Free Trade and Protectionism
Why Most Economists are Wrong
Russell Trenholme
© 2009 by Russell Trenholme
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Preface
In this book, I carefully examine the central argument cited by economists for adopting
free trade and for rejecting protectionist policies. This argument—the comparative
advantage argument—is one of the most praised dogmas of orthodox economic theory.
Yet a careful examination shows that it is deeply flawed and fails to refute protectionist
policies. I also examine a number of arguments for protectionism offered by economists
over the past two hundred years and demonstrate why much of the orthodox economic
criticism of these arguments is unpersuasive. Finally, I consider research on developing
Third World economies, and show how this research undermines the near-universal
advocacy of free trade and related free market policies. A persistent theme is that the
choice of economic policies is a matter of considering a variety of economic, social,
political and cultural conditions that characterize a country at a particular time. General
theory is a terrible guide to policy making.
Background
I began working on the book in 2004, long before the financial crisis of 2008 had
appeared on the horizon. During late 2008, observers, particularly those on the left,
proclaimed the end of capitalism and the emergence of a new era of government
intervention in the economy. However, with the passage of time, panic has abated and the
ideology of free enterprise capitalism has emerged largely unscathed. Economists retain
their status as caretakers of the economy, counselors to the American President and to
leaders of other advanced industrialized nations. Free trade continues to be nearly
universally defended, although many of the accompanying doctrines of the “Washington
Consensus”—deregulation, privatization, and fiscal austerity—have yet to recover their
former status. Since this book is principally about free trade, and the theoretical and
empirical evidence offered in support of it, I think it is just as relevant now as before the
current economic crisis.
The book began as a byproduct of a larger project: a critical examination of modern
economic theory. That project began out of a personal desire to understand “economic
science,” an academic discipline whose practitioners have had a profound influence on
the opinions of political leaders and educated members of the general public over the past
several decades. It was apparent at the outset that the respect accorded economics and the
trust in the policies advocated by many of its leading practitioners had little if anything to
do with the arcane mathematical formalism of fundamental economic theory, which is
unintelligible to almost anyone other than mathematically-trained students of economics.
In fact, the respect accorded economics is similar to the respect accorded the natural
sciences and its practitioners—well-known physicists, biologists, and chemists who hold
prestigious university positions and win Nobel prizes for work that is incomprehensible
to non-specialists.
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Modern economic theory is a highly abstract, formalized version of a way of
conceptualizing economic activities that emerged in the latter half of the nineteenth
century. It borrowed analytical tools from early nineteenth century physics, in particular
from the mathematical analysis known to physicists as “least action principles.” Initially
this approach to economic theorizing was simply called “marginal analysis” in deference
to one of the principal mathematical techniques it employs. Later, as it sought to claim
continuity with the work of the earlier “classical” laissez-faire economists Smith,
Bentham, and Ricardo, it came to be called “neoclassical economic theory.” In fact, the
claims of continuity are highly misleading. Adam Smith, for example, provided an astute
defense of policies that would benefit the economy of late eighteenth century, just before
the radical changes that would occur with the industrial revolution. His analysis is filled
with psychological insights and practical reflections that are completely absent from the
formal models of neoclassical theory that emerged a hundred years later. For decades the
new neoclassical theory competed with alternative conceptions such as historicism and
institutionalism, but since the Second World War it has become so dominant in the
United States and other industrialized countries that the descriptive label “neoclassical”
has been dropped in most popular discussions, and it is usually referred to as “economic
science.”
Once I began to study neoclassical economic theory, initial intellectual curiosity
developed into skepticism and eventually into astonishment that a theory so clearly nondescriptive of real economic activities could have achieved the reputation and the
influence it currently possesses. My negative conclusions about the validity of economics
resulted from careful reading of economics text books and academic papers by prominent
economists, and was strengthened through personal reflection on how poorly neoclassical
economic theory described real business activities (pricing, production, and employment)
as I knew them through my personal experience in operating a successful business for
many years. Although I had limited academic training in economics, I did have a
sufficient grasp of mathematics to understand most of the theoretical issues. Moreover,
my training in the history and philosophy of science (I received a Ph.D. from Princeton in
that field) provided the tools needed to think critically about scientific theorizing. I
cannot claim anything approaching the level of knowledge of academically trained
economists; however, the task I had set myself was limited to an investigation of the
conceptual foundations of economics rather than a detailed study of the myriad
applications of economic theory.
Neoclassical theory assumes that there are two types of economic agents, individuals
(consumers) and firms (producers). Both are considered to be completely rational and in
possession of full knowledge of prices and costs. According to the theory, individuals
attempt to rationally maximize their “utility” by spending their incomes to purchase a
preferred commodity basket of goods and services. Firms are conceived of as operating
in a fully competitive market where each firm produces a product identical to that
produced by competing firms. Firms attempt to maximize profits, but due to the nature of
the competitive market, their profits are reduced to zero. There are never surpluses or
shortages (economists say that competitive markets “clear” at an equilibrium price). This
rigid and simplistic conceptual structure is quite alien to the pragmatic and nuanced
analysis given by Adam Smith.
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Economists often claim that economics is a “value-free positive science” like physics or
chemistry. However, it is obvious that most economists are strong advocates for policies
that (purportedly) move real economies in the direction of the idealized conceptual model
described above. They claim that utility is simply a short-hand way of talking about
(theoretically) observable individual preferences, and that individual utilities cannot be
aggregated to yield any overall concept of general welfare—yet they constantly extol
“free” markets as superior to regulated markets (because they produce greater general
welfare). For economists welfare is explicitly linked to maximizing consumption. This
largely explains the emphasis on economic growth—a concept missing from core neoclassical theory. I’ll discuss the conceptual structure of neo-classical theory in more detail
in Chapter 2. However, it should be apparent at the outset that aside from the artificiality
of the underlying conception, there is something very wrong with the fundamental
assumption that the more we consume the better off we are. This assumption ignores
what are known as “negative externalities,” negative effects of economic activities which
are not captured in the basic model of production and consumption. The most salient
example is global warming. The greater the level of production and consumption, at least
using current technology, the greater the production of green-house gases with all their
frightening effects. Although most of this book is concerned with strategies for economic
development, the unfortunate reality is that in addition to concern for the economic
welfare of a particular society, the negative externality of green-house gas emissions has
to be incorporated into decisions regarding economic policies. I do not deal much with
this issue in this book since the focus is on free trade and protectionism. But the obvious
deficiencies of the fundamental conceptual model of neo-classical economic theory
should make readers question the identification of welfare with consumption, an
identification which explains the near-universal praise of economic growth by
economists.
Free Trade and Globalization
After I became convinced of the falsity of the foundations of neoclassical economic
theory, I went on to question the way it has been invoked to persuade voters and elected
officials to support and implement policies of market deregulation, privatization, and
other so-called “economic reforms.” Although empirical arguments are sometimes
offered in support of these policies, the strongest and most commonly encountered
arguments are theoretical, allegedly derived from fundamental “economic science.” I then
came to realize that the controversy over “globalization” was closely associated with the
merits of these same policies when applied internationally.
Free trade plays a central role in the debate over globalization. The principal argument in
favor of free trade, the comparative advantage argument, is theoretical, although it
relates to fundamental neoclassical theory only indirectly, as a corollary of the
fundamental neoclassical belief in the self-regulating nature of markets. In fact, the
comparative advantage argument predates neoclassical theory and is independent of it. It
has attained a prestige among economists that is unique; and in part because of that
prestige, free trade is more widely supported by economists than any other neoclassical
doctrine. Even economists who have rejected key elements of neoclassical theory
(notably John Maynard Keynes) have generally supported free trade. Because of the
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importance of the contemporary debate over free trade, and because the principal
arguments in favor of globalization and free trade are conceptually simpler than
arguments based on fundamental neoclassical theory, I thought it would be appropriate to
write a short book on free trade and globalization directed towards non-economists. My
ultimate goal was to supply some of the intellectual tools needed to counter “expert”
support for free trade policies, and ideally to facilitate more intelligent discussion
regarding the course economic development should take in various countries.
This book is far shorter and far more accessible than the larger work on neoclassical
theory that I began several years ago. This is because the theoretical arguments for free
trade, and related arguments against protectionism are a lot simpler—and much less
technical—than arguments rooted in the highly complex and technical conceptual
structure of foundational neoclassical theory. Moreover, the topics covered here are of
greater practical importance since free trade and related free-market policies are being
urged upon—or imposed upon—Third World countries by the World Trade
Organization, the World Bank, and the International Monetary Fund. It seems clear that,
despite rising doubts, both the majority of citizens and political leaders of the advanced
industrialized nations continue to believe that free trade is almost universally beneficial
and we are helping Third World countries by urging (or pressuring) them to adopt free
trade and related free-market policies.1
In this book I argue that the intellectual backing for these policies, in particular for free
trade, is based on numerous errors. It might be objected that the general reader is not
interested in economic theory, only in the practical consequences of various policies.
