to borrow from
private capital markets to cover its short-run losses. Such borrowing obviates the
need for a subsidy because it enables the firm to sell its goods at the world price
and cover its short-term losses with the borrowed funds. Thus, as long as capital;
markets are efficient and not "strongly averse to risk," infant industries should be
able to borrow at an interest rate that reflects the social rate of return on capital.
If a firm can't borrow at an interest rate that reflects the social rate of return to
capital, then the market is essentially saying that this industry is not the best place
to invest society's scarce resources. Consequently, the firm shouldn't be supported
with subsidies or tariffs (Kenen 1994, 281). In other words, when capital markets
are efficient, the firm should borrow rather than rely on the government; if ft can't
borrow, the government shouldn't help it either.
This critique of government intervention fails to hold in two circumstances.
First, a firm may be reluctant to borrow from private markets when the problem it
faces arises from economies of experience. In such instances, borrowed funds yield
long-run efficiency by allowing workers employed at a particular firm to gain the
skills required to operate efficiently. Yet, once workers have acquired these skills,
they may go to work for other firms. If they do, the firm that has paid for their
training will be unable to achieve economies of experience and cannot repay the
loan. In this instance, government support for the industry might be helpful, but :■ >
economists argue that government assistance in such cases should take the form
of broad government-funded training programs rather than narrow subsidies to a
specific firm.
The criticism of subsidies also fails to hold if the private capital market is
inefficient and therefore won't loan to a firm entering an infant industry. If this is
the case, the firm will have little capacity to gain the financial resources it needs to
cover its short-term losses. Even here, however, economists argue that a subsidy or
(Continued)
94
CHAPTER 5
A State-Centered Approach to Trade Politics
a tariff may not be the right response. If the government is determined to support
the development of a specific industry, then it should do what the private capital
market won't and extend loans to firms in this industry rather than provide a
subsidy. If the government is primarily interested in raising social welfare, however,
economists argue that the best thing it can do in this circumstance is strengthen
the private capital market so it does operate efficiently (Baldwin 1969). Thus,
even though most economists agree that there will be instances in which firms
that are not efficient in the short run can become efficient in the long run, there is
considerable skepticism about the extent to which government intervention is the
only, or the best, solution to this dilemma. ■
Therefore, tariffs and other form s o f government intervention m ay som e­
times im prove social w elfare, because a disjuncture between the so cial and
private returns from a particular industry m ay prevent the shift o f factors out
of relatively low-return industries and into relatively high-return industries
(B alassa and A ssociates 1 9 7 1 , 93). In other w o rld s, certain industries m ay
offer high social returns over the long run (that is, they will provide large
benefits to society as a w hole), but the short-run private returns (that is, the
profits realized by the person or firm m aking the investment) are likely to be
negative. Consequently, factors d on ’t move autom atically into the potentially
high-return industry. A tariff, or another form o f governm ent intervention,
m ay encourage facto rs to m ove into this industry by raisin g the short-run
return above w hat it would be without a tariff.
The logic o f the infan t-in dustry case for protection has been ad o p ted
by governm ents in many late-industrializing countries. A late-industrializing
country is one that is trying to develop m anufacturing industries in competition
with established m anufacturing industries in other countries. This term obvi­
ously describes m ost developing countries in the contem porary international
economic system. But it once described many o f to d ay ’s advanced industrial­
ized countries, including the United States, as they attem pted to develop m anu­
facturing industries in the face o f dom inant British m anufacturing pow er in the
nineteenth century. Indeed, the infant-industry argum ent w as first developed
by an A m erican, A lexander H am ilton, in 1791 as an explicit policy for the
development o f m anufacturing industry in the United States. H am ilton’s argu­
ment was further developed by the Germ any political econom ist Fredrick List
in the mid-nineteenth century. Like H am ilton, L ist w as prim arily interested
in thinking about how the G erm an governm ent could encourage the grow th
of m anufacturing industries in the face o f established British dom inance. The
infant-industry argum ent continued to have an im portant im pact on govern­
ment trade policies throughout the twentieth century. M any argue that Ja p a n ’s
postw ar trade policies reflect the logic o f the infant-industry argum ent as the
Jap an ese governm ent used a variety o f policy instrum ents to encourage the
developm ent of advanced m anufacturing industries in the face of Am erican
State Strength: The Political Foundation of Industrial Policy
95
com petitive ad v an tages. M an y developing-country governm ents also em ­
braced the logic o f the infant-industry argument throughout the early postwar
periods, as we will see in greater detail in Chapter 6.
The policies that governments have adopted to prom ote the development
of infant industries are known collectively as industrial policy. Industrial pol­
icy can be defined as the use o f a broad assortm ent o f instrum ents, includ­
ing tax policy, subsidies (including the provision o f state credit and finance),
traditional protectionism , and government procurem ent practices, in order to
channel resources aw ay from som e industries and direct them tow ard those
industries that the state w ishes to prom ote. The use o f such policies is typi­
cally based on long-term econom ic developm ent objectives defined in terms
of boosting econom ic grow th, im proving productivity, and enhancing inter­
national com petitiveness. The specific g o als that governm ents pursue often
are determined by explicit com parisons to other countries’ economic achieve­
ments (W ade 1990, 2 5 -2 6 ). In postw ar Ja p a n , for exam ple, the explicit goal
of Jap an ese industrial policy w as to catch up with the United States in hightechnology industries. In much of the developing w orld, industrial policy was
oriented tow ard creating econom ic structures that paralleled those of the ad ­
vanced industrialized countries.
STATE STRENGTH: THE POLITICAL
FOUNDATION OF INDUSTRIAL POLICY
The ability o f any government to effectively design and implement an indus­
trial policy is dependent on the p o litical institutions w ithin which it oper­
ates. The various institutional characteristics that m ake som e states more and
others less able to design and im plem ent coherent industrial policies can be
sum m arized by the concept o f state strength. State strength is the degree to
which national policym akers, a category that includes elected and appointed
officials, are insulated from dom estic interest-group pressures.
Strong states are states in which policym akers are highly insulated from
such pressure, whereas weak states are those in which policym akers are fully
exposed to such pressures. Strong states are characterized by a high degree
o f centralization o f authority, a high degree o f co o rd in atio n am ong state
agencies, and a lim ited num ber o f channels through which societal actors
can attem pt to influence policy. In contrast, w eak states are characterized by
decentralized authority, a lack o f coordin ation am ong agencies, and a large
num ber o f channels through which dom estic interest gro u p s can influence
economic policy.
T hese ch aracteristics o f po litical institutions m ake it easier for strong
states to form ulate long-term plans em bodying the national interest. In weak
states, p o licy m ak ers m ust resp on d to the p a rticu la ristic and often shortrun dem ands o f interest groups. Strong states also m ay be m ore able than a
w eak state to remove protection once an infant industry has m atured. In ad ­
dition, strong states m ay be m ore able to implement industrial policies that
96
CHAPTER 5
A State-Centered Approach to Trade Politics
redistribute societal resources, because policym akers need w orry less that poli­
cies that redistribute resources from one dom estic group to another will have
a negative im pact on their position in power.
Ja p a n is often depicted as the preem inent exam ple o f a strong state that
has been able and w illing to use industrial policy to prom ote econom ic de­
velopm ent (see, for exam ple, Joh n so n 1982). The Jap an ese state centralizes
pow er and provides lim ited channels o f access to dom estic interest grou ps.
Because o f this highly centralized state, Ja p a n has been able to pursue a coher­
ent industrial policy throughout the postw ar period. The M inistry o f Interna­
tional T rade and Industry (M ITI: now called the M inistry o f Econom y, T rade,
and Industry or M ETI) and the M inistry o f Finance (M oF) were the principal
agencies involved in developing and implementing industrial policy. In the im ­
m ediate postw ar period, these agencies gave priority to econom ic reconstruc­
tion and to improving the prew ar industrial economy. Since the 1960s, greater
em phasis has been placed on prom oting rap id econom ic grow th and devel­
oping internationally com petitive high-technology industries (Pempel 1977,
732).
With this goal firmly in mind, the Japan ese state pursued an active indus­
trial policy (called adm inistrative guidance) through which it channeled re­
sources to those industries it determined critical to Japanese success. Together,
the M ITI and M oF targeted specific industries for development, starting with
heavy industries (steel, shipbuilding, autom obiles) in the early postw ar period
and then shifting to high-technology industries during the 1 970s. The state
pressured firms to invest in the industries targeted for development, and those
th at m ade such investm en ts benefited fro m ta r iff an d n o n ta riff fo rm s o f
protection, tax credits, low -cost financing, and other governm ent subsidies.
Some scholars suggest that Ja p a n ’s rem arkable postw ar economic perform ance
w as a direct result o f this state-centered approach to econom ic developm ent
(Johnson 1982).
France also relied heavily upon industrial policies throughout m uch of
the postw ar period (H art 1992). The French state is highly centralized, and
French bureaucracies are tightly insulated from societal group pressures, as in
Jap an . This structure allow ed the French governm ent to pursue an industrial
policy aim ed at developing key industries with little direct influence from d o ­
mestic interest groups. A form er director of the M inistry of Industry described
the policy-m aking process: “ First, we m ake out a report or draw up a text,
then we p ass it around discreetly within the adm in istration. Once everyone
concerned within the adm in istration is agreed on the final version, then we
p ass this version around outside the adm inistration. O f course, by then it is
a fait accom pli and pressure cannot have any effect” (quoted in Katzenstein
1977, 18).
In the early p o stw ar period , the French state form ulated developm ent
plans to “ establish a com petitive econom y as an essential base fo r po litical
independence, economic grow th, and social progress” (Katzenstein 1977, 22).
French industrial policy in this period w as based on a strategy o f “ N ation al
C h am p ion s,” under which specific firm s in industries deemed by the French
State Strength: The Political Foundation of Industrial Policy
97
state to be critical to French econom ic developm ent received support. In the
1950s and 1960s, for exam ple, tw o French steel com panies and a sm all num­
ber o f French auto producers (R enault, Sim ca, Peugeot) received state su p ­
port. D uring the 1960s and 1 9 70s, the French state attem pted to develop a
dom estic com puter industry by channeling resources to specific French com ­
puter com panies such as M achines Bull. M ost regard this strategy as relatively
unsuccessful, because French nation al cham pions failed to becom e com peti­
tive in international m arkets (H art 1992). H ow ever, the current French gov­
ernment seem s poised to revive this approach , announcing in early 2 0 0 5 the
creation o f a new industrial policy oriented tow ard prom oting national cham ­
pions in high-technology industries.
In contrast to Ja p a n and France, the United States typically is character­
ized as a w eak state (Katzenstein 1977; Ikenberry et al. 1988). Political power
in the United States is decentralized through federalism , through the division
o f pow ers within the federal governm ent, and through independent bureau­
cratic agencies. This decentralization o f pow er in turn provides multiple chan­
nels through which dom estic interest grou ps can attem pt to influence policy.
C onsequently, “ A m erican state o fficials find it difficult to act purposefully
and coherently, to realize their preferences in the face o f significant o p p o si­
tion, and to m anipulate or restructure their domestic environment” (Ikenberry
et al. 19 8 8 , 11). Am erican trade and econom ic policy therefore m ore often
reflects the interests o f societal pressure groups than the “ nation al interest”
defined by state policymakers.
This does not mean that the United States has been unable to support crit­
ical industries. American national security and defense policies have channeled
substan tial resources to m aintaining technological leadership over potential
rivals. T o m aintain this lead, the U .S. governm ent has financed the basic re­
search that underlies m any high-technology products, including com puters,
telecom m unications, lasers, advanced m aterials, and even the Internet. In ad ­
dition, D epartm ent o f D efense contracts have supported firm s that produce
both military and civilian items. Thus, even though the United States is a weak
state, we do see a form o f industrial policy in the U .S. governm ent’s support
for basic research and in its defense-related procurement practices designed to
meet national security objectives.
The state-centered approach therefore argues that state policym akers can
use industrial policy to im prove social w elfare. In con trast to the stan d ard
m odel o f trade, this approach argu es that facto rs m ay not m ove au to m ati­
cally from relatively low-return industries into relatively high-return indus­
tries. In such instances, targeted governm ent intervention, in the form o f a
tariff or a production subsidy, can encourage movement into these industries.
Over the long run, the w elfare gains generated by this industry are substan­
tially larger than the w elfare losses incurred during the period o f protection.
The ability o f policym akers to effectively pursue such policies, how ever, is
strongly influenced by the institutional structure o f the state in w hich they
operate. In strong states, such as Ja p a n and France, policym akers are insulated
from dom estic interest groups and are therefore able to use industrial policy
98
CHAPTER 5
A State-Centered Approach to Trade Politics
PO LIC Y A N A L Y S I S AND D E B A T E
Green Industrial Policy in the U.S.?
Question
Should the U.S. government employ industrial policy to encourage the development
of green technology?
Overview
During the 2008 presidential campaign, Barack Obama pledged to spend $150
billion over 10 years developing new green technologies, and another $60 billion
improving energy-related infrastructure. In January 2010, President Obama began
a new program that provided $2.3 billion in funding to 183 firms engaged in
clean-energy manufacturing, arguing that such programs boost employment while
benefiting the environment. At the same time, President Obama has indicated that
he will be hesitant to approve of any new trade agreements that do not include
environmental protections. On several dimensions, in other words, the Obama
administration is attempting to reorient the U.S. economy and trade around
environmentally friendly manufacturing and infrastructure. This has generated
debate over the government's role in shaping the national economy.
Why is the use of industrial policy controversial? Advocates of green industrial
policies— including former Secretary of Labor Robert Reich, the AFL-CIO, and
political commentators like Thomas Friedman— claim that government investment
is needed to overcome high start-up costs for new industry, boost productivity in
high-growth technologies, and maintain competitiveness in globalized markets.
Without government involvement, advocates say, the United States will sacrifice
the gains from early development of new technologies to other countries. Opponents
of green industrial policies— including many economists, business groups, and
free-trade advocates— claim that government intervention misdirects investment
to less productive industries, that choosing economic winners and losers in the
political arena leads to corruption, and that American industry will have an unfair
advantage over their foreign competitors. Both sides can point to examples of
industrial policies that provide evidence for their claims.
Policy Options
• Use the power of the U.S. government to promote the development of new
green technologies by shifting resources into sectors through taxation and
redistribution.
• Allow technological development to occur through the market, and resist
government interference.
Policy Analysis
• What interest, if any, do other states have in the U.S. industrial policy? Why is
this the case?
Industrial Policy in High-Technology Industries
99
• How might U.S. trading partners react to greater U.S. government
involvement? Is this optimal?
• What role does domestic politics play in determining international outcomes in .
trade and environmental policies?
Take A Position
• What option do you prefer? Justify your choice.
• What criticisms of your position should you anticipate? How would you defend
your recommendations against these criticisms?
Resources
Online: Online searches for "industrial policy'' and "green jobs."
in Print: For a less rigorous, but best-selling, discussion of this topic see Thomas L.
Friedman, Hot, Flat, and Crowded: Why We Need a Green Revolution - Ami How It Can
Renew America (New York: Farrar, Straus, & Giroux, 2008), For a more academic
treatment of development and industrial policy, see Dam Rodrik, One Economics,
Many Recipes: Globalization, Institutions, and Economic Growth (Princeton,: NJ: Princeton
University Press, 2008).
to prom ote economic development. In w eak states, such as the United States,
policym akers cannot easily escape interest-group pressures. As a consequence,
trade and econom ic policy is more likely to reflect the particularistic dem ands
o f these groups than any broader conceptions o f social welfare.
INDUSTRIAL POLICY IN
HIGH-TECHNOLOGY INDUSTRIES
High-technology industries have been one area in which governments in many
advanced industrialized countries have relied heavily on industrial policies.
B oostin g the international com petitiveness o f such industries h as been the
principal go al o f such policies. H igh-technology industries are highly valued
for the contribution they make to national income. These industries tend to
earn rents; that is, they earn a higher-than-norm al return on an investment,
and they pay higher w ages to w orkers than do stan dard m anufacturing in­
dustries. In addition, relatively recent developm ents in econom ic theory that
build on the basic insight o f the infant-industry case for protection suggest
that governm ents can use industrial policy to create internationally com peti­
tive domestic high-technology industries. We exam ine these issues here, focus­
ing first on the econom ic theories that justify the use o f industrial policy in
high-technology industries and then exam ining tw o cases in which industrial
100
CHAPTER 5
A State-Centered Approach to Trade Politics
policy appears to have enabled high-technology firm s based in Ja p a n and the
EU to becom e internationally com petitive at the apparen t expense o f hightechnology firms based in the United States. We conclude by returning to the
current U .S.-EU dispute in com m ercial aircraft.
Strategic-Trade Theory
Strategic-trade theory provides the theoretical justification for industrial p o l­
icy in high-technology industries. Strategic-trade theory expands on the basic
insight o f the infant-industry case for protection. Like the infant-industry case,
strategic-trade theory asserts that governm ent intervention can help dom estic
firms achieve econom ies o f scale and experience in order to becom e efficient
and competitive in global m arkets. In contrast to the classical infant-industry
argum ent, which assum es that m arkets are perfectly com petitive, strategictrade theory asserts that m any high-tech industries are characterized by oli­
gopolistic com petition; that is, they feature com petition between only a few
firms. The com bination o f economies o f scale and experience on the one hand
and oligopolistic com petition on the other creates a theoretical rationale for
government intervention to raise national income.
An oligopoly is an industry dom inated by a sm all num ber o f firm s. The
w orld auto industry, for exam ple, is dom inated by only ab o u t eight firm s.
The world m arket for long-distance com m ercial aircraft is dom inated by only
two firms. Such industries are clearly different from , say, agriculture, in which
thousands o f farm s produce for the w orld m arket. Econom ic dynamics in oli­
gopolistic m arket structures are quite different from the dynam ics we see in
perfectly competitive m arkets. The economic analysis o f oligopolistic com peti­
tion can be quite com plex, however, and a detailed analysis o f such com peti­
tion would take us far from our prim ary concern. Consequently, we will leave
a detailed analysis o f such com petition to the side and simply state that firms
operating in oligopolistic m arkets earn excess returns— p ro fits greater than
could be earned in equally risky investments in other sectors o f the econom y
(Krugman and Obstfeld 1994, 282).
Suppose an Am erican firm dom inates the w orld m arket for com m ercial
aircraft. The United States captures the excess returns available in this indus­
try. As a result, Am erican w orkers em ployed in this industry, as well as the
people who have invested their savings in this industry, earn higher incom es
than they w ould earn in the next-best use o f their lab or or savings. A m eri­
can national income is higher than it w ould be otherwise. If a European firm
dom inates the world m arket for com m ercial aircraft, Europe captures the ex­
cess returns and enjoys the higher “ n a tio n al” incom e. And because an o li­
gopolistic industry is one in which only a limited number of firms can operate,
only a small number o f countries can capture the available excess returns. It is
certainly reasonable to suppose, therefore, that societies w ould com pete over
these industries. Strategic-trade theory thus suggests that in som e industries
global economic interaction gives rise to zero-sum com petition over the excess
returns available in oligopolistic high-tech industries.
v-
Industrial Policy in High-Technology Industries
101
W ho is likely to win this com petition? In the absence o f intervention by
any governm ent, the firm that is the first to enter a particular industry will
win, and in doing so effectively deter subsequent entry by poten tial rivals.
Thus, such industries offer a first-mover advantage. This first-m over advan ­
tage arises from econom ies o f scale and experience. Sup pose an A m erican
high-tech firm is the first to produce and m arket a product such as commercial
jet aircraft. Because achieving economies o f scale and experience is central to
the ability to produce com m ercial jets efficiently, the United States, by virtue
o f being first into the m arket, has a production cost advantage over rivals who
m ay w ant to enter the m arket at a later time. A s a consequence, a European
firm that could be competitive once it achieved economies o f scale and experi­
ence is deterred from entering the industry because the cost advantage enjoyed
by the established American firm m akes it very difficult to sell enough aircraft
to achieve these econom ies. After all, who will buy the new entrant’s highercost output? Absent such sales the new firm will never realize the econom ies
o f scale and experience essential to long-term success. The U .S. firm, therefore,
has an advantage in the industry only because it is the first into the m arket.
Consequently, the United States will enjoy the higher national income yielded
by the excess returns in the commercial aircraft industry. Other countries are
denied these excess returns, even though were they able to achieve the neces­
sary economies o f scale and experience, they w ould be every bit as successful
as the American first mover.
G overnm ent intervention m ay have a pow erful effect on the w illingness
o f a latecom er to enter the industry. T h at is, targeted governm ent interven­
tion may enable late entrants to successfully challenge first m overs. By doing
so, government intervention shifts the excess returns available in a particular
industry from a foreign country to the nation al econom y. The logic o f this
argum ent can be illustrated using som e fairly sim ple gam e theory (K rugm an
1987). Let’s assum e that there are two firms, one American and one European,
interacting in a high-tech industry, say com m ercial aircraft, which w ill su p ­
port only one producer. Each firm has two strategies: to produce com m ercial
aircraft or to not produce. The p ay o ffs th at each firm gain s from the four
possible outcom es are depicted in Figure 5 .1 a . There are tw o possible equi­
librium outcom es in this gam e, one in which the American firm produces and
the European firm does not (cell II), and one in which the European firm pro ­
duces and the American firm does not (cell IV). Thus, this particular high-tech
industry will be based in the United States or in E urope, but never in both.
Whichever country hosts the firm earns 100 units in income.
Which country captures the industry depends upon which firm is first to
enter the m arket. L et’s suppose that the A m erican firm is first to enter the
industry and has realized econom ies o f scale and experience. In this case, the
European firm has no incentive to enter the industry, because, by doing so, it
would earn a profit o f 25 . If we assum e that the European firm is first to enter
the m arket, then it realizes econom ies of scale and experience. In this case,
the Am erican firm has no incentive to enter the m arket. T h us, even though
both firm s could produce the product equally well, the firm that enters first
102
CHAPTER 5
A State-Centered Approach to Trade Politics
European Firm
American Firm
Produce
Not Produce
Produce
-5, -5 (1)
100,0(11)
Not Produce
0, 100 (IV)
0, 0 (III)
(a) Payoff Matrix with no Subsidy
European Firm
American Firm
Produce
Not Produce
Produce
Not Produce
-5, 5 (1)
100, 0 (II)
0,110 (IV)
0,0 (III)
(b) Payoff Matrix with European Subsidy
| FIGURE 5.1
I The Impact of Industrial Policy in High-Technology Industries
dom inates the industry. A ccording to strategic-trade theory, therefore, the
firm that is first to enter a p articu lar high-technology industry will hold a
competitive advantage, and the country that is home to this firm will capture
the rents available in this industry.
A gainst this backdrop, we can exam ine how governm ents can use indus­
trial policy to help dom estic high-technology firm s. Governm ent intervention
can help new firms enter an established high-technology industry to challenge,
and eventually com pete w ith, establish ed firm s. G overnm ent assistan ce to
these new firms can come in many form s. Governments m ay provide financial
assistance to help their new firm s pay for the costs o f research and develop­
ment. Such subsidies help reduce the costs that private firms m ust bear in the
early stages of product development, thereby reducing the up-front investment
a firm m ust m ake to enter the industry. E uropean governm ents participating
in the A irbus consortium , for exam ple, have subsidized the developm ent o f
Airbus aircraft. Governm ents also m ay guarantee a m arket for the early and
more expensive versions of the firm ’s products. T ariffs and quotas can be used
to keep foreign goods out, and government purchasing decisions can favor d o ­
mestic producers over im ports. The Jap an ese governm ent, for exam ple, p u r­
chased m ost of its supercom puters from Japanese suppliers in the 1980s, even
though the supercom puters produced by the A m erican firm C ray Industries
were cheaper and perform ed at a higher level. The guaranteed m arket allow s
dom estic firm s to sell their high-cost output from early stages o f production
at high prices. The com bination o f financial support and guaranteed m arkets
allows domestic firms to enter the m arket and move down the learning curve.
Once the new firms have realized economies o f scale, they can com pete against
established firms in international markets.
Strategic Rivalry in Semiconductors and Commercial Aircraft
103
We can see the im pact o f such policies on firm s’ production decisions by
returning to our simple game (see Figure 5.1b). Suppose that the American firm
is the first to enter and dom inates the industry. Suppose now that European
governments provide a subsidy of 10 units to the European firm. The subsidy
changes the pay offs the European firm receives if it produces. In contrast to
the no-subsidy case, the European firm now m akes a profit o f 5 units when it
produces, even if the American firm stays in the market. The subsidy therefore
m akes it rational for the European firm to start producing. Governm ent su p ­
port for dom estic high-technology firms has a second consequence that stems
from the oligopolistic nature o f high-tech industries. Because such industries
support only a sm all number o f firm s at profitable levels o f output, the entry
o f new firm s into the sector m ust eventually cause other firm s to exit. T hus,
government policies that prom ote the creation o f a successful industry in one
country undermine the established industry in other countries.
This outcome is also clear in our simple game. Once the European firm be­
gins producing, the American firm earns a profit of 25 if it continues to produce
and a profit o f 0 if it exits the industry. Exit, therefore, is the American firm ’s
rational response to the entry o f the European firm. Thus, the small 10-unit sub­
sidy provided by European governments enables the European firm to eliminate
the first-mover advantage enjoyed by the American firm, but ultimately drive
the Am erican firm out o f the industry. A s a consequence, E urope’s national
income rises by 100 units (the 110-unit profit realized by the European firm
minus the 10-unit subsidy from E uropean governm ents), w hereas A m erica’s
national income falls by 100 units. A sm all government subsidy has allowed
Europe to increase its national income at the expense of the United States.
Strategic-trad e theory su g g e sts, th erefore, th at the lo catio n o f hightechnology industries has little to do with cross-national differences in factor
endowm ents and a lot to do with m arket structure and the assum ptions we
m ake ab ou t how production co sts vary with the quantity o f output. T his is
a w orld in which the classical m odel o f com parative advantage doesn’t hold.
International com petitiveness and the pattern o f international specialization
in high-technology industries are attributed as much to the timing o f m arket
entry as to underlying factor endowments.
STRATEGIC RIVALRY IN SEMICONDUCTORS
AND COMMERCIAL AIRCRAFT
The sem iconductor industry and the com m ercial aircraft industry illustrate
these kinds o f strategic trade rivalries between the United States, Jap an , and
the EU in the contem porary global econom y. In the sem iconductor industry,
American producers enjoyed first-mover advantages and dom inated the world
m arket until the early 1980s. The sem iconductor industry prospered in the
United States in p art due to governm ent support in the form o f funding for
research and development (R & D ) and for defense-related purchases. The U.S.
governm ent financed a large portion o f the basic research in electronics— as
104
CHAPTER 5
A State-Centered Approach to Trade Politics
much as 85 percent of all R & D prior to 1958, and as much as 50 percent dur­
ing the 1960s. At the sam e time, the U.S. defense industry provided a critical
m arket for semiconductors. Defense-related purchases by the U .S. government
absorbed as much as 100 percent o f total production in the early years. Even
in the late 1960s, the governm ent continued to purchase as much as 40 per­
cent o f production. These policies allow ed Am erican sem iconductor firm s to
move down the learning curve and realize economies o f scale. This first-mover
advantage w as transform ed into a dom inant position in the global m arket. In
the early 1970s, U .S. sem iconductor producers controlled 98 percent o f the
American m arket and 78 percent o f the European market.
Beginning in the 1 9 70s, the Jap an e se governm ent targeted sem iconduc­
tors as a sector for priority developm ent and used tw o policy m easures to
foster a Jap an e se sem icon ductor industry. First and m ost im portan tly, the
Jap an e se governm ent used a variety o f m easu res to pro tect Jap an e se sem i­
conductor producers from A m erican com petition. T ariffs and q u o tas kept
Am erican chips out o f the Jap an e se m arket. The Jap an e se governm ent also
approved very few applications for investment by foreign sem iconductor firms
and restricted the ability o f Am erican sem iconductor firm s to purchase exist­
ing Japanese firms. As a direct result, American sem iconductor firms were un­
able to jump over trade barriers by building sem iconductor production plants
in Jap an . The Jap an ese industrial structure— a structure in which producers
develop long-term relatio n sh ips w ith input su p p liers— helped ensure that
Jap an ese firm s that used sem iconductors as inputs purchased from Jap an ese
rather than Am erican suppliers. Finally, governm ent purchases o f com puter
equipm ent discrim inated again st products that used Am erican chips in favor
o f com puters that used Jap an ese sem iconductors. Second, the Jap an ese go v ­
ernment provided financial assistance to more than 60 projects connected to
the sem iconductor and com puter industry. Such financial assistance helped
cover many of the R & D costs Japan ese producers faced.
The extent o f Jap an ese protectionism can be appreciated by com parin g
U.S. m arket shares in the EU, and Japanese m arkets. W hereas American semi­
conductor firms controlled 98 percent o f the American m arket and 78 percent
o f the EU market in the m id-1970s, they held only 20 percent o f the Japanese
m arket (Tyson 1995, 93). By 1976, Japan ese firms were producing highly so ­
phisticated chips and had displaced American products from all but the m ost
sop h isticated ap p licatio n s in the Jap an e se m arket. Success in the Jap an e se
m arket w as follow ed by success in the global m arket. Ja p a n exported m ore
sem iconductors than it im ported for the first time in 1979. By 1986 Japan ese
firm s had cap tu red a b o u t 4 6 percen t o f g lo b a l sem ico n d u cto r revenues,
w hereas the A m erican firm s’ share h ad fallen to 4 0 percent (T yson 1 9 9 5 ,
1 0 4 -1 0 5 ). By protecting dom estic producers and subsidizing R & D costs, the
Jap an ese governm ent helped Jap an ese firm s successfully challenge Am erican
dominance o f the sem iconductor industry.
A sim ilar dynam ic is evident in U .S.-E u ro p ean com petition in the com ­
m ercial a ircraft sector. T w o A m erican firm s, B oein g an d D o u g la s (later
M cD onnell D ou glas), dom inated the global m arket for com m ercial aircraft
Strategic Rivalry in Semiconductors and Commercial Aircraft
105
throughout the postw ar period, in part because o f U.S. government support to
the industry provided through the procurem ent of military aircraft (Newhouse
1982; United States O ffice o f T echnology Assessm ent 19 9 1 , 345). W ork on
military contracts enabled the two m ajor American producers to achieve econ­
om ies o f scale in their com m ercial aircraft operations. Boeing, for exam ple,
developed one of its m ost successful commercial airliners, the 707, as a m odi­
fied version o f a military tanker craft, the K C -135. This allow ed Boeing to re­
duce the cost o f developing the com m ercial airliner. Both jets in turn benefited
from the experience Boeing had gained in developing the B -47 and the B-52
bom bers (O T A 19 9 1 , 345). As Jo se p h Sutter, a Boeing executive vice presi­
dent, noted, “ We are go od . . . partly because we build so m any airplan es.
We learn from our m istakes, and each o f our airplanes em bodies everything
we have learned from our other airp lan es” (quoted in N ew house 1 9 82, 7).
The accum ulated knowledge from m ilitary and com m ercial production gave
the tw o American producers a first-mover advantage in the global m arket for
commercial airliners sufficient to deter new entrants.
In 1 9 6 7 , the French, G erm an, and British governm ents launch ed A ir­
bus Industrie to challenge the glo b al dom inance o f Boeing and M cD onnell
D ouglas. Between 1970 and 1991, these three European governments provided
between $10 billion and $18 billion o f financial support to A irbus Industrie,
an am ount equal to about 75 percent of the cost of developing Airbus airliners
(O TA 1991, 354). As a consequence, by the early 1990s Airbus Industrie had
developed a family o f com m ercial aircraft capable o f serving the long-range,
m edium -range, large passenger, and sm aller passenger routes. A irbus’s entry
into the commercial aircraft industry had a dram atic im pact on global market
share. As T ab le 5.1 m akes clear, in the m id -1970s Boeing an d M cD onnell
D ou glas dom inated the m arket for large com m ercial airliners. A irbus began
to capture m arket share in the 1 9 80s, how ever, and by 1990 it had gained
control o f 30 percent o f the m arket for large com m ercial airliners. In 1994
A irbus sold m ore airliners than Boeing for the first tim e. A nd the ensuing
10 years indicates that 1994 w as no fluke, as A irbus has firm ly established
itself as a dom inant force in the global m arket for long-range com m ercial jets.
\
TABLE 5.1
‘z * *
r
.
, -
v
B.oefng w . .
1975 - - . ■ i - ,.— 67% .
19&5 K X ^ j t ^ . i f 4 X 63% - .
. 1990 .*.: . v r 54% 2005-2007 . * : .*„. 50.8% -
•*;
‘•'•!^UV'.*i.» tA;.- ■?!-^r: -‘’yAS* £ & £ & $ &
.McDoooelj^ojjglas*
„ , , , £ &
-------- ----------- t t ------ y z T L — "— ’
1
'
-* •»
33% , , iff- * j.» ",
ir{w j
. -20%i.... t
. . ' U ‘ 1 2 % ,W t
.-16% ' . . j * i; \ i ' i 30!%iW'i
.■ .n.a.* • « : • ■.:■!
j - i . i49.2%^',
■*•■'
•.
. ...
wi *Met^ed\wfBoeStg in 1997; its commercial aircraft fleet Jsho longer j#bcJu<!e& ^**^s*J
- *n.a., not available. ' :
'■ .
-*
. .. - tir - . "
,v5t&
• • S o u r t t i Datj^for.J975-1990 areolculated from Tyson J995,15^-159. Data.for^005-:Jp07 ^ij^
from Boeing and Airbus! *
’'
’
”
' '
" '
'
‘
*<
t$
A
'* 7
*
Wtv'
'v
-*
<*' ’ ' 1 ♦*»***♦
106
CHAPTER 5
A State-Centered Approach to Trade Politics
As a consequence o f A irbus’s success, a substantial portion o f the rents avail­
able from the production and sale o f com m ercial airliners has been transferred
from the United States to Europe. T hus, by subsidizing the initial costs o f air­
craft developm ent, E uropean governm ents have been able to capture a sig ­
nificant share o f the glo b al m arket for com m ercial aircraft and the incom e
generated in this sector, at the expense of the United States.
Strategic-trade rivalries of this kind have been a source o f conflict in the
international trade system . C ountries losing high-technology industries as a
consequence o f the industrial policies pursued by other countries can respond
by supporting their own firm s to o ffset the ad v an tages enjoyed by foreign
firms or by attem pting to prevent foreign governm ents from using industrial
policy. In the United States, which considered itself a victim o f the industrial
policies adopted by Jap an and the EU, the national debate has focused on both
responses. Considerable pressure em erged during the 1 980s and early 1990s
for a national technology policy. Proposals were advanced for the creation of
a governm ent agency charged with reviewing global technology and “ evalu­
ating the likely course o f key A m erican industries; com paring these baseline
projections with visions o f industry path s that w ould be com patible with a
prosperous and competitive economy; and m onitoring the activities o f foreign
governments and firms in these industries to provide an early w arning o f p o ­
tential competitive problem s in the future” (Tyson 1995, 289). M any recom ­
mended that the U .S. governm ent reduce its R & D su p p ort for m ilitary and
dual-use projects (dual use refers to projects with military and com m ercial ap ­
plications) and increase the am ount o f support provided to strictly commercial
applications. Proponents o f a nation al technology strategy also encouraged
greater cooperation between the public and private sector on precom petitive
research in a wide range of advanced technologies. Such p ro posals played an
im portant role in the first C linton adm in istration ’s thinking a b o u t interna­
tional trade, a role reflected in C linton’s selection o f L au ra D ’Andrea Tyson,
an econom ist and one o f the m ost prom inent proponents o f such policies, to
be the chair o f his Council o f Econom ic Advisors.
The United States also put considerable pressure on other governments to
stop their support o f high-technology industries. A series o f negotiations with
Ja p a n that w as conducted during the 1 9 8 0 s and early 1 9 9 0 s were designed
to pry open the Jap a n e se m arket to in tern ation ally com petitive A m erican
high -technology in d ustries. Such n e go tiatio n s to o k place in sem icon d u c­
to rs, com puters, telecom m unications, and other sectors. The ratio n ale for
these negotiations is evident from the previous discussion ab ou t first-m over
advantages. If Jap an e se firm s could be denied a protected m arket for their
early p ro d u ctio n run s, they w o u ld never realize the scale eco n om ies re ­
quired to compete in international m arkets. Opening the Jap an ese m arket to
Am erican high-technology producers w ould prevent the em ergence o f co m ­
petitive Jap an ese high-technology firm s and thereby help m aintain Am erican
high-technology leadership. D uring the 1980s and early 1990s, therefore, the
United States responded strategically to the use of industrial policies by Jap an
and, to a lesser extent, the EU and adopted policies designed to counter them.
Conclusion
/
107
It is within this context that we can understand the current U .S.-E U con­
flict in the commercial aircraft industry. Boeing has long been concerned about
the gains A irbus has m ade in the glo b al m arket and h as long pressured the
U.S. government to try to limit the subsidies that European governments offer.
In 1992 the U nited States and the E uropean U nion reached agreem ent that
both would not provide subsidies greater than one-third o f the total cost o f de­
veloping a new airliner or greater than 3 percent o f the firm ’s annual revenue.
In early summer o f 2004 the Bush adm inistration, facing considerable pressure
from Boeing, informed the EU that it w as time to renegotiate this agreement.
The time for such a move looked right, at least to Boeing, for both companies
were beginning to develop new aircraft, and Boeing argued that each should
do so w ithout governm ent support. As Boeing C E O H enry Stonecipher said,
the 1992 agreement “ no longer reflected m arket realities” and had “ outlived
its usefulness” (King 2004). Given A irbus’s current m arket position, it should
stop expecting E uropean governm ents to give it “ tru ck lo ad s” o f m oney to
cover a portion o f new aircraft development. “ W e’re saying enough is enough.
Y o u ’re very su ccessfu l, y o u ’re delivering and selling m ore airp lan es than
B o e in g .. . . Why don’t you go to the bank and borrow m oney?” It w as, Boeing
argued, “ time fo r A irbus to accept the financial and m arketplace risks that
true commercial com panies experience” (Casert 2004, p. E.03).
Efforts to renegotiate the 1992 agreement proved unsuccessful. Although
EU officials seemed willing to accept the Am erican claim that A irbus had re­
ceived governm ent support (though they denied that such support am ounted
to more than a token), they asserted that Boeing had itself been the beneficiary
o f $23 billion o f government subsidies since 1992. These subsidies had come,
the EU argued, from U .S. government R 8cD contracts and from $3.2 billion in
tax reductions, ta x exem ptions, and infrastructure improvements provided by
the state o f W ashington. Consequently, the EU w as willing to discuss a reduc­
tion of E uropean assistance to A irbus only in conjunction with an American
w illingness to accept a reduction o f such assistan ce fo r Boeing. When the
United States proved unw illing to either accept the EU claim or to provide
inform ation that w ould dispute the claim , the negotiations broke down. D ays
later, the United States announced that it w as w ithdraw ing from the 1992
agreement and filed a dispute with the W TO alleging that the EU w as in viola­
tion o f its W TO obligations concerning the use o f subsidies that cause harm
to foreign com petitors. The EU responded im m ediately by initiating its own
W TO dispute in which it alleged the sam e thing o f the U nited States. The
stakes are high, as estimates suggest that over the next 2 0 years sales o f large
commercial aircraft will generate $2 trillion (Blustein 2004b ). It remains to be
seen whether American or European producers will capture this income.
CONCLUSION
Even though a state-centered ap p roach directs our attention to the im por­
tan t role that states play in sh apin g the structure o f their dom estic econo­
m ies, it does have som e im portant w eaknesses. Three such w eaknesses are
108
CHAPTER 5
A State-Centered Approach to Trade Politics
perhaps m ost im portant. First, the state-centered approach lacks explicit m i­
crofou n d atio n s. The ap p ro ach asserts that states act in w ays th at enhance
nation al w elfare. A critical studen t m ust resp on d to this assertio n by a sk ­
ing one sim ple question: W hat incentive does the state have to act in w ays
that do in fact enhance n ation al w elfare? Anyone w ho has visited the P al­
ace o f V ersailles in France or h as spent any tim e read in g a b o u t the e x p e ­
rience o f other au to n o m o u s rulers know s th at a u to n o m o u s states have as
much (if not m ore) incentive to act in the private interests o f state officials
as they have to act in the interest o f society as a w hole. W hy then w ould
autonom ous state actors enrich society when they m ight ju st as easily enrich
them selves? A nsw ering this question requires us to think a b o u t how state
acto rs are rew arded for p ro m otin g policies th at enhance n atio n al w elfare
and are punished for failing to do so. In answ ering this question, we develop
m icrofoundations— an exp lan ation that sets out the incentive structure that
encourages state o fficials to ad o p t policies th at p ro m ote n ation al w elfare.
But the state-centered ap p ro ach currently does n o t o ffer a g o o d answ er to
this question. The rew ard structure that state po licym akers face can n ot be
elections, for that pushes us back tow ard a society-centered approach . The
rew ard structure m ight be security related; one could reason ably argue that
states intervene to enhance the pow er and po sition o f the n ation in the in ­
tern ational system . We m ust still exp lain , how ever, how these b ro ad co n ­
cerns ab ou t n ation al security create incentives for individual policym akers
to m ake specific decisions a b o u t resource allo catio n . The poin t is not that
such m icrofo u n d atio n s could not be developed, but rath er, a s far as I am
aw are, that no one has yet done so. A s a result, the state-centered approach
provides little justification for its central assertion that states w ill regularly
act in w ays that enhance national welfare.
Second, the assum ption that states m ake policy independent o f dom estic
interest-group pressure is m isleading. Even highly auton om ous states do not
stand above all societal interests. Interest grou ps need not dictate policy, as
the society-centered approach claim s, but they do establish the param eters in
which policy m ust be m ade. Even in Ja p a n , which probably com es closest to
the ideal auton om ous state, the Liberal D em ocrat Party’s (LDP) position in
government w as based in part on the support o f big business. Is it merely a co ­
incidence that Jap an ese industrial policy channeled resources to big business,
or did the Japanese state adopt such policies because they were in the interest
of one of the LD P’s principal supporters? T hus, whereas the society-centered
approach assu m es to o little room for au to n o m o u s state actio n , the statecentered approach assum es too much state autonom y. We m ay learn m ore by
fitting the two approaches together. This w ould lead us to expect governments
to intervene in the economy to prom ote specific econom ic outcom es, but often
such policies are consistent with and shaped by the interests o f the coalition of
societal groups upon which the government’s pow er rests.
Finally, strategic-trade theory itself, which provides the intellectual ju s­
tificatio n for governm ent intervention in high -techn ology in d u stries, h as
con siderable w eak n esses. Strategic-trad e theory is a s m uch a prescriptive
Conclusion
109
theory— one used to derive policy p ro posals— as it is an explan atory theory.
As such, it has som e im portant lim itations. The claim that governm ent inter­
vention can im prove national w elfare is not particularly robust. The conclu­
sions one derives from any theory are sensitive to the assum ptions one m akes
when building the theory. If the conclusions change greatly when one alters
som e o f the underlying assum ptions, then the confidence one has in the ac­
curacy o f the theory m ust be greatly dim inished. Strategic-trade theory has
been criticized for producing strong conclusions only under a relatively re­
strictive set o f assum ptions. Although the specific criticism s are too detailed
to consider here, the bottom line is that altering the assum ption s ab o u t how
one country’s established firms respond to a foreign governm ent’s subsidy of
its firms, about how many firms are in the sector in question, and about where
firm s sell their products can either weaken the central claim considerably or
introduce so much com plexity into the model that the policy im plications be­
come opaque.
T hus, strategic-trade theory does not provide unam biguous su p p ort for
the claim that government intervention in high-technology industries can raise
national income. In addition, even if we assum e that strategic-trade theory is
correct, it is not easy for governm ents to identify sectors in which interven­
tion will raise national income. It is difficult to identify sectors that offer such
gains and then to calculate the correct subsidy that will shift this activity to
domestic producers at a net gain to social welfare. If governments choose the
wrong sectors or provide too little or too much support, intervention can re­
duce rather than raise national welfare. T hus, the precise policy im plications
of strategic-trade theory are unclear, in part because the theory itself is weak
and in part because it is not easy to translate the theory’s sim pler conclusions
into effective policies.
In sp ite o f these w e a k n e sse s, the state -ce n te re d a p p ro a c h p ro v id e s
a useful check on the tendency o f the society-centered ap p ro a ch to focu s
exclusively on the interests o f so cietal interest gro u p s. The state-centered
ap proach po in ts our attention to the interests o f governm ent o fficials and
underscores the need to think ab o u t the ability o f these o fficials to act in­
dependent from , and even again st, the interests o f dom estic interest groups.
By doing so, it suggests that trade policy m ay not alw ays reflect the balance
o f pow er betw een interest gro u p s and tells us th at we m ight need to take
into account how state interests intervene in this com petition in w ays that
produce outcom es that no interest grou ps desire. Y et, in spite o f these use­
ful insights, I believe that the absence o f clearly specified m icrofoundations
in this ap proach represents a fatal flaw . W ithout such foun dation s, the a p ­
proach can tell us that auton om ous state officials will act, but it can n ot tell
us how they will act. Adding such m icrofoundations, perhaps by com bining
the dynam ics highlighted by the society-centered approach with the rich in­
stitutional environm ent em phasized by the state-centered ap p ro ach , w ould
enable us to begin thinking ab ou t the conditions under which state officials
have the capacity for auton om ous action and ab ou t the ends to which such
autonom ous officials will direct their energies.
110
CHAPTER 5
A State-Centered Approach to Trade Politics
KEY TERMS
Economies of Experience
Economies of Scale
Industrial Policy
Infant-Industry Case for
Protection
Oligopoly
Rents
State Strength
Strategic-Trade Theory
SUGGESTIONS FOR FURTHER READING
Douglas Irwin provides an excellent discussion of the historical development of the
infant-industry case for protection in his Against the Tide: An Intellectual History
o f Free Trade (Princeton, N J: Princeton University Press, 1996). The original
formulation can be found in Alexander Hamilton, Secretary of the Treasury, Report
on Manufactures, communicated to the House of Representatives, December
5, 1791, in Papers on Public Credit, Commerce and Finance, S. Mckee, Jr., ed.,
pp. 175-276 (New York: Columbia University Press, 1934).
On the issues posed by industrial policy in high-technology industries, see Laura
D’Andrea Tyson, Who’s Bashing Whom? Trade Conflict in High Technology In­
dustry (Washington, DC: Institute for International Economics, 1995). For a more
polemical discussion written by a former trade negotiator in the Reagan administra­
tion, see Clyde V. Prestowitz, Trading Places: How We Are Giving Our Future to
Japan and How to Reclaim It (New York: Basic Books, 1988). For a more technical
treatment, see Paul R. Krugman, ed., Strategic Trade Policy and the New Interna­
tional Economics (Cambridge, UK: Cambridge University Press, 1986).
6c h a p t e r
Trade and
Development I:
Import Substitution
Industrialization
M
exico has experienced an econom ic revolution during the last 20
years. Until the m id -1980s, M exico w as one o f the m ost heavily
protected and highly directed nonsocialist econom ies in the world.
Im porting anything into the country required form al governm ent approval.
Even with such approv al, tariffs were very high, averaging over 25 percent
and rising as high as 100 percent for many goods. M oreover, M exico did not
belong to the General Agreem ent on T ariffs and T rade (G A T T ), and it w as
hard to im agine any conditions under which M exico w ould seek a free-trade
agreement with the United States. Behind these high tariff w alls, the M exican
government intervened deeply in the dom estic econom y. Government-owned
financial institutions channeled investm ent capital to favored private indus­
tries and projects. The governm ent created state-ow ned enterprises in many
sectors o f the economy (about 1,200 o f them by 1982) that together attracted
m ore than one-third o f all in d ustrial investm ent (L a P o rta and L o pez de
Silanes 1997). T od ay , by contrast, M exico is one o f the m ost open develop­
ing countries in the w orld. M exico entered the G A T T in 1987 and the N orth
American Free T rade Agreement (N A FTA ) in the early 1990s. The M exican
government has retreated sharply from involvement in the dom estic economy.
It has sold state-ow n ed enterprises, liberalized a w ide variety o f m arketrestricting regulations, and begun to integrate M exico deeply into the global
econom y. In less than 10 years, the M exican governm ent opened M exico to
foreign com petition and drastically scaled back its role in m anaging M exican
economic activity.
M exico’s experience is hardly unique. Governments in India, China, much
o f Latin A m erica, and m ost o f sub-Sah aran A frica opted out o f the global
trade system follow ing W orld W ar II. M o st governm ents erected very high
trade barriers, and to the extent that they participated at all in the G A T T ,
111
112
CHAPTER 6
Trade and Development I: Import Substitution Industrialization
they sought to alter the rules governing international trade. Convinced that
the G A T T w as biased again st their interests, developing countries w orked
through the United N ation s to create international trade rules that they be­
lieved w ould be m ore favorable tow ard in d ustrialization in the developing
world. Like M exico, m ost governments intervened extensively in their econo­
mies in an attem pt to prom ote rapid industrialization. D raw ing on the logic
o f the infant-industry case for protection, governm ents used the pow er o f the
state to pull resources out o f agriculture and push them into m anufacturing.
And, like M exico, these policy orientations have changed fundam entally since
the late 1980s. M ost developing countries have dism antled the protectionist
systems they m aintained in the first 30 years o f the postw ar period, have be­
come active participants in the W orld T rade O rganization (W TO ), and have
abandoned the quest to institute far-reaching changes to international trade
rules. M ost have greatly reduced the degree o f government intervention in the
domestic economy.
This chapter and the next examine how political and economic forces have
shaped the adoption and evolution o f these new trade and developm ent poli­
cies. This chapter examines why governments in so many developing countries
intervened deeply in their dom estic econom ies, insulated themselves from in­
ternational trade, and sought changes in international trade rules. The next
chapter focuses on why so many governm ents have dism antled these policies
during the last 30 years. We look first at how econom ic and political change
throughout the developing world brought to power governments supported by
import-competing interests. We then examine the economic theory that guided
policy during those times. As we shall see, this theory provided governm ents
with a com pelling justification for transform ing the protectionism sought by
the im port-com peting producers that supported them into policies that em ­
phasized industrialization through state leadership. H aving built this base, we
turn our attention to the specific policies that governments pursued during that
period, looking first at their dom estic strategy for industrialization and then
examining their efforts to reform the international trade system.
DOMESTIC INTERESTS, INTERNATIONAL
PRESSURES, AND PROTECTIONIST COALITIONS
D eveloping countries’ trade policies underw ent a sea change in the first h alf
o f the twentieth century. Until the First W orld W ar, those developing coun­
tries that were independent, as well as those regions o f the w orld held in co ­
lonial em pires, adopted liberal trade policies. They produced and exported
agricultural goods and other prim ary com m odities to the advanced industrial­
ized countries and im ported m ost o f the m anufactured go od s they consum ed.
Governments and colonial rulers m ade little effort to restrict this trade. But by
the late 1950s, these liberal trade policies had been replaced by a protection­
ist approach that dom inated the developing countries’ trade policies until the
late 1980s and whose rem nants rem ain im portant in many countries today.
Domestic Interests, International Pressures, and Protectionist Coalitions
^
a
113
We begin our investigation o f developing countries’ trade and developm ent
policies by looking at this initial shift to protectionism.
T ra d e an d d ev elo p m en t p o licie s in d ev elo p in g co u n trie s have been
strongly shaped by political com petition between rural-based agriculture and
urban-based m anufacturing. Developing countries pursued liberal trade p o li­
cies prior to W orld W ar I because export-oriented agricultural interests dom i­
nated politics. In general, developing countries are abundantly endowed with
land and poorly endowed with capital (Lai and M yint 1996, 104-110).
The relative im portance o f land and capital in developing countries’ econ­
omies can be appreciated by exam ining the structure o f those econom ies, to ­
gether with exp orts, as presented in T ab le 6.1 and T ab le 6.2. For the tim e
being, we will focus on 1960, as this will allow us to put to the side the con­
sequences o f the developm ent policies that governm ents adopted during the
postw ar period. W ith a few exception s (particularly in Latin A m erica), be­
tween one-third and one-half o f all econom ic activity in developing countries
in 1960 w as based in agriculture, whereas less than 15 percent w as based in
m anufacturing. By contrast, agriculture accounted for only 5 percent o f gross
dom estic product (GDP) in the advanced industrial econom ies. If we include
the “ other industry” category, which incorporates mining, then in all regions
o f the developing world other than Latin America, agriculture and nonmanufacturing industries accounted for more than half o f all economic activity.
A sim ilar pattern is evident in the com m odity com position o f developing
countries’ exp orts (T able 6.2). In 1 9 62, developing countries’ exp orts were
T A B L E 6.1
•• t *• *
** ■ *
«*r■*9'*
~ *
Economic Structure.in Developing Countries (Sector as a Percent of
Dross Domestic Product)
Agriculture
Manufacturing
Other Industry*
Services.
1960 1980 1995
i96019801995196019801995
19601980 1995 *■■■••
~ ir t ^ u i f
•---'V HM■ -■‘-t T - *- ■" o r " '
---- ..........................................f
SubAfrica
36
-
24
«
■
20
12
12
15
- <*?. • - v '
East A$ia '46 *' 2r
18
24
«•
<
-tv txt
15
40
38
48
-
- .
41
-- -
M
and the
'
.
Pacific
South Asia
49
39
30
13
15
17
6
9
10
33
35
Latin
16
10
IQ
21
-25
21
10
12
12
53
51 .5 5
* "
•~
Am erica' ’
’’ \
'
'
'•‘ i
‘ '' ” ’ ■ ” ‘ f
Figures may not sum to 100 because of rounding.
‘
•
♦Includesmining, construction,’gas, andwaters '
"
'
- " V,"1'
S ources: Data for I960 from World Bank, W o rtd T o b le s, 3rd ed. (Washington, DC: The World Bank,;.;
1983). Data for 1980 and 1995 from World Bank, W o rk ! D evelopm ent M c M o rs (Washmgtori^DC:JJ)e,
World Bank, 1997).
' ’ ‘
,
•''
r
114
CHAPTER 6
Trade and Development I: Import Substitution Industrialization
T A B L E 6.2
Developing Countries’ Export Composition
(Sector as a Percent of Total Exports)
Fuels, Minerals,and
Other Primary
Metals
Commodities
Manufactures
1962 1980 1993 1962 1980 1993 1962 1980 1993
Sub-Saharan
Africa
Cameroon
Ghana
Kenya
Nigeria
South Africa
Zaire
21
73
2
11
23
16
33
17
36
97
33
56
51
25
16
94
16
69
75
31
89
81
47
75
64
82
52
2
28
14
35
52
66
4
11
13
4
4
14
1
9
8
26
10
1
13
0
40
31
23
19
2
74
18
East Asia and
the Pacific
Hong Kong
Indonesia
Malaysia
Singapore
South Korea
T aiwan
South Asia
India
Pakistan
2
2
2
3
5
3
93
93
96
37
n.a.
76
35
32
14
63
n.a.
22
46
15
21
0
n.a.
3
20
52
24
n.a.
31
1
2
14
3
2
18
57
n.a.
18
9
10
6
4
5
30
20
n.a.
51
90
88
53
65
80
94
9
0
8
8
7
1
47
33
44
18
14
44
25
59
48
75
85
2
6
86
11
65
73
11
56
12
95
4
88
8
60
71
11
57
25
28
38
9
3
5
3
4
16
23
3
39
10
12
32
75
93
Latin America
Argentina
Bolivia
Brazil
Chile
Mexico
91
9
87
24
43
17
50
25
15
19
60
19
75
not available.
Data for 1962 from World Bank, W o rld T a b le s , 3rd ed. (Washington, DC: The World Bank,
1983). D ataforl980 and 1993 from World Bank, W o rld D e v e lo p m e n t In d ic a to rs l Washington, DC: The
World Bank, 1997).
n .a .,
S o u rc e s:
heavily concentrated in prim ary com m odities: agricultural products, m iner­
als, and other raw m aterials. R oughly speaking, in each developing country,
prim ary com m odities accounted for m ore than 50 percent o f ex p o rts, and
in more than half o f the listed countries prim ary com m odities accounted for
more than 80 percent o f exports. In addition, each country exported a narrow
range of prim ary com m odities. Some countries were m onoexporters; that is,
Domestic Interests, International Pressures, and Protectionist Coalitions
115
their exports were alm ost fully accounted for by one product. For exam ple
m ore than 80 percent o f Burundi’s exp o rt earnings cam e from coffee and
cocoa accounted for 75 percent of G hana’s export earnings (Cypher and D i­
etz 1997, 339). Sim ilar patterns were evident in Latin America: In 1950, cof­
fee and cocoa m ade up about 69 percent o f Brazil’s exports, and copper and
nitrates constituted about 74 percent of C h ile’s exp orts (Thorp 1999, 346).
The structure o f their economies and the com position of their exports thus un­
derline the central point: Developing countries are abundantly endowed with
land and have little capital.
The precise form through which landow ners dom inated politics prior to
W orld W ar II differed considerably across regions. In Latin America, an indig­
enous landow ning elite dom inated dom estic politics. In Argentina and Chile,
for exam ple, the landowners controlled government, often in an alliance with
the military. Even though these political system s were constitutionally dem o­
cratic, participation w as restricted to the elite, a group that am ounted to about
5 percent o f the population, in a system that has been characterized as “ oli­
garchic dem ocracy” (Skidmore and Smith 1989, 47). In other Latin American
countries such as M exico, Venezuela, and Peru, dictatorial and often military
governm ents ruled, but they pursued policies that protected the interests o f
the landowners (Skidmore and Smith 1989, 47). With landowners dominating
dom estic politics, Latin American governm ents pursued liberal trade policies
that favored agricultural production and exp ort at the expense o f m an ufac­
tured goods (R ogow ski 1989, 47). As a result, m ost Latin American countries
were highly open to international trade, producing and exporting agricultural
g o o d s and other prim ary com m odities and im porting m anufactured go od s
from G reat Britain, Europe, and the United States.
In A sia and in A frica, export-oriented agricu ltu ral interests dom inated
local politics through colonial structures. In T aiw an and K orea, for exam ple,
Jap an e se colon ization led to the developm ent o f enclave agriculture— that
is, export-oriented agricultural sectors that h ad few linkages to other parts
o f the local econom y (H aggard 1990). A gricultural producers bought little
from local suppliers and exported m ost o f their production. In both coun ­
tries, agricultural production centered on the production and export o f rice;
in Taiw an, sugarcane w as a staple crop as well. India produced and exported
a range o f prim ary com m odities, including cotton, jute, wheat, tea, and rice.
In exchange, India im ported m ost o f the m anufactu red go od s it consum ed
from Britain. In A frica, colonial pow ers encouraged the production o f cash
crops and raw m aterials that could be exported to the mother country (H op­
kins 1979; Ake 19 8 1 , 1996). In the G old C o a st (now G hana), the cocoa in­
dustry w as a sm all p art o f the econom y in 1 8 70. U nder British rule, G hana
becam e the w o rld ’s largest co co a producer by 1 9 1 0 , and cocoa accounted
for 80 percent o f its exp o rts. In Senegal, France prom oted groundnut (the
American peanut) production, and by 1937 close to half o f all cultivated land
w as dedicated to this single product (Ka and V an de Walle 1994, 296). Simi­
lar patterns with other com m odities were evident in other African colonies
(H opkins 1979).
116
CHAPTER 6
Trade and Development I: Import Substitution Industrialization
T h ese p o litic a l arran gem en ts b egan to ch an ge in the early tw entieth
century. A s they did, the dom inance o f exp ort-orien ted interests gave w ay
to the interests o f im port-com peting m anufacturers. In m any instances, the
m ost im portant triggers for this change originated outside o f developing so ­
cieties. In Latin A m erica, international econom ic shocks beginning with the
First W orld W ar and extending into the Second W orld W ar played a central
role (T horp 1 9 9 9 , C h ap ter 4 ). G overn m en t-m an d ated ratio n in g o f g o o d s
and prim ary co m m odities in the U nited States and E urope durin g the tw o
W orld W ars m ade it difficult for Latin A m erican countries to im port m any
o f the consum er g o o d s they had previously pu rch ased from the in d u strial­
ized cou n tries. In a d d itio n , fallin g co m m o d ity prices a sso c ia te d w ith the
G reat D epression and the d isruption o f norm al trade pattern s arisin g from
the Second W orld W ar reduced exp o rt revenues. T he interruption o f “ n o r­
m a l” Latin A m erican trade pattern s led governm ents in m any countries to
introduce trade barriers and to begin producin g m any o f the m anufactured
go od s that they had previously im ported. The rise o f dom estic m an ufactu r­
ing in turn produced a grow ing urban m iddle class as w orkers and industri­
alists began to m ove o u t o f agricultural production and into m anufacturing
industries.
The emergence o f m anufacturing industries gave rise to interest grou ps,
industry-based associations, and labor unions that pressured the governm ent
to ad o p t econom ic policies favorable to people w orking in the im port-com ­
peting sector. The creation o f organized grou ps to represent the interests of
import-competing m anufacturing generated its own political logic. On the one
hand, the grou ps that saw their incom es rise from protection had a strong
incentive to see protection ist policies continued in the p o stw ar period (see
R ogow ski 1989; H aggard 1990). On the other hand, the emergence o f new
organized interests and a grow ing urban middle class created an opportunity
for politicians to construct new political coalition s based on the su p p ort of
the urban sectors. In Argentina, for exam ple, Ju an Peron rose to pow er in the
late 1940s with the support o f labor, industrialists, and the military. A similar
pattern w as evident in Brazil, where Getulio V argas w as elected to the presi­
dency in 1950 with the su p p ort o f industrialists, governm ent civil servants,
and urban labor. N o r were A rgentina and Brazil unique: T h rough out Latin
America, postw ar governments were much less tightly linked to landed inter­
ests than governm ents had been before W orld W ar I. Instead, governm ents
rose to pow er on the basis o f po litical su p p o rt from interest grou ps w hose
incomes were derived from im port-com peting m anufacturing (C ard o so and
Faletto 1979). Such governments had a clear incentive to m aintain trade poli­
cies that protected those incomes.
A similar dynamic is evident in India. The global economic collapse o f the
1930s forced India to become increasingly self-reliant. M arkets for Indian ex­
ports constricted sharply, thereby greatly constraining Indian export revenues.
U nable to earn foreign exchange, India had to reduce im ports o f m an u fac­
tured goods as well. Under this forced self-reliance, India began to create an
indigenous m anufacturing sector. By the end of the Second W orld W ar, India
Domestic Interests, International Pressures, and Protectionist Coalitions
117
had em erged as “ the tenth largest produ cer o f m an u factu red go od s in the
w o rld ” (Tom linson 1 9 7 9 , 31). The indigenous urban m anufacturing sector
then fused with the burgeoning n ation alist m ovem ent during the late 1930s
to lead the push for Indian independence and to supplant the predom inantly
foreign-owned export sector at the center o f the Indian political system. By the
time India achieved independence in 1947, it w as com m itted to a strategy of
autonom ous industrialization.
In Pacific A sia, the shift in political pow er cam e about as a product o f de­
colonization. In Korea and T aiw an political change resulted from the defeat of
Imperial Jap an in W orld W ar II (see H aggard 1990). In South K orea, Ja p a n ’s
defeat tran sferred p o w er fro m a foreign colon izer to in d igen ous gro u p s.
A lthough the landow ners initially dom inated p o stw ar po litics, the K orean
W ar of the early 1950s and a series o f land reform s implemented during that
sam e decade greatly reduced the landow ners’ pow er an d increased the rela­
tive pow er o f the emerging urban sector. O n m ainland China, Ja p a n ’s defeat
w as follow ed by the defeat o f the n ation alist Chinese governm ent and the
m igration of the Chinese nationalists to the island of T aiw an . Once installed
in Taiw an, the Chinese nationalists instituted land reform s to assert their au­
thority over indigenous landowners and to prevent a repeat o f their experience
on the m ainland, where the rural sector had supported the Com m unists. As
in South K orea, land reform s reduced the pow er o f landow ners and increased
the power o f the urban-industrial sector.
A fric a ’ s tr a n sitio n cam e la te r, a s d e c o lo n iz a tio n b egan only in the
1 9 5 0 s, and it to o k a sligh tly differen t form . T he p u sh to w ard d eco lo n i­
zation w as led by a c o a litio n o f in d igen o u s p r o fe ssio n a ls w ho had been
educated by the colonial pow ers and had then acquired position s in the ad ­
m inistration o f colonial econom ic and political rule. O ne facto r m otivating
A frica’s push fo r independence w as d issatisfactio n w ith the discrim inatory
practices o f colon ial adm inistration. C olonies were run for the profit o f the
colonists, with colon ial econom ic enterprises staffed and m anaged by men
from the co lo n ial pow er. T he lo cal p o p u latio n had lim ited opportu n ities
to participate in these econom ic arrangem en ts other than as w orkers. The
n ation alist struggles for independence that em erged in the 1 9 5 0 s sought to
transfer control over existing econom ic practices from the colonial govern­
ments to indigenous elites.
The period dem arcated by the start o f the First W orld W ar and the end
o f decolonization in sub-Saharan A frica thus brought a fundam ental change
to patterns o f political influence in developing countries. Political structures
once dom inated by export-oriented agricultural interests were now largely un­
der the control o f im port-com peting m anufacturing interests. Consequently,
governments beholden to the im port-com peting sector had a clear incentive
to abandon liberal trade policies and to continue the protectionist arrange­
ments they had built during the 1930s. As we will see, the political interest in
protectionism w as reinforced by an elaborate theoretical structure that argued
that protectionism w as the only path to the establishm ent o f industrialized
economies.
118
CHAPTER 6
Trade and Development I: Import Substitution Industrialization
THE STRUCTURALIST CRITIQUE: MARKETS,
TRADE, AND ECONOMIC DEVELOPMENT
Although protectionism reflected the interests o f the politically influential
import-competing m anufacturing sector, it did not represent a coherent eco­
nomic development strategy. And m ost governments were com m itted, at least
rhetorically, to the adoption o f policies that w ould prom ote econom ic devel­
opment. M ost governments wanted to shift resources out o f agricultural p ro ­
duction and into m anufacturing industries because they believed that poverty
resulted from too heavy a concentration on agricultural production. H igher
standards o f living could be achieved only through industrialization, and ac­
cording to w hat w as then the dom inant branch o f developm ent econom ics,
called structuralism , the shift o f resources from agriculture to m anufacturing
would not occur unless the state adopted policies to bring it ab o u t (see L ai
1983; Little 1982).
The belief that the m arket w ould not prom ote industrialization provided
the intellectual and theoretical justification for the two central aspects o f the
development strategies adopted by m ost governments throughout much o f the
postw ar era. Because structuralism played such an im portant role in shaping
developing countries’ trade and development policies, understanding the poli­
cies governments adopted requires us to understand the structuralist critique.
M arket Imperfections in Developing Countries
Structuralists argued that m arket im perfections inside developing countries
posed serious obstacles to the reallocation o f resources from agriculture to
m anufacturing industries. Structuralists argued that m arkets w ould not bring
about the necessary shift o f resources because developing econom ies were too
inflexible.
M ost im portant, according to the stru cturalists, w as the belief that the
market would not prom ote investment in m anufacturing industries (Scitovsky
1954). The structuralists pointed to two coordin ation problem s that w ould
limit investment in manufacturing industries. The first problem , called comple­
mentary dem and, arose in the initial transform ation from an econom y based
largely on subsistence agriculture to a m anufacturing econom y (RosensteinRodan 1943). In an econom y in which few people earned a m oney w age, no
single manufacturing firm would be able to sell its products unless a large num­
ber of other manufacturing industries were started simultaneously. Suppose, for
exam ple, that 100 people are taken out o f subsistence agriculture and paid a
wage to manufacture shoes, whereas the rest o f the population remains in non­
wage agriculture. T o whom will the new factory sell its shoes? The only workers
earning money are those producing shoes, and these 100 w orkers are unlikely
to purchase all of the shoes that they make. In order for this shoe factory to suc­
ceed, other factories employing other people must be created at the same time.
Suppose instead, that five hundred th o u san d w orkers are taken out of
subsistence agriculture and sim ultaneously em ployed in a large num ber of
The Structuralist Critique: Markets, Trade, and Economic Development
119
factories producin g a variety o f different g o o d s; som e m ake sh oes, others
make clothing, and still others produce refrigerators or processed foods. With
this larger num ber of w age earners, m anufacturing enterprises can easily sell
their good s. Shoe w orkers can buy refrigerators and clothes, w orkers in the
clothing factory can purchase shoes, and so on. T hus, a m anufacturing enter­
prise will be successful only if many m anufacturing industries began produc­
tion simultaneously.
Structuralists doubted that uncoordinated m arket behavior w ould p ro ­
duce simultaneous investment in multiple m anufacturing industries. N o single
entrepreneur has an incentive to invest in a m anufacturing enterprise unless
she is certain that others will invest sim ultaneously in other industries. People
willing to invest will thus w ait until others invest and, a s a consequence, no
one will invest in m anufacturing unless all potential investors could som ehow
coordinate their behavior to ensure that all will invest in m anufacturing at the
same time. The problem o f complementary dem and thus m eant that if invest­
ment were left to the m arket, there would be little investment in m anufactur­
ing industries.
The second coordin ation problem , called pecuniary external econom ies,
aro se from interdependencies am on g m ark et p ro c e sse s (Scitov sk y 1 9 5 4 ).
Think ab ou t the econom ic relationship betw een a steel p lan t and an a u to ­
m obile factory. Suppose that the ow ners o f a steel factory invest to increase
the am ount o f steel they can produce. A s steel p ro d u ctio n in creases, steel
prices begin to fall. The autom obile facto ry , w hich uses a lo t o f steel, b e­
gins to realize rising profits a s the price o f one o f its m o st im p ortan t inputs
falls. These increasing p ro fits in the au tom obile industry could induce the
ow ners o f the car plant to invest to exp an d their ow n produ ction capacity.
Such a sim ultaneous exp an sion o f the steel and auto industries w ould raise
national income.
The two firm s face a coordination problem , however. The owners o f the
steel plant will not increase steel production unless they are sure that the auto
industry will increase car production. Yet, the ow ners o f the auto plant will
not increase auto production unless they are certain that the steel producer
will make the investments needed to expand steel output. Thus, unless invest­
m ent decisions in the steel and auto industry are co ord in ated , neither firm
will invest to increase the am ount it can produce. Once again , structuralists
argued, the m arket could not be expected to solve this coordination problem.
The stru cturalists’ assertion that coordin ation problem s w ould prevent
investment in m anufacturing w as a serious problem for governm ents intent
on industrialization. Fortunately, the structuralists offered a solution to the
problem . Structuralists argued that the w ay to overcom e these coordination
problem s w as with a state-led big push. T he state w ould engage in economic
planning and either m ake necessary investments itself or help coordinate the
investm ents o f private econom ic actors. T h u s, w hat the m arket could not
bring about, the state could achieve through intervening in the economy. The
structuralist critique o f the m arket therefore provided a com pelling theoretical
justification for state-led strategies o f industrialization.
120
CHAPTER 6
Trade and Development I: Import Substitution Industrialization
M arket Imperfections in the International Economy
Structuralists also argued that international trade provided few benefits to de­
veloping countries. T his argum ent w as form ulated during the 1 9 50s, princi­
pally by R aul Prebisch, an Argentinean econom ist who w orked for the United
N ation s Econom ic Com m ission for Latin Am erica (EC LA ), and H an s Singer,
an academ ic developm ent econom ist. A ccording to the Singer-Prebisch the­
ory, participation in the G A T T -b ase d trade system w ould actually m ake it
harder for developing countries to industrialize by depriving them o f critical
resources.
The Singer-Prebisch theory divides the w orld into tw o distinct blocks—
the advanced-industrialized core and the developing-w orld periphery— and
focuses on the term s o f trade between them . The term s o f trad e relate the
price o f a country’s exports to the price o f its im ports. An im provem ent in a
country’s terms of trade means that the price o f its exports is rising relative to
the price o f its im ports, but a decline in a country’s term s o f trade m eans that
export prices are falling relative to its im port prices. As a country’s term s o f
trade improve, it can acquire a given am ount o f im ports for a sm aller quantity
of exports. Thus, an improvement in its term s o f trade m akes a country richer,
but a decline in its terms o f trade m akes it poorer.
The Singer-Prebisch theory argu es th at developing co u n tries’ term s o f
trade deteriorate steadily over time. When they developed this theory, devel­
oping countries exported prim ary com m odities and im ported m anufactured
goods. Singer and Prebisch argued that prim ary com m odity prices steadily fell
relative to m anufactured good s prices, thereby steadily reducing the incom es
o f developing countries. The periphery’s terms o f trade deteriorate, according
to this theory, in large p art as a result o f differences in the incom e elasticity
of dem and for prim ary com m odities versus industrial go od s (see Lew is 1954;
United N ations 1964; Gilpin 1987, 2 7 5 -2 7 6 ).
The incom e elasticity o f dem and is the degree to w hich a change in in­
come alters dem and for a particular product. For a product with a low income
elasticity o f dem and, a large increase in income produces little change in de­
mand for the good. For a product with a high income elasticity o f dem and, a
sm all increase in incom e produces a large change in dem and for a particular
good. Structuralists argued that the income elasticity o f dem and for prim ary
com m odities w as quite low , but incom e elasticity o f dem and fo r m an u fac­
tured goods w as relatively high. Thus, as incomes rise in the core countries, a
smaller and smaller percentage o f those countries’ income will be spent on im ­
ports o f prim ary com m odities. But as incomes rise in the periphery countries,
a larger percentage o f those countries’ income will be spent on m anufactured
imports from the core. Falling dem and for prim ary com m odities will cause the
periphery countries’ export prices to fall, whereas rising dem and for m anufac­
tured go od s will cause the periphery countries’ im port prices to rise. R ising
im port prices relative to export prices yields deteriorating terms o f trade.
M ost research disputes the claim that developing countries face a continu­
ous decline in their term s o f trade (see, for exam ple, Borensztein et al. 1994;
Domestic and International Elements of Trade and Development Strategies
121
see also Bloch and Sapsford 2 0 0 0 ). Yet, the objective validity o f the SingerPrebisch hypothesis is not the central consideration. W hat mattered w as that
governments in developing countries believed the hypothesis. Governments of
developing countries were convinced that industrialization w ould not occur if
they participated in the G A T T -based international trade system. This convic­
tion played an im portant role in shaping the trade and developm ent policies
that developing countries adopted.
DOMESTIC AND INTERNATIONAL ELEMENTS
OF TRADE AND DEVELOPMENT STRATEGIES
Structuralism enabled governm ents to transform the protectionist trade p o li­
cies that benefited their prin cipal p o litical su p p orters into com prehensive
state-led development strategies. The trade and development policies that m ost
governments adopted following W orld W ar II had both a domestic and an in­
ternational dimension. At home, the desire to prom ote rapid industrialization
led governments to adopt state-led development strategies that were sheltered
by high protectionist barriers. In the international arena, concern ab o u t the
distributional im plications o f international trade led developing countries to
seek far-reaching changes to the G A T T -based trade system. We exam ine each
dimension in turn.
Import Substitution Industrialization
Structuralism provided the intellectual justification for a state-led d evelop­
m ent strategy. Confidence that the state could achieve w hat m arkets w ould
not w as based in part on evidence o f the dram atic industrialization that the
Soviet U nion had achieved between 1930 and 1950 with an approach based
on centralized planning and state ow nership o f industry. In developing so ­
cieties outside the Soviet bloc, this state-centered approach to developm ent
came to be called im port substitution industrialization, or ISI. The strategy of
ISI w as based on a simple logic: Countries w ould industrialize by substitut­
ing dom estically produced go od s for m anufactured items they had previously
imported.
Governments conceptualized ISI as a tw o-stage strategy. (See T able 6.3.)
Its initial stage w as “ wholly a matter o f im itation and im portation o f tried and
tested procedures” (H irschm an 1968, 7). E asy ISI, as this first stage w as o f­
ten called, focused on developing domestic m anufacturing o f relatively simple
consum er goods, such as sod a, beer, apparel, shoes, and furniture. The ratio ­
nale behind the focus on sim ple consum er good s w as threefold. First, there
w as a large dom estic dem and currently satisfied by im ports. Second, because
these items were m ature products, the technology and m achines necessary to
produce them could be acquired easily from the advanced industrialized coun­
tries. Third, the production o f relatively simple consum er good s relies heavily
on low-skilled labor, allow ing developing societies to draw their populations
122
CHAPTER 6
Trade and Development I: Import Substitution Industrialization
TABLE 6.3
Stages of Industrialization in Mexico and Brazil,'1880-1968*
Commodity Exports,
1880-1930
Primary ISI,
1930-1955
Main
Industries
Mexico: Precious
metals,
minerals, oil
Brazil: Coffee,
rubber, cocoa,
cotton
Mexico and Brazil:
Textiles, food,
cement, iron
and steel, paper,
chemicals,
machinery
Major
Economic
Actors
Mexico: Foreign
investors
Mexico and
Brazil: National
private firms
Orientation of
the Economy
World market
Brazil: National
private firms
Domestic market
Secondary ISI,
1955-1968
Mexico and Brazil:
Automobiles,
electrical and
nonelectrical
machinery,
petrochemicals,
pharmaceuticals
Mexico and Brazil:
State-owned
enterprises,
transnational
corporations,
and national
private firms
Domestic market
*ISI, import substitution industrialization.
Gereffi 1990, 19.
S o u rc e :
into m anufacturing activities w ithout m aking large investm ents to upgrade
their skills.
Governm ents expected to realize tw o broad benefits from easy ISI. Ini­
tially, the expansion o f m anufacturing activities w ould increase w age-based
em ploym ent as underutilized lab o r w as draw n out o f agriculture and into
m anufacturing. In addition, the experience gained in these m anufacturing in­
dustries w ould allow dom estic w orkers to develop skills, collectively referred
to as general hum an ca p ita l, that could be ap p lied su bsequen tly to other
m anufacturing businesses. O f particu lar im portance were the m anagem ent
and entrepreneurial skills that w ould be gained by people who w orked in and
m anaged the m anufacturing enterprises established in this stage. Success in the
easy stage w ould therefore create m any o f the ingredients necessary to m ake
the transition to the second stage of ISI.