However, the primary interpreters of globalization are professional economists and
economic journalists who are generally convinced of the fundamental truth of
(neoclassical) economic theory and of the benefits of various free-market policies
supported by that theory. Given this strong bias, it is obvious why these interpreters have
so readily accepted and endorsed arguments and facts that support their convictions. And
most educated readers in turn have come to accept the views of these “experts.”
Nevertheless, I believe that those readers who take the trouble to read through the
analysis presented here will, for the most part, come to the conclusion that many of these
highly praised arguments are, in fact, invalid. If so, they will be far more skeptical of the
policy recommendations of economists and economic journalists, and will assess the
empirical evidence relevant to one or another trade policy far more critically.
Of course, there is already considerable intellectual opposition to free-market policies
from both within and without the academic community. For example, a number of
development economists who focus on the details of various development policies have
become skeptical of the applicability of core neoclassical doctrines to developing
economies, and many have rejected doctrinaire free trade and free-market policies. Even
so, the views of these economists are invariably shaped by their training as professional
economists. They typically believe that one or another formal variant of neoclassical
theory will eventually provide the key for discovering the optimal strategy for economic
development. I discuss material from some of these economists extensively later in this
book, and interested readers will find that works by these economists provide a valuable
supplement to the necessarily brief summaries given here.2 Unfortunately, the dissenting
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opinions of these economists have had relatively little effect on public attitudes. First,
because the dissenting economists offer a variety of complex and often conflicting
critiques. Second, because most of the dissenting opinions are found only in textbooks
and specialized papers that have far less influence on public opinion than the best-sellers
authored by the proponents of free market development policies, including influential
journalists such as Thomas Friedman who endorse the standard package of “economic
reforms” as the key to economic success.
There is a great deal of populist opposition to free trade policies and to “globalization”
conceived of as the implementation of these policies. Unfortunately, most of this
opposition lacks intellectual foundation. As a result the intellectual high ground in the
debate over free trade and globalization is ceded to economists and sympathetic
journalists who typically deride opponents of free-market policies as ignorant fanatics or
selfish special interests. The dominance of neoclassical economic theory within the most
vocal and influential sector of the economics profession coupled with the prestige and
political power the profession has achieved in recent decades has discouraged the
development and dissemination of alternative analyses thereby depriving voters and
politicians of the intellectual resources needed to fairly evaluate alternative policies. The
impoverished intellectual opposition to free-market policies consists of largely outdated
Marxist theory supplemented by populist appeals and, in a few cases, romantic nativist
theories. This book attempts to provide an intellectual foundation for a thoughtful
opposition to the usual package of “reforms” by commending an empirical approach that
is far more sensitive to differences in culture, in resources, and other country-specific
factors that relate to economic development.
I do not claim that there are not beneficiaries of free trade policy. Some economies, most
notably early nineteenth century England, have benefitted. And multi-national
corporations are major beneficiaries when they freely move capital investments in
manufacturing from country to country seeking an absolute advantage. Producing an
identical branded product for less (generally due to lower wage rates) and selling that
product into an existing market for a price at or little below the former price is highly
profitable. The focus of this book is on the overall welfare benefit for the inhabitants of a
country and on the claims that free trade maximizes welfare in all participating countries.
I think this view is incorrect on both theoretical and empirical grounds (despite some
exceptions).
Organization of the Book
The chapters of this book are divided into three parts which may largely be read
independently of one another. Part I provides a critique of globalization—as it is
conceived of by free-market advocates. After a brief discussion of some of the different
conceptions of globalization, I offer a detailed critique of a best-seller entitled Why
Globalization Works, by Martin Wolff which may be skipped without affecting an
understanding of the rest of the book.
In Chapter 2, I provide a brief non-technical account of neoclassical economic theory,
including a discussion of the normative belief structure implicitly shared by almost all
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professional economists and by popular defenders of free trade. Part I is readily
accessible to general readers who may have unreflectively accepted the usual “received
wisdom” with respect to free-market “reforms” and the benefits of globalization.
Part II is more technical. In particular, the appendix to Chapter 3 (a graphical discussion
of the comparative advantage argument) is primary addressed to students of economics.
Part II consists of two chapters, the first devoted to a detailed critique of the highlypraised “comparative advantage” argument which is generally presented as an irrefutable
argument for free trade, and the second devoted to an analysis of arguments offered by
economists over the past 150 years in support of various types of protectionism or
managed trade. In that chapter I carefully analyze criticisms of these protectionist
arguments offered by a leading economist and defender of free trade, Douglas Irwin,
demonstrating just how weak many of these criticisms are. I conclude that the optimal
trade policy for a country depends on specific economic, social, and cultural conditions
and that free trade is only one among many options.
Parts III and IV are less technical, although familiarity with the arguments for
protectionism discussed in Chapter 4 will be helpful. In Part III, I touch on the vast
literature of empirical development studies, discussing a number of findings that conflict
with free market prescriptions. I also discuss the problems encountered by development
economists who attempt to reconcile neoclassical theory with the recalcitrant reality they
encounter in their empirical work. Part IV contains a brief discussion of topics related to
the choice of development and trade strategies for various kinds of economies, both of
developing countries and of advanced industrial countries.
The book is essentially a review and critique of published economic work, and I make no
claim to original research. For the most part, I have worked with two types of sources:
first, various defenses of globalization and of free trade and other free-market policies,
generally of a popular character. I subject these writings to critical scrutiny. The second
type of source material consists of works by economists which, although not overly
technical, are not well known to the general public. In these works, the authors—in many
cases, the same economists who author popular books praising free-market policies—
draw distinctions and make concessions that undermine much of what is presented in
more popular works.
The analysis provided might be characterized as a “meta-analysis.” That it, it analyzes the
arguments given by proponents and opponents of the main-stream view that globalization
through free-market “reforms” is a near-universal formula for economic growth and
improved human welfare. The focus is on how fundamental neo-classical economic
theory has warped thinking about development issues.
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Part I
Introduction to the Debate
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Chapter 1: Globalization
Introduction
...almost all of us still do believe, stubbornly, in some kind of optimal thinking.
We believe, vaguely or explicitly, that liberal democracy, with all its faults, is the
best of all possible political systems, that globalization, with all its injustices, is
the best of all possible futures... (Adam Gopnik, Voltaire’s Garden, book review
essay in the New Yorker, Mar. 7, 2005, p. 78)
The fact that Adam Gopnik, a liberal intellectual, writing in a leading liberal magazine,
endorses “globalization,” albeit reluctantly, is a testament to a sea-change in the ebb and
flow of “big ideas.” Endorsing globalization is, in effect, endorsing a group of economic
ideas that used to be thought of as highly conservative. Some might dispute this
conclusion, holding that the term “globalization” refers, neutrally, to a heterogeneous set
of economic and social changes that have been occurring throughout the world over the
past several decades—changes related to increased international trade and associated
movements of people and capital. But that would be a mistake. The term “globalization”
is almost always used to refer to a putatively homogenous process set in motion and
sustained by what are known as “free-market policies.” Gopnik’s comment is consistent
with this interpretation; if globalization were no more than a diverse set of economic
changes there would be no need to coin a new term or to weigh the merits of these
changes as if they constituted a unified process. Instead, we would find a variety of
discussions about one or another specific economic or social change occurring in one or
another country or region. In fact, such discussions do exist, but not in the popular press.
Judging by the prominence of the concept of globalization, and by the nature of the
debate over its merits, it is clear that both defenders and critics have adopted the view
that there is, in fact, a more or less homogenous process occurring throughout world, and
that this process has been set in motion and sustained by various free-market policies
(generally labeled “economic reforms”). Globalization critics blame corporations,
governments, and international agencies that promote and act on these policies for
aspects of the process they consider harmful. Defenders of globalization claim that these
same policies have produced a preponderance of beneficial changes. And even reluctant
liberals like Gopnik agree with the defenders, reluctantly perhaps, because of the
existence of “injustices.”
Globalization is an example of one of those “big ideas” that capture the imagination of
entire generations or cultural milieus. It stands right up there with Manifest Destiny, the
White Man’s Burden, Democracy, the Proletarian Revolution, Socialism, and various
religious ideologies. These big ideas were recently discussed in an empirical study of
expert prediction, Expert Political Judgment: How Good Is It?, by Philip Tetlock.
Tetlock found that those who base their judgments and predictions of one big idea—and
globalization is noted as one of these—have a surprisingly poor track record. According
to the cover blurb:
Classifying styles using Isaiah Berlin’s prototypes of the fox and the hedgehog,
Tetlock contends that the fox—the thinker who knows many little things, drawn
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from an eclectic array of traditions, and is better able to improvise in response to
changing events—is more successful in predicting the future than the hedgehog,
who knows one big thing, toils devotedly within one tradition, and imposes
formulaic solutions on ill-defined problems. He see a perversely inverse
relationship between the best scientific indicators of good judgment and the
qualities that the media most prize in pundits—the single-minded determination
required to prevail in ideological combat.
Most of the rest of this chapter is devoted to a detailed examination of an example of
globalization presented as a big idea that is changing the world, the best-seller Why
Globalization Works by Martin Wolf.