Easy ISI would eventually cease to bear fruit. The dom estic m arket’s c a ­
pacity to absorb sim ple consum er go od s w ould be exh austed, and the range
o f such goods that could be produced w ould be limited. At som e point, there­
fore, governments w ould need to shift from easy ISI to a second-stage strategy
characterized by the developm ent o f more com plex m anufacturing activities.
One possibility would be to shift to w hat som e have called an export substi­
tution strategy, in w hich the labor-intensive m anufactured go od s industries
Domestic and International Elements of Trade and Development Strategies
123
developed in easy ISI begin to export rather than continue to produce exclu­
sively for the dom estic m arket. M any E ast A sian governm ents adopted this
approach, as we shall see in Chapter 7.
The second alternative, and the one adopted by m ost governm ents o u t­
side o f E ast A sia, w as secondary ISI. In secondary ISI, em phasis shifts from
the m an u factu re o f sim ple consum er g o o d s to con su m er d u rab le g o o d s,
interm ediate inputs, and the capital go od s needed to produce consum er d u­
rables. In Argentina, Brazil, and Chile, for exam ple, governm ents decided to
prom ote dom estic autom obile production as a central com ponent o f secondary
ISI. Each country im ported cars in pieces, called com plete knockdow ns, and
assem bled the pieces into a car for sale in the dom estic m arket. Dom estic auto
firm s were required to gradually increase the percentage o f locally-produced
parts used in the cars they assem bled. In Chile, for exam ple, 2 7 percent o f
a locally produced c a r’s com ponents h ad to be m anufactured dom estically
in 1964. The percentage rose to 32 percent in 1965 and then to 4 5 percent
in 1966 (Johnson 1967).
By increasing the percentage o f local com ponents o f cars and other goods
in this manner, governments hoped to prom ote the development of backw ard
linkages throughout the economy (Hirschman 1958). Backw ard linkages arise
when the production o f one good, such a s a car, increases dem and in indus­
tries that supply com ponents for that go od . T hus, increasing the percentage
o f locally produced com ponents o f cars, by increasing the dem and for indi­
vidual car parts, would increase domestic part production. The latter w ould in
turn increase dem and for inputs into part production: steel, glass, and rubber,
for exam ple. Industrialization, therefore, w ould spread backw ards from final
goods to intermediate inputs to capital goods as backw ard linkages multiplied.
Governments prom oted secondary ISI with three policy instruments: gov­
ernment planning, investment policy, and trade barriers. M o st governm ents
structured their efforts around five-year plans (Little 1982, 35). Planning w as
used to determ ine which industries w ould be targeted for developm ent and
which w ould not, to figure out how much should be invested in a particular
industry, and to evaluate how investment in one industry w ould influence the
rest o f the economy. India’s second Five Y ear Plan (1 9 5 7 -1 9 6 2 ), for exam ple,
sought to generate am bitious growth in m anufacturing by targeting the devel­
opment o f capital goods production (Srinivasan and Tendulkar 2 0 0 3 , 8). The
plan thus served as the coordination device that governm ents thought neces­
sary, given their belief that the m arket itself could not coordinate investment
decisions.
With a plan in place, governments used investment policies to promote tar­
geted industries. M ost governments either nationalized or heavily controlled the
financial sector in order to direct financial resources to targeted industries. Gov­
ernments also invested directly in those economic activities in which they thought
the private sector would not invest. M uch of the infrastructure necessary for in­
dustrialization— things such as roads and other transportation networks, elec­
tricity, and telecommunications systems— it w as argued, would not be created by
the private sector. In addition, the private sector lacked access to the large sums
124
CHAPTER 6
Trade and Development I: Import Substitution Industrialization
of financial support needed to m ake huge investments in a steel or auto plant.
M oreover, it was claimed that private-sector actors lacked the technical sophis­
tication required for the large-scale industrial activity involved in secondary ISI.
G overnm ents invested in these industries by creating state-ow ned and
mixed-ownership enterprises. In Brazil, for exam ple, state-ow ned enterprises
controlled m ore than 50 percent o f to tal productive assets in the chem ical,
telecommunications, electricity, and railw ays industries and slightly more than
one-third o f all productive assets in m etal fabrication (T rebat 1983). Indian
state-owned enterprises provided 2 7 percent o f total em ployment and 62 per­
cent of all productive capital (Krueger 1993a, 2 4 -2 5 ). In Africa, governments
in G hana, M ozam bique, N igeria, and T an zan ia each created m ore than 300
state-ow ned enterprises, and in m any A frican countries, state-ow ned enter­
prises accounted for 20 percent o f total w age-based employment (W orld Bank
1994b, 101). T hroughout developing societies, therefore, the shift to second­
ary ISI w as accom panied by the emergence o f the state as a principal, and in
many instances the largest, owner o f productive capacity.
Finally, governments used trade barriers to control foreign exchange and
protect infant industries. Because export earnings were limited, governm ents
controlled foreign trade to ensure that foreign exchange supported their devel­
opm ent objectives (Bhagw ati 1978, 2 0 -3 3 ). After all, m any elements critical
to industrialization, including intermediate inputs and capital good s, had to be
imported. Protection also allowed infant industries to gain experience needed
to compete against established producers. In Brazil and India, for instance, the
state prohibited im ports o f any good for which there w as a dom estic su bsti­
tute, regardless o f price and quality differences.
The scale and the structure o f protection that governm ents used to p ro ­
m ote industrialization are illustrated in T ab le 6 .4 , which focu ses on Latin
America in 1960. In all but two o f the listed countries, nom inal protection on
TABLE 6.4
Nominal Protection in Latin America, circa I960 (percent)
Nondurable Durable
SemiIndustrial
Consumer Consumer Manufactured
Raw Capital
Goods
Goods
Goods
Materials Goods
Argentina
Brazil
Chile
Colombia
Mexico
Uruguay
European Economic
Community
S o u rc e :
176
260
328
247
114
23
17
Bulmer-Thomas 1994, 280, Table 9.1.
266
328
90
108
147
24
19
95
80
98
28
28
23
7
55
106
111
57
38
14
1
98
84
45
18
14
27
13
Domestic and International Elements of Trade and Development Strategies
^
-<
^
125
nondurable consum er go od s w as well over 100 percent, and for all but three
countries, tariffs on consum er durables also were over 100 percent. M exico
and U ruguay stand out as clear exceptions to this pattern, which has more to
do with those countries’ extensive use of im port quotas in place o f tariffs than
with an unwillingness to protect dom estic producers (Bulm er-Thom as 1994,
279). It is also clear that tariffs were lower for sem i-m anufactured go od s, in­
dustrial raw m aterials, and capital goods (all o f which were items that devel­
oping countries needed to im port in connection with industrialization) than
they were for consum er good s. This pattern of tariff escalation w as com m on
in much o f the developing w orld (Balassa and A ssociates 1971).
The costs o f ISI were borne by agriculture (see Krueger 1 993a; Krueger,
Schiff, and Valdes 1992; Binsw anger and Deininger 1997). Governments taxed
agricultural exports through m arketing boards that controlled the purchase
and export o f agricultural com m odities (Krueger et al. 1 9 9 2 ,1 6 ). O ften estab­
lished as the sole entity with the legal right to purchase, transport, and export
agricultural products, m arketing boards set the price that farm ers received for
their crops. In the typical arrangem ent, the marketing board w ould purchase
crops from dom estic farm ers a t prices well below the w orld price and then
w ould sell the com m odities in the w orld m arket at the w orld price. The dif­
ference between the price paid to dom estic farm ers and the w orld price represented a ta x on agricu ltu ral incom es th at the state co u ld use to finance
industrial projects (Amsden 1979; Bates 1988; Krueger 1993a). The trade bar­
riers that protected dom estic m anufacturing firm s from foreign com petition
also taxed agriculture. T ariffs and quantitative restrictions raised the domestic
price o f m anufactured good s well above the world price. People employed in
the agricultural sector, who consum ed these m anufactured go od s, therefore
paid more for them than they w ould have in the absence o f tariffs and quanti­
tative restrictions (Krueger 1993a, 9).
Such government policies transferred income from rural agriculture to the
urban m anufacturing and non trad ed -good s sectors. The size o f the incom e
transfers w as substantial. As a W orld Bank study summarized,
the total impact o f interventions . . . on relative prices [between agri­
culture and m anufactu ring] w as in som e countries very large. In
Ghana . . . farmers received only about 40 percent of what they would
have received under free trade. Stated in another way, the real incomes
of farmers would have increased by 2.5 times had farmers been able to
buy and sell under free trade prices given the commodities they in fact
produced. While Ghanaian total discrimination against agriculture was
huge, Argentina, Cote d’Ivoire, the Dominican Republic, Egypt, Pakistan,
Sri Lanka, Thailand, and Zam bia also had total discrimination against
agriculture in excess of 33 percent, implying that in all those cases, farm
incomes in real terms could have been increased by more than 50 percent
by removal of these interventions. (Krueger 1993a, 63)
Thus, ISI redistributed income. The incomes o f export-oriented producers
fell while those of im port-com peting producers rose.
126
CHAPTER 6
Trade and Development I: Import Substitution Industrialization
A CLOSER LOOK
Import Substitution Industrialization in Brazil
In the late nineteenth and early twentieth centuries, Brazil was the classic case
of a country that exported primary commodities. Its principal crop, coffee,
accounted for a large share of its production and the overwhelming majority of
its export earnings. This economic structure was supported by a political system
dominated by the interests of coffee producers and other agricultural exporters
(Bates 1997). Political authority in Brazil was decentralized, and the states used
their power in the country's federal system to influence government policy. As a
result, Brazil pursued a liberal trade policy throughout the late nineteeth and early
twentieth centuries. The First World War and the Great Depression disrupted
these arrangements. The world price for coffee fell sharply in the late 1920s and
early 1930s, generating declining terms of trade and rising trade deficits. The
government responded to this crisis by adopting protectionist measures to limit
imports. The initial turn to protectionism was accompanied by political change. A
military coup in 1930 handed power to Getulio Vargas, who centralized power by
shifting political authority from the states to the federal government. Even though
Vargas did not adopt an ISI strategy, this period represented in many respects the
easy stage of ISI (Haggard 1990,165-166). Protectionism promoted the growth
of light manufacturing industries at a rate of 6 percent per year between 1929
and 1945 (Thorp 1999, 322). Concurrently, the centralization of power created
a state that could intervene effectively in the Brazilian economy. Although the
export-oriented interests did not lose all political influence in this new political
climate, the balance of power had clearly shifted toward new groups emerging in
urban centers: the professionals, managers, and bureaucrats who constituted the
emerging middle class and the nascent manufacturing interests. As Brazil moved
into the post-World War II period, therefore, the stage was set for the transition to
secondary ISI.
A full-blown ISI strategy emerged in the 1950s. The government restricted
imports tightly with the so-called law of similars, which effectively prohibited
the import of goods similar to those produced in Brazil. In 1952, the Brazilian
government created the National Economic Development Bank (BNDE), an
important instrument for industrial policy through which the Brazilian state
could finance industrial projects. In the late 1950s, the government created
a new agency, the National Development Council, to coordinate and plan its
industrialization strategy. In taking up its task, the council was heavily influenced
by structuralist ideas (Haggard 1990, 174). Studies conducted within these
agencies—and, in some instances, in collaboration with international agencies such
as the United Nations (UN) Economic Commission on Latin America— focused on
how best to promote industrialization (Leff 1969, 46). Most of these studies came
to similar conclusions: Industrialization in Brazil would quickly run into constraints
caused by inadequate transportation networks (road, rail, and sea), shortages
Domestic and International Elements of Trade and Development Strategies
A
127
of electric power, and the underdevelopment of basic heavy industries such as
steel, petroleum, chemicals, and nonferrous metals. Building up those industries^
thus became die focus of the government's development policies. The Brazilian-;
government had little faith that the private sector would createandexpand these
critically important industries. Instead, policymakers determined that the state,
would have to play a leading role. In the early 1950s, the state nationalized the oil
and electricity industries and began investing heavily in the expansion.gf capacity
in both. A similar approach was adopted in the transportation sector (in which’ the-;
government owned the railways and other infrastructure), in the steel industry/apd
in telecommunications. By the end of the 1950s, the state ^accounted for ^p^r^ntof all investment made in the Brazilian economy. Asa result, the
owned enterprises grew rapidly, from fewer than 35 in 1950 to more than 600. .
by 1980.
* .
•'
Beyond creating these basic industries, the Brazilian government also sought ’
to create domestic capacity to produce complex consumer goods. .To achieve.this- •
objective, Brazil, in contrast to many other developing countries, drew j^avi|y; • ,
upon foreign investment to promote the development of certain industries. Thp auto
industry is an excellent example. In 1956, the Brazilian government pirpbihited ^,
all imports of cars. Any foreign producer that wanted to sellcarsfnthe BrazidanV,
market would have to set up production facilities in the country. To.ensure-tbit,
such foreign investments were not simple assembly operations in w h i c h . *,
company imported all parts from its suppliers at home, the Brazilian g^rnnjent_vinstituted local rules that required the foreign automakers operating in the country/,,,
to purchase 90 percent of their parts from Brazilian firms. Inordgr tp.ioduce/ ; ss
foreign automakers to invest in Brazil under these conditions, the government / - /
offered subsidies; by one account, the subsidies offset about 87 pereehlpl.thq/!^
total investment between 1956 and 1969. Relying on this strategy, Brazilian auto
production rose from close to zero in 1950 to almost 200,
Brazil's ISI strategy helped transform the country's economy ifv-a
fv
short time. Imported consumer nondurable goods (the products tqrget^/ifyring^ 1
easy ISI) had been almost completely replaced with domestic production.by .the
early 1950s (Bergsman and Candal 1969,37). Imported c o n s u m e r d o y t - f *
final goods targeted in secondary ISI, fell from 60 percent of total, consumption to
less than 10 percent of total consumption by 1959. Imports of capital goods also
fell, from 60 percent of total domestic consumption in 1949, to about 35j)e»cent
of consumption in 1959, and then to only 10 percent by 1964.Trinaity/Jmports of
intermediate goods, the inputs used in producing final goods, also fell continually
throughout the decade, to less than 10 percent of.total consump^ioqJby,^.^4*v.;:;...
Thus, as imports were barred and domestic industries created, BraziJIah^isimers ‘
and producers purchased a much larger percentage of the goods they .used from,- \
domestic producers and a much smaller percentage from foreign produced. A$ A »
consequence, the importance of manufacturing in the.Brazilianeconomy.inqrea^ed*.
sharply: Whereas manufacturing accounted for only 26 percent of total Brazilian '
production in 1949, by 1964 it accounted for 34 percent. ■
\/ /.
128
CHAPTER 6
Trade and Development I: Import Substitution Industrialization
The strategy o f ISI prom oted rap id econom ic grow th in the 1 9 6 0 s and
1970s: Developing countries’ economies grew at annual average rates of between
6 percent and 7.6 percent during this period. In many countries, it w as the m anu­
facturing sector that drove economic growth. Argentina, Brazil, Chile, M exico,
M ozam bique, Nigeria, Pakistan, and India, to select only a few exam ples, all
enjoyed average annual rates o f m anufacturing growth between 5 percent and
10 percent during the 1960s. A glimpse back at Table 6.1 indicates that, in Latin
America, manufacturing’s share o f the total economy increased substantially be­
tween 1960 and 1980. Thus, although the policies that governments adopted
had important effects on the distribution o f income, they also appeared to be
transforming developing societies into industrialized economies.
Reforming the International Trade System
Developing countries also tried to alter the rules governing international trade.
For many developing-country governments, these efforts reflected their experi­
ence with colonialism. India’s perspective w as not unique: International trade
was “ a whirlpool o f econom ic im perialism rather than a positive instrum ent
for achieving economic grow th” (Srinivasan and Tendulkar 2 0 03, 13). Conse­
quently, as early as 1947, India, Brazil, and Chile were arguing that the multi­
lateral rules the United States and G reat Britain were writing failed to address
the economic problem s that developing countries faced (K ock 1969, 3 8 -4 2 ).
Advancing the infant-industry justification for protection, m any developing
countries argued that their firms could not compete with established producers
in the United States and Europe. Yet, G A T T rules not only m ade no provi­
sion for the infant-industry justification for protection but indeed, explicitly
prohibited the use o f quantitative restrictions and tightly restricted the use of
tariffs. Developing countries insisted that they be given a relatively free hand
in the use o f trade restrictions to prom ote economic development, because the
G A TT failed to do so.
Developing countries continued to press for G A T T reforms throughout the
1950s (see K ock 1969, 2 3 8 ; Finger 1991). By the early 1 9 60s, a coalition o f
developing countries dedicated to far-reaching reform had emerged. Its first im­
portant success w as achieved with the form ation o f the United N ations Confer­
ence on T rade and Development (U N CTAD ) in M arch o f 1964. The U N C T A D
was established as a body dedicated to prom oting the interests o f developing
countries in the world trade system. At the conclusion o f this first U N C T A D
conference, 77 developing-country governments signed a joint declaration call­
ing for reform o f the international trade system. Thus w as born the G roup o f
77, the leading force in the cam paign for systemic reform . D uring the next 20
years, trade relations between the developing world and the advanced industri­
alized countries revolved alm ost wholly around competing conceptions o f inter­
national trade rules embodied in the G A T T and U N C T A D .
During the 1960s, the G roup o f 77 used U N C T A D to pursue three inter­
national m echanism s that w ould increase their share o f the gains from trade
(Kock 1969; U N C T A D 1964; W illiam s 1991). First, the G roup o f 77 sought
Domestic and International Elements of Trade and Development Strategies
129
com m odity price stabilization schem es. C om m odity price stabilization w as
to be achieved by setting a floo r below which com m odity prices w ould not
be allow ed to fall and by creating a finance m echanism , funded largely by
the advanced industrialized countries, to purchase com m odities when prices
fell below the floor. Stabilizin g com m odity prices w o u ld be an im portant
step tow ard stabilizing developing countries’ term s o f trade (recall the SingerPrebisch hypothesis). The G roup o f 77 also sought direct financial transfers
from the advanced industrialized countries to com pensate them for the pur­
chasing pow er they w ere lo sin g from declining term s o f trad e (U N C T A D
1964, 80). D eveloping countries also sought greater access to core-country
m arkets, pressuring the advanced industrialized countries to eliminate trade
barriers on prim ary com m odities and to provide m anufactured exports from
developing countries with preferential access to the core countries’ markets.
These reform efforts yielded few concrete results. C ore countries agreed
to incorporate concerns specific to developing countries into the G A TT char­
ter. In 1964, three articles focusing on developing countries were included in
the G A T T Part IV. Part IV called upon core countries to im prove m arket ac­
cess for commodity exporters, to refrain from raising barriers to the import of
products o f special interest to the developing w orld, and to engage in “ joint
action to prom ote trade and developm ent” (Kock 1969, 2 42). In the absence
of meaningful changes in the trade policies pursued by the advanced industrial­
ized countries, however, Part IV provided few concrete gains. The advanced in­
dustrialized countries also allowed the developing countries to opt out o f strict
reciprocity during G A T T ta riff negotiations. The developing countries that
belonged to the G A T T were therefore able to benefit fro m tariff reductions
without having to offer concessions in return. Benefits from this concession
were more apparent than real, however; G A T T negotiations focused primarily
on manufactured goods produced by the advanced industrialized countries and
excluded agriculture, textiles, and many other labor-intensive goods. Develop­
ing countries were therefore exporting few o f the goods on which the advanced
industrialized countries were actually reducing tariffs. In the late 1960s, the ad­
vanced industrialized countries agreed to the Generalized System o f Preferences
(GSP), under which m anufactured exports from developing countries gained
preferential access to advanced industrialized countries’ m arkets. This conces­
sion, too, was o f limited importance, because advanced industrialized countries
often limited the quantity o f go od s that could enter under preferential tariff
rates and excluded some m anufacturing sectors from the arrangement entirely.
Even though their effo rts durin g the 1 9 6 0 s had achieved few concrete
gains, the G roup o f 77 escalated its dem ands in the early 1 970s. Escalated
demands were sparked by the 1973 oil shock. The oil shock w as a clear illus­
tration o f the potential for com m odity pow er. The w orld’s m ajor oil-produc­
ing countries, w orking together in the O rganization o f Petroleum Exporting
Countries (O PEC), used their control o f oil to im prove their term s o f trade.
O PEC’s ability to use com m odity pow er to extract income from the core coun­
tries strengthened the belief within the G roup o f 77 th at com m odity pow er
could be exploited to force fundam ental systemic change.
130
CHAPTER 6
Trade and Development I: Import Substitution Industrialization
Greater confidence in the possibilities that their control o f com m odities
offered led the G roup o f 77 to develop a set o f radical dem ands dubbed the
N ew International E conom ic O rder (N IE O ). The N IE O represented an a t­
tempt to create an international trade system whose operation w ould prom ote
development (see K rasner 1985). The N IE O , which the U N G eneral A ssem ­
bly adopted in Decem ber 1974, em bodied a set o f reform s that w ould have
radically altered the operation o f the international econom y. In addition to the
three mechanisms that developing countries had dem anded during the 1960s,
the N IEO included rules that w ould grant developing countries greater con­
trol over m ultinational corp oration s operating in their countries, easier and
cheaper access to northern technology, a reduction in foreign debt, increased
foreign aid flow s, and a larger role in the decision-m aking processes o f the
World Bank and International M onetary Fund (IM F).
G overnm ents in the advanced industrialized countries refused to m ake
significant con cessio n s, and by the m id -1 9 8 0 s the N IE O had d isap p eared
from the international agenda. The failure o f the N IE O has been attributed
to a num ber o f factors. First, developing countries were unable to establish
and maintain a cohesive coalition. The heterogeneity o f developing countries’
interests m ade it relatively easy for the advanced industrialized countries to
divide the G roup o f 77 by offering limited concessions to a sm all num ber of
governments in exchange for defection from the broader group. In addition,
the G roup o f 77 had hoped that O P E C w ould a ssist it by linking access to
oil to acceptance o f the N IE O . But O PEC governm ents were unwilling to use
their oil pow er to help other developing countries achieve broader trade and
development objectives.
M ost im portantly, however, by the early 1980s, m any developing coun­
tries were facing serious balance-of-payments problem s and turned to the IM F
and the W orld Bank for financial support. The need to obtain IM F and W orld
Bank assistance altered the balance o f pow er in favor o f the advanced indus­
trialized countries. T his pow er shift sparked a reform process that changed
fundamentally development strategies throughout the developing w orld.
POLICY A N A LY S IS AND D EBATE
The Millennium Development Goals
Question
Can the Millennium Development Goals eradicate extreme poverty?
Overview
Members of the UN agreed in 2000 to focus their development policies around
the eight Millennium Development Goals (MDGs). The MDGs are ambitious, and
include (among other things) cutting extreme poverty (measured as living on less
Domestic and International Elements of Trade and Development Strategies
131
than one dollar per day) in half by 2015. Governments are to achieve these goals
through extensive planning at the domestic and international levels. Policies based
on these plans will in turn be supported by foreign aid offered by the international
community. For that purpose, the UN has called upon rich countries to increase
foreign aid expenditures to 0.7 percent of GDP by 2015 (from the then current
average of about 0.25 percent).
The logic upon which MDGs rest is similar to the thinking that shaped ISI. The
MDGs rest on a diagnosis of poverty that emphasizes structural factors. Rather
than emphasize market failure, however, contemporary thinking emphasizes a
"poverty trap." "When poverty is extreme, the poor do not have the ability—by
themselves—to get out of the mess . . . When [people] are utterly destitute, they ‘
need their entire income, or more, to survive . . . There is no margin of income •
above survival that can be invested for the future" (Sachs 2005, 56). Peopie can
escape the poverty trap only with the help of the contemporary analogue of the "big
push." The international community must provide "a teg up" through well-funded
and well-conceived government policy initiatives. Given the logic upon which they
are based, do you think the MDGs will cut extreme poverty by 50 percent?
Policy Options
• An MDG-like strategy is necessary if the world is to eradicate extreme poverty.
Governments must embrace these goals.
• The MDGs rest on faulty logic and thus cannot reduce extreme poverty.
Governments should reevaluate their approach to the problem of global poverty.
Policy Analysis
• Do developing-country governments have incentives to implement the policies
called for by the MDG strategy? Why or why not?
• Do advanced industrialized countries have incentives to provide the foreign aid
that is required to support MDG policies? Why or why not?
Take a Position
• Which option do you prefer? Justify your choice.
• What criticisms of your position should you anticipate? How would you defend
your recommendation against these criticisms?
Resources
Online: To learn more about the MDGs and current progress toward achieving thertl, :
conduct an online search for the keywords UN and MDGs. Look especially for the .
UN's annual progress reports.
In Print: Read the alternative perspectives embodied in Jeffrey Sachs' Ending Poverty:
Economic Possibilities of Our Time (New York: Penguin Press, 2005), and William
Easterly's The White Man's Burden: Why the West's Efforts to Aid the Rest Have Done So Much
III and So Little Good W ew York: Penguin Publishers, 2006).
132
CHAPTER 6
Trade and Development I: Import Substitution Industrialization
CONCLUSION
Throughout much o f the postw ar period, developing countries insulated them­
selves from the w orld trade system . The interaction between dom estic p o li­
tics on the one hand, and econom ic shocks and decolonization on the other,
generated governments that were highly responsive to the interests o f importcom peting m anufacturing industries and a grow ing class o f urban w orkers.
Influenced greatly by stru ctu ralism , m o st go vern m en ts tran sfo rm e d the
political incentive to protect these domestic industries into am bitious state-led
development strategies. Structuralism ’s critique o f the ability o f dom estic and
international m arkets to prom ote industrialization led governm ents to inter­
vene in domestic m arkets to overcom e the m arket im perfections that reduced
private incentives to invest in m anufacturing activities.
T o the extent that developing countries participated in the global trade sys­
tem, they sought to achieve far-reaching reform of the rules governing the system.
Again, the structuralist critique served an im portant role in this effort, as it
suggested that developing countries could not expect to gain from trade with the
advanced industrialized countries until they themselves had industrialized. M ore­
over, structuralism claimed that trade based on G A T T rules would only make
industrialization harder to achieve. Rather than accept participation in the global
economy on what they viewed as vastly unequal terms, developing countries bat­
tled to change the rules governing international trade in order to capture a larger
share of the available gains. Thus, an international struggle over the distribution
of the gains from trade arose as an important counterpart of the domestic strategy
of redistributing resources from agriculture to industry embodied in ISI.
KEY TERMS
Backward Linkages
Big Push
Complementary Demand
Easy ISI
Enclave Agriculture
Export Substitution
Strategy
GATT Part IV
Generalized System of
Preferences
Group of 77
Import Substitution
Industrialization
Monoexporters
New International
Economic Order
Pecuniary External
Economies
Secondary ISI
Singer-Prebisch Theory
Structuralism
Terms of Trade
United Nations
Conference on Trade
and Development
SUGGESTIONS FOR FURTHER READING
For a readable introduction to structuralism and development strategies more
generally, see Ian Little, Economic Development (New York: Basic Books, 1982).
For an in-depth look at Latin America, see Victor Bulmer-Thomas, The Economic
Elistory of Latin American since Independence (Cambridge: Cambridge University
Press, 2003). For a comparative study of the role of the state in development, see
Atul Kohli, State-Directed Development: Political Power and Industrialization in
the Global Periphery (Cambridge: Cambridge University Press, 2004).
For a detailed examination of the New International Economic Order, see Stephen
Krasner, Structural Conflict: The Third World against Global Liberalism (Berkeley:
University of California Press, 1985).
CHAPTER
7
Trade and
Development II:
Economic Reform
hereas structuralism and im port substitution industrialization (ISI)
shaped development strategies during the first 35 years o f the post­
w ar period , the last 30 years have been dom inated by neoliberal­
ism and export-oriented industrialization. In contrast to structuralism , with
its skepticism about the m arket and faith in the state, neoliberalism is highly
skeptical o f the state’s ability to allocate resources efficiently and places great
faith in the m arket’s ability to do so. And in con trast to stru cturalism ’s ad ­
vocacy o f protectionism and state intervention, neoliberalism advocates the
state’s w ithdraw al from the econom y, the reduction (ideally, elim ination) of
trade barriers, and reliance on the m arket to generate industries that produce
for the w orld market.
Like structuralism , neoliberalism has dram atically affected policy. Across
the developing w orld, governm ents have reduced tariffs an d rem oved other
trade barriers, thereby opening their econom ies to im ports. They have sold
state-owned enterprises to private groups. They have deregulated their econo­
mies to allow prices to reflect the underlying scarcity o f resources. They have
shifted their em phasis from producing for the dom estic m arket to producing
for the global m arket. Countries that had never joined the General Agreement
on T ariffs and T rade (G A TT) sought m em bership in the W orld T rade O rga­
nization (W TO). T hus, the last 30 years have brought a com plete reversal of
the developm ent strategies that m ost governm ents had adopted. Belief in the
pow er o f states has been replaced by belief in the efficacy o f the m arket; skep­
ticism about trade has been replaced by concerted efforts to integrate deeply
into the w orld trade system. N eoliberalism has replaced structuralism as the
guiding philosophy o f economic development.
The shift from structuralism to neoliberalism emerged from the interplay
between three developments in the global economy. First, by the early 1970s,
ISI w as generating econom ic im balances. The emergence o f these im balances
su g g e ste d th at eco n o m ic refo rm o f so m e type w a s r e q u ire d , alth o u gh
it d id not poin t to a specific solu tion . Secon d, at a b o u t the sam e tim e, it
W
133
134
CHAPTER 7
Trade and Development II: Economic Reform
w as becom ing ap p aren t th at a sm all gro u p o f E ast A sian econom ies were
outperform in g all other developing countries based on w hat m any view ed
as a neoliberal strategy. T h ird, a severe econom ic crisis in the early 1 9 8 0 s
forced governm ents to em bark on reform , and as they did, the International
M onetary Fund (IM F) and W orld B ank strongly en couraged them to base
reform on the neoliberal model.
We exam ine each o f these three developments. We look first at the factors
that caused ISI to generate econom ic im balances. This exam ination allow s us
to understand the problem s ISI created and the reasons that reform o f som e
type w as necessary. We then turn our attention to the E ast A sian countries.
We briefly com pare their perform ance with that o f the rest o f the develop­
ing world. We next exam ine two contrasting explanations for this rem arkable
perform ance, one that em phasizes the neoliberal elements o f those countries’
strategies and one that em phasizes the role E ast A sian states played in the
developm ent process. We then turn to econom ic crisis and reform . We look
at how the crisis pushed developing countries to the W orld Bank and the IM F
and at how these tw o institutions shaped the content o f the reform s govern­
ments adopted. The chapter concludes by exam ining the challenges that devel­
oping countries now confront as active participants in the W TO .
EMERGING PROBLEMS WITH IMPORT
SUBSTITUTION INDUSTRIALIZATION
By the late 1 9 60s, ISI w as generating tw o im portan t econom ic im balances,
which together suggested that it had reached the lim its o f its utility as a de­
velopment strategy. The first imbalance lay in government budgets. ISI tended
to generate persistent budget deficits because it prescribed heavy governm ent
involvement in the economy. Since governments believed that the private sector
would not invest in industries that were im portant for the success o f secondary
ISI, governments themselves often m ade the investments, either in partnership
with private-sector groups or alone by creating state-owned enterprises.
Yet, m any o f these state-ow ned enterprises never becam e profitable. By
the late 1970s, state-ow ned enterprises in developing countries were running
combined operating deficits that averaged 4 percent of gross dom estic product
(GDP) (W aterbury 1992, 190). Governm ents kept these enterprises a flo at by
using funds from the state budget. Government investment and the subsequent
need to cover the losses o f state-owned enterprises com bined to generate large
and persistent budget deficits throughout the developing w orld.
D om estic politics aggrav ated the budget deficits generated by ISI. For
m any go v ern m en ts, u rb an resid e n ts p ro v id ed critica l p o litic a l su p p o rt.
G o v ern m en ts m a in ta in e d th is su p p o r t by s u b sid iz in g e sse n tia l ite m s.
E lectricity, w ater and sew er, tran sp o rtatio n , telephone service, and fo o d
were all m ade available to urban residents at below -m arket prices. T his w as
possible only by using governm ent revenues to cover the difference between
the true cost and the price charged. In addition, m any governm ents expanded
Emerging Problems with Import Substitution Industrialization
^
A
^
135
the civil service to em ploy urban dw ellers. In Benin, for exam ple, the civil
service tripled in size between 1960 and 1980, not because the governm ent
needed so m an y civ il se rv a n ts, but b ecau se the g o v e rn m e n t u sed it to
em ploy urban residents in order to m aintain support. Such practices added
to governm ent exp en ditu res and add ed nothing to governm ent revenues,
thereby worsening the budget deficit.
ISI also gen erated a secon d im p ortan t im balan ce: p ersisten t currentacco u n t d eficits. T he cu rren t acco u n t registers a co u n try ’ s im p o rts and
e x p o rts o f both g o o d s an d services. A current-account deficit m eans that
a country is im porting m ore than it is exporting. Im port substitu tion gave
rise to current-account deficits because it generated a considerable dem and
for im ports while sim ultaneously reducing the econom y’s ability to export.
Som ew hat iron ically, ISI depended on im ports. In d u strializatio n required
countries to im port the necessary machines, and once these m achines were in
place, production required continued im port o f parts that were not produced
in the dom estic economy.
E x p o rts declined fo r tw o reason s. First, the m an u factu rin g industries
created through im p ort substitution were not com petitive in international
m arkets. Production in m any o f the heavy industries th at governm ents ta r­
geted in secondary ISI is ch aracterized by econom ies o f scale. The dom estic m arket in m ost developing countries, how ever, w as to o sm all to allow
dom estic producers to realize econom ies o f scale. These inefficiencies were
com pounded by excess capacity— the creation o f m ore production capacity
than the dom estic m arket could absorb (see Little, Scitovsky, and Scott 1970,
9 8). C onsequently, the new ly created m an ufactu rin g in dustries could not
export to the w orld market.
Second, the p o licies th at governm ents used to p ro m o te in d u strializa­
tion weakened agriculture. The decline in agricultural production w as m ost
severe in sub-Sah aran A frican countries, which, as a region, taxed farm ers
heavily (Schiff and V aldes 1992). H eavy tax burdens reduced farm ers’ incen­
tives to produce, hence the rate o f grow th o f agriculture declined. In G hana,
for exam ple, the real value o f the paym ents that cocoa farm ers received from
the governm ent m arketing board fell by about two-thirds between 1960 and
1965. Falling prices gave co co a farm ers little incentive to invest in order to
m aintain, let alone increase, co coa output (Killick 1 9 78, 119). In addition,
cocoa farm ers smuggled much o f w hat they did produce into the Ivory C oast,
where they could sell cocoa at world prices (Herbst 1993, 40).
These m icroeconom ic inefficiencies were reinforced by the tendency o f
m ost governm ents to m aintain overvalued exchange rates. Ideally, a govern­
ment should m aintain an exchange rate that equalizes the prices o f go od s in
the dom estic and foreign m arkets. H ow ever, under ISI, m any governm ents
set the exchange rate higher than that, and as a result, foreign g o o d s were
cheaper in the home m arket than they should have been and dom estic goods
were more expensive in foreign m arkets than they should have been. Because
foreign go od s were underpriced in the dom estic m arket, cap ital g o o d s and
intermediate inputs could be acquired from abroad at a low er cost than they
136
CHAPTER 7
Trade and Development II: Economic Reform
could be produced at home. This difference in price created a strong incentive
to import, rather than creating the capacity to produce the goods locally. The
result w as rising im ports. Because dom estic good s were overpriced in foreign
m arkets, domestic producers, even when efficient, found it difficult to export.
The emergence o f budget deficits and current-account deficits indicated
that ISI w as creating an economic structure that couldn’t pay for itself. M any
o f the m anufacturing industries created during secondary ISI could not sell
their products at prices that covered their costs o f production. M any develop­
ing countries could not exp ort enough to pay for the im ports dem anded by
the m anufacturing industries they were creating. Such im balances could not
persist forever; som e reform w as clearly necessary.
Yet, the dom estic politics o f ISI greatly constrained the ability o f govern­
ments to implement reform s. The balance o f pow er am ong dom estic interest
groups created multiple veto players that limited the ability o f governments to
alter policies. Because governm ents depended so heavily on urban residents
for political su pp ort, they could not easily reduce benefits provided to that
grou p (W aterbury 1 9 9 2 , 192). In 1 9 7 1 , fo r exam ple, the G h an aian prim e
minister devalued the exchange rate in an attem pt to correct G han a’s currentaccount deficit. Concern that devaluation w ould raise the prices o f m any im ­
ported goods consum ed by urban residents contributed to a coup again st the
government a few days later. Once in pow er, the new regime quickly restored
the currency to its previous rate (H erbst 1993, 2 2 -2 3 ). W hat m essage did that
send to politicians who might be contem plating m easures to address the eco­
nomic im balances they were facing?
In addition, the adm inistration o f ISI had created opportunities for rent
seeking and other corrupt practices. T h ose w ho engaged in these activities
had a vested interest in the continuation o f the system . On the one h an d,
governm ent intervention had established an environm ent conducive to rent
seeking (K rueger 1 9 7 4 ; B h agw ati 1 9 8 2 )— effo rts by priv ate a cto rs to use
the political system to achieve a higher-than-m arket return on an econom ic
activity. C on sid er, for exam ple, the consequences o f governm ent con tro ls
on im ports. G overnm ents controlled im ports by requiring all residents who
w anted to im p o rt som eth in g to first gain the p erm issio n o f govern m en t
authorities. Such restrictions m eant that im ported g o o d s were scarce, thus
imports purchased at the w orld price could be sold at a much higher price in
the domestic m arket. The difference between the w orld price and the domestic
price provided a rent to the person w ho im ported the go o d . A governm ent
license to im port, therefore, w as valuable. Consequently, people had incentives
to pay governm ent civil servants to acquire licenses, and governm ent civil
servants had incentives to sell them.
Such behavior w as extraordinarily costly. It has been estim ated, for exam ­
ple, that rent seeking cost India about 7 percent and Turkey about 15 percent
of their national incomes during the 1 960s (Krueger 1974, 2 9 4 ). Because so
many people inside the government and in the econom y were benefiting from
the opportunities for rent seeking, they had a very strong incentive to resist
any efforts by the government to dismantle the system.
The East Asian Model
137
Finally, even if governm ents could overcom e these obstacles, it w as un­
clear w hat m odel they should shift to. Far-reaching reform s w ould require
them to reevaluate the underlying strategy they were using to industrialize.
The only available alternative to ISI w as a market-oriented development strat­
egy (one we w ill lo ok at in detail in the next section). In the 1 9 7 0 s, how ­
ever, it was precisely this strategy that the G roup o f 77 w as fighting against in
the U N C T A D and with the N IE O . Even m oderate reform s held little appeal.
M ost governments were unwilling to scale back their industrialization strate­
gies. Instead, they looked for a w ay to cover the twin deficits without having
to scale back their am bitious plans.
Facing economic im balances, unable and unwilling to change policy, many
governments sustained ISI by borrow ing from abroad. Yet foreign loans could
provide only a tem porary solution; foreign lenders w ould eventually question
whether loans could be repaid. When they concluded that they couldn’t, they
w ould be unwilling to lend m ore, and governm ents w ould be forced to co r­
rect budget and current-account deficits. This point arrived in the early 1980s
and ushered in a period o f crisis and reform . Before we exam ine this period,
however, we m ust look at economic developments in E ast A sia, as these devel­
opments played a critical role in shaping the content o f the reform s adopted
throughout the developing world after 1985.
THE EAST ASIAN MODEL
W hereas ISI w as generating im balances in Latin A m erica an d sub-Saharan
Africa, four E ast Asian econom ies— H ong Kong, Singapore, South Korea, and
Taiw an— were realizing dram atic gains on the basis o f a very different devel­
opment strategy. The dram atic perform ance gap is evident in three economic
indicators. (See Table 7.1.)
■ Per capita income in E ast A sia grew alm ost three times faster than in
Latin America and South A sia and more than twenty-six times higher
than in sub-Saharan Africa.
■ M anufacturing output grew by 10.3 percent per year between 1965 and
1990. N o other developing country came close to this grow th for the
period as a whole
■ Exports from E ast A sia grew 8.5 percent per year between 1965 and
1990 while exports from Latin Am erica shrank by 1 percent per year.
As a consequence, m anufacturing grew in im portance in E ast A sia, while
the im portance o f agriculture dim inished. T his differed su bstan tially from
ISI countries, where agriculture’ s im portance fell but m anufacturing failed
to grow. (See T able 6.1.) The grow ing m anufacturing sector transform ed the
com position o f East A sia’s exports. (See T able 6.2.) By the m id-1990s, m anu­
factured goods accounted for m ore than 80 percent o f E ast A sian exports. By
contrast, only in Brazil, M exico, India, and Pakistan did m anufactured goods
account for m ore than 50 percent o f to tal exp orts by the 1 9 9 0 s, and m ost
o f these gains were realized after 1 9 80. Finally, per cap ita incom es in E ast
138
CHAPTER 7
Trade and Development II: Economic Reform
TABLE 7.1
Comparative Economic Performance, Selected Developing Countries
(Average Annual Rates of Change)*
1965-1990
1985-1995
Growth of per Capita GNP
East Asia and the Pacific
Sub-Saharan Africa
South Asia
Latin America and the Caribbean
5.3
0.2
1.9
1.8
7.2
1.1
2.9
Growth of Manufacturing
East Asia and the Pacific
Sub-Saharan Africa
South Asia
Latin America and the Caribbean
10.3
n.a.
4.5
8.3
15.0
0.2
5.3
2.5
8.5
6.1
1.8
2.1
9.3
0,9
Growth of Exports
East Asia and the Pacific
Sub-Saharan Africa
South Asia
Latin America and the Caribbean
0.3
6.6
5.2
*n.a., not available; GNP, gross national product.
Source: World Bank, World Development R e p o rt, various issues.
A sia soared above those in other developing countries (Table 7.2). In 1 9 60,
per capita incomes in E ast A sia were low er than per capita incom es in Latin
America; by 1990, E ast Asian incomes were higher than— in some cases twice
as large as— per capita incomes in Latin America.
Why did E ast A sian countries outperform other developing countries by
such a large m argin? M ost who study E ast A sian developm ent agree that the
countries in the region distinguished themselves from other developing coun­
tries by pursuing export-oriented developm ent. In an export-oriented strat­
egy, em phasis is placed on producin g m anufactured g o o d s that can be sold
in international m arkets. Scholars disagree ab o u t the relative im portance o f
the m arket and the state in creating export-oriented industries. One position,
the neoliberal interpretation, is articulated m ost forcefully by the IM F and the
W orld Bank. This thesis argues that E ast A sia’s success w as a consequence of
m arket-friendly developm ent strategies. In con trast, the state-oriented inter­
pretation, advanced by m any specialists in E ast A sian political econom y a r­
gues that East A sia’s success is due in large part to state-led industrial policies.
The IM F and the W orld Bank contend that E ast A sia’s econom ic success
derived from the adoption o f a neoliberal approach to development. T his in­
terpretation places particular em phasis on the w illingness o f E ast A sian gov­
ernments to em brace o f international m arkets and their ability to m aintain
The East Asian Model
139
TABLE 7.2
Gross National Product per Capita, Selected Developing . •>,, - h ..
Countries (1996 U.S. Dollars)
1960
1990
Hong Kong
3,090
20,827
26,699
Singapore
Taiwan
South Korea
Mexico
Malaysia
Argentina
Chile
2,161
17,933
24,939*
1,054
1,430
10,981
17,056**
1,093
1,495
9,952
. 15,876
3,980
7,334
8,762
2,119
2000
Percent Change 1960-2000
764
- -
,
x;
x
%2
7,219
11,006
3,853
6,148
9,926
Brazil
Thailand
Zaire/Congo
Indonesia
Pakistan
India
Nigeria
2,371
6,218
7,190
203
6,857
528
Kenya
Zambia
Tanzania
980
572
281*** ■. X X
2,851
'■ 5,642 ■ -'/ X X
633
2,008
847
1,675
1,095
2,479
, •
-
,4V,
796
1,207
1,336
1,244
382
494
, t-71
X 2 8 9 -r
217
193 ' '
707
-3 2 .
: 56
1,021.
‘ Data for 1996; “ data for 1998; “ ‘ datafor 1997.
Source:
. '
i5 8 -
936
1,033
;
'
H-(
1,091
«cr\
■ 9 ,9 19
^CO
6,525
7,371
.
%
X
'
t
..........................' J
Penn World Tables.
stable m acroeconom ic environm ents. (See W orld B ank 1 9 8 9 , 1 9 9 1 , 1993;
Little 1 9 82; L ai 1983; for critiques, see T oye 1994 and R od rik 1999.) M ost
E ast A sian governm ents ad o p ted ISI strategies in the im m ediate p o stw ar
period. Unlike governments in Latin America and Africa, however, E ast Asian
governments shifted to export-oriented substitution once they had exhausted
the gains from easy ISI. In T aiw an , for exam ple, the governm ent shifted in
1958 from production for the dom estic m arket to a strategy that emphasized
production for export m arkets. South K orea ado pted sim ilar reform s in the
early 1 9 6 0 s. A second w ave o f newly in d u strializin g countries (N IC s)— a
group that includes Indonesia, M alay sia, and T h ailan d — follow ed the sam e
path starting in the late 1960s (W orld Bank 1993). The em phasis on exports
forced A sian m anufacturing firm s to w orry ab ou t international com petitive­
ness. As a result, the W orld Bank and the IM F argue, A sian societies invested
their resources in domestic industries profitable in w orld m arkets.
The shift to export-oriented strategies w as follow ed by selective im port
liberalization. A sian governm ents did not engage in w holesale im port liber­
alization. The T aiw anese and South K orean governm ents continued to rely
heavily on tariff and nontariff barriers to protect dom estic m arkets. In Taiw an,
140
CHAPTER 7
Trade and Development II: Economic Reform
for exam ple, approxim ately two-thirds o f im ports were subject to som e form
o f tariff or nontariff barrier greater than 30 percent, and as late as 1980 more
than 40 percent o f im ports faced protection greater than 30 percent (W orld
Bank 1993, 297). A sim ilar pattern appeared in South K o rea, where, as late
as 1983, “ m ost sectors were still protected by som e com bination o f tariffs and
nontariff barriers” (W orld Bank 1993, 297). However, selective liberalization
helped prom ote exports by reducing the cost o f critical inputs. Reducing tar­
iffs on key intermediate goods, such as loom s and yarn in the textile industry,
enabled dom estic producers to acquire inputs at w orld prices. T his kept ex ­
ports competitive in international m arkets.
E ast Asian governm ents also m aintained stable m acroeconom ic environ­
ments. Three elements o f the m acroeconom ic environm ent were particularly
im portant. First, inflation w as much low er in E ast A sia than in other devel­
oping countries. Between 1961 and 1991, inflation averaged only 7.5 percent
in the E ast A sian econom ies. By contrast, annual inflation rates in the rest of
the developing w orld averaged 62 percent (W orld Bank 1993, 110). Second,
because governments kept inflation under control, they could maintain ap p ro ­
priately valued exchange rates. In m any developing countries, high inflation
caused the domestic currency to rise in value against foreign currencies, m aking
exporting difficult. In the East Asian countries, by contrast, governments were
able to maintain exchange rates that allowed domestic firms to remain com pet­
itive in foreign markets. Third, East Asian governments pursued relatively con­
servative fiscal policies. They borrow ed little, and when they did borrow , they
tapped domestic savings rather than turning to international financial markets.
This approach w as in stark contrast to Latin American governments, which ac­
cumulated large public-sector deficits financed with foreign capital.
This stable m acroeconom ic environment had beneficial consequences for
Asian economic perform ance. Low inflation prom oted high savings rates and
investment (W orld Bank 1993, 12). Savings rates in the A sian N IC s averaged
more than 20 percent o f GDP per year, alm ost twice the level attained in other
developing countries, w hereas investm ent rates were 7 percentage points o f
G DP higher, on average, than in other developing coun tries (W orld B ank
1993, 16, 221). A stable m acroeconom ic environm ent also m ade it easier to
open the econom y to international trade. Because inflation w as low and e x ­
change rates were m aintained at approp riate levels, trade liberalization did
not generate large current-account deficits. Finally, the ability to m aintain rel­
atively stable and appropriately valued real exchange rates encouraged private
actors to invest in export-oriented industries.
The interaction between the export orientation, the relatively liberal im ­
port policy, and the stable m acroeconom ic environment prom oted econom ic
development. As D oner and H aw es (1 9 9 5 , 150) sum m arize the W orld Bank
perspective, the
pattern of limited government intervention in the market, coupled with cheap
labor and an open economy, [has] guaranteed the private sector stability
and predictability, the means to achieve competitiveness on a global scale,
The East Asian Model
141
and access to the international market so that entrepreneurs could actually
discover areas where they have comparative advantage. In shorthand, the
model is often reduced to “ getting the prices right” and letting market-based
prices determine resource allocation. Doing so results in export growth that
is in turn positively correlated with broader economic growth.
A ccording to the W orld B ank and the IM F , E a st A sia succeeded because
m arkets played a large role, and states play ed a sm all role, in allo catin g
resources.
Other scholars have argued that E ast A sia’s success had less to do with al­
lowing markets to w ork and much m ore to do with well-designed government
industrial policies (see W ade 1990; Amsden 1989; H aggard 1990). In what has
com e to be called the E ast A sian m odel o f developm ent, econom ic develop­
ment is conceptualized as a series o f distinct stages. Governm ent intervention
in each stage identifies and prom otes specific industries likely to be profitable
in the face o f international com petition. In the first stage, industrial policy
prom otes labor-intensive light industry, such as textiles an d other consumer
durables. In the second stage, industrial policy em phasizes heavy industries
such as steel, shipbuilding, petrochem icals, and synthetic fibers. In the third
stag e, governm ents ta rg e t skill- an d research an d d ev elo p m en t (R & D )intensive consumer durables and industrial machinery, such as machine tools,
sem iconductors, com puters, telecom m unications equipm en t, rob o tics, and
biotechnology. Governments design policies and organizations to prom ote the
transition from one stage to the other (Wade 1994, 70).
These three stages o f industrialization are evident in the path s traced by
T aiw an and South K orea. (See T ab le 7.3.) In T aiw an , in d ustrialization fo ­
cused initially on light m anufacturing, textiles in particular. By the m id-1950s,
textiles were T aiw an ’s m ost im portant export. The governm ent also encour­
aged production o f simple consum er durable go od s such a s television sets. In
the late 1950s, the T aiw anese governm ent began to em phasize heavy indus­
tries. A joint venture between several Taiw anese firm s and an American firm
w as formed in 1954 to produce synthetic fibers (W ade 1 9 9 0 , 80). In 1957, a
plant to produce polyvinyl chloride w as constructed under governm ent su­
pervision and then w as handed to a private entrepreneur, Y. C. W ang (Wade
1990, 79). The government created state-owned enterprises in the steel, ship­
building, and petrochemical industries. During the 1970s, attention shifted to
skill-intensive industries, with particular emphasis on machine tools, semicon­
ductors, com puters, telecom m unications, robotics, and biotechnology (Wade
1990, 94). By the m id -1980s, electrical an d electronic g o o d s h ad replaced
textiles as T aiw an ’s largest export (Wade 1990, 93).
The South K orean governm ent adopted sim ilar policies (Am sden 1989).
In the 1950s, the government em phasized textile production, and textiles be­
cam e South K o rea ’s first im portan t m anufacturing exp ort. D uring the late
1960s, the South K orean state initiated the development o f the chemical and
heavy-machinery industries. It created the Pohang Iron an d Steel Com pany,
know n as P O SC O , which subsequently becam e one o f the w o rld ’s leading
142
CHAPTER 7
Trade and Development II: Economic Reform
TABLE 7.3
Stages of Industrialization in Taiwan and South Korea, 1880-1968
Main
Industries
Commodity
Exports
1880-1930
Primary ISI*
1930-1955
Primary ExportOriented Industries
1955-1968
Taiwan: Sugar,
rice
South Korea:
Taiwan and South
Korea: Food,
beverages,
Taiwan and South
Korea: Textiles and
apparel, electronics,
Rice, beans
Major
Economic
Actors
Orientation of
the Economy
Taiwan and
South
Korea: Local
producers
(colonial
Japan)
External markets
tobacco, textiles,
clothing,
cement, light
manufactures
(wood, leather,
plywood, plastics
(Taiwan), wigs
(South Korea),
rubber, and
paper products)
petroleum, paper,
and steel products)
Taiwan and South
Taiwan and South
Korea: Private
national firms
Internal market
intermediate
goods (chemicals,
Korea: National
private firms,
multinational
corporations, stateowned enterprises
External markets
*ISI, import substitution industrialization.
S o u rc e : Gereffi 1990, 19.
steel producers. The governm ent also provided extensive support to H yundai
H eavy Industry, a shipbuilder that subsequently becam e a w orld leader in
this industry. Then in the late 1970s, the South K orean governm ent began to
give priority to skill- and R & D -intensive sectors, and it is during this period
that the South Korean electronics and autom obile industries began to emerge
(Amsden 1989).
In the E ast A sian m odel o f developm ent therefore, governm ent policy
drives in d u stria liz a tio n fro m lo w -sk illed , lab o r-in ten siv e p ro d u c tio n to
capital-intensive form s o f production and from there to industries that rely on
high-skilled labor and technology-intensive production. Each stage is asso ci­
ated with particular types o f governm ent policies, and as each stage reaches
the lim its o f rapid grow th, em phasis shifts to the next stage in the sequence
(W ade 1 9 94, 71). M oreover, at each stage, governm ents stress the need to
develop internationally competitive industries.
E ast A sian governm ents relied heavily on industrial policies. They used
in d u strial policy to achieve fo u r p o licy g o a ls: reduce the c o st o f in v e st­
ment funds in targeted industries, create incentives to export, protect infant
The East Asian Model
143
industries, and prom ote the acquisition and application o f skills. T aiw an and
South Korea created incentives to invest in industries that state officials identi­
fied as critical to development. T o do so, governments in both countries pro­
vided firm s investing in these industries with preferential access to low -cost
credit. In South K o rea, the governm ent nationalized the banks in the early
1960s and in the ensuing years fully controlled investment capital. Control o f
the banks allowed the governm ent to provide targeted sectors with access to
long-term investment capital at below-market rates o f interest (H aggard 1990,
132). Although the banking sector w as not nationalized in T aiw an , the gov­
ernment did influence banks’ lending decisions. During the 1960s, banks were
provided with governm ent-form ulated lists of industries that were to receive
preferential access to bank loan s. D uring the 1 9 7 0 s, the ban ks them selves
were required to select five or six industries to target in the com ing year. As
a result, about 75 percent of investment capital w as channeled to the govern­
m ent’s targeted industries (Wade 1 9 9 0 ,1 6 6 ).
A sian governm ents also implemented policies that encouraged exports.
One method linked access to investment funds at low interest rates to export
perform ance. In T aiw an, for exam ple, firm s that exported paid interest rates
o f only 6 -1 2 percent, whereas other borrowers paid 2 0 - 2 2 percent (H aggard
19 9 0 , 94). In South K orea, short-term loans were extended “ w ithout lim it”
to firm s with confirm ed exp ort orders (H aggard 1 9 90, 65). Credit w as also
m ade available to exporters’ input suppliers and to these suppliers’ suppliers
(H ag g ard 1 9 90, 6 5 - 6 6 ). In add ition , “ deliberately undervalued exchange
r a te s ” im proved the com petitiven ess o f e x p o rts in in tern atio n al m arkets
(W orld Bank 1 9 9 3 ,1 2 5 ). Finally, a variety of m easures ensured that domestic
firm s could purchase their intermediate inputs at world prices. These measures
often entailed the creation o f free-trade zones and export-processing zones—
areas of the country into which interm ediate go od s could be im ported duty
free as long as the finished goods were exported. E xport-processing zones al­
low ed dom estic producers to avoid paying tariff duties that w ould raise the
final cost of the goods they produced.
The Taiwanese and South Korean governments also protected infant indus­
tries at each stage. In som e instances, the m easures they used were straightfor­
w ard form s o f protection. The South Korean government, for exam ple, enacted
legislation in 1983 th at “ proh ibited the im p ort o f m ost m icrocom p uters,
som e m inicomputers, and selected m odels o f disk drives,” in order to protect
domestic producers in the computer industry (Amsden 1989, 82). PO SC O ini­
tially produced steel behind high import barriers. In other instances, protection
w as less transparent. H yundai Heavy Industry, for instance, w as protected in
p art through a government policy that required K orean oil im ports to be car­
ried in ships operated by a merchant marine that Hyundai H eavy Industry had
itself created (Amsden 1989, 273). Taiw an adopted similar policies.
Finally, the Taiw anese and South Korean governments put in place policies
that raised skill levels. Investments in education were m ade to im prove labor
skills. In Taiw an, enrollment in secondary schools had reached 75 percent o f
the eligible age group by 1980. Enrollm ent increases were accom panied by
144
CHAPTER 7
Trade and Development II: Economic Reform
rising expenditures on education; per pupil expenditures increased eightfold in
primary schools, threefold in secondary schools, and tw ofold at the university
level between the early 1960s and 1980s (Liu 1992, 369). Sim ilar patterns are
evident in South K orea, where enrollment in secondary schools increased from
35 percent in 1965 to 88 percent in 1987 and “ real expenditures per pupil at
the primary level rose by 355 percent” (W orld Bank 1993, 4 3 , 45).
G overnm ents also invested in scientific in frastru ctu re to facilitate the
application of skills to R8cD activities. In T aiw an, the Industrial Technology
Research Institute was formed in 1973, and nonprofit organizations were created
during the 1970s to perform research and disseminate the results to firms in the
private sector. A science-based industrial park designed to realize agglomeration
effects was created in 1980 (H aggard 1990, 142). In South Korea, tax incentives
were used to induce chaebols, the large South Korean firms, to create laboratories
for R & D pu rp oses. An industrial estate for com puter and sem icon ductor
production was created, and the Electronics and Telecommunications Research
Institute, a government-funded institute oriented tow ard product development
w as form ed in the industrial estate (Amsden 1989, 82). These policies raised
skill levels and created an infrastructure that allow ed the m ore highly skilled
labor force to work to its full potential. This skill upgrading w as critical to the
transition to the third stage of the industrialization process.
The two explanations discussed thus present different argum ents for East
A sia’s success. One suggests that E ast A sia succeeded because governm ents
allow ed m arkets to w ork. The other suggests that E ast A sia succeeded be­
cause governments used industrial policy to prom ote economic outcom es that
the m arket could not produce. Which argum ent is correct? Although we lack
definitive answ ers, we m ay conclude that both exp lan atio n s have value. By
“ getting prices righ t,” the exp ort orientation and the stable m acroeconom ic
environment encouraged investments in industries in which E ast A sian coun­
tries had or could develop com parative advantage. By targeting sectors where
com parative advantage could be created, by reducing the costs o f firm s oper­
ating in those sectors, by encouraging firms to export, and by upgrading skills,
industrial policy encouraged investments in areas that could yield high returns.
As Stephan H aggard (1990, 67) has sum m arized, m acroeconom ic “ and trade
policies established a permissive fram ew ork for the realization o f com parative
advantage, and more targeted policies pushed firms to exploit it.”
Although the relative im portance o f the state and the m arket in account­
ing for E ast A sia’s success rem ains in dispute, w hat is clear is that the experi­
ence o f the E ast Asian N IC s w as vastly different from the experience o f Latin
America and sub-Saharan A frica. E ast A sian governm ents adopted develop­
ment strategies that emphasized exports rather than the dom estic m arket, and
they realized substantial improvements in per capita income. The development
strategies adopted by governm ents in other developing countries em phasized
the dom estic m arket over exp orts and generated econom ic im balances and
m odest im provem ents in per capita incom es. Consequently, when econom ic
crises forced governments to adopt reform s, the E ast Asian exam ple provided
a powerful guide for the kind o f reforms that would be implemented.
Structural Adjustment and the Politics of Reform
145
STRUCTURAL ADJUSTMENT
AND THE POLITICS OF REFORM
By the early 1 9 80s, governm ents in m any developing countries were recog­
nizing the need for reform . The im balances generated by ISI created pressure
for reform , and E ast A sia’s success provided an attractive alternative model.
It to ok a m assive econom ic crisis, however, for governm ents to im plem ent
reform. We will examine this crisis in detail in Chapter 14; here, we say a few
w ords a b o u t it in order to understand how it produced the w ave o f reform
that swept the developing world during the 1980s.
E conom ic crises struck developing countries during the early 1 9 8 0 s in
large p a rt as a consequence o f governm ents’ decision to borrow to finance
their budget and current-account deficits. Using foreign loans to finance bud­
get and current-account deficits is not an inherently p o o r choice. But tw o
factors m ade this decision a particularly bad one for developing countries in
the 1 9 7 0 s. First, m any o f the funds th at governm ents borrow ed were used
to pay for large infrastructure projects or dom estic consum ption, neither of
which generated the export revenues needed to repay the loan s. A s a result,
the am ount that developing countries ow ed to foreign lenders rose, but the
countries’ ability to repay the debt did not.
Second, between 1973 and 1982, developing countries were buffeted by
three international shocks: an increase in the price o f oil, a reduction in the
term s o f trade between prim ary com m odities and m anufactured good s, and
higher interest rates on the foreign debt those countries had accum ulated.
These shocks increased the am ount o f foreign debt that developing countries
owed to foreign banks, raised the cost o f paying that debt, and greatly reduced
export earnings. By the early 1980s, a num ber o f developing countries were
unable to m ake the scheduled payments on their foreign debt.
As crisis hit, governm ents turned to the IM F an d the W orld Bank for
financial assistance. The international institutions linked financial assistance
to econom ic reform . The W orld Bank and the IM F encouraged governments
to adopt such reform s under the banner o f structural adjustm ent program s—
policy reform s designed to reduce the role o f the state an d to increase the
role o f the m arket in the econom y. The specific content o f the reform s that
the IM F and the W orld Bank advocated were shaped by their belief that E ast
A sia ’s success had resulted from export-oriented and m arket-based devel­
opm ent strategies (see W orld Bank 1 9 9 1 , 1993). In the W orld B an k ’s ow n
w ords, “ the approach to developm ent that seems to have w orked m ost reli­
ably, an d which seem s to offer m ost prom ise, suggests a reap p raisal o f the
respective roles for the m arket and the state. Put sim ply, governm ents need
to do less in those areas where m arkets w ork, or can be m ade to w ork, rea­
sonably w ell” (1991, 9).
T o this end, structural adjustm ent em phasized changing those aspects of
developing economies that were m ost unlike conditions in A sia. Governments
were encouraged to create a stable m acroeconom ic environm ent, to liberal­
ize trade, and to privatize state-owned enterprises (W illiam son 1990, 1994).
146
CHAPTER 7
Trade and Development II: Economic Reform
M acroecon om ic stability w as to be achieved by tran sform in g governm ent
budget deficits into budget surpluses. G overnm ents were encouraged to lib­
eralize im ports by dism antling import-licensing system s, shifting from quotabased form s o f protection to tariffs, simplifying com plex tariff structures, and
reducing tariffs and opening their economies to imports.
The IM F and the W orld Bank also en couraged p riv atizatio n o f stateowned enterprises— that is, selling such enterprises to private individuals and
groups. The IM F and the W orld Bank argued that reducing governm ent in­
volvem ent in the econom y w ould foster com petition and that greater co m ­
petition w ould in turn help create a m ore efficient private sector that could
drive economic development. Through structural adjustm ent, therefore, gov­
ernments were encouraged to scale back the role o f the state in econom ic de­
velopment and to enhance the role played by the m arket.
M any governments implemented structural adjustm ent program s between
1983 and 1995. (See Table 7.4.) They liberalized trade substantially beginning
in the m id-1980s (see Figure 7.1). In Latin A m erica, average tariffs fell from
41.6 percent prior to the crisis to 13.7 percent by 1990 (Inter-American Devel­
opment Bank 1997, 42). They began to privatize state-owned enterprises in the
late 1980s. In Latin America, “ more than 2 ,0 0 0 publicly owned firms, includ­
ing public utilities, banks, and insurance com panies, highways, ports, airlines,
and retail shops, were privatized” between 1985 and 1992 (E dw ards 1 9 95,
170; see also C orbo 2000). They liberalized investment regimes, thus opening
T A B L E 7.4
Countries Adopting Trade and Domestic Policy Reforms, 1980-1996
Africa
Benin
Burkina Faso
Burundi
Cameroon
Central African Republic
Chad
Congo
Cote d'Ivoire
Ethiopia
Gabon
The Gambia
Ghana
Guinea
Guinea-Bissau
Kenya
Madagascar
S o u rc e s:
Latin America
Malawi
Mali
Mauritania
Mauritius
Mozambique
Niger
Nigeria
Rwanda
Senegal
Sierra Leone
Tanzania
Togo
Uganda
Zambia
Zimbabwe
World Bank 1994a; Thorp 1999.
Argentina
Bahamas
Barbados
Belize
Bolivia
Brazil
Chile
Colombia
Costa Rica
Dominican Republic
Ecuador
El Salvador
Guatemala
Guyana
Haiti
Honduras
Mexico
Nicaragua
Panama
Paraguay
Peru
Suriname
Trinidad
Uruguay
Venezuela
V
Structural Adjustment and the Politics of Reform
1980
1985
1990
147
1995
FIGURE 7.1
Average Tariffs, Developing Countries
Source:
World Bank 2008
k T A B L E 7.5
Nontariff Barriers in Developing, Cijuntries’(as aVercent
of All Industry C ategories).,
, K..
_
4 t-‘
1989-199* f i ,
Hong Kong, China
'.Indonesia
'
*■ '"
«■ >,
;
*1995-1998
............ 2.1 ’
2.1 '
'
'31.3 ’
Korea
■ 50.0 '*
■ - Malaysia
' *■
- "
*iw>~
56.3
19.6 -
Singapore
-’ 2.1
•
Thailand
17.5
*
‘
93.8 -
*.
'Indla-
■ 9 4 . 0 ‘
Nigeria
’ -South Africa
Morocco
58.3 1 •
’t j •'
*$.'4’
'
Turkey'
i4.'8
‘-Argentina :
mmmmm
Brazil
16.5
’Chile
Colombia
'
-si
’ 55.2
Mexico
.Uruguay •
21.6 '
27.8
• '
. Sour ce: World Bank 2008.
32.3
-
•
10.3'
13.4.
;
' 0.0 \
:
148
CHAPTER 7
Trade and Development II: Economic Reform
to multinational corporations. They deregulated industries and reduced gov­
ernment intervention in the financial system.
Structural adjustment program s had a dram atic im pact on average incomes
in the short run and the distribution o f income in the long run. The crisis and
the reforms brought about a sharp contraction o f economic activity. Income fell
sharply as a result. In Latin Am erica, income fell by about 8 percent between
1981 and 1984. In sub-Saharan Africa, incomes fell, on average, by about 1.2
percent per year throughout the 1980s (Thorp 1999, 220; W orld Bank 1993).
The dismantling o f ISI also redistributed income from the urban sector to
agriculture and em erging export-oriented m anufacturing industries. In The
Gambia, producer prices on groundnuts tripled as a consequence o f structural
adjustment policies (Jabara 1994, 309). These policies hurt producers based in
the import-competing sector, as well as those employed in the nontraded-goods
sector. In The G am bia, for exam ple, the government raised the price o f petro­
leum products, public transportation, water, electricity, and telecommunications
in connection with structural adjustm ent (Jab ara 1994, 309). In G uinea, the
elimination of government rice subsidies doubled the price that households paid
for rice, an important staple in their diets (Arulpragasam and Sahn 1994, 79).
Privatization and civil-service reform usually resulted in large job losses. In
Guinea, the civil service w as reduced in size from 1 0 4,000 in 1985 to 7 1 ,0 0 0
in 1989 (Arulpragasam and Sahn 1994, 91). In The G am bia, government em ­
ployees were reduced by 25 percent in 1 9 8 5 - 1 9 8 6 , and w ages and salaries
o f those retained in the governm ent sector were frozen (Ja b ara 1 9 9 4 , 3 1 2 ,
318). In pursuing structural adjustm ent, therefore, governm ents redistributed
income: Export-oriented producers benefited from the successful im plementa­
tion o f these policies, whereas people em ployed in the im port-com peting and
nontraded-goods sectors saw their incomes fall.
The econom ic consequences o f structural adjustm ent drove the dom estic
politics o f reform (see N elson 1990; Rem m er 1986; H aggard and K aufm an ,
1992; O atley 2 0 0 4 ). G ro u p s th at w o u ld lose fro m stru ctu ral ad ju stm en t
attem pted to block the reform s, w hereas those w ho stoo d to gain attem pted
to prom ote reform . Governm ents were forced to m ediate between them , and
in many countries governments were heavily dependent upon political support
from the import-competing and nontraded-goods sectors. Thus, reform s were
hard to implement.
Over time, however, the econom ic crisis triggered a realignm ent o f inter­
ests, discrediting groups associated with the old policies and giving greater in­
fluence to groups that proposed an alternative approach (Krueger 1993a). By
weakening key interest groups and by forcing many to redefine their interests,
the crisis gradually eroded m any o f the political obstacles to far-reaching re­
form. Yet, this process took time, as reform s could be implemented only after
new governm ents responsive to new interests had replaced the governm ents
that presided over ISI.
Econom ic perform ance under the neoliberal regime has been uneven. In
Latin Am erica, average grow th rates have been substantially higher since the
early 1990s, however, and in 2 0 0 4 Latin American grow th rose to 5.5 percent.
The picture in A frica is a bit m ore m ixed. A frican governm ents stru ggled
Structural Adjustment and the Politics of Reform
^
-i
149
with structural adjustment. In som e instances, efforts to implement economic
reform were overtaken and greatly com plicated by civil and international
conflict. Even so, average grow th rates have been higher since 1990 than the
average rate during the 1980s. M oreover, the last few years have been particu­
larly encouraging. A frican countries have enjoyed their fastest grow th since
the 1970s, averaging 5.4 percent per year since 2005.
C om paring average grow th rates across decades is m isleading, however,
because such com parisons fail to recognize that som e governm ents have re­
formed much more than others. T hus, to get a better appreciation o f the im­
pact o f reform s on long-run grow th, we need to control for the variation in
reform across countries. Figure 7.2 depicts the relationship between progress
on reform and the gain in economic grow th between the 1980s and the 1990s.
Progress on reform is m easured as the change in an index o f structural a d ­
justm ent developed by researchers at the Inter-American Developm ent Bank
(IADB). T his index sum m arizes the extent to which nation al econom ies are
characterized by stable m acroeconom ic conditions, liberal trade, privatized in­
dustries, and flexible labor m arkets. The higher the score on the index (which
ranges from 0 to 1), the clo ser the country ap p ro x im ate s the “ n eoliberal
id eal.” I calculated the change in this index between 1985 and 1995 for each
country to m easure the extent to which each has m oved from ISI tow ard a
neoliberal fram ework. I then plotted this measure o f structural change against
the difference between average grow th in the 1990s and average growth in the
1980s. Neoliberalism leads us to expect a strong positive relationship between
progress on reform and change in grow th: Countries that have reform ed the
FIGURE 7.2
Reform and Growth in Latin America
Source:
Reform index from 1997, 96; growth rates from World Bank, World Development Indicators
150
CHAPTER 7
Trade and Development II: Economic Reform
m ost should see large im provem ents in grow th, w hereas countries that have
reformed less should see sm all grow th gains. T h at expectation finds som e sup­
port in this graph. The overall relationship is positive, indicating that countries
that have progressed furthest alon g the trajectory o f reform s have e xp eri­
enced larger gains in grow th. Countries that have reform ed less have realized
smaller, and in some cases, negative, changes in growth.
Even this m ore nuanced evalu ation is m isleadin g, how ever, because it
com pares the w rong grow th rates. T o fully understand reform ’s im pact on
long-run grow th, we should com pare grow th rates after reform with grow th
rates that would have occurred had governm ents never im plem ented reform .
That is, suppose Latin Am erican governm ents continued along the path they
were on in the early 1970s. W hat rate o f econom ic grow th w ould they then
have realized during the 1 9 8 0 s and 1 9 9 0 s? We can co m pare these grow th
rates with grow th rates follow ing reform to see reform ’s im pact on long-run
growth. This com parison is obviously difficult to m ake, because we can ’t re­
play history to see w hat w ould have happened if governments had not adopted
reforms. The best we can do is to estimate w hat grow th rates w ould have been
for Latin American countries had they not adopted reform s. A num ber of such
analyses have been conducted, and they suggest that Latin Am erican grow th
in the po streform period h as been betw een 1.9 and 2 .2 percen tage poin ts
higher than it w ould have been had governm ents not im plem ented reform s
(see Easterly, M ontiel, and Loayza 1997; M ontiel and Fernandez-Arias 2 0 01;
Lora and Barrera 1997; and the useful sum m ary in IADB 1997, 54).
POLICY ANALYSIS AND DEBATE
Shifting from the Washington
to the Beijing Consenus?
Question
Should the "Washington Consensus" be replaced by the "Beijing Consensus" as a
development model?
Overview
The 1980s were turbulent for the developing world. The decade began with sovereign
debt crises in several Latin American countries, and ended with the collapse of the
Berlin Wall and political and market reforms in Eastern Europe. Responding to
these events, economist John Williamson identified the "Washington Consensus" on
the policies that developing countries must implement to ensure a return to growth.
Williamson called this package the Washington Consensus because the World Bank,
IMF, and U.S. Treasury Department— all based in Washington D.C.— concurred with
these policy recommendations. Key to the Consensus was eliminating government
involvement in the economy: "stabilize, privatize, and liberalize."
151
Structural Adjustment and the Politics of Reform
The recent success of China and other East Asian countries as well as what some
characterize as disappointing achievements from the Washington Consensus, have
led some to suggest that a so-called "Beijing Consensus" is replacing or should
replace the Washington Consensus. If the "Washington Consensus" espoused
.
decentralized market fundamentalism, then the "Beijing Consensus" advocates a
return to a state-led development strategy. This new development path appeals to
many governments for two reasons: First, it promises rapid results without a loss of
sovereignty to Western governments that many developing country governments saw
as a major part of the Washington Consensus. Second, it increases the government's
power within the country by creating a justification for state intervention and
allocation. Advocates for the Beijing Consensus emphasize its potential for
delivering rapid development. Critics,ask why governments would be expected to
have better success with a state-led strategy now than they experienced under ISI.
Policy Options
,
;
1
O
• Washington-based institutions should continue to promote neoliberal politics. I f ,,
governments do not comply, Washington-Based institutlonsshould withhold aid * .
and consider trade sanctions.
,
.
V
• Governments should be allowed to pursue,development as they see fit; and • t
development aid and trade relations should not tiie contingent u^n'the adbp^^,. ••
of any particular policy orientation.
,
.
'" 1 ’/ f
Policy Analysis
• What differences do you see between the Washington Consensus andtBe.feeijing
Consensus? What about between the Beijing Consensusand the ISI strategy?
What interest, if any, does the United States have in promoting nebliberal
reforms like .those of the VWzShingtori Consensus"? Why Slight ihetiiftted
States oppose diffusion of a s ta te ^ stra^^?*/
Why might developing countries'resist heoiiberal development programs and
favor a more state-centric model?
Take A Ppsition
• Should the United States pressure developing countries to pursue jneoliberal ,
policies? Should developing countries resist? Justify your answer. '
• What criticisms of your position should you anticipate? How would you defend
your recommendations against these criticisms?.
‘
Resources
Online: Do online searches for "Washington Consensus" and "Beijing Consensus.*’You
might begin with a speech given by John Williamson titled "Did the Washington
Consensus Fail?" (located at http://www.iie.com/publications/papers/paper. ~
cfm? Research ID=488). Kenneth Rogoff, former head of the IM F, wrote an.ppeh
letter to Joseph Stiglitz in response to criticisms of IMF neolibera! policies
iContinued)
152
CHAPTER 7
Trade and Development II: Economic Reform
(located at http://www.imf.org/external/np/vc/2002/070202.HTM).One
influential criticism of the "Washington Consensuses
DaniRodpkyTIGoOdbye
Washington Consensus, Hello Washington Confusion?" (located athttp^/www
.hks.harvard.edu/fs/drodrik/Research%20papers/Lessons%20of%20the.%20,
1990s%2 Oreview%20_J E L_.pdf).
- -,
,
In Print: There are many lengthy criticisms o f,the "Washington Consensus", the best-
known of which may be Joseph StigiitZ, Globalizationand Its Discontents. (f\lew York,
NY: W.W. Norton & Co., 2002), which prompted (logoff's reply (linked above).
On balance, then, evidence suggests that the short-run adjustm ent costs o f
structural adjustment have been followed by stronger grow th than w ould have
occurred in the absence o f reform. This is not to suggest that the resumption of
growth has eliminated poverty in Latin America or sub-Saharan Africa. It hasn’t.
In fact, during much of the last 20 years, poverty rates have remained stubbornly
high and national income has rem ained very unevenly distributed. Even the
staunchest supporters of neoliberalism don’t claim that this approach guarantees
that poverty will be eliminated. Instead, they argue that neoliberalism offers the
surest path to that goal. As David Dollar and Aart Kraay, two researchers at the
W orld Bank, argue, growth through trade is good for the poor (see D ollar and
Kraay 2004, 2002). Over time, the short-run pains brought about by structural
adjustm ent should be rew arded with falling poverty and a narrow ing o f the
income gap between the advanced industrialized countries and the developing
world. It remains to be seen whether this optimistic perspective will be realized.
A CLOSER LOOK
Economic Reform in China
China's emergence as a global economic power also has been driven by dramatic
market reforms. China has followed a distinct path to the global market,
however, because it embarked on the journey as a centrally planned economy: All
economic activity was conducted by state-owned enterprises in line with targets
established by the Communist Party's central plan. China's move to a market
economy has followed a strategy of "gradualism" in which it sought to "grow out
of the planned economy" (Naughton 1995). Rather than quickly replacing the
centrally planned economy with a market economy. China maintained the planned
economy while simultaneously encouraging market-based activities. As China's
market economy grew, the relative importance of the planned economy shrank.
During the last 25 years, therefore, a market economy gradually emerged in
place of the previous state-centered economy.