As noted above, the usual conception of globalization has two implicit assumptions: that
there is, in fact, a single, dominant process behind the variety of changes that have
occurred in a number of very different national economies, and second, that this process
has been set in motion and sustained by various free-market policies. The second
assumption underlies policy recommendations of the World Bank, IMF, and other
international bodies. There is ample evidence that many of these recommendations have
had adverse results, but these failures have had relatively little effect on enthusiasm for
free market policies on the part of these organizations or in the popular economics press.
It is important to recognize that the two implicit have served to narrow the scope of
discussion of problems confronting various national economies and also have diverted
attention from two critical questions. The first question is how to analyze the economic
policy choices facing a specific national economy in view of its particular cultural, social,
and economic history. This typical “fox” question (to adopt the Berlin dichotomy) is
obscured when the principal debate is over the benefits of the free-market policies
advocated by the pro-globalization camp. The second question that is ignored by the
usual debate concerns an analysis of the constraints to be imposed on economic growth to
minimize environmental and social damage on a global basis. This question is ignored
because orthodox neoclassical economic theory has little if anything to say about the
negative consequences of economic growth—at best, such consequences are lumped in
with other so-called “negative externalities” and it is held that there are “market
solutions” to deal with these.
The Role of Free Market Policies in Economic Development
Claiming that viewing globalization as a relatively homogenous process driven by freemarket policies distorts reality and suppresses debate over important questions does not
mean that free-market policies do not play a prominent role in many of the social and
economic changes that have occurred in one or another country over the past few
decades. Thus the principal effect of these policies in the advanced industrialized nations
has been to lessen the economic role of government through “privatization” and
“deregulation,” the goal being the enhancement of economic welfare through a move
towards unfettered free markets. And in Third World countries the same ideas and
policies are bundled under the rubric “the Washington Consensus,” which represents the
consensus views of World Bank, the International Monetary Fund, and the World Trade
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Organization—all three ultimately dominated by the major industrialized nations and
especially by the United States.
Central among these free-market policies are free trade, free capital markets, and fiscal
conservatism. When these policies are adopted by a country, they are collectively labeled
“economic reforms,” held to remedy the supposedly backward and corrupt intrusion of
Third World governments into their nations’ economies. The vast majority of
contemporary academic economists, together with economic and financial journalists, the
leaders of the governments of most industrialized countries, and a majority of educated
voters have adopted this conceptual structure and the corresponding descriptive labels.
Gopnik’s remark exemplifies the general view across most of the political spectrum that
globalization, fostered by economic “reforms,” is on balance beneficent phenomenon.
Although free trade is the centerpiece of the package of free-market policies associated
with globalization, there are a number of other policies that are derived from strongly
held views about the nature of economic exchange that hold that unregulated (“free”)
markets confer optimal welfare benefits. In an oft-cited passage, Adam Smith wrote that
the pursuit of self-interest in trade achieves a collective good, as if guided by an
“invisible hand.” Smith’s eighteenth century concept is enshrined in the conceptual
structure of the neoclassical economic theory that emerged in the latter half of the
nineteenth century. In the past, neoclassical economics was one of several competing
“schools” of economic thought, but today the neoclassical school has become so
dominant that it has become identified with “economic science.” The core model of
neoclassic theory is a completely unregulated (or rather, self-regulated) competitive
market structure in a state of “competitive equilibrium,” meaning that the price of each
commodity is just what is required to match supply and demand, thereby “clearing”
markets of all goods offered. It is this model which gives credence to the idea that
“freeing” markets from government interference represents a “reform.”
Other aspects of the free-market policy package come from independent but related
sources. The demand for fiscal “responsibility”—meaning balanced budgets and
relatively tight money—derives from fears of inflation or even hyper-inflation as
experienced by Germany during the 1920s and by various Third World countries since.
But it also reflects an abhorrence of government entry into the economic sphere through
so-called “populist” spending. On the theoretical level, it is closely associated with
“monetarism,” a variant of neoclassical thought. The emphasis on fiscal responsibility
also accords with the desire of First-World governments to insure that their banks get
repaid the loans that they make to Third World countries. The latter concern relates to the
demand for “institutional reform,” in particular for a judicial system that insures the
repayment of loans, the enforcement of contracts, and the protection of “private property
rights.” By a further rhetorical extension, the notion of private property rights has been
expanded to include so-called “intellectual property” (including computer software), and
the long-term protection of these supposed rights under strengthened copyright laws has
been incorporated into international trade agreements as a result of pressure from the
United States. This kind of rhetorical creep has helped obscure the fundamental
contradiction between free trade in a competitive market and the protection of the
monopolistic power implicit in patents and copyrights.
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I will usually use the phrase “free trade and related free-market policies” to refer to the
policies advocated by supporters of globalization, but sometimes I will speak of “market
liberalization policies,” “neoliberal policies” (the name favored by globalization critics),
or “the Washington Consensus” (the specific group of policies adopted by the IMF and
World Bank that include “market stabilization measures”).
To summarize: one side of the debate over globalization is shaped by the ideology of
neoclassical economic theory based on an idealized model of an economy in a state of
“competitive equilibrium” that supposedly maximizes welfare. The various economic
“reforms” that drive the globalization process are derived from this model; in this
conceptualization, globalization itself is seen as a movement towards the competitive
market ideal. On the other side of the debate we find critiques grounded in an array of
conflicting views held by a disparate group of environmentalists, socialists, populists,
cultural localists, trade unionists, displaced farmers, and humanitarians. Although all of
them generally agree in blaming free-market policies for the social and economic changes
they deplore, they don’t agree on any alternative policy. The strategy adopted by the two
sides are quite different. The pro-globalization group calls the globalization opponents
“activists” because the most effective tactic of the opponents has been street
demonstrations and moral invective. The pro-globalization group claims the intellectual
high ground because of the access that orthodox economists, with their tenured university
positions, have to a multitude of intellectual resources. The works of these professors
contain arcane theoretical arguments and have countless references to obscure empirical
studies. Thus economic and financial journalists who interpret the views of these
academics for the educated public are able to offer their readers, with suitably deferential
awe, the opinions of distinguished scholars including Nobel prize laureates in support of
globalization and free-market policies.
Moreover, the pro-globalization group often claims moral as well as intellectual
superiority to globalization opponents. Those who demonstrate against the IMF, World
Bank, and World Trade Organization are labeled “spoiled children” who want to deny the
gift of economic growth to impoverished peoples. (Wolf, p. 10) Another common moral
attack claims that those opposed to globalization (identified with free-market reforms)
want to deny the inhabitants of poor countries the “freedom” of choosing to eat at a
MacDonald’s or enjoying various gadgets associated with Western consumerism.3 An
typical accusation is found in William Easterly’s study of failed growth policies. Easterly
sees economists as engaged in a “quest” to help “poor nations suffering from pestilence,
oppression, and hunger.” He goes on to deplore “protestors from Seattle to Prague [who]
call for abandoning the quest altogether.” (xiii) Thus the pro-globalization group often
denies the good intentions of the anti-globalization protestors, refusing to see the dispute
as a debate over the best means of achieving greater social welfare in developing nations.
In this book, I won’t attempt to adjudicate the issue of moral superiority; however, I will
argue that the pretensions to intellectual superiority by the supporters of globalization are
unfounded.
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Two Obvious Flaws in the Conventional Case for Globalization
Before entering the detailed discussion of trade and globalization issues that occupies the
rest of this book, it is worth noting at the outset two rather obvious problems for
proponents of globalization.
First, there is the fact that despite years of attempts at various development policies,
including several decades of “free market reforms,” almost no country in Africa or the
Middle East and few countries in Latin America has succeeded in breaking out of the
Third World pattern of endemic poverty for a majority of its citizens and sluggish or nonexistent economic growth. Mainstream economists, by and large, attribute this failure to
the lack of “best practice” institutions required to successfully implement free-market
reforms. These include a legal system that protects private property rights and the sanctity
of contracts and transparent financial institutions. Yet the supposed paradigm of freemarket success, the United States, has experienced rising poverty and an emerging
pattern of income distribution resembling that of many Third World countries, whereas
the greatest recent economic success story, China, has achieved unprecedented rates of
growth without the institutional structure considered essential by orthodox economists
and with most of its industry controlled by the state or by local governments. In fact, the
East Asian success stories—Japan, Singapore, South Korea, and Taiwan—and even
many European countries exhibit a wide range of institutional structures at variance with
the neoclassical ideal. This suggests that specific cultural factors have played a dominant
role in economic development in the advanced industrial countries and that models that
ignore these factors are probably inadequate models for many developing countries.
Second, and even more significantly, the presumption that the advanced industrial
countries of North America and Europe, and a few East Asian countries such as Japan,
Korea, Taiwan, and Singapore provide a universal model for economic development is
untenable. Economic development in these advanced countries has been accomplished
through an enormous increase in consumption of natural resources and in emission of
green-house gases and other pollutants which have brought the world to the edge of
environmental disaster. The combined population of these countries represents less than
one-quarter of the world’s population. A similar pattern of development in the rest of the
world is sure formula for environmental disaster. This alone should make it obvious that
radically different models of development need to be developed.