China based reform on three pillars. The first pillar, implemented in the late
1970s, brought market incentives to agricultural production. This Household
Responsibility System encouraged farmers to lease land from their agricultural
153
Structural Adjustment and the Politics of Reform
commune. The government required farmers that took advantage of this
opportunity to sell some of their crop to the state at state-set prices. They could
sell the remainder at market prices and retain the resulting profits. The Chinese
government also changed state-set prices to more accurately reflect the supply of
and demand for agricultural commodities. In doing so they encouraged farmers to
respond to market prices rather than state production targets. By most accounts,
the reform was a dramatic success, raising agricultural productivity and farm
incomes sharply during the 1980s (Pyle 1997, 10). Agricultural reform also,
released labor from the Chinese countryside. Consequently, China has experienced
substantial rural-to-urban migration of about 10 million people each year.
,
The second reform pillar, introduced in 1984, brought market incentives to
manufacturing. This Enterprise Responsibility System encouraged enterprises
to manage themselves like profit-oriented firms. Enterprises were increasingly
required to acquire their inputs from and to sell their output in markets at marketdetermined prices rather than through state agencies at state-set prices. The
government reduced production subsidies and required enterprises to turn to banks
for working capital. This withdrawal of state financial support forced enterprises
to care about profitability. Over time, private contracts based on market prices
replaced state-determined targets as the basis for production (Jefferson and Rawski
2001, 247). By 1996, about 9.4 million non-state enterprises were operating in the
Chinese economy, accounting for about 75 percent of total industrial output (Shen
2000, 148). Here we clearly see China growing out of the planned economy— each.
year a larger share of total output is produced by non-state enterprises and a
smaller share by the state-owned sector.
The third pillar of reform, the open door policy, opened China to the global
economy by liberalizing foreign direct investment and trade. The government . .....
attracted foreign investment by creating Special Economic Zones along China's
.
southern coast. Special Economic Zones (SEZs) allowed more market-basedactivity
than was permitted in the rest of the economy. Tariffs were reduced, labor market . restrictions were relaxed, private ownership was allowed, and taxes were reduced in
the SEZs. The SEZs thus provided useful "reform la^ratories^'Whjch.joH|cial&^>;..
could experiment before implementing reforms throughout the country (§hen 2000;Grub and Lin 1991).The decision to locate the SEZs along the southern coast w v.-,,
reflected the desire to attract investment by Chinese nationals living abroad.The . ;
SEZs in Guangdong province bordered Hong Kong, for example, whereas the S E Z
.
established in Fujian Province faced Taiwan. The policy was extended to the entire ;
coastal region and selectively extended into the interior in 1988. The government
also liberalized trade. It expanded the number of companies allowed to conduct
-
foreign trade from 12 to more than 35,000 (Lardy 2002, 41). The government also,.
reduced trade barriers, first shifting from a quota-based to a tariff-based system and
then reducing tariffs sharply to the current average rate of 15 percent. In December. ,
2002, China joined the WTO after almost 15 years of negotiations.
„
These reforms have transformed China from a sleeping dragon into a powerful
,
force in the global economy. China has grown more rapidly than almost all other .
(Continued)
154
CHAPTER 7
Trade and Development II: Economic Reform
economies since the early 1980s, with the best estimates suggesting annual growth .
rates of 6 to 10 percent since the early 1980s (Lardy 1992,12). Stich rapid growth
has raised per capita incomes, which doubled between 1979 and 1990;and then
doubled again during the 1990s. Rising incomes haveln turn reduced poverty. >
The World Bank estimates that the ."proportion of populationTiving in poverty in
China fell from 53 percent to just 8 percent" between 1981 and 2001 (World Bank
2006). Thus, 400 million fewer Chinese citizens live in extreme poverty today than
25 years ago. China also has emerged as an important player in the global economy.
It is currently the leading recipient of foreign direct investment in the developing
world, and now hosts one-third of all Foreign Direction Investment based on the
developing world. China's share of world trade has grown from less than 1 percent
in the 1970s to 6 percent today (Lardy 2002, 55; WTO 2006). As a consequence,
China is now the world's third largest merchandise exporter (WTO 2006a).
China's transformation is not yet complete. The state-owned sector remains
saddled with inefficient enterprises that employ millions of people (OECD 2005). It
remains to be seen whether the Chinese government can close these enterprises, or
encourage them to operate more efficiently, without sparking massive protests that
prompt a government crackdown. In addition, rapid growth has widened the income
gap between urban and rural regions, as industrial incomes rise more rapidly than
agricultural incomes. In fact, farm incomes have even fallen a bit over the last five
years. Rising inequality has sparked rural protests, which have been met with rather
brutal government responses. Thus, although China has made substantial progress
toward a market economy, substantial challenges remain. ■
DEVELOPING COUNTRIES AND THE WORLD
TRADE ORGANIZATION
The changing orientation tow ard the role o f trade in developm ent, and the
subsequent dram atic grow th rates that have accom panied this reorientation
in some societies have brought substantial and potentially profound changes
to the international trade system. R apid economic grow th in the w orld’s m ost
populous countries is bringing about “ a fundam ental shift in pow er centers
in the global econom y” (Gu, Humphrey, and M essner 2 0 0 7 , 275). This redis­
tribution o f global econom ic pow er has in turn had a profound influence on
bargaining within the W TO.
T w o simple m easures provide clear evidence of the economic pow er shift.
At the broadest level, the share o f world output produced by Brazil, India, and
China (the BICs) has increased sharply since 1980. Indeed, in 1980 the BICs
collectively produced 8 percent o f the w orld’s total output. Since 1990, how­
ever, their share has risen to about one-fifth o f w orld output. C hina’s grow th
accounts for m ost of this increase, as China’s share o f world output rose from 2
percent to 11.3 percent in this period. Yet, India and Brazil have grown rapidly
since the m id-1990s and appear poised to assum e a larger share. Similar trends
are evident in international trade, where robust econom ic grow th in com bi­
nation with the export orientation o f contem porary developm ent strategies
Developing Countries and the World Trade Organization
155
has increased the three countries’ share of world trade. The three big emerg­
ing market countries saw their share o f world exports rise from 2.3 percent in
1980 to alm ost 12 percent in 2008. Again, China’s transform ation dominates
as its share of w orld exp orts rose from 3 percent during the early 1990s to
alm ost 9 percent by 2008. As a consequence, China has emerged as the world’s
third largest trading nation (behind the United States and Germany).
The B IC s are now using their greater econ om ic an d trad e pow er to
attempt to capture a larger share o f the gains available from international trade
cooperation. One sees this process clearly in the Doha Round. During the 1990s,
Brazil and India blocked the launch o f a new round of trade negotiations, most
visibly at the Seattle Ministerial Conference in December 1999. Their resistance
reflected dissatisfaction with the rate at which the United States and the EU
were implementing their Uruguay Round obligations and with the agenda that
the United States and the EU were proposing for the new round. They shaped
the agenda of the Doha Round, managing to keep m ost o f the Singapore Issues
out o f active negotiations and forcing a focus on issues o f critical importance
to d eveloping co u n tries— especially agricu ltu re. T hey have been able to
prevent conclusion o f the D oha Round based on a package that fails to offer
them substantial m arket access in agriculture or that requires them to offer
significant liberalizing concessions on their own. Indeed, they blocked agreement
at the Cancun M inisterial Conference in 2003 and at the Geneva M inisterial
Conference in 2008 (see N arlikar and Tussie 2 0 0 4 ; Blustein 2 009). The BICs
have thus used their grow ing economic power to craft an agenda that focuses
on issues central to their interests and to insist on a final agreement that allows
them to capture the larger share of the gains from trade cooperation.
The BICs also have taken steps to institutionalize their grow ing influence.
M ost prominently, Brazil and India took the lead in creating the G roup of 20
in response to the U.S. and EU agriculture proposals in 2003. The Group of 20
has in turn promoted the emergence o f other developing country groups within
the W TO , such as the G -33, com posed o f low-income W TO m em bers seek­
ing to protect their farm sectors from liberalization under any eventual Doha
agreement. The G roup o f 20 has helped organize the ACP countries (Africa,
Caribbean, and Pacific nations), which collectively fear the loss o f preferential
m arket access as a result o f a D oha agreement on agriculture. They have also
helped craft a 90-member group of developing countries with a particular inter­
est in W TO rules covering Special and Differential Treatment. Thus, in addition
to pursuing their own interests within the organization, the BICs have sought
to institutionalize their new position and take the lead in organizing a broader
and more effective developing country coalition within the W TO. Their greater
importance has in turn been explicitly recognized by the form ation o f the Group
of Six (United States, EU, Jap an , Brazil, India, and Australia) as the critical firstcut decision-making vehicle within the Doha Round.
The ability to translate grow ing economic power into bargaining power is
not without a few problem s, however. The BICs are not fully unified in either
bargaining strategy or interests. Brazil and India have adopted a fairly aggres­
sive bargaining strategy; they have played a critical role in shaping the agenda,
in creating the Group of 20, and have been willing to reject U.S. and EU offers.
156
CHAPTER 7
Trade and Development II: Economic Reform
China, in contrast, has been relatively quiet within the W TO (see Gu et al. 2007;
Nenci 2008). It views the G roup of 20 as a useful instrument but did not play a
leading role in its creation. It has not embraced an assertive bargaining strategy.
Indeed, China has allowed India and Brazil to represent its interests within the
Group of 6. China’s economic interests also differ from its two partners. As the
world’s third largest trading nation, it has more at stake in global m arkets than
Brazil and India. As a labor-abundant rather than land-abundant econom y, it
has som ewhat less at stake in the outcome o f agriculture negotiations. N o r do
Brazil and India alw ays see eye-to-eye. D uring the Ju ly 2 0 0 8 M inisterial, for
example, the Brazilian trade minister prodded his Indian counterpart to accept
W TO Secretary General Pascal Lam y’s proposal and w as unhappy when India
refused (Wolfe 2009). M ore broadly, Brazil and India seem to be competing for
leadership status am ong developing countries within the W TO. Consequently,
the BICs coalition is not entirely self-sustaining.
M oreover, other developing country governm ents rem ain w ary o f allow ­
ing the BICs to represent their interests in trade negotiations. Som e o f these
concerns focus on apparent procedural inequities. Ju st as Brazil and India com ­
plained about unequal treatment when they were excluded from “ green ro o m ”
negotiations, governments from non-BICs com plain about the inequities associ­
ated with the B IC s’ inclusion in the inner circle. W ariness about procedure is
reinforced by uncertainty about whether India and Brazil have the best interests
of the W T O ’s poorest members in mind. In particular, there is concern that the
determ ination o f India and Brazil to extract m axim um concessions from the
United States and the EU while offering little in return will prevent a less am bi­
tious agreement that would still offer substantial gains to low-income countries.
It is important to bear in mind, however, that talk o f a fundam ental change
in the distribution of power is som ewhat hyperbolic. The BICs are large econo­
mies and their emergence as im portant players in the w orld trade system does
mark an important change to this system. However, the BICs are also mediumincome developing societies; they are populous but still relatively poor.
CONCLUSION
Neoliberalism supplanted structuralism as the guiding philosophy o f economic
development as a result of the interplay am ong three factors in the global econ­
omy. Im port substitution generated severe econom ic im balances that created
pressure for reform o f some type. The success o f E ast Asian countries that ad ­
opted an export-oriented development strategy provided an alternative model
for development. Finally, the emergence of a severe economic crisis in the early
1980s, a crisis that resulted in part from the imbalances generated by ISI and in
part from developments in the global economy, pushed governments to launch
reform s under the supervision o f the IM F and the W orld Bank. By the mid1980s, m ost governments were implementing reform s that reduced the role of
the state and increased the role of the m arket in economic development.
The im plem entation o f these reform s has been neither quick nor p ain ­
less. The depth o f the reform s brought su b stan tial short-run co sts as aver­
age incomes fell and as this sm aller income w as redistributed am ong groups.
Suggestions for Further Reading
157
The proponents of neoliberal reform s argue that the short-run costs are worth
paying, however, for they establish the fram ew ork for strong and sustainable
grow th far into the future. Achieving that outcom e will require developing
societies to consolidate and build upon the reform s already implemented. In
addition, it will require the advanced industrialized countries to accept shortrun adjustm ent costs o f their ow n in order to m eet the legitim ate dem ands
that developing countries now m ake about m arket access.
The adoption o f neoliberal reform s in the developing w orld is also trans­
form ing the global econom y. For the first time since the early twentieth cen­
tury, the developing world has integrated itself into that economy. In doing so,
developing countries have altered the dynamics o f global economic exchange.
Stan d ard trad e theory tells us to exp ect trad e betw een cap ital-ab u n d an t
and labor-abun dan t societies. Y et, trade barriers have greatly lim ited such
trade for m o st o f the p o stw ar era. A s these barriers have fallen during the
last 20 years, trade between countries with different factor endow m ents has
becom e increasingly im p ortan t. B u sin esses are increasingly locatin g their
activities in those p a rts o f the w orld w here they can be p erfo rm ed m ost
efficiently. Labor-intensive aspects o f production are being shifted to devel­
oping societies, whereas the capital-intensive aspects o f production rem ain in
the advanced industrialized countries. The expansion o f N orth -South trade is
thus creating a new global division o f labor.
KEY TERMS
Current Account
East Asian Model of
Development
Export-Oriented Strategy
Rent Seeking
Structural Adjustment
program
SUGGESTIONS FOR FURTHER READING
x
On the East Asian Model of Development, see Robert Wade, Governing the Market: Eco­
nomic Theory and the Role of Government in East Asian Industrialization (Princeton,
NJ: Princeton University Press, 1990), Stephan Haggard, Pathways from the Periphery:
The Politics of Growth in the Newly Industrializing Countries (Ithaca, NY: Cornell
University Press, 1990), and Dani Rodrik, One Economics, Many Recipes: Global­
ization, Institutions, and Economic Growth (Princeton: Princeton University Press,
2008). The single best account of China’s trajectory is Barry Naughton, The Chinese
Economy: Transitions and Growth (Cambridge: MIT Press, 2007).
On structural adjustment, see Tony Killick, Aid and the Political Economy o f Policy
Change (London: Routledge, 1998). On the politics of reform, a useful place to
start is Stephan Haggard and Robert Kaufman, eds.,The Politics o f Economic
Adjustment: International Constraints, Distributive Conflicts, and the State
(Princeton, NJ: Princeton University Press, 1992), and Anne O. Krueger, Economic
Policy Reform (Chicago: University of Chicago Press, 2000).
For a detailed examination of agriculture, developing countries, and the WTO, see
Kimberly Ann Elliott’s Delivering on Doha: Farm Trade and the Poor (Washington,
DC: The Institute for International Economics, 2006).
CHAPTER
8
Multinational
Corporations in the
Global Economy
M
ultinational corporations occupy a prom inent and often controver­
sial role in the global econom y. When a corp oration based in one
country creates a new production facility in a foreign country or
buys an existing one, it extends m anagerial control across national borders.
This m anagerial control enables the firm to m ake decisions ab o u t how and
where to em ploy resources that have consequences for the country in which
it is based and for the country in which it invests. In m any instances, the de­
cisions that firm s m ake are based on global strategies for corporate success,
rather than on the basis o f conditions within any o f the countries in which
the firm conducts its business. A s a result, m ultinational corp oration s high­
light the tensions inherent in an economy that is increasingly organized along
global lines and political system s that continue to reflect exclusive nation al
territories.
Because m ultinational co rp oratio n s operate sim ultaneously in nation al
political system s and glo b al m arkets, they have been the subject o f co n sid ­
erable controversy am ong governm ents and am on g observers o f the inter­
national political econom y. Som e consider m ultinational corp oration s to be
productive instrum ents o f a liberal econom ic order: M ultination al co rp o ra­
tions ship capital to where it is scarce, transfer technology and m anagem ent
expertise from one country to another, and prom ote the efficient allocation
of resources in the global econom y. O thers consider m ultinational co rp o ra ­
tions to be instrum ents o f capitalist dom ination: M ultinational corporations
control critical sectors o f their h o sts’ econom ies, m ake decisions ab o u t the
use o f resources with little regard for host-country needs, and w eaken labor
and environmental standards. A bout all that these tw o divergent perspectives
agree on is that m ultinational corporations are prim ary drivers of, and benefi­
ciaries from , globalization.
This chapter and the next exam ine the econom ics and the politics o f m ul­
tinational corp oration s (M N C s). T h is chapter focu ses on a few o f the core
econom ic issues concerning these geographically far-reaching organizations.
158
Multinational Corporations in the Global Economy
159
The first section provides a broad overview o f M N C s in the global economy.
We define w hat M N C s are, briefly exam ine their origins and developm ent,
and then exam ine their rapid growth over the last 30 years. The second sec­
tion exam ines stan dard econom ic theory developed to explain the existence
o f M N C s. This theory will both deepen our understanding o f the differences
between M N C s and other firms and help us understand when we are likely to
see M N C s operating and when we are likely to see national firm s. The final
section exam ines the im pact of M N C s on the countries that h ost their fo r­
eign investments. We look first at the potential benefits that M N C s can bring
to host countries and then exam ine how M N C activities som etim es limit the
extent to which host countries are able to realize those benefits.
MULTINATIONAL CORPORATIONS
IN THE GLOBAL ECONOMY
For many people, a multinational corporation and a firm that engages heavily
in international activities are one and the sam e thing. Yet, an M N C is more
than just a firm that engages in international activities, and many firms that en­
gage heavily in international activities are not M N C s. The standard definition
of an M N C is a firm that “ controls and m anages production establishm ents—
plants— in at least tw o countries” (C aves 1 9 96, 1). In other w ords, M N C s
place multiple production facilities in multiple countries under the control o f a
single corporate structure.
The preceding definition does not capture the full range o f M N C activities,
however. M N C s are engaged simultaneously in economic production, interna­
tional trade, and cross-border investment. C onsider, for exam ple, the U.S.based com pany G eneral Electric (G E), which is regularly ranked am ong the
w orld’s largest M N C s. G E controls some 2 5 0 plants located in 26 countries
in N orth and South Am erica, Europe, and Asia. Although production in these
facilities is obviously im portant, the ability to engage in international trade
is equally critical to G E ’s success. M any o f the g o o d s G E produces cross n a­
tional borders, either as finished consumer goods or as com ponents for other
finished products. W ashers, dryers, and m icrow ave ovens that G E produces
in A sia and Latin A m erica, for exam ple, are sold in the United States and
E urope. T o create this global production and trade netw ork, G E has had to
m ake many cross-border investm ents. Each time that G E establishes a new
pro d u ctio n facility or u p grad es an existin g facility in a foreign country,
it invests in that country. M N C s are thus also an im p ortan t source o f fo r­
eign capital for the countries that host their affiliates. T hus, even though GE
certainly controls and m anages factories in at least tw o countries, this does
not describe the full range of G E ’s international activities. Like all M N C s, GE
engages sim ultaneously in production, trade, and cross-border investment.
M N C s are not recent inventions. They first emerged as significant and endur­
ing components of the international economy during the late nineteenth century.
This first wave of multinational businesses w as dominated by Great Britain, the
160
CHAPTER 8
Multinational Corporations in the Global Economy
world’s largest capital-exporting country in that century. British firms invested
in natural resources and in manufacturing within the British Empire, the United
States, Latin America, and Asia. In 1914, British investors controlled almost half of
the world’s total stock of foreign direct investment, and multinational manufactur­
ing was taking place in a large number of industries, including chemicals, pharma­
ceuticals, the electrical industry, machinery, automobiles, tires, and processed food
(Jones 1996,29-30). American firms began investing abroad in the late nineteenth
century. Singer Sewing Machines became the first American firm to create a per­
manent manufacturing facility abroad when it built a plant in Glasgow, Scotland,
in 1867 (Wilkins 1970, 41-42). By the 1920s, the United States w as overtaking
Britain as the world’s largest source of foreign direct investment (see Jones 1996).
Although M N C s are not a recent innovation, w hat is novel is the rate at
which firm s have been transform ing them selves into M N C s. We can see the
unprecedented grow th o f M N C s in tw o different sets o f statistics. The first
tracks the number o f M N C s operating in the global econom y. (See Figure 8.1.)
In 1969, just at the tail end o f the period o f Am erican dom inance, there were
only ab o u t 7 ,3 0 0 M N C paren t firm s o peratin g in the glo b al econom y. By
1988, 18,500 firms had entered the ranks o f M N C s, an impressive grow th in
20 years. During the next 20 years, however, the number o f M N C s operating
in the global economy more than quadrupled, rising to more than 82,000 parent
firm s by 2 0 0 8 . T ogether, these paren ts con trol a to tal o f 8 1 0 ,0 0 0 foreign
9 0 .0 0 0 r
8 0 .0 0 0 7 0 .0 0 0 w
6 0 ,0 0 0 -
E
1
o
5 0 ,0 0 0 -
t*.
|
4 0 ,0 0 0 -
2
3 0 ,0 0 0 -
20.000
-
10,000
-
0L
1914
1969
1988
1992
1997
Year
FIGURE 8.1
The Growth of Multinational Corporation Parent Firms
Sources:
Gable and Bruner 2003, 3; UNCTAD 2009, Annex Table A. 1.8.
2000
2004
2007
' ^
V
Multinational Corporations in the Global Economy
161
TABLE 8.1
Foreign Direct Investment Outflows, 1986-2008 ($U.S. Billions)
World
European Union
North America
Japan
Southeast Asia
Eastern Europe
Latin America
Africa
1986-1991
1998-2002
80.5
100.4
856.9
566.5
176.4
29.8
46.3
2.4
8.4
31.3
33.1
8.3
n.a.*
n.a.
n.a.
2003-2006 2007-2008
2,002.0
1 , 0 1 5 .0 :
413.7
10.8
872.6
457.0
180.4
38.9 • ’
12.6
14.4 v,r
• 33,6 '5:
180.6
.$7.5''*
0.8 r •
t
f
*
*n.a.( not available.
,
> - ! / >
Sour ce: United Nations Conference on Trade and Development, 200$.
** t
«^
-rtf
-
;
‘
’
affiliates. Thus, in just over 4 0 years, the number o f firms engaged in interna­
tional production has increased about elevenfold.
The second set o f statistics track s the grow th o f foreign direct invest­
ment over the sam e period. Foreign direct investm ent (FDI) occurs when a
firm based in one country builds a new plant or a factory , or purchases an
existing one, in a second country. A national corp oration thus becom es an
M N C by m aking a foreign direct investment. As T able 8.1 illustrates, the to ­
tal volum e o f foreign direct investm ent has grow n d ram atically during the
last 25 years. D uring the late 1 980s, cross-border FDI flow s equaled about
$180 billion per year. The figure alm ost doubled by the m id-1990s and then
continued to increase throughout the second h alf o f the 1 9 90s. Follow ing a
brief dip in the early 2 0 0 0 s, FD I grow th rebounded in the second half o f the
decade, and in 2 0 0 8 equaled a b o u t $1 .8 5 trillion, or ten tim es as m uch as
20 years earlier. As a consequence, the w orld’s stock o f FD I, the total am ount
o f foreign investment in operation, has grown from $ 6 9 2 .7 billion in 1980 to
$16.2 trillion in 20 0 8 , an increase of over 2,3 0 0 percent in less than 30 years
(U N CTA D 2009, 251). The last 30 years have thus brought a dram atic accel­
eration o f the number o f firms that are internationalizing their activities.
As the num ber o f M N C s h as increased, the role th at they play in the
global economy has likewise gained in importance. The United N ation s (UN)
estim ates that M N C s currently account for about a third o f global exp orts
and employ some 77 million people worldwide (U N C TA D 2 0 0 9 , xxi). M uch
of this activity is concentrated in a relatively sm all num ber o f firms. The one
hundred largest M N C s account for more than 9 percent o f the total foreign
assets controlled by all M N C s, for 16 percent o f all M N C sales, and for 11
percent of all M N C em ploym ent (U N C TA D 2 0 0 9 , xxi). Together, these one
hundred firms account for ab o u t 4 percent o f w orld gross dom estic product
(GDP). M uch o f this is intrafirm trade— that is, trade that takes place between
an M N C parent and its foreign affiliates. M N C s thus play an im portant role
162
CHAPTER 8
Multinational Corporations in the Global Economy
T A B L E 8.2
Parent Corporations and Affiliates by Region, 2008
'
Parent Corporations
Foreign Affiliates
Based in the
Based in the
Year
Economy
Economy
Developed Economies
2008
58,783
366,881
European Union
United States
Other Developed
Economies
Japan
2008
2002
43,492
2,418
335,577
5,664
2008
7,161
9,721
2006
297
489
Developing Economies
2008
2008
2008
21,425
746
3,533
425,258
6,084
39,737
2008
2008
17,124
1,845
378,996
15,224
Africa
Latin America and the
Caribbean
Asia
Southeast Europe
and the CIS
S o u rc e : United Nations C o n f e r e n c e o n T r a d e a n d Development, "World Investment Report 2009,
Annex Table A. 1.8," h t t p r f w w w .u n c la d .o rg fT e m p la te s /W e b F ly e r.a s p ? in tIte m ID = 5 0 3 7 & la r > g = l
in the contem porary global econom y, a role that h as grow n at a rap id pace
during the last 30 years.
A lthough M N C s have a g lo b al reach , their activities are overw helm ­
ingly concentrated in the advanced industrialized countries. We can see just
how co n cen trated M N C o p e ra tio n s are by lo o k in g at som e sta tistic s on
the nationality o f paren t firm s and on the global distribution o f FD I flow s.
Ninety-two of the one hundred largest M N C s are headquartered in the United
States, W estern Europe, or Ja p a n , and ab o u t 73 percent o f all M N C parent
corporations are based in advanced industrial countries. (See T able 8.2.) The
advanced industrialized countries historically have been the largest suppliers
o f FDI as well. During m ost of the 1980s, the United States, W estern Europe,
and Ja p a n together supplied about 90 percent o f FDI. (See T able 8.1.) Their
share fell to ab o u t 82 percent during the early 1990s with the emergence of
new E ast A sian M N C s as im portan t foreign investors. A lthough this share
rose in the years follow ing the A sian financial crisis, one sees the advanced
industrialized countries once again supplying 81 percent o f w orld FDI in 2008
(U N C TA D 2009).
The advanced industrialized countries also have been the largest recipients
of the w orld’s FDI. Until the late 1980s, Western Europe and the United States
regularly attracted a little m ore than three-quarters o f the w orld ’s total FDI
inflows each year. (See T able 8.3.) T his share fell during the 1 9 9 0 s, and by
1997 the share o f FDI flowing into Western Europe and the United States had
Multinational Corporations in the Global Economy
163
TABLE 8.3
Foreign Direct Investment Inflows, 1986-2008 ($U.S. Billions)
1986-1991
World
Western Europe
North America
Japan
Southeast Asia
Eastern Europe*
Latin America
Africa
180.5
100.4
31.3
3.1
8.3
n.a7
n.a.
n.a.
1998-2002
2003-2006
2007-2008
842.4
452.5
231.4
889.5
369.6
142.6
2.6
38.1
15.8
74.6
25.5
1.8
708.9
370.2
7.9
106.5
25.4
68.9
12.2
23.5
64.7
11.9
135.9
78.4
* After 1999 Eastern Europe figures are included in European Union.
'n.a., not available.
S o u rc e : United Nations Conference on Trade and Development, "World Investment Report: In­
ward FDI Flows, by Host Region and Economy, 1970-2004," w w w .u n c ta d .o rg /s e c tio n s /d ite jS irM o c s /
w ir 2 0 0 9 J n f lo w s _ e n .x ls .
dropped to ab ou t half the total. As with FD I outflow s, however, this trend
reversed itself between 2003 and 20 0 6 : Europe and N orth America attracted
a b o u t 60 percen t o f all FD I. By 2 0 0 8 , th at num ber w as a p p ro x im a te ly
57 percent. A lthough the future evolution o f the precise distribution o f new
investments between the advanced industrialized and developing w orlds bears
w atching, this should not disguise the fact that whether we lo o k at parent
firms or FDI flow s, we see quite clearly that the m ajority o f M N C activities is
concentrated in the advanced industrialized w orld. T hat is, m ost such activi­
ties involve American and Japan ese firm s investing in Europe, European and
Jap an ese firm s investing in the United States, and Am erican and European
firms investing in Jap an .
Although M N C activities are concentrated in the advanced industrialized
w orld, M N C activities in the developing w orld have increased substantially
during the last 30 years. They have done so in tw o w ays. H istorically, de­
veloping countries have hosted M N C investm ents, but the am ou n t o f FDI
they have attracted has been relatively sm all. Since the late 1980s, however,
M N C s have been investing more heavily in developing countries. As a group,
the developing w orld saw its share o f FDI inflow s rise from one-quarter to
alm ost one-half o f total w orld investment between 1980 and 1997, totaling
ab o u t $ 1 9 0 billion. (SeeT able 8.3.) Over the next decade, the absolu te in­
crease w as even larger. By 2 0 0 8 , FDI inflows to the developing w orld totaled
over $620 billion, although their share of total FDI inflows fell to just above
one-third o f the total. These greater investments were not evenly distributed
across the developing w orld, how ever, but have been heavily concentrated
in a sm all num ber o f A sian and Latin Am erican countries. By 2 0 0 8 A sia re­
ceived over 60 percent o f all FD I inflow s to the developing w orld; China
alone attracted nearly one-third o f that. Latin A m erica’s share o f w orld FDI
164
CHAPTER 8
Multinational Corporations in the Global Economy
inflows increased by ab ou t 50 percent over the sam e period, increasing from
6 percent o f to tal w orld FD I in the late 1 9 8 0 s to 9 percent in 2 0 0 8 . Y et,
only four countries— Brazil, Argentina, Chile, and M exico— captured 64 per­
cent o f these inflow s. T h u s, M N C investm ent in the developing w orld has
increased during the last 30 y ears, but the m ajority o f this investm ent has
been concentrated in a very sm all num ber o f developing countries. M uch o f
the developing w orld, and particularly sub-Saharan A frica, saw little increase
in FDI during the period.
The last 30 years also have seen som e developing countries em erge as
home bases for M N C parent firm s. A ccording to the U N , over one-quarter
o f the w orld ’s M N C paren t firm s in 2 0 0 8 were based in developing co u n ­
tries. A gain , how ever, this d evelopm en t is lim ited to a sm all num ber o f
cou n tries, such as H o n g K o n g , C h in a, South K o re a , Sin g ap o re , T aiw a n ,
V enezuela, M e x ico , and B razil. Sev en ty-six o f the to p 100 M N C s from
developing coun tries cam e from So u th east or E a st A sia. M o reo v er, these
d evelopin g-w orld M N C s are co n sid e rab ly sm aller th an M N C s b a se d in
the advanced industrialized w orld. O nly seven developing-country M N C s
ranked am ong the w orld’s one hundred largest M N C s in 2 0 0 7 . A s a grou p,
the 100 largest M N C s from developing countries control a com bined $ 7 6 7
billion o f foreign assets, 2 0 percent o f the foreign asse ts con trolled by the
100 largest M N C s based in the advanced industrialized countries (U N C TA D
2 0 0 9 , 23). Even though M N C s based in developing countries are still rela­
tively sm all, the emergence o f these M N C s is nonetheless a significant change
in the glo b al econom y. It indicates th at, for the first tim e in history, som e
developing countries really are shifting from a position in which they are only
the host to foreign M N C s to a position in which they are both host o f foreign
firms and home to dom estic M N C s.
The rap id grow th o f M N C s durin g the last 30 years h as pu sh ed these
firm s into the center o f the debate ab o u t glo balizatio n . Indeed, practically
every aspect o f globalization has been linked to the activities o f M N C s. R oss
Perot, for exam ple, claim ed during his unsuccessful bid for the presidency
in 1992 that the N o rth A m erican Free T ra d e A greem ent (N A FT A ) w ould
produce a “ giant sucking so u n d ” a s A m erican M N C s shifted jo b s from the
United States to their affiliates located in M exico. Other critics o f glo baliza­
tion claim that M N C affiliates based in developing countries are sw eatshops
engaged in the system atic exp lo itatio n o f w orkers in those coun tries. Still
others argue that the ability o f M N C s to m ove pro d u ctio n w herever they
w ant is gradually eroding a broad range o f governm ent regulations designed
to protect w orkers, consum ers, and the environment. We will exam ine these
argum ents in greater detail in C hapter 16. For our pu rposes here, it is suffi­
cient to note that criticism o f M N C activities has emerged from the grow ing
sense that the last 30 years have seen a fundam ental change in the nature
o f corporate behavior within the global econom y. Falling trade barriers and
improvements in communications technology have made it substantially easier
for firm s to internationalize their activities. Firm s have responded to these
changes by internationalizing at historically unprecedented rates.
Economic Explanations for Multinational Corporations
165
ECONOMIC EXPLANATIONS FOR
MULTINATIONAL CORPORATIONS
One might w onder why all o f the econom ic transactions that occur between
M N C parent firms and their foreign affiliates are not simply handled through
the m arket. Indeed, the prevalence o f M N C s in the contem porary interna­
tional economy is puzzling to neoclassical econom ists. When the GAP or the
Lim ited acquire clothes from producers in Bangladesh, they handle m ost o f
these transactions through the market. They sign contracts with locally owned
Bangladeshi firms that produce clothes and then sell them to the retailer. The
GAP and the Lim ited do not own the firm s th at produce their clothes. In
other instances, however, alm ost identical transaction s are taken out o f the
m arket. When V olksw agen decided to assem ble som e o f its cars in M exico,
it could have signed co n tracts w ith lo cally ow ned M ex ican firm s, w hich
then could have produced com ponents that met V olksw agen’s specifications;
assem bled them into Jetta s, Beetles, and G olfs; and sold the finished cars to
V olksw agen. V o lk sw agen , how ever, d id n ’t o p t fo r this m arket-based a p ­
proach, but instead built an assem bly plant in M exico. Volksw agen thus took
the econom ic tran saction s that w ould otherw ise have taken place between
suppliers o f com ponents, assem blers, and corporate headquarters out o f the
m arket and placed them under the sole control o f V olksw agen headquarters.
The rapid grow th o f M N C s implies that an increasing num ber o f firm s have
opted to take their international transactions out o f the m arket and to inter­
nalize them within a single corporate structure. Why have they done so?
In finding an answer to this puzzle, we deepen our understanding o f how
M N C s are som ething more distinctive than simply “ large firm s.” M any M N C s
are large, but w hat truly distinguishes them from other firm s is the fact that
they organize and m anage their international activities very differently than
other firm s d o. A firm ’s d ecision ab o u t w hether to conduct in tern ation al
transactions through the m arket or instead to internalize these transactions in­
side a single corporation reflects som e specific characteristics o f the economic
environment in which it operates. In conceptualizing how this environm ent
shapes the firm ’s decision, econom ists have placed the greatest em phasis on
the interaction between locational advantages and m arket imperfections.
Locational Advantages
As a first step, we need to understand the facto rs that encourage a firm to
internationalize its activities— that is, what factors determine when a firm will
stop sourcing all o f its inputs and selling all o f its output at home and begin
acquiring its inputs or selling a portion o f its output in foreign m arkets? At
a very broad level, it is obvious that a firm will internationalize its activities
when it believes that it can profit by doing so. Location al advantages derive
from specific country characteristics that provide such opportunities. H istori­
cally, locational advantages have been based on one o f three specific country
characteristics: a large reserve o f natural resources, a large local m arket, and
166
CHAPTER 8
Multinational Corporations in the Global Economy
opportunities to enhance the efficiency o f the firm ’s operations. A firm based
in one country will internationalize its activities in an attem pt to profit from
one o f these characteristics in a foreign country.
L o catio n al ad v an tages in n atu ral-reso u rce investm ents arise fro m the
presence of large deposits o f a particular natural resource in a foreign country.
The desire to profit from the extraction o f these natural resources w as per­
haps the earliest m otivation for international activities. The Am erican copper
firm s A naconda and Kennecott, for exam ple, m ade large direct investm ents
in mining operations in Chile in order to secure supplies for production in the
United States. American and European oil com panies have invested heavily in
the M iddle E ast because the countries o f that region hold so large a p ro p o r­
tion o f the w o rld ’s petroleum reserves. The desire to gain access to natural
resources remains im portant today. Indeed, as T able 8.4 illustrates, petroleum
and mining together account for about 10 percent o f the one hundred largest
M N C s currently in operation.
Locational advantages for m arket-oriented investm ents arise from large
consum er m arkets that are expected to grow rapidly over tim e. Firm s lo o k ­
ing to sell their products in foreign m arkets clearly prefer countries with large
and grow ing dem and to those with sm all and stagnan t dem and. In addition,
the degree o f industry com petition within the host country is im portant. The
less indigenous com petition there is in a particular foreign m arket, the easier it
will be for the M N C to sell its products in that m arket. Finally, the existence
TABLE 8.4
Industry Composition of the Top One Hundred MNCs (percent)
Electronics/electrical equipment/computers
Motor vehicle and parts
Petroleum (exploration, refining, distribution) and mining
Food, beverages, tobacco
Chemicals
Pharmaceuticals
Diversified
Telecommunications
Trading
Retailing
Utilities
Metals
Media
Construction
Machinery/engineering
Other
S o u rc e :
UNCTAD 2000, 78; UNCTAD 2009,
Annex
Table A.1.9
1990
1998
2007
14
17
13
13
9
12
6
2
2
7
0
0
6
2
4
3
7
14
9
13
10
9
3
9
5
8
4
3
8
3
0
0
0
16
11
10
8
8
6
6
4
3
3
2
2
1
5
Economic Explanations for Multinational Corporations
167
of tariff and nontariff barriers to im ports is another im portant consideration
for this type o f investment. By investing inside the country, firm s essentially
jump over such barriers to produce and sell in the lo cal m arket. Countries
that have large and fast-grow ing m arkets, with a relatively sm all num ber of
indigenous firm s in the particular industry, and that are sheltered from in­
ternational com petition represent attractive opportunities for market-oriented
M N C investment.
M uch o f the cross-border investm ent in auto production within the a d ­
vanced industrialized w orld fits into this category. D uring the 1960s, many
American autom otive M N C s made direct investments in the EU to gain access
to the emerging com m on market. During the 1980s and early 1990s, Japanese
and German autom otive M N C s, such as T oyota, N issan , H onda, BM W , and
M ercedes, built production facilities in the United States in response to the
emergence o f voluntary exp ort restraints (V ER s) that limited auto im ports.
As Table 8.4 indicates, like petroleum and mining, the auto industry is heavily
represented am on g the largest M N C s, accou n tin g fo r another 13 percent
of the one hundred largest. O f course, the desire to gain access to foreign
markets has not been limited to the auto industry, but has been an im portant
motivation for much FDI in m anufacturing as well.
Finally, lo catio n al ad v an tages in efficiency-oriented investm ents arise
from the availability at a lower cost o f the factors of production that are used
intensively in the production o f a specific product. In these efficiency-oriented
investments, parent firms allocate different stages of the production process to
different parts o f the w orld, matching the factor intensity o f a production stage
to the factor abundance of particular countries. In com puters, electronics, and
electrical equipm ent, for exam ple, the hum an and physical capital-intensive
stages o f production, such as design and chip fabrication, are perform ed in the
capital-abundant advanced industrialized countries, w hereas the m ore laborintensive assem bly stages o f production are perform ed in labor-abundant de­
veloping countries. Locational advantages thus arise from factor endowments.
When the contem plated investment is in low -skilled, labor-intensive produc­
tion, labor-abu n dan t countries have obvious ad v an tages over labor-scarce
countries. When the contem plated investment draw s heavily upon advanced
technology, the availability o f a pool o f highly trained scientists is important.
Am erican firm s in the com puter industry, for exam ple, have opted to base
many o f their overseas activities in E ast A sian countries, where the average
skill level is very high, rather than in Latin Am erica, where, on average, skill
levels are lower.
L ocation al advantages thus provide the econom ic rationale for a firm ’s
decision to internationalize its activities. These advantages can arise from a
country’s underlying com parative advantage, as in mineral deposits or abun­
dant labor. They can also be a product o f governm ent policies, as in the ex­
istence o f high tariffs or the creation o f a reliable econom ic infrastructure.
W hatever the underlying source, lo cation al advan tages create a com pelling
m otivation for a firm based in one country to engage in econom ic tran sac­
tions with a foreign country. Locational advantages thus help us understand
168
CHAPTER 8
Multinational Corporations in the Global Economy
why a firm elects to engage in econom ic transactions with one country rather
than another, for som e countries offer potential benefits from cross-border
exchange, whereas others do not.
M arket Imperfections
Locational advantages help us understand why som e firms opt to internation­
alize their activities, but they do not help us understand why firms som etim es
choose to take the resulting tran saction s out o f the m arket and place them
within a single corp orate structure. Why d idn ’t A m erican firm s sim ply buy
copper from Chilean firms, rather than establish their own mining operations
in Chile? Why didn’t A m erican com puter firm s sim ply buy sem iconductors
and other com ponents from indigenous E ast A sian firm s, rather than create
their own chip fabrication factories in E ast A sia? Why didn’t Am erican auto
firms simply export to the EU and Brazil, rather than build assem bly plants in
those countries?
T o understand why firm s som etim es take their tran saction s out o f the
m arket and place them under the control o f a single corp orate structure, we
need to exam ine the im pact o f m arket im perfections. A m arket im perfection
arises when the price mechanism fails to prom ote a welfare-im proving tran s­
action. In the global economy, this means that, under certain conditions, firms
will be unable to profit from an existing locational advantage unless they in­
ternalize the international tran saction . T w o different m arket im perfections
have been used to understand tw o different types o f internalization: horizon­
tal integration and vertical integration.
H orizontal integration occurs when a firm creates multiple production fa ­
cilities, each o f which produces the sam e good or good s. In the international
econom y, horizontally integrated M N C s produce the sam e p ro du ct in m ul­
tiple nation al m arkets. A uto producers are a go o d exam ple. F o rd , G eneral
M oto rs, V olksw agen, and the m ajor Jap an e se auto producers each produce
essentially the sam e line o f cars in factories located in the United States, W est­
ern Europe, and Jap an . Firm s integrate horizontally when a cost advantage is
gained by placing a num ber o f plants under com m on adm inistrative control
(Caves 1996, 2). Such cost advantages m ost often arise when intangible assets
are the m ost im portant source o f a firm ’s revenue.
An intangible asset is som ething w hose value is derived from know ledge
or from “ a set o f skills or repertory routin es p o ssessed by the firm ’s team
o f hum an (and other) in p u ts” (C aves 1 9 9 6 , 3). An intangible asset can be
based on a patented process or design, or it can arise from “ know-how shared
am ong em ployees o f the firm ” (C aves 19 9 6 , 3). Intangible assets often give
rise to horizontally integrated firm s because those assets are difficult to sell
or license to other firms at a price that accurately reflects their true value. In
other w ords, m arkets will fail to prom ote exchanges between a willing seller
o f an intangible asset and a willing buyer. The m arket failure arises because
ow ners o f know ledge-based assets confront w hat has been called the “ fun­
dam ental p arad o x o f inform ation” : “ [The] value [of the inform ation] for the
Economic Explanations for Multinational Corporations
169
purchaser is not known until he has the inform ation, but then he has in effect
acquired it without c o st” (Teece 1993, 172). In other w ords, in order to con­
vey the full value o f an intangible asset, the owner m ust reveal so much o f the
information upon which the asset’s value is based that the potential purchaser
no longer needs to pay to acquire the asset. If the owner is unwilling to reveal
that inform ation, potential buyers will be unsure o f the asset’s true value and
will therefore be reluctant to pay for the asset.
Suppose, for exam ple, that I have developed a production process that
reduces by one-half the cost o f m anufacturing cars. This innovation is purely
a m atter o f how the production process is organized and m anaged, and has
nothing to do with the m achines and technology actually used to produce
cars. I try to sell this knowledge to Ford M o to r C om pany, but, in our nego­
tiations, F o rd ’s board o f directors is skeptical o f my claim that I can cut the
firm’s costs by 50 percent. The board members insist that I disclose fully how
I will accom plish this before they will even consider purchasing my know l­
edge, and they w ant specifics. Once I disclose all o f the details, however, they
will know exactly w hat changes they need to m ake in order to realize the cost
reductions. As soon as they have this knowledge, they have no reason to pay
me to acquire it. Like all other ow ners o f intangible assets, I will receive less
than my asset’s true worth when I sell it to another firm.
Such m arket failures create incentives for horizontal integration. Suppose
an individual ow ns an intangible asset that can generate m ore revenue than
is currently being earned, because dem and for the go od s produced with the
use o f this asset will be greater than can be met from the existing production
facility. H ow can the owner earn the add ition al revenue that the asset will
generate? The only way he or she can do so is to create additional production
sites— that is, to integrate horizontally and allow each o f these facilities to
make use o f the intangible asset. Because the sam e firm ow ns all o f the p ro ­
duction sites, it can realize the full value o f its intangible asset w ithout having
to try to sell it in an open market. H orizontal integration, therefore, internal­
izes economic transactions for intangible assets.
V ertical in tegration refers to instances in which firm s internalize their
transactions for intermediate goods. An intermediate good is an output o f one
production process that serves as an input into another production process.
Standard O il, which dom inated the A m erican oil industry in the late nine­
teenth century, is a classic exam ple o f a vertically integrated firm . Standard
Oil owned oil w ells, the netw ork through which crude oil w as transported
from the well to the refinery, the refineries, and the retail outlets at which the
final product w as sold. T hus, each stage o f the production process w as con­
tained within a single corporate structure. Why w ould a single firm incorpo­
rate the various stages o f the production process under a single administrative
control, rather than purchase its inputs from independent producers and sell
outputs to other independent firm s, either a s inputs into addition al produc­
tion or as final goods to independent retailers?
T o explain the internalization of transactions within a single vertically in­
tegrated firm, econom ists have focused on problem s caused by specific assets.
170
CHAPTER 8
Multinational Corporations in the Global Economy
A specific asset is an investm ent that is dedicated to a p articu lar long-term
economic relationship. Consider a hypothetical case o f a shipowner and a rail­
road. The shipowner would like to transport the goods he delivers to his dock
to m arket by rail. H e contacts the railroad and ask s that a rail spur be built
from the m ain line dow n to the dock so that he can o fflo ad g o o d s directly
onto railcars. If the railro ad agrees to build the spur, then this spur will be
dedicated to the tran sport o f that particular shipow ner’s g o o d s to the m ain
rail line. In other w ords, this rail spur is an asset that is specific to the ongoing
relationship between the shipowner and the railroad owner.
Specific assets create incentives for vertical integration because it is diffi­
cult to write and enforce long-term contracts. Returning to our exam ple o f the
shipowner and the railroad, suppose that, under the term s o f the initial agree­
ment, the shipow ner agreed to pay the railro ad a certain fee per ton to carry
goods to m arket once the spur w as built. This initial fee m ade it profitable for
the railroad to build the spur. Once the spur has been built, however, the ship­
owner has an incentive to renegotiate the initial con tract to achieve a m ore
favorable shipping rate. The shipow ner recognizes that, because the railroad
m ust incur costs if it decides to reallocate the resources it used to build the
spur, the railroad owner will be better o ff accepting renegotiated term s than
refusing to carry the goods. Thus, the existence o f a specific asset creates p o s­
sibilities for opportunistic behavior once the investm ent has been m ade: One
party in the long-term relationship can take advantage o f the specific nature
o f the asset to extract a larger share o f the value from the transaction (Teece
1993, 1 6 6 -1 6 9 ; W illiamson 1985).
The recognition that asset specificity creates incentives for opportunistic
behavior after the investm ent has been m ade can cause econom ic acto rs to
refuse to m ake investments. In our exam ple, the railroad owner will recognize
that the shipowner has an incentive to behave opportunistically after the spur
is built; therefore, quite rationally, the railroad owner will refuse to build the
spur. As a result, a m utually beneficial transaction between the shipper and
the railroad will go unrealized.
By incorporating the tw o parties to the transaction within the sam e ow n­
ership structure, vertical integration eliminates the problem s arising from spe­
cific assets. If the shipow ner also ow ned the railro ad (or vice v ersa), there
w ould be little incentive for o ppo rtu n istic behavior once the rail spu r had
been built. The shipping division o f this now vertically integrated firm could
pay the firm ’s railro ad division a sm aller fee for transporting its go o d s, but
this w ould sim ply shift revenues and expenditures between units o f the sam e
firm; the firm ’s overall bottom line w ould rem ain constant. By internalizing
transactions involving specific assets, therefore, vertical integration enables
welfare-improving investments that would not otherwise be m ade.
Firm s thus internalize their tran saction s— take them out o f the m arket
and place them under the control o f a single corporate structure— in response
to m arket imperfections. When firms earn a substantial share o f their revenues
from intangible assets, they face strong incentives to integrate horizontally—
that is, to create m ultiple p ro d u ctio n facilities all co n tro lled by a single
Economic Explanations for Multinational Corporations
171
corporate headquarters. When firms earn a substantial share of their revenues
from specific assets, they face strong incentives to integrate vertically— that is,
to place all of the various stages o f production under the control o f a single
corporate structure. In both cases, the incentive to take tran saction s out of
the m arket and place them within a single corporate structure arises from the
inability of the m arket to accurately price the value o f the asset that generates
the firm ’s income.
Locational Advantages, M arket Imperfections,
and M ultinational Corporations
Although locational advantages and market imperfections often occur indepen­
dently o f each other, we expect to see M N C s— firms that internalize economic
transaction s across national borders— when both factors are present. L o c a ­
tional advantages tell us that cross-border activity will be profitable, whereas
m arket imperfections tell us that the firm can take advantage of these opportu­
nities only by internalizing the transactions within a single corporate structure.
T able 8.5 illustrates how the interaction between lo cation al advantages
and m arket im perfections shapes the kinds o f firm s we expect to see in the
global econom y. When locational advantages and intangible assets are both
present, we expect to find horizontally integrated M N C s that have under­
tak en foreign investm ent to gain m ark et access. H o rizo n ta lly in tegrated
M N C s are therefore often present in m an ufactu rin g sectors. F D Is by auto
producers in the m arkets of other advanced industrial countries are perhaps
the prototypical exam ple o f this type o f M N C . In the auto industry, intangi­
ble assets arising from knowledge about the production process are o f great
value to individ ual firm s, but are h ard to price accu rately in the m arket.
T ogether with im portant location al ad v an tages— especially the availability
o f large local m arkets— intangible assets induce foreign investm ent. W estern
E u ro p e an d the U nited States o ffe r larg e m ark e ts fo r a u to m o b ile s, and
governm ents in the EU and in the U nited States have used V E R s to restrict
T A B L E 8.5
Market Imperfections, Locational Advantages, and Multinational
Corporations (MNCs)
Market Imperfection.
Yes
Locational Advantages
Intangible Assets
Specific Assets
Horizontally integrated
Vertically integrated
MNC
MNC
Market based
Natural resource based
Cost based
No
Horizontally integrated
Vertically integrated
domestic firm
domestic firm
172
CHAPTER 8
Multinational Corporations in the Global Economy
im ports from foreign auto producers. The com bination o f m arket im perfec­
tion s and lo catio n al ad v an tag e s in the au to in dustry th erefore h as led to
considerable FD I by all o f the m a jo r au to pro d u cers in the E u ro p ean and
Am erican m arkets.
When locational advan tages com bine w ith specific assets, we expect to
find vertically integrated M N C s that have invested in a foreign country either
to gain secure access to natural resources or to reduce their costs o f produc­
tion. The best exam ple o f firms investing to secure access to natural resources
is found in the oil industry. An oil refinery m ust have repeated transaction s
with the firm s that are drilling for oil. The refinery is highly vulnerable to
threats to shut o ff the flow o f oil, because an inconsistent supply w ould be
highly disruptive to the refinery and its distribution networks. Thus, we would
expect a high degree o f vertical integration in the oil industry. T his knowledge
helps us understand why petroleum com panies are so heavily represented in
the w orld’s one hundred largest M N C s.
The best exam ple o f firms investing ab ro ad to reduce the cost o f produc­
tion may be found in the factories built by auto producers in developing coun­
tries. The individual com ponents involved in au to produ ction are com plex
and specific to the final good: One cannot produce a Ford with parts designed
for a N issan . T h us, auto producers m ust have long-term relationships with
their parts suppliers, and these relationships create incentives for vertical inte­
gration across borders. It is no surprise, therefore, that the auto industry also
is heavily represented in the one hundred largest M N C s.
The m atrix presented in T able 8.5 also points to those industries in which
we w ould not expect to find a sign ifican t am ount o f M N C activity. When
locational advantages exist, but there are neither intangible nor specific a s­
sets, we do not expect to find a significant am ount o f M N C activity. Instead,
firm s will prefer to purchase their inputs from independent suppliers and to
sell their products through international trade, or they will prefer to enter
into subcontracting arrangem ents with firm s located in the foreign country
and owned by foreign residents. A pparel production fits nicely into this cate­
gory. Apparel production is a labor-intensive activity and is increasingly done
in labor-abundant developing countries. The m ajor retailers in the advanced
ind ustrialized w orld, such a s the GAP an d the L im ited , rely heavily upon
producers located in developing countries, but they rarely own the firm s that
produce the ap p arel they sell. Instead, they enter into contracting relatio n ­
ships with independent firms.
In sum, M N C s are more than just large firms. M N C s are firms that have
responded in predictable w ays to the specific characteristics o f the econom ic
environment in which they operate. The creation o f an M N C is m ost often
the result o f a co rp orate respon se to a lo cation al ad v an tage and a m arket
im perfection. L o cation al ad v an tages create incentives to extend operation s
across borders in order to extract natural resources, sell in foreign m arkets,
or achieve cost reductions. Intangible and specific assets create incentives for
firm s to shift their econom ic transactions out of the m arket and into a single
corp orate structure. W hen lo cation al advan tages and m arket im perfections
Economic Explanations for Multinational Corporations
173
coexist, we expect to find M N C s— firm s that have internalized transaction s
across national borders.
Multinational Corporations and Host Countries
Up to this point, we have focused exclusively on what M N C s are, where they
operate, and why they are established. In doing so, we have neglected the impact
of M N C s on the countries that host their affiliates. We conclude the chapter by
looking at this im portant dimension o f M N C activity. FDI creates a dilemma
for host countries. On the one hand, FDI has the potential to m ake a positive
contribution to the host country’s econom ic w elfare by providing resources
that are not readily available elsewhere. On the other hand, because M N C a f­
filiates are m anaged by decision makers based in foreign countries, there is no
guarantee that FD I will in fact make such a contribution. The politics o f host
country-M N C relations, a topic that we explore in depth in the next chapter,
revolves largely around governments’ efforts to manage this dilemma. Here, we
look at the benefits that FDI confers on host countries in theory, as well as at a
few M N C practices that can erode these benefits.
M N C s can bring to host countries im portant resources that are not e a s­
ily acquired otherwise. Three such resources are perhaps the m ost im portant.
First, FDI can transfer savings from one country to another. Econom ic grow th
is dependent on investm ent in physical capital as well as in hum an capital.
T o invest, however, a society needs to save, and in the absence o f som e form
o f foreign investm ent, a society can invest only as much as it is able to save.
Foreign investm ent allow s a society to draw on the savings o f the rest o f the
w orld. By doing so, the country can enjoy faster grow th than w ould be p o s­
sible if it were forced to rely solely on its dom estic savings. M oreover, fixed
investments— factories that are not easily rem oved from the country— are sub­
stantially m ore stable than financial capital flow s and thus do not generate
the boom and bust cycles we will exam ine in Chapter 14 and C hapter 15. In
addition, because M N C s invest by creating dom estic affiliates, direct invest­
ment does not raise host countries’ external indebtedness. O f the m any p o s­
sible w ays that savings can be transferred acro ss borders, direct investm ent
might be the m ost stable and least burdensome for the host countries.
M N C s also can bring technology and m anagerial expertise to host coun­
tries. Because M N C s control intangible assets based on specialized knowledge,
the investments they m ake in host countries often can lead to this knowledge
being transferred to indigenous firm s. In M alay sia, for exam ple, M o to ro la
M alaysia transferred the technology required to produce a particular type o f
printed circuit board to a M alaysian firm, which then developed the capacity
to produce these circu it b o ard s on its ow n (M o ran 1 9 9 9 , 7 7 - 7 8 ). In the
absence o f the technology transfer, the indigenous firm w ould not have been
able to produce the products.
Such tech n ology tran sfers can generate sign ifican t po sitive ex te rn ali­
ties with wider im plications for developm ent (see G raham 1996, 1 2 3 -1 3 0 ).
Positive externalities arise when economic actors in the host country that are
174
CHAPTER 8
Multinational Corporations in the Global Economy
not directly involved in the transfer o f technology from an M N C to a local
affiliate also benefit from this tran saction . If, fo r exam ple, the M ala y sia n
M otorola affiliate were able to use the technology it acquired from M otorola
to produce inputs for other M alaysian firm s at a lower cost than these inputs
were available elsewhere, then the technology transfer w ould have a positive
externality on the M alaysian economy.
M N C s can also transfer managerial expertise to host countries. Greater ex­
perience at managing large firms allows M N C personnel to organize production
and coordinate the activities o f multiple enterprises more efficiently than hostcountry managers can. This knowledge is applied to the host-country affiliates,
allowing them to operate more efficiently as well. Indigenous m anagers in these
affiliates learn these m anagem ent practices and can then apply them to indig­
enous firms. In this way, m anagerial expertise is transferred from the M N C to
the host country.
Finally, M N C s can enable host-country producers to gain access to m ar­
keting netw orks. When direct investm ents are m ade as part o f a global p ro ­
duction strategy, the local affiliates o f the M N C and the dom estic firm s that
supply these affiliates becom e integrated into a global m arketing chain. Such
integration creates export opportunities that w ould otherwise be unavailable
to indigenous producers. The M alaysian firm to which M oto ro la transferred
the printed circuit board technology, for exam ple, not only w ound up supply­
ing M otorola M alaysia, but also began to supply com ponents to 11 M otorola
plants worldwide. These opportunities would not have arisen had the firm not
been able to link up with M otorola M alaysia.
M N C s provide these benefits at a price, however. T o capture the benefits
that M N C s offer, a country m ust be willing to allow foreign corporations to
make decisions about how resources will be used in the host country. A s long
as foreign m anagers m ake decisions about how much capital and technology
are transferred to the host country, about how the resources M N C s bring to
the host country will be com bined with local inputs, and ab ou t how the rev­
enues generated by the local affiliate will be used, there will be som e chance
that a particular investment will not enhance, and m ay even detract from , the
welfare of the host country.
M N C s can reduce, rather than increase, the am ou nt o f funds available
for investment in the host country, as a result o f a num ber o f different p rac­
tices. M N C s som etim es borrow on the host country’s capital m arket instead
o f bringing capital from their home country. This practice crow ds out dom es­
tic investm ent; that is, by using scarce dom estic savings, the M N C prevents
domestic firms from m aking investments. M N C s also often earn rents on their
products and repatriate m ost o f these earnings. Consequently, the excess prof­
its wind up in the M N C ’s hom e country rather than rem aining in the host
country, where they could be used for additional investment.
In addition, M N C s typically charge their host-country affiliates licensing
fees or royalties for any technology that is transferred. W hen the affiliates
pay these fees, additional funds are transferred out o f the host country to the
M N C ’s home base. Finally, M N C s often require the local affiliate to p u r­
chase inputs from other subsidiaries o f the sam e corporation. These internal
Economic Explanations for Multinational Corporations
175
transaction s take place at prices that are determined by the M N C parent, a
practice called transfer pricing. Because such transactions are internal to the
M N C , the parent can set the prices at whatever level best suits its global strat­
egy. When the parent overcharges an affiliate for the good s it im ports from
affiliates based in other countries and underprices the same affiliate’s exports,
revenues are transferred from the local affiliate to the M N C parent. Som e­
times such transfers can be very large: An investigation revealed that C olom ­
bia paid $3 billion m ore for pharm aceutical im ports through M N C s than it
w ould have paid in m arket-based transactions. All o f these practices reduce
the am ount o f funds that are available to finance new pro jects in the host
country. In extrem e cases, M N C s m ight reduce the total am ou n t o f funds
available for investment, rather than increase them.
An M N C might also drive established host-country firms out o f business.
Suppose an M N C enters an industry already populated by local firms. Suppose
also that the M N C controls technology or management skills that enable it to
produce at a lower cost than the local firms. As the M N C affiliate’s local pro­
duction expands, the established local firms will begin to lose sales to this new
low-cost com petitor. Some of these businesses will eventually fail. The failure
of the local final-good producers may have a secondary im pact on local input
suppliers. Local firms often acquire their inputs from local firms. In contrast,
m ost M N C s source their inputs from global networks o f suppliers. If the new
M N C affiliate drives local firms out o f business, then the demand for the inputs
provided by local firms will fall. The local input suppliers will thus face serious
pressure, and many of them will probably go out of business as well. Although
such instances may be an example of a more efficient firm replacing less efficient
com petitors, the dynam ic is one in which local firm s are gradually replaced
by foreign firm s and local m anagers by foreign m anagers. If the transfer of
skills and technology from foreign to local producers is one o f the purported
benefits o f FD I, then a dynamic in which foreign firms drive local firms out of
business suggests that very little technology transfer is occurring.
Technology transfers can be further limited by the incentive that M N C s
have to m aintain fairly tight control over technology and m anagerial p o si­
tions. A s w e have seen, one o f the principal reason s for M N C investm ent
arises from the desire to m aintain control over intangible assets. Given this
desire, it is hard to understand why an M N C w ould m ake a large fixed in­
vestment in order to retain control over its technology, but then transfer that
technology to host-country firm s. The transfer o f m anagerial expertise also
m ay be limited because M N C s are often reluctant to hire host-country resi­
dents into top-level m anagerial positions. Thus, the second purported benefit
of M N C s— the transfer o f technology and m anagerial expertise— can be sty­
mied by the very logic that causes M N C s to undertake FDI. If this happens,
M N C affiliates will function like enclaves, failing to be tightly integrated into
the rest o f the host-country economy and never realizing any spillover effects.
Finally, the decisions by M N C s a b o u t how to use the revenues gener­
ated by their affiliates m ay bear no relationship to the host-country govern­
m ent’s econom ic objectives. In a w orld in which governm ents cared little
about the type of econom ic activity that w as conducted within their borders,
176
CHAPTER 8
Multinational Corporations in the Global Economy
this w o u ld be o f little consequence. But when governm ents use a w ide vari­
ety o f policy instruments to try to prom ote certain types o f econom ic activ­
ity, whether it be manufacturing in a developing country or high-technology
in d ustries in an advanced in d ustrialized country, foreign co n tro l o f these
revenues can pose serious obstacles to governm ent policy. If, for exam ple, a
country’s export earnings derive entirely from copper exp orts, but an M N C
controls the country’s copper-mining operations, then decisions about how to
use the country’s foreign exchange earnings will be m ade by the M N C rather
than by the government. O r, if the revenues generated by the local affiliate
are sufficient to finance addition al investm ent, decisions ab o u t whether this
investment will be m ade in the host country or som ewhere else and, if in the
host country, then in which sector, are m ade by the M N C rather than by the
government. In short, control by M N C s over the revenues generated by their
affiliates m akes it difficult for governm ents to channel resources tow ard the
economic activities they are trying to encourage.
A CLOSER LOOK
Redistributing Venezuelan Oil Profits
The relationship between major international oil,companies and Venezuela's
President Hugo Chavez richly illustrates the potential for distributional conflict
between host-country governments and MNCs over the income generated by the
exploitation of natural resources via FDI.
In 1976, the Venezuelan government nationalized its oil sector, thereby ending
foreign participation. The government reversed this policy in the late 1980s,
however, as it confronted severe budgetary pressure. Oil revenues fell sharply in the
1980s as Venezuelan oil production stagnated and world oil prices fell sharply. The
Venezuelan government turned to the International Monetary Fund and the World
Bank for financial assistance and accepted a broad structural adjustment program.
In connection with these reforms, Venezuela reopened the oil sector to foreign
investment. The rationale for doing so was straightforward. The government hoped
foreign oil companies would bring the capital and technology needed to boost
oil production. Expanded production would in turn provide revenues to ease its
budgetary and balance-of-payments constraints. Given Venezuela's large known
reserves, the world's oil companies rushed to invest. By 1996, Venezuela had
become the world's most attractive location for investment in oil exploration and
production (Vogel 1996).
Although foreign firms believed that investment in Venezuela was relatively low
risk (indeed, as one energy market analyst commented at the time, "the opening is
not reversible"; Vogel 1996), by the early 2000s, newly elected Hugo Chavez was
moving to renegotiate the terms of foreign participation in Venezuela's oil sector.
Working through Venezuela's state-owned enterprise, Petroleos de Venezeuela
Economic Explanations for Multinational Corporations
177
(PDV), Chavez first forced foreign companies to renegotiate the terms governing
their investments in the marginal oil fields. Through these renegotiations, Chavez
pressed the major oil companies to transform their local affiliates into joint
ventures in which PDV held a controlling interest (at least 60 percent ownership).
As a consequence, approximately $3.7 billion of income over the life of the
investment was transferred from the foreign firms to PDV (Reed and Ixer 2006).
Chavez then focused on four major projects in Venezuela's Orinoco Belt. The
Orinoco Belt holds an unknown quantity of heavy crude, a tar-like oil that is
somewhat complex to extract and refine. The Venezuelan government estimates
the Belt could hold as much as 275 billion barrels, which, if accurate, would
give Venezuela one of the largest known oil reserves. Six foreign oil companies,
France's Total, the Norwegian firm Statoil, Britain's BP, and the American firms
ExxonMobil, Chevron, and ConocoPhillips had together invested more than $15
billion in this region since the late 1990s. The initial agreement under which they
invested required them to pay only 16.7 percent royalty and 34 percent income
tax. In early 2007, Chavez announced his intention to reassert control over these ’
resources. He seized operational control of the oil fields on May 1, 2007. In doing
so he announced, "Today we are ending this perverse era." "We have buried this
policy of the opening up of our o il. . . an opening that was nothing more than an
attempt to take away from Venezuelans their most powerful and biggest natural
resource" (Romero 2007). In the course of the year he raised the royalty rate to 30
percent and the income tax to 50 percent, and forced the foreign firms to transform
their local affiliates into joint ventures in which PDV held majority ownership* Any
firm that refused to form a joint venture was forced to leave.
In less than 2 years, therefore, Chavez dramatically altered how income
generated from Venezuelan oil reserves is distributed between foreign oil companies
and the Venezuelan state. Two key factors enabled Chavez to successfully
redistribute this income. First, the major oil companies have few alternatives.
to Venezuela. Oil is not evenly distributed across the globe, andmost of the
countries that have large oil reserves are less open to foreign participation than
Chavez's Venezuela. Chavez also benefited from the fact that his predecessors
opened Venezuela to foreign investment. By 2006, foreign oil companies had
invested billions in Venezuela that they could neither afford to abandon nor could
easily remove from Venezuela. It is unlikely that Chavez could have captured for
Venezuela as large a share of the oil revenues had he been trying to attract new
investment rather than renegotiating the terms of existing investment. We will look
more systematically at how these factors shape bargaining in Chapter 9,
The open question is what impact this renegotiation will have on oil production
in Venezuela. The risk, for Venezuela, is that as a consequence of Chavez's
renegotiation international oil companies now view Venezuela as too risky for
investment. If they do, they will invest less, with potentially negative consequences
for the productivity of Venezuelan oil. If this does occur, one might suggest that
Chavez redistributed income from foreign oil companies to the Venezuelan state
today at the expense of the future. ■
178
CHAPTER 8
Multinational Corporations in the Global Economy
H o st co u n tries th erefore face a d ilem m a in th eir re latio n sh ip s w ith
M N C s. On the one hand, M N C s can provide resources to host countries, in­
cluding access to new sources o f capital, innovative technologies, m anagerial
expertise, and m arket linkages that are not available elsewhere. On the other
hand, because FDI extends foreign m anagerial control into the host country’s
economy, there is no guarantee that a particular investment will in fact yield
the aforesaid benefits. An M N C m ight consum e scarce local savings, replace
local firm s, refuse to transfer technology, and repatriate all o f its earnings.
This dilemma has led many to suggest that governm ents m ay need to play an
active role in structuring the conditions under which M N C s operate within
their econom ies. A s we will see in the next chapter, much o f the politics o f
M N C s revolve around governm ent efforts to shape these conditions in order
to extract as m any benefits from M N C s that they can and to m inim ize the
costs o f ceding m anagerial control to foreign decision m akers.
CONCLUSION
The last 30 years have seen rap id grow th in the num ber o f M N C s o p e ra t­
ing in the global econom y. By 2 0 0 8 , the num ber o f such co rp o ratio n s w as
eleven times the num ber in operation in the early 1980s. As that num ber has
increased, the role these firm s play in glo b al p roduction , trad e, and crossborder investment has also increased. The activities o f contem porary M N C s
are heavily concentrated in the advanced industrialized countries. M o st FDI
in the global econom y involves a firm based in one advanced industrialized
country establishin g a facility in another advan ced industrialized country.
A lthough M N C s have recently begun to shift m ore o f their activities to the
developing w orld, only a sm all num ber of developing countries have received
substantial am ounts o f investment. It will take many m ore years o f investment
before the developing w orld’s share o f M N C activities approaches the share of
the advanced industrialized countries.
M N C s are m ore than ju st large firm s. They are firm s that organize and
m anage their activities quite differently than traditional firm s do. In particu­
lar, they have opted to rem ove many o f their international transactions from
the m arket and to place them within a single corporate structure. T hus, even
though m any firm s engage in international activities, only a subset o f these
firm s— those that own productive establishm ents in at least two countries—
can be classified as M N C s. M N C s have opted for this distinctive o rgan iza­
tion structure because they face opportu n ities to p ro fit from international
exchange; but, because they earn a substantial share o f their income from in­
tangible and specific assets, they can capture these profits only by internalizing
the associated transactions. Thus, the modern M N C has emerged as an o rga­
nizational response to a specific econom ic problem in the global economy.
M o st an alysts o f M N C activities believe that FD I can benefit the host
country as well as the investing firm. Such investm ents can transfer savings,
technology, and m anagerial expertise to h ost countries and can allow local
producers to link into glo b al m arketing netw orks. N one o f these resources
Suggestions for Further Reading
179
are readily available to host countries— especially developing host countries—
unless they are willing to open them selves to M N C activity. Yet, opening a
country to M N C activity does not guarantee th at the benefits will be real­
ized. M N C s are profit-m aking enterprises, and their activities are oriented
tow ard that end and not tow ard raising the w elfare o f their host countries.
Consequently, societies that host M N C s face a dilemma: They need to attract
M N C s to capture the benefits that FD I can offer, but they need to ensure that
activities by M N C s actually deliver those benefits. As we shall see in the next
chapter, m ost of the politics o f M N C s revolve around governm ent efforts to
manage this dilemma.
KEY TERMS
Efficiency-Oriented
Investment
Foreign Direct Investment
Horizontal Integration
Intangible Asset
Locational Advantages
Market-Oriented
Investment
Natural-Resource
Investment
Positive Externalities
Specific Asset
Vertical Integration
SUGGESTIONS FOR FURTHER READING
For a good introduction to the economics of MNCS, see Richard E. Caves, Multina­
tional Enterprise and Economic Analysis (Cambridge, UK: Cambridge University
Press, 1996). Another excellent source is John H. Dunning, Multinational Enter­
prises and the Global Economy (Reading, MA: Addison Wesley, 1993).
The best single source on the history of M NCs is Geoffrey Jones, The Evolution of
International Business: An Introduction (London: Routledge, 1996). The most
comprehensive treatment of American M NCs is Myra Wilkins, The Emergence
o f Multinational Enterprise: American Business Abroad from the Colonial Era
to 1914 (Cambridge, MA: Harvard University Press, 1970). Current challenges
confronted by MNCs are examined in Raymond Vernon, In the Hurricane’s Eye:
The Troubled Prospects o f Multinational Enterprises (Cambridge, MA: Harvard
University Press, 1998).
9
ter
ap
h
C
The Politics of
Multinational
Corporations
T
ip O ’N eill, a form er Sp eaker o f the U .S. H o u se o f R epresen tatives,
once said, “ All politics is lo c a l.” H e m ight have said the sam e thing
a b o u t econ om ic p ro d u ctio n . F o r no m atter how “ g lo b a liz e d ” the
world economy becom es, econom ic production will alw ays be based in local
communities and will always employ resources drawn from those communities.
M ultinational C orporations (M N C s) do not alter this basic reality. M N C s do
alter the nature o f economic decision m aking, however. Historically, decisions
about production have been m ade by local business ow ners with reference
to local conditions. When M N C s are involved, how ever, foreign m anagers
make production decisions with reference to global conditions. Yet, whereas
the fram e o f reference for much econom ic decision m aking has shifted, the
frame of reference for political decision making has not. Governments continue
to address local concerns in response to the dem ands o f local interest groups. As
one prominent scholar of M N C s has written, “ the regime o f nation states is built
on the principle that the people in any national jurisdiction have a right to try to
maximize their well-being, as they define it, within that jurisdiction. The M N C ,
on the other hand, is bent on maximizing the well-being o f its stakeholders from
global operations, without accepting any responsibility for the consequences of
its actions in individual national jurisdictions” (Vernon 1998, 28).
The tension inherent in these overlapping decision-m aking fram ew orks
shapes the dom estic and in tern ation al p o litics o f M N C s. In the dom estic
arena, m ost governm ents have been unwilling to forgo the potential benefits
of foreign investment, yet few have been willing to allow foreign firm s to o p ­
erate without restriction. Consequently, m ost governments have used national
regulations and have bargained with individual M N C s to ensure that the o p ­
erations of foreign firms are consistent with national objectives. G overnm ents’
efforts to regulate M N C activities carry over into international politics. H ost
countries, especially in the developing w orld, pursue international rules that
codify their right to control the activities o f foreign firm s operatin g within
their borders. Countries that serve as home bases for M N C s— essentially, the
180
Regulating Multinational Corporations
181
advanced industrialized countries— pursue international rules that protect
their overseas investments by limiting the ability o f host countries to regulate
the activity by M N C s.
We exam ine these dynam ics here. We look first at the variety o f instru­
ments governments have used to extract as many o f the benefits from FDI as
they could, while at the same time minimizing the perceived costs arising from
allow ing foreign firm s to control local industries. We then focu s on efforts,
unsuccessful to date, to negotiate international rules defining the respective
rights and obligations o f host countries and M N C s.
REGULATING MULTINATIONAL CORPORATIONS
Rather than forgo the potential benefits available from h osting M N C affili­
ates, m ost governm ents have sought to define the term s under which M N C s
operate within their borders. Governm ents have regulated proscriptively and
prescriptively— that is, they have prohibited foreign firm s from engaging in
certain activities, and they have required them to engage in others. All o f these
regulations have been oriented tow ard the sam e goal: extracting as m any of
the benefits from FD I as possible, while sim ultaneously m inim izing the cost
associated with ceding decision-m aking authority to foreign firm s. We look
first at how developing countries attem pted to regulate M N C activity and
then turn our attention to practices com m on in the advanced industrialized
w orld. As we will see, even though both developed and developing countries
regulate M N C activities, developing countries have relied far m ore heavily
on such practices. T hus, we conclude this section by exam ining why the two
groups of countries adopted such different approaches tow ard M N C s.
Regulating M ultinational Corporations in the Developing W orld
In the early p o stw ar period, m ost developing-country governm ents viewed
M N C s with considerable unease. “ The association o f foreign com panies with
former colonial pow ers, their em ployment o f expatriates in senior positions,
their past history (real or im agined) o f discrim ination again st local w orkers,
and their embodiment o f alien cultural values all contributed to the suspicion
with which foreign [M N C s] were regard ed ” in developing countries (Jones
1996, 291). Governments in newly independent developing countries wanted
to establish their political and econom ic autonom y from form er colonial pow ­
ers, and often this entailed taking control o f existing foreign investments and
m anaging the terms under which new investments were made.
Concerns about foreign dominance reflected the continuation o f historical
practice. M o st developing countries entered the postw ar period as prim arycom m odity producers and exporters. Yet, M N C s often controlled these sec­
tors and the exp ort revenues they generated. In the alum inum industry, for
exam ple, six M N C s controlled 77 percent o f the nonsocialist w orld’s bauxite
output, 87 percent o f its alum ina output, and 83 percent o f its production
of aluminum. In agricultural products, the fifteen largest agricultural M N C s
182
CHAPTER 9
The Politics of Multinational Corporations
controlled approxim ately 80 percent o f developing countries’ exports (U N C ­
T A D 1983). And although foreign direct investm ent (FD I) shifted to w ard
m anufacturing activity during the 1 9 60s, M N C affiliates also played an im ­
portant role in these sectors. In Singapore, M N C affiliates currently account
for 52 percent o f all m anufacturing em ploym ent, 75 percent o f all sales, and
approxim ately 61 percent o f all exp orts. In M ala y sia , the figures are co m ­
parable: 44 percent o f m anufacturing em ploym ent, 53 percent o f sales, and
51 percent o f exports (U N C TA D 2001). Although Singapore and M alaysia sit
at the high end of the spectrum , M N C s also control large segments o f m anu­
facturing activity in other developing countries.
A llow ing foreign co rp o ratio n s to con trol critical sectors raised p o liti­
cal and econom ic concerns. The central political concern w as th at foreign
ownership o f critical natural-resource industries com prom ised the hard-w on
national autonom y achieved in the struggle for independence. It seem ed incongruent to achieve political independence from co lo n ial pow ers and yet
continue to struggle under the econom ic dom inance o f the colonial p o w er’s
multinational firms. Econom ic concerns arose a s governments adopted im port
substitution industrialization (ISI) strategies. If M N C s were allow ed to co n ­
trol export earnings, governm ents w ould be unable to use these resources to
prom ote their developm ent objectives. M oreover, if M N C s were allow ed to
enter the local econom y freely, there w ould be no necessary relationship be­
tween the investm ents they m ade and the governm ent’s developm ent go als.
FD Is m ight rem ain in the extractive industries, an d m an u factu rin g invest­
ments might not transfer technology. As a result, econom ic activities w ould
continue to reflect the interests o f foreign actors instead o f the governm ent’s
development objectives.