A Critical Examination of Wolf’s Why Globalization Works
Before beginning the detailed analysis of the theoretical arguments for and against free
trade, and evaluating empirical data relating to development, it is worthwhile reviewing
in some depth an excellent example of a popular work defending globalization, the bestseller entitled Why Globalization Works by the British financial journalist Martin Wolf.
Wolf’s book is typical of recent popular defenses of free-market policies such as Naked
Economics by Charles Wheelan, a number of popular books by the well-known
economist Jagdish Bhagwati, and the Lexus and the Olive Tree and The World is Flat by
Thomas Friedman. These various popular defenses conceive of globalization as a unified
process that has spread wealth and happiness through the application of free-market
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“reforms” to various developing economies. It will be seen that many of Wolf’s
arguments are polemical in nature and unconvincing when examined carefully. The
deficiencies of these arguments cast doubt on the conventional wisdom that claims almost
universal beneficial effects of free-market reforms. Since this is a popular book, the
critical conclusions I arrive at are only suggestive of deeper underlying problems which
will be explored in depth later in the book.
Wolf conceives of his book as presenting a “case for globalization” (conceived as in the
preceding discussion). He organizes the book in two parts. The first is a presentation of
what he refers to as the “liberal market model,” and lays out his claims regarding the
historical role of this model in improving human welfare. This presentation contains very
little explicit argument; rather he seeks to persuade the reader through abundant appeals
to the works of like-minded professional historians and economists. In fact, this sort of
appeal-to-authority pervades the entire book whose 360 pages contain include more than
60 pages of footnotes often referring to technical works who relevance to the discussion
is unclear.
However, the principal part of his case for globalization occurs in the second part of the
book (“Why the Critics are Wrong”) which adopts a framework that takes globalization
to be “on trial.” Wolf extracts a number of polemical attacks from the large body of
criticisms of free-market reforms and globalization. At the same time, he rarely discusses
less polemical and more technical critiques. This approach encourages counter-polemics,
and all too often mockery and name-calling substitute for genuine analysis. Wolf assumes
(undoubtedly correctly) that his readers are, for the most part, at least mildly sympathetic
to globalization and that its “acquittal” of various charges will help erase any lingering
doubts they may have. Given this context, the “case for globalization” is made indirectly
through supposed refutation of a limited selection of criticisms of free-market policies.
At times, Wolf’s arguments involve disingenuous semantical tricks. For example, one
way that he evades the issue of whether a variety of different policies may be more
appropriate for addressing differing national social and economic conditions than a
uniform set of “liberal reforms,” is to simply withhold the label “globalization” from
economies that have failed to develop. Thus even when the “reforms” failed, that’s not a
problem for globalization since the countries involved are excluded from the data set!
Countries that have languished—for example various Latin American and African
countries—are said to exhibit “non-globalization”—even when such countries have
implemented the liberal-market reforms urged upon them by economists. Wolf writes,
“the poorest regions (countries) were not hurt by globalization. They just failed to be part
of it.” (167) This verbal sleight-of-hand leads obviously leads to the conclusion that
“globalization” (thus restricted to countries that have grown economically promotes
national economic growth. Wolf then makes a further leap by substituting “welfare” for
“growth” and thereby concluding that globalization increases national welfare. (Although
the latter step comes from his adoption of the framework of neoclassical economic theory
which equates welfare with consumption, so that increasing consumption implies
increasing welfare.)
14
Almost as bad is Wolf’s argument that “non-participation in globalization” is due to
incorrect governmental policy. India serves as his primary example. Wolf states that only
when India “abandoned the absurdities of its pseudo-Stalinist ‘control raj’ in favor of
individual enterprise and the market” did its real GDP begin to increase. (141) However,
as will be seen in the discussion of various national economies found later in this book,
the rapid growth experienced by India in the 1980s (under the government of Rajiv
Gandhi) occurred with only minor modifications of previous rigid governmental controls.
Because India has experienced growth Wolf includes it in the globalization group. Rather
than taking India’s growth in the 1980s as a counterexample, Wolf is willing, when it
suits his case, to take even relatively minor modifications of the model of rigid state
control as sufficient to qualify a country for inclusion in the globalization group. (See the
discussion of India in Chapter 6.) And the fact that the country with the greatest rate of
growth in history—China—retains extremely strong elements of state control undermines
his assumption that the standard package of liberal economic reforms are a prerequisite
for economic growth.
Moreover, the second step—from equation of national economic growth with increasing
welfare—ignores a number of welfare-adverse consequences of rapid industrial growth
for Third World economies: the breakdown of traditional culture, rampant corruption,
increasing poverty and social distress among the majority rural population, increases in
crime and other measures of social disorder, both urban and rural, and a popular backlash
against the forms that growth has taken.
Wolf’s Conception of the Liberal Market Ideal
Wolf sees himself as the intellectual heir of the classical economists of the late eighteenth
and early nineteenth centuries, and of the libertarians of the twentieth century notably the
conservative icon, Friedrich Hayek. Wolf’s political ideal is a progressive, liberal,
democratic polity (“contemporary liberal democracy”) that he claims facilitates the
development of a beneficent integrated world market structure. For Wolf, globalization is
the historic culmination of a centuries’ old process that was interrupted by the First
World War, leading to “thirty years of catastrophe.” Wolf claims that this alleged
interruption was resulted from the dissemination of “bad ideas”—Communism, fascism,
imperialism, militarism, and nationalism. However, in recent years, these ideas have been
discredited, and the world is engaged in the process of building a new and better liberal
international order. Nevertheless, various regressive forces identified as anarchists,
Marxists, fascists, nationalists, environmental romantics—jointly labeled “the intellectual
heirs of Rousseau”—continue to oppose the beneficent new order. These forces, labeled
as misguided and malevolent, are in league with corrupt governments and selfish
economic interests in striving to withhold the benefits of the free market from the poor of
the world.
This grandiose normative conceptual framework leads Wolf to a Manichean division of
thinkers, political activists, organizations, and governments into those on the right side
and those on the wrong side—a mode of thinking typical of the “big ideas” hedgehog
thinkers. The dichotomization is used to justify Wolf’s repeated use of pejorative
adjectives and nouns to describe those in the “bad” camp. Thus in the book’s preface,
15
Herbert Marcuse and Jacques Derrida are described as “pied pipers” who “return in every
generation” “spreading their havoc upon the innocent young.” Contemporary supporters
of socialism and state ownership are described as being not “sane” (xii); more generally,
critics of globalization are described with what Wolf calls “the happy label” of “New
Millennium Collectivists.” (322; also see Chapter 1). At other times he sarcastically
refers to “antiglobalization.com”. Anti-globalization protesters are referred to as “spoiled
children.” (10) Various anti-globalization claims are labeled “an intellectual swindle”
(17). He speaks of “lauded and successful critics” of globalization as indulging in
“paranoid fantasies.” (55) Ideas like comprehensive national economic planning are not
merely mistaken, they are “ludicrous.” (60). When Wolf disagrees with a theory—for
example the theory that that imperialism, militarism, and fascism are a natural
consequence of capitalism and liberal democracy—he labels it “one of many big lies.”
(37)
In contrast, writers favoring free-market policies are regularly described as
“distinguished,” and if they are economists who received the recently endowed
“Economics Prize in Honor of Albert Nobel” (funded in 1968 by the Bank of Sweden),
they are invariably identified as “Nobel laureates.” 4 Various books and papers that Wolf
cites in support of his positions are labeled “classic” (27) or “brilliant” (50; 96).
A good example of Wolf’s polemical denigration of globalization critics is seen is his
discussion of the author John Gray. Gray had compared the liberal market ideal to
Marxism, calling it another “deluded secular creed.” Wolf calls the comparison
“grotesque.” Why? Because Marxism is “the ideology of totalitarian despots that, on
some calculations, cost 100 million lives.” (10) It is clear, however, that Gray is
considering Marxism as an ideology, and is not addressing the actions of those who have
claimed to subscribe to it. In fact, few widely supported ideologies can claim that all their
adherents have clean hands. In fact, the vast majority of Marxists have been quick to
denounce the acts of Stalin or Mao, just as most proponents of the liberal market ideal are
quick to denounce the slave trade, child labor, or other market activities engaged in by
those who have strongly supported property rights and free markets in the past.
Wolf’s moralizing tone—again typical of “big idea” theorists—pervades Wolf’s book.
On the “good” side of the divide are societies conforming to his liberal market model,
labeled “free” societies. They are said to be underpinned by the fundamental value of
“the worth of the active, self-directing individual.... a belief in individual freedom.” (24)
According to Wolf, the bedrock of such a beneficent society is property rights. (25) Free
societies are held to be rich because long-term contractual arrangements are honored.
Such societies are characterized by “the rule of law.” A “free society” is “hated” by “its
enemies” because it means “perpetual and unsettling change.”
Wolf views governments one-dimensionally, as ranging from the “predatory”
governments of most poor Third World countries to the ideal of a minimalist liberal
democratic government functioning as “a humble and honest servant.” At times, Wolf
even suggests that there is a direct correlation between the quality of government and the
economic wealth of a country: “the difference between poor countries and richer ones is
16
not that the latter do less, but that what they do is better directed...and more competently
executed.” (64)
A persistent anglophilia also runs through Wolf’s presentation. Market liberalism is
identified as an English idea; for Wolf the governments of the United Kingdom and
United States are “quite simply, the best in history.” Chapter 8 is introduced by a long
quote from the libertarian free-market proponent Friedrich Hayek; in it, Hayek speaks of
the advance of “English ideas” during the period up till 1870, followed by sixty years in
which illiberal ideas (“particularly socialism”) developed in Germany came to dominate
thinking, although fortunately we are now living in the second incarnation of liberal
market ideal.
Wolf admits that “some” would argue that countries with governments that involve
themselves in their national economies (such a Sweden, Switzerland, or France) do better
with respect to welfare than less intrusive governments such as those of the United
Kingdom or the United States. His response is that the “distinctions are modest.” This is a
puzzling statement in view of his invective against statism and high marginal
(“predatory”) tax rates. (67) He makes the even more puzzling claim that liberal
democracies are unlikely to go to war (the two world wars are viewed as “aberrations”)
and that democratic countries are unwilling to sustain heavy casualties for national
aggrandizement.
Wolf’s Conception of the Market
The above discussion concerns Wolf’s political ideas. The economic side of Wolf’s
argument for globalization idealizes a market economy operating within the framework
of a limited liberal democratic government. For Wolf, the role of government is to
facilitate market-friendly institutions; the appropriate form of government for a free
society is “a constitutional democracy with representative parliaments—government
accountable to the governed.” (28)5 Such a government adopts policies that reinforce
property rights, deregulate of industries and markets, or privatize previously
governmentally administered activities; such policies are labeled “reforms” in conformity
with standard pro-globalization nomenclature. Thus the “liberal market model” is
characterized by two complementary components, one economic, one political.
Free markets are viewed as “magical” devices for increasing human welfare, chiefly
through promoting what Wolf calls “Promethean” growth. (Chapter 4) Wolf holds that
innovation is “hard-wired into capitalism.” However, in invoking the concept of growth,
Wolf cites Joseph Schumpeter, an economist better-known for his positive views of
monopoly and the allegedly beneficial effects of monopoly profits in promoting research,
innovation, and growth. Wolf in fact states that he favors a model with a “substantial
degree” of “monopoly and instability.” (53) However, despite also invoking Adam Smith
and later classical and neo-classical economists in praise of a competitive market
economy, he never discussed the conflict between the neo-classical views of a
competitive market economy and the Schumpeterian conception. The core neo-classical
model is that of an economy composed of interrelated, purely competitive markets with
equilibrium prices arrived at through competition among individuals and firms that in fact
17
realize no profits (in the normal sense of the word) and who lack the ability to affect
market prices. Although this model of a competitive equilibrium is the ultimate
intellectual foundation for assumptions about full employment and the welfare benefits of
free markets, it is essentially static, having nothing to say about innovation and growth
(which was a central theme of the economist Joseph Schumpeter). Wolf’s account
ignores this inconsistency, glossing over it by simply stating that despite various
monopoly powers, contemporary corporations are “servants of market forces, not their
overlords.” (49).
Even more significantly both Wolf and other defenders of globalization ignore the
conflict between the competitive equilibrium model and the reality of modern capitalist
economies in which large corporations exercise pricing power (even when they fail to
conform to the neoclassical description of a pure monopoly), holding that advanced
Western economies approximate the idealized purely competitive markets of neoclassical
economic theory. This identification is facilitated by applying the label “free-market
economy” to both the theoretical model and to actual economies.
Wolf also ignores the centuries of complex social and economic development that
occurred in Europe, North America, and the developed Asian nations in favor of a
simplistic historical account in which the development and spread of the free-market
ideal is seen as the principal cause of economic growth. (51) However, much of the
earlier part of this period of economic expansion was dominated by mercantilist policies,
and some of the fastest growing economies of the late nineteenth and early twentieth
century—notably the United States, Germany, and Japan—were highly protectionist.
Wolf insists that the policies to be adopted by poor countries wishing to become rich
conform to his liberal market model (free trade, free movements of investment capital,
minimal interference of government in markets). However, the successful economies he
continually holds up as examples fail to fit the model. Where, within his dichotomy, are
we to place China, the fastest growing economy ever known? Or South Korea, Malaysia,
Thailand, Hong Kong, or even Singapore? Or Japan during its period of rapid growth
from the 1870s on? It seems obvious that many of the most successful developed
economies conform neither to the model of state socialism he deplores nor to his freemarket model with a commitment to free trade, absence of government intervention in
markets, and free movements of capital. The case studies in development economics
discussed in a later chapter reveal a wide range of institutional and cultural characteristics
of both successful and unsuccessful economies, and demonstrate the futility of simplistic
generalizations about the requisites of development success.
Wolf acknowledges that some prominent economists have argued for a far more flexible
approach to economic development than the neo-liberal free-market model. He does not
so much refute these objections as minimize them: for example, he argues that just
because successful economies promoted infant industries doesn’t demonstrate that such
promotion caused the success; after all, many countries that protect industries fail to
achieve success and investment, per se, does not generate success; etc. Surprisingly, he
labels these comments “powerful criticisms” (204).
18
Perhaps in recognition that his analysis is (at the very least) highly over-simplified, Wolf
ultimately acknowledges that “success has not required adoption of the full range of socalled ‘neo-liberal’ policies—privatization, free trade and capital-account liberalization.”
(143) Rather he concludes that “what the successful countries all share is a “move
towards the market economy, one in which private property rights, free enterprise, and
competition increasingly took the place of state ownership, planning and protection.”
This is a very weak claim, since the concept of a “move towards a market economy” can
accommodate quite minor changes. Once again, there is a failure to appreciate the
complex variety of possible growth-oriented policies, most of which have involved some
form of managed trade. China, the super-star among the growth economies, retains a very
high level of government planning, makes very few concessions to private property
rights, and manages trade through targeted exports, severe restrictions on foreign
investment, and an artificially low, pegged exchange rate, all to encourage the
development of its manufacturing sector. Only in the eyes of Wolf and other free-market
ideologues can China be viewed as exemplifying free-market policies.
Wolf goes on to make a series of commonsensical statements about economic growth:
institutions are very important; corrupt, predatory, or brutal governments inhibit growth;
geography, in particular location in the tropics is a “handicap” (but Singapore,
Malaysia?); natural wealth can actually retard growth (the so-called “Dutch disease” that
allegedly afflicts Nigeria and Venezuela); labor-intensive manufacturing has proven the
most successful route to development, etc. The latter is, in fact, a very important point,
and Wolf emphasizes the critical role played by manufacturing in promoting growth.
However, he spends very little time discussing the negative consequences of laborintensive manufacturing and urban development, such as the emergence throughout the
Third World of sprawling mega-cities afflicted by chronic underemployment, high crime
rates and other indicators of social disorder and malaise. Even more than the pull-factor
of manufacturing jobs, this urban growth has been fueled by the push factor of massive
emigration from rural distress—distress fostered by neglect and by imports of cheap (and
subsidized) agricultural goods from the mechanized agricultural producers of the various
developed countries. Low wage manufacturing in the Third World feeds off immigration
to cities and manufacturing zones of impoverished rural workers.
Case studies of Third World economies do not support Wolf’s view that free-market
policies invariably reduce government corruption and incompetence (witness Indonesia,
the Philippines, Bolivia, and Argentina)—even though there is certainly evidence of a
(relatively weak) negative correlation between economic success and corruption. (73) It
is true that Wolf briefly notes, in passing, that China does not adhere to the rule of law.
But rather than taking this as a challenge to claims for the liberal market model that he
holds up as the universal key to economic growth, he merely notes that a lack of respect
for “the rule of law” “may prove a decisive hindrance to China’s long-term
development.” (26)
We can see an almost Hegelian conception of the progressive march of History pervading
Wolf’s discussion of the liberal market model. The “market economy” at the core of the
model is reified: “it” “satisfies the desires of the majority;” “it is the basis of freedom and
democracy;” “it makes people richer and more concerned about environmental damage,
19
pain and injustice;” (57) “markets want to be cosmopolitan;” (78) “markets want to cross
borders;” (92)
Wolf often relies on very simplistic reasoning in claiming unique superiority for his
liberal market model. For example, he claims “the collapse of socialism between 1989
and 1991 has shown that liberal democracy is the only political and economic system
capable of generating sustained prosperity and political stability.” (32) Again, the
examples of China, and other stable and economically successful dictatorships are
ignored as are democratically-governed countries with a large government role in their
economies. This sort of either/or thinking is also reflected in his citing Friedrich Hayek’s
discussion of the “fatal conceit,” the belief in the ability to plan and control human
destiny. Wolf then goes on to attack “the faith” “that the entire national economy not only
could—but should—be brought under central control and direction,” (58-9) a view he
associates with Soviet-style state socialism. Wolf writes as if there is only one alternative
to the Soviet system so that the collapse of that system vindicates that unique alternative:
a constitutional democracy subject to the rule of law, that respects private property and
contracts, protects freedom of speech and inquiry, recognizes fundamental human rights,
has an elected government and an independent and honest judiciary. (33) He continues
“if central planning is unworkable, the market is inescapable. There is no third way of
running a complex modern economy...” (p. 61) And for Wolf, “the market” is a free
market functioning within a liberal constitutional democracy with a free press, legal
protections of property rights and contracts, etc. Wolf claims that “advanced economies
have all become liberal democracies.” (38) Surprising he even cites Singapore and Hong
Kong as examples of successful, rich economies without seeming to notice just how
badly their authoritarian governments fit his liberal ideal.