In general, developing countries responded to these concerns by regulat­
ing rather than prohibiting FD I. R ather than shut themselves o ff com pletely
from the potential benefits FDI prom ised, governm ents sought to m anage ac­
cess to their economies to ensure that the benefits were in fact delivered. G ov­
ernments did block foreign investm ent in som e sectors o f the econom y. For
exam ple, they prohibited M N C ow nership o f public utilities, iron and steel,
retailing, insurance and banking, an d extractive industries (Jenkins 1 9 8 7 ,
172). When foreign firm s already owned enterprises in these sectors, govern­
ments nationalized the industries. Through nationalization, the host-country
government took control o f an affiliate created by an M N C .
N ation alization w as com m on during the late 1960s and the first h alf o f
the 1970s (see Figure 9.1). N ationalizations occurred m ost often in the extrac­
tive industries and in public utilities such as pow er generation and telecom ­
m unications. N ation alization served both political and econom ic objectives.
Politically, governm ents could rally dom estic su p p o rt and silence dom estic
critics “ by taking over the m ost obvious sym bols o f ‘foreign exp lo itatio n ’ ”
(Shafer 1983, 94). N ation alization also m ade “ ration al econom ic planning
possible for the econom y as a whole and enhance[d] the governm ent’s finan­
cial position sufficiently to m ake econom ic diversification and . . . balanced
economic grow th attainable” (Shafer 1983, 9 3 -9 4 ).
Regulating Multinational Corporations
183
FIGURE 9.1
Expropriation Acts in Developing Countries
Source: V e rn o n 1 9 9 8 , 6.
Governm ents also created regulatory regim es to influence M N C activi­
ties. M any governments required local affiliates to be m ajority owned by local
shareholders, instead o f allow ing M N C s to own 100 percent o f the affiliate.
Local ownership, governments believed, w ould translate into local control o f
the affiliate’s decisions. Governments also limited the am ount o f profits that
M N C affiliates could repatriate, as well a s how much affiliates were allowed
to pay parent firms for technology transfers. Such m easures, governm ents be­
lieved, would help ensure that the revenues generated by M N C activity within
the country remained in the country and available for local use.
Governm ents also im posed perform ance requirem ents on local affiliates
in order to prom ote a specific econom ic objective. If a governm ent w as try­
ing to prom ote backw ard linkages, for exam ple, it required the affiliate to
purchase a certain percentage o f its inputs from domestic suppliers. If the gov­
ernment w as prom oting export industries, it required the affiliate to export a
specific percentage o f its output. Som e governm ents also required M N C s to
conduct research and development inside the host country. Finally, m any gov­
ernments limited the access o f M N C s to the local capital m arket. All o f these
restrictions were aimed at avoiding the downside of M N C involvement, while
simultaneously trying to capture the benefits that M N C s could offer.
O f course, not all developing countries adopted identical regimes. Govern­
ments that pursued ISI strategies im posed the m ost restrictive regim es. India,
for exam ple, hosted a large stock o f foreign investment upon achieving inde­
pendence. The Indian government w as determined, however, to limit the role of
184
CHAPTER 9
The Politics of Multinational Corporations
M N Cs in the Indian economy (Jones 1996, 299). T o achieve this goal, the gov­
ernment enacted highly restrictive policies tow ard new foreign investments and
began to “ dislodge” existing investments (Encarnation 1989). It forced existing
enterprises that owned more than 4 0 percent o f the local subsidiary to either
sell equity to Indian firms or leave India. They made exceptions only for M N C s
operating in high-priority areas or using sophisticated technologies. As a result,
India experienced a net capital outflow during the 1970s when som e M N C s,
such as Coca-Cola and IBM , left and few new investments arrived.
O ther developing countries actively sou gh t FD I in connection with the
shift to secondary im port substitution, but regulated the term s under which
M N C s could invest. Because the Brazilian m arket w as quite large, the Brazilian
governm ent could en courage foreign investm ent on term s th at pro m o ted
domestic auto production. The governm ent thus banned all auto im ports in
1956 and forced foreign au to m an ufactu rers to produce in B razil in order
to sell in Brazil. It im posed high dom estic content requirem ents on M N C s;
35 to 50 percent o f ca rs’ parts had to be locally produced in 1 9 5 6 , and the
figure w as increased to 9 0 -9 5 percent by the m id-1960s. As a consequence, by
the m id-1960s, eight foreign-controlled firm s were producin g cars in Brazil,
and by 1980 over one million cars were being produced annually. T hus, even
those developing countries that welcom ed M N C s sought to ensure that their
activities corresponded with the governm ent’s development goals.
East Asian governments pursuing export-oriented developm ent strategies
were more open to FDI. Singapore and H on g K ong im posed few restrictions;
to the contrary, Singapore based its entire development strategy on attracting
foreign investm ent. South K o rea and T aiw an were less open to investm ent
than Singapore and H ong K ong: In both countries, the government developed
a list o f industries that were open to foreign com panies, but pro p o sals to in­
vest in these industries were not autom atically approved. Each project had to
meet requirements concerning local content, the transfer o f technologies, the
payment o f royalties in connection with technology transfers, and the im pact
on imports (H aggard 1990, 199).
Still, Taiw an and South Korea did more to attract foreign investment than
most governments in Latin America or Africa. Beginning in the m id-1960s and
early 1 9 7 0 s, both the T aiw anese and the South K orean governm ent created
export-processing zones (EPZs) to attract investment. Export-processing zones
are industrial areas in which the government provides land, utilities, a transporta­
tion infrastructure, and, in some cases, buildings to the investing firms, usually at
subsidized rates (H aggard 1990, 201). Foreign firms based in EPZs are allowed
to import com ponents free o f duty, as long as all o f their output is exported.
Taiw an created the first EPZ in East Asia in 1965, and South K orea created its
first in 1970. These assembly and export platform s attracted a lot of investment
from American, European, and Japanese M N C s. Finally, both countries further
liberalized foreign investment during the m id-1970s in an attempt to attract hightechnology firms into the local economies (H aggard and Cheng 1987).
M ost developing countries have greatly liberalized FD I since the 1980s.
Sectors previously closed to foreign investm ent, such as telecom m unications
and natural resources, have been opened. Restrictions on 100-percent foreign
v
v
^
Regulating Multinational Corporations
185
ownership have been lifted in m ost countries. Restrictions on the repatriation
o f profit have been eased. Tw o factors have encouraged this liberalization.
First, restrictive regimes yielded disappointing results (Jones 1 996). FD I fell
during the 1 9 7 0 s as nation alization s and regulation led M N C s to seek o p ­
portunities elsewhere. M N C s that did operate in developing countries were
reluctant to bring in new technologies, and the sectors that governm ents had
nationalized perform ed well below expectations (Shafer 1 9 8 3 ). Second, the
decision to liberalize FD I cam e as p art of the broader shift in developm ent
strategies. G overnm ents intervened less in all segm ents o f the econom y, in­
cluding FDI, as they shifted to m arket-based strategies.
D eveloping countries’ governments have not abandoned efforts to control
M N C activity. Although they have become more open to FDI, they “ continue
to look on m ultinational enterprises from the vantage point o f their p a st ex­
periences. M uch as they welcom e the contribution o f foreign-ow ned enter­
prises . . . these countries will have grave doubts from time to time ab ou t the
long-term contribution o f such enterprises, especially as they observe that the
grand strategy o f the enterprise is built on the pursuit of glo b al sources and
global m arkets” (Vernon 1998, 108).
Regulating Multinational Corporations in the Advanced
Industrialized Countries
The typical advanced industrialized country has been m ore open to FD I and
less inclined to regulate the activities o f M N C s than the typical developing
country. Only Ja p a n and France required explicit governm ent ap p ro v al for
m anufacturing investm ents by foreign firm s (Safarian 1 993). M o st govern­
m ents have excluded foreign firm s from ow ning industries deem ed “ criti­
c a l,” but they have not draw n the lists o f sectors from which foreign firm s
are excluded so broadly as to discourage M N C investment (Safarian 1993).
In the United States, for exam ple, foreign firm s cannot own radio and televi­
sion broadcasting stations, cannot own a dom estic airline, and are prohibited
from participating in defense-related industries. N o r are American restrictions
unique, as m ost advanced industrialized countries prohibit foreign ownership
in many o f these same sectors.
Ja p a n w as the clearest exception to this tendency throughout much o f the
postw ar period. Until 1970, Ja p a n tightly regulated inward FDI (see Safarian
1993; M ason 1992). Japanese government ministries reviewed each proposed
foreign investment and approved very few. Proposals that were approved usu­
ally limited foreign ownership to less than 50 percent o f the local subsidiary.
Such restrictions were m otivated by the Jap an ese governm ent’s econom ic de­
velopm ent objectives. Government officials feared that Jap an ese firm s w ould
be unable to com pete with M N C s if FD I w as fully liberalized. In particular,
the Ja p a n e se governm ent feared that un restricted FD I w o u ld prevent the
developm ent o f dom estic industries cap ab le o f producin g the technologies
deemed critical to the country’s econom ic success (M ason 1 9 92, 1 5 2 -1 5 3 ).
Regulations on inward investment thus com prised an im portant com ponent of
Ja p a n ’s industrial policy.
186
CHAPTER 9
The Politics of Multinational Corporations
A CLOSER LOOK
Sovereign Wealth Funds
Foreign ownership of local industry has recently generated renewed concern1
and political activity in the United States and the EU. The'trigger has been the
visible activities of sovereign wealth funds. Sovereign wealth funds (SWFs) are
government-owned funds that purchase private assets in foreign markets. Many
SWFs, so-called commodity SWFs, are funded with revenues generated by stateowned oil companies in the Gulf states and in Norway. And although commodity
SWFs have been around for 50 years (Kuwait established the first in 1953), the
recent sharp rise in oil and natural gas prices has stimulated their rapid growth.
Noncommodity SWFs are funded via the foreign exchange reserves generated by
persistent balance-of-payments surpluses. China's SWF, the China Investment
Corporation, for example, was established using some of the foreign exchange
reserves the Chinese government has accumulated. Continued growth of these funds
is thus directly linked to balance-of-payments positions.
More than twenty governments currently have SWFs, and perhaps six others
may be about to create them. The single largest fund, the United Arab Emirate's
Abu Dhabi Investment Authority, controls approximately $875 billion. Norway's
SWF, the second largest, controls just shy of $400 billion. As a group, the twenty
active SWFs control approximately $3 trillion, and projections suggest that they
could grow to $10 trillion by 2012 (Johnson 2007). To put the size of SWFs in
perspective, consider that U.S. gross domestic product (GDP) is more than $13
trillion, and the total value of traded securities in the world is about $165 trillion.
SWFs are thus large, but as two percent of total global assets, not dominant
players in global finance.
The recent growth of SWF activity has worried some American and European
policymakers. Some fear that governments intend to use their SWFs to achieve
political rather than economic objectives. Gal Luft, the Executive Director of the
Institute for the Analysis of Global Security, expressed such concerns in testimony
to the U.S. House Committee on Foreign Affairs in May of 2008. "Governments,"
he argued, "have a broader agenda Ethan private investors]—to maximize their
geo-political influence and sometimes to promote ideologies that are in essence
anti-Western" (Luft 2008). Luft found particularly worrying the fact that many of
the largest SWFs are owned by Gulf states. Persistent high oil prices, he argued,
could dramatically increase the size of SWFs and enable them to purchase large
segments of the U.S. economy. "At $200 oil," he argued, "OPEC could potentially
buy Bank of America in one month worth of production, Apple Computers in a
week, and General Motors in just three days. It would take less than 2 years of
production for OPEC to own a 20 percent stake (which essentially ensures a voting
block in most corporations) in every S&P 500 company" (Luft 2008, 4).
Few observers are as worried as Luft about the national security implications
of SWFs. But even those who are more sanguine about the security implications
Regulating Multinational Corporations
A
187
of SWFs do raise concerns about SWFs' impact on financial markets (see, for
example, Kimmitt 2008). Many of these concerns reflect the lack of transparency
in SWF operations and the absence of a common regulatory framework. Few
SWFs are open about the strategies that motivate their investment decisions or
about the assets that they own. As they grow in size, their investment decisions
increasingly will affect markets. In the absence of better information about what
they own and what motivates their purchases, other market participants will
wind up guessing. Such dynamics could give rise to disruptive and potentially
destabilizing trading activity.
American and European policymakers have responded to SWF activity in three
ways. One strong impulse has been to welcome SWF investment in the. midst of the
extended difficulties in the American financial system. SWFs from Gulf states and
China have purchased significant stakes in American financial institutions such
as Citigroup, Blackstone Private Equity Group, and Merrill Lynch since August
of 2007. These investments and others like them (estimated at as much as $69billion) have helped recapitalize American banks. In this context, then,. SWFs have
played an important stabilizing role in the global financial system.
Simultaneously, however, policymakers have become a bit more protectionist
regarding foreign investment. The German government is currently considering a
law, for example, that would review purchases of more than 25 percent of German
companies by groups outside the EU. The government also recently blocked
a Russian effort to invest in Deutsche Telekom AG and European Aeronautic i ;
Defence and Space Company NV (the parent firm for Airbus; Braude 2008). Such
moves reflect heightened German concern about foreign government investment
in the German economy. In the United States, Congress recently strengthened the
scrutiny applied to proposed foreign investments that involve direct control by a
government entity.
Finally, American and European policy makers have sought to reconcile
these two conflicting tendencies—sometimes welcoming and sometimes blocking
investments by foreign governments— by trying to develop international rules, or
codes of best practices, to govern SWF activities. U.S. Treasury Secretary Henry
Paulson convened a dinner in October of 2007 that drew together finance ministers
from the Group of Seven (G-7); top officials from the International Monetary Fund
(IMF), the World Bank, and the Organisation for Economic Co-operation and
Development (OECD); as well as finance ministers and heads of SWFs from eight * countries (China, Kuwait, Norway, Russia, Saudi Arabia, Singapore, South Korea,
and United Arab Emirates). The dinner was followed by an IMF initiative intended
to develop a code of best practices for SWFs (Kimmitt 2008). These efforts have
not yet produced a regulatory framework, but when they do, this framework will
probably incorporate obligations on both sides (see Bennhold 2008). SWFs might
agree to reveal more information about their trading strategies and portfolio
holdings, while U.S. and EU governments might agree to limit their review of
individual SWF investments in their economies. ■
188
CHAPTER 9
The Politics of Multinational Corporations
Jap an ese restrictions on inw ard direct investm ent w ere designed to en­
co u rage technology tran sfers (M a so n 1 9 9 2 , 1 5 1 ). Ja p a n e se o ffic ia ls first
pressured foreign firm s to license their technologies to Jap an ese firm s. If this
strategy proved unsuccessful, the Jap an e se governm ent w ould consider a di­
rect investm ent, but it often attem pted to force the foreign firm to create a
joint venture with a Japan ese firm in order to transfer technology to Jap an ese
firms working in the same industry. Only if a firm w as unwilling to license its
technology or to form a joint venture— and then, only if that firm controlled
technologies that were not available elsewhere— did the Jap an ese government
permit the creation o f a wholly ow ned foreign subsidiary in Ja p a n , and even
then the governm ent often attach ed conditions to the investm ent. IBM , for
exam ple, w as forced to license critical technologies to seven Jap an ese com peti­
tors in exchange for being allowed to produce com puters in Jap an .
Jap an e se investm ent restrictions have been greatly liberalized since the
late 1960s. In 1967, Jap an increased the num ber o f industries open to foreign
investment and began to allow 100 percent ownership in som e sectors. A ddi­
tional measures taken in the 1970s and early 1980s further liberalized inward
FDI, so that Jap an now has no form al barriers to such investments. In spite of
this liberalization, however, Ja p a n continues to attract only a sm all share of
the w orld’s foreign investment. (See Figure 8.2.)
D espite the general tendency tow ard greater openness, governm ents in
the advanced industrialized countries have been sensitive to foreign control
o f critical sectors. T w o instances illustrate such concerns. The China N ation al
O ffshore Oil C orporation (C N O O C ) sought to purchase U nocal in the sum ­
mer o f 2 0 0 5 . In early 2 0 0 6 the U nited A rab E m irates-ow ned D u b ai Ports
W orld sought to acquire a British firm that operated American seaports. Both
transactions prom pted strenuous congressional opposition , and this o p p o si­
tion led both firm s to w ithdraw their offers. L en o vo ’s acquisition o f IB M ’s
personal com puter unit w as closely scrutinized but ultimately w as approved in
20 0 5 . These recent cases indicate that Am erican policym akers rem ain highly
sensitive to foreign ownership of critical industries.
In sum m ary, even though the advanced industrialized countries have been
m ore open to FD I than developing countries, they have attem pted to m an­
age the terms under which M N C s invest in their countries. Governm ents that
used industrial policies have attem pted to protect national firms from com pe­
tition by restricting foreign investment. Even governments that refrained from
prom oting active industrial policies restricted foreign ow nership o f sensitive
industries, such as those at the forefront o f high-technology sectors as well as
industries closely connected to national security.
Bargaining with M ultinational Corporations
M any host countries try to restrict M N C activities, but few can dictate the
term s under which M N C s invest. Instead, h o st countries and M N C s often
bargain over the terms under which investment takes place. We can think o f
this bargaining as oriented tow ard reaching agreem ent on how the incom e
generated by an investment will be distributed between the M N C parent and
Regulating Multinational Corporations
^
A
189
the host country. The precise distribution will be determ ined by each side’s
relative bargaining power.
Bargaining power arises from the extent to which each side exerts monopolistic control over things valued by the other. T o w hat extent does the host
country have m onopolistic control over things vitally im portant to the M N C ?
Does the host country control natural resources that are not available in other
parts o f the w orld? D oes the h ost country control access to a large dom estic
m arket? D oes the host country control access to factors o f production that
yield efficiency gains th at cannot be achieved in other countries? T he m ore
the host country has exclusive control over things o f value to the M N C , the
more bargaining power it has. Equally critical is the extent to which the M N C
exerts m onopolistic control over things of value to the host country. D oes the
M N C control technology that cannot be acquired elsewhere? M ore broadly,
are there other M N C s capable o f m aking, and w illing to m ake, the contem ­
plated investment? The more the M N C has exclusive control over things the
host country values, the m ore bargaining pow er the M N C h as. Bargaining
power, therefore, is a function o f m onopolistic control.
H ost countries have the greatest bargaining pow er when they enjoy a m o­
nopoly and the M N C does not. In such cases, the host country should capture
m ost o f the gains from investm ent. In contrast, an M N C has its greatest advantage when it enjoys a m onopoly and the host country does not. In these
cases, the M N C should capture the largest share of the gains from investment.
Bargaining pow er is approxim ately equal when both sides have a m onopoly.
In such cases, each should capture an equal share o f the gain s fro m the in­
vestment. The gains also should be evenly distributed when neither side has
a m onopoly on things the other values. In these cases, neither side has much
bargaining power, and they should divide the gains relatively equally. The dis­
tribution of the gains from any investm ent, therefore, will be determ ined by
the relative bargaining pow er o f the host country and the M N C .
We can apply the logic of this kind of bargaining analysis to investments
in natural-resource industries and in low-skilled labor-intensive m anufactur­
ing industries. In natural-resource investments, bargaining pow er initially fa ­
vors the M N C . Few countries enjoy a m onopoly over any natural resource;
thus, M N C s can choose where to invest. A lso, because an M N C often does
have a m onopoly over the capital, the techniques, and the technology required
to extract and refine the natural resources, and because the return on the in­
vestment is initially uncertain, the M N C bears all o f the risk. The M N C can
exploit this pow er asymmetry to initially capture the larger share o f the gains
from the investment.
Over time, however, bargaining pow er shifts to the host country in a dy­
namic that has been called the obsolescing bargain (M oran 1974). The M N C
cannot easily remove its fixed investment from the country, so the investment
becomes a hostage. In addition, the M N C ’s monopoly over technology dimin­
ishes as the technology is gradually transferred to the h ost country and in­
digenous workers are trained. If the investment proves successful, uncertainty
ab ou t the return on the investm ent dim inishes. U nable to threaten to leave
the country w ithout sufferin g su b stan tial co sts, and no longer controlling
190
CHAPTER 9
The Politics of Multinational Corporations
technology needed by the host country, the M N C sees its earlier bargaining
pow er weaken while the host country’s pow er strengthens. The host country
can exploit this pow er shift to renegotiate the initial agreem ent and extract a
larger share o f the gains from the project. Indeed, one m ight suggest that the
w idespread nation alization s during the 1 9 6 0 s and 1 9 7 0 s reflected precisely
this shift of bargaining pow er to host countries.
M N C s enjoy m ore bargaining pow er than host countries in low -skilled
labor-intensive m anufacturing investments. O n the one hand, no host country
enjoys a m onopoly on low -skilled lab or; thus, M N C s can pick and choose
between many potential host countries. N o r are such investments very suscep­
tible to the obsolescent bargain. Often, investments in low-skilled m anufactur­
ing entail a relatively sm all am ount o f fixed capital that can be readily moved
out o f a particular country. In addition , technology in m any m anufacturing
industries changes rapidly and therefore is not easily transferred to the host
country. Consequently, unlike natural-resource investm ents, m anufacturing
investm ents do not becom e h ostages, and host countries do not gain pow er
once the investment has been m ade (Kobrin 1987).
Evidence that M N C s enjoy greater bargaining pow er than do host coun­
tries when it com es to m anufacturing investm ent can be seen in the grow ing
competition between host countries to attract such investment. T his com peti­
tion has emerged in the form o f location al incentives— p ack ages h ost coun­
tries offer to M N C s that either increase the return o f a particular investment
or reduce the cost or risk o f that investment (U N C TA D 1995, 2 8 8 -2 8 9 ). H ost
countries offer two types of incentives to M N C s. M o st offer tax incentives. In
one such incentive, M N C s are granted a reduced corporate incom e ta x rate.
M any governm ents also provide “ ta x h o lid ay s,” usually a period o f 5 years
during which the firm p ay s no ta x . M N C s also are exem pted from im port
duties, are permitted to depreciate their investm ents at accelerated rates, and
are allowed substantial deductions from their gross incomes. M any advanced
industrialized countries also offer M N C s direct financial incentives. In som e
instances these are provided as a grant from the governm ent to the M N C , in
some as a subsidized loan (M oran 1999, 95).
The willingness o f governm ents to offer locational incentives and the size
o f the typical package have both increased rapidly during the last 20 years.
Across the entire O rganisation for Econom ic Co-operation and Developm ent
(O EC D ), 285 incentive program s offering a total o f $11 billion were provided
to M N C s in 1989. By 1993— the last year for which comprehensive d ata are
available— 362 pro gram s offering incentives totalin g $18 billion were p ro ­
vided. Within the United States, the typical p ack age averaged between $ 5 0
m illion and $70 m illion, but the value o f that pack age has been increasing
(M oran 1999). A lab am a provided H o n d a w ith m ore than $ 1 5 8 m illion in
1999s to attract this auto producer’s new plant. In 2 0 0 5 , N orth Carolina p ro ­
vided incentives totaling $ 2 4 2 million to induce Dell, the personal com puter
m anufacturer, to build a facility in the state. The N orth Carolina package for
Dell, for exam ple, am ounted to slightly m ore than $ 1 6 1 ,3 3 3 per job (Kane,
Curliss, and M artinez 2004). The grow ing use o f locational incentives suggests
Regulating Multinational Corporations
191
that host countries are at a disadvantage when bargaining with M N C s over
manufacturing investments.
In sum, few governm ents have allow ed foreign firm s to operate without
any restrictions, and many have actively m anaged the terms o f their activities,
in part by using national regulations and in part by bargaining with M N C s.
As we have seen, the typical advanced industrialized country has been less
inclined to try to restrict the activities o f foreign firm s than has the typical
developing country. We conclude this section, therefore, by considering a few
factors that account for this difference.
A CLOSER LOOK
Luring The German Luxury Car Producers
to the U.S. South
In the early 1990s, the German automaker BMW decided to create a new assembly
plant outside Germany. Such a move represented a real shift for BMW, which
had never previously assembled cars outside of Bayarfa. The firm's decision to
begin assembling cars outside Germany was motivated by a determmatron to
r•
reduce its costs. German automakers were earning about $2fTan hour, far greater
than the average of $16 an hour that unionized autoworkers fnake in the United
States. In addition, the persistent strengthening of tfie*German mark against the
dollar during the late 1980s bad further eroded the ability of BMW to compete
in the American market. BMW spent 3 years and looked at 250 different sites in 10 countries before deciding in 1992 to build the plant in Spartanburg, South, y
Carolina (Faith 1993). In late September 1992, BMW began construction of,the
$400 million assembly plant that would employ some 2,000 people and produce '
as many as 90,000 cars a year. In 1998, BMW expanded this production facility
from 1.2 million square feet to 2.1 million square feet. The facility remains
BMW's only American production site (www.BMW.cqfn). 1 ’ , :
’
Why did BMW choose Spartanburg over,other potential sites? A range Of
considerations, including financial incentives offered by the State of South
Carolina, shaped BMW's decision to base production in'Spartanburg. First,-the -r
city had some advantages arising from its locatidrij'tt is cfose to Charteston,.South ’
Carolina, a deep-water seaport, and is connected to this pdrtby a good Interstate
highway. This transportation network would allow BMW to transport the cars
destined for overseas markets easily. In addition, labor in South Carolina was
relatively cheap—averaging about $10 to $15 an hour—and nonunionized. In
addition, the state and local government in South Carolina put together a financial
package that offset a substantial share of BMW's investment. Officials advanced
about $40 million to purchase the 900 acres of land upon which the plant would be
built, and they agreed to lease the site to BMW for only $1 per year. In addition,
about $23 million was spent preparing the site and improving the infrastructure,
(Continued)
192
CHAPTER 9
The Politics of Multinational Corporations
including such things as water, sewer, and roads. Another $71 million of .tax* breaks
were offered over a twenty-year period. Finally,, state^ local, and federal money was
provided to improve the airportin nearby £ reenviIle <Harrison 1992). Altogether,
the incentives offered by South Carolina to BMW totaled about$135 million, an
amount equal to $67,500 for each job BMW would create. .
,
The use of financial incentives to attract an investmantfrom a,German
automaker reached new heights in Alabama's courtship of Mercedes-Benz in the*
mid-1990s. For reasons identical to those that motivated BMW, Mercedes-Benz
decided to build an assembly plant outside of Germany (Myerson 1996). The firm
eventually constructed a $300 million plant in Vance, Alabama, employing about ,
1,200 workers to produce 65,000 sport utility^vehteles each year. In its initial
search for suitable sites, Mercedes-Benz focused on 62 possibilities, none of which
were in Alabama. As Andreas Renschler, who led the search for the site, remarked,
"Alabama was totally unknown" (quoted in Myerson 1996). Government officials in
Alabama were determined to attract Mercedes to their state, however. The governor,
James E. Folsom Jr., flew to Mercedes-Benz headquarters in Stuttgart three times
and, working with other state politicians, put together a financial package to attract
the German firm to Alabama. The package included $92.2 million to purchase and
prepare the site for construction; $75.5 million in infrastructure improvements
for water, sewage, and other utilities; $5 million each year to pay for employee
training; and tax breaks. In addition, at a cost of about $75 million, the state of
Alabama agreed to purchase 2,500 of the sport-utility vehicles that Mercedes-Benz
intended to build in the factory. The total package was estimated at between $253
million and $300 million, an amount equal to $200,000 to $250,000 for each job
Mercedes-Benz intended to create (Waters 1996).
Although BMW and Mercedes officials publicly deny that the incentive packages
they received played an important role in their decisions to invest in Spartanburg
and Vance, respectively, it is hard to escape the conclusion that these packages did
matter. In BMW's case, the incentive probably mattered at the margin. Spartanburg
was one of at least two suitable sites in the United States. (Omaha, Nebraska, was
the other site that BMW considered.) The willingness of South Carolina to offer a
more generous package of incentives than Nebraska probably did tip the balance
in its favor. In the case of Mercedes-Benz, it seems clear that Vance, Alabama,
held few of the natural advantages enjoyed by sites in North Carolina and South
Carolina, the other two finalists in the competition. In fact, the site Mercedes-Benz
considered in North Carolina enjoyed many of the same characteristics that had
attracted BMW to Spartanburg. The willingness of Alabama to offer an incentive
package more than twice as large as that offered by North Carolina—which is
reported to have offered Mercedes-Benz about $109 million in incentives— probably
enabled Alabama to overcome its initial disadvantage (Burritt 1994).
Because incentive packages do shape the investment decisions that firms make,
governments cannot easily opt out of the incentive game. As Harlan Boyles, former
treasurer of North Carolina, commented following the Mercedes-Benz-Alabama
deal, "All the competition [for investment] has been forced upon the states" by the
Regulating Multinational Corporations
193
MNCs. "Until there is meaningful reform and an agreement between states not to
participate, very little will change" (quoted in McEntee 1995). Of course, although
Boyles's comment was directed at competition for investment among states within
the United States, its logic applies equally well to competition among national
governments in the international economy. ■
A
Three such factors are probably m ost im portant. First o f all, developing
countries have been m ore vulnerable to foreign d om in ation than advanced
industrialized countries have been. The advanced industrialized countries have
larger and more diversified econom ies than the developing countries; conse­
quently, a foreign affiliate is m ore likely to face com petition from dom estic
firms in an advanced industrialized country than in a developing country. The
lack o f diversification is com pounded by the fact that, in the early postw ar
period, m ost FDI in the developing world w as concentrated in politically sen­
sitive natural-resource industries. In contrast, m ost FDI in the advanced indus­
trialized countries flow ed into m anufacturing industries. A s a result, foreign
firms were much m ore likely to dom inate a developing country than an advanced industrialized country, and the advanced industrialized countries have
felt less compelled to regulate M N C activity.
There also appears to be a strong correlation between a country’s role as a
home for M N C s and its policies toward inward FDI. The two largest foreign in­
vestors during the last 140 years— the United States and the United Kingdom—
also have been the m ost open to inward foreign investment. Jap an began to open
itself to inward investment as Japanese firm s started to invest heavily in other
countries. When countries both host foreign firms and are home base to M N C
parents, they are unlikely to adopt policies that reflect purely host-country con­
cerns. Attempts by the United States or G reat Britain to regulate inw ard FDI
would invite retaliation that would make it harder for their own firms to invest
abroad. Because developing countries have historically hosted foreign investment
but rarely have been home bases for M N C s, their concerns are more narrowly
based on host-country issues untempered by the fear o f retaliation.
Finally, there have been fundam ental differences in how governm ents
approach state intervention in the national econom y. A lthough many devel­
oping countries pursued ISI strategies that required state intervention, m ost
advanced industrialized countries have been more willing to allow the market
to drive economic activity. Different attitudes about the governm ent’s role in
the national economy translated into different approach es to FDI. Even the
exceptions to the nonintervention tendency in the advanced industrialized
countries are consistent with this factor: The two governm ents that were most
restrictive tow ard FDI, Jap an and France, were also the tw o governments that
relied m ost heavily on industrial policies to prom ote domestic economic activ­
ity. T hus, attem pts to regulate M N C activity w ere m ost likely in countries
where governments played a large role in the economy.
194
CHAPTER 9
The Politics of Multinational Corporations
All o f these factors suggest that we are unlikely to see an abrupt shift aw ay
from the more liberal attitude tow ard FDI that has prevailed in the developing
w orld since the late 1990s back to the m ore restrictive practices that charac­
terized much o f the postw ar period. Developing countries have becom e m ore
diversified and now are attracting more foreign investment in m anufacturing
than in natural resources. As a consequence, som e, though certainly not all, o f
these countries are less vulnerable to foreign dom ination today than they were
in the mid-twentieth century. In addition, som e developing countries are grad ­
ually moving aw ay from only hosting foreign investment to being a home base
for M N C parents as well. This trend, although involving only a sm all number
o f E ast A sian and Latin Am erican countries, will gradually m ake these go v ­
ernments increasingly reluctant to restrict the activities o f foreign firm s they
host. Finally, there is no evidence of an impending shift back tow ard interven­
tionist strategies. A s long as developing countries continue to pursue liberal
strategies, they will continue to m ake it easier, rather than harder, for foreign
firms to participate in the local economy.
THE INTERNATIONAL REGULATION
OF MULTINATIONAL CORPORATIONS
There are no com prehensive international rules governing the activities o f
M N C s. This is not because governments have never tried to create m ultilateral
rules. In fact, governm ents repeatedly have tried to create such rules during
the last 50 years. But to date, these efforts have yielded little. There are p a r­
tial rules set out within the W orld T rade O rganization (W TO), as well as less
binding rules within the O E C D . There are also som e well-established interna­
tional rules, such as the investment chapter o f the N orth American Free T rade
Agreement (N A FTA ), that apply to a few countries. The reason there are no
com prehensive in tern ation al investm ent rules is th at co n flict betw een the
capital-exporting advanced industrialized countries and the capital-im porting
d eveloping coun tries h as prevented agreem ent on such rules. D evelo pin g
countries have advocated international rules that codify their right to control
foreign firm s operating within their borders. A dvanced industrialized coun ­
tries have pursued rules that protect foreign investment by limiting the ability
o f host countries to regulate the M N C s operating in their econom ies. Given
these divergent go als, agreem ent on com prehensive rules has proved im p os­
sible. We next exam ine the efforts to negotiate international investment rules,
tracing them from the late nineteenth century.
H istorically, international rules governing FD I have been based on four
legal principles. First, foreign investments are private property to be treated at
least as favorably as dom estic private property. Second, governm ents have a
right to expropriate foreign investments, but only for a public purpose. Third,
when a government does expropriate a foreign investment, it m ust com pensate
the owner for the full value o f the expropriated property, or, in legal term i­
nology, com pensation m ust be “ adequate, effective, and p ro m p t” (Akehurst
1984, 9 1 -92). Finally, foreign investors have the right to appeal to their home
The International Regulation of Multinational Corporations
195
country in the event of a dispute with the host country. Although such princi­
ples are designed to protect the property of foreign investors and therefore to
clearly reflect the interests o f the capital-exporting countries, capital-exporting
and capital-im portin g countries alike accepted them th rou gh ou t the nine­
teenth century (Lipson 1985). The one exception cam e from Latin American
governm ents’ challenge to the right o f foreign governm ents to intervene in
host countries in support o f their firms. By the late nineteenth century, Latin
Am erican governm ents were invoking the C alv o doctrine (nam ed after the
Argentinean legal scholar C arlos C alvo, who first stated it in 1868), which
argues that no governm ent has the right to intervene in another country to
enforce its citizens’ private claim s (Lipson 1985, 19).
The capital-im porting countries began to challenge these legal principles
m ore intensively follow ing W orld W ar I (Lipson 1 9 8 5 ). T he first challenge
cam e in the Soviet U nion, where the 1 9 1 7 revolution b rou gh t to pow er a
M arxist-Len in ist governm ent that rejected the idea o f private property. The
com prehensive n ation alization o f industry th at follow ed “ constituted the
m ost significant attack ever waged on foreign capital” and radically redefined
the role o f the governm ent in the econom y (L ipson 1 9 8 5 , 6 7 ). Som e Latin
American governments also began to expropriate foreign investments during
this period, particularly in the extractive industries and public utilities. These
acts broadened the notion o f “ public p u rp o se” that stoo d behind the inter­
nationally recognized right of expropriation, extending it from its traditional
association with eminent dom ain to a much wider association with the state’s
role in the process o f economic development. In addition, such widespread na­
tionalizations posed a challenge to the principle o f com pensation. The Soviet
government linked com pensation o f foreign investors, for exam ple, to claims
on W estern governm ents for d am ages caused by their m ilitaries during the
civil w ar that followed the revolution (Lipson 1985, 67).
The United States attempted to reestablish the traditional legal basis for in­
vestment protection following the Second W orld W ar. A s the largest and, in the
immediate postw ar period, only capital-exporting country, the United States
had a clear interest in establishing m ultilateral rules that secured Am erican
overseas investments. But U.S. efforts to achieve this goal by incorporating the
historical legal principles into the International Trade O rganization (ITO) ran
into opposition from the capital-im porting countries. Governm ents from Latin
Am erica, India, and A ustralia were able to create a final set o f articles that
elaborated the right o f host countries to regulate foreign investm ents within
their borders m ore than they provided the security that A m erican business
w as seeking (Brown 1950; Lipson 1985, 87). Consequently, Am erican busi­
ness strongly opposed the IT O ’s investment com ponents. As the U .S. N ational
Foreign Trade Council commented, “ [The investment] article not only affords
no protection for foreign investments o f the United States but it w ould leave
them with less protection than they now enjoy” (Diebold 1 9 52, 18). O pposi­
tion to the investment articles from American business proved a m ajor reason
for the IT O ’s failure to gain congressional support.
The ITO experience is im portant for two reasons. First, the failure of the
ITO meant that there would be no international rules governing FDI. Instead,
196
CHAPTER 9
The Politics of Multinational Corporations
the General Agreement on T ariffs and T rade (G ATT) became the center o f the
trade system, and that treaty had little to say about foreign investment. Second,
and more broadly, the failure o f the ITO reflected a basic conflict that has dom i­
nated international discussions about rules regulating FD I to this day. C apital
exporting countries have pursued international rules that regulate host-country
behavior in order to protect the interests o f their M N C s. Capital importing coun­
tries have pursued international rules that regulate the behavior o f M N C s so that
they can maintain control over their national economies. This basic conflict has
prevailed for more than 50 years o f discussions about international investment
rules and has thus far prevented agreement on any comprehensive rules.
During the 1960s and 1970s, developing countries largely set the agenda for
international discussions about FDI. W orking through the United N ations (UN),
the developing countries sought to create international investment rules that re­
flected their interests as capital importers. The effort to regulate M N C s became a
central element o f the New International Economic Order (N IEO), under which
developing countries sought two broad objectives that were designed to “ m axi­
mize the contributions of M N C s to the economic and social development o f the
countries in which they operate” (Sauvant and Aranda 1994, 99).
Developing countries sought international recognition o f their right to exert
full control over all economic activity within their territories. T o this end, those
countries secured the passage o f the United N ation s R esolution on Permanent
Sovereignty over N atu ral R esources in 1962. T his resolution recognized the
right o f host countries to exercise full control over their natural resources and
over the foreign firms operating within their borders extracting those resources.
The resolution affirm ed the right o f host-country governm ents to expropriate
foreign investm ents and to determ ine the ap p ro p riate com pen sation in the
event of expropriation (de Rivero 1980, 9 2 -9 3 ; Akehurst 1984, 93). The intent
of the resolution, and o f the others that follow ed during the 1960s and 1970s,
w as to shift the legal basis for com pensation aw ay from paym ent for the full
value o f the expropriated property to paym ent that would be in line with w hat
the exp ro p riatin g governm ent determ ined to be ap p ro p riate . A s A kehurst
(1984, 93) points out, this approach implied that com pensation w as likely to
be quite low. Developing countries also sought to write a code o f conduct that
w ould ensure that M N C activities “ were com patible w ith the m edium and
long-term needs which the governments in the capital im porting countries had
identified in their development plan s” (de Rivero 1980, 96).
The developing countries’ efforts to write a code o f conduct for M N C s,
like the broader N IE O , o f which that code form ed one part, m et opposition
from the advanced industrialized countries. Although the developing countries
wanted the code to be binding, the advanced industrialized countries pushed
for a voluntary code; in addition , although the developing countries w anted
to regulate only M N C s, the capital-exporting governm ents insisted that any
code that regulated M N C behavior be accom panied by a code that regulated
the behavior o f host countries (Sauvant and A randa 1994, 99). Governm ents
worked on both codes throughout the late 1970s and early 1980s, completing
drafts o f both by 1982. The resulting codes were never im plem ented, how ­
ever, but they were never form ally rejected either. Instead, the codes rem ained
The International Regulation of Multinational Corporations
197
in lim bo for 10 years until, in 1 9 9 2 , a U N com m ittee recom m ended that
governments seek an alternative approach (Graham 1996, 7 8 -7 9 ).
By the early 1980s, bargaining power in international negotiations shifted
back tow ard the advanced industrialized countries. T hese capital-exporting
countries used this advantage to shift the agenda back tow ard regulating hostcountry behavior. Some initial steps were taken during the U ruguay R ound.
Under pressure from the U nited States, trade-related investm ent m easures
(T R IM s) were placed on the agenda. A trade-related investm ent m easure is
a governm ent policy tow ard FDI or M N C s that has an im pact on the coun­
try’s im ports or exports. For exam ple, dom estic-content or trade-balancing
requirements force firms to im port fewer inputs or export m ore output than
they w ould without such governm ent-im posed requirem ents. Consequently,
such requirements distort international trade. In placing T R IM s on the G A TT
agenda, the United States sought to limit the ability o f host countries to use
such m easures (Croom e 1 9 9 5 ). M an y o f the other advanced industrialized
countries supported the U .S. effort, although not all shared the Am erican de­
sire for such a far-reaching agreement.
Developing countries opposed the scope of American proposals. M ost were
reluctant to see T R IM s incorporated into the G A T T at all. They argued that
“ development considerations outweighed whatever adverse trade effects T R IM s
might have, and that no new G A TT provisions to regulate them were needed”
(Croom e 1995, 258). Developing countries wanted to restrict any final agree­
ment to m easures that addressed “ the direct and significant adverse trade ef­
fects” o f investment policies (Croome 1995, 259). Even then, the group wanted
to limit the effect o f such m easures, putting forw ard a list o f thirteen develop­
ment objectives that its members claimed justified the use o f investment m ea­
sures. The only international restriction the group proposed w as a nonbinding
approach that would encourage governments to “ seek to avo id ” using T R IM s
in a way that distorted trade or caused injury to another G A T T member.
A limited agreement w as eventually reached as a result o f two changes that
affected negotiations. The advanced industrialized countries scaled back their
dem ands, agreeing to focus on four investment m easures: dom estic-content
rules, trade-balancing m easures that required a firm ’s im ports to be offset by
its exports, restrictive foreign exchange practices, and constraints on the ability
to link investment incentives to export-performance requirements. A t the same
time, developing countries’ attitudes tow ard FDI also were changing: The late
1980s brought the progressive liberalization of FDI throughout the developing
world. This reduction in the perceived need of developing countries to regulate
M N C activity extensively translated into a greater willingness to accept some
international rules that constrained their behavior as host countries.
Failure to achieve a m ore extensive agreement in the U ruguay Round led
the advanced industrialized countries to begin negotiation on a M ultilateral
Agreement on Investment (MAI) in the O E C D in M ay 1995. The O E C D ap ­
peared to offer at least three advantages over the W TO as a forum for an in­
vestment agreement. Because O E C D membership is restricted to the advanced
industrialized countries, all o f which shared a commitment in principle to lib­
eral rules, negotiations in the O E C D seemed more likely to produce agreement.
198
CHAPTER 9
The Politics of Multinational Corporations
M oreover, because m ost FDI flows between advanced industrialized countries,
an agreem ent am ong O E C D m em bers w ould regulate the m ajority o f inter­
national investment. Finally, an O E C D -based agreem ent w ould not preclude
participation by developing countries. The agreement w as envisaged as an in­
strument to which non-O ECD governments could accede if they desired.
Governm ents intended the M A I to further liberalize FDI and to provide
greater security to M N C s. Liberalization w as to be achieved by basing the agree­
ment on two central principles. The first was national treatment, which requires
governments to treat foreign-owned firms operating in their economy no differ­
ently than domestic firms. The second principle w as m ost favored nation, which
required governments to treat the foreign firms from each party to the agreement
on the same terms it accorded to firms from all other parties to the agreement.
The two principles im plied that governm ents could not discrim inate again st
firms from any country in favor o f domestic firms or foreign firms from other
countries. T o provide greater security to foreign investors, the agreement incor­
porated the historical standard governing expropriation, thereby codifying the
right to prom pt, effective, and adequate com pensation. In addition, the draft
agreement restricted the ability o f governments to limit the ability o f firm s to
remit profits, dividends, and proceeds from the sale o f assets. The agreement was
also to provide for a dispute-settlement mechanism patterned on that of N A FTA ,
which would allow for both state-to-state claims and firm-to-state claims.
Negotiations proved fruitless, however, due to conflict am ong O E C D gov­
ernments and to strong and vocal opposition from groups outside the process.
Conflict am ong O E C D governments slowed the negotiating process greatly, as
governments first established the guidelines and then busied themselves w rit­
ing exceptions to the general rules. By 1997, O E C D governments had attached
several hundred pages of exceptions covering the sale o f farmland, cultural indus­
tries (film and television in particular), and governm ent-sponsored investment
prom otion agencies. The United States pressed for the inclusion o f labor and
environmental standards. Developing countries also began to express opposition
to the emerging agreement, arguing that it regulated host-country behavior, but
did nothing to regulate M N C activities. M oreover, developing countries were
concerned that the M AI subsequently would be used as a template for a wider
investment agreement negotiated within the W TO . They w ould then be forced
to accept investment rules that they had played no role in negotiating.
Conflict within the negotiations w as accom panied by opposition from a co­
alition o f interest groups. As Stephen Kobrin notes, “ [A] coalition o f strange
bedfellows arose in opposition to the treaty, including the A F L -C IO , Amnesty
International, Australian Conservation Foundation, Friends o f the Earth, Public
Citizen, Sierra Club, Third W orld N etw ork, United Steelworkers o f Am erica,
Western Governors’ Association, and W orld Development M ovem ent” (Kobrin
1998, 98). In all, som e 6 0 0 organizations in alm ost 70 countries spoke out
again st the proposed treaty (K obrin 1998, 97). The com bination o f conflict
am ong O E C D governm ents ab ou t the specific content o f the treaty, o p p o si­
tion from developing countries outside the negotiations, and public opposition
proved fatal. Negotiations ceased in December 1998 without a final treaty.
The International Regulation of Multinational Corporations
199
POLICY A N A LY SIS AND DEBATE
The Race to the Bottom
Question
How should governments respond to the threat of a "race to the bottom" dynamic
that weakens public interest regulation?
Overview
Some scholars have argued that the growth of MNC activity has given rise to a
"race to the bottom" dynamic in government regulation. The world's governments
maintain different regulatory standards. Some enact stringent regulations
concerning how firms can treat workers, how they must handle their toxic waste
and other pollutants, and how they must conduct their other business activities.
Others maintain less stringent regulatory environments, allowing firms to engage in
activities that are illegal in other countries.
Many of these regulations affect production costs. It is more expensive, for
example, for a firm to treat chemical waste before it is disposed than simply to
dump the raw waste in a landfill. Hence, national regulations that require firms to
treat their chemical waste raise production costs. Consequently, even if all other
production costs in two countries are the same, different regulatory standards can
make it less costly to produce in the country with the lower standard.
MNCs might therefore engage in regulatory arbitrage.'That is, they might shift
their activities out of countries with stringent regulatory standards and into countries
with lax regulatory standards. Governments in high-standard countries wifi then
feel pressure to relax their standards in order to encourage firms to keep production
at home. As a consequence, national regulation will increasingly converge on the
regulatory practices of the least restrictive country. Governments that refuse to
engage in this competition for investment will be left behind, enjoying the*benefits of
strict regulations but suffering the cost of substantially less investment. How should
governments respond to the threat of this race to the bottom?
Policy Options
• Negotiate international rules that harmonize regulations throughout the worfd. ‘
Creating common regulations will prevent regulatory arbitrage and the race to ■
the bottom.
*
'
• Restrict foreign direct investment and the activities of MNCs. Such restrictions
would limit corporations' mobility, thus enabling governments to maintain
distinct national regulations.
Policy Analysis
• Is regulatory arbitrage necessarily a bad thing from the perspective of economic*
efficiency? Why or why not?
• How easy or difficult will it be for governments to reach agreement about
common regulatory standards? How should we weigh these costs?
(Continued)
200
CHAPTER 9
The Politics of Multinational Corporations
Take A Position
• Which option do you prefer? Justify your choice.
• What criticisms of your position should you anticipate? How would you defend
your recommendation against these criticisms?
Resources
(M'ne: Search for "Race to the Bottom" MNCs.This search will yield more
information than you can possibly digest, much of it highly critical of
globalization. Miles Kahler's paper, "Modeling Races to the Bottom/' surveys
many of the issues concerned.
In Print: David Vogel and Robert Kagan, eds., The Dynamics of Regulatory Change: How
Globalization Affects National Regulatory Policies (Berkeley: University of California Press,
2004); Daniel Drezner, "Bottom Feeders," Foreign Policy 121 (November/December
2000): 64-70; Debora Spar and David Yoffie, "Multinational Enterprises and the
Prospects for Justice," Journal of International Affairs 52 (Spring 1999): 557-581.
A lthough governm ents have spent alm o st 3 0 years n egotiatin g rules to
regulate foreign direct investm ent— within the U N , within the G A T T , and
within the O E C D —they have yet to agree on a regulatory fram ew ork. Conflict
between capital-exporting countries and capital-im porting countries over the
basic purpose o f such a regime is the prim ary reason for this lack o f success.
Governm ents have been unable to agree whether such rules should regulate
host countries or M N C s. The obvious com prom ise— that international rules
might usefully regulate both— has yet to materialize in a meaningful way.
CONCLUSION
The politics o f M N C s emerge from the com peting interests o f host countries,
home countries o f the M N C s, and the M N C s themselves. Each group has dis­
tinctive interests regarding FDI. M N C s w ant to operate freely across the globe,
with few governm ent-im posed restrictions on their activities. H o st countries
want to ensure that the M N C s operating within their borders provide benefits
to the local econom y that offset the loss o f decision-m aking authority that
is inherent in foreign ow nership. The home countries o f the M N C s w ant to
ensure that their firm s’ overseas investments are secure. The politics o f M N C s
emerge when these distinct interests come into conflict with each other.
As we have seen, alm ost all governm ents im pose som e restrictions on the
activities o f foreign firm s that operate inside their countries. M any govern­
ments, especially in the developing w orld, have tried to harness m ultinationals
to their development objectives, but even the advanced industrialized countries
have been unwilling to allow foreign firms to control critical sectors o f the n a­
tional econom y. Sim ilarities arise from the com m on concern ab ou t the local
im pact of foreign decision m aking. D ifferences arise from the fact that m ost
developing countries are only hosts to M N C activities, whereas the advanced
Suggestions for Further Reading
201
industrialized countries are both hosts and home bases. Consequently, devel­
oping countries’ concerns about foreign dom ination are not tempered by the
need to ensure that foreign governments respect the investments o f the devel­
oping countries’ own M N C s.
The basic conflict between capital-im porting and capital-exporting coun­
tries is evident also in the international politics o f M N C s. In the international
arena, politics have revolved around efforts to negotiate comprehensive rules
for international investm ent. Yet, conflict between the capital-exporting and
the capital-importing countries so has far prevented agreement on comprehen­
sive investment rules. A s we have seen, this conflict reflects a basic disagree­
ment about what the rules should regulate. Should international rules regulate
the ability o f host countries to control the M N C s that invest in their countries,
or should international rules regulate the range o f activities that M N C s are
allow ed to engage in? T he inability o f the advanced industrialized countries
and the developing countries to agree on an answer to this question, as well as
the apparent unwillingness of both groups to com prom ise, has prevented the
creation of comprehensive rules to regulate international investment.
KEY TERMS
Calvo Doctrine
Export-Processing Zones
Locational Incentives
Multilateral Agreement
on Investment
Obsolescing Bargain
Performance
Requirement
Trade-Related Investment
Measures
United Nations
Resolution on
Permanent Sovereignty
over Natural
Resources
SUGGESTIONS FOR FURTHER READING
For a detailed discussion of the obsolescing bargain model and an application of this
model to Chile, see Theodore H. Moran, Multinational Corporations and the Politics
o f Dependence: Copper in Chile (Princeton, NJ: Princeton University Press, 1974).
For a detailed description of the policies governments have used to regulate MNCs and
FDI in the postwar period, see A. E. Safarian, Multinational Enterprises and Pub­
lic Policy: A Study of Industrial Countries (Brookfield, VT: Edward Elgar, 1993).
For U.S. regulation of FDI, see Edward M. Graham and David M. Marchick, U.S.
National Security and Foreign Direct Investments (Washington, DC: Institute for
International Economics, 2006).
For an overview of international negotiations over investment rules prior to the MAI,
see Samuel K. B. Asante, “ United Nations Efforts at International Regulation of
Transnational Corporations,” in Legal Aspects o f the New International Economic
Order, ed. Kamal Hossain, 123-136 (London: Frances Pinter, 1980).
For a sophisticated response to many of the criticisms of M NC activities, see Edward
M. Graham, Fighting the Wrong Enemy: Antiglobal Activities and Multinational
Enterprises (Washington, DC: Institute for International Economics, 2000).
Chapter 10
The International
Monetary System
T
he sole pu rp ose o f the international m onetary system is to facilitate
international econom ic exchange. M o st countries have nation al cu r­
rencies that are not generally accepted as legal paym ent outside their
borders. You w ouldn’t get very far, for exam ple, if you tried to use dollars to
purchase a pint of ale in a London pub. If you want this pint, you have to first
exchange your dollars for British pounds. If you are an A m erican car dealer
trying to im port V olksw agens for your dealership, you will need to find som e
way to exchange your dollars for euros. If you are an American trying to purchase shares in a Japanese com pany, you will have to find som e w ay to acquire
Japanese yen. International transactions are possible only with an inexpensive
m eans o f exchanging one n ation al currency fo r another. The international
m onetary system ’s prim ary function is to provide this m echanism . When the
system functions sm oothly, international trade and investm ent can flourish;
when the system functions poorly, or when it collapses completely (as it did in
the early 1930s), international trade and investment grind to a halt.
The purpose o f the international m onetary system is simple, but the factors
that determine how it w orks are more com plex. For exam ple, how many d ol­
lars it costs an American tourist to buy a British pound, a euro, or 100 Japanese
yen (or any other foreign currency) is determined by the sum total o f the mil­
lions o f international transactions that Americans conduct with the rest o f the
world. M oreover, for these currency prices to remain stable from one month to
the next, the United States m ust som ehow ensure that the value o f the goods,
services, and financial assets that it buys from the rest o f the w orld equals
the value o f the products it sells to the rest o f the w orld. Any im balance will
cause the dollar to gain or lose value in terms o f foreign currencies. Although
these issues m ay seem rem ote, they m atter substan tially to your well-being.
For every time the d ollar loses value again st foreign currencies, you becom e
poorer; conversely, you become richer whenever the dollar gains value. This is
true whether you travel outside the United States or not.
T his chapter and the n ext develop a b asic un d erstan din g o f the inter­
n ation al m on etary system . T h is ch ap ter presen ts a few central econom ic
concepts and exam ines a bit o f p o stw ar exchange-rate history. C h apter 11
builds on this base while exam ining con tem porary international m onetary
202
x
J
The Economics of the International Monetary System
■
203
arrangements. In the current chapter, we explore one basic question: Why do
we live in a world in which currency values fluctuate substantially from week
to week, rather than in a w orld o f more stable currencies? The answer we pro­
pose is that the international m onetary system requires governments to choose
between currency stability and national economic autonom y. Given the need
to choose, the advanced industrialized countries have elected to allow their
currencies to fluctuate in order to retain national autonom y.
THE ECONOMICS OF THE INTERNATIONAL
MONETARY SYSTEM
We begin by exam in in g three econom ic concepts th at are cen tral to un­
derstanding the international m onetary system . We lo o k first at exchange
rates and exchange-rate system s. We then exam ine the balance o f paym ents
and conclude by lo okin g closely at the dynam ics o f balan ce-of-paym en ts
adjustment.
Exchange-Rate Systems
A
x
An exchange rate is the price o f one currency in term s o f another. As I write
this sentence, for exam ple, the dollar-yen exchange rate is 107 which m eans
that 1 d ollar w ill purchase 1 0 7 Jap an e se yen. A currency’s exchange rate
is determined by the interaction between the supply o f and the dem and for
currencies in the foreign exchange m arket— the m arket in which the w orld’s
currencies are traded. When an American business needs yen to pay for goods
im ported from Ja p a n , for exam ple, it goes to the foreign exchange m arket
and buys them. T h ou san d s o f such transactions undertaken by individuals,
businesses, and governm ents each day— som e lo okin g to buy yen and sell
dollars and others looking to sell yen and buy dollars— determ ine the price
o f the dollar in term s o f yen and the prices of all o f the w orld ’s currencies.
Imbalances between the supply o f and the dem and for currencies in the foreign
exchange market cause exchange rates to change. If m ore people want to buy
than sell yen, for exam ple, the yen will gain value, or appreciate. Conversely,
if more people want to sell than buy yen, the yen will lose value, or depreciate.
An exchange-rate system is a set of rules governing how much national
currencies can appreciate and depreciate in the foreign exchange m arket.
There are two prototypical system s: fixed exchange-rate systems and floating
exchange-rate system s. In a fixed exchange-rate system , governm ents establish a fixed price for their currencies in term s o f an external stan dard , such
as gold or another country’s currency. (Under p o st-W orld W ar II arran ge­
m ents, fo r exam ple, the U nited States fix ed the d ollar to go ld at $35 per
ounce.) The government then m aintains this fixed price by buying and selling
currencies in the foreign exchange m arket. In order to conduct these tran s­
action s, governm ents hold a stock o f other countries’ currencies as foreign
exchange reserves. T hus, if the d ollar is selling below its fixed price against
the yen in the foreign exchange m arket, the U .S. governm ent w ill sell yen
204
C H A P T E R 10
The International Monetary System
that it is holding in its foreign exchange reserves and w ill purchase dollars.
These transaction s will reduce the supply o f d ollars in the foreign exchange
m arket, causing the dollar’s value to rise. If the dollar is selling above its fixed
price against the yen, the U .S. governm ent will sell dollars and purchase yen.
These transactions increase the supply of dollars in the foreign exchange m ar­
ket, causing the d ollar’s value to fall. The yen the United States acquires then
become part o f its foreign exchange reserves. Such governm ent purchases and
sales o f currencies in the foreign exchange m arket are called foreign exchange
m arket intervention.
In a floating exchange-rate system, there are no limits on how much a cur­
rency can move in the foreign exchange m arket. In such system s, governments
do not m aintain a fixed price for their currencies again st gold or any other
standard. N o r do governments engage in foreign exchange m arket intervention
to influence the value o f their currencies. Instead, the value o f one currency in
term s o f another is determ ined entirely by the activities o f private actors—
firm s, financial institutions, and individuals— as they purchase and sell cu r­
rencies in the foreign exchange m arket. If private dem and for a particu lar
currency in the m arket falls, that currency depreciates. Conversely, if private
demand for a particular currency in the m arket increases, that currency appre­
ciates. In contrast to a fixed exchange-rate system , therefore, a pure floating
exchange-rate system calls for no government involvement in determining the
value o f one currency in term s o f another.
Fixed and floating exchange-rate systems represent the tw o ends o f a con­
tinuum . O ther exchange-rate system s lie between these tw o extrem es. In a
fixed-but-adjustable exchange-rate system — the system that lay at the center
o f the post-W orld W ar II m onetary system and the E uropean U nion (EU )’s
regional exchange-rate system between 1979 and 1999— currencies are given
a fixed exchange rate again st som e stan dard , and governm ents are required
to m aintain this exchange rate. H ow ever, governm ents can change the fixed
price occasionally, usually under a set o f well-defined circum stances. Other
systems lie closer to the floating exchange-rate end o f the continuum , but pro­
vide a bit m ore stability to exchange rates than a pure flo at. In a m anaged
float, which perhaps m ost accurately characterizes the current international
m onetary system , governm ents do not allow their currencies to flo at freely.
Instead, they intervene in the foreign exchange m arket to influence their cur­
rency’s value again st other currencies. H ow ever, there are usually no rules
governing when such intervention will occur, and governments do not com m it
themselves to m aintaining a specific fixed price against other currencies or an
external standard. Because all exchange-rate system s fall som ewhere between
the tw o extrem es, one can usefully distinguish between such system s on the
basis o f how much exchange-rate flexibility or rigidity they entail.
In the contem porary international m onetary system , governm ents m ain­
tain a variety o f exchange-rate arrangem ents. Som e governm ents allow their
currencies to float. O thers, such as m ost governm ents in the EU, have opted
for rigidly fixed exchange rates. Still others, particularly in the developing
w orld, m aintain fixed-but-adjustable exchange rates. H ow ever, the w o rld ’s
v
The Economics of the International Monetary System
205
m ost im portant currencies— the dollar, the yen, and the euro— are allow ed
to float again st each other, and the m onetary authorities in these countries
engage only in periodic intervention to influence their values. Consequently,
the contem porary international m onetary system is m ost often described as
a system o f floating exchange rates. We will exam ine the operation o f this
system in detail in Chapter 11.
Is one exchange-rate system inherently better than another? N o t nec­
essarily. R ather than rank system s as better or w orse, it is m ore useful to
recognize that all exch an ge-rate system s em body an im p o rtan t trad e -o ff
between exchange-rate stability on the one hand, and dom estic econom ic
autonom y on the other. Fixed exchange rates provide exchange-rate stability,
but they also prevent governm ents from using m onetary policy to m anage
dom estic econom ic activity. Floatin g exchange rates allow governm ents to
use m onetary policy to m anage the dom estic econom y but do not provide
much exchange-rate stability. Whether a fixed or a floating exchange rate is
better, therefore, depends a lot on the value governm ents attach to each side
o f this trade-off. Fixed exchange rates are better for governm ents that value
exchange-rate stability m ore than d om estic auton om y. F lo atin g exchange
rates are better for governm ents that value dom estic autonom y m ore than
exchange-rate stability.
The Balance of Payments
The balance of payments is an accounting device that records all international
transactions between a particular country and the rest of the world for a given
period. For instance, any tim e an A m erican business exp orts or im ports a
product, the value o f that transaction is recorded in the U .S. balance o f p ay ­
ments. Any time an American resident, business, or government loans funds to
a foreigner or borrow s funds from a foreign financial institution, the value o f
the transaction is recorded. All of the governm ent’s international transactions
also are recorded. When the U .S. governm ent spends money in Iraq support­
ing the military, or provides foreign aid to Egypt, these payments are recorded
in the balance o f payments. By recording all such transactions, the balance of
paym ents provides an aggregate picture o f the international transactions the
United States conducts in a given year.
Table 10.1 presents the U.S. balance of payments for 2007, the latest year
for which complete data are currently available. The transactions are divided
into two broad categories: the current account and the capital account. The
current account records all current (nonfinancial) transactions between Amer­
ican residents and the rest o f the w orld. These current transactions are divided
into four subcategories. The trade acco un t registers im ports and exports o f
goods, including m anufactured items and agricultural products. The service
account registers im ports and exports of service-sector activities, such as bank­
ing services, insurance, consulting, transportation, tourism , and construction.
The income account registers all payments into and out o f the United States in
connection with royalties, licensing fees, interest payments, and profits.
206
C H A P T E R 10
The International Monetary System
_____ 1
__________________________________________________ _________
w T A B L E 10.1
|
U.S. Balance of Payments, 2007 (Millions of U.S. Dollars)
Current Account
Trade in Goods
Imports
-1,967,853
1,148,481
Exports
Trade in Services
Net Military Transactions
Other Government
Net Travel and Transportation
Royalties and License Fees
Other Services, Net
-16,768
-2,972
2,181
57,566
79,108
Balance on Goods and Services
700,257
817,779
-736,030
Income Receipts
Income Payments
81,749
Balance on Income
Unilateral Transfers, Net
-114,548
Balance on Current Account
-733,056
Capital Account
Total U.S. Owned Assets Abroad
-1,289,854
U.S. Official Reserve Assets
Other U.S. Government Assets
U.S. Private Assets
-122
-22,273
-1,267,459
Foreign Owned Assets in the United States
2,057,703
Foreign Official Assets
Other Foreign Assets
411,058
1,646,645
Balance on Capital Account
Financial Derivatives, Net
Overall Balance (Statistical Discrepancy)
767,849
6496
41,289
N o te : l incorporated the transactions that the Bureau of Economic Analysis classifies as Capital
Account into unilateral transfers, as per prior balance of payments accounting methodology.
Source: Bureau of Economic Analysis, "U.S. International Transactions Data," h t t p j / w w w .b e a .g o v /
in te rn a tio n a l/x ls /ta b le l.x ls (accessed August 7, 2008).
Finally, the unilateral transfers accoun t registers all unilateral transfers
from the United States to other countries and vice versa. Am ong such transfers
are the w ages that im m igrants w orking in the United States send back to their
home countries, gifts, and foreign-aid expenditures by the U .S. governm ent.
In all fou r categories, paym ents by the United States to other countries are
recorded as debits, and paym ents from other countries to the United States
are recorded as credits. Debits are balanced against credits to produce an over­
all current-account balance. In 2 0 0 7 , the United States ran a current-account
deficit o f about $733 billion. In other w o rd s, to tal paym ents by Am erican
The Economics of the International Monetary System
207
residents to foreigners were $733 billion greater than foreigners’ total p ay ­
ments to American residents.
The capital account registers financial flow s between the United States
and the rest o f the world. Any time an American resident purchases a financial
asset— a foreign stock, a bond, or even a factory — in another country, this
expenditure is registered as a capital outflow . Each time a foreigner purchases
an American financial asset, the expenditure is registered as a capital inflow.
C a p ital ou tflow s are registered as n egative item s and cap ital inflow s are
registered as positive items in the cap ital account. In 2 0 0 7 , A m erican resi­
dents other than the U .S. government purchased about $1.2 trillion worth of
foreign financial assets, w hereas foreigners (including foreign governm ents)
purchased ab ou t $2 trillion o f A m erican fin an cial assets. C apital outflow s
are set against capital inflows to produce a capital-account balance. In 2 0 07,
the U.S. capital-account balance w as approxim ately $767.8 billion. T o calcu­
late the overall balance-of-payments position, sim ply add the current account
and the capital account together. In 2 0 0 7 , the United States ran an overall
balance-of-payments surplus of $41 billion.
The current and capital accounts m ust be m irror im ages o f each other.
T h at is, if a country has a current-account deficit, it m ust have a capitalaccount surplus. Conversely, if a country has a current-account surplus, it must
have a capital-account deficit. G raspin g w hy this relationship m ust exist is
easiest in the case o f a country with a current-account deficit. Having a currentaccount deficit means that the country’s total expenditures in a given year— all
o f the money spent on goods and services and on investments in factories and
houses— are larger than its total income in that year. The U .S. case is instruc­
tive. American consumers spent a combined total o f $9.7 trillion in 2007. The
U.S. government spent an additional $2 .7 trillion. American firms and house­
holds invested an additional $2.1 trillion. Altogether, these expenditures totaled
$14.5 trillion. Yet, Am erican residents earned only $13.8 trillion in total in­
come in 2 0 0 7 . The difference between w hat Am erican residents earned and
what they spent is thus equal to $700 billion. N ow look back at the “ Balance
on Current Account” in Table 10.1. It too is approxim ately $700 billion. (The
tw o w ould m atch exactly if we used exact, rather than rounded, num bers.)
H ence, the A m erican current-account deficit equ als the difference between
American income and American expenditures in a given year.
The United States w as able to spend m ore than it earned in incom e be­
cause the rest o f the world w as willing to lend to American residents. The U.S.
capital-account surplus thus reflects the willingness o f residents of other coun­
tries to finance Am erican expenditures in excess o f Am erican income. If the
rest of the w orld were unwilling to lend to A m erican borrow ers, the United
States could not spend m ore than it earned in incom e. T hus, a country can
have a current-account deficit only if it has a capital-account surplus.
The same logic applies to a country with a current-account surplus. Sup­
pose we divide the world into two countries: the United States and the rest of
the world. We know that the United States has a current-account deficit with
the rest o f the world and thus the rest o f the w orld has a current-account surplus
208
C H A P T E R 10
The International Monetary System
with the United States. If the United States can have a current-account deficit
only if the rest o f the world lends money to the United States, then the rest of
the world can have a current-account surplus with the United States only if it
lends money to American residents. If it doesn’t, Americans can’t buy as many
o f the rest of the w orld’s goods. The rest o f the w orld’s current-account surplus
(as well as the American current-account deficit) then will disappear. T hus, a
country with a current-account surplus m ust have a capital-account deficit. In
term s o f our income and expenditure fram ew ork, a current-account surplus
means that the country is spending less than it earns in income. The balance—
the country’s savings— is lent to countries with current-account deficits.
Balance-of-Payments Adjustment
Even though the current and capital accounts m ust balance each other, there
is no assurance that the m illions o f international tran saction s that individu­
als, businesses, and governm ents conduct every year will necessarily produce
this balance. When they don ’t, the country faces an im balance o f paym ents.
A country m ight have a current-account deficit that it can n ot fully finance
through capital im ports, for exam ple, or it might have a current-account sur­
plus that is not fully offset by capital outflow s. When an im balance arises, the
country m ust bring its paym ents back into balance. The process by which a
country does so is called balance-of-paym ents adjustm ent. Fixed and floating
exchange-rate systems adjust im balances in different ways.
In a fixed exchange-rate system , balance-of-paym ents adjustm ent occurs
through changes in dom estic prices. We can m ost readily understand this a d ­
justment process through a simple exam ple. Suppose there are only tw o coun­
tries in the w orld— the United States and Ja p a n — and su p p o se further that
they m aintain a fixed exchange rate according to which $1 equals 100 yen.
The United States has purchased 800 billion yen worth o f good s, services, and
financial assets from Jap an , and Jap an has purchased $4 billion o f items from
the United States. T hus, the United States has a deficit, and Ja p a n a surplus,
o f $4 billion.
A CLOSER LOOK
The Classical Gold Standard
Governments based their exchange rates on the gold standard prior to World
War I. In this system, governments exchanged national currency notes for gold
at a permanently fixed rate of exchange. Between 1834 and 1933, for example,
the U.S. government exchanged dollar notes for gold at the rate of $20.67 per
ounce. Because all national currencies were fixed to gold, all national currencies
were permanently fixed against each other as well. The gold standard emerged at
the center of the international monetary system during the 1870s. Great Britain
had adopted the gold standard in the early eighteenth century, but most other
The Economics of the International Monetary System
209
currencies remained based on silver or on a combination of silver and gold (a
"bimetallic" standard). During the 1870s, most European countries, as well as the
United States, abandoned silver as a monetary standard. Much of the rest of the
world followed during the 1880s and 1890s. This rapid shift to gold reflected what
economists call "network externalities"—the benefit of adopting gold grew in line
with the number of countries that had already adopted gold. This exchange-rate
stability facilitated the rapid growth of international trade and financial flows in
the late nineteenth century.
With exchange rates permanently fixed, prices in each country moved in response
to cross-border gold flows; prices rose as gold flowed into the country and fell
when gold flowed out. Cross-border gold flows were in turn driven by the relatively
autonomous operation of the "price specie-flow mechanism." The price specie-flow
mechanism worked in the following way. Suppose the United States experienced
a sudden acceleration of economic growth, With the U.S. money supply (its stock
of gold) fixed in the short run, the growth spurt would place downward pressure
on American prices (with more goods to buy with a fixed amount of money, the „ .
average price of goods must fall). As American prices fell, American exports would
rise and American imports would fall, thereby generating a balancerof-payrtients .
surplus. This payments surplus would pull goid into the United States from the
rest of the world. The resulting monetary expansion would push American ptfceS' .
back up to their initial level. The rest of the world would simultaneously experience
countervailing dynamics. It would develop a payments deficit as the necessary
counterpart to the American surplus. This deficit would generate a gold outflow— ’
the necessary counterpart to the American gold inflow— and this gold outflow wouid
push prices down in the rest of the world. The price specie-flow mechanism thus
imposed recurrent bouts of inflation and deflation on the societies linked by gold. .
Governments were not supposed to use their monetary policy to counter these
price movements. Instead, governments were supposed to follow the "rules, of
the game." These rules required countries losing gold as a result of an external;
deficit to raise the discount rate—the interest rate at which the central bank ,
loaned to other banks— to restrict domestic credit and slow domestic investment.
Tighter credit would reinforce the deflationary pressure caused by gold
outf lows. Countries accumulating gold as a consequence of an external surplus
were expected to lower the discount rate in order to expand credit and boost
investment. Lower interest rates would reinforce the inflationary pressure caused
by gold inflows. In essence, therefore, the rules of the game required central
banks to set monetary policy in response to developments in.their balance of
payments rather than in response to conditions in the domestic economy. In this
way, the gold standard forced governments to subordinate internal price stability
to external exchange rate stability.
The resulting instability of domestic prices was substantial. In the United,,
States, for example, domestic prices fell by 28 percent between 1869 and 1879, .
rose by 11 percent in the following 5 years, fell by an additional 25 percent 1
(Continued)
210
C H A P T E R 10
The International Monetary System
between 1884 and 1896, and then gradually rose through the next l5 years
(Rockoff 1990, 742). The coefficient of variation-provides a more systematic
measure of domestic price instability. This coefficient is the ratio of .the standard.
deviation of annual percentage change in domestic prices to the average annual
percentage change. Greater price instability generates a larger coefficiertt of'
variation. Between 1880 and 1913, the coefficient of Variation for,the:United
States was 17. In comparison, the coefficient for the post-WorJd War II era—a
period of greater exchange-rate flexibility was 0.8 (Bordo 2002), Thus, even
though the gold standard stabilized exchange rates, this external stabilitycame at
the price of substantial domestic price instability.
Domestic price instability provoked political conflict. One such episode occurred
in the United States in the late nineteenth century. Western grain farmers were
hit particularly hard by deflation during 1884-1896. Commodity prices fell more
rapidly than did the prices of the manufactured goods and services that farmers
purchased, thereby reducing farm purchasing power. In addition, most farmers
were in debt and falling commodity prices required them to dedicate more of
their income to debt service. The West responded by advocating the return to a
bimetallic monetary system. They argued that monetizing silver would expand the
money supply and raise commodity prices. The movement peaked in 1896 when the
pro-silver wing of the Democratic Party defeated the pro-gold wing at the party's
National Convention. This victory was symbolized by the nomination of William
Jennings Bryan, who had delivered a passionate speech to the convention in which
he avowed that farmers would not be "nailed to a cross of gold," as the party's
candidate for the 1896 presidential election. Bryan lost the presidential election to
the Republican William McKinley, and the silverites subsequently lost strength as
commodity prices rose and remained high until the end of World War I. ■
This payments im balance creates an im balance between the supply o f and
the dem and for the dollar and yen in the foreign exchange m arket. Am erican
residents need 800 billion yen to pay for their im ports from Jap an . They can
acquire this 800 billion yen by selling $8 billion. Jap an ese residents need only
$4 billion to pay for their im ports from the United States. They can acquire
the $4 billion by selling 4 0 0 billion yen. T hus, Am erican residents are selling
$4 billion m ore than Jap an ese residents w ant to buy, and the dollar depreci­
ates against the yen.
Because the exchange rate is fix e d , the U nited States and J a p a n m ust
prevent this depreciation. T hus, both governm ents intervene in the foreign
exchange m arket, buying dollars in exchange for yen. Intervention has tw o
consequences. First, it elim inates the im balance in the foreign exchange m ar­
ket as the governm ents provide the 4 0 0 billion yen that A m erican residents
need in exchange for the $4 billion that Japan ese residents do not want. With
the supply of each currency equal to the dem and in the foreign exchange m ar­
ket, the fixed exchange rate is sustained. Second, intervention changes each
country’s money supply. The American money supply falls by $4 billion, and
Jap an ’s money supply increases by 400 billion yen.
The Economics of the International Monetary System
^
A
211
The change in the money supplies alters prices in both countries. The reduc­
tion of the U.S. money supply causes American prices to fall. The expansion of
the money supply in Jap an causes Jap an ese prices to rise. As Am erican prices
fall and Japanese prices rise, American goods become relatively less expensive
than Japanese goods. Consequently, American and Japanese residents shift their
purchases away from Japanese products and toward American goods. American
im ports (and hence Jap an ese exports) fall, and Am erican exports (and hence
Japan ese im ports) rise. As Am erican im ports (and Japanese exports) fall and
American exports (and Japanese imports) rise, the payments imbalance is elimi­
nated. Adjustment under fixed exchange rates thus occurs through changes in
the relative price of American and Japanese goods brought about by the changes
in money supplies caused by intervention in the foreign exchange market.
In floating exchange-rate system s, balance-of-paym ents adjustm ent oc­
curs through exchange-rate movements. Let’s go back to our U .S .-Ja p a n sce­
nario, keeping everything the sam e, except this time allowing the currencies to
float rather than requiring the governments to maintain a fixed exchange rate.
Again, the $4 billion paym ents im balance generates an im balance in the for­
eign exchange market: Americans are selling more dollars than Jap an ese resi­
dents w ant to buy. Consequently, the dollar begins to depreciate again st the
yen. Because the currencies are floating, however, neither governm ent intervenes in the foreign exchange m arket. Instead, the dollar depreciates until the
m arket clears. In essence, as Americans seek the yen they need, they are forced
to accept fewer yen for each dollar. Eventually, however, they will acquire all
o f the yen they need, but will have paid more than $4 billion for them.
The d ollar’s depreciation lowers the price in yen o f Am erican g o o d s and
services in the Jap an e se m arket and raises the price in d ollars o f Jap an e se
good s and services in the Am erican m arket. A 10 percent devaluation o f the
dollar against the yen, for exam ple, reduces the price that Jap an ese residents
pay for American goods by 10 percent and raises the price that Am ericans pay
for Japanese goods by 10 percent. By m aking American products cheaper and
Jap an ese good s more expensive, depreciation causes Am erican im ports from
Ja p a n to fall and A m erican exp orts to Ja p a n to rise. As A m erican exp orts
expand and imports fall, the payments imbalance is corrected.
In both system s, therefore, a balan ce-of-paym en ts ad ju stm en t occurs
as prices fall in the country with the deficit and rise in the country w ith the
su rp lu s. C o n su m ers in both coun tries resp o n d to these price ch an ges by
purchasing fewer of the now -m ore-expensive go od s in the country with the
surplus and m ore o f the now -cheaper go od s in the country with the deficit.
These shifts in consum ption alter im ports and exports in both countries, m ov­
ing each o f their paym ents back into balan ce. The m echanism th at causes
these price changes is different in each system , however. In fixed exchangerate systems, the exchange rate rem ains stable and price changes are achieved
by changing the money supply in order to alter prices inside the country. In
floating exchange-rate systems, internal prices remain stable, while the change
in relative prices is brought about through exchange-rate movements.