Wolf briefly discusses several well-known theoretical problems with market functioning,
for example, the problem of how market participants acquire the complete consumer
information assumed by neoclassical theory. Wolf seeks to respond to this theoretical
problem by turning a well-known criticism of globalization—the manipulative power of
international brands—into a supposed benefit. He claims that the branding attacked by
Naomi Klein in her book No Logo, is actually beneficial because brand names convey
information to consumers, thus serving to make markets more efficient. However, Wolf
does not discuss the role of advertising in creating brand images independently of product
quality, nor the use of advertising in shaping consumer opinion independently of product
features.
At times Wolf makes claims for the “market economy” that seem not merely overdrawn,
but obviously wrong. Thus he writes that “only in a market economy could books
condemning society’s rich and powerful be published and promoted with such success.”
(55) If Wolf is correct, the manifestly free press of early post-independence India would
qualify it as a market economy—contradicting Wolf’s strident denunciation of what he
refers to as a “pseudo-Stalinist ‘control raj’.” On the other hand, Wolf praises a number
of dictatorships which adopted one or another “free-market reform,” even when pres
censorship existed, for example, Chile under Pinochet. The is part of the gross
simplification of his conceptual scheme which assumes, without foundation, the universal
20
concurrence of free-market economic policies and governments akin to those of Western
Europe.
Problems with Free Markets: Institutional Reform
In the wake of the failure of the “economic reforms” urged on the Russian economy
during the early 1990s, orthodox economists have increasingly come to stress the
importance of what are known as “institutional reforms” as a precondition of
liberalization and effective globalization. Wolf is typical in stressing the importance of
various institutions in making a market economy work—especially institutions involved
in enforcing contracts and protecting private property. In fact, he considers the presence
of such institutions “the most important single condition” for a market economy. (47).
Wolf even admits a role for government because he acknowledges that markets may have
“side effects” which damage “third parties” (i.e., those not participating in particular
transactions). He is alluding to what economists refer to as “negative externalities,” for
example, environmental damage caused by industrial production. However, beyond a
brief mention of this problem, Wolf has little to say other than to acknowledge that there
may have to be some modification of property rights, and that sometimes solutions will
have to be imposed by the state, without discussing how such state intervention should
occur. (48)
Wolf also, somewhat inconsistently, takes a “soft” line on provision of social welfare,
stating that government will have to supply certain public goods, and provide a safety-net
for those who are “more vulnerable to what happens within the market than society finds
tolerable.” (61) But he fails to explain how this could occur without strongly progressive
taxation such as that existing in the mixed economies of northern Europe. This is
denounced as “predatory taxation” in other sections of the book.
Despite his perfunctory remarks on negative externalities and social welfare, Wolf,
consistent for orthodox economic theory, repeatedly endorses a minimalist role for
government. He emphasizes the necessity of an independent judiciary to “protect citizens
from the predatory activities of the government.” According to Wolf, “even well-run
liberal democracies do far more than they can do well and almost certainly far more than
they need to do.” (65) And despite his praise of liberal democracy, he expresses little
faith in the rationality of voters (e.g., see his discussion of what he considers to be
irrational opposition to genetically-modified foods (68)). His says that his faith is in “the
market” not in government, and he labels as “nonsense” the view that democraticallyarrived at policies are more representative of popular will than market decisions (68)
According to Wolf, relying on government “to do a sensible job of remedying so-called
market failures when it busily introduces so many failures of its own is absurd.” (70) As
examples of areas in which even liberal democratic governments produce such failures,
he lists “most trade policy, much environmental policy, the treatment of risk across
different activities, energy policy, labour policy in much of continental Europe.” (70)
Wolf favors privatization (for example, of utilities, 74), and sees globalization as a means
of reducing governmental incompetence and corruption through opening economies to
global economic forces.
21
Wolf’s discussion conflates two different issues. First, there is the dubious claim that
markets are more representative of popular will than policies determined (in principle) by
electorates in which a wealthy person and a poor person each have a single vote as
opposed to “market decisions” (about what gets produced and sold at what price). The
latter are weighed by wealth and income and wealthy persons obviously have many times
the market power of poor persons. Second, there is the claim that “the market” makes
more intelligent decisions regarding trade, the environment, energy, and labor than
government policy. This issue is more complicated, but the proper conclusion would
seem to be that it all depends on which government and which policy. Globalization
critics cite numerous instances of market outcomes that have resulted in severe
environmental damage and that have created a badly exploited labor force. One obvious
example is the slave trade which was a pure free market operation when not opposed by
government. The second issue illustrates the gross over-simplification of proponents of
free trade and other free market policies who take a specific package of institutional and
economic “reforms” as a universal panacea.
Globalization and Free Trade
According to Wolf, globalization involves not only global economic integration but the
application of the liberal government model to more and more countries, thereby
supposedly conveying the benefits of the market through liberal market “reforms”—or as
Wolf puts it, “the global spread of market-oriented policies in both the domestic and
international spheres.” (14) As noted, there is an almost Hegelian notion of the
Progressive and Beneficent March of History.
For Wolf and most neo-classical economists, free trade is the centerpiece of market
reform program. Certainly free trade was an integral part of the early liberal economist
icons, Smith and Ricardo who wrote at the beginning of the industrial revolution when
England took the lead in low-cost industrial production. And the mathematically-minded
neoclassical economists of the later nineteenth century saw free trade as an obvious
corollary of their general equilibrium model. Nevertheless, there is ample historical data
to counter the view that free trade has been an essential for economic success. The United
States did not adopt free trade policies during its period of “promethean growth” in the
nineteenth century, nor was free trade characteristic of the market economies of Europe
and the United States from the First World War up until the nineteen-seventies. The
period of rapid economic growth during the so-called “golden age” from 1945 to 1970 —
was characterized by relatively high tariffs (not to mention high marginal tax rates,
extensive regulation, and extensive public ownership of industry). The more recent
decades have, in fact, seen the spread of Wolf’s liberal market ideas including the
progressive reduction of tariffs. But these decades have been characterized by relatively
weak economic growth in the advanced industrial democracies, a sharp increase in
income and wealth disparities throughout the world, and (at least in Western Europe)
chronic unemployment. Undoubtedly the lowering of tariff barriers by the advanced
industrialized countries has facilitated rapid growth among the industrializing Asian
economies. Yet most of these economies have maintained extensive controls on imports
through a variety of protectionist measures. Despite these obvious facts, most
contemporary supporters of globalization, including Wolf, continue to assume that
22
positive economic consequences depend on adoption of free-market policies with free
trade as the centerpiece. A better conclusion would be that free trade assists economies in
so far as they have a competitive advantage in their production whereas it may damage
countries striving to increase their economic competitiveness. And that many high growth
economies that are heavily involved in international trade have relied on a variety of
protectionist policies.
The pro-free trade argument is facilitated through subtle changes in terminology. In many
accounts, the concept of globalization is associated with the vague concept of “economic
integration.” (96) and the term “free trade” often dropped in favor of the imprecise term
“liberal trade.” Rather than praising countries for adopting free trade (which few have),
Wolf praises countries for adopting what he calls an “outward orientation.” Wolf (and
other supporters of globalization) generally ignore the fact that the governments of most
successful developing countries with an “outward orientation” have adopted policies that
encourage certain types of exports and discourage importation of competing goods. The
means used have included subsidies, tariffs, quotas, and administrative impediments such
as onerous inspections or content certification requirements. The slippery movement in
terminology from “free trade” to “liberal trade” to “outward orientation,” has been used
to demonstrate (statistically, at least) that countries that adopt an “outward orientation,”
as measured by the relative volume of foreign trade, grow faster than those that do not
and this is somehow taken to justify the view that free trade facilitates growth. Even the
more restricted claim that an outward orientation facilitates growth requires evidence of
causation rather than correlation: is the country’s outward orientation the cause of its
growth or is there some common cause underlying both the country’s economic growth
and the outward orientation of its trade policies?