Contrasting the balance o f paym ents adjustm ent process under fixed and
floating exchange rates highlights the trade o ff that governments face between
212
C H A P T E R 10
The International Monetary System
exchange rate stability and dom estic price stability: G overnm ents can have
a stable fixed exchange rate or they can stabilize dom estic prices, but they
cannot achieve both goals sim ultaneously. If a government w ants to m aintain
a fixed exchange rate, it m ust accept the o ccasio n al deflation and inflation
caused by balance-of-paym ents adjustm ent. If a governm ent is unw illing to
accept such price m ovem ents, it cannot m aintain a fixed exchange rate. This
trade-off has been the central factor driving the international m onetary system
tow ard floatin g exchange rates during the last 100 years. We turn now to
exam ine how this trad e-off first led governm ents to create innovative inter­
national monetary arrangem ents follow ing W orld W ar II and then caused the
system to collapse into a floating exchange-rate system in the early 1970s.
THE RISE AND FALL OF THE BRETTON
WOODS SYSTEM
The Bretton W oods system represents both a first and a last in the history o f
the international m onetary system . O n the one hand, Bretton W oods repre­
sented the first time that governments explicitly m ade exchange rates a m atter
o f international cooperation. D raw ing lessons from their experiences during
the interw ar period, governm ents attem pted to create an innovative system
that w ould enable them to enjoy exchange-rate stability and dom estic eco­
nom ic autonom y. On the other hand, the Bretton W oods system represents
the final effort, at least to date, to base the international m onetary system on
som e form o f fixed exchange rates. The effort w as relatively short-lived. The
system w as not fully im plem ented until 1 9 5 9 , and by the early 1 960s it w as
beginning to experience the stresses and strains that brought about its collapse
into a system o f floating exchange rates in the early 1970s.
Creating the Bretton Woods System
American and British policym akers began planning for postw ar m onetary ar­
rangem ents in the early 1940s. H arry D exter W hite, an econom ist w orking
at the U .S. T reasury, developed an Am erican plan, and Jo h n M . Keynes, an
econom ist who w as advising the British T reasu ry, developed a British plan.
Bilateral con su ltation s yielded a join t U .S.-B ritish plan th at w as published
in 1943. T his “Jo in t Statem ent,” as the plan w as called, served as the basis
for the A rticles o f A greem ent that em erged from a m ultilateral conference
attended by 44 countries in Bretton W oods, N ew H am psh ire, in 1944. The
international m onetary system they built, the Bretton W oods system, provided
an exp licit code o f co n d u ct fo r in tern atio n al m o n etary relatio n s an d an
institutional structure centered on the International M onetary Fund (IM F).
The Bretton W oods system attem pted to establish a system o f fixed ex ­
change rates in a w orld in which governm ents were unw illing to accept the
loss o f dom estic auton om y that such a system required. G overnm ents had
become increasingly reluctant to accept the dom estic adjustm ents im posed by
fixed exchange rates as a result o f a shift in the balance o f p o litical pow er
The Rise and Fall of the Bretton Woods System
A
213
within European political systems follow ing W orld W ar I. We will explore
these developments in greater detail in Chapter 12. For now, we note only that
the grow ing strength o f labor unions ensured that deficit adjustm ent w ould
occur through falling output and rising unem ploym ent, while the emergence
of m ass-based dem ocracies made governments reluctant to accept these costs.
The emergence of political constraints on dom estic adjustm ent ruled out
a return to rigidly fixed exchange rates following W orld W ar II. Yet, floating
exchange rates were viewed as no more acceptable. It w as widely agreed that
the experiment with floating exchange rates in the 1930s had been disastrous.
As an influential study published by the League o f N ation s in 1944 sum m a­
rized, “ If there is anything that the interw ar experience has dem onstrated,
it is that [currencies] cannot be left free to fluctuate from day to day under
the influence o f m arket supply and d em an d” (quoted in D am 19 8 2 , 61). In
creating the Bretton W oods system, therefore, governm ents sought a system
that would provide stable exchange rates an d sim ultaneously afford domestic
economic autonomy. T o achieve these goals, the Bretton W oods system intro­
duced four innovations: greater exchange-rate flexibility, capital controls, a
stabilization fund, and the IM F.
First, Bretton W oods explicitly in corporated flexibility by establishin g
fixed-but-adjustable exchange rates. In this arrangem ent, each government established a central parity for its currency against gold, but could change this
price of gold when facing a fundam ental disequilibrium . A lthough govern­
ments were never able to define this term precisely, it w as generally accepted
that it referred to paym ents im balances large enough to require inordinately
painful domestic adjustm ent. In such cases, a governm ent could devalue its
currency. E xchange rates w ould thus be fixed on a d ay-to-day b a sis, but
governments could change the exchange rate when they needed to correct a
large imbalance. It w as hoped that this element o f flexibility w ould reduce the
need for domestic adjustm ent but still provide stable exchange rates.
Governments also were allow ed to lim it international capital flow s. An
important component o f the international economy, capital flows allow coun­
tries to finance current-account imbalances and to use foreign funds to finance
productive investm ent. M any governm ents believed, how ever, that capital
flow s had d estab ilized exchange rates d urin g the interw ar p eriod . L arge
volumes of capital had crossed borders, only to be brought back to the home
country at the first sign o f economic difficulty in the host country. This system
resulted in “ disequilibrating” capital flow s in which countries with currentaccount deficits shipped capital to countries with current-account surpluses,
rather than “ equilibrating” flows in which countries with surpluses exported
capital to countries with deficits in order to finance current-account deficits.
The resulting payments deficits required substantial domestic adjustm ents that
governments were unwilling to accept.
In the early 1 9 3 0 s, m ost governm ents began to limit capital flow s with
exchange restrictions— government regulations on the use o f foreign exchange.
In the m ost restrictive regim es, the central bank establishes a m onopoly on
foreign exchange. Any private actor w anting foreign currency or w anting
214
C H A P T E R 10
The International Monetary System
to exchange foreign currency into the dom estic currency m ust petition the
central bank, which can then restrict the types o f tran saction s for w hich it
exchanges currencies. It might, for exam ple, refuse to supply foreign currency
to a dom estic resident who w ants to buy financial assets in a foreign coun ­
try. A lternatively, it m ight refuse to supply dom estic currency to a foreign
resident who w ants to buy dom estic financial assets. By controlling purchases
and sales o f foreign exchange in this m anner, governm ents can limit financial
capital flows into and out o f their dom estic economies.
Following W orld W ar II, the question w as whether governments should be
allowed to retain these exchange restrictions. American policymakers wanted all
restrictions eliminated in order to restore liberal international capital m arkets.
Other governments wanted to retain the restrictions. Keynes, for exam ple, be­
lieved that it was “ vital” to “ have a means . . . o f controlling short-term specu­
lative movements o f flights o f currency” (cited in D am 1982, 98). In the absence
of such controls, Keynes argued, exchange rates would be vulnerable to specu­
lative attacks that w ould force governments to float their currencies. Keynes’s
position carried the day. The IM F’s Articles o f Agreement required governments
to allow residents to convert the dom estic currency into foreign currencies to
settle current-account transactions, but they allowed (but did not require) gov­
ernments to restrict the convertibility o f their currency for capital-account trans­
actions. M ost governments took advantage o f this right, and as a consequence,
international capital flows were tightly restricted until the late 1970s.
The Bretton W oods system also created a stab ilizatio n fund— a credit
m echanism consisting o f a po o l o f currencies contributed by m em ber coun ­
tries. Each country that participated in the Bretton W oods system w as assigned
a share o f the total fund (called a quota), the size o f which corresponded to
its relative size in the global econom y. Each country then contributed to the
fund in the am ount o f its quota, paying 25 percent in gold and the rem aining
75 percent in its national currency. A s the w orld’s largest econom y, the United
States had the largest quota, a contribution o f $2 .7 5 billion. Britain had the
second-largest quota, a contribution o f $1.3 billion. O ther governm ents had
much smaller quotas; France, for exam ple, had a quota o f only $450 million,
whereas Panam a’s w as only $0.5 million. In 1944, the stabilization fund held
a total o f $8.8 billion. A government could draw on the fund when it faced a
balance-of-paym ents deficit. D oin g so w ould obviate the need to respond to
a small paym ents deficit by devaluing currency or by im posing barriers to im ­
ports (De Vries and H orsefield 1969, 2 3 -2 4 ).
Finally, the Bretton W oods system created an international organization,
the IM F, to m onitor member countries’ m acroeconom ic policies and balanceof-paym ents p o sition s, to decide when devaluation w as w arran ted , and to
m anage the stabilization fund. The IM F w as intended to lim it tw o kinds o f
opportunistic behavior. First, the exchange-rate system created the potential
for competitive devaluations. Governments could devalue to enhance the com ­
petitiveness o f their exports. If one government devalued in an attem pt to boost
exports, other governments would be likely to devalue in response, setting o ff
a tit-for-tat dynamic that would destroy the exchange-rate system (D am 1982,
The Rise and Fall of the Bretton Woods System
215
63-64). Second, governm ents might abuse the stabilization fund. Easy access
to this fund might encourage governments to run large balance-of-paym ents
deficits. Countries could im port more than they exported and then draw on the
stabilization fund to finance the resulting deficit. If all governm ents pursued
such policies, the stabilization fund would be quickly exhausted, and countries
would face large deficits that they could not finance. Countries w ould then
float their currencies and perhaps restrict imports as well.
The IM F limited such opportunistic behavior by having authority over
exchange-rate changes and access to the stabilization fund. For exchange-rate
changes, the Articles o f Agreem ent specified that governm ents could devalue
or revalue only after consulting the IM F, which w ould then evaluate the coun­
try’s paym ents position and either agree or disagree with the governm ent’s
claim that it faced a fun dam en tal d isequilibrium . If the IM F o p p o sed the
devaluation, the governm ent could still devalue, but it w ould not be allow ed
to draw from the stabilization fund (Dam 1982, 90). The IM F also controlled
access to the fund. IM F rules limited the total am ount that a government could
borrow to 25 percent o f its quota per year, up to a m axim um o f 200 percent
of its quota at any one time. It w as agreed, however, that governments w ould
not have autom atic access to these funds. Each member governm ent’s quota
w as divided into four credit tranches o f equal size, and draw ings from each
tranche required approval by the IM F’s Executive Board. A pproval for draw ­
ings on the first tranche w as autom atic, as these w ith d raw als represented
borrow ings again st the gold that each member h ad paid into the stab iliza­
tion fund. D raw ing on the higher credit tranches, however, w as conditional.
Conditionality required a mem ber governm ent to reach agreem ent with the
IM F on the m easures it w ould take to correct its balance-of-paym ents deficit
before it could draw on its higher credit tranches. Conditionality agreements
typically require governm ents to reduce the grow th o f the m oney supply
and to reduce governm ent spending. Conditionality thus forces governm ents
to correct the dom estic econom ic im balances th at cause their balan ce-ofpayments problem s. The practice o f IM F conditionality is controversial, and
we will return to it in greater detail in Chapter 14.
Implementing Bretton Woods: From Dollar Shortage to Dollar Glut
Governm ents had intended to implement the Bretton W oods system im m e­
diately follow ing the Second W orld W ar. T his proved im possible, however,
because E uropean governm ents held such sm all foreign exchange reserves
(dollars and gold) that they were unwilling to m ake their dom estic currencies
freely convertible into foreign currencies. G overnm ents needed to conserve
w hat little foreign exchange they had to im port fo o d , capital good s, inputs,
and many o f the other critical com ponents essential to econom ic reconstruc­
tion. Allowing residents to convert the dom estic currency freely into dollars
or gold, as the rules o f Bretton W oods required, w ould produce a run on a
country’s limited foreign exchange reserves. Governments w ould then have to
reduce imports and slow the pace of economic reconstruction.
216
C H A P T E R 10
The International Monetary System
An aborted British attem pt to restore the convertibility o f the poun d in
1947 starkly illustrated the threat (Eichengreen 19 9 6 , 103). U nder pressure
from the United States, and with the support o f a $3.75 billion Am erican loan,
the British government allowed holders o f the British pound to purchase gold
and dollars for current-account transactions. T hose who held pounds rushed
to exchange them for dollars and, in doing so, consum ed the Am erican loan
and a large share o f B ritain ’s other foreign exch an ge reserves in only six
weeks. As its reserves dw indled, the British governm ent suspended the con ­
vertibility o f the pound. Convertibility— and indeed the im plementation o f the
Bretton W oods system— w ould have to w ait until European governments had
accumulated sufficient foreign exchange reserves.
In o rd er fo r E u ro p ean govern m en ts to accu m u late foreign exch an ge
reserves, how ever, d o llars had to be tran sferred from the U nited States to
E uropean governm ents. T he U .S. balance-of-paym ents deficit provided the
m echanism th rou gh w hich this tran sfer w as ach ieved . (See Figure 1 0 .1 .)
Initially, the United States exported dollars through its foreign aid and military
expenditures. The M arsh all Plan, implemented between 1948 and 1952, is the
m ost prom inent exam ple o f this A m erican policy. By the late 1 9 5 0 s, h ow ­
ever, private capital also w as flow ing from the United States to Europe (Block
1977). American deficits m eant that m ore dollars flow ed out from the United
States each year than flowed in. These dollars were accum ulated by European
governm ents, which held them as foreign exchange reserves and used them
to pay for im ports from the United States and other countries. Governm ents
FIGURE 10.1
U.S. Balance of Payments, 1950-1974
Source:
Block 1977.
x
The Rise and Fall of the Bretton Woods System
*
217
could exchange whatever dollars they held into gold at the official price o f
$35 an ounce. By 1959, this m echanism had enabled European governm ents
to accumulate sufficient d ollar and gold reserves to accept fully convertible
currencies. In 1959, therefore, the Bretton W oods system w as finally im ple­
mented, alm ost 15 years after it had been created.
American policy during the 1950s also had an unintended consequence:
The dollar became the system ’s prim ary reserve asset. In this role, the dollar
became the currency that other governments held as foreign exchange reserves
and used to make their international payments and to intervene in foreign ex­
change markets. This w as reasonable: The United States w as the largest econ­
omy in the world, and at the end o f the Second W orld W ar the United States
held between 60 and 70 percent o f the w orld’s gold supply. The d ollar w as
fixed to gold at $35 per ounce, and other governm ents were w illing to hold
dollars because dollars were “ as good as g o ld .” As a consequence, however,
the stability of the Bretton W oods system came to depend upon the ability of
the U.S. government to exchange dollars for gold at $35 an ounce.
The American ability to fulfill this commitment began to diminish as the
postwar dollar shortage w as transform ed into a dollar glut during the 1960s.
The dollar glut w as the natural consequence of continued American balanceof-payments deficits. Between 1958 and 19 7 0 , the United States ran average
annual payments deficits of $3.3 billion. These deficits remained fairly stable
during the first half of the 1960s, but then began to grow after 1965. Deficits
were caused by U.S. military expenditures in connection with the Vietnam War
and expanded welfare program s at home, as well as by the unwillingness o f the
Johnson and N ixon administrations to finance these expenditures with higher
taxes. The result was an expan sionary m acroeconom ic policy in the United
States that sucked in imports and encouraged American investors to send capital
abroad. The dollars accumulated by governments in the rest of the world as the
result represented foreign claims on the American government’s gold holdings.
The rising volume of foreign claims on American gold led to dollar overhang:
Foreign claims on American gold grew larger than the amount o f gold that the
U.S. government held. The progression of dollar overhang can be seen in the evo­
lution of foreign dollar holdings and the U.S. gold stock during the 1950s and
1960s. In 1948, foreigners held a total o f $7.3 billion against U.S. gold holdings
of $24.8 billion. In this period, therefore, there was no uncertainty regarding the
American ability to redeem all outstanding foreign claims on U.S. gold. By 1959,
foreign dollar holdings had increased to $19.4 billion, but U.S. gold holdings had
fallen to $19.5 billion. By 1970, American gold holdings had fallen to $11 billion,
while foreign claims against this gold had risen to $47 billion. Thus, persistent
balance-of-payments deficits reduced the ability of the United States to meet for­
eign claims on American gold reserves at the official price of $35 an ounce.
D ollar overhang threatened the stability o f the Bretton W oods system (see
Triffin 1960). As long as the d ollar rem ained the system ’s prim ary reserve
asset, the grow th o f dollars circulating in the global econom y w ould have to
keep pace with the expansion o f world trade. This meant that dollar overhang
w ould w orsen. Yet, as that happened, people w ould lose confidence in the
218
C H A P T E R 10
The International Monetary System
ability o f the A m erican governm ent to exchange d ollars for gold at $35 an
ounce. Once this confidence evaporated, anyone who held dollars w ould rush
to sell them before the d ollar w as devalued or A m erican gold reserves were
exhausted. Declining confidence in the dollar, in other w ords, w ould encour­
age foreign dollar holders to bet again st the d ollar’s fixed exchange rate with
gold. Eventually, this dynam ic w ould generate crises that w ould undermine
the system.
Preventing these crises w as co m plicated by the d o lla r’s central role in
the system. The United States w ould have to reverse its balance-of-paym ents
position to eliminate dollar overhang. R ather than run deficits that pum ped
dollars into the international econom y, the United States w ould have to run
surpluses that pulled d ollars back in. Y et, because the d o llar served as the
system ’s prim ary reserve asset, reducing the num ber o f dollars circulating in
the glo b al econom y w ould reduce the liquidity th at financed w orld trade.
As governm ents defended their fixed exchange rates in the face o f this con ­
traction of liquidity, the w orld econom y could be pushed into a deflationary
spiral (Eichengreen 1996, 116). The Bretton W oods system therefore faced a
dilemma: D ollar overhang would eventually trigger crises that undermined the
system o f fixed exchange rates, but m easures to strengthen the d ollar could
trigger global deflation that might also destroy the system.
This liquidity problem , as it came to be called, w as not simply an obscure
technical matter. It w as also a source o f political conflict, particularly between
France and the United States. The French argued that the United States gained
considerable advantages from the dollar’s role as the system ’s prim ary reserve
asset. N o other country could run persistent balance-of-paym ents deficits, be­
cause it would eventually run out of foreign exchange reserves and be forced to
eliminate the deficit. But the United States did not face this reserve constraint:
It could run deficits as long as other governm ents were willing to accum ulate
dollars. The French claimed that this asymmetry enabled the United States to
pursue an “ imperialistic” policy. In the economic arena, the United States could
buy French companies, and in the geostrategic arena, the United States could ex­
pand its activities with few constraints, as it w as doing in Vietnam (Dam 1982,
144). The French government decried this “ exorbitant privilege” and advocated
the creation o f an alternative reserve asset to provide international liquidity.
The French even advocated a return to the gold standard to eliminate the ben­
efits the United States realized from the d ollar’s role in the system. E fforts to
solve the liquidity problem , therefore, became inextricably linked to American
power in the international monetary system and in the wider global arena.
Governments did respond to the liquidity problem , creating a new reserve
asset to supplement the dollar. W orking in conjunction with the IM F, govern­
ments created the Special D raw ing R ight (SD R ), a reserve asset m anaged by
the IM F and allocated to m em ber governm ents in p ro portio n to the size o f
their quotas. The SD R is not backed by gold or any other stan d ard , cannot
be used by private individuals, and is not traded in private financial m arkets.
Its sole purpose is to provide a source o f liquidity that governm ents can use
to settle debts with each other arising from balance-of-paym ents deficits. The
intention w as that SD R s w ould supplem ent dollars as a source o f liquidity in
The Rise and Fall of the Bretton Woods System
219
the international m onetary system. The first allocation of SD R s occurred in
1970. By this time, however, the Bretton W oods system w as m oving tow ard
its ultimate demise, and the SD R never played an im portant role.
The End of Bretton Woods: Crises and Collapse
The continued viability o f the Bretton W oods system depended upon restoring
confidence in the d ollar, and this in turn required elim inating the underly­
ing payments im balances. Adjustment could be achieved through one o f three
paths: devalue the dollar against gold, restrain economic activity in the United
States in order to reduce Am erican im ports, or expan d econom ic activity in
the rest o f the w orld in order to increase A m erican exports. G overnm ents
proved unwilling to adopt any o f these measures. Instead, they were paralyzed
by political conflict over who should bear the costs o f the adjustm ents neces­
sary to eliminate the im balances that were weakening the system.
The sim plest solution would have been to devalue the dollar against gold.
D evaluation w as not easily achieved, how ever. Am erican policym akers be­
lieved that they could not change the d o llar’s exchange rate unilaterally. If
they devalued again st gold, Europe and Ja p a n w ould sim ply devalue in re­
sponse. As a consequence, the only w ay to devalue the dollar w as to convince
European and Jap an ese governm ents to revalue their currencies. Europe and
Jap an were unwilling to revalue their currencies again st the dollar, however,
because doing so w ould rem ove any pressure on the United States to under­
take adjustm ent m easures o f its own (Solom on 1 9 77, 170). R evaluation, in
other w ords, w ould let the United States off the hook.
With currency realignm ent o ff the table, only tw o other solution s were
left: adjustm ent through economic contraction in the United States or adju st­
ment through econom ic expan sion in other countries. In the United States,
neither the Jo h n so n nor the N ix o n adm in istration w as willing to ad o p t the
policies required to eliminate the U .S. balance-of-paym ents deficit. U .S. Sec­
retary o f the T reasu ry H enry Fow ler spelled out the tw o Am erican options
in a memo to President John son in m id-1966. The United States could either
“ reduce the deficit by cutting back U.S. commitments overseas,” a choice that
would entail “ m ajor changes in [U.S.] foreign policy,” or “ reduce the deficit
by introducing new econom ic and balance o f paym ents m easures at h om e”
(U nited States D epartm en t o f State). N eith er o p tio n w as attractiv e. The
John son adm inistration w as not willing to allow the balance o f paym ents to
constrain its foreign-policy goals, and restricting dom estic economic activity
to correct the deficit w as politically inconvenient.
R ichard M . N ix o n , who assum ed the presidency in 1969, w as no more
w illing to a d o p t p o licie s to elim inate the A m erican deficit. In stead , the
N ixon adm inistration blam ed other governm ents for international m onetary
problem s (D am 19 8 2 , 186). T he d o llar’s w eakness w as not a result o f the
American balance-of-payments deficit, the adm inistration claimed, but w as in­
stead caused by surpluses in Germ any and Jap an . Because other governments
were at fault, the adm inistration began to push these other governm ents to
change policies, acting “ like a bull in a china sh o p,” threatening to wreck the
220
C H A P T E R 10
The International Monetary System
international trade and financial system unless other governm ents supported
the dollar in the foreign exchange m arket and took m easures to stim ulate im ­
ports from the United States (Eichengreen 1996, 130).
Governm ents in W estern E urope and Ja p a n initially supported the d o l­
lar, in large part “ because [the dollar] w as the linchpin o f the Bretton W oods
system and because there w as no consensus on how that system m ight be re­
form ed or replaced ” (Eichengreen 1996, 130). But there were clear lim its to
their w illingness to continue to do so. The case o f G erm any illustrates both
sides. Germany had done more to support the dollar than any other European
government. The Germ an government had agreed not to exchange the dollars
it w as accum ulating for Am erican gold, in stark con trast to the French, who
regularly dem anded gold from the United States for the dollars they acquired.
In addition, G erm any had negotiated a series o f “ o ffset pay m en ts” through
which a portion o f A m erican m ilitary expenditures in G erm any were offset
by G erm an expenditures on A m erican m ilitary equipm ent. Such paym ents
reduced the exten t to w hich A m erican m ilitary e x p e n d itu re s in E u ro p e
contributed to the U .S. balance-of-payments deficit.
Germ any’s willingness to support the dollar, however, w as limited by that
country’s aversion to inflation. Germ any had experienced hyperinflation dur­
ing the 1 9 2 0 s, with prices rising at the rate o f 1 ,0 0 0 percent per m onth in
1923. This experience had caused G erm an officials and the G erm an public to
place great value on price stability (see Emminger 1977; Henning 1994). Sup­
porting the dollar threatened to increase G erm an inflation. A s confidence in
the dollar began to erode, dollar holders began to sell dollars and buy German
m arks. Intervention in the foreign exchange m arket to prevent the m ark from
appreciating expanded the G erm an money supply and created inflation in the
country, which then m ade Germany reluctant to support the dollar indefinitely.
Continued German support w ould be based on clear evidence that the United
States w as adopting domestic policies that were reducing its paym ents deficit.
Governments, therefore, were unwilling to accept the dom estic econom ic
costs arising from the adjustm ents needed to correct the fundamental source of
weakness in the system. A s a consequence, the United States continued to ex ­
port dollars into the system, dollar overhang worsened further, and confidence
in the d ollar’s fixed exchange rate eroded. As confidence eroded, speculative
attacks— large currency sales sp ark ed by the an ticipation o f an im pending
devaluation— began to occur with increasing frequency and m ounting ferocity.
In the first six m onths o f 1971, private holdings o f dollars fell by $3 billion,
a sign that people expected devaluation (D am 1982, 187). European govern­
ments purchased m ore than $5 billion defending the d o llar’s fixed exchange
rate. The speculative attacks reached a new high in M ay as Germ any purchased
$2 billion in only two days, a record am ount at that time (Kenen 1994, 500).
Such massive intervention breached the limits o f German willingness to support
the dollar, and the German government floated the m ark.
Speculative attacks resum ed in the sum m er o f 19 7 1 , and in A ugu st the
N ixon adm inistration suspended the convertibility o f the dollar into gold and
im posed a 10 percent surcharge on im ports (see G ow a 1 9 8 3 ). The U nited
The Rise and Fall of the Bretton Woods System
221
States had abandoned the central com ponent of the Bretton W oods system; it
would no longer redeem foreign governm ents’ dollar reserves for gold.
Governments made one final attem pt to rescue the Bretton W oods sys­
tem. During the fall of 1971, they negotiated a currency realignment that they
hoped would reduce the U.S. payments deficit and stabilize the system. The re­
alignment w as finalized in a December meeting held at the Sm ithsonian Insti­
tution in Washington, DC. The dollar w as devalued by 8 percent against gold,
its value falling from $35 per ounce to $38 per ounce. E uropean currencies
were revalued by about 2 percent, thus producing a total devaluation o f the
dollar of 10 percent. In addition, the m argins of fluctuation in the exchangerate system were widened from 1 percent to 2.25 percent, to give the system a
bit more exchange-rate flexibility.
A lthough N ix o n hailed the Sm ith so n ian realign m en t a s “ the g re a t­
est m onetary agreem ent in the history o f the w o rld ,” it solved neither the
economic im balances nor the political conflicts that w ere the cause o f the
system ’s weakening. The United States refused to ad o p t m easures to reduce
its payments deficit. Rather than tighten m onetary policy to support the new
exchange rate, the N ixon adm inistration loosened m onetary policy, “ trigger­
ing the greatest m onetary expan sion in the postw ar e r a ” (Em m inger 1977,
33). German officials remained unwilling to accept the inflation that w as the
necessary consequence of intervention to support the m ark against the dollar.
With neither government willing to adjust to support the new exchange rates,
speculative attacks quickly reemerged. A m assive crisis in the first m onths o f
1973 brought the system dow n, as m ost advanced industrialized countries
abandoned their fixed exchange rates and floated their currencies.
POLICY A N A LY S IS AND D EBATE
Who Should Adjust?
Question
Who should adjust in order to eliminate payments imbalances?
- .. -
-.»■ . ,.
Overview
The payments imbalances at the center of the Bretton Woods system gerierated a
distributive conflict about who should bear the cost of adjustment. The United States
ran a large deficit, whereas Europe and Japan ran large surpluses. The elimination
of either of these imbalances would necessarily eliminate the other. The situation
gave rise to the dispute concerning who should alter its policies in order to adjust.
Should the United States restrict its monetary and fiscal policies to shrink its deficit,
or should Europe and Japan expand their monetary and fiscal policies to reduce
their surpluses? The inability of governments to agree on how to distribute these
adjustment costs eventually brought the Bretton Woods system down.
(Continued)
222
C H A P T E R 10
The International Monetary System
Distributive conflict over the costs ofadjusting the balance of payments is o f,
more than historical interest. The contemporary global economy has large currentaccount imbalances quite similar to those at the center of the Bretton Woods
system. The United States runs large current-account deficits. Asian countries,
most of which peg their currencies to the dollar, run large current-account
surpluses. Asian surpluses finance American deficits. Rather than accumulating
claims to American gold, however, as European governments did under Bretton
Woods, Asia accumulates U.S. Treasury bills, which represent a claim on future
American income.
v
Distributive conflict over the costs of adjustment has arisen during the last few
years as current-account imbalances have expanded. Since 2000 or so, the United
States has been pressuring China (one of the largest countries with a surplus) to
devalue its currency. China has resisted such pressure thus far. Given the current
size of the American deficit, one can imagine that the United States will pressure
other Asian countries to adjust as well. Thus, the conflict over who adjusts shapes
contemporary international monetary relations, just as it shaped monetary
politics in the Bretton Woods system. Who should alter policies to eliminate large
payments imbalances?
Policy Options
• The United States should implement the domestic policy changes required to
reduce the size of its current-account deficit.
• The United States should pressure Asia to implement the domestic policies
required to reduce the size of their current-account surpluses.
Policy Analysis
• What policies would the United States need to implement to eliminate its
deficit? What would Asia have to do to eliminate its surplus?
• Is one of the two policy options less painful for the world economy than the
other? If so, which one and why?
Take A Position
• Which option do you prefer? Justify your choice.
• What criticisms of your position should you anticipate? How would you defend
your recommendation against these criticisms?
Resources
-<
Online: Search for "Are We Back to a Bretton Woods Regime?" and "The Dollar and
the New Bretton Woods System."
In P rin t: To examine past instances of distributive conflict, see Barry J. Eichengreen,
Golden Fetters: The Gold S tand ard and the G reat Depression (New York: Oxford University
Press, 1992), and Barry J. Eichengreen and Marc Flandreau, eds., The Gold Stand­
a rd in Theory an d H istory, 2nd ed. (New York: Routledge, 1997).
Conclusion
223
T hus, the p o stw ar attem pt to create an international m onetary system
that provided exchange-rate stability and dom estic econom ic auton om y was
ultimately unsuccessful. The reasons for its failure are not hard to find. Some
argue that the system w as undermined by dollar overhang. Others suggest that
it was destroyed by the speculative attacks that ultimately forced governments
to abandon fixed exchange rates. Even though these factors w ere im portant,
the fundam ental cause o f the system ’s collapse lay in the adjustm en t p ro b ­
lem. T o sustain fixed exchange rates, governments had to accept the domestic
costs of balance-of-paym ents adjustm ent. N o governm ent w as w illing to do
so. The United States w as unwilling to accept the unem ploym ent that would
have arisen from eliminating its deficit, and Germany was unwilling to accept
the higher inflation required to eliminate its surplus. This unwillingness to ad­
just aggravated the dollar overhang, which then created an incentive to launch
speculative attacks against the dollar.
CONCLUSION
The creation and collapse o f the Bretton W oods system highlights tw o cen­
tral conclusions a b o u t the w orkings o f the international m onetary system .
F irst, even th ough govern m en ts w o u ld like to m ain tain sta b le exch an ge
rates and sim ultan eously preserve their dom estic econom ic au to n o m y , no
one h as yet fou n d a w ay to do so . G overn m en ts co n fro n t th is trad e -o ff
because each co u n try ’s balan ce-of-p ay m en ts p o sitio n h as a d irect im pact
on its exchange rate. When a country has a paym ents deficit, the resulting
im balance in the foreign exchange m arket causes the currency to d epreci­
ate. When a country has a paym ents surplus, the foreign exch an ge m arket
im balance cau ses the currency to appreciate. If the governm ent is pledged
to m aintain a fixed exchange rate, it m ust intervene in the foreign exchange
m arket to prevent such currency changes. As governm ents do so , they alter
the m oney supply, thereby sp ark in g the changes in the d om estic econom y
needed to correct the paym ents im balance. If a governm ent is unw illing to
accept these dom estic adjustm ents, it will be unable to m aintain a fixed ex­
change rate. The Bretton W oods system collapsed because neither Germ any
nor the United States w as w illing to accept the dom estic adjustm ents needed
to sustain it.
Second, when forced to choose between a fixed exchange rate and d o ­
mestic econom ic autonom y, governm ents have opted for dom estic economic
autonom y. They have done so because dom estic adjustm ent is costly. In the
short run, the country with the deficit m ust accept falling output, rising un­
employment, and recession in order to m aintain its fixed exchange rate. As
American behavior in the Bretton W oods system illustrates, governm ents are
rarely willing to do so. The country with the surplus m ust accept higher in­
flation, and as G erm any’s behavior in the Bretton W oods system indicates,
surplus governments are not willing to accept these costs. Governments in the
advanced industrialized countries have been unw illing to p ay the dom estic
224
C H A P T E R 10
The International Monetary System
economic costs in order to m aintain fixed exchange rates again st each other.
Consequently, the w o rld ’s largest countries have allow ed their currencies to
float against each other since the early 1970s.
The shift to floating exchange rates did not reflect agreem ent am ong gov­
ernments that the international m onetary system w ould perform better under
floating rates than under fixed rates (although many econom ists did argue that
it w ould). Instead, the shift to floating exchange rates reflected the political
conclusion that fixed exchange rates were too costly. T hus, the answ er to the
question posed in this chapter’s introduction is that we live in a w orld o f float­
ing exchange rates because politics m akes governments unwilling to accept the
domestic costs im posed by fixed exchange rates.
KEY TERMS
Balance of Payments
Balance-of-Payments
Adjustment
Bretton Woods System
Capital Account
Conditionality
Current Account
Exchange-Rate System
Exchange Restrictions
Fixed Exchange-Rate
System
Fixed-but-Adjustable
Exchange-Rate System
Floating Exchange-Rate
System
Foreign Exchange Market
Foreign Exchange
Reserves
Fundamental
Disequilibrium
Managed Float
Speculative Attacks
Stabilization Fund
SUGGESTIONS FOR FURTHER READING
Perhaps the most readable account of the evolution of the international monetary sys­
tem during the last one hundred years is Barry J. Eichengreen, Globalizing Capi­
tal: A History o f the International Monetary System (Princeton, N J: Princeton
University Press, 1996). For a detailed account of the interwar period, see Barry J.
Eichengreen,Golden Fetters (Oxford, UK: Oxford University Press, 1994).
For further exploration of the Bretton Woods system, see Robert Solomon, The Inter­
national Monetary System, 1945-1976: An Insider’s View (New York: Harper &c
Row Publishers, 1977); Joanne Gowa, Closing the Gold Window: Domestic Politics
and the End o f Bretton Woods (Ithaca, NY: Cornell University Press, 1983); and
Francis J. Gavin, Gold, Dollars, and Power: The Politics o f International Monetary
Relations, 1958-1971 (Chapel Hill: University of North Carolina Press, 2004).
CHAPTER
11
Cooperation,
Conflict, and Crisis
in the Contemporary
International
Monetary System
I
n the summer of 2010, U.S. President Barack O bam a sent a letter to leaders
of the w orld’s largest economies calling upon them to em brace m easures
that would “ strengthen domestic sources o f grow th” (White H ouse 2010).
Though inelegant, the letter constituted a call for governments to enact fiscal
stimulus to help promote global economy recovery without aggravating global
current-account im balances. G erm an C h ancellor A ngela M erkel, O b a m a ’s
primary target in the letter, rebuffed the request, asserting that it w as time to
shift from fiscal stim ulus to consolidation (W alker and Karnitschnig 2 0 1 0 ).
Germ an Finance M inister W olfgang Schauble offered an explanation for the
German position: “ While US policymakers like to focus on short-term correc­
tive m easures, we take the longer view and are, therefore, m ore preoccupied
with the im plications o f excessive deficits and the dangers o f high inflation ”
(Schauble 2010). Thus, not only w ould Germany ad o pt additional stim ulus, it
would begin to reduce its budget deficit.
This contem porary conflict over fiscal policy rem inds us th at the m ore
things change, the more they seem to remain the sam e. It doesn’t take all that
much im agination to see that O bam a and M erkel are engaged in the sam e
dispute that brought down the Bretton W oods System in the early 1970s. This
is som ew hat surprising because aban don in g Bretton W oods w as su pp osed
to provide dom estic econom ic autonom y and relegate such conflicts to the
past. Shifting to floating exchange rates w as supp osed to provide dom estic
autonom y in tw o ways. First, governments hoped that in a system o f floating
exchange rates w ould allow m acroeconom ic policies to pursue distinct o b ­
jectives. Any current-account im balances that em erged w ould be elim inated
225
226
C H A P T E R 11
Cooperation, Conflict, and Crisis
autom atically through these exchange-rate movements. N o longer w ould gov­
ernments be forced to alter their m acroeconom ic policies to elim inate p a y ­
ments’ imbalances.
Governments have found, however, that neither the shift to more flexible
exchange rates nor the creation o f a regional m onetary system am ong deeply
integrated European economies has prevented distributive conflicts o f the kind
that ultimately brought down the Bretton W oods system. The determination to
set macroeconomic policy independent o f foreign considerations has generated
large current-account im balances that in turn give rise to large cross-border
capital flow s, disruptive exchange-rate m ovem ents, and episodes o f financial
instability. These economic consequences in turn generate political pressure for
policy coordination in order to correct the underlying im balances. A s a result,
governments have found themselves engaged in the sam e types o f distributive
conflict that brought down the Bretton W oods system in the early 1970s.
This chapter exam ines how politics generate these im balances, and how
these im balances drive the politics o f cooperation and conflict in the contem ­
porary international m onetary system. We look first at the tw o episodes that
have occurred within the broader international m onetary system. The first un­
folds during the 1 9 8 0 s, while the second begins in the late 1 9 9 0 s and ends
with the great financial crisis o f 2 0 0 7 - 2 0 0 9 . We then turn our attention to
monetary cooperation and conflict in the E uropean Union (EU), tracing how
disputes over distribution o f the costs o f exchange-rate stability have shaped
the evolution of this regional monetary system.
FROM THE PLAZA TO THE LOUVRE: CONFLICT
AND COOPERATION DURING THE 1980s
The 1980s saw the emergence o f global im balances and distributive conflict
over the adjustm ent o f these im balances that echoed the political dynam ics
that triggered the collapse o f the Bretton W oods system. The 1970s had seen
relatively sm all current-account im balances in the m ajor industrial countries
that generally adjusted quickly. T his period o f relative balance gave w ay to
an extended period o f current-account im balances in the early 1 9 8 0 s (Fig­
ure 11.1). After 1980, the United States developed the largest current-account
deficit in the global econom y. By 1 9 84, the U .S. current-account deficit had
widened to a then-record $ 1 0 0 billion. From there it d eteriorated further,
reaching $150 billion, or about 3.5 percent o f G D P, by 1987. Am erican def­
icits were offset by large current-account surpluses in Ja p a n and G erm any.
J a p a n ’s current-account surplus increased stead ily th rou gh ou t the decade
and at its peak equaled close to half o f the Am erican current-account deficit.
Current-account surpluses em erged in G erm any as well, though they lagged
behind and were som ewhat sm aller than the surplus in Jap an .
C u rren t-acco u n t im b alan ces w ere a p ro d u ct o f d ivergen t m a c ro e c o ­
nomic policies in the three m ajo r industrial econom ies. In the United States,
the R eagan adm inistration entered office in 1981 and quickly cut taxes and
-*■
From the Plaza to the Louvre: Conflict and Cooperation during the 1980s
227
FIGURE 11.1
Current Account Imbalances, 1981-1990
S o u r c e : In t e r n a tio n a l M o n e t a r y F u n d , I F S O n lin e .
increased military spending. The resulting expansion o f the government budget
deficit fueled domestic dem and and pulled in imports. In contrast, governments
placed macroeconom ic policy on a more restrictive basis in Germany and Jap an .
German policym akers em barked on a period o f fiscal consolidation beginning
in 1981. Confronting large deficits inherited from the 1970s, a new conserva­
tive government took steps to return the government budget to balance. At the
same time, the Bundesbank tightened monetary policy to com bat inflation. The
Japanese government also shifted from the rather expansionary policy orienta­
tion that had characterized the 1970s to fiscal retrenchment (Suzuki 2 0 0 0 ).
The government sought to restore its budget to surplus by 1985 and embraced
a restrictive m onetary policy as well. In both countries, restrictive m acroeco­
nomic policies generated large current account surpluses.
A CLOSER LOOK
Savings, Investment, and the Current Account
We can deepen our understanding of macroeconomic policy coordination by
looking more closely at the relationship between fiscal policy and current-account
imbalances. The standard Savings-Investment framework will help us do so. As
we learned in Chapter 10, a country's current-account balance is equal to the
difference between its national income and expenditures. The Savings-Investment
(Continued}
228
C H A P T E R 11
Cooperation, Conflict, and Crisis
framework builds on and refines this basic relationship to suggest that the current
account is equal to the difference between national savings and national investment.
We can see this relationship by manipulating the standard national Income
identity. The national-income identity states:
Y = G + C + I + (X - M)
(1)
In words, national income (Y) equals the sum of the government sector (G),
private consumption expenditures (C), investment expenditures (I), and the current
account (exports [X3 minus imports CM3). National savings equals the portion of
national income that is not consumed by government and individuals. Thus:
Y - (G + C) = I + (X - M)
(2)
S = Y — (G + C)
And substituting
S = I + (X - M)
(3)
Where S stands for national savings. Finally, we subtract I from both sides:
S - I = (X - M)
(4)
The difference between national savings and national investment equals the
•*.
current account. Increased savings or decreased investment improves the current
account, while falling savings or increased investment worsen the current account.
Fiscal policy affects the current account via its impact on national savings. We
can define private savings and government savings. We can define private savings
Sp = Y - C - T
(5)
where T is taxes paid to the government. We can define government savings as
SG = T - E
(6)
where E is government expenditures. Government savings are thus a function of
the budget balance. Tax revenues greater than expenditures (a budget surplus)
generate government savings. Tax revenues less than expenditures (a budget
deficit) generate government dissavings. Fiscal policy thus affects the current
account balance directly. Assuming that all else remains constant, a larger budget
deficit (or smaller surplus) worsens the current account. Conversely, a smaller
budget deficit (or larger surplus) improves the current account.
It is important to recognize that the relationship between fiscal policy and the
current account is indeterminate. Our conclusion that a change in fiscal policy
produces an equivalent change in the current-account balance rests on the key
assumption that all else remains constant. This means that a change in fiscal policy
will affect the current account so long as neither private savings nor investment
responds to the change in fiscal policy. Is this always a reasonable assumption?
Individuals might recognize that a larger government deficit must eventually
generate higher taxes and respond by saving more. Moreover, during the 1990s,
From the Plaza to the Louvre: Conflict and Cooperation during the 1980s
229
the impact on the current account of a smaller budget deficit was offset by an
investment boom that may in fact have been a consequence of lower interest rates
induced by fiscal consolidation. Hence, although the savings-investment framework
is a useful framework, it does not establish deterministic cause-and-effect
relationships.
In spite of this qualification, the savings-investment framework helps us better
understand the motivation for macroeconomic policy coordination. Governments
discuss fiscal policy coordination as a means to adjust global current-account
imbalances, because manipulation of tax and expenditures directly alters national
savings rates and can affect current-account balances. It is not hard to understand
why such coordination has proven difficult to achieve. Few issues pose greater
domestic political obstacles to change than taxes and government programs. ■
^
Capital flow s lrom Jap an and Germ any financed the U .S. current-account
deficit. Foreign governm ents purchased an add ition al $ 1 8 4 billion o f U .S.
government-issued debt between 1980 and 1989. Foreign institutional inves­
tors acquired an addition al $ 1 5 0 billion o f governm ent debt a s well as an
additional $ 4 0 0 billion o f A m erican corporate securities. By the end o f the
decade, Am erican foreign debt to the rest o f the w orld had increased from
$440 billion to m ore than $2 trillion. As a consequence, the U nited States
transitioned from a net international creditor to a net international debtor.
A net international creditor country is one for which foreign assets owned by
residents are greater than the total value o f domestic assets owned by foreign­
ers. As figure 11.2 illustrates, the U .S. position as a net creditor diminishes as
the decade progresses. By 1984, the U .S. had shifted into net debtor status and
by the end o f the decade, the United States net investment position stood at
minus $260 billion.
The ability o f the U nited States to attra ct cap ita l flow s from su rplus
countries depended upon ensuring that the return to investm ent w as greater
in the United States than in other econom ies. Consequently, in order to pull
capital from Ja p a n and G erm any, the U nited States h ad to m aintain rela­
tively high real interest rates. T hus, as the U .S. budget and current-account
deficits widened, interest rates rose in the United States. As cap ital flow ed
into the American economy in response, the dollar strengthened dramatically.
Figure 11.3 depicts the d ollar’s value, on a trade-weighted basis, since 1980.
From a postw ar low in 1979, the dollar strengthened sharply after 1980. By
1985, the dollar had appreciated by 50 percent.
The Reagan adm inistration did nothing to reduce the current-account def­
icit or reverse the dollar’s appreciation during its first term in office. Although
foreign governm ents were grow ing increasingly concerned ab ou t the im bal­
ance and the soaring dollar, the R eagan team cham pioned the dollar’s rise as
evidence of a strong American economy. This policy of benign neglect changed,
however, as the series o f record current-account deficits and strengthening
C H A P T E R 11
Cooperation, Conflict, and Crisis
Billions of U.S. Dollars
230
FIG UR E 11.2
United States International Investment Position
S o u r c e : B u re a u o f E c o n o m ic A n a ly s is , 2 0 1 0 h ttp :/ / w w w .b e a .g o v / in te rn a tio n a l/ x ls / in tin v 0 9 _ t2 .x ls
140
130
120
110
100
90
80
70
FIG UR E 11.3
Dollar's Exchange Rate, 1980-2010
S o u r c e : F e d e r a l R e se rv e B a n k h t tp :/ / w w w .fe d e ra lre se rv e .g o v / re le a s e s/ h lO / S u m m a ry
2010
2003
2004
2005
2006
2007
2008
2009
2002
2001
2000
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
60
From the Plaza to the Louvre: Conflict and Cooperation during the 1980s
231
dollar generated substantial protectionist pressure. Congressional hearing a f­
ter congressional hearing decried the decline o f American international com ­
petitiveness. Business and political elite attributed this decline to policies and
practices of foreign governments, particularly o f the foreign government with
which the United States had its largest bilateral trade deficit—Jap an . Hence,
the trade im balance generated a wave of Ja p a n bashing that cam e to define
U.S. trade policy for much o f the decade (see C h apter 2). On the one hand,
Congress pressured the Reagan adm inistration to take steps to force a change
in Japanese policy. The desired changes involved eliminating Jap an ese barri­
ers to Am erican im ports and ending Jap an ese industrial policies perceived to
give to Jap an ese firm s an unfair advantage over their Am erican com petitors
in global m arkets. The Senate p assed a bill by a 92-0 m argin, for exam ple,
linking the ability o f Ja p a n e se a u to m ak ers to sell in the U nited States to
market-opening initiatives in Jap an . A t the sam e time, congressional and busi­
ness elite threatened to raise trade barriers to protect American firms from un­
fair competition. A bill introduced in 1985 threatened to impose a 20 percent
tariff rate on Jap an ese im ports, and then reduce this rate by one point for each
$1 billion improvement in the bilateral trade balance (Suzuki 2 0 0 0 ,1 4 0 ).
In 1985, the R eagan adm in istration responded to the increasingly p ro ­
tectionist Congress by seeking an international solution to currency m isalign­
ments and current-account im balances. The m om ent looked favorable. The
dollar’s appreciation appeared to have peaked, and in the spring o f 1985 the
dollar actually had begun to depreciate. Secretary o f the T reasury Jam e s A.
Baker III initiated discussions with the G erm an, Japanese, British, and French
governments to see whether they w ould be w illing to cooperate in order to
realign the dollar, yen, and m ark (Funabashi 1988). Initial discussions led to
a meeting o f the G 5 finance m inisters at the Plaza H otel in N ew Y ork City
on Septem ber 2 2 , 1985. In a com pact know n as the Plaza A ccord, the five
governments agreed to reduce the value of the dollar against the Japan ese yen
and the Germ an m ark by 10 to 12 percent. T o achieve this realignment, gov­
ernments consented to intervene in the foreign exchange m arkets whenever it
appeared that the m arket w as pushing the d ollar up. In other w ords, rather
than pushing the dollar dow n, the G 5 w ould try to prevent the m arket from
pushing it up. They agreed to allocate $18 billion to these interventions, with
the United States, G erm any, and Ja p a n each bearing 25 percent o f the total
costs, and Britain and France sharing the other 25 percent. O ver the next
15 months, governments intervened in the foreign exchange m arket whenever
the dollar’s depreciation appeared to be slowing or threatening to reverse.
By early 1987, the dollar had fallen alm ost 40 percent from its peak. Govern­
ments moved to prevent further depreciation. M eeting in at the French Ministry
of Finance at the Louvre in Paris in February 1987, governments agreed to strive
to stabilize exchange rates at their current values. This Louvre Accord marked
the end o f the period of realignment and the beginning of a conversation about
whether governments could shift to more institutionalized exchange-rate coop­
eration moving forward. In particular, policymakers discussed the creation o f a
variant o f fixed-but-adjustable exchange rates called a target zone, in which all
232
C H A P T E R 11
Cooperation, Conflict, and Crisis
currencies would have a central parity surrounded by wide margins— one prom i­
nent proposal advocated margins o f plus or minus 10 percent— within which the
exchange rate would be allowed to fluctuate (Williamson 1983; Solomon 1999).
When a currency moved outside the m argins, governments would be obligated
to intervene in the foreign exchange m arket or to alter dom estic interest rates
in order to bring it back inside. The idea, which w ould require substantial and
continuous policy coordination, failed to attract sufficient support. As a result,
exchange rate cooperation fell off the global agenda.
Governments also embarked on discussions about and accepted som e rela­
tively broad commitments to coordinate monetary and fiscal policies in order to
promote adjustment of the current account imbalances. The agreement reached
in Paris called on the surplus countries to “ follow policies designed to strengthen
domestic demand and to reduce their external surpluses while maintaining price
stability” (Group of 6, 1987). For their part, deficit countries agreed to “ follow
policies designed to encourage steady, low-inflation growth while reducing their
domestic imbalances and external deficits” (Group o f 6, 1987). In practice this
m eant that Germ any and Ja p a n were pressured to ad o pt m ore expansionary
fiscal policies, largely by reducing taxes, in order to spur domestic dem and and
increase imports. For its part, the United States w ould adopt a more restrictive
fiscal policy to reduce its budget deficit, thereby decreasing dom estic dem and
and U.S. imports. In conjunction with the d ollar’s depreciation, the coordina­
tion o f fiscal policies would prom ote current-account adjustment.
In practice, however, dom estic politics frustrated the im plem entation o f
the agreement reached in Paris. In Jap an , Am erican pressure to ado pt a more
exp an sio n ary fiscal policy m et little success th rou gh 1 9 8 7 (Suzuki 2 0 0 0 ).
Baker had begun pressu ring the Jap an e se governm ent to a d o p t a m ore e x ­
pansionary fiscal policy as early a s 1985. Yet, with a m ajority o f the ruling
Liberal D em ocratic Party committed to fiscal consolidation, the Jap an ese gov­
ernment could not m ake substantial concessions to the United States. It took
the com bination o f continued threats o f protection ist m easures by the U .S.
Congress, a yen that continued to appreciate and thus weaken Ja p a n ’s export
com petitiveness, and a w orrying increase in Jap an ese unem ploym ent before
the Jap an ese governm ent shifted course. By late 19 8 7 , the Jap an ese govern­
ment had secured support for a 6 trillion yen fiscal stimulus.
Yet, as reluctant as the Jap an ese were to alter fiscal policy, they were the
m ost willing and able o f all o f the governm ents to m ake adjustm ents. In the
United States, disagreem ent between C ongress and the adm inistration ab ou t
how to reduce the deficit blocked progress. The D em ocrats, w ho controlled
Congress, wanted to reduce the deficit through a com bination o f higher taxes
and reduced military expenditures. The Republican adm inistration, however,
preferred to trim other expenditures, with a particular em phasis on social pro­
gram s. With each party pushing for alternative solutions, the result w as dead­
lock: “ [bjoth parties called the deficits a scandal but could not agree on how
to reduce them. The president rem ained adam an tly again st any further ta x
increases and held tenaciously to his defense buildup. The [House] D em ocrats
wanted Social Security shielded from budget cutters and dug in their heels o p ­
posing further domestic program cu ts” (LeLoup 2 0 05, 82).
From the Plaza to the Louvre: Conflict and Cooperation during the 1980s
233
In G erm any, m acroeconom ic stim ulus w as blocked by continued reluc­
tance to jeopardize price stability. G erm an policym akers pointed to prior ex ­
perience with international coordination (Greenhouse 1987). D uring the late
1970s, for example, they had acceded to pressure exerted by the Carter admin­
istration and implemented a fiscal stimulus to help pull the world economy out
of recession. The initiative had done little to produce growth, they argued, but
did generate unwelcome inflation in Germany. M onetary stimulus w as blocked
by the Germ an central bank, the Bundesbank. Bundesbank policym akers ap ­
peared to be split, although a minority recognized the need for Germ an con­
tribution to global adjustment. The m ajority o f mem bers, however, focused on
German economic conditions and believed that using Germ an m onetary policy
to promote global adjustment would merely stimulate inflation at home.
The inability and reluctance to implement the commitments made at Paris
concerning m acroeconom ic policy generated tension between Am erican and
German policymakers that eventually spilled out into the public where it trig­
gered financial m arket turbulence. In late Septem ber, policym akers met and
agreed to maintain interest rates at then-current levels. Only tw o weeks later,
however, the Bundesbank raised interest rates in G erm any. The G erm an ac­
tion angered the R eagan adm inistration. A s Baker com plained in front of the
American press, G erm an interest rate increases “ were inconsistent with the
spirit o f” the agreem ents they had reached that year (K ilborn 1987). Higher
interest rates, Baker argued, would slow the G erm an econom y, thereby reduc­
ing German dem and for American products. The m oves would therefore make
it m ore difficult for the United States to reduce its current-account deficit.
Baker suggested that the trend of higher interest rates in Germ any might force
the United States to allow the dollar to depreciate further in com pensation.
Baker’s remarks annoyed German policymakers. On the one hand, German
officials noted that public criticism o f currency values and interest rates was
dangerous. D isagreem ent between the United States an d G erm any in public
could easily trigger m arket unrest (Schmemann 1 987). G erm an officials also
noted that the American trade deficit w as not caused by Germ an monetary pol­
icy. Its cause lay squarely in the U.S. government’s budget deficit. According to
the Germans, therefore, Baker might better focus on reducing the deficit rather
than criticizing the Bundesbank. Finally, the Bundesbank noted that its interest
rate increases were driven by market developments outside their control.
G erm an concerns ab ou t the peril arising from airing grievances in pu b­
lic were prescient, for on the M on d ay follow ing B aker’s public criticism, eq­
uity m arkets around the w orld registered large, and in m any cases, record
losses. In Germany, equity m arkets tum bled by m ore than 7 percent; in Paris
and Italy losses topped 6 percent. In G reat Britain, the FT SE 100, the British
equivalent to the A m erican D ow Jo n e s, lo st 11 percent. The biggest slide
came in the United States, however, where the D ow Jo n e s Industrial Index
lost 22 .6 percent, its largest single-day loss since the First W orld W ar. And
although one should alw ays be cautious when attributin g financial sell-offs
such as this to specific events, analysts seemed to agree that the financial tur­
bulence w as a direct m arket response to the evident inability o f the United
States and Germany to find a cooperative solution to global imbalances.
234
C H A P T E R 11
Cooperation, Conflict, and Crisis
Financial turmoil brought about the policy changes that negotiations alone
failed to achieve. The G erm an Bundesbank cut a key interest rate and injected
liquidity into the G erm an financial system. In the United States, the deadlock
between congressional D em ocrats and a R epublican adm inistration that had
blocked m eaningful deficit reduction broke. President R eagan announced his
willingness to consider any p ro posal C ongress m ight m ake. C ongress m oved
quickly to convene a sum m it that w ould construct a political coalition around
the elem ents o f a deficit-reduction p ack ag e . O u t o f this p ro cess cam e the
Gram m -Rudm an-H ollings Act, legislation that helped the United States place
the budget on a deficit-reduction path during the late 1980s and early 1990s.
International m onetary politics during the 1 980s, therefore, provide nei­
ther domestic policy autonom y nor sm ooth painless adjustm ent of im balances
via exchange-rate m ovem ents. In stead , the d ecad e b rou gh t larg e currentaccount im balances as a result o f governm ents pursuing divergent m acroeco­
nomic objectives. The large cross-border flow s that financed these im balances
generated exchange-rate m isalignm ents that aggrav ate d the problem . A nd
although governm ents agreed that these im balances needed correction, they
disagreed about who should change policy to correct them. In many respects,
these disagreem ents arose from the im pact o f dom estic politics on m acroeco­
nomic policym aking. The United States sought to push the burden o f ad ju st­
ment onto surplus econom ies. G overnm ents in Ja p a n and G erm any resisted
and pressed the United States to balan ce its budget. The conflict over w ho
w ould a d ju st persisted until a pu b lic sp a t betw een the U nited States and
Germany sparked m assive turbulence in global equity m arkets.
GLOBAL IMBALANCES AND THE GREAT
FINANCIAL CRISIS OF 2007-2009
The first decade o f the twenty-first century saw the emergence o f second epi­
sode o f m ajor global im balances, political conflict over the adjustm ent o f these
im balances, and financial crisis. Figure 11 .4 depicts the evolution o f global
current-account im balances between 1996 and 2 0 10. The im provement o f the
U.S. current-account position that had been achieved by the early 1990s re­
versed at the end o f the decade. By the middle o f the first Bush adm inistration,
the Am erican current-account deficit had widened to more than $400 billion.
The deficit then widened further, to slightly m ore than $800 billion in 2 0 0 6 ,
and then held stead y at a b o u t $ 7 0 0 billion in 2 0 0 7 an d 2 0 0 8 . A s a share
of Am erican national income, these current-account deficits were larger than
those of the 1980s, rising to 6 percent o f G DP at their peak.
American current-account deficits were offset by surpluses in other econo­
mies. Jap an and Germ any were once again im portant surplus countries. W hat
distinguishes this episode from the 1 9 80s, however, is the emergence o f new
surplus countries throughout E ast A sia, with China assum ing particular im ­
portance. E ast A sian econom ies began to run large current-account surpluses
follow ing the severe financial crisis they suffered in 1 9 9 7 (see C h apter 15).
Global Imbalances and the Great Financial Crisis of 2007-2009
237
an EU issue. For its part, the Chinese government resisted American pressure to
allow the R M B to appreciate, though they did shift to a more flexible crawling
peg exchange-rate regime in the summer of 2005 (see Bowles and W ang 2008).
They too tended to view the U .S. “ global savings glu t” argum ent with su spi­
cion and suggested that the United States could adjust by balancing its budget.
Because each government sought m axim um policy change by others and mini­
mum policy change at home, negotiations failed to generate policy changes that
would reduce the magnitude of the imbalances.
Governments’ reluctance to alter macroeconomic policies in order to reduce
current-account imbalances facilitated the development o f the financial w eak­
nesses that ultimately sparked the great financial crisis o f 2 0 0 7 -2 0 0 9 . The con­
nection between imbalances and the financial crisis lay in the flow of cheap and
plentiful credit from the surplus countries to the United States at an unprece­
dented rate. The ability to borrow large volumes at low interest rates created
credit conditions that typically generate asset bubbles. In the U.S. context, this
asset bubble emerged in residential real estate. M ortgage lenders in the United
States issued about $1 trillion o f new mortgages (and home equity lines o f credit)
a year in 2002 and 2003. This amount grew further to about $1.4 trillion of new
mortgage debate between 2004 and 2006. As a result, investment in residential
real estate as a share of GDP increased sharply from 2 6 to 37 percent o f GDP
between 2 0 0 0 and 2007. The surge o f investment drove real estate prices up;
nationwide, home prices rose by 60 percent between 2000 and the peak in 2006.
The magnitude of this housing boom was unprecedented in American history.
Financial institutions channeled about one-third o f these funds into real
estate with com plex financial instrum ents. M ortgage-backed securities and
collateralized debt obligations allowed financial institutions to bundle m ort­
gages with different risks into a single financial instrument and sell them on to
investors. This slicing and bundling created a single security that w as itself a
claim on a fairly diverse pool o f m ortgages. It w as believed that these instru­
ments enabled investors to choose how much risk they were willing to hold in
their real estate lending. At the same time, credit default sw aps, sold by insur­
ers such as AIG, appeared to reduce the risk o f m ortgage lending even further
by appearing to promise to repay loans if the original borrowers did not. And
although these instruments sheltered investors from risk arising from isolated
m arkets— such as increased loan defaults in one region o f the country— they
did not shelter investors from a nationwide collapse o f real estate prices. Yet,
financial institutions discounted the risk of a nationwide collapse of real estate
prices because such an event had never before happened— at least not since
the 1930s. The worst-case scenario they planned for w as a large regional co l­
lapse, such as the crisis that occurred during the 1980s.
Yet, real estate prices did collapse nationwide, falling by alm ost 25 percent
during 2007 and early 2008. By the end of 2008, the average price o f residential
real estate across the United States had fallen back to the pre-bubble price level.
As home prices fell, the market value (though not the face value) of the securi­
ties issued to purchase real estate fell, too. Consequently, financial institutions
that held these securities in large am ounts suffered large losses. And because
so many o f these financial institutions had purchased securities with borrowed
238
C H A P T E R 11
Cooperation, Conflict, and Crisis
funds (called leverage), the losses they suffered as a consequence of falling real
estate prices created debt-service difficulties. Debt-service problem s extended
the negative impact from the collapsing real estate bubble throughout the finan­
cial system. Finally, with foreclosures and defaults rising in frequency, AIG and
other firms that had insured these assets found themselves on the hook for an
am ount they couldn’t possibly pay out. As a consequence, by late 2 0 0 7 some
of the w orld’s largest banks were reporting m ultibillion-dollar losses (Guillen,
n.d.). The Swiss bank UBS reported a loss o f $3.9 billion; Citibank reported a
loss of $5.9 billion; Merrill-Lynch reported a loss of $7.9 billion.
The crisis acquired a global dim ension for three reasons. First, a few EU
countries, such as G reat Britain and Spain, experienced their own real estate
bubbles that follow ed the sam e tim e line as the A m erican bubble. Second,
European financial institutions purchased m ortgage-backed securities in large
quantities. As a result, European financial institutions also suffered large losses
from the collapse o f the U .S. real estate bubble. Finally, the freezing o f global
credit m arkets follow ing the bankruptcy o f Lehm an Brothers in the fall of
2008 made it difficult for all financial institutions to secure the credit needed
to finance their activities. As credit dried up, interest rates on interbank lending
rose sharply, a clear indication that all m arket participants, wherever they were
based, were struggling to roll over their debt and otherwise secure financing.
As the crisis struck, governm ents and central banks tried to prevent the
total collapse o f the system. Initially, central banks injected liquidity into the
banking system to sm ooth m arket turbulence. In A ugust 2 0 0 7 , for instance,
the European Central Bank, along with the Federal Reserve and the Bank o f
England, injected m ore than $ 2 0 0 billion into m arkets. Sim ilar operation s
occurred in Decem ber o f 2 0 0 7 . As the crisis deepened, interventions became
more heavy-handed. G overnm ent regulators closed m any banks rendered in­
solvent by their exposure to real estate. C aliforn ia-based IndyM ac w as shut
down in Ju ly o f 2 0 0 8 , and W ashington M u tu al in Septem ber. In other in­
stances, policym akers w orked feverishly to arrange the sale o f large banks
about to collapse. The Federal Reserve helped arrange the sale o f the A m er­
ican investm ent bank Bear Stearns to J.P . M o rgan C h ase. The governm ent
helped negotiate the sale o f M errill Lynch to the Bank o f America and the sale
o f Wachovia to Wells Fargo. The government tried, but failed, to find a buyer
for Lehman Brothers, a failure that many suggest triggered the w orst stage o f
the crisis during the fall o f 2008.
Larger banks deemed “ too big to fa il” benefited from policies that chan­
neled governm ent funds to them to keep them alive— the so-called bailouts.
In Septem ber, 2 0 0 8 , for exam ple, the U .S. governm ent seized Freddie M ac
and Fannie M ae, tw o governm ent-sponsored agencies that were the largest
purchasers o f m ortgage-backed securities in the United States. T reasury Sec­
retary Henry Paulson noted that the tw o agencies were o f such system ic im ­
portance that their failure w ould severely w orsen the crisis and could even
destroy the financial system . In N ovem ber o f 2 0 0 8 , the U .S. governm ent in­
vested $20 billion in Citigroup in exchange for preferred stock and guaranteed
$300 billion o f C itigro u p ’s debt. The U .S. governm ent’s T o x ic A sset R elief
Global Imbalances and the Great Financial Crisis of 2007-2009
239
Program, passed in late fall o f 2008, provided more than $700 billion to pur­
chase risky and hard-to-value assets from the largest banks.
M ost broadly, governm ents held a series o f G -20 sum m its to coordinate
their responses to the crisis. M eeting first in W ashington, D .C ., in N ovem ber
of 2008 and then in London during April o f 2 0 0 9 , governm ents agreed to
coordin ate fiscal stim ulus m easures in order to b o o st econom ic activity in
the wake o f the financial turbulence. They also agreed to expan d the IM F ’s
lending capacity. Also o f great importance, governments agreed to establish a
Financial Stability Board charged with coordinating and m onitoring efforts on
the reform o f financial regulation (Nelson 2 0 09, 10-11).
Although this process produced little in the w ay o f policy change, it did
prom pt a change in process. Follow ing its creation in 1999 as a perm anent
forum in which developed and emerging m arket countries discussed issues of
common concern, the G-20 remained second in importance as an arena behind
the G-7. As imbalances gave way to financial crisis in 2008, however, European
and American policymakers shifted management o f the crisis as well as macroeconomic policy cooperation out of the G-7 and into the G-20 arena. And while
some argue that this development w as the natural consequence of the growing
importance o f emerging m arket countries, others suggest it reflected efforts by
G-7 countries to enhance their bargaining power. European governments, some
argue, wanted to bring China into the conversation in order to dilute American
influence. The U .S. wanted to bring more countries into the process as a bal­
ance against E urope’s numeric dominance o f the G-7 (N elson 2 0 0 9 , 5-6). At
the G -20 sum m it in Pittsburgh in September of 2 0 0 9 , governm ents created a
fram ework for policy coordination targeted at reducing current global im bal­
ances and at preventing the re-emergence of large imbalances in the future.
POLICY ANALYSIS AND DEBATE
A Coordinated Global Recovery?
Question
Should the United States and the EU coordinate fiscal and monetary policies fn
response to the global economic downturn?
'
'
'
Overview
Global economic recovery from the recession caused by the recent financial crisis
has been slow. The United States and the EU have responded to this lagging
recovery in different ways, however. In the United States, high unemployment
(above 9%) led the Federal Reserve to dramatically loosen monetary policy
^
and the federal government to spend nearly $800 billion in fiscal stimulus: The
;
Obama administration has made no secret of its determination to defer fiscal
consolidation until the recovery is well underway. The European central bank
(Continued)
240
C H A P T E R 11
Cooperation, Conflict, and Crisis
responded to the financial crisis by lowering interest rates, but not to the extent
of its American counterpart. Meanwhile, the recession accentuated sovereign debt
problems in southern European economies,such as Greece, Spain, and Portugal.
Faced with a possibility of debt default in these countries, EU governments ■
agreed to extend emergency financing to needy countries on the condition that the
recipient governments enact austerity programs to. reduce budget deficits through
a combination of reduced government expenditures and tax increases. So while the
United States has enacted expansionary fiscal and monetary policies, the EU has
insisted on conservative fiscal and monetary policies.
Why have the United States and the EU pursued divergent policies? The United
States is primarily concerned with reducing unemployment. The United States
believes that if it alones pursues an expansionary policy, fiscal and monetary
stimulus will "leak" to other countries, thereby increasing American imports from
Germany rather than reducing American unemployment. Many EU governments are
less concerned about short-run unemployment and more concerned about protecting
the European banking system, which is heavily exposed to European sovereign debt
by avoiding large defaults on sovereign debt. As I pointed out in the introduction
to this chapter, the Obama administration pressured EU governments and China
to embrace coordinated stimulus to jump-start global recovery as they prepared to
summit in Toronto. EU governments remained committed to fiscal discipline, even
if consolidation prolonged the recession. As a result, despite the global nature of
the economic downturn, U.S. and EU economic policies remain uncoordinated. In
some ways, they are even working at cross-purposes.
Policy Options
• Promote a cooperative international solution to the global economic downturn
by coordinating fiscal and monetary stimulus programs in the United States and
the EU.
• Allow the United States and the EU to pursue independent monetary and fiscal
policies that are each suited to the economic and political pressures in each country.
Policy Analysis
• What interest, if any, does the United States have in maintaining the credibility
of the Euro and the European banking system?
• Why might the United States wish EU governments to pursue expansionary
fiscal policies even if they have a strong interest in the EU currency and banking
stability?
• Why might European authorities hesitate to follow American advice regarding
its fiscal and monetary arrangements?
Take A Position
• Which option do you prefer? Justify your choice.
• What criticisms of your position should you anticipate? How would you defend
your recommendations against these criticisms?
Exchange-Rate Cooperation in the European Union
241
Resources
Online: Do online searches for "U.S. stimulus" and "European austerity." You can
track the dispute through the Toronto Group of 20 Summit via your library's
electronic news databases. The Financial Times had particularly detailed coverage.
Find President Obama's letter to Group of 20 governments on the White House
server (http://www.whitehouse.gov/sites/default/files/rss_viewer/president_
obama_letter_to_g-20_061610.pdf).
In Print: Because events are still unfolding, it is difficult for me to guide your search. It
might be useful, however, to read the history of some previous financial crises. A
good starting point is Carmen M. Reinhart and Kenneth S. Rogoff, This Time Is Differ­
ent: Eight Centuries of Financial Folly (Princeton, NJ: Princeton University Press, 2009).
You can read about prior macroeconomic policy coordination in Yoichi Funabashi,
Managing the Dollar: From the Plaza to the Louvre (Washington, DC: Institute for Inter­
national Economics. 1988) and Robert D. Putnam and Nicolas Bayne, Hanging
Together.the Seven Power Summits (Cambridge: Harvard University Press, 1987).
International m onetary politics during the last decade m irror the events
that dom inated the 1980s. The decade brought large current-account im bal­
ances, larger than those that emerged during the 1980s, as governm ents pur­
sued divergent m acroeconom ic objectives. The large cross-border flow s that
financed these im balances in turn generated substan tial exchange-rate m is­
alignm ents that aggravated the problem . And although governm ents agreed
that these imbalances were unsustainable, they disagreed fundam entally about
w ho should change policy to correct them. The United States tried to push
adjustm ent onto surplus economies. The Germ an and Chinese governm ents
resisted adjustm ent and pressed the United States to adopt policy changes. Be­
cause all parties refused to adjust, im balances generated serious financial imi-Koi- nlfimsfplv nrprinit-atprl the largest financial crisis since the Great
Billions of U.S. Dollars
Global Imbalances and the Great Financial Crisis of 2007-2009
FIGURE 11.4
Current Account Imbalances, 1996-2009
235
242
Cooperation, Conflict, and Crisis
C H A P T E R 11
which trades m ost with other EU countries. As a result, exchange-rate m ove­
ments within the EU are m ore disruptive to individual econom ies in the EU
than in the broader international m onetary system (see Frieden 1996). In other
w ords, the cost o f floating in the EU is so high that European governments are
more willing to sacrifice dom estic autonom y to stabilize their exchange rates.
Yet, even within this tightly integrated regional econom y, governm ents
have found that their w illingness to stabilize exchange rates has been a con­
sequence o f the extent to which they share com m on m acroeconom ic policy
objectives. Throughout m ost o f the last 30 years, m ost European governments
did not consider the loss o f dom estic econom ic autonom y to be very costly.
M eaningful costs arise when governm ents w ant to pursue different m onetary
policies but cannot. During the 1970s, for exam ple, EU governments moved on
divergent paths. Some, such as the French and the Italians, pursued expansion­
ary m acroeconom ic policies that boosted inflation. O thers, such as Germ any
and the Netherlands, were more conservative and emphasized the maintenance
o f low inflation. With each governm ent com m itted to different policy objec­
tives, a common exchange-rate system would have been quite costly.
By the late 1970s, m ost EU governm ents believed that reducing inflation
had to be their chief objective, and as a consequence, alm ost all governm ents
used m onetary policy to restrict inflation. Because all governm ents were pu r­
suing low inflation, all could participate in a com m on exchange-rate system
without any having to sacrifice the ability to pursue a desired policy objective.
Thus, the cost o f participating in a fixed exchange-rate system w as quite low.
As EU government policy objectives converged, therefore, they found it easier
to create and m aintain a com m on exchange-rate system . M oreover, and for
reasons we explore in detail in C h apter 13, governm ents thought that p a r ­
ticipating in a fixed exchange-rate system w ould help them achieve and m ain­
tain price stability. The resulting exchange-rate system , called the E uropean
m onetary system (EM S), began operation in 1979. The E M S w as a fixed-butadjustable system in which governm ents established a central parity again st
a basket o f EU currencies called the E uropean Currency Unit (ECU ). Central
parities against the ECU were then used to create bilateral exchange rates be­
tween all EU currencies. EU governments were required to m aintain their cur­
rency’s bilateral exchange rate within 2 .2 5 percent o f its central bilateral rate.
In p ractice, the E M S revolved aro u n d G erm an m on etary po licy . The
Bundesbank w as reluctant to participate in the E M S because it w as concerned
that it w ould be forced to continually intervene in the foreign exchange m ar­
ket to su p p ort the w eaker E uropean currencies. C ontinued intervention to
defend these weaker currencies w ould raise Germ an inflation, just as interven­
tion to defend the dollar had done under Bretton W oods. G erm an p articip a­
tion in the E M S w as secured, therefore, by allow ing the Bundesbank to use
G erm an m onetary policy to m aintain low inflation in G erm any. O ther EU
governments would alter their m onetary policies in order to m aintain the peg
to the m ark. The burden o f m aintaining fixed exchange rates therefore fell
principally upon the countries with high inflation. Other EU governments ac­
cepted this arrangem ent in p art because they had created the E M S to help
1 Uliv
JUV11
v-o—
J
-
c/
X
variety of trade policy responses, including a surcharge on Chinese imports, and
changes to American law to enable producers to gain administered protection
,
. .
,
-
,
i
. ■
V
r
.
•
nnl
I
11
5
Exchange-Rate Cooperation in the European Union
243
them reduce inflation. Pegging their currencies to the German m ark, therefore,
would force EU governm ents and central banks to mimic G erm any’s low-in­
flation m onetary policy stance. Over time, therefore, inflation rates through­
out the EU w ould converge on inflation rates in Germany.
Few observers initially gave the E M S much chance o f success. Inflation
rates averaged just above 10 percent in EU countries, whereas G erm an inflation
stood below 5 percent. Such divergent rates o f inflation, reflecting substantially
different monetary policies, could easily pull the system apart. Indeed, the EM S
got o ff to a rocky start. Currency realignm ents were frequent in the system ’s
first year of operation, and a conflict between France and G erm any alm ost
destroyed the system in 198 1 -1 9 8 3 . Conflict arose when newly elected French
president Francois M itterrand adopted an expansionary m acroeconom ic policy
in 1981. T his expan sion caused French inflation to rise, the French balance
of paym ents to deteriorate, and the franc to weaken in the E M S. M itterrand
blamed the franc’s weakness on the restrictive macroeconomic policies pursued
in Germ any (and the other EU countries), refused to alter French policy, and
dem anded that Germ any loosen its policy in line with France. After eighteen
months of uncertainty about whether M itterrand would remove the franc from
the system or accept the system ’s constraints, he reversed course and adopted
restrictive m acroeconom ic policies. The EM S stabilized in the following years.
Inflation rates converged and currency realignments became infrequent. The
EM S had defied its critics’ expectations. The EM S worked, however, primarily
because its member governm ents placed high value on stable exchange rates
and because they all gave priority to the sam e domestic objective: keeping in­
flation low. Consequently, participation in the system did not require any gov­
ernment to give up the pursuit of its domestic objectives.
Conflict am ong E M S participants em erged as perceptions o f the cost of
participation in the system changed. By the late 1980s, many EU governments
were becoming dissatisfied with the Bundesbank’s role in the E M S. EU govern­
ments were content to place Germ any at the center of the EM S as long as they
were striving to reduce inflation. They were less content with this asymmetry
once inflation had come down. M any governments began to question why the
Bundesbank should continue to set monetary policy for the system as a whole.
They argued that the Bundesbank should be required to conduct a share of
the foreign exchange m arket intervention necessary to stabilize the m ark in
the EM U. In addition, because Germ an monetary policy w as transmitted by the
EM S throughout the EU, the other EU governments argued that they should
have som e influence over that policy. By 1987, France and Italy, along with
some officials in the E uropean C om m ission, were suggesting that it w as time
to reform the EM S in order to reduce Germ any’s privileged role in the system
(Oatley 1997). The parallel to French and German criticism o f U.S. monetary
policy under the Bretton W oods system during the late 1960s is striking.
D issatisfaction with the distribution o f the costs of exchange-rate stability
in conjunction with an unwillingness to revert back to more flexible exchange
rates created pressures to change EU exchange-rate institutions. M om entum
for such institutional reform w as reinforced by the reinvigoration o f European
244
CHAPTER l l
Cooperation, Conflict, and Crisis
integration. A part from the E M S, EU governments had launched few new ini­
tiatives during the 1970s, as the oil shock, the collapse o f the Bretton W oods
system , and econom ic stagn atio n m ade few governm ents w illing to further
integrate their economies. EU governments relaunched integration in the mid1 980s by elim inating the rem aining barriers to intra-EU flow s o f products,
labor, and capital. The Single European Act, as this initiative w as called, gave
rise to pressure for m onetary union because m any EU officials believed that
the gains from a single m arket could be realized only with a single currency
(see Em erson 1992). M onetary union thus emerged from dissatisfaction with
the d istribution o f co sts w ithin the E M S and gained m om entum from the
broader effort to complete the single market.
G erm any, and in p articu lar the B u n desban k , w as relu ctan t to pu rsue
deeper m onetary cooperation. The B u ndesban k’s concerns were fundam en­
tally sim ilar to those that caused it to be reluctant about participation in the
EM S: it feared that EM U w ould force Germ any to accept higher inflation than
it desired. The Bundesbank recognized that in a m onetary union it w ould share
control o f m onetary policy with all EU m em bers. It believed that m any EU
governments were willing to tolerate higher inflation than it considered ideal.
Bundesbank policym akers were particularly concerned ab ou t joining a m on­
etary union alongside M editerranean econom ies. Greece, Italy, Portugal, and
Spain all had substantial government budget deficits and large debt burdens as
well as persistently high inflation. In addition, the business cycle in these M ed­
iterranean econom ies w as not well-synchronized with N orthern Europe. As a
consequence, Bundesbank policym akers were concerned that participating in
a m onetary union with the M editerranean countries w ould necessarily force
Germany to accept monetary policies that were not well-suited to the Germ an
econom y. A s a result, Germ any w ould have to accept a higher inflation rate
than it considered necessary.
Although the Bundesbank opposed m onetary union, it appears that n ar­
row m onetary objection s were trum ped by b ro ad er geo p o litical co n sid er­
ations. The pressure to create a E uropean m onetary union em erged ju st as
the Berlin W all co llapsed. The French governm ent saw the co llap se o f the
Berlin W all as an o pportu n ity to achieve m onetary union. They therefore
conditioned French support for G erm an political and econom ic reunification
on G erm an support for m onetary union. G erm an Chancellor H elm ut K oh l’s
determ ination to reunify G erm any led him to subordinate the B undesban k’s
specific monetary objections to his conception o f Germ any’s broader interests.
Germany w ould thus unify and sim ultaneously com m it itself m ore deeply to
the European integration project.
Once Bundesbank policym akers recognized that they could not prevent
G erm an participation in m onetary union, they sought to craft m onetary in­
stitutions that w ould safeguard its conception o f G erm any’s econom ic inter­
ests. In particular, Bundesbank policym akers pushed for rules to govern the
new E uropean Central Bank (ECB) that w ould insulate its m onetary policy
decisions from p o litics. They pushed fo r a set o f convergence criteria that
they believed m ight prevent the M editerranean countries from qualifying for
Exchange-Rate Cooperation in the European Union
245
membership in monetary union. They pushed for rules that required members
to pursue relatively conservative fiscal policies. Finally, the Bundesbank in­
sisted that the EC B be prohibited from purchasing government debt, a neces­
sary check that would prevent governments from creating inflation by running
large fiscal deficits. In short, Bundesbank policym akers did everything they
could to ensure that monetary union w ould not generate inflation in Germany.
For the first 10 years of monetary union, the Bundesbank’s ability to shape
EM U institutions appeared to have secured G erm any’s interests. Inflation re­
mained low across Europe and there were few indications that the M editer­
ranean countries were impinging on G erm any’s ability to pursue its economic
policy objectives. The only source of disagreement am ong the system’s govern­
ments during the euro’s first few years involved the currency’s external value,
and here the E C B refused to actively encourage euro depreciation. T his calm
collapsed into heated conflict in 20 0 9 , however, as severe sovereign debt prob­
lems emerged in the M editerranean countries. Portugal, Ireland, Italy, Greece,
and Spain had all borrowed heavily from international lenders between 2000
and 2008. C apital inflows generated robust grow th and asset bubbles, very
much like the experience of the United States. When these asset bubbles popped
in 2 0 08, these econom ies fell into severe recession and faced m ounting debt
service problem s. As debt service problem s emerged, EU governments battled
over how the costs o f adjustm ent in the face o f this debt problem should be
distributed between northern and southern European economies.
The conflict is well illustrated by the case o f Greece, the first to experience
a severe debt crisis. The G reek governm ent borrow ed heavily from foreign
lenders to fund budget and current account deficits. Between 2 0 0 0 and 2008,
Greek budget deficits averaged 5 percent of G DP and its current account defi­
cits averaged 9 percent o f GDP (N elson, Belkin, and M ix 2010). Borrow ing to
cover these deficits pushed Greece’s external debt to 115% o f G DP by 2008.
T his already precario u s finan cial p o sitio n w orsened in 2 0 0 9 a s the G reek
economy moved into recession. With government expenditures rising and gov­
ernment revenues falling, the budget deficit rose to 13 percent o f G D P. The
announcement o f this large deterioration caused m arkets to question whether
Greece could service its debt. Consequently, the G reek governm ent found it
more expensive and more difficult to borrow . Indeed, by early 2 0 1 0 interest
rates on Greek governm ent debt were 4 0 0 basis points higher than rates on
equivalent Germ an government debt— a clear sign of the m arket’s loss of con­
fidence in Greece’s ability to service its debt. It looked increasingly likely that
the Greeks w ould be driven to default.
The Greek debt crisis brought into the open for the first time a distribu­
tive conflict that had alw ays been im plicit in the EU ’s m onetary union. This
distributive conflict focused on one central question: who w ould bear the cost
of Greek’s excessive debt burden? W ould Greece default, thereby pushing the
cost onto the institutions and individuals that held Greek debt? W ould Greece
implement an austerity program to elim inate its budget and current account
deficits and thereby generate the fun ds needed to service its foreign debt?
W ould other EU governm ents lend to Greece so it could service its foreign
246
CHAPTER l l
Cooperation, Conflict, and Crisis
debt w ithout ad o ptin g harsh austerity m easures? T h is optio n w ould even­
tually shift the risk o f a G reek default from private financial institutions to
taxpayers in Germ any, France, and other northern European countries. If the
Greek government were to default on loans from the EU, residents in these EU
countries w ould have to pay. W ould the EC B depreciate the euro, thereby im­
proving G reece’s international com petitiveness and enabling it to em bark on
an export-led recovery? A lthough a w eaker euro m ight benefit Greece, who
lacks international competitiveness, a w eaker euro w ould generate inflation in
northern Europe.
EU governments struggled to select am ong these alternatives. The Greek gov­
ernment asserted that in the absence o f financial assistance from the EU, it would
be forced to default on some o f its debt. EU governments made it clear that any
loans to Greece from the EU would necessitate Greek austerity measures. These
negotiations unfolded under the shadow of similar sovereign debt problem s in
Spain, Portugal, and Italy. If Germ any went easy on Greece, this w ould signal
other indebted governments that they could expect easy terms as well. This signal
would possibly encourage other governments to dump their debt burdens on the
broader EU membership. Determined to avoid sending this signal, the Germans
bargained hard, demanding stiff austerity measures as the price o f EU assistance.
Their ability to im pose harsh austerity w as limited, however, by Greece’s abil­
ity to turn to the IM F. Hence, German (or EU) demands could be no more stringent than the austerity measures the IM F would require. By late M arch, Greece
had reached agreement with the EU on a package that included $40 billion of
loans from the EU and the IM F and a set of fairly stringent austerity m easures
that would reduce the budget deficit by 7 percent o f GDP.
It proved difficult to gain public supp ort for the agreem ent, a necessary
step for its implementation. In Germ any, opinion polls indicated that as many
as 85 percent o f the Germ an electorate opposed a Greek “ bailou t” (Connolly
2 0 1 0 ). M an y expected the G reek governm ent to d efau lt, thereby fo rcin g
G erm an w orkers to w ork longer hours to p ay for generous G reek pension
plans. Set again st public opposition w as the recognition that G erm an banks
held a lot o f G reek debt, so a G reek d efau lt w ould w eaken G erm an banks
and perhaps precipitate a broader financial crisis that required an even larger
response from the G erm an government. The situation in Greece w as also dire.
People pro tested the austerity p ack age. As m any as 5 0 ,0 0 0 w o rk ers to o k
to the streets to disp lay their d issatisfactio n with budget cuts and pension
reforms. In one action, three people were killed.
A lthough ail governm ents ratified the agreem ent, the w ay EU go vern ­
m ents handled the G reek crisis failed to convince m arkets that they had a
solution to EU governm ents’ sovereign debt problem s. R ather than reassure
m arkets, the whole process suggested that default w ould be the m ost likely
outcom e in the event o f a new shock in Greece or deterioration in another
M editerranean country. Events in Greece indicated that governments face ex­
treme public opposition to austerity m easures. Events in G erm any indicated
that creditor governm ents could not lend freely to deeply indebted govern­
ments. In this environm ent, m arket participants concluded that no one w as
'J
Conclusion
247
willing to accept the costs required to service the debt. C onsequently, m ar­
kets rem ained turbulent, forcing EU governm ents to develop a more robust
response. This they did in M ay o f 2 0 1 0 , creating a joint EU /IM F emergency
funding facility totaling nearly $1 trillion. Governments m ay or may not con­
vert this emergency fund into a permanent element of EM U .
The crisis also raised broader questions about the viability o f EM U . The
core question at the base o f the issue is whether it is reason able for govern­
ments to accept the constraints im posed by m onetary union or whether they
w ouldn’t be better o ff with greater exchange rate flexibility. If Greece were
not a member of m onetary union, it could devalue its currency to regain ex­
port com petitiveness. And while this w ouldn’t elim inate the need for budget
cuts, it m ight enable the cuts to occur in a grow ing rather than contracting
economy. M oreover, m ore flexible currency arrangem ents w ould have obvi­
ated the need for other EU m em ber governm ents to fin d a solu tion to the
Greek debt problem. Hence, the crisis regenerated a discussion about whether
the EU should be a m onetary union and, if so, who should be a member.
CONCLUSION
Developments in the contem porary international m onetary system reflect the
same dynamics that shaped developments under the Bretton W oods system. In
concrete term s, the United States continues to run large current account defi­
cits. Am erican deficits continue to be o ffset by large surpluses in Germ any,
Japan, and more recently China. These global imbalances generate conflict. The
United States continually pressures its largest creditors, Ja p a n and Germany in
the 1980s and Germany and China in the 2 0 0 0 s, to alter policies to prom ote
adjustment. Creditor governments in turn pressure the United States to put its
government finances in order. The refusal by all governm ents to m ake m ean­
ingful policy adjustments generates financial instability— a sharp drop in equity
prices in one case and a severe crisis o f the global financial system in another.
In more abstract terms, developments in the contem porary international mon­
etary system is driven by distributive conflict between governments in creditor
and debtor economies over who should bear the costs o f adjustment.
M oreover, the experience o f EU governm ents indicates that distributive
conflicts are endemic to international m onetary system s rather than a conse­
quence o f disagreements am ong specific governments. For even when govern­
ments place great value on exchange-rate stability, exchange rate cooperation
has been profoundly shaped by distributive conflict. Indeed, the EU ’s transi­
tion to monetary union w as shaped in large part by a desire to redistribute the
costs of exchange-rate stability. The ongoing debt problem s in Ireland, Greece
and other M editerranean econom ies indicate that different m acroeconom ic
policy objectives in northern and southern Europe continue to shape the sys­
tem’s evolution. In the broader international m onetary system as well as in the
regional systems, the im balances themselves, as well as the conflict about who
should adjust to eliminate them, emerge from the w ay dom estic politics shape
macroeconom ic policies.
248
C H A P T E R 11
Cooperation, Conflict, and Crisis
Against the backdrop of these constant characteristics o f the international
m onetary system s, we see substantial change over the p ast few years. O f p ar­
ticular importance has been China’s emergence as a fundam entally im portant
creditor country in the international m onetary system . C h in a’s emergence in
this capacity has affected A m erican policy— shifting A m erican focu s from
Germ any and Ja p a n to C hina. It has also affected glo b al governance struc­
tures. The broadening o f the policy coordination process from the G roup of 7
to the G roup o f 20 is sym bolic o f this change. M ore fundam entally, C h ina’s
emergence as a creditor country has placed an em erging m arket econom y in
the center of the international m onetary system for the first time in its history.
It will be interesting to follow the im pact o f this change in the years to come.
KEY TERMS
European Monetary
System
International Investment
Position
Louvre Accord
Monetary Union
Plaza Accord
Target Zone
SUGGESTIONS FOR FURTHER READING
For the evolution of the international financial system since the Second World War,
see Eric Helleiner, States and the Re-emergence o f Global Finance: From Bretton
Woods to the 1990s (Ithaca, NY: Cornell University Press, 1994), and Robert
Solomon, Money on the Move: The Revolution in International Finance since 1980
(Princeton, NJ: Princeton University Press, 1999).
For those interested in the European monetary system, see Peter Kenen, Economic
and Monetary Union in Europe: Moving beyond M aastricht (Cambridge, UK:
Cambridge University Press, 1995); Kathleen MacNamara, The Currency o f Ideas
(Ithaca, NY: Cornell University Press, 1997); and Thomas Oatley, Monetary Poli­
tics: Exchange Rate Cooperation in the European Union (Ann Arbor: University of
Michigan Press, 1997).
CHAPTER
12
A Society-Centered
Approach to
Monetary and
Exchange-Rate
Policies
O
ur focus on the international monetary system in the last tw o chapters
hinted at but did not deeply explore an im portant question— w hat
determ ines the specific exch an ge-rate p o licies th at govern m en ts
ad o p t? Why do som e governm ents fix their exch an ge rate w hile others
float? Why do some governments prefer strong, and m aybe even overvalued
currencies, whereas others prefer weak and undervalued currencies? We take
up this question in this chapter and the next by exam ining tw o approaches
to m onetary and exchange-rate po litics ro o ted in d om estic p o litics. T his
chapter develops a society-centered approach. The society-centered approach
argues that governm ents’ m onetary and exchange-rate policies are shaped
by politician s’ responses to interest-group dem ands. The E u rop ean Union
(EU )’s willingness to fix exchange rates reflects EU governm ents’ responses
to the dem ands o f domestic interest grou ps. The Am erican reluctance to fix
the dollar, or even to do much to stabilize it, reflects American policym akers’
responses to the demands of American interest groups.
T o understand the political dynam ics o f this com petition , the societycentered approach emphasizes the interplay between organized interests and
political institutions. The approach is based on the recognition that monetary
policy and exchange-rate m ovements have distributional consequences. For
exam ple, when the d ollar rose in value a g ain st A m erica’ s la rg est trading
partners by about 30 percent between 1995 and 2 0 01, some groups benefited
and some suffered. American businesses and consumers could im port goods at
lower prices. This translated into higher real incomes for consum ers, and lower
production costs for businesses. The strong d ollar hurt others as Am erican
249
250
C H A P T E R 12
A Society-Centered Approach to Monetary and Exchange-Rate Policies
exporters found it increasingly difficult to sell in foreign m arkets. G ay lo rd
C o n tain er C o rp o ra tio n , fo r e x a m p le , lo st sales in G erm an y b ecau se the
strong dollar m ade it difficult to compete against Scandinavian and C anadian
producers (Hilsenrath 2001). Im port-com peting businesses also faced tougher
foreign com petition in the U .S. m arket. A u to m atic Feed C o m p an y , b ased
outside T o le d o , O h io, m akes m achines th at unroll 7 5 ,0 0 0 poun d coils o f
steel for autom akers. As the dollar strengthened, it retreated from exporting
to focus on the Am erican m arket, only to discover that Am erican carm akers
were buying less expensive m achines from G erm any (H ilsenrath 2 0 0 1 ). For
this group, the strong dollar yielded falling incomes.
These distributional consequences generate political com petition as the
winners and losers turn to the p o litical arena to advance and defend their
econom ic interests. Businesses that benefit from a w eak d ollar pressure the
government for policies that will keep the dollar undervalued again st foreign
currencies. By 2 0 0 3 , A m erican producers had established a “ C o alition for
a Sound D o llar” that coordin ated the lobbying energies o f m ore than sixty
trade associations representing a very broad range o f Am erican traded-goods
industries. Businesses that benefited from a strong d ollar, such as the W all
Street firm s that gained from im porting foreign capital, lobbied to keep the
dollar strong. Exactly how this competition unfolds— which groups organize to
lobby, what coalitions arise, how politicians respond to interest-group dem ands,
which group’s interests are reflected in m onetary and exchange-rate policy, and
which grou ps’ interests are not— are shaped by specific characteristics o f the
political institutions within which the competition unfolds.
T his chapter develops this society-centered approach to m onetary and
exchange-rate policy. We focus first on the trade-off between domestic economic
autonom y and exchange-rate stability. We exam ine how changes in political
institutions and innovations in economic theory combined to create incentives for
governments to value domestic autonomy more than exchange-rate stability. The
chapter then explores three society-centered models o f monetary and exchangerate policy. We conclude by considering some weaknesses of this approach.
ELECTORAL POLITICS, THE KEYNESIAN
REVOLUTION, AND THE TRADE-OFF BETWEEN
DOMESTIC AUTONOMY AND EXCHANGE-RATE
STABILITY
We learned in the previous tw o chapters that governm ents confront a trad e­
o ff between exchange-rate stability and dom estic econom ic auton om y. T o
m ain tain a fixed exch an ge rate, a govern m en t m u st surren d er its ability
to m an age the d om estic econom y. T o m an age the d om estic eco n om y , a
government m ust accept a floating exchange rate. Although this trade-off has
always been present, it is only since the 1920s that governm ents have chosen
dom estic econom ic auton om y over exchange-rate stability. Prior to W orld
W ar I, m ost governments sacrificed dom estic econom ic autonom y to maintain
Electoral Politics and the Keynesian Revolution
251
fixed exchange rates in the gold standard. Our first goal is to understand how
changes in dom estic politics and econom ic theory that occurred during the
interwar period led governments to place greater value on dom estic economic
autonom y and to attach less importance to exchange-rate stability.
The tran sform ation o f electoral system s—the rules governing who has
the right to vote— throughout W estern E urope follow in g the F irst W orld
War fundamentally changed the balance of power in domestic political systems.
T his new balance o f pow er had trem endous repercussions on governm ent
attitudes toward economic management. Prior to the First W orld W ar, electoral
systems in m ost W est European countries were extremely restrictive. The right
to vote w as generally limited to males, usually aged 25 years or older, who met
explicit property or income conditions. In European countries with parliamentary
governments, less than one-quarter o f the total male population in the relevant
age group met these conditions. In G reat Britain, for example, only 3.3 percent
of the population could vote until 1884; reforms enacted in 1884 extended the
right to vote to only about 15 percent o f the population. Even in D enm ark,
where the right to vote w as much broader, m ass participation w as restricted
to lower house elections (the Folketing), and the monarch did not have to respect
lower house majorities in forming governments (Miller 1996).
European electoral systems were substantially reformed after the First World
W ar. By 1921, restrictive property-based electoral rules had been eliminated
and universal male suffrage had been adopted in all West European countries.
C h anges in electoral law s h ad a p ro fo u n d im pact on the co n stellation o f
political parties in West European parliaments. Table 12.1 displays the share of
parliam entary seats held by each o f the m ajor political parties in a few W est
E uropean countries before and after the First W orld W ar to illustrate this
political transform ation. Prior to W orld W ar I, political parties o f the right—
Conservatives, Liberals, and Catholics— dominated European parliaments. After
World W ar I, leftist parties— Socialists, Social Democrats, and Labour— became
large, and in som e instances, the largest parliam en tary parties in the W est
European countries. This shift in the balance of political power within European
parliaments altered the pattern of societal interests that were represented in the
political process. Before World War I, the propertied interests represented by the
political parties of the right had a virtual monopoly on political power, whereas
the interests of workers were all but excluded from the political process.
F o llo w in g W orld W ar I, how ever, w o rk in g-class in terests gain ed an
authoritative voice in national parliam ents. As a consequence, governm ents
were forced to respond for the first time to the dem ands o f w orkers in order
to m ain tain their hold on p o litical pow er. And w o rk ers, w ho on average
hold little wealth and whose standard o f living thus depends heavily on their
weekly pay, have less concern about inflation than propertied interests, whose
real value o f w ealth is eroded by in flation . W hat w orkers care a b o u t are
the em ploym ent opportunities available to them and the w ages they earn in
these jobs. The rise of worker pow er therefore created political incentives for
governm ents to ad o pt econom ic policies that w ould raise em ploym ent and
keep w ages relatively high. Such policies were not alw ays con sisten t with
252
C H A P T E R 12
A Society-Centered Approach to Monetary and Exchange-Rate Policies
T A B L E 12.1
Percentages of Seats Held by Parties in Parliament,
Pre- and Post-World War I
1870-1900
1920-1930
Belgium
Catholic (46%-93%)
Liberals (4%-53%)
Denmark
Liberals (60%-75%)
Conservatives (25%-30%)
France
Republicans (60%—80%)
Germany
Center (20%)
National Liberals(12%-30%)'
Conservatives (10%-20%)
Catholic (40%)
Liberals (12%-15%)
Workers Party (35%-40%)
Social Democrats (32%-40%)
Liberals (30%—35%)
Conservatives (16%~20%)
Republican Union (30%-35%)
Socialists (16%-25%)
Radical Socialists (17%-25%)
Social Democrats (20%-30%)
National People's Party (20%)
Netherlands
Britain
Liberal Union (35%-53%)
Catholics (25%)
Anti-revolutionary (15%-25%)
Conservatives (37%-50%)
Liberals (26%-48%)
S o u rc e :
Center (13%)
People's Party (10%)
Catholics (28%)
Social Democrats (20%)
Anti-revolutionary (12%)
Conservatives (40%-67%)
Labour (30%-47%)
Mackie and Rose 1991.
a continued com m itm ent to the gold stan dard . The shift in political pow er
produced by electoral reform , therefore, created political incentives to move
aw ay from the rigid constraints o f a fixed exchange-rate system to avoid the
domestic costs of balance-of-payments adjustment.
The second im portant change during the interwar period arose from revo­
lutionary ideas in economic theory that emerged during the 1930s. These ideas
provided a com pelling theoretical rationale for governm ents to use m onetary
policy to m anage the dom estic econom y. Joh n M ayn ard Keynes spurred this
revolution in his role as academ ic econom ist. Keynes’s m ost influential w ork
w as shaped by his observations o f the British econom y during the 1920s and
1930s. W hat Keynes focused on in particular w as unemployment. British un­
employment rose to about 20 percent in the early 1920s and never fell below
10 percent during the rem ainder o f the decade (Skidelsky 1994, 130; Tem in
1996). Such persistently high rates o f unem ploym ent defied the expectations
of the standard economic theory, neoclassical econom ics.
N eoclassical econom ics argued that such persistent high unem ploym ent
was im possible because m arkets have equilibrating m echanism s that keep the
economy at full employment. High unemployment m eant that the dem and for
labor w as lower than the supply o f labor at the prevailing w age rate. Because
labor m arkets are no different from any other m arket, an im balance between
Electoral Politics and the Keynesian Revolution
^
*
253
supply and demand should give rise to an adjustm ent process that eliminates
the im balance. In this case, the excess supply o f la b o r represented by high
unemployment should cause the price o f labor— w ages— to fall. As the price
o f labor falls, the demand for labor will increase. Eventually such adjustments
will guide the economy back to full employment. In neoclassical theory, there­
fore, unemployment w as expected to give rise to an au tom atic adjustm ent
process that would lead the economy back to full employment.
The persistence of high unemployment in interwar Britain caused Keynes
to reevaluate the n eoclassical ex p lan atio n o f unem ploym ent (Lekachm an
1966; Skidelsky 1994). Keynes’s thinking culminated in a book written in the
early 1930s (and published in 1936) called The G eneral Theory o f E m ploy­
ment, Interest, and Money, which challenged neoclassical econom ics in two
connected w ays. First, Keynes suggested th at n eoclassical econom ists were
wrong to think that an economy would alw ays return to full employment au­
tom atically. For reasons that we explore in a m om ent, Keynes argued that
an economy could get stuck at an equilibrium characterized by underutilized
production capacity and high unem ploym ent. Second, Keynes argued that
governments need not accept persistent high unemployment. Instead, govern­
ments could use macroeconomic policy— m onetary policy and fiscal policy—
to restore the economy to full employment.
According to Keynes, economies can get stuck at high levels o f unemploy­
ment because of the fragility of investment decisions. Investment expenditures
typically account for about 20 percent o f total national expenditures. Variation
in investment expenditures, therefore, can have an im portant influence on the
overall level of economic activity: When investment rises, the economy grow s,
and when investment falls, the economy stagnates. Investment decisions, in turn,
are strongly influenced by firms’ expectations about the future demand for their
products. When firms expect future demand to be strong, they will invest and the
economy will experience robust growth. When firms expect future demand to be
weak, however, they will make few new investments and economic growth will
slow. If an economy is hit by some sort of shock that causes domestic demand
to collapse and unemployment to rise, firms will develop very pessimistic fore­
casts of the demand for their products in the future. N ew investments will not be
made and the economy will remain stuck at a high level o f unemployment. This,
according to Keynes, is what had happened to Britain during the 1920s.
Because Keynes believed that the cause o f persistent high unemployment
ultimately lay in inadequate demand for good s, he proposed that governments
use fiscal and m onetary policy to m an age aggreg ate d em an d . A ggregate
dem and is the sum o f all consum ption and investm ent expenditures m ade
by the governm ent, by dom estic and foreign consum ers, and by producers.
Governments m anage aggregate dem and with fiscal and m onetary policies.
F iscal and m onetary po licies each affe ct ag g re g ate d em an d in differen t
w ays. Fiscal policy affects aggregate dem and directly. When the government
cuts taxes without reducing expenditures, aggregate dem and increases because
private individuals’ consum ption expenditures increase by som e proportion
of the tax reduction. When the government increases its expenditures without
raising taxes, total government expenditures rise. The additional dem and for
254
C H A P T E R 12
A Society-Centered Approach to Monetary and Exchange-Rate Policies
goods and services that results from these increased expenditures causes firms
to hire m ore w orkers to produce the additional good s being dem anded.
M onetary policy affects aggregate dem and indirectly by changing dom es­
tic interest rates. An increase in the m oney supply will cause the dom estic
interest rate to fall. Low er interest rates m ake it cheaper to borrow . A s the
cost of borrow ing falls, the dem and for investment-related expenditures, such
as new homes and high-price consum er items like cars, rises because these are
usually purchased with credit and are therefore sensitive to the interest rate.
Firm s will hire m ore w orkers in order to produce the higher level o f output
being demanded. A m onetary expansion, therefore, will lead to falling interest
rates, low er interest rates w ill increase ag g reg ate d em an d , an d increased
aggregate dem and will cause output and employment to rise.
In short, Keynes argued that by spending when others w ould not or by
increasing the money supply to induce others to spend, the government could
increase dem and in the economy. By increasing total dem and in the economy,
investm ent w ould rise and unem ploym ent w ould fall. T h us, by using m ac­
roeconom ic policy to m anage aggreg ate dem and, governm ents could keep
the econom y running at full em ploym ent. K ey n es’s G en eral T heory there­
fore represented a substan tial challenge to the prevailing w isdom ab o u t the
role governments could and should play in m anaging the dom estic economy.
N eoclassical econom ists saw the m arket econom y as an inherently stable sys­
tem that w ould return au tom atically to full em ploym ent follow in g a shock
that raised unemployment. There w as therefore no need for active government
management o f the economy. In contrast, Keynes saw the m arket econom y as
potentially unstable and susceptible to large and sustained departures from
full employment. Such an unstable econom ic system needed a stabilizer, and
in Keynes’s vision governm ents could perform this stabilizing function by us­
ing m acroeconom ic policy to m anage aggregate dem and. In one rem arkable
book, Keynes “ rewrote the content of economics and transform ed its vocabu­
lary . . . [He] inform ed the w orld that fatalism tow ard econom ic depression,
m ass unemployment, and idle factories w as w ron g” (Lekachm an 1966, 59).
By the end o f W orld W ar II m any governm ents had reevaluated the role
they could and should play in the dom estic econom y. Legislation enacted in
the United States and G reat Britain illustrates the im pact that this reevaluation
had on governm ent policy. In 1945 the U .S. C ongress considered “ The Full
Employment Act” that assigned to the federal government the responsibility for
maintaining full employment. Even though Congress did not pass the 1945 act, in
1946 the bill was renamed and passed as the Employment Act. And although the
Employment Act replaced the term full employment with maximum employment,
the bill nevertheless symbolized a fundamental change: N o longer would the U.S.
government leave the operation o f the American economy fully to m arket forces
(Stein 1994, 7 6 -7 7 ). In Britain, the government published a “ White Paper on
Employment Policy” in 1944, which stated in its very first line, “ the government
accepts as one o f their primary aim s and responsibilities the maintenance o f a
high and stable level o f em ployment after the w ar” (cited in H all 1 9 86, 71).
This commitment provided the foundation for the m acroeconom ic policies o f
successive British governments until the late 1970s.
Society-Based Models of Monetary and Exchange-Rate Politics
255
Together, electoral reform and the Keynesian revolution had a profound
effect on exchange-rate policies. E lectoral reform altered the balance o f p o ­
litical pow er, shifting the center o f gravity aw ay from the propertied classes
tow ard the w orkers. This created political incentives to use m onetary policy to
m anage the dom estic economy. The Keynesian revolution m ade governments
and publics more aware o f the policy m easures that could be used to promote
em ploym ent and at the sam e time broke the neoclassical strictures on their
use. As a consequence, voters have com e to expect governments to m anage the
economy, and governments have responded by becoming more willing to use
monetary policy to meet these expectations (H all 1989, 4).
In this w orld, exchange-rate politics revolve around com petition between
groups with very different interests. In som e cases, this com petition involves
factor- or class-based groups pressing the government to adopt their preferred
monetary policy. In other cases, this com petition involves sector-based groups
pressuring the governm ent to ad o pt their preferred exchange-rate policy. In
all instances, m onetary and exchange-rate politics are driven by com petition
between groups pressuring the governm ent to use these policies in w ays that
advance or defend their econom ic interests. We turn now to lo o k at three
models of this competition.
SOCIETY-BASED MODELS OF MONETARY
AND EXCHANGE-RATE POLITICS
S c h o la rs h ave d ev elo p ed three so c ie ty -b a se d m o d els o f m o n e tary an d
exchange-rate politics: an institutional m odel, a partisan m odel, and a sectoral
model. The institutional and partisan m odels assum e that a governm ent’s exchange-rate policy reflects its m onetary policy decisions. Both m odels assum e
that a ll governm ents w ant to retain m onetary policy auton om y in order to
m anage the domestic economy. Sometimes the monetary policy that a govern­
ment adopts is consistent with a fixed exchange rate and som etim es it is not.
These m odels then exam ine how po litics shape m onetary policy in order to
understand the government’s exchange-rate policies.
A CLOSER LOOK
The Unholy Trinity
- / '^
The standard framework used to conceptualize the trade-off between domestic ...
economic autonomy and exchange-rate stability is “the Unholy Trinity," The
concept starts from the recognition that governments have three policy goals, each
of which is desirable in its own right: (1) a fixed exchange rate, (2) autonomy of
monetary policy (using monetary policy to manage the domestic: economyl,,and ■
(3) capital mobility (allowing financial capital to flow freely into and out of the
(Continued)
256
C H A P T E R 12
A Society-Centered Approach to Monetary and Exchange-Rate Policies
domestic financial, system). It then tells us.^at.a governmentj^n achiesve only,"
two of these three goals simultaneously.If a government w£nt|mon$tjpy,palicy
autonomy, it must choose between capital mobility and. a fixqdfxchange rate. If a r
government wants a fixed exchange, rate, }t must,choose, between monetary policy
autonomy and capital mobility.
,
An example illustrates this trade-off in practice. In early 1981, France was
.
maintaining a fixed exchange rate within the-European monetary systemvIn sp|te of
this commitment, it adopted an expansionary monetary policy and cut French interest
rates. France was relatively open to.capital flows, so financial markets responded to
the lower interest rates by selling francs and purchasing foreign currencies. These «
capital outflows produced an imbalance in the foreign exchange market. Demand for
the franc fell, and it began to depreciate within the European monetary system.
If France wanted to maintain the fixed exchange rate, it had to intervene in the
foreign exchange market. Intervention would reduce the supply of francs, thereby
causing French interest rates to rise and tightening monetary policy. The franc
would stabilize once French interest rates again equaled interest rates in foreign
countries. Thus, to defend the exchange rate, France would have to reverse its
initial monetary expansion. Because France was unwilling to raise interest rates/
it was forced to devalue the franc. Given capital mobility, therefore, France was
forced to choose between using monetary policy to stimulate the French economy
and using monetary policy to maintain a fixed exchange rate.
The French government could have maintained the fixed exchange rate and used
monetary policy to manage the domestic economy (at least for a while) if it had
prevented capital flows. Suppose France implemented capital controls and then
cut interest rates and expanded the money supply. The fall in French interest rates
would then have created an incentive for capital to move out of France, but the
capital controls would have prevented it from actually doing so. Without capital
outflows, no large imbalance would develop in the foreign exchange market, and
the franc would not depreciate. Thus, a government that prohibits capital flows can
maintain a fixed exchange rate and retain monetary policy autonomy.
Restricting capital mobility, however, does not provide complete autonomy; it
merely relaxes the trade-off between exchange-rate stability and autonomy. Even if
France had prohibited capital flows before embarking on its monetary expansion,
it would have been forced eventually to choose between the fixed exchange rate and
the monetary expansion. It would have been forced to do so because the monetary
expansion would have generated a current-account deficit as greater demand led to
rising imports. The current-account deficit would in turn generate an imbalance in the
foreign exchange market, causing the franc to depreciate. France would then have to
intervene to prevent this depreciation. Continued intervention would eventually exhaust
France's foreign exchange reserves. France would then have to either allow the franc
to depreciate or tighten monetary policy. Thus, even if capital flows are restricted,
France still faces a trade-off between exchange-rate stability and monetary autonomy.
The trade-off is stricter in a world with capital flows, however, than it is in
a world without capital flows, for two reasons. First, when capital is mobile,
Society-Based Models of Monetary and Exchange-Rate Politics
257
imbalances arise rapidly following a change in monetary policy. In a world without
capital flows, imbalances arise slowly as the current account moves into deficit
Second, in a world with capital flows, imbalances can be very, very large. The
imbalance equals the difference between large capital outflows and much smaller
capital inflows. This difference can be as much as billions of dollars per day.
Without capital flows, imbalances remain pretty small. In sucha world, imbalances
equal the gap between imports and exports, and although this gap might be large
over the course of the year, on any given day it will be relatively small and will never
approach the multibillion-dollar gaps that characterize a world with capital flows.
Because imbalances are smaller and emerge more slowly in a.world without •
.
capital flows, a government's foreign exchange reserves fast, lodger than they do .
when capital is mobile. The large imbalances generated by capital .outflows can ,
rapidly exhaust a government's foreign exchange reserve; indeed, a government can
run through its reserves in a day or two. France spent $32 billion in a single week
defending the franc against a speculative attack in 1992. In a similar vein, Great Britain spent half of its foreign exchange
reserves
in two -days, In*a • world
without
.
.
^
^t •
*
capital flows, the smaller imbalances generated by current-account deficits do not
exhaust a government's foreign exchange reserves nearly sqqulckty. A, government ,
can pursue monetary expansion and spend its reserves defending the exchange rate ,
over the course of the year. 5till, reserves will eventually run out, and when they ..
do, the government will be forced to tighten monetary policy or float the currency^;,,
Prohibiting capital flows, therefore, doesn't eliminate the trade-off, between monetary
policy autonomy and exchange-rate stability, but it does reiax it substantially. ■ -
The secto ral m odel assu m es th at exch an g e-rate p o licy is determ ined
by com petition between sector-based interest gro u p s. T his m odel does not
assum e that all governm ents value m on etary-policy au ton om y m ore than
exchange-rate stability. Instead, it assu m es th at each interest grou p values
each side o f th is trad e -o ff d ifferen tly . Som e g ro u p s a ttach co n sid e rab le
value to exch an ge-rate stab ility an d little v alu e to m o n etary au ton om y ;
others attach little value to exchange-rate stab ility and considerable value
to m onetary auton om y. W hether the govern m en t fix e s the exchange rate
or whether it retains m onetary auton om y is determ ined by the balan ce of
pow er am ong these com peting groups. A lthough the m odels each provide a
distinct perspective, they all agree that exchange-rate policies emerge from
political com petition.
The Electoral Model of Monetary and Exchange-Rate Politics
The electoral m odel argues that exchange-rate policy reflects decisions that
governments m ake concerning monetary policy. It assum es that governments
care m ost ab ou t m onetary-policy auton om y an d will m aintain a fixed e x ­
change rate only when the m onetary policy required to do so correspon ds
258
C H A P T E R 12
A Society-Centered Approach to Monetary and Exchange-Rate Policies
with its dom estic econom ic objectives. In the electoral m odel, dom estic eco­
nomic objectives are in turn shaped by the need to win elections.
In dem ocratic political system s governm ents m ust periodically stand for
reelection. In m ost advanced industrialized societies, dom estic econom ic con­
ditions have an im portant influence on how voters evaluate incum bent go v ­
ernments, so governments have an incentive to establish their m acroeconom ic
policy objectives with at least one eye on the electoral calendar (see K ram er
1971; N ord h aus 1989; T ufte 19 7 8 ; D razen 2 0 0 0 ). In particular, politicians
may be more likely to adopt expansionary m acroeconom ic policies in the eigh­
teen m onths prior to an election in order to create strong econom ic grow th
and falling unemployment at the time o f the election (Tufte 1978, 9). Even if
politicians are not inclined to engineer preelectoral econom ic boom s (and ex­
isting research does not provide com pelling evidence that there is a system atic
electoral cycle in m acroeconom ic policy), politicians m ay believe that voters
will punish them for p o o r econom ic conditions. As an election approach es,
politicians might therefore be reluctant to cede m onetary authority, choosing
to allow exchange rates to fluctuate instead (Bernhard and Leblan g 1999).
The im portant point is that because econom ic perform ance shapes how peo ­
ple vote, politicians will be less inclined to adopt econom ic policies that slow
econom ic grow th and raise unem ploym ent and m ore inclined to ad o p t p o li­
cies that boost economic grow th and lower unemployment.
B ut p o litic ia n s o p e ra te w ith in a sp e c ific in stitu tio n a l c o n te x t th at
lim its their ab ility to a d ju st m acro eco n o m ic p o licie s to their benefit. In
constitutional dem ocracies politicians m ust win the approval o f veto players,
which are actors or organ ization w hose ap p ro v al is necessary for enacting
policy. E xam p les o f veto p lay ers can include o p p o sitio n p o litical p arties
and independent governm ent institutions (Bearce 2 0 0 2 ; Broz 2 0 0 2 ; T sebelis
2002). For exam ple, in federal dem ocracies the parties that control the central
governm ent m ay be restricted in their ability to control fiscal policy. They
m ust not only overcome objections from the opposition party, but subnational
or su p ran atio n al governing units also have som e influence over econom ic
policy (H allerberg 2 0 0 2 ). In the United States these include the fifty states,
which have their own budgets, authority to raise or low er ta x e s, and other
fiscal policy tools. In such cases where discretion over fiscal policy is limited,
a national governm ent m ay wish to m aintain m onetary policy autonom y in
order to m ore directly control the national econom y. T hus, by limiting fiscal
autonom y veto players can heighten the im portance o f m onetary authority
and provide incentives to opt for flexible exchange rates.
One o f the m ost widely publicized instances o f a governm ent sacrific­
ing a fixed exchange rate to electoral po litics occurred in the U nited States
in the early 1 9 70s. The United States ended the convertibility o f the d ollar
into gold in A ugust 1971 and devalued the dollar by 10 percent in the follow ­
ing m onths. According to one scholar, the decision by President R ichard M .
N ixon to break the link with gold and devalue w as viewed “ through a lens that
focused on the 1972 presidential election, then fifteen m onths aw ay ” (G ow a
1983, 163). Am erican econom ic conditions in 1971 were not enhancing the
Society-Based Models of Monetary and Exchange-Rate Politics
259
prospects of N ix o n ’s reelection. Early in his first term N ix o n had allowed his
economic team to reduce inflation, which w as at a then-high level o f about
5 percent, and by 1970 the Am erican econom y had slipped into a recession
and unemployment w as beginning to rise (Stein 1994, Chapter 5).
The rise in unemployment evoked painful memories for N ixon . In 1960,
Nixon, who w as at the time vice president, had run for president against John
F. Kennedy. The 1960 cam paign took place in the context o f a recession, and
in O ctober unem ploym ent increased by alm ost h alf a m illion. N ix o n w as
convinced that the rise in unemployment just prior to the N ovem ber election
caused him to lose to Kennedy. “ All the speeches, television broadcasts, and
precinct w ork in the world could not counteract that one hard fact” o f higher
unemployment, he later wrote (N ixon 1962, 309). N ixon w as determined to
avoid again falling victim to an economic slump in the 1972 election.
With econom ic forecasts predicting that unem ploym ent w ould rise to
6 percent in 19 7 2 , the N ix o n adm inistration decided to m ake the reduction
of unemployment the number-one objective o f m acroeconom ic policy (Tufte
1978, 4 8). As one senior adm inistration official later recounted, “ [in 1971]
the word went out that 1972, by G od, w as going to be a good year” (cited in
Tufte 1978, 4 8 ). Action w as taken on both m onetary and fiscal policy. The
adm inistration m ade it know n that it w anted the Federal Reserve Bank (the
Fed) to increase the rate of grow th o f the money supply, and the Fed obliged
(though it rem ains unclear whether the Fed’s expansion w as coincidental or a
direct response to White H ouse pressure). In addition, governm ent spending
was increased through a range o f measures. By the middle of 1971, the N ixon
adm inistration w as using m onetary and fiscal policies to reduce unem ploy­
ment in the run-up to the 1972 presidential election.
The consequences for the d ollar’s fixed exchange rate again st gold were
clear and dram atic. The boost to dom estic dem and caused by the expansion­
ary policy widened the U .S. trade deficit. Interest-rate cuts led to capital out­
flow s. The com bination o f a w idening current-account balance and capital
outflow s w orsened the United States’ overall balance-of-paym ents position
and provoked gold outflow s. It quickly becam e apparent that the N ix o n ad ­
m inistration w ould have to choose between its dom estic econom ic expansion
and the d ollar’s fixed exchange rate (G ow a 1983, 170). In an A ugust 1971
meeting at C am p D avid, therefore, the N ixon adm inistration m ade tw o deci­
sions that were inextricably linked: to push forw ard with its m acroeconom ic
exp an sio n in the hope that this w ould reduce unem ploym ent in the run-up
to the election, and to end the convertibility o f the dollar into gold, in effect
devaluing the d ollar. One might suggest, therefore, that the Bretton W oods
system collapsed so that N ixon might win the 1972 presidential election.
T h e end of dollar convertibility therefore nicely illustrates the logic of the
electoral approach to exchange-rate policy. President N ix o n ’s concern that
high unemployment would reduce his chances for reelection led him to adopt
expan sionary m acroeconom ic policies. When it became apparent that expan­
sionary m acroeconom ic policies were inconsistent with a fixed exchange rate,
the N ix o n adm inistration devalued the dollar.
260
C H A P T E R 12
A Society-Centered Approach to Monetary and Exchange-Rate Policies
Although the electoral approach highlights an im portant dynamic driving
m acroeconom ic and exchange-rate policy, it does suffer from tw o im portant
weaknesses. First, it offers only a limited explanation o f exchange-rate policy.
It tells us that a government might abandon a fixed exchange rate prior to an
election, but it tells us little ab ou t exchange-rate policy at other tim es. If the
government wins the election, for exam ple, will it return to a fixed exchange
rate? Second, the electoral ap proach does not provide determ inistic predic­
tions. The approach does not claim that all governments will abandon a fixed
exchange rate prior to an election. Rather, it suggests only that governm ents
som etim es have an incentive to do so. T hus, the electoral ap proach offers a
quite limited explanation o f exchange-rate policy.
The Partisan Model of Monetary and Exchange-Rate Politics
The partisan approach also links exchange-rate policy to the governm ent’s
monetary-policy decisions. Like the electoral model, the partisan model assumes
that every governm ent values m onetary autonom y m ore than exchange-rate
stability. All governments will thus m aintain a fixed exchange rate only when
the monetary policy required to do so is consistent with its domestic economic
objectives. In the partisan model, however, different political parties pursue dis­
tinct macroeconomic objectives. Some parties use monetary policy to reduce unemployment and are forced to float their currency. Other parties use monetary
policy to limit inflation and can more readily maintain a fixed exchange rate.
The partisan m odel is based on a trad e-off between unem ploym ent and
inflation called the Phillips curve. The Phillips curve is nam ed after British
econom ist A. W. Phillips, who in 1958 w as the first to posit such a relation­
ship. It suggests that a governm ent can reduce unem ploym ent only by cau s­
ing m ore rap id inflation and can reduce in flation only by cau sin g higher
unem ploym ent. One can clearly see the trad e-o ff between inflation and un­
employment that Am erican policym akers faced between 1961 and 1970 (see
Figure 12.1). Each d ata point in Figure 12.1 represents the rate o f inflation
and unemployment for a single year. N otice how, in the years when inflation
was low, unemployment w as high, whereas in years when unemployment w as
low , inflation w as high. T his relationship produces the negative line on the
figure, characteristic of the Phillips curve trade-off.
Political econom ists have used the apparen t trad e-off between inflation
and unem ploym ent to suggest that different po litical parties use m acroeco­
nom ic p o licy to m ove the d om estic econom y to differen t p o rtio n s o f the
Phillips curve. Parties from the political left, such as Socialist parties, Social
Dem ocratic parties, Com m unist parties in W estern Europe, the L ab o u r party
in Britain, and the D em ocratic Party in the United States, have traditionally
given priority to achieving a low level o f unem ploym ent, even though this
entails higher inflation. Such parties will try to shift the econom y to the u p ­
per left portion o f the Phillips curve. Parties from the political right, such as
the Conservative party in Britain, the R epublican party in the United States,
Liberal parties, and Christian D em ocratic parties in Europe, have traditionally
*
Society-Based Models of Monetary and Exchange-Rate Politics
261
7
1961
6.5
6
Inflation (percent)
5.5
5
4.5
4
3.5
3
2.5
2
0
1
2
3
4
5
Unemployment (percent)
FIG URE 12.1
The Phillips Curve in the United States, 1961-1971
S ource:
United States Government,
E conom ic Report o f the President
(Washington, DC; Government Printing Office,
2 0 0 2 ).
given priority to low inflation even though this entails higher unemployment.
These parties will use m acroeconom ic policy to m ove the econom y to the
lower right portion o f the Phillips curve.
These distinct partisan m acroeconom ic policies reflect the interests of the
different social grou ps represented by parties o f the left an d parties o f the
right. Leftist parties traditionally have had strong ties to organized labor. Be­
cause employment is a central concern of labor unions, the tight link between
organized labor and leftist parties creates an incentive for leftist governments
to use macroeconom ic policy to maintain high levels o f employment. Parties of
the right have traditionally had closer links to business interests, the financial
sector, and the middle class. These social groups are typically less concerned
about unemployment and more concerned about protecting the value o f their
accum ulated wealth. Because in modern economies people maintain large por­
tions o f their wealth in financial instruments, the desire to protect the value of
wealth is transformed into a desire to protect the real value o f financial assets.
And since inflation erodes the real value o f financial w ealth, w ealth holders
have an interest in policies that m aintain stable prices. In representing the in­
terests of people with accum ulated wealth, therefore, parties o f the right have
an incentive to adopt m acroeconom ic policies that maintain stable prices.
A large body of research suggests that leftist and rightist governments in the
advanced industrialized countries have in fact pursued distinct macroeconom ic
6
262
C H A P T E R 12
A Society-Centered Approach to Monetary and Exchange-Rate Policies
policies throughout the postw ar period. Research on W est E uropean dem oc­
racies has found that leftist governm ents have been m ore w illing to tolerate
inflation and more inclined to pursue expansionary fiscal and m onetary poli­
cies than rightist governm ents (O atley 1997, 1999; G arrett 1998). Studies o f
m acroeconom ic policy and m acroeconom ic-policy outcom es in the U nited
States have identified similar patterns. Eight o f the ten recessions that have oc­
curred in the United States between 1946 and 2 0 0 2 , for exam ple, cam e under
Republican adm inistrations, and only two occurred under D em ocratic adm in­
istrations (Keech 1995, 7 2 -7 3 ). M oreover, historically, unem ploym ent rates
have been 2 percentage points higher, on average, under R epublican than un­
der D em ocratic adm inistrations, w hereas the grow th o f incom es has been 6
percentage points lower under R epublican leadership than under D em ocrats
(H ibbs 1987). Republican adm inistrations appear, therefore, to be m ore w ill­
ing to tolerate rising unemployment in order to restrain inflation than D em o­
cratic administrations. Even though there have certainly been exceptions to this
general pattern, research suggests that political parties from the left and right
have in fact pursued distinct m acroeconom ic policies when in office.
Distinct partisan m acroeconom ic policies can give rise to distinct partisan
exchange-rate policies. A ccording to the p a rtisa n a p p ro a ch , leftist p arties
are less likely to m aintain a fixed exchange rate. E xp an sio n ary policies will
reduce dom estic interest rates and raise dom estic dem and. Such policies will
in turn cause capital outflow s and increasing im ports. C apital outflow s and a
widening current-account deficit will in turn lead to foreign exchange m arket
imbalances and a weakening currency. Com m itted to the domestic expansion,
leftist governments are likely to resist the policy changes required to support
a fix ed exch an g e rate a g a in st these p re ssu re s. C o n se rv ativ e p a rtie s are
more likely to m aintain a fixed exchange rate. R estrictive m onetary policies
are less likely to generate capital outflow s or to increase dom estic dem and.
A s a result, co n servative governm ents are unlikely to co n fro n t p ersisten t
imbalances in the foreign exchange m arket and therefore will not be forced to
change their m onetary policies to sustain a fixed exchange rate. Conservative
governm ents are therefore m ore likely to estab lish an d m ain tain a fixed
exchange rate. Thus, the partisan approach suggests that leftist governm ents
are less likely to maintain a fixed exchange rate than rightist governments.
The politics o f m acroeconom ic policy in France between 1978 and 1982
nicely illustrate how changes in the partisan com position o f a governm ent can
affect m acroeconom ic and exchange-rate policies. A center-right government,
led by President Valery G iscard d ’Estaing and Prime M inister Raym ond Barre,
held office in France during much o f the 1970s. G iscard and Barre gave priority to reducing inflation (Oatley 1997). This choice w as by no m eans dictated
by econom ic conditions. French inflation w as high during the 1 9 7 0 s, rising
to 13 percent in 1975 and hovering around 10 percent for the rest o f the de­
cade. But French unemployment had also risen steadily throughout the 1970s,
from a low o f 2 .7 percent in 1971 to 6 percent by the end o f the decade. The
governm ent’s decision to give priority to reducing inflation thus reflected a
partisan preference.
*
^
^
Society-Based Models of Monetary and Exchange-Rate Politics
263
This em phasis on reducing inflation, along with the associated policy of
a fixed exchange rate, was abandoned in the early 1980s when the Socialist
Party, led by Francois M itterrand, defeated G iscard d’Estaing in presidential
elections in M ay o f 1981. M itterrand quickly abandon ed the anti-inflation
stance in an attem pt to reduce French unem ploym ent. A gain, this decision
was not dictated by economic conditions. Inflation remained strong, rising to
about 13 percent in 1981, despite the previous government’s efforts to reduce
it. Unemployment had also continued to rise in the late 1970s and early 1980s,
reaching what w as then a postwar high o f 7 percent in 1981. M itterrand’s de­
cision to focus on unemployment and pay less attention to inflation w as thus a
reflection o f this government’s close ties to the French working class.
M itterran d ’s governm ent im plem ented exp an sio n ary m acroecon om ic
policies. The government budget deficit w as increased, pum ping m ore govern­
ment spending into the economy, and the Bank o f France reduced dom estic
interest rates. This expansion was inconsistent with the franc’s fixed exchange
rate inside the EM S. Financial capital began flowing out o f France in response
to the falling interest rates. The French current-account deficit w idened as
strong domestic dem and limited the goods available for export and pulled in
imports. The deteriorating balance-of-payments position weakened the franc
in the foreign exchange m arket, generating a series o f speculative attack s
against the franc’s parity in the E uropean M onetary System (EM S). R ather
than abandon its effort to reduce unemployment, the Socialist government de­
valued the franc three times between M ay 1981 and M arch 1 9 83. T hus, a
leftist government implemented an expansionary policy that w as inconsistent
with a fixed exchange rate, and when forced to choose between the tw o objec­
tives, it abandoned the fixed exchange rate.
The French case therefore highlights how partisan politics can shape m ac­
roeconomic and exchange-rate policies. A rightist governm ent com m itted to
low inflation tightened monetary policy and em braced a fixed exchange rate.
The leftist government that followed gave priority to reducing unemployment,
adopted expan sionary m acroeconom ic policies in pu rsuit o f this objective,
and repeatedly devalued the currency. Although the partisan approach tells us
more about how politics shape m onetary and exchange-rate politics than the
electoral approach, it too has w eaknesses. Its chief w eakness is that partisan
macroeconomic policies are differentiated too sharply. N o t all leftist govern­
ments pursue expan sionary m acroeconom ic policies and ad o p t floating e x ­
change rates. The French Socialists, for exam ple, em braced a fixed exchange
rate inside the E M S in m id-1983, and then m aintained this fixed rate for the
remainder o f the decade. N or do all rightist governments adopt fixed exchange
rates. The Conservative Party government led by M argaret Thatcher that gov­
erned Britain throughout the 1980s, for exam ple, steadfastly refused to adopt
a fixed exchange rate for the pound. And even once the pound w as placed
in the EM S after Joh n M ajor replaced Thatcher in 1990, it w as a C onserva­
tive Party government that took the pound out o f the system and returned to
a floating exchange rate in 1992. T hus, even though the partisan approach
highlights the historical tendency for distinct partisan m acroeconom ic and
264
C H A P T E R 12
A Society-Centered Approach to Monetary and Exchange-Rate Policies
exchange-rate policies, it is im portant to rem ain sensitive to the specific con ­
text when applying this approach to a particular case.
The Sectoral Model of Monetary and Exchange-Rate Politics
The sectoral model links exchange-rate policy choices to com petition between
se cto r-b ase d in terest g ro u p s. U nlike the ele cto ra l an d p a r tisa n m o d e ls,
the sectoral m odel does not assu m e th at all governm ents value m onetary
autonom y more than exchange-rate stability. Instead, government preferences
refle ct in te re st-g ro u p p re fe re n c e s. A n d in te re st g r o u p s h o ld d iffe re n t
preferences over the trad e-o ff betw een d om estic econom ic au ton om y and
exchange-rate stability. Some interest groups prefer floating, but others prefer
fixed exchange rates. Some interest groups prefer a strong currency, but others
prefer a w eak currency. Each group lobbies the governm ent on behalf o f its
preferred exchange-rate policy. E xchange-rate policy is determ ined by the
group that has the greatest influence.
The secto ral m odel sp lits d om estic acto rs into fo u r d om estic interest
groups or sectors: im port-com peting producers, export-oriented producers,
nontraded-goods producers, and the financial services industry (see Frieden
1 9 9 1 ,1 9 9 7 ). We have encountered each o f these groups previously, so we will
not describe their characteristics again here. Each group has preferences over
tw o dim ensions o f exchange-rate policy. First, each grou p has a preference
regarding the degree o f exchange-rate stability. Som e grou ps prefer a fixed
exchange rate but others prefer a floating exchange rate. Second, each group
has a preference regarding the level o f the exchange rate. Some groups prefer a
strong currency but others prefer a w eak currency.
Preferences over exchange-rate stability reflect the im portance that each
sector attach es to exchange-rate stability and m onetary-policy auton om y.
Sectors w hose econom ic interests are dam aged by exchange-rate m ovem ents
place con siderable value on exch an ge-rate stab ility. T h o se secto rs w hose
interests are not dam aged by such m ovem ents place less value on exchangerate stability. Sim ilarly, sectors th at con du ct m o st o f their business in the
domestic economy want to ensure that domestic economic conditions provide
adequate dem and. They will therefore place considerable value on monetarypolicy autonom y. Sectors that conduct m ost o f their business in international
m ark ets are less co n cern ed a b o u t d o m e stic eco n om ic c o n d itio n s. T h ey
therefore place very little value on m onetary-policy autonom y. T hus, sector
preferences over exchange-rate stability reflect the value that each attach es
to exchange-rate stability and m onetary-policy auton om y. Sectors that are
harm ed by exchange-rate m ovem ents and that lose little from surrendering
m onetary autonom y prefer fixed exchange rates. Sectors that are not harm ed
by exchange-rate m ovem ents and that lose from the loss o f m onetary-policy
autonom y prefer floating exchange rates.
This framework generates clear preferences for three o f the four sectors. The
export-oriented sector prefers a fixed exchange rate. Export-oriented producers
are heavily engaged in in tern ation al trad e, and exchange-rate m ovem ents
Society-Based Models of Monetary and Exchange-Rate Politics
265
damage their economic interests. They therefore place great value on exchangerate stability. Because export-oriented producers are heavily engaged in foreign
trade, they lose very little if the governm ent cannot use m onetary policy to
manage the domestic economy. They therefore attach little value to monetarypolicy autonom y. The export-oriented sector, therefore, is willing to give up
monetary-policy autonomy to maintain a fixed exchange rate.
The nontraded-goods and the im port-com peting sectors prefer a floating
exchange rate. N either o f these sectors is deeply integrated into the global
econom y; both generate their revenues from sales in the dom estic m arket.
As a consequence, these sectors are not greatly affected by exchange-rate
movements, and they attach little value to exchange-rate stability. M oreover,
because producers in these sectors con du ct their business in the dom estic
economy, they have a keen interest in retaining the governm ent’s ability to
use m onetary policy to m anage the dom estic economy. They therefore assign
great value to m onetary-policy au ton om y . The n o n trad ed -go o d s an d the
import-competing sectors therefore w ant to retain monetary-policy autonom y
and accept flexible exchange rates to do so.
The financial services sector’s preferences are less clear. Financial services
are highly internationalized, and exchange-rate movements can dam age their
interests. This international exposure creates som e interest in exchange-rate
stability. At the sam e tim e, how ever, financial institutions p ro fit from e x ­
change-rate volatility. Currency trading has become an im portant source of
profits for the financial services industry. In addition, banks offer services that
help businesses engaged in international trade manage their exchange-rate risk
(Destler and H enning 1 9 8 9 , 133). T h us, it is not clear how much value the
financial services sector attaches to exchange-rate stability. Financial institu­
tions do value monetary-policy autonomy. They depend upon the central bank
to maintain the stability o f the domestic banking system and to keep domestic
inflation in check. Both objectives require monetary-policy autonomy. In addi­
tion, financial institutions are dam aged by excessive fluctuations in dom estic
interest rates, and using monetary policy to maintain a fixed exchange rate can
produce more volatile domestic-interest rates. These crosscutting interests have
led many to conclude that on balance, the financial sector prefers monetarypolicy autonom y and is willing to accept exchange-rate flexibility (Destler and
Henning 1 9 8 9 ,1 3 3 - 1 3 4 ; see Frieden 1991 for an alternative view).
Sectors also have preferences over the level o f the exchange rate. These
preferences arise from the im pact th at currency values have on incom es in
each sector. The export-oriented and im port-com peting sectors both prefer
a weak or undervalued currency. A w eak dom estic currency reduces the for­
eign currency cost o f domestic traded goods and raises the dom estic currency
cost o f foreign traded good s. These price levels enhance the com petitiveness
of export-oriented producers in global m arkets, thereby allow ing them to ex­
pand their exports. They also reduce the competitiveness o f foreign producers
in the dom estic m arket, m aking it easier for im port-com peting producers to
dom inate the home m arket. T hus, firm s in the traded-goods sector prefer an
undervalued or weak currency.
266
C H A P T E R 12
A Society-Centered Approach to Monetary and Exchange-Rate Policies
The n o n trad ed -go od s secto r prefers a stro n g o r overvalued currency.
A strong currency raises incom e in this sector. People em ployed in the non­
traded-goods sector consume a lot o f traded goods. A strong dom estic currency
reduces the domestic currency price o f traded goods, both those im ported from
abroad and those produced at home. When the dollar appreciates, for exam ple,
foreign goods become cheaper in the Am erican m arket and dom estic produc­
ers m ust m atch these falling prices to rem ain com petitive. A strong or over­
valued exchange rate, therefore, raises the incomes o f people em ployed in the
nontraded-goods sector. For this reason, this sector prefers a strong currency.
The financial services sector again has crosscu ttin g interests. Financial
institutions benefit from a stro n g currency because it allo w s them to p u r­
chase foreign assets at a low er price. But, other facto rs create an interest in
a w eak currency. M o st financial institutions, even those deeply involved in
international business, continue to lend heavily to dom estic firms. Because an
overvalued exchange rate harm s firm s in the trad ed-good s sectors, a strong
currency can weaken financial institutions that have loaned heavily to firm s
in the trad ed-good s sector. In add ition , financial institutions purch ase and
hold foreign assets for the returns they provide. As these returns are typically
denom inated in foreign currencies, a w eak currency w ill raise the d o m es­
tic currency value o f these returns. It is not easy for financial institutions to
balance these crosscu ttin g co n sid eratio n s. W hat best su its the interests o f
financial institutions is the ability to buy foreign assets when the dom estic
currency is strong and repatriate the returns on these assets when the domestic
currency has w eakened. Because o f these crosscutting interests, financial in­
stitutions “ tend to be agnostic with respect to the level o f the exchange rate”
(Destler and Henning 1989, 132).
B rin g in g th ese tw o d im e n sio n s o f e x c h a n g e - r a te p o lic y to g e th e r
provides a full picture o f sectoral preferences over exchange-rate policy (see
T able 12.2). The colum ns in T able 12.2 depict the degree o f exchange-rate
stability. The column labeled “ H igh ” denotes a fixed exchange rate (and thus
T A B L E 12.2
Sectoral Exchange-Rate Policy {preferences
Preferred Degree of Exchange-Rate Stability
High
Nontradable-goods
industry
Financial services
High
Preferred Level of
the Exchange Rate
S o u rc e :
Low
Based on Frieden 1991, 445.
Low
Export-oriented
industries
Import-competing
industries
Financial services
Society-Based Models of Monetary and Exchange-Rate Politics
*
267
no monetary-policy autonom y), w hereas the colum n labeled “ L o w ” denotes
a floating exchange rate (and thus full monetary-policy autonom y). The rows
in the table depict the level o f the exchange rate. The row labeled “ H ig h ”
denotes a strong currency, w hereas the row labeled “ L o w ” denotes a w eak
currency. Each cell of the table thus represents a com bination o f the degree o f
exchange-rate stability and the level o f the exchange rate.
We can place each sector in the cell co rre sp o n d in g to its exchangerate policy preference. The “ H ig h -H ig h ” cell is em pty; no sector desires a
strong currency and a fixed exchange rate. The nontraded-goods sector and
the financial services in dustry occupy the “ H ig h - L o w ” cell. Firm s in the
nontraded-goods sector w ant a strong currency to m axim ize their purchasing
pow er, and they want a floatin g exchange rate so the governm ent can use
m onetary policy to m anage the dom estic econom y. The financial services
industry fits less clearly in this cell. Its preference for a floating exchange rate
places it in the left column, but its agnosticism about the level o f the exchange
rate prevents us from assigning it definitively to the top row.
The export-oriented sector occupies the “ Lo w -H igh ” cell. Export-oriented
firms want a weak currency to enhance their export competitiveness, and they
want a stable exchange rate to minimize the disruptions caused by exchange-rate
volatility. Because these industries are not heavily dependent on the domestic
economy, they are willing to sacrifice monetary-policy autonomy to stabilize the
exchange rate. Finally, the import-competing sector occupies the “ L o w -L o w ”
cell. Firms in this sector want a weak currency to enhance their competitiveness
against imports in the domestic market, and they want a floating exchange rate
so the government can use monetary policy to manage the domestic economy.
PO LICY A N A L Y S IS AND D E BA T E
A Strong Dollar or a Weak Dollar?
Question
Should the United States pursue a strong dollar or a weak dollar?
Overview
As the United States moved into recession in the wake of the 2008 financial
crisis, the newly elected administration began to develop an export-led
economic recovery strategy. In his State of the Union address in January
2010, President Barak Obama pledged to double American exports in 5 years
in order to create two million additional jobs. In pursuit of this goal, the
administration has been willing to accept, and in some instances been inclined
to encourage, a depreciation of the dollar against America's primary trade
partners. Indeed, from its peak in the November 2008, the dollar has lost
(Continued)
268
C H A P T E R 12
A Society-Centered Approach to Monetary and Exchange-Rate Policies
about 10 percent in nominal terms against the United States' principal trade
partners. The depreciation is even larger— between 30 and .40 percent— relative
to the dollar's high point in 2003. Supporters of this policy argue that a weaker
dollar is a necessary component of American current account adjustment and
economic recovery.
Critics of the Obama administration highlight the costs and potential dangers
associated with a weaker dollar. Some analysts argue that market expectations
of prolonged dollar weakness could lead to,higher interest rates in the United
States. Higher interest rates would raise the cost of investment for the private
sector and raise the federal government's borrowing costs. Higher interest rates
could thus slow recovery. Others suggest that a determined policy of undervaluing
the dollar will eventually spark foreign retaliation, thereby raising the possibility
of a trade war. More profoundly, a loss of foreign confidence in the commitment
by American policymakers to a strong dollar could cause foreign governments
to shift from the dollar to the euro as their primary vehicle currency and
reserve asset. Such a shift would precipitate a major collapse of the dollar and
substantially raise borrowing costs in the United States. For advocates of this
position, a strong dollar is a critical American interest. What is the right value
for the dollar?
Policy Options
• Pursue policies to strengthen the dollar against foreign currencies.
• Pursue policies to keep the dollar relatively undervalued In order to promote
exports.
Policy Analysis
• What are the costs and benefits to the United States of a weak dollar?
• What are the costs and benefits to the United States of a strong dollar?
Take A Position
• Which option do you prefer? Justify your choice.
• What criticisms of your position should you anticipate? How would you defend
your recommendation against this critique?
Resources
Online: Do an online search for "strong dollar weak dollar." Look for C. Fred Bergsten's webpage at the Institute for International Economics (www.IIE.com.). He
writes regularly about dollar policy. See in particular his "The Correction of the
Dollar and Foreign Intervention in the Currency Markets." Search also for Barry
Eichengreen's home page (at the University of California at Berkeley). He has
some interesting papers under his policy section.
In Print: C. Fred Bergsten, "The Dollar and the Deficits," Foreign Affairs (November/
December 2009); Paola Subacchi and John Driffill. Beyond the Dollar: Rethinking the
International Monetary System (London: Chatham House, 2010).
Society-Based Models of Monetary and Exchange-Rate Politics
^
V
269
The political dynam ics surrounding the sh arp appreciation o f the U .S.
dollar in the early 1980s and its subsequent depreciation after 1985 nicely
illustrates how these com petin g interest-grou p preferen ces seek to shape
exchange-rate policy in the United States (see D estler an d H enning 1 9 89;
Frankel 1990). The U .S. d o llar ap p reciated by 5 0 percent betw een 1 9 8 0
and 1985. Interest grou ps m obilized in an attem pt to influence the R eagan
adm inistration’s ap p roach to both the level and the stability o f the dollar.
Export-oriented pro du cers organized and lo bbied for a w eaker and m ore
stable dollar. Farmers, for exam ple, argued that the strong dollar w as reducing
their incomes, and they pressu red the R eagan ad m in istration to bring the
dollar down. M anufacturing industries, led by the Business R oundtable and
the N ation al A ssociation o f M an u factu rers, also pressed for depreciation.
The Business R oundtable put together a broad-based coalition o f businesses,
including rep resen tatives fro m C ate rp illa r, F o rd , U .S. Steel, H oneyw ell,
M otorola, IBM, and X erox, to pressure the U .S. Treasury, the Federal Reserve,
and Congress for policies to weaken the dollar.
This group also advocated m easures to increase the stability o f the dollar
against the other m ajor currencies. Although few suggested that the United
States return to a fixed exchange rate, m ost o f the executives in the coalition
welcomed the process of coordinated foreign exchange m arket intervention
initiated by the 1985 Plaza A ccord and encouraged the R eagan adm in istra­
tion to pursue ad d ition al coordin ated intervention. In add ition , the group
applauded the 1 9 8 7 Louvre A ccord, under which the United States, Jap an ,
Germany, Great Britain, and France agreed to stabilize exchange rates at their
current levels. And finally, they encouraged the U .S. governm ent to explore
the possibility of implementing a target zone to bring stability to international
monetary arrangements on a more permanent basis. Thus, just as the sectoral
approach suggests, export-oriented producers pressured for a w eak dollar and
for greater exchange-rate stability.
The financial services industry also exhibited the preferences highlighted
by the sectoral approach. D uring the early 1980s, the financial services indus­
try displayed little concern about the dollar’s appreciation. For the m ost part,
this industry benefited from the falling prices o f foreign assets that the strong
dollar implied. T o the extent that financial services firms voiced any concerns
as the dollar appreciated, they focused on the im pact the strong d ollar w as
having on traded-goods industries in the United States (Destler and Henning
1989). Financial institutions also failed to register stron g o pposition to the
Reagan adm inistration’s concerted effort to engineer a depreciation o f the d ol­
lar after 1985. Thus, the financial sector w as neither a strong supporter of the
strong dollar nor a vocal opponent of a w eaker dollar.
Financial services firm s did react stron gly, how ever, to the attem pt by
the traded-goods sector to pressure the R eagan adm inistration to stabilize the
dollar. The Am erican Bankers’ A ssociation’s Econom ic A dvisory Committee
argued that the G ro u p o f 5 (G 5) agreem ent to stab ilize the d o llar under
the Louvre A cco rd w as a m istak e. In a d d itio n , the co m m ittee o p p o sed
broader international monetary reforms that w ould lead to the adoption o f a
270
C H A P T E R 12
A Society-Centered Approach to Monetary and Exchange-Rate Policies
target-zone system. M onetary policy, they argued, should not be dedicated to
maintaining a stable exchange rate, and foreign exchange m arket intervention
should be undertaken only in “ exception al circu m stan ces.” A s the sectoral
ap p ro a ch lead s us to ex p ect, th erefore, the fin an cial serv ices se cto r w as
agnostic ab ou t the level o f the exchange rate but w as o p p o sed to efforts to
stabilize the d ollar at a fixed exchange rate. A m erican exchange-rate policy
during the 1 9 8 0 s thus highlights the dynam ics em ph asized by the sectoral
approach. The interests and pow er o f tw o prom inent sectors o f the American
econom y, exp ort-orien ted p ro d u ce rs and the fin an cial services in d u stry ,
shaped American exchange-rate policy.
The sectoral ap proach provides greater detail ab o u t exchange-rate p o l­
icy than the partisan approach , but it too has w eaknesses. Three such w eak­
nesses are m ost troublesom e. First, the sectoral approach m ay overestim ate
the im portance that export-oriented firm s attach to exchange-rate stability.
Although exporters m ay be harm ed by exchange-rate volatility, it is also true
that businesses can reduce their exposure to volatility by using forw ard m ar­
kets to cover the risk they face. A s a consequence, exchange-rate volatility
m ay be less d am agin g in practice. Second, the m odel m ay overestim ate the
im portance that the trad ed-good sector attach es to a w eak currency. In an
open econom y, m any firm s im port interm ediate inputs. Because a w eak cur­
rency raises the dom estic currency price o f these im ports, it raises production
costs. As a consequence, a portion o f the gains that these firm s realize from
a weak currency is eliminated. Finally, the sectoral m odel tells us little about
exchange-rate policy o utcom es. A s w ith the society-centered ap p ro a ch to
trade policy, this m odel does not provide much help understanding which of
the com peting sectoral dem ands will ultim ately be represented in exchangerate policy. Insofar as we are interested in explaining policy outcom es, this
will remain an im portant w eakness o f the sectoral model.
CONCLUSION
The society-centered m odels thus argu e th at d om estic p o litical p ressu res
determ in e the m o n e tary an d e x c h a n g e -ra te p o lic ie s th a t g o v e rn m e n ts
ado pt. The three approach es presented here su ggest that governm ents face
a multitude o f social pressures— from voters, from classes, and from sectorbased interest groups. These pressures are transm itted to governments through
multiple channels, including m ass-based elections, class-based party system s,
and interest-group lobbyin g. So cial p ressu res can influence exchange-rate
policy indirectly by shaping a governm ent’s m acroeconom ic policy objectives,
and they can influence exchange-rate policy directly by shaping the choices
that a governm ent m ak es betw een a fixed or flo a tin g exch an ge rate and
between a strong or w eak currency. R ather than suggestin g th at m onetary
and exchange-rate policies are determined exclusively by one type o f pressure
or another, it is probably the case that they are influenced by all o f the social
pressures discussed here. One approach m ay be better suited to som e countries
than to others, or to som e time periods than to others. A full understanding
Conclusion
271
o f how dom estic p o litics influence m onetary and exch an ge-rate p o licies,
however, will probably require attention to all three approaches.
As a group, however, these society-centered approaches to exchange-rate
politics are susceptible to some o f the sam e criticisms that have been directed
tow ard society-centered ap p roach es to dom estic trade politics. C h ap ter 4
pointed to three specific criticisms: They don ’t explain outcom es, they omit the
interests o f noneconom ic interest groups, and they assum e that governm ents
do not have independent preferences. H ow powerful are these criticisms when
applied to a society-centered approach to m onetary and exchange-rate policy?
Let us look at each of these criticisms in turn. The claim that society-centered
models tell us a lot about interests but little about outcom es is less pow erful in
the context o f exchange-rate politics than in the context o f trade politics. Tw o
o f the three m odels we looked at provide explicit linkages between societal
interests and policy outcom es. In the electoral m odel, outcom es result from
government m acroeconom ic policy choices taken in reference to electoral con­
cerns. In the partisan m odel, policy outcom es result from decisions m ade by
the party that controls government. The sectoral approach is more vulnerable
to this criticism. As w as noted above, the sectoral approach convincingly ac­
counts for interest-group preferences over monetary and exchange-rate policy,
but it tells us little about the process through which these com peting interests
are transformed into policy outcom es.
Society-centered m odels o f exchange-rate and m onetary policy are less
vulnerable to the claim that they ignore the interests of noneconom ic actors.
Although these m odels do exclude noneconomic interest groups, such interest
groups appear to have less o f a stake in m onetary and exchange-rate policies
than they may have in trade policy. The exchange rate is a rather blunt policy
instrument. A governm ent cannot easily use exchange-rate policy to punish
or reward specific foreign governments for their hum an rights records or for
their environmental policies. For exam ple, even though the United States can
deny China access to the U .S. m arket w ithout disturbing its other trade re­
lationships, the United States cannot easily alter the d ollar’s exchange rate
again st the yuan (the Chinese currency) w ithout also altering the d o lla r’s
exchange rate again st other currencies. For this reason, hum an rights activ­
ists, environmental grou ps, and other noneconom ic interest groups have not
pressured governments to use exchange-rate policy to achieve specific foreign
policy objectives. Thus, the om ission of noneconomic interest groups from the
society-centered approach may be less w orrying in the context o f exchangerate and monetary policies than in trade policy.
Finally, our society-centered m o dels o f m on etary and exch an ge-rate
policy do overstate the ability of domestic interest groups to influence policy,
and they underestim ate the im portance o f independent state action. A fairly
large literature suggests that monetary and exchange-rate policies are heavily
insulated from dom estic pressure grou ps (see, for exam ple, K rasn er 1 9 7 7 ;
Odell 1982). In the United States, for exam ple, exchange-rate and monetarypolicy decisions are m ade by the T reasury D epartm ent, the Federal Reserve,
and the White H ouse, all o f which are “ well insulated from particular societal
272
C H A P T E R 12
A Society-Centered Approach to Monetary and Exchange-Rate Policies
pressu res” (K rasner 1 9 7 7 , 65). M oreover, in m any countries central banks
operate with co n siderable independence from elected o fficia ls. P olitically
independent central banks can pursue m onetary and exchange-rate policies
free from interest-group pressu res and from p artisan and electoral politics.
In fact, over the last 15 years more and more governments have granted their
central banks greater political independence, h opin g to insulate m onetary
policy from social an d, m ore broadly , p o litical pressu res. We take up this
topic in the next chapter.
KEY TERM
Phillips Curve
SUGGESTIONS FOR FURTHER READING
For a good introduction to the politics of macroeconomic policy, see William R.
Keech, Economic Politics: The Costs o f Democracy (Cambridge, UK: Cambridge,
University Press, 1995). For a more advanced treatment, see Alan Drazen, Political
Economy in Macroeconomics (Princeton, NJ: Princeton University Press, 2000).
For an in-depth and readable exploration of the development of Keynes’s economic
ideas, see Robert Skidelsky, John Maynard Keynes: The Economist as Saviour
1920-1937 (New York: Penguin Press, 1992).
Two excellent treatments of the impact of the interwar changes are Beth Simmons,
Who Adjusts: Domestic Sources o f Foreign Economic Policy during the Interwar
Period (Princeton, NJ: Princeton University Press, 1994), and Barry J. Eichengreen,
Golden Fetters: The Gold Standard and the Great Depression, 1919-1939 (Oxford,
UK: Oxford, University Press, 1992).
A detailed discussion of the partisan approach to exchange-rate politics can be found
in Thomas Oatley, Monetary Politics: Exchange Rate Cooperation in the European
Union (Ann Arbor: University of Michigan Press, 1997).
Two excellent readings on the sectoral approach to exchange-rate politics are Jeffry A.
Frieden, “Invested Interests: The Politics of National Economic Policies in a World
of Global Finance,” International Organization 45 (Autumn 1991): 425-451,
and Jeffry A. Frieden, “ Monetary Populism in Nineteenth Century America: An
Open-Economy Interpretation,"The Journal o f Economic History 57 (June 1997):
367-395.
CHAPTER
13
A State-Centered
Approach to
Monetary and
Exchange-Rate
Policies
D
uring 1999 and 2 0 0 0 , the European Central Bank (ECB) began rais­
ing interest rates in an attem pt to stem the euro’s depreciation against
the dollar. European governm ents and m any European business and
labor groups complained strongly about the rising interest rates. In an already
sluggish European econom y, higher interest rates w ould only further depress
grow th, and a stronger euro would only m ake it m ore difficult for European
firms to export. Although the EC B m ay have heard these com plaints, it did
not respond to them. It continued to raise interest rates— six tim es, in fact,
during the next twelve months— in order to achieve the economic objective it
deemed m ost im portant: maintaining low inflation.