The Theoretical Argument for Free Trade
The subtleties of national trade policy are far too messy to fit into the simple dichotomy
that underlies Wolf’s analysis. Wolf freely shifts from “free trade,” to “liberal trade,” to
an “outward orientation” without acknowledging the difference according to what he
wishes to argue for. For example, he reverts to the concept of free trade when he wishes
to provide theoretical backing for his position. The standard economic argument
advanced for free trade is the comparative advantage argument first advanced by Robert
Torrens and then made famous by David Ricardo in 1817. (This argument is discussed in
detail in Chapter 3.)
There is, however, a still earlier argument for free trade, familiar to the readers of Adam
Smith, who appealed to the benefits of a global extension of the division of labor. Wolf
invokes Smith’s argument through a thought experiment. Imagine the United States
economy broken up into separate state economies or the European Union regressing to
the fragmented national economies of 1945. It seems obvious that this change would
result in a decline in trade between the separated regions with a consequent decline in
wealth and living standards. Wolf then concludes that the world would benefit from
more, not less, globalization.
23
One long-recognized problem with Smith’s division-of-labor argument for free trade is
that it says nothing about the possibility of global losers in the wake of an increased
division of labor. Smith argument in fact suggests that countries with an absolute
advantage with respect to the production of various products will benefit at the expense
of the others. The more famous comparative advantage argument is supposed to provide
the answer to this concern. The easiest way to understand the comparative advantage
argument is through an analogy to the way the division of labor might work between
individuals. If Jack is better both at repairing cars and cleaning clogged drains than Jim,
but relatively speaking, he is much better at repairing cars compared with Jim than he is
cleaning drains, then Jack will be better off leaving all the drain cleaning to Jim. He can
then use his higher earnings from repairing cars to hire Jim when he needs drains cleaned.
Economists say that Jack has an “absolute advantage” over Jim in both activities, but Jim
has the “comparative advantage” over Jack in drain-cleaning. The famous comparative
advantage argument is analogous: it considers the case of two countries each producing
two products, but at different relative costs. Thus, in his original example, Ricardo argued
that even if Portugal could produce both cloth and wine with fewer labor hours than
England, it would nevertheless benefit Portugal to dedicate its entire work-force to wine
production, leaving cloth-making to England—because England has a comparative
advantage in cloth-making. It is easy to show that, given the assumptions of the model,
England (like Jim who is at an absolute disadvantage with respect to both activities) will
also benefit. The comparative advantage argument is discussed in extensive technical
detail in a later chapter.
For some reason, serious economists, as well as journalists such as Wolf, seem to regard
this simplistic argument as both profound and irrefutably true. According to Wolf, the
comparative advantage “idea” is “perhaps the cleverest in economics.” (81) Yet the
comparative advantage argument suffers from a number of problems, some simple, others
more complex and technical. For example, the argument assumes full employment after
trade occurs, taking for granted that workers who lose jobs due to the comparative
disadvantage of the industry in which they had been working will all be absorbed by the
industry in which the country has a comparative advantage. Moreover, comparative
advantage is really only an argument for the advantages of international trade over
economic isolation (autarky); it is not—despite claims to the contrary—an argument for
free trade. It says nothing about the terms of trade (the relative valuations of the traded
products) that determine how much a country gains from trade. Moreover, Wolf ignores a
well-known argument that is generally accepted by orthodox economists—the terms of
trade argument—that concludes that the terms of trade may be altered to a country’s
advantage through the imposition of a so-called “optimum” tariff. Because of this
argument, many economists hold that the removal of tariff barriers depends on what sort
of policies are pursued by a country’s trading partners. Ignoring the terms of trade
argument, Wolf takes the position that a country should remove tariff barriers regardless
of the protectionist policies pursued by others (89-90). In support of this, he notes the
rising prosperity of countries that have pursued “liberal” trade policies (the industrialized
West and countries like Singapore and Hong Kong). But “liberal” trade is not free trade;
it is often merely some form of managed trade that favors exports. Wolf’s loose
terminology contributes to his failure to recognize the potential benefit of managing trade
to maximize a country’s terms of trade.
24
Of course even if in general trade (whether free, liberal, or managed) increases the wealth
of a participating country, there remains the issue of winners and losers within that
country. This problem was recognized by the early nineteenth century English
economists who argued in favor of the repeal of England’s Corn Laws. Free trade
advocates often treat losers and potential losers who argue for subsidies, import quotas,
or protective tariffs as selfish, if not irrational. However, according to orthodox economic
theory, these agents are acting rationally, seeking to maximize their “utility” since every
agent is a “utility-maximizer” (or “utility-optimizer”). The usual response to the problem
of losers from free trade on the part of orthodox economists is either denial—they claim
that displaced workers will obtain new and better jobs—or they claim that the displaced
workers will be compensated out of the increased national wealth resulting from trade
liberalization. The latter expectation finds little support in actual practice, and to suppose
that “winners” (supposedly the majority) will vote to increase their taxes to provide
subsidies for the “losers” conflicts not only with practical experience but also with the
assumption of self-interested utility-maximization that is at the core of orthodox
economic theory.
It is important to recognize that even if the comparative advantage argument is true, the
gain is one-time only. The analysis is static and says nothing about the effect of trade on
economic growth, even through for Wolf and other pro-globalization enthusiasts growth
is the principal benefit of trade. This is not to say that growth is not a consequence of
trade, merely that the constantly invoked comparative advantage argument does not make
the case for the link. According to Wolf, growth arises from increased international
competition and from transnational technology flows. Increased competition is certainly
associated with international trade, but it is especially characteristic of countries that have
eschewed complete free trade in favor of some form of trade management using subsidies
and tariff or regulatory protection. Technology flows are also often associated with
managed trade. A good example is Japan during the 1960s and 1970s: while Americans
were stereotyping the Japanese as mere “copycats,” they were also attacking the
protectionist measures that enabled Japan to build its powerful export industries. In the
end, the choice facing a country is almost never the either/or choice of autarky or free
trade; rather countries choose from a variety of country-specific economic policies,
including protectionist trade policies, some quite subtle. The one-size-fits-all free-market
model propounded by Wolf and other globalization advocates is only one among a great
number of possibilities.
Free Trade and Migration
One of the criticisms of free trade often voiced by industrial workers in advanced
industrial economies is that free trade will result in a move towards wage equalization,
with a decline in wages in the advanced countries. Wolf claims that “free trade does not
equalize wages” (85). It is a bit disingenuous of Wolf to argue that equalization does not
occur when he asserts that “liberal trade” has raised the wage levels of countries like
Singapore and South Korea to levels approaching those of European countries. But the
real issue is whether free trade lowers wages in advanced industrial countries. Wolf, like
many other defenders of globalization (notably Thomas Friedman) claims that the
workers in advanced countries are better (i.e., more efficient) workers than those in
25
developing countries: productive efficiency “diverges” (sic) across countries. Of course,
economic development—whether or not associated with free (or “liberal”) trade—
involves capital investment that increases (total factor) productivity. Investment in
education increases human factor productivity. But this does not address the principal
concern of workers in advanced countries. (This issue is further discussed in the
subsection “Traumatized by Trade” found later in this chapter.)
In fact, despite trade, enormous wage disparities remain, especially between the wages in
underdeveloped countries and those in older industrialized countries. Wolf correctly
notes that “the simplest thing we can do to alleviate mass human poverty is to allow
people to move freely or their labour services to be traded freely.” But rather than
confronting the consequences of emigration from poor countries to rich ones, Wolf
blandly asserts that such movement “benefits rich countries and the skilled migrants, but
harms the poor they leave behind.” (87) What he has in mind is the restricted emigration
of physicians and other professionals from countries like India to the U.K. As noted, free
trade advocates early on recognized that there would be losers when markets are opened
to foreign competition, an issue glossed over by invoking the two kinds of “solutions”
that have been offered—the claim that new and better jobs will be created through growth
resulting from trade, and the claim that the losers can be compensated by their
government. But such “solutions” are even less convincing if we envision a global free
labor market. In such a market, the winners will be the immigrants—ambitious, hard
working, and talented workers from poor countries—and the losers will the formerly
relatively highly paid workers of advanced industrialized countries. This is an issue that
Wolf chooses not to pursue.
Free Capital Flows
Wolf is much less assertive in his advocacy of transnational capital flows than he is in his
advocacy of free trade, or even free immigration, although in the end he generally favors
free capital flows and is unconvinced by criticisms offered by economists such as Joseph
Stiglitz who has blamed the flow of “hot money” for precipitating the Asian financial
crisis of a few years ago. Wolf’s preferred form of capital flow is direct capital
investment by corporations in developing countries, and he is less supportive of loan
programs which he thinks they tend to support corrupt governments. (83-85) Wolf pays
little attention to internal savings, private or governmental, as a means of financing
investment. He is particularly skeptical of governmental development programs
presumably because of his low regard for governments—especially the governments of
poor countries.