T h is e p iso d e , w hich d id n o t even m a k e th e fro n t p a g e o f m a jo r
n ew sp ap ers, reflects the rev olu tio n ary ch an ges th at have sw ept th rou gh
m onetary politics during the last 20 years. D uring the 1970s and 1980s, and
even as late as the m id-1990s, European governments used m onetary policy to
pursue their particular economic policy goals. And as we saw in Chapter 12,
governm ent policy goals typically reflected the interests o f dom estic interest
grou ps. In to d a y ’s E urope, the E C B sets interest rates; m onetary policy is
dedicated to achieving the E C B ’s prim ary objective, which is low inflation;
and European governments can do little to change the E C B ’s policy. In a very
short period, therefore, the E uropean U nion (EU) has m oved from a w orld
in which governments retained full control over m onetary policy to a world in
which they have practically no control over this im portant policy instrument.
N o r is the change restricted to Europe: G overnm ents throughout the w orld
have h an ded m o n etary p o licy to p o litic a lly in d epen d en t cen tral b an k s.
273
274
C H A P T E R 13
A State-Centered Approach to Monetary and Exchange-Rate Policies
C hanges in the institutional fram ew ork governing m onetary policy have in
turn altered the w ay that dom estic politics shapes m onetary and exchangerate policies.
T h is ch apter exam in es the tran sfo rm a tio n from govern m en t to bank
co n tro l th rou gh the lens o f a state-cen tered a p p ro a c h to m o n etary and
exchange-rate politics. Even though the approach is not often called a statecentered approach, it contains the central characteristic o f such an approach:
insulating policym akers from short-term po litical p ressu res that can raise
social welfare. We begin by exam ining contem porary econom ic theories that
argue that political control o f m onetary policy dim inishes social w elfare by
generating too much inflation. We then consider how , in theory, institutions
that insulate m onetary policy from politics, such as independent central banks
and fixed exchange rates, can elim inate this inflation and thus raise social
welfare. We next investigate how the emergence o f independent central banks
is likely to shape the domestic politics o f monetary and exchange-rate policies.
Finally, we conclude by looking at som e weaknesses o f this approach.
MONETARY POLICY AND UNEMPLOYMENT
The state-centered approach is based on econom ic theories that have increas­
ingly replaced the Keynesian m odels that dom inated m acroeconom ic policy­
m aking after W orld W ar II. The m odels we exam ined in C hapter 12, as well
as the Keynesian econom ic theories on which they are b ased , assum ed that
governm ents face a stable trad e-o ff between inflation and unem ploym ent.
Governm ents can exploit this trad e-off to guide the econom y tow ard low er
unemployment or lower inflation. Contem porary economic theory asserts that
no such stable trade-off between inflation and unemployment exists. There is
a trade-off in the short run, but a governm ent cannot use m onetary policy to
reduce unem ploym ent fo r any extended period w ithout generating an everhigher rate o f inflation (Friedman 1968; Phelps 1968).
At the center of this theory is the claim that all countries have a natural rate
o f unemployment, the econom y’s long-run equilibrium rate o f unemployment.
T h at is, the natural rate o f unem ploym ent is the rate o f unem ploym ent to
which the economy will return after a recession or a boom (Sachs and Larrain
1993). The natural rate o f unemployment is determined by the economy-wide
real w age, w hich is the w age at which all w orkers w ho w an t to w ork can
find em ploym ent. The natural rate o f unem ploym ent is never zero and can
in fact be substan tially above zero. Every econom y w ill alw ays experience
som e unem ploym ent. Som e peo p le will have left one jo b an d be seekin g
another. N ew entrants into the labor m arket, such as recent high school and
college grad u ates, will not find jo b s im m ediately. M oreover, lab o r m arket
institutions, such as labor unions, and labor m arket regulations that govern
m inim um w ages, hiring and firing practices, unem ploym ent com pen sation ,
and other social w elfare benefits can raise the natural rate o f unem ploym ent
substantially. These institutions can raise the economy-wide real w age, thereby
reducing the dem and for labor and raising the natural rate o f unemployment.
Monetary Policy and Unemployment
A
275
Because such institutions differ from one country to another, each country
will have a distinct natural rate of unemployment.
C on tem p orary econom ic theory argu es that a governm ent can n o t use
monetary policy to move unemployment below or above the natural rate o f
unemployment for more than a short time. T o understand this claim we must
first look at how w age bargaining affects unemployment in the short run. We
can then exam ine how monetary policy affects unemployment in the short run
and in the long run. In the short run, such as a one- or two-year period, the
unemployment rate is determined by the w age agreements concluded between
unions and businesses. Suppose that, in the current year, the econom y is at
its natural rate o f unemployment and labor is bargaining with m anagem ent
to determine the real w age for the next year. This w age bargaining is com pli­
cated by inflation. Workers care about their real w age— the actual purchasing
pow er of the m oney they are paid each w eek— but they are paid a nom inal
w age— a specific am ount o f cash per hour or per week. Because w age con ­
tracts usually fix w ages for a particular period, typically from 1 to 3 years,
the nominal w age em bodied in a contract will lose purchasing power a s prices
rise over the life o f the agreement. Because w orkers recognize that inflation
will erode the value of their nom inal w age, they will take inflation into ac­
count when negotiating their w age contracts. In other w ords, w orkers will
seek nominal w age agreements that protect their desired real wage against the
inflation they expect. If labor is seeking stable real wages for the next year, for
exam ple, but expects prices to rise by 4 percent in the course o f the year, it
will seek a 4 percent nominal wage increase.
H ow does labor know what inflation rate will prevail in the future? The
obvious answ er is that it doesn’t. Instead, labor will form ulate expectations
about the future rate o f inflation, which are essentially its “ best gu ess” about
the inflation rate during the period covered by the impending contract. In for­
m ulating these expectations, labor unions look at a variety o f factors. They
may look to the current government’s track record; if inflation has persistently
run at around 5 percent during the last few years, it might be reasonable to ex ­
pect 5 percent inflation in the next few years. They m ay also look for evidence
that the government is committed to reducing inflation in the future or, to the
contrary, for evidence that the government is likely to produce higher inflation
in the future. They m ay also take into account the partisan com position o f
the government or its position in the electoral cycle. Irrespective o f the source,
however, these expectations are likely to be imprecise.
When nom inal w age agreements are based on an expected inflation rate
that turns out to be mistaken, the real wage will rise or fall. If w orkers secure
a nominal w age increase that is greater than the actual rate o f inflation, then
the real w age will rise by the difference between the nom inal w age increase
and the rate o f inflation. So if a w age agreem ent raises nom inal w ages by
8 percent, but inflation is only 4 percent, then the real w age w ill rise by 4
percent. Conversely, if w orkers secure an agreement that raises their nominal
wage by less than the actual rate of inflation, real w ages will fall by the dif­
ference between the nominal wage increase and the rate o f inflation. So if the
276
C H A P T E R 13
A State-Centered Approach to Monetary and Exchange-Rate Policies
wage agreement calls for a 4 percent nom inal w age increase, but actual infla­
tion is 8 percent, the real wage will fall by 4 percent.
Changes in the real w age in turn affect the short-run unemployment rate.
An increase in the real w age m akes labor more costly to employ. The dem and
for labor therefore falls, cau sin g unem ploym ent to rise. A reduction in the
real w age m akes lab o r less costly to em ploy. The dem and fo r la b o r there­
fore rises, causing unem ploym ent to fall. T h us, in the short run, unem ploy­
ment rises above or falls below the natural rate o f unemployment in response
to changes in the real wage.
We can now exam ine how m onetary policy affects unem ploym ent in the
short run and in the long run. In the short run, an unanticipated change in m on­
etary policy that produces a rate of inflation different from the rate that unions
expected and incorporated into their nom inal w age contract shifts unemploy­
ment above or below the natural rate. An unexpected increase in the rate o f
inflation generated by a m onetary expansion will lower the real w age and re­
duce unemployment; an unexpected reduction in the rate o f inflation caused
by monetary contraction will raise the real w age and increase unemployment.
In the long run, how ever, these changes are reversed by la b o r m ark et
ad ju stm en ts th at pu sh un em p loym en t b ack to its n a tu ra l rate. S u p p o se
unanticipated inflation h as reduced the real w age. A s unem ploym ent falls
as a result, fewer people are available to w ork and businesses will have to
compete against each other to attract new workers and to retain their current
em ployees. T his com petition w ill cause real w ages to rise, m akin g it m ore
costly to em ploy w orkers. As the real w age rises, the dem and for lab or falls
and unemployment gradually returns to its natural rate.
N o w su p p o se th at low er-th an -an ticipated in flation h as in creased the
real w age, cau sin g unem ploym ent to rise above the n atu ral rate. B ecause
unem ploym ent has risen, a larger num ber o f people are now com peting for
fewer jobs. Competition between workers for scarce jobs will cause real wages
to fall, as each worker offers to accept employment at a real wage below those
of other workers. As real w ages are bid dow n, the unemployment rate returns
to its natural rate. Over time, therefore, labor m arket adjustments bring the real
wage back to the wage that clears the labor market, and the economy returns to
its natural rate of unemployment. Thus, even though an unanticipated change in
monetary policy can move unemployment below or above the natural rate in the
short run, the effects will be reversed over the long run. Therefore, governments
cannot use m onetary policy to reduce unem ploym ent over the long run. Any
monetary expansion will reduce unemployment for a short while, but eventually
labor market adjustments will restore unemployment to its natural rate.
M oreover, a government determined to use monetary policy to keep unem­
ployment below the natural rate for any lengthy period will have to continually
increase the rate of inflation to do so. (This is called the accelerationist principle.)
We can see why from a m odified version of the Phillips curve (Figure 13.1). In
this version, the economy is characterized by multiple Phillips curves. In each
short-run period, policym akers face a trade-off between inflation and unem ­
ployment— the dow nw ard-sloping curves labeled T v T2, and T 3 in the figure.
V
^
Monetary Policy and Unemployment
277
Inflation
I FIGURE 13.1
I
<
The Long-Run Phillips Curve
Because there is no long-run trade-off between inflation and unemployment, the
long-run Phillips curve is drawn as a vertical line that crosses the horizontal axis
at the economy’s natural rate o f unemployment (Un).
N o w suppose that, from the natural rate o f unemployment— point A on
Phillips curve T x— the government expands monetary policy in an attem pt to
push the rate o f unemployment below the natural rate, say, to point Ub. Infla­
tion rises, thereby reducing real w ages and boosting employment. T his effect
in turn pushes the econom y along the short-run Phillips curve T j to point B.
As workers and businesses react to the now-higher inflation, however, the real
wage rises back to its initial level and unemployment returns to its natural rate.
The inflation produced by the expansion is perm anent, however; conse­
quently, the government now faces a new short-run Phillips curve, labeled Tr
If the government wants to push unemployment below the natural rate again,
it m ust expand the money supply once more. If so, then the resulting inflation
reduces the real wage and causes unemployment to fall to point D . However,
adjustments again restore the economy to its natural rate o f unemployment at
an even higher rate o f inflation, point E on short-run Phillips curve T y Thus,
if a government w ants to keep unemployment below the natural rate for any
extended period, it m ust continually increase the rate o f inflation.
The experience o f the United States since the early 1960s illustrates this
dynam ic at w ork. One can identify fou r distin ct short-run Phillips curves
for the United States between 1961 and 1999. (See Figure 13.2.) D uring the
1960s, the inflation-unem ploym ent trade-off occurred within a fairly narrow
range of relatively low inflation (an average o f 3 percent). In the early 1970s,
the A m erican econom y jum ped to a new short-run Phillips curve that per­
sisted until about 1983. The trade-off between inflation and unemployment is
278
C H A P T E R 13
A State-Centered Approach to Monetary and Exchange-Rate Policies
FIGURE 13.2
Phillips Curves in the United States, 1961-2009
S o u r c e : E c o n o m ic R e p o rt o f the P re s id e n t , 2 0 1 0 .
apparent on this new Phillips curve, but it occurs at a higher rate o f inflation
(which averaged about 8.2 percent throughout the period), w ithout a corre­
sponding decrease in the average level o f unem ploym ent. In fact, unem ploy­
ment averaged 7.2 percent during this period, much higher than the level that
prevailed during the 1960s.
The American economy m oved to a third short-run Phillips curve between
1984 and 1994. Once again , the trade-off between inflation and unem ploy­
ment is apparent in this period, although now it takes place at a low er rate
of inflation. M oreover, the reduction in inflation in this period did not cause
unemployment to rise. In fact, average unemployment w as lower during these
10 years (6.5 percent) than in the previous 10 years, precisely the opposite of
what we would expect if a stable long-run Phillips curve trade-off were at work.
Finally, during the 1 9 9 0 s, the United States m igrated to a fourth shortrun Phillips curve, which coincides well with the curve that held during the
1 9 60s. A s w as the case durin g the previous 10 y ears, fallin g in flation did
not raise unem ploym ent relative to the earlier period. In fact, unem ploym ent
th ro u g h o u t th is p e rio d h as a g a in been lo w er, on a v e ra g e , th an it h ad
been durin g the p revio u s 10 y ears. The A m erican experien ce d u rin g the
last 40 years therefore illustrates the absence o f a stable long-run trad e-o ff
between inflation and unem ploym ent. H igher inflation during the 1970s did
not reduce unemployment relative to the 1960s; lower inflation in the 1980s
did not raise unem ploym ent relative to the 1970s; and low er inflation in the
1990s did not raise unemployment relative to the 1980s.
The American experience w as not unique, but w as instead widely shared
by m ost advanced industrialized countries. Average inflation rates in the EU
Monetary Policy and Unemployment
279
TABLE 13.1
Inflation and Unemployment, 1964-1990 (period averages)
1964-1970
1971-1980
1981-1990
Inflation Unemployment Inflation Unemployment Inflation Unemployment
United
States
Germany
France
Britain
Italy
Japan
S o u rc e :
3.0
4.2
7.4
6.4
7.1
4.2
3.7
0.7
5.3
2.2
6.0
2.8
4.4
2.0
9.9
4.1
9.3
6.3
4.2
1.7
14.0
3.8
9.7
6.5
4.5
5.0
14.8
6.1
9.5
0.4
5.4
1.2
7.6
1.8
2.5
1.4
OECD 1995.
during the 1970s, rising to 11 percent, were more than twice as high as they
had been during the 1960s. (See T ab le 13.1.) Som e countries experienced
much higher inflation than these averages suggest; Italy and G reat Britain,
for exam ple, saw their inflation rates rise above 20 percent in the m id-1970s.
Yet, this higher inflation failed to produce any sustained reduction in unem ­
ployment. In fact, unemployment rose alm ost continuously throughout the de­
cade. (See T able 13.1.) U nem ploym ent m ore than doubled in the EU during
the 1970s, jum ping from 2.3 percent at the end o f the 1960s to 5 .4 percent
in 1980. Thus, economic developments during the 1970s suggested that there
w as no stable trad e-off between inflation and unemployment. Any gains in
em ployment realized from m onetary expansion were short term at best and
were accom panied by a persistent increase in the rate of inflation.
All of this w ould be o f little concern if inflation were innocuous. Inflation
isn’t innocuous, however, and may have a large negative impact on a country’s
economic perform ance. Inflation raises uncertainty am ong firms and unions,
and this uncertainty can reduce investment and economic grow th rates. Less
investment and lower econom ic grow th can in turn raise the natural rate of
unemployment. The advanced industrialized countries provide som e evidence
about how inflation has affected economic performance during the last 26 years.
Figure 13.3 illustrates the relationship between inflation and economic growth
rates for fifteen advanced industrialized countries over that period. Each point
on the graph represents the average rate o f inflation and the average rate o f
economic growth for one country between 1969 and 1995. The data suggest that
countries with relatively high inflation rates have experienced lower economic
growth, whereas countries with relatively low rates o f inflation have had higher
economic growth. Admittedly, this relationship is not very strong. In fact, Japan,
which had one o f the lowest rates of inflation and the fastest rate o f economic
growth o f all the countries, is a bit o f an anom aly. If we exclude Ja p a n , the
negative relationship between inflation and economic growth disappears.
A som ewhat stronger pattern is evident when we look at the relationship
between inflation and unem ploym ent in these sam e countries (Figure 13.4).
Inflation (percent)
Economic Growth (percent)
FIGURE 13.3
Inflation and Growth, 1969-1995
Inflation (percent)
S o u rce : O E C D 1 9 9 5
FIGURE 13.4
Inflation and Unemployment, 1969-1995
S o u rce : O E C D
The Time-Consistency Problem
281
Here, each data point represents the average rate of inflation and the average
rate of unem ploym ent for one country between 1969 and 19 9 5 . These data
suggest that countries with high inflation have had relatively high unem ploy­
ment rates, w hereas countries with low inflation have had relatively low er
unemployment rates. At the high end, inflation in Italy averaged just under 12
percent and unemployment just under 8 percent. At the low end, inflation in
Jap an averaged 4.9 percent, and unem ploym ent only 2 percent. A gain, how ­
ever, the relationship is not terribly strong.
O f course, the determinants o f economic growth and unemployment are far
more complex than this simple correlation suggests. It may be that once the other
factors that determine economic growth and unemployment are taken into ac­
count, inflation has no impact at all. What does seem clear, however, is that high
inflation has not been associated with better economic perform ance. There is
no evidence that countries with higher inflation experienced stronger economic
growth or lower unemployment. Consequently, economists argue that, because
inflation provides no permanent gains in terms of higher employment or growth
and carries potentially large costs in terms of fewer jobs and less growth, society
is best served by monetary policies that consistently deliver low inflation.
The apparent collapse o f a stable Phillips curve trade-off between inflation
and unem ploym ent during the 1 970s, com bined with innovative econom ic
theories that reconceptualized the relationship between inflation, em ploy­
ment, and m onetary policy, altered the way governments thought about m on­
etary policy. The Keynesian strategies that m ost governments had adopted in
the early postw ar period were based on the assum ption o f a stable long-run
trade-off between inflation and unemployment. As evidence accum ulated that
such a trade-off did not exist, and as econom ists developed new theories to
explain why it should not exist, governm ents began to question the utility of
Keynesian strategies. If m onetary policy could not be used to m aintain full
employment, but only produced inflation, and if inflation in turn had a nega­
tive im pact on economic perform ance, what go od was served by continuing to
pursue Keynesian strategies of dem and management?
D uring the 1 9 80s, governm ents increasingly concluded that the answer
to this rhetorical question w as “ not m uch .” And as they did, they began to
abandon the Keynesian approach to m acroeconom ic m anagem ent in favor o f
an alternative approach to m onetary policy. In this alternative approach, the
only proper objective o f m onetary policy w as to achieve and m aintain a very
low and stable rate o f inflation. The shift from Keynesian strategies to the
pursuit of price stability occurred first in G reat Britain, under the leadership
o f M argaret T hatcher, and in the United States at the tail end o f the C arter
adm inistration. Governm ents in the other advanced industrialized countries
adopted similar policies during the 1980s.
THE TIME-CONSISTENCY PROBLEM
Although m ost governm ents were determ ined to achieve and m aintain low
inflation, few could easily do so. E xpectations o f high inflation were deeply
embedded in society. By the 1980s, the ten-year history o f high inflation had
282
C H A P T E R 13
A State-Centered Approach to Monetary and Exchange-Rate Policies
convinced workers and businesses to expect similarly high rates o f inflation in
the future. These expectations in turn shaped w age bargaining, giving infla­
tion a momentum o f its own. Expecting high inflation, unions dem anded, and
business provided, large annual nom inal w age increases to keep pace. G overn­
ments then faced the unpleasant choice o f delivering these high inflation rates
or imposing high unemployment. In order to end inflation w ithout generating
a sharp increase in unem ploym ent, each governm ent w ould have to m ake a
credible commitment to deliver low inflation. T h at is, each governm ent would
have to convince w orkers and businesses that it w as truly determined to bring
inflation down and keep it down.
Governments could not easily m ake credible com m itm ents to low infla­
tion, however, because they confronted time-consistency problems (Kydland and
Prescott 1977). A time-consistency problem arises when the best course of action
at a particular moment in time differs from the best course of action in general
(Keech 1995, 38). Examinations in college courses offer an excellent exam ple of
the problem (Drazen 2000, 103). Professors are interested principally in getting
their students to learn the material being taught in the course. Exam inations are
important only because they force students to study more than they would other­
wise. As the semester begins, therefore, the professor’s optimal strategy— that is,
the best course of action in general— is to schedule a final exam. If no final exam
is scheduled, most students will study little, but with the threat o f a final exam ,
students will study harder and learn more from the course.
Once exam day arrives, how ever, the p ro fe sso r’s optim al strategy is to
cancel the exam . Because students expected an exam , they have studied hard
and have learned as much about the m aterial as they can. Giving the exam is
pointless. M oreover, the pro fesso r is better o ff if he or she does not give the
exam ; he or she need not devote time to grading the exam and can use that
time for other purposes. The students are also better off, for they are spared
the time and the anxiety associated with taking the exam . T h us, the p ro fes­
sor’s optim al strategy at the beginning o f the semester— to declare that a final
exam will be given— is not his or her optim al strategy at the end of the semes­
ter. The professor, therefore, has time-inconsistent preferences.
Governm ents often have tim e-inconsistent m onetary-policy preferences.
The government’s optim al strategy this year is to declare that it will use m on­
etary policy next year to m aintain price stability. If w orkers believe that the
government is committed to price stability, they will set nominal wages accord­
ingly. Once next year’s nominal wages are set, however, the government can use
monetary policy to reduce the rate o f unemployment. By raising inflation above
the level that it had announced and on which workers had based their nominal
wage contracts, the government reduces real wages and raises employment. This
decrease in unemployment can boost the governm ent’s popularity, m aking it
more likely to win the next election. The government’s monetary-policy prefer­
ences, therefore, are not consistent over time. It has an incentive to convince
wage bargainers that it is committed to low inflation, but then, once it has done
so, it has an incentive to expand the money supply to reduce unemployment.
B e c a u se the g o v e rn m e n t h a s tim e - in c o n s iste n t m o n e ta r y - p o lic y
preferences, w age b argain ers have little incentive to believe any inflation
Commitment Mechanisms
283
target that the government announces. Imagine, for exam ple, that you know
that in every p ast semester your current pro fesso r has alw ays announced at
the beginning of the semester that there will be a final exam but subsequently
has always cancelled the exam . H ow credible w ould you find this professor’s
current beginning-of-the-semester prom ise to give a final exam ination? You
w ould disregard the p ro fe sso r’s prom ise because you recognize that he has
an incentive to renege and because you have know ledge that he has reneged
in the past. H ow much w ork w ould you then put into the course? Unless you
were deeply interested in the subject, it is likely that you would w ork less hard
in that class than in others in which you know that a final will be given.
The sam e logic applies to w orkers’ responses to governm ent statem ents
a b o u t in flatio n . B ecause w o rk ers recogn ize th at the govern m en t h as an
incentive to renege on a prom ise to deliver low in flation , they will alw ays
expect the governm ent to deliver higher inflation than it pro m ises. These
e x p e ctatio n s o f h igh er-th an -an n o u n ced in flatio n c a u se w o rk e rs to seek
nominal w age agreements that protect real w ages from the inflation that they
expect rather than the am ount that the government prom ises to deliver.
This interaction between wage bargainers and the government has perverse
consequences for social welfare. Suppose the government truly intends to keep
inflation next year at 2 percent and publicly announces its intention to do so.
Workers disregard this promise, however, and expect the government to actually
deliver 6 percent inflation during the next year. They then negotiate a nominal
wage increase on the basis of this expectation. The government m ust now choose
between two suboptimal monetary-policy responses. On the one hand, the gov­
ernment can refuse to expand the money supply in response to the 6-percent
wage increase and stick to its promise to deliver 2-percent inflation. If it does so,
however, real wages will rise by 4 percent, and as a consequence, unemployment
will rise. On the other hand, the government can expand the money supply in
order to deliver the 6-percent inflation that labor anticipated but that nobody re­
ally wants. Thus, either inflation or unemployment will be higher than it would
be if the government could make a credible commitment to low inflation.
M o st E u rop ean governm ents faced precisely this situ atio n in the late
1970s. The ten-year history o f high inflation generated expectations o f con­
tinued high inflation in the future. Unions thus sought, and business generally
provided, nom inal w age increases based on the expectation o f annual infla­
tion rates o f 8 to 10 percent. With these wage contracts in place, governments
faced the unpleasant choice between delivering the high inflation that every­
one expected but nobody really wanted or tightening m onetary policy, reduc­
ing inflation, and raising unem ploym ent substantially. Unwilling to embrace
either option, m any governm ents began to search for som e w ay to m ake a
credible commitment to price stability.
COMMITMENT MECHANISMS
G overnm ents tried to establish a credible com m itm ent to low inflation by
creating com m itm ent m echanism s in the form o f institutions that tied their
hands. Tw o institutions have been particularly prom inent in this quest for a
284
C H A P T E R 13
A State-Centered Approach to Monetary and Exchange-Rate Policies
commitment mechanism: independent central banks and fixed exchange rates.
In theory, both can provide a credible commitment by preventing the govern­
ment from using monetary policy to achieve short-term objectives. In practice,
however, only central-bank independence has actually done so.
Central-bank independence is the degree to which the central bank can set
m onetary policy free from interference by the government. M ore specifically,
central-bank independence is a function o f three things: the degree to which
the central bank is free to decide w hat econom ic objective to pursue, the de­
gree to which the central bank is free to decide how to set m onetary policy
in pu rsuit o f this objective, and the degree to which central-bank decisions
can be reversed by other branches o f governm ent (Blinder 1999, 54). A fully
independent central bank has com plete freedom to decide w hat econom ic
goals to pursue, the capability o f determining on its own how to use monetary
policy to pursue those goals, and com plete insulation from attem pts by other
branches o f government to reverse its decisions.
Sw itzerland’s central bank, the Sw iss N ation al Bank, provides a go od il­
lustration o f a highly independent central bank (Eijffinger and Schaling 1993,
8 0 -8 1 ). The N atio n al Bank L aw that establish ed the Sw iss N a tio n al Bank
contains no provision w hatsoever for allow ing the governm ent to influence
m onetary policy. In addition , the b an k ’s principal policy-m aking body, the
Bank Com m ittee, is com posed o f ten m em bers who are selected by the Bank
Council, a group o f forty individuals responsible for the m anagem ent o f the
bank. T hus, the governm ent has no direct role in selecting the people that
m ake m onetary-policy decisions. As a consequence, the Sw iss governm ent
cannot easily influence the m onetary policies adopted by the Sw iss N atio n al
Bank, which thus controls Switzerland’s monetary policy independently o f the
everyday vicissitudes o f Swiss politics.
At the other end o f the spectrum lies a fully su bord in ate central ban k.
Politically subordinate central banks implement m onetary policy on behalf of,
and in response to, the governm ent, which determines the go als o f m onetary
policy, instructs the central bank how to set m onetary policy to achieve those
go als, and can reverse the b an k ’s decisions if they are contrary to the ones
desired by the governm ent. The Reserve Bank o f A ustralia provides a good
illustration of such a central bank (Eijffinger and Schaling 1993, 8 2 -8 3 ). The
Australian secretary of the treasury, a governm ent minister, has final author­
ity over monetary-policy decisions and m ust approve any interest-rate changes
that the bank p ro poses. In add ition , one governm ent official h as a vote on
the Reserve Bank Board, the principal monetary-policy decision-m aking body.
The Australian government thus has considerable control over the monetarypolicy decisions m ade by the Reserve Bank. A s a result, A ustralian m onetary
policy can be strongly influenced by the governm ent’s political needs.
Granting the central bank independence solves the time-consistency p ro b ­
lem by taking monetary policy completely out o f politicians’ hands. M onetary
policy is no longer set by politician s m otivated by short-run political co n ­
siderations. Instead, appointed officials who cannot easily be rem oved from
office set m onetary policy, which is thus insulated from politics. Insulating
Commitment Mechanisms
285
m onetary-policy decisions from short-term political incentives m akes it less
likely that monetary policy will be directed tow ard short-term g o als, such as
a tem porary increase in employment, and m ore likely that it will be oriented
tow ard price stability. An independent central bank, therefore, can m ake a
credible commitment to low inflation even though a government cannot.
The central bank’s commitment to low inflation should in turn affect wage
bargaining. Because the central bank is not m otivated by political objectives,
labor unions and businesses will believe that the central bank will deliver the
inflation rate it prom ises to deliver. They will then negotiate next year’s wage
contract to em body this stated inflation target rather than their best guess
o f next year’s inflation. As a consequence, they are m ore likely to establish
a nom inal w age that m aintains the appropriate real w age. The result should
be lower inflation, as well as less variation in the rate of unem ploym ent and
growth. Granting the central bank independence should lead to lower inflation,
higher economic growth, and lower unemployment over the long run.
D o independent central banks actually have the econom ic consequences
that are attributed to them in theory? There is som e evidence th at they do.
Figure 13.5 depicts the relationship between central-bank independence and
average inflation rates in fifteen advanced industrialized countries between
1969 and 1 9 9 5 . The grap h show s quite clearly th at co u n tries w ith m ore
independent central banks (the countries located farther to the right alon g
the horizontal axis) have experienced low er rates o f in flation , on average,
than countries with less independent central banks. Germ any, A u stria, and
FIGURE 13.5
Central-Bank Independence and Inflation, 1969-1995
Source: OECD 1995 and Cukierman 1992. Higher index values indicate greater independence.
286
C H A P T E R 13
A State-Centered Approach to Monetary and Exchange-Rate Policies
the United States, home to three o f the m ost independent central banks in the
advanced industrialized countries, have enjoyed substantially low er inflation
than Italy and Britain, w here p o litician s con trolled m on etary policy until
quite recently.
PO LIC Y A N A L Y S I S AND D E B A T E
Central Bank Independence and Democracy
Question
Should democracies grant central banks political independence?
Overview
As we have seen, governments have granted their central banks considerable
independence during the last 10 years. The justification for doing so lies in theories
asserting that, by doing so, governments are able to commit to low inflation, which
in turn generates better economic performance. Yet, granting the central bank
independence is not costless. One important dimension of these costs is political. As
Alan Blinder, former member of the Federal Reserve Board, has asked, "Isn't there
something profoundly undemocratic about making the central bank independent
of political control? Doesn't assigning so much power to unelected technocrats
contradict some fundamental tenets of democratic theory (Blinder 1999, 66)?"
Blinder has a point, for monetary policy is perhaps the single most important
and single most powerful policy instrument at a government's disposal, and one
might reasonably question the legitimacy of conferring such power on people who
are not easily held accountable. In fact, it is surprising that democracies confer
such independence. Could you imagine voters supporting a decision allowing an
institution that was independent of political control to determine income tax rates?
Blinder also highlights two factors that he thinks reduce the inconsistency
between democracy and independent central banks. First, legislatures confer
independence on central banks; thus, they can withdraw this independence.
Accordingly, society retains some influence over monetary policy. Second, central
bankers are typically appointed by elected officials and can be removed from office
(or not reappointed) if they behave in a manner that is inconsistent with societal
interests. Therefore, society sacrifices its ability to influence day-to-day decisions,
but retains the ability to set the broad parameters within which monetary policy
is made. Should society give up some of its political rights in exchange for the
economic benefits that independent central banks are supposed to provide?
Policy Options
• Grant the central bank independence and allow it to set monetary policy without
political interference.
• Assert political control over the central bank to ensure that monetary policy
reflects the public interest.
Commitment Mechanisms
287
Policy Analysis
• How important are the economic benefits that central-bank independence
provides?
• How large are the political costs arising from central-bank independence?
• Are any other political institutions granted independence from electoral politics
in democracies?
Take A Position
• Which option do you prefer? Justify your choice.
• What criticisms of your position should you anticipate? How would you defend
your recommendation against these criticisms?
Resources
Online: Look for two readings focusing on the European Central Bank: Christa
Randzio-Plath and Thomas Padoa-Schippo, "The European Central Bank:
Independence and Accountability" (www.zei.de/download/zei_wpB00-16.pdf),
and Paivi Leino, "The European Central Bank and Legitimacy" (m m
.jeanmonnetprogram.org/papers/00/001101.html).
In Print: Alan Blinder, Central Banking in Theory and Practice (Cambridge, MA: MIT Press,
1999); Kathleen MacNamara and Sheri Berman, "Bank on Democracy: Why
Central Banks Need Public Oversight," Foreign Affairs 78 (March-April 1999);
Joseph E. Stiglitz, "Central Banking in a Democratic Society," De Economist 142
(2), 1998:199-226.
O ther evidence indicates, how ever, that the low er inflation enjoyed by
countries with independent central banks m ay not have com e w ithout cost.
Figure 13.6 suggests that countries with more independent central banks have
experienced lower rates o f economic growth, on average, than countries with­
out independent central banks. Econom ic grow th in Germ any, for exam ple,
averaged 2.8 percent in the tw enty-six-year period from 1969 to 1995, com ­
pared with 3.6-percent average annual grow th rates in Italy. A sim ilar effect
appears to exist for unemployment: Countries with independent central banks
have had higher rates o f unemployment, on average, than countries w ithout
independent central banks (Figure 13.7). Germ any and the United States, for
exam ple, averaged higher unemployment over the 1 9 6 9 -1 9 9 5 period than did
N orw ay and Sweden, tw o countries in which governm ents retained control
over monetary policy.
T h u s, although independent central ban ks ap p ear to reduce inflation,
there is som e evidence that they m ay also be asso ciated w ith low er grow th
and higher unemployment. Once again, however, we should not conclude too
much from these simple correlations. Econom ic outcom es are determined by a
com plex set of factors. Once these other factors are taken into account, it may
C H A P T E R 13
A State-Centered Approach to Monetary and Exchange-Rate Policies
Economic Growth (percent)
288
FIGURE 13.6
Central-Bank Independence and Economic Growth, 1969-1995
Unemployment Rate (percent)
S o u r c e : O E C D 1 9 9 5 a n d C u k ie r m a n 1 9 9 2 . H ig h e r in d e x v a lu e s in d ic a te g re a te r in d e p e n d e n c e .
FIGURE 13.7
Central-Bank Independence and Unemployment, 1969-1995
Source:O E C D 1995 and Cukierman 1992. Higher index values indicate greater independence.
Commitment Mechanisms
A
A
A
289
turn out that independent central banks do not have a negative im pact on eco­
nomic growth and the rate of unemployment. W hat does seem clear, however,
at least for this set o f countries, is that independent central banks have been
better able to deliver low inflation than governments have.
In the early 1980s, however, few European governments had independent
central banks. Consequently, they sought to establish a credible commitment
by using the E uropean m onetary system (R M S) a s an alternative to centralbank independence (G iavazzi and Giovannini 1989; O atley 1997). The EM S
offered the possibility o f a credible com m itm ent to low inflation because it
w as centered on the G erm an cen tral b an k — the B u n d e sb an k — the m o st
independent central bank in the EU. A s a result, G erm an m onetary policy
w as little influenced by po litical pressu re, and it could therefore com m it
to low inflation. M oreover, the Bundesbank had a strong record o f delivering
low inflation. In fact, German inflation w as the lowest am ong all EU countries,
averaging only 4.4 percent between 1975 and 1984 (Oatley 1997, 82). A fixed
exchange rate with G erm any, therefore, m ight allow the EU countries with
high inflation to “ im port” both the Bundesbank’s low inflation policy and its
credible commitment to that policy.
Governments im ported Germ an monetary policy by pegging their curren­
cies to the Germ an m ark. The Bundesbank used m onetary policy to m aintain
price stability in Germ any and w as relatively passive tow ard the m ark ’s ex­
change rate against other EU currencies. The bank did engage in som e foreign
exchange m arket intervention, but only reluctantly and only when required
to do so by the system ’s rules. Other governm ents used their m onetary pol­
icies to peg their currencies to the G erm an m ark. By pegging to the m ark,
governments enduring high inflation were forced to mimic the Bundesbank’s
monetary policy. When the Bundesbank tightened that policy, other govern­
ments had to tighten their m onetary policies in order to m aintain their fixed
exchange rates. As long as the Bundesbank continued to m aintain low infla­
tion in G erm any, a fixed exchange rate inside the E M S w ould force other
EU governments to pursue low-inflation m onetary policies, too. By pegging to
the m ark, therefore, the high-inflation countries could “ im p ort” the Bundes­
bank’s low-inflation monetary policy.
In o rd er to “ im p o r t” the B u n d e sb an k cred ib le co m m itm en t to low
inflation, however, unions and businesses had to believe that the governm ent
w as determ ined to m aintain its fixed exchange rate. If these social partners
viewed the fixed exchange rate as an irrevocable com m itm ent— one that the
governm ent w ould not alter, regardless o f dom estic econom ic developm ents—
they w ould adjust their w age-bargaining behavior accordingly. Recognizing
th at their governm ent w as com m itted to the B u n d esb an k ’ s low -in flation
m onetary policy to m aintain the fixed exchange rate, unions and businesses
w ould reduce their estim ates o f future inflation rates. A s these inflationary
expectations fell, unions w ould seek sm aller nom inal w age increases. Thus,
if a governm ent co u ld m ake a credible com m itm ent to the fixed exchange
rate, it co u ld break the large n o m in al w age in creases th at w ere d riving
European inflation.
290
C H A P T E R 13
A State-Centered Approach to Monetary and Exchange-Rate Policies
It proved very difficult for governm ents to dem onstrate th at they were
irrev ocab ly co m m itted to a fix e d exch an g e rate . T he E M S did n o t tak e
control o f m onetary policy aw ay from the governm ent and p lace it in the
hands of appointed officials insulated from political pressures. Consequently,
w orkers and businesses sim ply shifted their atten tion aw ay fro m whether
the governm ent w as com m itted to som e inflation target and focused instead
on whether the governm ent w as truly com m itted to its fixed exchange rate.
Then, because EU governm ents retained full discretion over their currencies’
exchange rates in the E M S, unions and businesses were never convinced that
the governm ent w ould not devalue within the system when it w as politically
convenient to do so. Governments gave them plenty o f reason to be skeptical,
as currency devaluations were quite com m on in the first 7 years o f the system ’s
operation. Consequently, even though EU governm ents did reduce inflation
during the 1980s, and though the EM S facilitated this achievement by enabling
countries with high inflation to “ im p o rt” G erm an m onetary policy, there is
little evidence that the fixed exchange rate provided a credible com m itm ent to
price stability. Instead, inflation fell because European governm ents accepted
the higher unemployment that tight monetary policies generated in the context
of large nominal wage increases.
EU governm ents’ quest for a credible commitment to low inflation played
an im portant role in the shift to, and the design of, econom ic and m onetary
union. The EU ’s central bank, the E C B , w as established in Jan u ary 1999 and
is one o f the w orld’s m ost independent central banks. European governments
participating in the EM U no longer have national m onetary policies, a factor
that greatly reduces their ability to determ ine n ation al m onetary policy. In
addition, as a condition for m em bership in the E M U , EU governm ents have
granted their own national central banks, which have becom e the operating
agencies o f the EC B , independence from politics. Finally, the law s governing
the ECB and m onetary policy in the EU prohibit national governm ents from
attem pting to influence the vote o f their respective national central-bank gov­
ernors in the EC B , and they also prohibit the EU ’s Council o f M inisters from
attem pting to influence E C B decisions. N atio n al governm ents in the E M U ,
therefore, are three tim es rem oved from m onetary-policy decisions: once by
the EM U itself, a second time by dom estic central-bank independence, and yet
a third time by the rules governing decision m aking within the ECB.
T he E U ’s sh ift to highly independent cen tral ban kin g fin ds echoes in
the rest o f the advanced industrialized w orld. The A m erican central bank,
the Federal R eserve, has been highly independent since its creation. O ther
governm ents have reform ed central-bank law s to gran t their ban ks greater
independence. Ja p a n m oved to provide its central bank, the Bank o f Ja p a n ,
w ith g reater in d epen d en ce in the m id -1 9 9 0 s. G re a t B ritain g ra n te d its
central bank, the Bank o f England, full independence in 19 9 7 , even though
it is not yet p a rticip a tin g in the E M U . N ew Z e a la n d g ran ted its cen tral
bank greater independence in 1 9 8 9 . T h u s, a lm o st all central b an k s in the
advan ced in d ustrialized w orld enjoy su b stan tial independence, and m o st
have gain ed this independence only recently. Indepen dent cen tral b an k s
V
A
Commitment Mechanisms
291
have directed m onetary policy tow ard the m aintenance o f price stability, an
objective that is often defined as about 1 to 2 percent inflation per year.
A CLOSER LOOK
Explaining Policy Variation Among
Independent Central Banks
Most scholarship on central banks assumes that all independent central banks
are basically alike. As we have seen, scholars assume that the major policy­
relevant distinctions differentiate the behavior of independent central banks from
the behavior of central banks that are subordinate to the political system. Freed
from the pressures of electoral politics, independent central banks are generally
assumed to pursue price stability. Very little energy has been devoted to considering
whether and why the behavior and policies of one independent central bank differs
substantially from the behavior and policies of another.
Yet, contemporary events suggest that independent central banks are not
all cut from the same cloth. Consider how the European Central Bank and the
Federal Reserve have responded to economic conditions in the summer of 2010.
At the time, the global economy appeared to be poised on the brink of a "double
dip" recession. Recovery from the post-financial crisis recession had apparently =
stalled in the summer of 2010 and it looked like a slide into a second recession
was possible. This economic environment, common to the U.S. and EU economies,
generated very different responses from central banks in the two markets. In the
EU, the ECB responded to these developments by calling loudly and repeatedly for
fiscal and monetary consolidation (see Trichet 2010). Fearful that its operations to
rescue the banking system during the 2009 crisis and those it undertook to prevent
default during the Greek crisis of the spring of 2010 injected too much liquidity
into the financial system, ECB policymakers began to voice concern about inflation.
Such concerns have prompted the ECB to become more cautious about monetary
policy, suggesting that inflation is as great a risk in the contemporary environment
as deflation. Moreover, in the late spring of 2010, the ECB emerged as the leading
advocate for fiscal consolidation in the wake of the EU's coordinated bailout of the
Greek government.
.....
In contrast, in the United States the Federal Reserve has evinced much greater
concern about a possible stall of the recovery than about potential inflation
resulting from the monetary expansion. James Bullard, President of the Federal
Reserve Bank of St. Louis and traditionally an anti-inflation hawk, warned that the
greatest danger the U.S. economy faced was a Japan-style deflation. He advocated
a return to the policy of quantitative easing to supplement the zero-interest rate
policy already in place. Although Ben Bernanke, current Chairman of the Federal
Reserve Board, did not publicly share Bullard's concern, he has repeatedly noted
(Continued)
292
C H A P T E R 13
A State-Centered Approach to Monetary and Exchange-Rate Policies
the uncertainty surrounding current,prospects^and repeated hjsdetermination to
use monetary policy to support economic recovery. As he said in his semi-annual
appearance before Congress, "We . . . will act if the economy does not continue to
improve, if we don't see the kind of imprpvf^^ts jp.the labor market that we are •
hoping for and expecting" (Bernanke 2oi6#Berrranke also suggested/ in contrast '
to the ECB, that it was too soon to consider fiscal Consolidation: >'I believe we
should maintain our stimulus in the short term;" ’
The differences between the ECB and the Fed:are substantial; The two ■
independent central banks offer very different analyses of the current economic
environment and have pursued distinct policy responses. The ECB advocates
vigilance against inflation; the Fed views deflation as the greater danger. The
ECB advocates monetary and fiscal consolidation; the Fed advocates continued
zero-interest rate policies and short-run fiscal stimulus. How do we account
for such stark differences in the orientations of these two independent central
banks?
One could argue that the differences are a consequence of uncertainty about the
state of the economy and disagreement about the correct model of the economy.
Given the recent crisis and remaining turbulence in EU sovereign debt markets, it
may be especially difficult to forecast future economic conditions. Consequently,
perhaps the ECB's focus on inflation and the Fed's relatively greater concern
about a second recession or prolonged deflation reflect the extreme bounds of what
current forecasts suggest about conditions over the next year. Alternatively, the
two central banks might agree on the economic forecast, but disagree about what
economic model is correct. The ECB might adhere to an economic model in which
fiscal and monetary consolidation are necessary to generate economic recovery.
The Fed might adhere to a model that calls for fiscal stimulus and monetary
expansion in the current conditions.
Differences might also stem from broader differences in the political institutions
within which the two banks operate. The ECB's determination to doggedly pursue
price stability and advocate fiscal consolidation might reflect its belief that EU
institutions make it exceedingly difficult for EU governments to reduce ECB
independence. The EU, after all, is a polity with a large number of veto players.
Indeed a treaty change would be required to alter the ECB's charter and in treaty­
making every EU government is a veto player. Hence, changing the ECB's charter
would be an exceedingly difficult and extremely long process. This institutional
structure might make ECB officials confident that they can pursue potentially
unpopular policies without fearing that doing so will have repercussions for their
independence. The Federal Reserve is less well protected by institutionalized veto
players. In the current environment, the Democrats hold a majority in the Senate
and control the Executive, while Republicans control the House. Hence, only three
veto players are in play. In conjunction with the extreme criticism leveled at the
Fed for failing to prevent the financial crisis might encourage Fed authorities to
turn away from what they know will be unpopular policies and positions in order to
reduce the likelihood of legislated change.
Independent Central Banks and Exchange Rates
293
I am not certain that institutional differences account for the behavioral
differences. Perhaps we need to pay attention to differences in policymakers'
partisan preferences. Is the ECB being so determined about inflation because it
tends to be run by a group with partisan affiliations to conservative parties? Does
the Fed's more expansionary orientation reflect affiliation with Democrats on
the Fed Reserve Board? Or maybe the differences reflect the way that decision­
making rules within each bank aggregate the interests of distinct regional economic
entities. Though the explanation is uncertain, striving to understand why similarly
structured central banks behave so differently is an interesting question to which
current research lacks an answer. ■
The last 25 years have thus brought fundam ental changes to the politics
o f m onetary policy. T hroughout the advanced industrialized w orld, govern­
m ents have ab an d o n ed the K ey n esian strategies o f dem and m anagem en t
that d om in ated m onetary p o licy in the early p o stw a r p eriod . A s go vern ­
ments gradually, and in many cases grudgingly, accepted that there w as no
stable Phillips curve trad e -o ff betw een in flatio n and unem ploym ent th at
they could exp loit for p o litical ad v an tage, they began to lo o k for w ays to
tie their h an ds in o rd er to reduce in flatio n an d m ain tain price stab ility .
The solu tion they ad o p ted lay in gran tin g p o litical independence to their
central banks and allow ing those banks to set m onetary policy free o f daily
p o litic a l in terferen ce. A s a c o n seq u e n ce , th ro u g h o u t the in d u stria liz e d
w orld, m onetary policy is uniform ly focused on a single econom ic objective:
m aintaining price stability.
INDEPENDENT CENTRAL BANKS
AND EXCHANGE RATES
The creation of independent central banks will obviously have an im pact on
the way that domestic politics shapes m onetary and exchange-rate policy. Yet,
because the shift to independent central banks is such a recent phenomenon,
it is not clear how the dynam ics will change. We can, however, draw on the
models we developed in Chapter 12 to speculate a bit about how such politics
might evolve.
One possibility is that the politics o f m onetary and exchange-rate poli­
cies will be characterized by con flict betw een elected o fficials and central
banks. Such conflicts m ay emerge because of three interconnected aspects of
m onetary and exchange-rate politics in this new institutional environment.
First, although the institutional fram ew ork governing m onetary policy has
changed, interest-group preferences over monetary and exchange-rate policies
have not. Interest grou ps, class and sector based, are still affected by m on­
etary and exchange-rate policies in the w ays we examined in Chapter 12. As a
294
C H A P T E R 13
A State-Centered Approach to Monetary and Exchange-Rate Policies
consequence, interest groups retain incentives to pressure the governm ent and
the central bank to adopt the m onetary and exchange-rate policies they prefer.
The emergence o f independent central ban ks m eans only th at these grou p s
m ust pursue their goals through different channels.
Second, despite the creation o f highly independent central banks, m onetary
policy is not perfectly in sulated from po litical influence. Even as n ation al
governm ents have relinquished control over m onetary policy to independent
central banks, they have retained control over exchange-rate policy. In the
United States, the D epartm ent o f the T reasury, an executive-branch agency,
takes the lead in setting exch an ge-rate p o licy fo r the d o llar (D estler and
H enning 1989). T reasu ry o fficials are responsible for negotiatin g currency
agreem ents with foreign govern m en ts, and the T re asu ry m ak es d ecision s
ab ou t when to engage in foreign exchange m arket intervention (alth ough
intervention per se is conducted by the N ew Y ork Federal Reserve Bank). The
T reasu ry’s control over the d o llar’s exchange rate is not absolute, however.
In general, the T reasury is reluctant to act w ithout the consent of, or at least
the absence o f o p p o sitio n from , the Federal R eserve. M o reo v er, although
the T reasury can request the Federal Reserve to engage in foreign exchange
intervention, it cannot order it to do so on its account. T hus, although the
Treasury takes the lead in U.S. exchange-rate policy, it has consistently sought
cooperation with the Federal Reserve.
A sim ilar split of authority is evident in the EU (see Henning 2 0 0 7 , 782).
The M aastricht Treaty assigns to the E C B control over m onetary policy, but
to the Council of M inisters it assigns authority over exchange-rate policy (to
“ conclude form al agreem ents on an exchange rate system . . . in relation to
non-Com m unity currencies” and to “ form ulate general orientations” tow ard
n o n -E U currencies). In 1 9 9 9 and 2 0 0 0 , E u ro p ean finan ce m in isters and
monetary officials worked out a clearer division o f labor at meetings in T urku,
Finland, and in Luxem bourg. Under the resulting agreem ents, governm ents
recognized the E C B ’s sole com petence for d ecidin g in tervention, but the
E urogroup— the subset o f EU finance m inisters in the euro area— w ould set
the strategic direction of exchange-rate policy. M oreover, they agreed that key
o fficials w ould consult and coordin ate their public statem ents. O ne can be
forgiven if this clarification leaves control o f exchange-rate policy in the EU a
little uncertain.
Because m onetary and exchange-rate policies are tw o sides o f the sam e
coin, government control o f exchange-rate policy can be used to force the cen­
tral bank to pursue the m onetary policies that the governm ent and its supporters desire. For exam ple, some have argued that H elm ut Schmidt, who w as
the G erm an chancellor in the late 1 9 7 0 s and early 1 9 8 0 s, sou gh t to create
the E M S to force the Bundesbank to pursue a m ore exp an sion ary m onetary
policy (Oatley 1997). Fixing the Germ an m ark to the French franc, the Italian
lira, and other EU currencies, Schmidt thought, w ould force the Bundesbank
to intervene in the foreign exchange m arket. In m ost instances, this interven­
tion w ould prevent the m ark from appreciatin g inside the E M S and w ould
therefore cause an expansion o f the Germ an money supply. The exchange-rate
Independent Central Banks and Exchange Rates
^
A,
295
commitment would thus force the Bundesbank to pursue a looser m onetary
policy than it wanted.
An identical logic can be applied to the contem porary international m on­
etary system. A government or, in the case o f the EU, a group o f governments
that want a more expansionary monetary policy than the central bank is will­
ing to adopt might use its control over exchange-rate policy to force the cen­
tral bank to change its policy. C ontrol over exchange-rate policy, therefore,
provides governments with a back d oo r through w hich they can attem pt to
influence monetary policy. T o the extent that they use this back door, they are
likely to come into conflict with the central bank.
Such conflicts are m ost likely to arise when the central bank w ants the
exchange rate to move in one direction in order to m aintain price stability,
but the government wants the exchange rate to move in the other direction to
satisfy dem ands made by im portant interest groups. C onflicts o f this nature
arose periodically between the German government and the Bundesbank prior
to the creation o f the EM U and em erged in the EU in the fall o f 1999 and
summer of 2000. The euro depreciated sharply against the dollar and the yen in
its first 2 years of existence. The ECB became concerned that the depreciation
w ould generate inflation in the union a s the price o f trad ed go od s rose in
response to the euro’s weakening. A s M atti V anhala, governor o f the Bank
of Finland, and therefore a m em ber o f the E C B ’s G overning Council, noted,
the eu ro ’s w eakness is “ a bad thing fro m the po in t o f view o f the E C B ’ s
g o a ls.” The Bank o f France’s Jean -C lau d e T richet echoed these concerns,
emphasizing that the ECB needed to be “ vigilant about inflation risks” arising
from the euro’s weakness (Barber 2000b, 9). The EC B tried to stem the euro’s
depreciation by raising interest rates. European governments were much less
concerned about the euro’s w eakness and criticized EC B efforts to stabilize it.
German Chancellor Gerhard Schroder, for exam ple, stated th at “ the euro’s
low level [is] a cause for satisfaction rather than concern,” because it increases
Germ an grow th rates by m aking it easier for G erm an com panies to export
(Barber 2000a, 8).
Sim ilar d yn am ics em erged a s the eu ro a p p re c ia te d in 2 0 0 7 - 2 0 0 8 .
E uropean business a sso c iatio n s began w arn in g th at the rap id rise o f the
euro w as harm ing exporters and slow ing EU grow th and called upon EU
governments to pressure the United States, Jap an , and China to take steps to
strengthen their currencies (Echikson 2 0 0 7 ). EU finance m inisters, including
even the usually restrained G erm an finance minister, began voicing concerns
about the E C B ’s reluctance to cut interest rates in order to stem the eurorise.
N ew ly elected French P residen t N ic o la s Sark o zy h as p lay e d the lead in
this dram a, how ever. A lm ost im m ediately upon assu m in g office, Sarkozy
announced his intention to pursue a larger role for the Euro group in guiding
ECB interest-rate policy (Bennhold and D ougherty 2 0 0 7 ). The financial and
current account im balances in the M editerran ean m em bers have generated
calls for a w eaker euro to fac ilita te ad ju stm en t an d reduce the need to
domestic austerity measures. Such pressures, if successful, w ould substantially
reduce the E C B’s independence.
296
C H A P T E R 13
A State-Centered Approach to Monetary and Exchange-Rate Policies
Such conflicts are not simply between the government and the central bank:
Interest grou ps m ay exert pressures on whichever actor they believe is m ost
likely to pursue their preferred policies. T h u s, the sectoral m odel leads us
to expect firm s in the trad ed -go od s industries to pressu re the governm ent
for som e form o f exch an ge-rate arran gem en t b ecau se they ben efit fro m
a weak currency. Firm s in the nontraded-goods sector, which benefit from a
strong currency, might in turn become strong supporters o f the central bank.
N o r will industries in all countries have iden tical view s. Indeed, the m ost
recent euro app reciation h as hit French, Italian , an d Sp an ish firm s m uch
harder than German firms. In large part this reflects faster productivity grow th
in Germ any than in the other countries, which in turn reflects greater labor
m arket reforms.
Although it rem ains difficult to distinguish clear patterns in the new in­
stitutional environm ent, the po litical dynam ics o f m onetary and exchangerate policy have changed as governm ents have granted central banks greater
political independence. Electoral, partisan , and sectoral interest-group p res­
sures could rather easily influence the m onetary and exchange-rate policies
that governm ents adopted during the early po stw ar period. The granting o f
political independence to central banks m akes it much more difficult for these
groups to influence policy. N evertheless, interest grou ps are still affected by
m onetary and exchange-rate policies in the w ays detailed in the first h alf o f
this chapter. Consequently, these groups still have an incentive to try to influ­
ence those policies. H ow they do so and the extent to which they are success­
ful will become clear only as the future unfolds.
CONCLUSION
The state-centered approach to m onetary and exchange-rate politics em pha­
sizes the social welfare-enhancing role o f independent central banks. By taking
m onetary policy out of politics and placing it in the hands o f officials tightly
insulated from the push and pull o f p o litics, society enjoys low er inflation
and better overall econom ic perform ance than it w ould enjoy if governments
retained control o f m onetary policy. Governm ents have em braced this logic,
abandoning activist monetary policies and allow ing independent central banks
to dedicate m onetary policy to the maintenance o f price stability.
T w o principal criticism s can be advanced again st this state-centered a p ­
proach. First, it offers m ore o f a prescriptive fram ew ork than an explanatory
fram ew ork. The approach tells us that social welfare is greater with an inde­
pendent central bank than with a politically controlled central bank, and on
the basis o f this claim , it suggests that governm ents should gran t their cen­
tral banks greater political independence. It tells us very little, however, about
w hat factors m otivate elected officials to create independent central banks.
One might argue that governments create independent central banks to m axi­
mize long-term social welfare. Yet, such an explanation rests uneasily with the
central logic o f the time-consistency problem . After all, the entire rationale for
central-bank independence rests on the claim that elected officials care m ore
►
Suggestions for Further Reading
297
about short-term electoral gains than long-run social w elfare. We thus need
some explanation for why governments that are supposedly unconcerned with
long-run w elfare gains create central-bank institutions w hose sole purpose is
to raise long-run social welfare.
N o r does this state-centered ap proach exp lain how m onetary au th o ri­
ties who are responsible for an independent central bank are likely to behave.
Although an independent central bank that gives priority to price stability
may raise social w elfare, little attention has been devoted to the question o f
whether the people w ho run the independent central bank actually have an
incentive to give priority to price stability. Consequently, much w ork remains
before this approach offers an exp lan ation for the changes th at have taken
place in central-banking institutions since the early 1980s.
KEY TERMS
Accelerationist Principle
Central-Bank
Independence
Credible Commitment
Natural Rate of
Unemployment
Phillips Curve
Price Stability
Time-Consistency Problem
SUGGESTIONS FOR FURTHER READING
Perhaps the most comprehensive work on central-bank independence is Alex
Cukierman, Central Bank Strategy, Credibility, and Independence: Theory and
Evidence (Cambridge, MA: MIT Press, 1992). A good treatment of the politics
of central banking in Western Europe before the EMU can be found in John B.
Goodman, Monetary Sovereignty: The Politics o f Central Banking in Western
Europe (Ithaca, NY: Cornell University Press, 1992).
The classic statement of the time-consistency problem can be found in Finn Kydland
and Edward C. Prescott, “Rules Rather than Discretion: The Dynamic Inconsistency
of Optimal Plans,” Journal of Political Economy 83 (January 1977): 473-491.
The best discussion of the European Monetary System as a commitment mechanism
is found in Francesco Giavazzi and Alberto Giovannini,Limiting Exchange Rate
Flexibility in Europe (Cambridge, MA: MIT Press, 1989). For a contrasting view,
see Michele Fratianni and Jurgen von Hagen, The European Monetary System and
European Monetary Union (Boulder, CO: Westview Press, 1992).
CH A PT ER
14
Developing Countries
and International
Finance I: The Latin
American Debt Crisis
D
e v e lo p in g c o u n trie s h ave h ad a d iffic u lt re la tio n sh ip w ith the
international financial system. A t the center o f these difficulties lies a
seem ingly inexorable boom -and-bust cycle. The cycle typically starts
with changes in international capital m arkets that create new opportunities
fo r d ev elo pin g co u n tries to a ttra c t fo reign c a p ita l. W an tin g to ta p into
foreign capital to speed econom ic developm ent, developing countries exploit
this opportunity with energy. Eventually, developing countries accum ulate
large foreign debt burdens and are pushed tow ard default. L oom in g default
frightens foreign lenders, w ho refuse to provide new loan s an d attem pt to
recover many o f the loans they had m ade previously. As foreign capital flees,
developing countries are pushed into severe econom ic crises. G overnm ents
then turn to the International M onetary Fund (IM F) and the W orld Bank for
assistance and are required to im plem ent far-reaching econom ic reform s in
order to gain those o rgan ization s’ aid. T his cycle has repeated itself twice in
the last 25 years, once in Latin A m erica during the 1 9 7 0 s and 1 9 8 0 s, and
once in A sia during the 1 990s. A sim ilar, though distinct, cycle occurred in
sub-Saharan Africa. The political economy o f N orth -South financial relations
focuses on this three-phase cycle o f overborrow ing, crisis, and adjustment.
Each ph ase o f the cycle is shaped by developm ents in the international
financial system and inside developing societies. Developm ents in the international financial system, including changes in international financial m arkets,
in the activities o f the IM F and the W orld B an k, and in governm ent p o li­
cies in the advanced industrialized countries, pow erfully affect N o rth -So u th
financial relations. They shape the ability o f developing countries to borrow
foreign capital, their ability to repay the debt they accum ulate, and the eco­
nomic reform s they m ust adopt when crises strike. Events that unfold within
developing countries determine the am ount o f foreign capital that developing
298
A
Foreign Capital and Economic Development
299
societies accum ulate and influence how governments and econom ic actors in
those countries use their foreign debt. These decisions in turn shape the ability
of governments to service their foreign debt and therefore influence the likeli­
hood that the country will experience a debt crisis.
T his chapter and the next exam ine the evolution o f this cycle in N o rth South fin an cial relations. We begin with a short overview o f international
capital flow s in order to understand why they are im portant for developing
societies and how developing societies gain access to foreign capital. We then
briefly exam ine the relatively stable immediate postw ar period during which
capital flow s to developing countries were dom inated by foreign aid and for­
eign direct investment (FDI). The rest of the chapter focuses on the first m ajor
financial crisis o f the postw ar period: the Latin Am erican debt crisis o f the
1980s. We exam ine how it originated, how it w as m anaged, and its conse­
quences, political and economic, for Latin America.
FOREIGN CAPITAL AND ECONOMIC DEVELOPMENT
If a cycle of overborrowing, crisis, and adjustment has characterized the history
of capital flow s from the advanced industrialized countries to the developing
world, why do developing countries continue to draw on foreign capital? Why
do they not sim ply refrain from borrowing that capital, thus bringing the cycle
to an end? D eveloping countries continue to draw on foreign capital because
of the potentially large benefits that accom pany its apparent dangers. These
benefits arise from the ability to draw on foreign savings to finance economic
development.
Investm ent is one o f the m ost im portant factors determ ining the ability
of any society to raise per capita incomes (Cypher and Dietz 1997, 239). Yet,
investment in developing societies is constrained by a shortage o f dom estic
sav in gs (B ru ton 1 9 6 9 ; M cK in n on 1 9 6 4 ). T ab le 14.1 illu stra tes av erage
savings rates during the last 40 years throughout the w orld. The m ost striking
difference that the table highlights is between the high-income O rganisation
T A B L E 14.1
Average Savings Rates as a Percent of Gross Domestic Product,
1970-2006
High-Income OECD Countries*
Least Developed Countries
East Asia and the Pacific
Latin America and the Caribbean
Sub-Saharan Africa
South Asia
21.7
13.4
34.5
19.9
16.9
21.2
*0ECD, Organisation for Economic Co-operation and Development.
World Bank, W o rld D e ve lo p m e n t In d ic a to rs 2 0 0 8 C D - R O M (Washington, DC: World Bank
Publications, 2008).
S o u rc e :
300
C H A P T E R 14
Developing Countries and International Finance I
for E conom ic C o -o p eratio n an d D evelopm en t (O E C D ) co u n tries an d the
w o rld ’ s p o o re st co u n tries. O n av e rage , the high -in com e co u n tries sav ed
slightly more than one-fifth o f their national income each year between 1970
and 20 0 6 . In contrast, the least developed countries have saved less than 15
percent o f their national incom e per year. Even when a developing country
has a high savings rate, as in E ast A sia and the Pacific and in Latin Am erica,
the low incomes characteristic o f a developing society mean that the total pool
o f savings is sm all. The scarcity o f savings lim its the am ount, and raises the
cost, of investment in these societies.
Foreign capital adds to the pool o f savings available to finance investment.
M any studies have found a one-to-one relationship between foreign capital
inflows and investment: One dollar o f additional foreign capital in a develop­
ing country produces one dollar o f additional investment (see, e.g., Bosw orth
and Collins 1999; W orld Bank 2 0 0 1 a ). H igher investm ent in turn prom otes
economic development. Indeed, a considerable body o f research suggests that
developing countries that have participated in international financial m arkets
during the last 30 years have experienced faster econom ic grow th rates than
econom ies that rem ain insulated from international finance (see IM F 2 0 0 1 ;
W orld Bank 2 0 0 1 a ). A lthough foreign capital does not alw ays yield higher
grow th (see, for exam ple, R od rik 1 9 9 8 a ), a country that d raw s on foreign
capital has the opportunity to reach a higher developm ent trajectory. M an y
other factors, som e o f which lie inside developing countries and others that
inhere in the international financial system, shape the extent to which a devel­
oping country can take advantage o f this opportunity.
Foreign capital can be supplied to developing countries through a number
o f channels. The b ro a d e st d istin ction is betw een foreign aid an d priv ate
cap ita l flo w s. F o reign a id , or o fficia l d evelopm en t a ssista n c e , is foreign
capital provided by governm ents and by m ultilateral fin an cial institutions
such as the International B an k for Reconstruction and D evelopm ent (IBRD ),
known more com m only as the W orld Bank. The largest share o f foreign aid
is provided as bilateral developm ent assistance— that is, foreign aid granted
by one governm ent directly to another governm ent. In 2 0 0 9 , the advanced
industrialized countries together provided $119 billion o f bilateral assistance
to developing countries. The W orld Bank and other m ultilateral development
agencies provided an addition al $21 billion. The United States provided the
m ost aid in absolute terms in 2 0 0 9 , about $ 2 8 .7 billion (Figure 14.1). Jap an ,
France, G erm any, and G reat Britain w ere the fo u r n ext largest d o n o rs in
absolute terms. The rankings change considerably when we m easure aid as a
share of the donor country’s national income (Figure 14.2). By this m easure,
the sm aller northern E uropean countries are the m ost generous, dedicating
between 0 .6 and 1 percent o f their to tal n atio n al incom es to foreign aid.
The United States em erges as one o f the least generous o f the high-incom e
countries, dedicating only 0.2 percent o f its national income to foreign aid.
Private capital flows transfer savings to the developing world through the
activities o f private individuals and businesses. Private capital can be tran s­
ferred to developing countries in a number o f w ays. Com m ercial banks transfer
>-■
^
301
Foreign Capital and Economic Development
Germany
United Kingdom
Spain
Netherlands
Sweden
Norway
Canada
Italy
Denmark
Australia
Belgium
Switzerland
Finland
Austria ■
Ireland
Greece ■
Portugal ■
Luxembourg 1
New Zealand 1
C)
■ Millions of U.S. Dollars
1
5,000
1
10,000
1
15,000
i
20,000
i
25,000
i
30,000
i
35,000
FIGURE 14.1
Foreign Aid Expenditures, 2009
Source:
Official and private flows, OECD International Development Statistics (database).
capital by lending to private agents or governm ents in developing societies.
Private capital is also transferred when individuals and large institutional in­
vestors purchase stocks traded in developing-country stock m arkets. Private
capital can also be transferred through bonds sold by developing-country gov­
ernments and businesses to individuals and private financial institutions in
advanced industrialized societies. Finally, m ultinational corporations (M N C s)
transfer capital each time they build a new or purchase an existing factory or
other productive facility in a developing country. The relative im portance o f
each type o f private capital flow has varied across time, as we shall see as we
move through this chapter and the next.
T hroughout the p o stw ar period, private cap ital flow s have been larger
than foreign aid flow s. In general, private capital flow s typically constitute
somewhere between tw o-thirds and three-quarters o f all capital flow s to the
developing w orld. Yet, developing countries vary substantially in their abil­
ity to attract private cap ital inflow s; thus, som e countries rely m uch m ore
302
C H A P T E R 14
Developing Countries and International Finance I
FIGURE 14.2
Foreign Aid Expenditures as a share of National Income, 2009
Source:
Official and private flows, OECD International Development Statistics (database).
heavily than others on foreign aid. Figure 14.3 illustrates both poin ts. E ast
Asia and the Pacific, on the one hand, and Latin Am erica and the Caribbean,
on the other, attract far more private capital than do the M iddle E ast and subSaharan A frica. C onsequently, foreign aid constitutes a substan tially larger
share o f foreign capital inflows in the M iddle E ast and sub-Saharan Africa. In
fact, foreign aid accounts for half or more o f all foreign capital flow s to subSaharan A frica and between 30 and 4 0 percent in the other tw o regions. In
contrast, aid constitutes only ab ou t 10 percent o f the foreign capital flow ing
into the other regions.
These different abilities to attract private capital reflect private lenders’
need to balance return again st risk when investing in developing societies.
On the one hand, because savin gs are scarce, the return on an investm ent
should be substan tially higher in developing societies than in the advanced
industrialized world. Consequently, private lenders should earn a higher return
on an investment in a developing country than on an equivalent investment in
an advanced industrialized country. T his acts to pull in private capital. O n
the other hand, foreign investm ent is risky. Private lenders face the risk o f
default— the chance that a particular borrow er will be unwilling or unable to
repay a debt. Private lenders also face political risk— the chance that political
developments in a particular country will reduce the value o f an investm ent.
Political risk arises from political instability— coups, revolution, or civil w ar—
and, less dram atically, from the absence o f strong legal system s that protect
foreign investment. Large risks substantially reduce an investm ent’s expected
Foreign Capital and Economic Development
200-i
180 -
303
H Foreign Aid ■ Private Capital Flows
I 9 .1 i
160to 140-
5
o
Q 120CO
d 100
■S
<c/> 8 0 o
-
to
179.5
60-
116
40-
20-
0 -East Asia
and Pacific
Latin American
and Caribbean
Middle East
and North
Africa
South and
Central
Asia
Sub-Saharan
Africa
FIGURE 14.3
Private Capital and Foreign Aid flows, 2008
Source: Foreign aid flows from Organisation for Economic for Co-operation and Development, "Statistical
Annex of the 2007 Development Co-operation Report," Table 25, httfM y s a n d er.s o u rc e o e cd .o rg /p d f/d a c /4 32 0 0 80 1 1 e-0 6statsticalann ex.p ; Private capital flows from World Bank, "Global Development Finance," Tables A.2-A.17, h ttp //
sileresources.w orldbank.o rg/lN TG D G 2008/R esources/gdg_com plete_w eb-ap pen ded -6-12.pdf.
return. T his risk acts to push private capital aw ay from a country. Indeed,
such risks are one of, if not the principal, reasons why sub-Saharan A frica
attracts so little private capital.
Developing societies im port foreign capital, therefore, because it m akes it
possible to finance more investment at a lower cost than they could finance if
they were forced to rely solely on their domestic savings. And although devel­
oping countries can im port som e capital through foreign aid program s, such
program s are limited. T hus, if a developing society is to im port foreign sav­
ings, it m ust rely on private capital. The desire to im port foreign savings and
the need to rely on private capital flow s to do so creates difficulties for de­
veloping societies, for private capital never flow s to developing societies in a
steady stream . Instead, financial m arkets shift from excessive concern about
the risk o f lending to developing societies to exuberance about the opportuni­
ties available in those societies and then back to excessive concern about the
risk. As a consequence, a country that is unable to attract private capital one
year is suddenly inundated with private capital the next, and then, just as sud­
denly, is shut out o f global financial m arkets as private investors cease lend­
ing. The consequences are often devastating. We turn now to look at the first
revolution o f this cycle.
304
C H A P T E R 14
Developing Countries and International Finance I
COMMERCIAL BANK LENDING
AND THE LATIN AMERICAN DEBT CRISIS
The com position and scale o f foreign capital flow s to the developing w orld
changed fundamentally during the 1970s. In the 1950s and 1960s, foreign aid
and FDI were the principal sources o f foreign capital for developing countries,
and neither w as abundant. Only the United States had resources for foreign
aid, and these flows were quite limited. W orld Bank lending w as also limited.
It perceived its mission as providing loans at “ close-to-com m ercial rates o f in­
terest to cover the foreign exchange costs o f productive projects” (M ason and
Asher 1973, 381). And m ost o f its lending in this period also financed postw ar
reconstruction in Europe (M ason and Asher 1973).
Development aid increased a little during beginning in the late 1950s. The
W orld Bank created the International D evelopm ent A ssociation (IDA) and
began to provide concessional loans to many o f its mem ber governm ents. At
the sam e tim e, a num ber o f regional developm ent b an k s, such as the InterAmerican Developm ent Bank, the A sian Developm ent Bank, and the African
D evelopm ent B an k, w ere created to pro vid e co n cessio n al lending on the
m odel o f the ID A . A dvanced ind ustrialized coun tries also exp an d ed their
bilateral aid pro gram s during the 1 9 60s. A s a consequence, the am ount o f
aid provided through m ultilateral developm ent agencies increased fourfold
between 1956 and 1970, whereas bilateral development assistance m ore than
doubled during the sam e period. (See T able 14.2.) By the end o f the 1 9 60s,
official developm ent assistance to developing countries w as alm ost twice as
large as private capital flows.
The expansion o f foreign aid program s during the 1960s reflected chang­
ing attitudes in advanced industrialized countries. These changing attitudes
were in turn largely a product o f the dynamics o f decolonization. W orld Bank
TABLE 14.2
Financial Flows to Developing Countries, Millions of U.S. Dollars,
1956-1970
Official Development Assistance
Official Government Aid
Multilateral Organizations
Organization of the Petroleum
Exporting Countries (OPEC)
Private Finance
Foreign Direct Investment
Portfolio Flows
S o u rc e :
Wood 1986, 83.
1956
1960
1965
1970
2,900.0
272.5
4,236.4
368.5
5,773.1
312.9
6,587.4
1,176.0
443.5
1956
1960
1965
1970
2,500.0
0.0
1,847.9
408.2
2,207.4
3,557.2
836.0
777.0
Commercial Bank Lending and the Latin American Debt Crisis
305
officials recognized that governm ents in the newly independent countries
would have great difficulty borrow ing on private capital m arkets and would
be unlikely to qualify for lending under the W orld B an k ’s norm al terms. The
World Bank therefore began to reconsider its resistance to concessional lend­
ing. American attitudes tow ard foreign aid changed in response to political
consequences o f decolonization. American policym akers believed that the ris­
ing influence of developing countries in the United N atio n s w ould eventually
lead to the creation o f an agency that offered developm ent loan s at conces­
sional rates. The creation o f such a U N agency could undermine the W orld
Bank and weaken American influence over development lending. U.S. officials
began to support a concessional lending agency within the W orld Bank, there­
fore, in order to prevent the creation o f a rival within the United N atio n s,
where developing countries had greater influence.
At the same time, during the late 1950s and early 1960s, American policy­
makers increasingly came to view foreign aid as a w eapon in the battle against
the spread o f Com m unism throughout the developing w orld. N ow here w as
this more evident than in the Kennedy adm inistration’s “ Alliance for Progress,”
which was designed to use U.S. government aid to prom ote socioeconom ic re­
form in Latin America in order to prevent the spread o f Cuban-style socialist
revolutions throughout the region (Rabe 1999). These changes in attitude con­
tributed to the tremendous growth of foreign aid program s during the 1960s.
The paucity o f private lending to developing countries changed fu n d a­
mentally during the 1970s. On the one hand, com m ercial banks found them­
selves aw ash with deposits in the wake o f the 1973 oil shock. The oil shock
generated large current-account surplu ses in the o il-ex p o rtin g countries.
Saudi A rab ia ’s current-account surplus jum ped fro m $2 .5 billion in 1973
to $23 billion in 1974 and then averaged about $14 billion during the next
3 years. These surpluses, called petrodollars, provided the financial resources
that developing countries needed to cover their greater dem and for foreign
capital. Com m ercial banks intermediated the flow s, accepting deposits from
oil exporters and finding places to lend them. The process cam e to be called
petrodollar recycling.
It turned out that the grow ing supply o f lo an ab le funds w as m atched
by a grow ing dem and for foreign capital in developing countries. Higher oil
prices cost developing countries about $260 billion during the 1970s (Cline
1984). Because m ost developing countries were oil im porters, higher prices
for their energy im ports required them to reduce other im ports, to raise their
exports, or to borrow from foreign lenders to finan ce the larger currentaccount deficits they faced. Cutting im ports w as unattractive for governments
deeply com m itted to ISI strategies. Increasing exp orts w as also difficult, as
import substitution had brought about a decline in the export sector in m ost
countries. C on sequen tly, the higher co st o f oil w idened current-account
deficits throughout the developing world.
ISI a lso gen erated a g ro w in g d em an d fo r fo re ig n c a p ita l. In L a tin
America, governments were responsible for between one-third and one-half of
total capital form ation (Thorp 1999, 169). Governments created state-owned
306
C H A P T E R 14
Developing Countries and International Finance I
enterprises to drive in d u strialization , an d they pro vid ed su bsidized credit
to targeted secto rs. T h ese stra te g ie s led to an e x p an sio n o f govern m en t
expenditures in connection with the initial investment and then in connection
with continued su b sid ies to the u n p ro fitab le state-ow ned enterprises they
created (Frieden 1981, 420). Government revenues failed to grow in line with
these rising expenditures. As a consequence, budget deficits widened reaching,
on average in Latin America 6.7 percent o f gross domestic products (GDP) by
the end of the 1970s. In som e countries, deficits were even larger. Argentina’s
budget deficit rose to over 10 percent o f GDP in the m id-1970s and remained
ab ov e 7 percent o f G D P until the early 1 9 8 0 s. M e x ic o ’ s b u d get d eficit
increased in the early 1 9 7 0 s and then exp lo ded — to m ore than 10 percent
o f G DP— in the early 1 9 80s. G overnm ents needed to finance these deficits,
which generated a dem and for foreign capital.
C om m ercial banks lo okin g for places to lend and developing-country
govern m en ts lo o k in g fo r a d d itio n a l fu n d s fo u n d each oth er in the m id1 9 70s. C om m ercial banks loaned directly to governm ents, to state-ow ned
enterprises, and to governm ent-ow ned developm ent banks. The result w as
rapid accum ulation of foreign debt. (See T able 14.3.) In 1970, the developing
w orld as a whole owed only $ 7 2 .7 billion to foreign lenders. By 1 9 80, total
foreign debt had b allo on ed to $ 5 8 6 .7 billion. M o st w as ow ed by a sm all
num ber o f countries. The forty m ost heavily indebted developing countries
owed a total o f $461 billion in 1 9 8 0 , close to 80 percent o f the total. Latin
Am erican countries were am ong the largest borrow ers. The foreign debt o f
the seven m ost heavily indebted Latin American countries— Argentina, Brazil,
Chile, C olom bia, M exico, Peru, and Venezuela— increased by a factor o f ten
between 1970 and 1982. By the early 1980s, these seven countries accounted
for about 80 percent o f all Latin American debt and for about one-third o f all
developing-world foreign debt.
Initially, foreign debt fuelled econom ic grow th. The positive im pact o f
com m ercial bank lending is quite clear in aggregate statistics for the period.
In Latin America as a whole, econom ic grow th averaged 5.6 percent per year
between 1973 and 1 9 80. Som e L atin A m erican countries grew even m ore
rapidly. In B razil, one o f the largest borrow ers, the econom y grew by 7.8
percent per year between 1973 and 1980; M exico realized average grow th o f
6.7 percent over the sam e period.
Behind this robust economic grow th, however, lay som e worrying trends.
Debt problems emerge when foreign debt grows more rapidly than the country’s
ability to service its debt. A country’s debt-service capacity— its ability to make
the payments o f interest and principal required by the term s o f the loan— is
a function o f how much it needs to pay relative to its export earnings. T hus,
as a country increases its foreign debt, it m ust also expand its export earnings
to service the debt com fortably. E xports failed to keep pace with debt service
throughout Latin America. Governments invested foreign capital in nontradedgo o d s. M ex ico , A rgentina, and V enezuela, fo r exam p le, created m assiv e
hydroelectric projects that added nothing to export revenues (Thorp 1999, 209).
Governments borrowed to buy military equipment, to pay for more expensive
>
T A B L E 14.3
Developing-Country Foreign Debt, Billions of U.S, Dollars, 1970-1984
30 Most
Developing
Heavily Indebted
Latin American Countries
Countries1
Countries2
(See also remaining columns)
Argentina
72.7
391.7
65
317
•'28
480.8
377
586.7
703.2
461
1982
809.9
1983
880.1
1984
921.8
1970
1978
1979
1980
1981
7 Most Heavily Indebted
Brazil
Chile
5.8
5.7
142
13.3
54.6
2.2
5.1
174
21.0
27.2
61.3
71,5
3.0
7.4
9.4
12.1
6.9
261
35.7
81.5
15.7
8.7
606
294
43.6
93.9
17.3
661
316
45.9
686
328
48.9
98.5
103.9
17.9
19.7
539
■■■■' 214'..
■■ .
Colombia
Mexico
Peru
Venezuela
7.0
3.2
1.4
35.7
9.7
16.6
42.8
57.4
9.3
9.4
24.1
29.3
10.3
78.2
86.1
8.6
10.7
32.1
32.2
11.4
93.0
12.0
94.8
11.3
12.2
38.3
36.9
5.9
‘ All 157 low- and middle-income countries as defined by the World Bank.
Comprises Algeria, Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Cote d'Ivoire, Ecuador, Egypt, India, Indonesia, Jamaica, Malaysia, Mexico, Morocco, Nigeria,
Pakistan, Peru, Philippines, South Korea, Sudan, Syria;Thailand,Turkey, Uruguay, Venezuela, Yugoslavia, Zaire, Zambia.
Source: World Bank, W orld Development Indicators 2001 CD-RO M (Washington, DC: World Bank Publications, 2001).
Commercial Bank Lending and the Latin American Debt Crisis
All
307
308
C H A P T E R 14
Developing Countries and International Finance I
T A B L E 14.4
Debt-Service Ratios in Latin America [(Payments of Prirtiqnl plus
Interest)/Export Earnings], 1970-1984
V '-
All Latin
American
Argentina Brazil
Chile Colombia Mexico Peru Venezuela
Countries
1970
n.a.
n.a.
n.a.
n.a.
4
n.a.
42
58
54
28
12
n.a.
1978
n.a.
50
9
38
1979
23
63
44
14
34
1980
37
63
43
16
66
44
1981
46
66
65
22
46
1982
50
82
71
30
51
1983
70
55
54
38
1984
63
45
60
30
n.a., not available.
Source: World Bank, W orld Development Indicators 2001
Publications, 2001).
38
45
19
27 ;
59
23
40
45
49
34
30
27
47
41
45
30
25
39
CD-RO M
36
(Washington, DC: World Bank
oil, and to subsidize consumer goods. Even when foreign capital w as invested in
the traded-goods sector, ISI’s focus on capital-intensive projects failed to generate
exp orts. A s a consequence, debt service grew faster than e x p o rt revenues,
causing debt-service ratios to rise sharply (Table 14.4). By 1978, debt service was
consuming 38 percent o f Latin Am erica’s export revenues. Debt-service ratios
were even higher in Brazil, Chile, M exico, and Peru.
Rising debt service ratios rendered Latin American countries vulnerable to
international shocks. Three m ajor shocks hit Latin America in 1979 and the early
1980s. First, interest rates began to rise in the United States as the U.S. sought to
reduce inflation. Rising American interest rates were transmitted directly to Latin
America, because two-thirds of Latin Am erican debt carried variable interest
rates. Higher interest rates thus increased debt service costs. Second, recession
in the advanced industrialized world reduced the dem and for Latin American
exports and reduced their terms of trade (Cline 1984). Latin Am erica’s export
revenues thus declined. By 1980, therefore, Latin American governments were
facing larger debt-service paym ents and declining exp ort earnings. A s if this
wasn’t enough, oil prices rose sharply again in 1979, imposing a third shock.
M any governm ents responded to these sh ocks by borrow in g m ore. As
a result, foreign debt jum ped after 1 9 7 9 , risin g to $ 8 1 0 billion by 1 9 8 2 .
Debt-service ratios also rose sharply. (See T able 14.4.) For Latin Am erica as
a w hole, debt service consum ed alm ost 50 percent o f all exp o rt earnings in
1982. B razil’s position w as the m ost p recario u s, as debt service consum ed
m ore than 80 percent o f its exp ort revenues in 1 9 8 2 . These debt problem s
becam e an active debt crisis in A ugust o f 1 9 82, when M exico inform ed the
United States governm ent that it could not m ake a scheduled debt paym ent
(see K raft 1984). Com m ercial banks im m ediately ceased lending to M exico.
309
Managing the Debt Crisis
T A B L E 14.5
Economic Growth Rates (Percent) in Latin America, 1979-1983
Latin
America Argentina Brazil Chile
7
10
Mexico
Peru Colombia Venezuela
7
9
10
6
1980
9
4
9
8
9
3
5
4
1981
-1
-6
5
9
7
2
1982
-1
-1 0
-1
-1
1
-2
1983
-2
-5
4
-4
1
-3
-4
-4
-12
2
-4
1979
Source: World Bank,
W orld Development Indicators 2009 CD-RO M
.1
-4
0
(Washington, DC: World Bank
Publications, 2001).
.
>
Fearing that M ex ico ’s problem s were not unique, they sto p p ed lending to
other developing countries as well.
The abrupt cessation o f commercial bank lending forced governm ents to
eliminate the macroeconomic imbalances that their commercial bank loans had
financed. Current-account deficits had to be eliminated because governments
could not attract the capital inflows required to finance them. Budget deficits
had to be reduced because governments could no longer borrow from com m er­
cial banks to pay for them. Rapid adjustment in turn caused economic activity
to fall sharply throughout Latin America (Table 14.5). The m ost heavily in­
debted countries suffered the worst. Argentina’s economy shrank by 6 percent
in 1981 and then by another 5 percent in 1982. Brazil’s econom y shrank by
4 percent in 1981 and then by another 3 percent in 1983. M exico ’s economy
shrank by 1 percent in 1982 and by another 3 percent in 1983. The end o f
capital inflows, therefore, ended the economic boom o f the 1970s abruptly.
Com m ercial bank lending therefore proved a m ixed blessing. On the one
hand, it allowed many developing countries to finance the large current-account
deficits generated by the oil shock. In the absence o f these loans, governments
w ould have been forced to reduce consum ption sharply to p ay for energy
im ports. Com m ercial bank loans also allowed developing countries to invest
more than they could have otherwise. Private capital flow s therefore relaxed
many o f the constraints that had characterized the foreign aid -d om in ated
system o f the 1950s and 1960s. On the other hand, the rapid accum ulation
of commercial bank debt rendered developing countries vulnerable to shocks
im posed by developm ents in the U.S. and E urope. The m anagem ent o f this
debt crisis dominated North-South financial relations throughout the 1980s.
MANAGING THE DEBT CRISIS
By 1982, the thirty m ost heavily indebted developing countries ow ed m ore
than $600 billion to foreign lenders. Few could service that debt. As they de­
faulted, they turned to governm ents in the creditor countries for help. A s a
result, the Latin American debt crisis came to be m anaged within a fram ew ork
310
C H A P T E R 14
Developing Countries and International Finance I
that reflected the interests o f the creditors. This regime w as based on a sim ple,
if som ew hat unbalanced, exchange between the creditor and debtor govern­
ments. Creditor governments offered new loans and rescheduled the term s of
existing loans in exchange for policy reform in the indebted countries.
The debt regime w as based on the creditors’ strongly held belief that de­
veloping countries eventually could repay their debt. C reditors initially d iag­
nosed the debt crisis as a short-term liquidity problem . The creditors believed
that high interest rates and fallin g e x p o rt earnings had raised debt service
above the debtor governm ents’ current capacity to pay. Once interest rates fell
and grow th resum ed in the advanced industrialized w orld, developing coun­
tries could resume debt service.
This diagnosis shaped the creditors’ initial response to the crisis. Because
they believed that the crisis w as a short-term liquidity problem , they prescribed
short-term remedies. They required the debtor countries to implementing m ac­
roeconomic stabilization program s. M acroeconom ic stabilization w as intended
to eliminate the large current-account deficits in order to reduce the dem and
for external financing. The centerpiece o f the typical stabilization program w as
the reduction of the budget deficit. Balancing the budget has a powerful effect
on domestic economic activity, reducing domestic consum ption and investment
and thereby the dem and for im ports. M oreover, the resulting unem ploym ent
would reduce wages, making exports more competitive. Exchange-rate devaluation would further improve the balance o f trade. The smaller current-account
deficits that w ould follow w ould require sm aller capital inflows. In the ideal
world, stabilization would produce current-account surpluses.
In exchange for m acroeconom ic stabilization, creditor governm ents p ro ­
vided new loans and rescheduled existing debt to offset the liquidity shortage.
New loans were m ade available by the IM F and by com m ercial banks through
a pro cess called concerted lending. In 1983 and 1 9 8 4 , the IM F and co m ­
mercial banks provided a total o f $28.8 billion to the indebted governm ents
(Cline 1995, 207). D eveloping countries were also allow ed to reschedule e x ­
isting debt payments. D ebt owed to com m ercial banks w as rescheduled in the
London Club, a private association established and run by the large com m er­
cial banks. Rescheduling agreem ents neither forgave debt nor reduced the in­
terest paym ents attached to the debt. They merely rescheduled the paym ents
that d ebtor governm ents had to m ake, usually offering a grace period and
extending the m aturity o f the debt. Access to both, however, w as conditional
on prior agreement with the IM F on the content o f a stabilization package.
A CLOSER LOOK
The International Monetary Fund
The IMF is based in Washington* DC. It has a staff of about 2,690, most of whom
are professional economists, and a membership of 184 countries.The IMF controls
$311 billion that it can lend to member governments facing balance-of-payments
x
>
Managing the Debt Crisis
311
deficits.Two ruling bodies—the Board of Governors and the Executive Boardmake decisions within the IMF.The Board of Governors sits at the top of the IMF
decision-making process. Each country that is a member of the IMF appoints one
official to the Board of Governors.Typically, the country's central-bank president
or finance minister will serve in this capacity. However, the Board of Governors
meets only once a year; therefore, almost all IMF decisions are actually made by
the Executive Board, which is composed of twenty-four executive directors, each
of whom is appointed by IMF member governments. Each of eight countries (the
United States, Great Britain, France, Germany, Japan, China, Russia, and Saudi
Arabia) appoints an executive director to represent its interests directly. The other
sixteen executive directors represent groups of IMF member countries. For example,
Pier Carlo Padoan (an Italian) is currently the executive director representing
Albania, Greece, Italy, Malta, Portugal, and Spain, whereas B. P. Misra (from India)
is currently the executive director representing Bangladesh, Bhutan, India, and Sri
Lanka. The countries belonging to each group jointly select the executive director
who represents them. A managing director appointed by the Executive Board chairs
the Board. Traditionally, the managing director has been a European (or at least
non-American).
Voting in the Board of Governors and the Executive Board is based on a
weighted voting scheme. The number of votes each country has reflects the size of
its quota in the stabilization fund. The United States, which has the largest quota,
currently has 371,743 votes (17.14 percent of the total votes). Palau, which has
the smallest quota, currently has only 281 votes (.01 percent of the total votes).
Many important decisions require an 85 percent majority. As a result, both the
United States, with 17 percent of the total votes, and the EU (when its member
governments can act jointly), with more than 16 percent of the total vote, can =
veto important IMF decisions. As a block, developing countries also control votes
sufficient to veto IMF decisions. Exercising this developing-country veto requires a
level of collective action that is not easily achieved, however. In contrast with other
international organizations, therefore, the IMF is not based on the principle of
"one country, one vote." Instead, it is based on the principle that the countries that
contribute more to the stabilization fund have a greater say over how that fund is
used. In practice, this means that the advanced industrialized countries have much ■
greater influence over IMF decisions than developing countries.
The IMF lends to its members under a number of different programs, each of
which is designed to address different problems and carries different terms for
*
repayments:
• Standby arrangements are used to address short-term balance-of-payments
problems. This is the most widely used IMF program. The typical standby
arrangement lasts twelve to eighteen months. Governments have up to 5 years
to repay loans under the program, but are expected to repay these credits within
2 to 4 years.
• The Extended Fund Facility was created in 1974 to help countries address
balance-of-payments problems caused by structural weaknesses. The typical
(Continued)
312
CHAPTER 14
Developing Countries and International Finance I
arrangement under this programls twf^arlohg a%a'star^^e^^^me'Mi3
*
years). Moreover, governments have up to 10 years to repay;loans under the
program, but the expectation is thatthe$tfahfWljl
• The Poverty Reduction and Growth
^tablfshett in 199$.~<,
Prior to that year, the IMF had prbvidedffinancial-assistance to.lovi^hcbrne v ;
countries through its Enhanced StructuralAdjustment Facflity,(ESAF),‘ a y *
program that financed many of the structural adjustmentspackages.during the. ■
1980s and 1990s. In 1999, the PRGFf-replacediheJESAfvLoans undenthe.
PRGF are based on a Poverty Reductiori^StrategyPaper,-which is prepared ly
the borrowing government with input from civi (society and other-development i;
partners, including the World Bank. The interest rate on P RGF loans is only;0.5
percent, and governments have up to 10 years to, repay io|n$.
. .>
• Two new programs were established in the late 1990s in response to-financiaj'.
crises that arose in emerging markets. The Supplemental Reserve Facility artd
the Contingent Credit Line provide additional, financing for governments that,
are in the midst of or are threatened by a crisis and thus require substantial
short-term financing. Countries have up to 2.5 years to repay loans under both
programs, but are expected to repay within 1.5 years. To discourage the use of
these programs, except in a crisis, both programs carry a substantial charge on
top of the normal interest rate. ■
By 1 9 8 5 , the creditor coalition w as revising its initial d iagn o sis. Latin
A m erican econom ies failed to recover as grow th resum ed in the advanced
industrialized w orld. A lthough creditors still believed that countries could
repay their debt, they concluded that their ability to do so w ould require more
substantial changes to their econom ies. Stabilization w ould not be sufficient.
This new diagn osis generated a second, m ore invasive, set o f policy reform s
know n as structural adjustm ent. Structural adjustm ent rested on the belief
that the econom ic structures developed under ISI provided to o little capacity
for exp o rt expan sion. G overnm ents were to o heavily involved in econom ic
activity, econom ic production w as too heavily oriented tow ard the dom estic
m arket, and locally produced m an ufactu red g o o d s w ere uncom petitive in
w orld m arkets. T his econom ic structure stifled entrepreneurship, reduced
the capacity for econom ic grow th, and lim ited the poten tial for exportin g.
Structural adjustm ent program s sought to reshape the indebted econom ies by
reducing the governm ent’s role and increasing that o f the m arket. R eform s
sou gh t substan tial m arket liberalization in fou r areas: trad e liberalization ,
liberalization o f FD I, privatization o f state-ow ned enterprises, and broader
deregulation to prom ote economic competition.
Structural adjustm ent program s were accom panied by additional lending
by the W orld Bank, new IM F program s, and com m ercial banks. Com m ercial
banks were asked to provide $20 billion o f new loans over a 3 year period to
refinance one-third o f the total interest com ing due in the period. M ultilateral
Managing the Debt Crisis
313
T A B L E 14.6
Economic Conditions in Latin America, 1980-1990
GDP1
Consumption1
Investment1
Unemployment2
Real Wages3
Imports4
Exports4
Net Transfers4
Fiscal Deficit5
Inflation
1980-1981
1982
1983
1984
1985
1986-1990
100.0
77.0
24.4
6.7
100.0
-12.3
12.5
12.2
95.6
74.0
19.6
91.3
70.3
14.9
92.2
70.4
15.2
92.7
69.9
16.1
10.1
86.4
-7.9
14.2
-32.3
2.7
126.9%
94.1
71.6
15.9
8.0
68.9
-9.2
15.2
3.7
53.2%
-9.7
-7.5
-8.0
13.6
14.5
-31.6 -26.9
5.2
3.1
57.7% 90.8% 116.4%
12.6
-18.7
5.4
'As a percentage of 1980-1981 gross domestic product (GDP).
2Rate of open unemployment as a percentage of total labor force.
'Index of real wages in unemployment.
4$U.S. billions.
'Percent of GDP.
Sources; Thorp 1999; Edwards 1995, 24; Edwards 1989, 171.
financial institutions, particularly the W orld Bank, were ask ed to provide
an additional $10 billion over the sam e period. In all cases, fresh loans from
com m ercial banks hinged upon the ability o f d eb to r governm ents to gain
financial assistance from the IM F, and loans from the IM F and W orld Bank
were contingent upon the w illingness o f governm ents to agree to structural
adjustment program s.
This debt regime pushed the costs o f adjustm ent onto the heavily indebted
econom ies. T ab le 14.6 illu strates the econom ic consequences o f the crisis
for L atin A m erica as a w hole. Investm ent, co n su m p tio n , an d econ om ic
grow th in the region all fell sharply after 1982. Indeed, by the end o f the
decade m ost still had not recovered to their 1980 levels. The econom ic crisis
hit la b o r m ark ets p articu larly h ard ; unem ploym ent rose an d real w ages
fell by 30 percent over the course o f the decade. R eal exchange rates were
devalued by 23 percent, on average, and by m ore substantial am ounts in Chile
(96 percent), U ruguay (70 percent), and a few other countries (Edw ards 1995,
2 9 -3 0 ). This adjustm ent brought a small increase in exports, a sharp reduction
in im ports, and an overall improvement in trade balances. From an aggregate
$2 billion deficit in 1981, Latin Am erica as a whole m oved to a $39 billion
trade surplus in 1984 (Edw ards 1995, 23).
Latin American governments used these current-account surpluses for debt
service. N et transfers, which measure new loans minus interest-rate payments,
provide a m easure o f the scale of this debt service. In 1976, net transfers for
the seventeen m ost heavily indebted countries totaled $12.8 billion, reflecting
the fact that these countries were net im porters o f capital. Between 1982 and
314
C H A P T E R 14
Developing Countries and International Finance I
1 9 8 6 , net tran sfers for these sam e seventeen co u n tries av eraged negative
$26.4 billion per year, reflecting the substantial flow o f funds from the debtor
countries to banks based in the advanced industrialized countries (Edw ards
1 9 9 5 , 2 4 ). T h u s, d om estic econ om ic ad ju stm en t gen erated the reso u rces
needed to service foreign debt.
The puzzle in the m anagem ent o f this crisis concerns the ability o f credi­
tors to push such a large share o f the adjustm ent co sts onto the debtor gov­
ernments. T h at is, why were creditors so much m ore pow erful than debtors?
The short answer is that creditors were better able to solve the free-rider p ro b ­
lem than debtors. As a result, creditors could m aintain a com m on front that
pushed the costs onto the debtor governments.
Creditor power lay in the ability to condition lending to policy reform. In
order to exploit this pow er, the creditors had to solve a key free-rider problem
(see Lip son 1 985). Each individual creditor recognized th at debt service in
the short run required addition al financing and in the long run depended on
structural reform s that governments w ould not implement without additional
financing. But each individual creditor also preferred that other creditors p ro ­
vide these new loans. T hus, each creditor had an incentive to free ride on the
contributions of the other members o f the coalition.
Com m ercial banks had an incentive to free ride on IM F lending. L o an s
from the IM F would allow the debtor governments to service their commercial
bank debt. If the IM F carried the full burden o f new lending, com m ercial
banks would be repaid without having to put more o f their own funds at risk.
Within the group of commercial banks involved in the loan syndicates, smaller
banks had an incentive to free ride on the large banks. Smaller banks had much
less at stake in Latin Am erica than the large com m ercial banks had, because
the sm aller banks had lent proportion ately less as a share o f their cap ital.
Consequently, default by Latin American governm ents w ould not necessarily
imperil the smaller banks’ survival. Thus, whereas the large com m ercial banks
could not walk aw ay from the debt crisis, the smaller banks could (Devlin 1989,
2 0 0 -2 0 1 ). Smaller banks could refuse to put up additional funds knowing that
the large banks had to do so. Once the large banks provided new loan s, the
small banks would benefit from the resulting debt service.
The IM F helped creditors overcom e this free riding problem . T o prevent
large com m ercial banks from free riding on IM F lo an s, the IM F refused to
advance credit to a particular government until com m ercial banks pledged new
loans to the sam e government. This linkage between IM F and private lending
in turn encouraged the large com m ercial banks to prevent free riding by the
sm all com m ercial banks. Because the large com m ercial banks were unable to
free ride on the IM F, they sought to com pel the sm all banks to provide their
share o f the new private loan s. Large banks threatened to exclude sm aller
banks from participation in future syndicated loan s— a potentially lucrative
activity for the sm aller b an k s— and threatened to m ake it d ifficult fo r the
sm aller banks to operate in the interbank m arket. A m erican and E urop ean
central-bank officials also pressured the sm all banks. Free riding thus became
costly for the sm all banks.
>
^
Managing the Debt Crisis
315
POLICY ANALYSIS AND DEBATE
International Monetary Fund Conditionality
Question
Should the IMF attach conditions to the credits it extends to developing countries?
Overview
IMF conditionality has long been a source of controversy. Critics of the practice
argue that the economic policy reforms embodied in IMF conditionality agreements
force governments to accept harsh austerity measures that reduce economic growth,
raise unemployment, and push vulnerable segments of society deeper into poverty.
Moreover, the IMF has been accused of adopting a "one size fits all'' approach
when designing conditionality agreements. It relies on the same economic model in
analyzing each country, and it recommends the same set of policy changes for each
country that comes to it for assistance. Consequently, critics allege, IMF policy
reforms are often inappropriate, given a particular country's unique characteristics.
The IMF defends itself by arguing that most developing-country crises share a
common cause: large budget deficits, usually financed by the central bank. Such
policies generate current-account deficits larger than private foreign lenders are
willing to finance. Governments turn to the IMF only when they are already deep
in crisis. Because most crises are so similar, the solution to them should also be
similar in broad outline: Governments must bring spending in line with revenues,
and they must establish a stable base for participation in the international economy.
And though the short-term costs can be high, the economy in crisis must be returned
to a sustainable path, whether the IMF intervenes or not. Should the IMF require
governments to implement policy reforms as a condition for drawing from the fund?
Policy Options
• Continue to require conditionality agreements in connection with IMF credits.
• Abandon conditionality and allow governments to draw on the IMF without
implementing stabilization or structural adjustment measures.
Policy Analysis
>
• To what extent are the economic crises that strike countries that turn to the
IMF solely a product of IMF conditionality agreements?
• To what extend does conditionality protect IMF's resources? What would
happen to these resources if conditionality were eliminated?
Take A Position
• Which option do you prefer? Justify your choice.
• What criticisms of your position should you anticipate? How would you defend
your recommendation against these criticisms?
(Continued)
316
C H A P T E R 14
Developing Countries and International Finance I
Resources
Online:
Do an online search for "IMF cor^itionality.^Fo||oWthCiinksto some sites;»
that defend conditionality and to some that critidize the practice. The Hoover
Institution maintains a useful website that examines IMF-related issues. Search
for "Meltzer Commission" to find some strong criticisms of the IMF's activities.
The IMF explains and defends conditionality in a fact sheet: {Seardh'TMF facts
conditionality.")
Stiglitz, "What I Learned at the World Economic Crisis," The New
Republic, April 17,2000, and Globalization and Its Discontents (New York: W.W. Norton
and Company, 2002); Kenneth Rogoff,"The IMF Strikes Back," Foreign Policy
(January-February 2003): 38-46; Graham R. Bird, IMFLendingto Developing Courttries: Issues and Evidence (London: Routledge, 1995);Tony KilliCk, IM F Programmes in
Developing Countries: Design and Impact (New York: Routledge, 1995);
In Print: Joseph
The ability to solve the free-riding problem s produced a united front that
effectively controlled financial flow s to Latin America. The IM F and the com ­
mercial banks advanced new loans to Latin Am erican governm ents (although
the commercial banks did so quite reluctantly), and all accepted a share o f the
risks o f doing so. T his united front allow ed the creditors to rew ard govern­
ments that adopted a cooperative approach to the crisis with new financing
and to deny additional financing to governm ents that were unwilling to play
by the creditors’ rules.
Governments in the debtor countries were unable to exploit their potential
power. D ebtor pow er lay in the threat o f collective default. A lthough each of
the large debtors owed substantial funds to American banks— in 1982, for ex­
ample, M exico’s debt to the nine largest American com m ercial banks equaled
4 4 .4 percent o f those ban ks’ com bined capital— no single governm ent owed
so much that a unilateral default w ould severely dam age Am erican banks or
the Am erican econom y (Cline 1995, 7 4 -7 5 ). Collective action could provide
power, however. If all debtor governments defaulted, the capital o f the largest
American com m ercial banks w ould be elim inated, creating potentially severe
consequences for the Am erican economy. A credible threat to im pose such a
crisis m ight have com pelled the creditors to provide m ore finance on easier
terms, to demand less austerity, and perhaps to forgive a portion o f the debt.
Yet, d ebtor governm ents never threatened a collective d efau lt (Tussie
1988). Latin Am erican governm ents held a series o f conferences early in the
crisis to discuss a coordinated response. Governm ents used these conferences
to dem and that the creditors “ share responsibility in the search for a solution ,”
and they dem anded “ equity in the distribution o f the co sts o f ad ju stm en t,”
but they never threatened a collective default (Tussie 19 8 8 , 2 9 1 ). A rgentina
w as the only country to ad o pt a noncooperative stance tow ard the creditors’
coalition, and it tried to convince other Latin American governments to follow
suit. Those governments, however, were unwilling to take a hard line; in fact,
The Domestic Politics of Economic Reform
317
they encouraged Argentina to adopt a m ore cooperative stance (Tussie 1988,
2 8 8 ). T h us, instead o f threatening collective d efau lt, debtor governm ents
played by the creditors’ rules.
Debtor governments never threatened collective default because they were
caught in a prison ers’ dilem m a. Even though the threat of collective default
could yield collective benefits, each governm ent had an incentive to defect
from a collective threat in order to seek a better deal on its ow n. The in­
centive to seek the best deal possible through unilateral action, rather than
a reasonably good deal through collective action , arose because each debtor
governm ent believed that it possessed unique characteristics that enabled it
to negotiate more favorable term s than w ould be available to the group as a
whole. M exico, for exam ple, believed that it could exploit its proxim ity to the
United States and its close ties with the U .S. governm ent to gain m ore favor­
able terms. Brazil, which by 1984 w as running a current-account surplus, be­
lieved that it could use this stronger position to its advantage in negotiations
with its creditors (Tussie 1988, 288).
The bilateral approach that the creditors adopted reinforced these fears of
defection. Because creditors negotiated with each debtor independently, they
could adopt a “ divide and conquer” strategy. They could offer “ special d eals”
to induce particu lar governm ents to defect from any debtor co alitio n that
might form . If one government did defect, it w ould gain favorable treatment,
whereas the others w ould be punished for their uncooperative strategy. Pun­
ishment could include fewer new loans, higher interest rates and larger fees on
rescheduled loans, and perhaps more-stringent stabilization agreements. Thus,
even though coordinated action am ong the debtor countries could yield col­
lective gains, each individual government’s incentive to seek a unilateral agree­
ment dominated the strategy o f a collective threat o f default.
The debt regime pushed the adjustm ent co sts onto debtor governm ents,
therefore, because creditors were able to overcom e free riding problem s and
develop a coordinated approach to the debt crisis, and debtors were not. The
creditors used their pow er to create a regime that pushed the costs o f the debt
crisis onto the heavily indebted countries. The regime w as based on the dual
premises that all debt w ould be repaid in the long run, but debt service would
require the indebted governments to implement far-reaching econom ic policy
reform s. Conditionality thus provided a pow erful lever to induce developing
countries to adopt econom ic reform s: Few developing countries could afford
to cut themselves o ff com pletely from external financial flow s. A fter 1982,
these governm ents found that the price o f continued access to international
finance w as far-reaching economic reform.
THE DOMESTIC POLITICS OF ECONOMIC REFORM
Although the creditors established the structure for m anaging the debt crisis,
used conditionality to prom ote econom ic reform , and set the param eters on
the range o f acceptable policies that could em erge from the reform process,
the pace at which debtor governm ents ad o p ted stabilization and structural
318
C H A P T E R 14
Developing Countries and International Finance I
adjustm ent program s w as determined by dom estic politics. D om estic politics
caused m ost governm ents to delay im plem enting stabilization and structural
adjustm ent program s.
Econom ic reform required governm ents to im pose costs on pow erful d o ­
mestic interest groups. The need to im pose these costs generated distributive
conflict that delayed econom ic stabilizatio n . D istributive con flict revolved
around which domestic groups w ould bear the costs associated with balancing
the budget. Governments had to choose which program s w ould be cut. Would
the governm ent reduce subsidies o f foo d or energy, or w ould it reduce credit
subsidies to industry? In addition, governm ents had to decide which taxes to
raise and who w ould pay them.
The need to m ake these decisions generated a w ar o f attrition between
veto players. Each veto player pressured to reduce expenditures on program s
from which it did not benefit and to ta x other grou ps. Each blocked efforts
to cut its preferred program s or ta x it at a higher rate (Alesina and D razen
1991). This w ar o f attrition drove the politics o f stabilization throughout the
early 1 9 80s. The interest grou ps that had gained m ost from im port su b sti­
tution stoo d to lose the m ost from stabilizatio n and structural adjustm ent.
Im port-com peting firms that had benefited from governm ent credit subsidies
w ould be hit hard by fiscal retrenchment. State-ow ned enterprises w ould be
particularly hard hit, as they w ould lose the governm ent infusions that had
covered their operating deficits during the 1970s. W orkers in the urbanized
n on trad ed -good s sector w ho h ad benefited fro m governm ent su b sid ies o f
basic services, such as utilities and tran sp ortatio n , and essential fo o d item s
would also be hit hard by budget cuts. Public-sector em ployees w ould suffer
as well, as budget cuts brought an end to w age increases and forced large re­
ductions in the number o f government employees.
Unwilling to accept the reduction in incom e im plied by fiscal austerity,
interest gro u p s blocked large cuts in governm ent exp en ditu res. In B razil,
for exam ple, the m ilitary governm ent attem pted to im plem ent an o rth o d o x
stabilization program in the early 1 9 80s, but “ both capitalists and lab o r in
modern industry . . . dem anded relief from austerity. So too did much o f the
urban middle class including governm ent functionaries whose livelihood w as
imperiled by attacks on public spending” (Frieden 1992, 134). These groups
shifted their su pp ort to the civilian po litical oppo sition , which to ok pow er
from the m ilitary. Once in office, the new civilian governm ent aban d on ed
austerity m easures. The Brazilian case w as not unique: The im port substitution
c o a litio n w as w ell p o sitio n e d to b lo ck s u b sta n tia l cu ts in g o v ern m en t
program s in m ost heavily indebted countries.
The inability to reduce government expenditures resulted in high inflation
throughout Latin A m erica. M an y governm ents financed budget deficits by
selling bonds to their central banks. Printing m oney to pay for governm ent
expenditures sparked inflation. Annual average inflation in Latin America rose
from about 50 percent in the years im m ediately preceding the crisis to over
115 percent in 1984 and 1985 (Table 14.6). Worse, these regional averages hide
the m ost extreme cases. In Argentina, inflation averaged 787 percent per year
V
^
The Domestic Politics of Economic Reform
319
during the 1980s. Brazil fared a little better, enduring average rates o f inflation of
605 percent throughout the decade (Thorp 1999, 332). Bolivia’s experience was
the most extreme, with inflation rising above 20,000 percent in late 1985.
Even rap id in flation w as in su ffic ien t to induce g o v ern m en ts to cut
e x p e n d itu re s. In A rgen tin a, B ra z il, an d P eru, g o v e rn m e n ts re sp o n d e d
to high in flation with h e te ro d o x strate g ie s (see E d w ard s 1 9 9 5 , 3 3 - 3 7 ).
Advanced as an alternative to stan dard IM F stabilizatio n p lan s, h eterodox
stra te g ie s a tta c k e d in fla tio n w ith go v e rn m e n t c o n tro ls on w a g e s an d
p rice s. The A rgen tin ean an d B r a z ilia n p la n s illu str a te th e a p p r o a c h .
In both p ro g ra m s, the govern m en t froze prices an d w age s in the p u b lic
sector. Each governm ent also introduced new currencies and established a
fixed exchange rate. Initially, the pro gram s appeared to w ork, as inflation
d ropped sh arp ly in the first six m o n th s. E arly su cce sses w ere rev ersed,
however, b ecause neither govern m en t w as w illing to reduce govern m en t
e x p e n d itu re s. In less th an a year, in fla tio n r a te s r o se a g a in an d the
program s were scrapped (E dw ards 1995, 37).
It w asn’t until the late 1 9 8 0 s that Latin Am erica governm ents began to
m ake painful econom ic adjustm en ts. G overnm ents reduced fiscal deficits
and brought inflation under control. M acroeconom ic stabilization provided
a base upon w hich to begin stru ctu ral refo rm s. G o v ern m en ts b egan to
liberalize trad e and privatize state-ow n ed in d ustries. M an y governm ents
also began to reduce their role in dom estic financial system s and to liberalize
capital accounts as well (Edw ards 1995, 212).
Three fa c to rs induced govern m en ts to em b ark on eco n om ic reform .
F irst, the eco n om ic crisis a ltered in te rest-gro u p p o litic s. K ey m em bers
o f the im p ort su b stitu tio n co alitio n lo st strength an d faced higher co sts
from oppo sin g reform . A s a result, gro u p s that had once been w illing and
able to block reform increasingly lost the capacity to do so. The econom ic
crisis also cau sed “ in d ivid u als an d g ro u p s to accep t [the fact] th at their
special in terests need[ed] to be sacrificed . . . on the a lta r o f the general
g o o d ” (W illiam son 1994, 19). Econom ic crisis thus created a new political
consensus that the old order had failed and that reform w as necessary. By
w eakening key interest g ro u p s and by forcing m any o f these sam e gro u p s
to redefine their interests, the severity o f the econom ic crisis itself rem oved
the political obstacles to reform .
Second, the United States initiated a new approach to the debt crisis in
1989. In M arch of 1989, the United States encouraged com m ercial banks to
negotiate debt-reduction agreem ents with debtor governm ents. Under this
Brady Plan (named after N icholas J. Brady, the secretary o f the U .S. Treasury),
debtor governments could convert existing com m ercial bank debt into bondbased debt with a lower face value. The precise am ount o f debt reduction that
each governm ent realized w ould be determined by negotiations between the
debtor government and its com m ercial bank creditors. To m ake the proposal
attractive to commercial banks, the advanced industrialized countries and the
m ultilateral financial institutions advanced $30 billion with which to guar­
antee the principal of these Brady bonds. This guarantee allowed commercial
320
C H A P T E R 14
Developing Countries and International Finance I
banks to exchange the uncertain repaym ent o f a large bank debt for gu aran ­
teed repayment of a sm aller am ount o f bond debt.
T he B rady Plan stren gth en ed the incentive to e m b ark on refo rm by
increasing the dom estic benefits o f reform . Large debt burdens reduced the
incentive to adopt structural reform s because a significant share o f the gains
from reform w ould be dedicated to debt service. C om m ercial banks w ould
thus be the prim ary beneficiary o f reform . It is not hard to see why dom estic
groups would be reluctant to accept costly reform s. Reducing the debt burden
ensured that a larger share of the gains from reform w ould accrue to dom estic
groups. As a result, the short-run costs o f reform w ould be offset by long-run
gains. This plan created a greater incentive to accept the short-term costs that
stabilization and structural adjustm ent entailed.
M exico w as the first to take advantage o f the Brady Plan, concluding an
agreement in July 1989 (see Cline 1995, 2 2 0 -2 2 1 ). The deal reduced M ex ico ’s
net tran sfers by a b o u t $4 billion , an am ou n t equ al to a b o u t 2 percen t o f
M e x ic o ’s GDP. R ed u cin g d eb t service allo w e d the M e x ic a n eco n om y to
grow by 2 percentage points m ore than w ould have been p o ssib le w ithout
debt reduction (Edw ards 1995, 81). By 1994, Brady Plan agreements covered
about 80 percent o f com m ercial bank debt and reduced debt-service paym ents
by about one-third (Cline 1995, 232).
Finally, a s the econom ic crisis deepened, governm ents becam e m ore w ill­
ing to recognize that the E ast A sian m odel offered lessons for Latin Am erica.
The Econom ic C om m ission on Latin A m erica (E C LA ) played an im portan t
role in p ro m p tin g this recogn ition (see E co n o m ic C o m m issio n fo r L atin
Am erica and the C aribbean 1985). The E C L A had begun to lo ok closely at
E ast A sia in the m id -1980s and w as able to create a new consen sus am on g
Latin Am erican governm ents that the E ast A sian m odel w as relevant to Latin
Am erican developm ent. As an E C L A study recom m ended in the late 1 9 8 0 s,
“ [T]he debt problem requires a stru ctu ral tran sfo rm atio n o f the econom y
in at le ast tw o sen ses: the grow th strategy needs to be o u tw a rd o rien ted
and largely based on a d om estic e ffo rt to raise sav in gs an d p ro d u ctiv ity ”
(cited in Edw ards 1995, 148). The E C LA ’s transform ation “ w as like ‘N ix o n
in C h in a.’ When the institution th at had for decades defended im port su b ­
stitution expressed d oubts ab o u t its validity and recognized that there were
lessons to be learned from the E ast A sian experience with outw ard-oriented
policies, it w as difficult to dism iss those doubts as purely neo-liberal p ro p a ­
gan d a” (Edw ards 1995, 52).
The Latin American debt crisis w as declared over in the m id-1990s (Cline
1995, 39). In hindsight, it is clear that the crisis w as more than a financial one:
It w as a crisis o f econom ic developm ent. T he accum ulation o f foreign debt
during the 1 970s reflected efforts to rejuvenate the w aning energies o f ISI.
Moreover, the crisis itself, and the debt regime through which it w as m anaged,
tran sform ed developin g co u n tries’ developm en t strate g ie s. G overn m en ts
ab an d o n ed state-led ISI in fa v o r o f a m ark et-b ased an d e x p o rt-o rie n te d
strategy. As a consequence, developing countries fundam entally altered their
relationship with the international economy.
Suggestions for Further Reading
321
CONCLUSION
The Latin American debt crisis illustrates the tragic cycle at the center o f N orth South financial relations. A grow ing dem and for foreign capital generated in
part by international events and in p art by dom estic developm ents combined
with a grow ing willingness o f com m ercial banks to lend to developing societies
in order to generate large capital flow s to Latin American countries during the
1970s. The resulting accum ulation o f foreign debt rendered Latin Am erican
societies extremely vulnerable to exogenous shocks. When such shocks hit in
the late 1970s and early 1980s, governments found that they could no longer
service their com m ercial bank debt, and com m ercial banks quickly ceased
lending fresh funds. As the supply o f foreign capital dried up, Latin American
economies were pushed into crisis.
The Latin American debt crisis also forced governm ents in the advanced
industrialized world to establish an international regime to m anage the crisis.
In the resulting debt regime, the IMF, the World Bank, and com m ercial banks
provided additional financial assistance to the heavily indebted countries on
the condition that governments implement stabilization and structural adjust­
ment packages. This approach pushed m ost o f the costs of the crisis onto Latin
America. Moreover, the reforms it encouraged provoked far-reaching changes
in Latin American political and economic systems. With a few changes that we
will exam ine in the next chapter, this debt regime remains central to the m an­
agement of developing-country financial crises.
A lthough the Latin Am erican debt crisis is unique in m any respects, in
others it is all too typical. And though this crisis w as the first of the postw ar
period, it would not be the last. In fact, crises have become increasingly common
during the last 20 years, and the m ore recent ones share m any o f the central
characteristics of the Latin American crisis and have been m anaged in much the
same way. They have also generated much discussion about whether and how
the international financial system should be reform ed in order to reduce the
number and severity of such crises. We examine these issues in Chapter 15.
KEY TERMS
>
Brady Plan
Debt-Service Capacity
Foreign Aid
Heterodox Strategies
International Bank for
Reconstruction and
Development
International
Development
Association
Liquidity Problem
London Club
Macroeconomic
Stabilization
Petrodollar Recycling
Petrodollars
Regional Development
Banks
Structural Adjustment
World Bank
SUGGESTIONS FOR FURTHER READING
For a comprehensive history of the World Bank’s first twenty years, see Edward S.
Mason and Robert E. Asher, The World Bank since Bretton Woods (Washington,
DC: The Brookings Institution, 1973); and Devesh Kapur, John P. Lewis, and
322
C H A P T E R 14
Developing Countries and International Finance I
Richard Webb, The World Bank: Its First H a lf Century (W ashington, DC:
Brookings Institution, 1997). For a critical perspective, see Kevin Danaher, ed.,
SO Years Is Enough: The Case against the World Bank and the International
Monetary Fund (Boston: South End Press, 1994).
On the 1980s debt crisis and the politics of economic reform, see Robert Devlin, Debt
and Crisis in Latin America: The Supply Side o f the Story (Princeton, NJ: Princeton
University Press, 1989); Stephan Haggard and Robert Kaufman, eds., The Politics
o f Economic Adjustment: International Constraints, Distributive Conflicts, and the
State (Princeton, NJ: Princeton University Press, 1992); and Robert Bates and Anne
O. Krueger, eds., Political and Economic Interactions in Economic Policy Reform
(Oxford, UK: Blackwell, 1993).
Two excellent studies of the politics of IMF lending include Jam es Vreeland, The
International Monetary Fund: Politics o f Conditional Lending (New York:
Routledge, 2007) and Erica Gould, Money Talks: the International Monetary
Fund, Conditionality, and Supplementry Financiers (Palo Alto: Stanford University
Press, 2006).
CHAPTER
15
Developing Countries
and International
Finance II:
A Decade of Crises
P
rivate flows o f capital to the developing world resumed in the early 1990s,
but traditional commercial bank loans were increasingly accom panied,
an d in m any in stan ces su rp a sse d , by bond and equity flo w s. T he
emergence o f large and liquid private capital flow s to developing countries
contributed to a rash of crises during the decade. The crises began in M exico
in 1994 and continued, alm ost w ithout interruption, until the Argentinean
crisis of 2 0 0 1 - 2 0 0 2 . In between, financial crises struck A sia, R u ssia, Brazil,
and Turkey. Indeed, it is not too much o f an exaggeration to suggest that, in
hindsight, the decade w as a period o f continual crisis. As governm ents m an­
aged the fallout from one crisis, another began to develop. Without exception,
the domestic economic and political consequences o f these crises were severe:
Econom ies collapsed, incomes fell sharply, and governments toppled.
The rash o f fin an cial crises en co u raged governm ents to co n tem p late
changing the crisis management system. Initially, governments relied upon the
debt regime established during the 1980s to m anage them. A s the scale and
the consequences o f the Asian crisis began to sink in, dissatisfaction with that
regime grew . Som e people argued that by applying the logic o f stabilization
and structural adjustm ent to A sia, the International M onetary Fund (IM F)
had w orsened the resulting econom ic crisis, push ing econom ies into deep
recessions. They p ro posed that the IM F should change how it resp on d s to
crises. O thers argued that the w idespread belief that the IM F stoo d ready to
“ bail o u t” countries in distress itself encouraged the un sustain able private
capital flow s that created crises. These critics suggested that the IM F get out o f
the crisis m anagem ent business altogether. Still others argued that developing
countries should reintroduce controls to limit the volum e o f private capital
flows. Criticism s prom pted an extended discussion of w hat reform s could be
adopted to reduce the frequency and severity o f these new fin an cial crises,
323
324
C H A P T E R 15
Developing Countries and International Finance II: A Decade of Crises
as well as to m an age them m ore effectively. A lthough little cam e o f these
glo b al initiatives, A sian governm ents drew lesson s th at profou n d ly altered
the global financial system.
We exam ine this decade o f crisis and crisis m anagem ent in this chapter.
We lo ok first at the series o f crises th at struck during the 1 9 9 0 s, focu sin g
deeply on the largest o f them: the 1 9 9 7 A sian crisis. We then exam ine how
that crisis subsequently prom pted considerable discussion about reform ing the
international financial system in order to alter how crises are m anaged and
to try to reduce the frequency o f such crises in the future. We then turn our
attention to the other debt crisis that has dom inated N o rth -So u th relations
during the last 10 years, the one involving the w orld’s poorest countries. The
chapter concludes by draw ing som e more general lessons.
THE ASIAN FINANCIAL CRISIS
Developing countries attracted little new private capital during the 1980s. It
was not until the end of the decade and after reform had taken root that private
capital began flowing again. Private capital flow s resum ed in a changed envi­
ronment, however. On the one hand, policies tow ard private capital flows were
radically different. Although m ost governments had restricted capital flow s in
connection with import substitution, many dismantled these controls in connec­
tion with policy reforms implemented during the 1980s and early 1990s. Conse­
quently, it became much easier for private individuals to move capital into and
out of emerging markets. On the other hand, financial liberalization in advanced
industrialized countries had increased the importance o f securities— stocks and
bonds— as sources o f financing. The grow ing im portance o f nonbank capital
flows w as reinforced by the lingering effect o f the Latin Am erican debt crisis;
few banks were willing to lend to countries that had so recently defaulted.
These changes com bined to alter the com position, as well as the scale, o f
private capital flows to the developing w orld. The im portance o f com m ercial
bank lending dim inished, w hereas that o f bond and equity flow s increased.
M ost private capital flow s to Latin Am erica during the 1 9 9 0 s, for exam ple,
financed governm ent and co rp o rate bon ds and pu rch ased stocks in newly
liberalized stock m arkets. By the m id -1990s, private capital flow s to the en­
tire developing w orld had risen to ab ou t 3 percent o f these countries’ gross
dom estic product (GDP). (See Figure 15.1.) A sia w as the largest recipient o f
capital inflows prior to 1997, accounting for alm ost 50 percent o f total flow s
to all developing countries in the first h alf o f the decade. Latin Am erica w as
the second-largest recipient, obtaining between one-quarter and one-third o f
all flows to developing countries (IM F 2000).
The resum ption o f private capital flow s generated one crisis after another.
The grow ing im portance o f bond and equity flow s, often referred to as hot
money because they can be w ithdraw n at the first hint o f trouble, increased
the volatility o f private capital flow s to these “ em erging m ark et” countries.
Although developing countries have struggled with such volatility throughout
the last 100 years, volatility increased during the 1990s com pared with earlier
periods (IM F 2 0 0 1 , 1 6 3 ; W orld Bank 2 0 0 1 a ). H isto rical evidence suggests
The Asian Financial Crisis
325
150 -i1992 1993 1994 1995 199619971998 19992000 2001 2002 2003 2004 2005 2006 2007 2008
Billions of U.S. Dollars
100
50
0
-50
-100
FIGURE 15.1
Private Capita! Flows to the Developing World, 1992-2008
Sources: World Bank, Global D evelopm ent Finance 2 0 0 4 C D -R o m , Table 1.1 (Washington, DC: World Bank
Publications, 2004); World Bank, G lobal Developm ent Finance 2 0 0 5 C D -R o m , Table 1.1 (Washington, DC:
World Bank Publications, 2005) and World Bank, Global D evelopm ent Fin ance 2 0 0 8 C D -R o m , Table 1.1
(Washington, DC: World Bank Publications, 2008).
N o te : Excludes foreign direct investment flows.
that more volatile cap ital flow s have been asso ciated with low er econom ic
grow th rates over the lon g run (W orld B an k 2 0 0 1 a , 73). In ad d itio n , the
record of the 1990s indicates that increased volatility of private capital flows is
associated with more frequent financial crises that substantially reduce economic
growth for a year or two.
Such financial crises becam e all too com m on during the 1 9 90s. M exico
experienced the first one in late 1 9 9 4 . F o u r A sian co u n tries— In d o n esia,
M alaysia, South K orea, and Thailand— had severe crises in the sum m er and
fall o f 1997. Brazil and R u ssia both experienced crises in 1998. T urkey and
Argentina were struck by crises in 2 0 0 0 and 2 0 01. Each crisis w as distinctive
in some way, and yet all shared important similarities. (See Table 15.1.) First,
each country struck by a crisis maintained som e form o f fixed exchange rate.
In m ost instances, governments maintained a crawling peg or the slightly less
restrictive crawling band. Second, each country developed a heavy reliance on
short-term foreign capital
The combination proved perilous. Heavy dependence on short-term capital
required the continual rollover o f foreign liabilities. The ability to roll over these
liabilities depended critically on the governm ent’s ability to m aintain foreign
investors’ confidence in its com m itm ent to the fixed exchange rate. In each
crisis, foreign investors lost confidence in th at com m itm ent. The trigger for
crisis varied. Sometimes it was a political shock, as in M exico; sometimes it was
an economic shock, as in R ussia and Argentina; som etim es it w as contagion
from crises in other regions. In all instances, however, the evaporation o f foreign
326
C H A P T E R 15
Developing Countries and International Finance II: A Decade of Crises
T A B L E 15.1
A Chronology of Crises, 1994—2002
_________ _______Mexico (December 1994-Jahuary 1995)
Exchange Rate: Crawling band pegged to the dollar.
Financing Problem: The Mexican government began issuing short-term debt linked to
the U.S. dollar in April 1994 (Cetes, analogous to U.S. Treasury bonds) to reduce
its interest rate. The value of the Cetes issued soon exceeded the central bank's
foreign exchange reserves.
Trigger: Unrest in Chiapas province generated a speculative attack in early
December.
IMF Support: Mexico secured credits for $48.8 billion, including $17.8 billion from
the IMF and $20 billion from the U.S. government.
Fallout: The government devalued the peso by 15 percent on December 20 and then
floated the peso on December 22. The peso depreciated from 3.64 per, dollar
to more than 7 per dollar. Mexico suffered a depression and severe banking
problems that prompted government rescues.
Contagion: Speculative attacks spread throughout Latin America and Asia.
East Asia (July 1997-January 1998)
See details in this chapter.
Russia (August 1998)
Exchange Rate: Crawling band pegged to the dollar.
Financing Problem: The Russian government was paying very high interest rates on
large short-term debt.
Trigger: Falling prices for oil (the country's major export) and weak growth
generated speculative attacks. The government widened the ruble's band by
35 percent in August and then floated the ruble in early September. The ruble
depreciated from 6.2 per dollar to more than 20 per dollar.
IMF Support: Russia secured IMF credits of $11.2 billion in July 1998.
Fallout: The government defaulted on its ruble-denominated debt and Soviet-era
foreign debt and imposed a moratorium on private-sector payments of foreign
debt. The economy fell into recession. Many Russian banks became insolvent.
Contagion: Speculative attacks spread to Latin America, hitting Brazil especially
hard. The U.S. hedge fund Long Term Capital Management was pushed to the
brink of bankruptcy and was rescued in an effort coordinated by the Federal
Reserve Bank of New York.
Brazil (January 1999)
Exchange Rate: Crawling band pegged to the U.S. dollar.
Financing Problem: Growing government debt and a sizable current-account deficit
generated large short-term external debt.
327
The Asian Financial Crisis
TABLE 15.1 (continued)
Trigger: The Russian crisis and the subsequent collapse of Long Term.Capital
’
Management generated speculative attacks between August and October of
1998. Attacks resumed in early 1999 when a state government defaulted on ;;
payments to the federal government. The real was devalued by 9 percent on
January 13, 1999, and then floated on January 18. The currency depreciated
from 1.21 per dollar to 2.18.
IMF Support: Brazil secured an IMF credit of $18 billion on December 2, 1998.
Fallout: Mild; growth strengthened in 1999 and 2000. The financial system
suffered little.
Contagion: Brazil's devaluation contributed to recessions in Argentina and :
Uruguay and generated speculative attacks that forced Ecuador to float in
February 1999.
________Turkey (February 2001)
_____________ •
Exchange Rate: Crawling peg against the dollar and the German mark.
Financing Problem: Large government short-term debt and a large current-account
deficit generated heavy dependence on short-term foreign capital.
Trigger: Concern about a criminal investigation into ten government-run banks
in late November 2000 generated a speculative attack. Eight banks became
insolvent and were taken over by the government. Investors lost confidence
in February 2001 when conflict between the president and prime minister
weakened the coalition government. The government floated the lira on
February 22, and it depreciated from 668,000 per dollar to 1,6 million per
dollar by October 2001.
.
.....
IMF Support: Turkey secured an IMF credit of $10.4 billion on December 21,< *
Fallout: The Turkish economy contracted by 7.5 percent in 2001.
Contagion: None.
.
,
- . . .
^
Argentina (2001)
Exchange Rate: Fixed to the U.S. dollar,
Financing Problem: Large government short-term debt.
Trigger: Speculative attacks against this peg emerged in 2000 and continued
sporadically into 2001. The government introduced some exchange-rate
.......
flexibility in mid-2001, generating new speculative attacks. The goveniineni^s-v^
floated the peso in January 2002 and defaulted on its foreign debt.. , v
IMF Support: Argentina secured a total of $40 billion in credits from the IM F and : »
the advanced industrialized countries.
Fallout: Argentina's economy collapsed into deep depression,
Contagion: None.
.
.
■ ■ T.
Sources: Compiled from information in Eichengreen 2001; Joint Economic Committee 2003; and
material on the IMF website (www.IMF.org).
..
328
C H A P T E R 15
Developing Countries and International Finance II: A Decade of Crises
investors’ confidence in the governm ent’s com m itm ent to the fixed exchange
rate triggered massive capital outflow s that forced governments to devalue and
(with the lone exception o f Brazil) pushed the country into deep economic crisis.
In many instances, the economic crisis toppled governments as well.
The Asian financial crisis of 1997 provides the clearest illustration o f the
challenges these countries faced. The A sian crisis originated in political and
economic dynamics in four countries: Thailand, Indonesia, South K orea, and
M alaysia. During the late 1980s and early 1990s, the government in each country
liberalized their financial m arkets to m ake it easier for domestic banks and firms
to borrow on international financial m arkets. In T hailand, for exam ple, the
government created the Bangkok International Banking Facilities in 1992 in an
attempt to make Thailand an Asian banking center. The government hoped that
Thai banks w ould borrow on international m arkets and then lend the funds
obtained to borrowers across Asia. Financial liberalization thus enabled Asian
banks to intermediate the flow o f funds from international lenders to domestic
borrowers. The incentive for such intermediation w as powerful. Interest rates in
international m arkets were considerably lower than interest rates inside Asian
economies. Asian banks could thus borrow money at a relatively low rate of
interest, such as 9 percent, from foreign com m ercial banks and then lend it to
domestic borrowers at a much higher rate o f interest, such as 12 percent.
Such interm ediation w as risky. A sian banks contracted short-term loans
denom inated in dollars and other foreign currencies from foreign banks and
then offered these funds as long-term lo an s d en om inated in the d om estic
currency to lo cal b o rro w ers. A sian b an k s th us co n fro n ted tw o kin d s o f
risk. First, they faced exchange-rate risk, w hich aro se from the po ssibility
that the governm ent w ould devalue the local currency. Were this to happen,
the dom estic currency cost o f servicing the dollar-denom inated loan s w ould
rise su b stan tially . At the extrem e, the d om estic currency co st w o u ld rise
above the paym ents that A sian banks were receiving from the businesses to
which they had lent money. A sian banks were also exp osed to the risk that
foreign lenders w ould stop rolling over their short-term loans. Because Asian
banks had borrow ed on a short-term basis and then m ade long-term lo an s,
they needed foreign lenders to renew the loans every six or twelve m onths. If
foreign com m ercial banks becam e unw illing to rollover lo an s, A sian banks
w ould be forced to repay all o f their short-term debt at once. Yet, because
these funds were tied up in the long-term lo an s th at the A sian banks had
made to local borrow ers, the A sian banks w ould be unable to raise the funds
needed to repay their debts to foreign banks.
The ability o f A sian banks to interm ediate safely between international
and dom estic financial m arkets w as com prom ised by flaw s in A sian coun ­
tries’ financial regulations. The central w eakness w as a problem called m oral
hazard, which arises when banks believe that the governm ent will bail them
out if they suffer large losses on the loan s they have m ade. If banks believe
that the governm ent will cover their losses, they have little incentive to care­
fully evaluate the risks associated with the loans they m ake. If borrow ers re­
pay, banks earn money. If borrow ers default, the governm ent— and society’s
The Asian Financial Crisis
■ <.
329
taxpayers— pick up the tab. In such an environment, banks have an incentive
to m ake riskier loans than they would m ake in the absence o f a prom ise o f a
government bailout. This incentive arises because banks charge higher inter­
est rates to high-risk borrow ers. As a result, higher-risk loans, when they are
repaid, yield higher returns than low-risk loans. A government guarantee thus
creates a one-w ay bet for banks: Lend heavily to risky borrow ers and they
will profit greatly if the loans are repaid, yet they will suffer little if they are
not, because the governm ent will bail them out. The danger is that the p rac­
tice o f lending heavily to high-risk borrow ers m akes a systemic financial crisis
more likely. Banks will lend too much to risky borrow ers, and too m any o f
these high-risk borrow ers will default. Banks will therefore lose money, forc­
ing the governm ent to step in and bail them out. The governm ent guarantee
thus m akes a financial crisis more likely.
M oral hazard w as particularly acute in m any A sian countries. Financial
in stitu tio n s had clo se ties to go vern m en ts, som etim es th rou gh p e rso n al
relationships and sometimes through direct government ownership. In Indonesia,
for example, seven state-owned banks controlled half of the assets in the banking
system (Blustein 2 0 0 1 ,9 4 ), and relatives and close friends o f Indonesian President
Suharto controlled other financial institutions. In the past, such relationships
had led governments to rescue banks and other financial institutions in distress.
In T h ailan d , fo r exam ple, the governm ent rescu ed the B an gk o k B an k o f
Commerce in 1996 at the cost o f $7 billion (H aggard 20 0 0 , 25). In Indonesia,
tw o large corp orate grou ps rescued Bank D uta (which held d eposits from
President Suharto’s political foundations) after it had lost $500 million in foreign
exchange markets. The corporate rescuers were in turn rewarded by the Suharto
regime (H aggard 2 0 0 0 , 26). Given this recent history, foreign and dom estic
financial institutions participating in the Asian m arket had reason to believe that
Asian governments would not allow domestic financial institutions to fail. This
belief in turn led international investors to lend more to Asian banks, and Asian
banks to lend more to Asian businesses, than either would have been willing to
lend had Asian governments not rescued banks in the past.
In principle, governm ents can design financial regulations to prevent the
risky lending practices to which m oral h azard so often gives rise. Banking
regulation can limit the activities that financial firm s engage in and thereby
confine the overall risk in lending p o rtfo lio s. In the A sian-crisis countries,
however, such financial regulation w as underdeveloped, and where it did ex­
ist, it w as not effectively enforced. In Indonesia, for exam ple, any regulator
“ who attem pted to enforce prudential rules . . . w as rem oved from his po si­
tion” (H aggard 2 0 0 0 , 33). N o r w as this kind o f treatm ent restricted to civil
servants: The m anaging director of the central bank w as fired in 1992, and the
minister of finance w as fired in 1996 (H aggard 2 0 0 0 , 33). As H aggard notes,
the m ore general problem lay in the “ influence that business interests exer­
cised over legislation, regulation, and the legal p ro cess” (H aggard 2 0 00, 38).
In other w ords, the sam e network o f business-governm ent relations that cre­
ated the m oral hazard problem in the first place also weakened the incentives
that governments had to develop and enforce effective prudential regulations.
330
C H A P T E R 15
Developing Countries and International Finance II: A Decade of Crises
As a consequence, there were few regulatory checks on the lending practices
o f Asian financial institutions.
This regulatory fram ew ork enabled A sian banks to accum ulate financial
positions that could not easily w ithstand exogenous shocks. A sian econom ies
were hit by shocks in late 1996 and early 1997. First, Asian countries’ exchange
rates began to appreciate against the Japanese yen in the m id-1990s. M ost Asian
governm ents pegged their currencies to the dollar. A s the d ollar appreciated
against the yen in the m id-1990s, Asian currencies appreciated too. Exchangerate appreciation m ade it difficult for dom estic firm s to export to Jap an , one
o f their m ajor exp ort m arkets, which in turn created debt-service problem s
for export-oriented firms. Second, real-estate prices began to fall in late 1996,
creating debt-service problem s for real-estate developers. In M arch, the T hai
governm ent purchased $4 billion o f debt that property developers ow ed but
were unable to pay to domestic banks. By 1997, therefore, many o f the Asian
banks’ largest domestic borrow ers were struggling to service their debts. A s a
consequence, the num ber o f nonperform ing loan s— loan s on which interest
paym ents had not been m ade for six m onths or m ore— held by A sian banks
began to grow. Because dom estic borrow ers could not repay dom estic banks,
the domestic banks could not easily repay foreign banks. Dom estic debt-service
difficulties thus began to generate international debt-service difficulties.
W eaknesses in Asian financial systems became a source o f general concern
in the spring o f 1997. The trigger w as the discovery that one o f T h ailan d ’s
larg est fin an cial in stitu tio n s, Finance O ne, w as in solven t. T he d iscovery
caused foreign banks to look m uch m ore closely at banks throughout A sia.
Close inspection indicated that Finance O ne’s situation w as not unique; banks
across Asia were facing sim ilar problem s as a result o f appreciating currencies
and popping real estate bubbles. D eteriorating conditions in A sian financial
system s and shifting international m arket sentim ent com bined to produce a
panicked w ithdraw al o f funds from A sian m arkets in the sum m er o f 1997.
Foreign banks that had loaned heavily to A sian banks refused to roll over
existing loans and dem anded repaym ent o f whatever loans they could. Funds
also started flowing out o f Asian stock m arkets.
The panic began in Thailand in M ay 1997, where it quickly consumed the
Thai government’s foreign exchange reserves and forced the government to float
the baht. The panicked withdrawal of funds from Asia over the next six months
struck practically every country in the region. A fter their experience with
Thailand, financial markets shifted their attention to the Philippines, forcing the
government to abandon its fixed exchange rate after only ten days. Attention
shifted to Indonesia and M alaysia in July and August, and governments in both
countries responded to m assive capital outflow s by aban d on in g their fixed
exchange rates and allow ing their currencies to float. From there, speculation
targeted T aiw an , forcing a devaluation o f the T aiw anese d ollar, and H o n g
K ong, where capital flight caused the H ong K ong stock m arket to lose about
one-quarter o f its value in only four days. The crisis m oved to South K orea
in N ovem ber, forcing the governm ent to float the w on by the m iddle o f the
month. A total o f $60 billion w as pulled from the region in the second half of
The Asian Financial Crisis
*
331
1997, roughly two-thirds of all the capital that had flowed into the region the
year before. An additional $55 billion was pulled out in 1998 (IM F 1999, 92).
As the crisis struck, A sian governm ents turned to the IM F for financial
assistance. The Philippines was the first to do so, gaining a $1.1 billion credit
on July 14. The T hai government turned to the IM F two weeks later and was
provided $16 billion from the IM F and other Asian countries. Indonesia held
out longer, turning to the IM F only in O ctober and receiving a $23 billion
p ack age. South K o rea received the m o st su p p o rt fro m the in tern atio n al
community, acquiring a $57 billion package in early December. In all, the four
hardest-hit countries— South K o rea, Indonesia, T h ailan d , and M ala y sia —
received $ 1 1 7 .7 billion.
As in earlier crises, IM F assista n ce w as co n d itio n a l u p on econom ic
reform. The reform s incorporated into IM F conditionality agreem ents in the
Asian crisis targeted three broad areas: m acroeconom ic stabilization, reform
o f the financial sector, and structural reform . M acroeconom ic stabilization
program s were necessary, the IM F argued, to restore m arket confidence in the
crisis countries and to stem capital outflow. Governments tightened monetary
policy to stem the d ep reciation o f their currencies. T hey tightened fiscal
policies to generate the financial resources needed to rebuild the financial
sector. Finally, the IM F required A sian governments to implement structural
reform s, including trade liberalization, elim ination o f dom estic m onopolies
and other uncompetitive practices and regulations, and privatization o f stateowned enterprises. In T hailand, structural reform s targeted the civil service
and state-owned enterprises. In Indonesia, the IM F pressed the governm ent
to deregulate agriculture and reduce the m onopoly position o f the national
agriculture m arketing board. The IM F pressed the Indonesian government to
privatize thirteen state-owned enterprises and to suspend the development of
auto and commercial aircraft industries.
The crisis had severe economic and political repercussions. The financial
crisis and macroeconomic stabilization precipitated deep recessions throughout
A sia. (See T able 15.2.) Indonesia experienced the biggest dow nturn, with
economic output contracting by more than 13 percent in 1998. In m ost countries,
the economic crisis hit the poor the hardest, and as a consequence, poverty rates
rose sharply. In Indonesia, the number o f people living below the poverty line
grew from 11 percent of the population to 19.9 percent in 1998. In South Korea,
the poverty rate rose from 8.6 percent to 19.2 percent in 1998. Deteriorating
economic conditions sparked protest and political instability. In Indonesia,
economic crisis sparked large-scale opposition to the Suharto governm ent’s
corruption, nepotism, and cronyism. As the crisis deepened, regime opponents
demanded fundam ental political reform and a reduction o f basic com m odity
prices, particu larly o f energy and rice. Protests and o p p o sition peaked in
M ay 1998. Four students were killed by the military during an anti-Suharto
demonstration at Triskati University, sparking even larger protests during the
days that followed. By late M ay, Suharto stepped down from office.
The economic crisis sparked political change in Thailand as well. Thailand
had begun con stitution al reform in the early 1 9 9 0 s but had stalled under
332
C H A P T E R 15
Developing Countries and International Finance II: A Decade of Crises
T A B L E 15.2
Economic Growth and Current-Account Balances in A sia . t .
1995
1996
1997
Economic Growth (annual percent change)
Thailand
Indonesia
South Korea
8.8
8.2
8.9
5.5 .
8.0
7.1
' 1998
:
—0.4
4,6
5.5
-5.0
-13.7
-5.8
Current-Account Balance (percent of gross domestic product)
Thailand
Indonesia
South Korea
Source:
-7.8
-3.2
-1.9
International Monetary Fund (IMF),
-7.9
-3.3
-4.7
IM F Annual Report
—2^0
-1.8
-1.9
6.9
1.6
7.3
(Washington, DC: IMF, 1999).
com peting visions o f how the new political institutions should be structured.
Acceptance of the new constitution by the m ajor societal groups w as “ propelled
forw ard ” by the econom ic crisis. A s H aggard (2 0 0 0 , 94) notes, it is “ highly
doubtful that [this political reform] w ould have occurred in the way that it did
in the absence o f crisis circum stances.” In addition, the governm ent that had
presided over the economy in the years leading up to the crisis w as unable to
m aintain a m ajority coalition. It w as replaced in N ovem ber 1 9 9 7 by a new
government based on a five-party coalition dom inated by the D em ocrat Party,
the oldest political party in Thailand. The D em ocrat Party w as “ free of the more
egregious patronage, pork-barrel spending, and corruption o f its opponents”
(H aggard 2 0 0 0 , 94). In Indonesia and T h ailan d , therefore, econom ic crisis
provoked a reaction against the corruption o f previous governments, mobilized
societal support for far-reaching constitutional reform , and brought to pow er
groups committed to economic and political reform.
BRETT0N WOODS II
Perhaps the m ost profound consequence o f the Asian crisis concerned not just
E ast A sia but the entire international financial system. A rguably the roo ts o f
the 2 0 0 8 -2 0 0 9 global financial crisis lie in E ast Asian governm ents’ responses
to the 1997 crisis. E ast Asian governments drew one overarching lesson from
the crisis and crisis m anagem ent: D o n ’t allow the econom y to becom e vul­
nerable to shifts in m arket sentim ent or subject to IM F intervention. A s we
have seen, crises induced by capital flow s were politically destabilizing; IM F
conditions reflected Am erican interests and, as a consequence, carried deeply
intrusive and often in app ropriate policy dem ands. T h us, the central lesson
governments drew from the crisis w as, “ never again .”
E ast A sian governm ents relied on tw o m echanism s to reduce the likeli­
hood that they faced future crises that pushed them to the IM F. The first line
Bretton Woods II
333
o f defense w as self-insurance through the accum ulation o f large stocks o f for­
eign exchange reserves. Starting from less than zero in the crisis countries, and
not substantially above zero in other countries, E ast Asian governm ents as a
group accumulated more than $4 trillion in foreign exchange reserves between
1998 and the end o f 2009. This am ount constituted slightly m ore than half o f
global reserve holdings (U.S. D epartm ent o f the T reasury, 2 0 1 0 a ). China ac­
cum ulated the largest stock o f foreign exchange reserves by far, holding about
$2.4 trillion by the end o f 2009. Jap an , with the second largest stock, held just
less than $1 trillion.
A CLOSER LOOK
Crisis in Argentina
The long series of developing-world crises ended, at least for now, with a
spectacular crisis in Argentina in 2001 and 2002. Argentina had been the poster
child for neoliberal reform. It stabilized and restructured its economy during the
early 1990s and subsequently experienced strong growth— indeed, among the
strongest in all of Latin America (Krueger 2002). In 2001, Argentina collapsed in
a severe economic and financial crisis. The economy shrank by a quarter between
1998 and 2002. Unemployment doubled, reaching 24 percent in 2002. Wages fell
sharply, and the poverty rate doubled to more than 50 percent of the population.
The economic crisis shook the political system. Argentineans took to the streets,
banging on pots and pans in protest of government policy. More than twenty people
were killed in these protests. The public and the collapsing economy toppled one
government after another, as the country went through five presidents between midDecember 2001 and early January 2002. What went wrong?
Argentina's crisis resulted in part from the consequences of a previous
government decision to fix the Argentinean peso to the U.S. dollar in order to
control inflation (IMF 2003). Argentina had been heavily indebted during the
;
1980s and was still struggling to implement economic reform in the early 1990s.
This struggle manifested itself in part in hyperinflation, which peaked at 1,344 .
percent in 1990 (Joint Economic Committee 2003, 4). In 1991, Argentina
passed the Convertibility Law, which established a fixed exchange rate: one peso
equaled one dollar. The central bank was required to maintain sufficient dollars
to guarantee this exchange rate. Thus, new pesos could be created only when the
central bank had the dollars required to back them. Like EU governments, the
Argentinean government believed that this fixed exchange rate would provide a
credible commitment to low inflation that would break expectations of continued
high inflation. Initially, the approach was quite successful; by 1994, inflation had
fallen to 4 percent and remained quite low throughout the decade.
The Convertibility Law was less appropriate for the challenging international
^
environment that Argentina confronted at the end of the decade. Having pegged to
(Continued)
334
C H A P T E R 15
Developing Countries and International Finance II: A Decade of Crises
the dollar, Argentina's export competitiveness became linked to the'dollar's strength
in international markets. As the dollar appreciated in the late 1990s, the peso rose
as well, pricing Argentina's exports out of.foreign markets. Competitiveness was
further diminished when Brazil devalued the real in late 1998. The overvalued peso, .
combined with rising global interest rates, pushed Argentina into recession in 1998. .
The government could not use macroeconomic policy to stimulate the economy.
Because monetary policy was maintaining the exchange rate, the government could
not expand the money supply. Fiscal policy was also constrained (IMF 2003).
Government budget deficits throughout the 1990s had generated a government
debt of about 50 percent of GDP, and much of this debt was denominated in foreign
currencies. Fiscal expansion would require the government to borrow more, raising
doubts about its ability to repay the debt. Borrowing would raise interest rates,
thereby depressing economic activity. Fiscal expansion, therefore, was unlikely to
promote growth. Instead, the government tried to balance the budget, which it hoped
would reduce interest rates and spark renewed growth. Balancing the budget proved
difficult, however: Politics prevented large expenditure cuts, and revenues fell as
economic conditions deteriorated, thereby increasing the expenditure cuts needed to
balance the budget.
Facing few good options, the government began to introduce exchangerate flexibility in 2001, hoping that devaluing the peso would restore export
competitiveness and generate an export-led recovery. The peso's exchange-rate
peg was changed from a pure dollar peg to a peg against the dollar and the euro.
In June, the government created a separate lower exchange rate for exporters.
This tinkering with the exchange rate raised concerns in international financial
markets that the government was about to abandon the dollar peg. Such doubts
pushed interest rates up (the yield on a 10 year government bond denominated
in dollars rose by 20 percentage points, to 35 percent, during 2001) and caused
dollars to flow out from Argentina (Federal Reserve Board of San Francisco
2002). These dollar outflows quickly consumed Argentina's foreign exchange
reserves— almost 40 percent of the country's reserves disappeared during the first
seven months of 2001 (Eichengreen 2001, 11). Dollar outflows made it costly
to sustain the fixed exchange rate, for the government had to contract the money
supply, thereby placing strong downward pressure on the Argentinean economy.
Argentina turned to the IMF for assistance. The IMF responded by offering
support in exchange for a government commitment to meaningful fiscal
consolidation. Working with the IMF and individual advanced industrialized
countries, Argentina was granted $40 billion of support in March 2000. The
country returned to the IMF in January and September of 2001 in search of
additional support. When the government proved unwilling or unable to stabilize
its fiscal position, the IMF cut off access to its credits in December 2001. Unable
to attract additional private funding and unable to draw from the IMF, the
government defaulted on $155 billion in government bonds.
Could Argentina have avoided this crisis? In hindsight, it seems that two policy
changes could have prevented the crisis. First, the government could have changed
Bretton Woods II
335
its exchange-rate arrangements during the late 1990s after inflation had come
down. Establishing a more flexible exchange rate would have enabled exports to
recover, and this could have reinvigorated the economy. Second, the government
could have consolidated its fiscal position during the 1990s. It could then have
used fiscal policy as the recession emerged. Domestic politics prevented both policy
changes. The Convertibility Law was popular; it was seen to have cut inflation and
it restored confidence in the peso. Changing the law would have thus cut against
public opinion. Fiscal consolidation was limited by political opposition to the
necessary expenditure reductions. ■
A sian governm ents accum ulated foreign exchange reserves by running
persistent and large current account surpluses. Up until the 1997 crisis, m ost
economies ran current account deficits in most years. These deficits were financed
by the capital inflows that eventually triggered the crisis. These deficits disappear
in 1998, however, and from 1998 until the crisis hit in 2009, East Asian economies
ran large current account surpluses. Indeed, as we saw in Chapter 11, East Asian
economies emerged as important creditor countries after 2000.
E ast A sian econom ies have been able to run persistent current account
surpluses in part because East Asian governments have pegged their currencies
to the dollar at competitive (many analysts argue undervalued) exchange rates.
The com petitive exchange rates encourage exports and discourage im ports.
O f equal im portance, however, has been the dom inant tendency to engage in
sterilized intervention to maintain these exchange-rate pegs. Under sterilized
intervention, a government with a current account surplus will exchange local
currency for foreign currency at the fixed rate and then subsequently offset
the im pact o f these purchases on the dom estic money supply. Consequently,
government foreign exchange reserve holdings increase but the m oney supply
does not. The currency thus remains competitively valued. In E ast A sian coun­
tries, the government then used the foreign exchange reserves (largely dollars)
to purchase U .S. government securities and government-backed securities.
PO LIC Y A N A LY S IS AND D E B A T E
Does China's Creditor Status Confer
Political Power?
Question
Does the Chinese government's status as a large lender to the United States
government confer creditor power that China can exploit to alter American policy?'
(Continued)
336
C H A P T E R 15
Developing Countries and International Finance II: A Decade of Crises
Overview
During the last decade, the Chinese government has emerged as the shigl,e largest ‘
foreign lender to the United States government China's current account surpluses
have generated an increase in the Chinese government's olficial dollar holdings.
Rather than hold these reserves in the form Of dollars, which pay-no interest rates,
China has used them to purchase relatively safe financial instruments that do pay
interest. U.S. government debt is the safest instrument available. Hence, China's
current account surpluses have transformed China into a majorforeign funder of
U.S. government debt. At the end of May, 2010, China owned $868 billion worth of
U.S. government securities (United States Department of the Treasury, 2010a). This
constitutes about 6.5 percent of total U.S. debt, but about 22 percent of total foreignowned U.S. debt. Hence, a substantial share of U.S. government debt is controlled by
a single foreign government that is not closely allied with the United States, Moreover,
the ability for the United States to run deficits rests, in part, on the continued
willingness of the Chinese government to acquire and hold U.S. government debt.
China's emergence as an important creditor to the U.S. government has raised
questions about financial power. Some argue that its creditor status confers
upon China substantial power. China's creditor position might make it difficult
to defend American interests in Asia. As President Obama remarked during the
campaign, "it's pretty hard to have a tough negotiation when the Chinese are our
bankers" (cited in Drezner 2009,15). China might also gain leverage over U.S.
policy at home. A threat to dump U.S. debt or to refuse to purchase more could
sharply increase the cost of funding the debt. The desire to avoid these costs could
encourage the U.S. to change policy in line with China's interests. Other analysts
argue that creditor status does not confer much power. They emphasize the
interdependent nature of the relationship. China buys U.S. debt so that the United
States can buy Chinese goods. Moreover, because China holds so much U.S. debt, a
massive sell-off would be quite painful.
Policy Options
• China's status as a major creditor to the U.S. government confers power that
China can exploit and that must be a source of concern for the U.S. government.
• China's status as a major creditor results from economic interdependence and
thus does not generate exploitable power.
Policy Analysis
• What factors determine whether creditor status confers political power?
• How does China's trade relationship with the United States influe