Wolf opposition to government development programs, such a subsidization of infant
industries, conflicts with a well-known argument for protectionism known as “the infant
industry argument.” According to the infant industries argument new industries need
protection from foreign competition until they are strong enough to compete on their own
in international markets. Wolf rejects the argument because he thinks “infants almost
always fail to grow up.” (88) He has in mind countries like India and Nigeria that adopted
“import-substitution” policies (policies that seek to develop domestic production not for
export but to replace imports from advanced industrial countries) rather than successful
26
countries such as China and Japan. The latter focused not so much on creating domestic
industries to replace imports but rather have utilized various forms of protectionism to
grow domestic industries. The infant industries being protected or subsidized (and this is
also true of the United States and Germany during the late nineteenth century) were
industries that eventually became major exporters. Thus Wolf’s criticism of the infant
industries argument, adopts the strategy of selective use of historical data.
Wolf’s Defense of Globalization against Specific Charges
Much of the rhetorical force of the case for globalization in the second part of Wolf’s
book comes from ridicule directed at the anti-globalization movement and at its more
polemical claims. For Wolf, the critics of globalization, for the most part, are part of a
diverse coalition of those pursuing selfish economic interests (e.g. labor unions) and a
diverse group of fanatics and ideologues. In his opinion, among the worst are various
non-governmental organizations (NGOs) that support environmental, human, and gender
rights, and who allegedly form alliances with socialists and neo-Marxists from the left
and nationalists of various sorts from the right. These various critics are seen as the
source of irrational and ignorant arguments against the spread of the liberal market ideal.
Given his assumption that a liberal market economy operating in a liberal-democratic
state provides a universally applicable political-economic solution to the world’s
economic and social problems, it is hardly surprising that for the most part Wolf’s
“refutations” abstract from the specific cultural, social, and economic conditions that
characterize various national economies. The evidence he cites to refute criticisms of
globalization often involves statistics and generalizations that gloss over national
differences. Relying of global statistic, rather than individual country data provides a
means of obscuring the distorting effect on statistical aggregates of the enormous
populations of South and East Asia.
In addition, when social and cultural conditions fail to conform to his liberal market
model they are often treated as the result of corruption and greed, rather than as the result
of complex historical processes. This is perhaps natural given Wolf’s one—dimensional
classification of states in terms of the “quality” of their institutions—with quality
measured by the extent to which institutions promote markets. At one extreme are what
he refers to as “predatory states;” at the other, “liberal service states” that provide “good
governance.” (18) This simplistic classification does not accord with the observations of
development economists who find, for example, that some of the poorest African states
are actually less corrupt than some of the successful Asian economies.6 Moreover,
according to Wolf, predatory governmental behavior includes the high marginal tax
rates—rates that are characteristic of the advanced economies of Northern Europe which
are elsewhere held to exemplify the liberal market ideal.
The force of Wolf’s specific refutations often depends on acceptance of his dualistic
conceptual scheme in which the liberal market model is viewed as the sole alternative to
state control. This relieves Wolf of the task of providing serious positive arguments for
the free-market program that he takes as central to globalization, or of considering the
actual array policy alternatives. For Wolf globalization so conceived is vindicated if
27
various specific criticisms leveled against it are answered. Wolf’s way of addressing the
criticisms is to mix argument with ridicule as indicated by the rather sophomoric section
headings he uses to classify them: “Incensed about Inequality,” “Traumatized by Trade,”
“Cowed by Corporations,” “Sad about the State,” and “Fearful of Finance.” It is worth
discussing these in turn.
“Incensed about Inequality”
The past several decades have seen a sharp increase in the differential between the
income and wealth of the top group and the rest of the population in most advanced
industrial economies. Globalization critics have noted a similar phenomenon in various
developing countries held up as examples of the benefits of globalization. The roots of
the increasing divergences in wealth are complex and the issue is one of the least clear in
the entire globalization debate. Wolf attempts to strengthen his case for globalization by
choosing to begin with one of the murkiest complaints about globalization.
He scores a rhetorical point by noting that some complaints of increasing inequality
involve the “fallacy” of comparing the wealth of the richest individuals with the incomes
of the poorest. He also claims that increasing inequality is not bad, provided that the
increase in inequality results from more wealth for the wealthy rather than from a
decrease in wealth of the poor. His view that greater inequality is not ipso facto bad is
closely related to one of the core welfare tenets of neoclassical economic theory which
holds that a so-called “Pareto improvement” in welfare occurs when an economy in
equilibrium moves to a state where at least some are better off in terms of goods
purchased and no one is worse off. The concept of a Pareto improvement gives no weight
at all to equality as contributing to social welfare.
One factor that is ignored by this approach is that inequality of wealth is correlated with
inequality of power. Inequality of power leads to inequality of opportunity and a
diversion of national resources controlled by governments away from enhancing the
welfare of the poor. The issue of political and economic power does not concern Wolf
beyond occasional denunciation of abuse of power by “corrupt” government officials and
union leaders. However, Wolf does claim to recognize the danger of “great inequities” of
wealth and income. His criticism is not based on moral principle; instead, it has an elitist
flavor: too much inequality in wealth and incomes within a country may lead to a
(dangerous) “populist” democracy that seizes the wealth or incomes of the rich minority.
(29) In short, for Wolf the problem is not inequality per se but the possibility that certain
levels of inequality may provoke a reaction that lessen inequality through taxation or
perhaps confiscation—“seize” applies to both.
Wolf states that the case against globalization based on rising inequality reduces to seven
different claims: 1) the ratio of average incomes in the richest countries to those in the
poorest has risen; 2) the absolute gap in living standards has risen; 3) global inequality
among individuals has risen; 4) the number of poor in the world has risen; 5) the
proportion of people in poverty has risen; 6) the poor are today worse off not merely in
income but in quality of life; 7) income inequality has risen within all national
economies.
28
Wolf acknowledges that both the absolute and proportional gaps between living standards
in the richest and poorest countries has increased, and that inequality is increasing in
most large countries. However, he also claims that, among individuals, the gap has been
narrowing. By this he means that the average income of the poorest countries that jointly
contain half the world’s population has risen higher than the average income of the
remaining countries—the wealthier countries that contain the remaining half of the
world’s population. This is hardly surprising, since the average income level in the
poorest group of countries is dominated by the enormous Chinese population whose
average income has grown rapidly in proportion to the rapid growth of the Chinese
economy (coupled with very low aggregate population growth). The choice of a division
of the world’s population into the top and bottom 50% is favorable to Wolf’s argument. If
one were to compare the top 10% of the world’s population (aggregated) with the bottom
10% the conclusion would be quite different since poverty has deepened among the
poorest nations, whereas the income and wealth of the top earners has everywhere grown
disproportionately.
The fourth claim—that the number of poor in the world has risen—has attracted a great
deal of attention. The issue is complicated by a debate over how to define poverty and
how to measure it given the enormous heterogeneity of economic and cultural conditions,
deficiencies in national statistics, and the need for estimation. Best known are studies by
the World Bank and by independent authors, notably by the economist Xavier Sala-IMartin, a strong supporter of free-market laissez-faire policies. There is considerable
disagreement among the various studies as to whether the number of the world’s poor, as
measured by an income of less than either $1 or $2 per day, has increased over the past
twenty years. But this well-publicized debate appears to be little more than an exercise in
applied statistics that tells us little about the nature of poverty in different countries, or
about the optimality of various growth strategies, including the strategy of adopting the
free-market reforms commended by Wolf.
Wolf argues (based on World Bank statistics) that world-wide poverty, defined as an
income of less than $1 per day, has declined from about 50% of the world’s population in
1950 to approximately 24% (in 1992) although he acknowledges that is unclear whether
the absolute number of those living in poverty so-defined has decreased. His discussion
of inequality becomes mired in a morass of details about the correct measures of poverty,
inter-country versus inter-populations comparisons, and the quality of available data.
After pages of discussion of the statistical problems of measuring poverty—with
emphasis on the uncertainty of the estimates—the only conclusions reached are that the
world-wide rate of poverty has declined over the past several decades, and that it is
“plausible, though not certain” that the number of persons in absolute poverty has
declined (163). Wolf also concludes, plausibly, that the cause of these declines has been
accelerated economic growth in East Asia. This is hardly a controversial conclusion. I
return to this issue in a later chapter.
In an effort to bolster his argument about the positive effect of growth on welfare, he
goes on to cite statistics showing an increase in average life expectancy and female
literacy, and a proportional (though not absolute) decline in chronic undernourishment.
He also cites as positive indicators a world-wide shift to democracy and an increase in
29
personal economic opportunity, especially in India and China. But, once again, the
discussion evades the fundamental issue: what particular policies should a given country
follow to enhance the welfare of its people? Granting that such policies may often
involve export-oriented economic growth does nothing to support the claim that the best
formula for welfare-enhancement is adoption of a standard package of free-market
“reforms.” If that were the case, countries like Bolivia and Argentina, rather than China,
would be the prime examples of economic success.
He closes his discussion of inequality with the fact of widening income disparities in the
industrialized Western nations, and in the United States in particular. He recognizes that
this change is associated with a decline of American manufacturing in the face of
competition form developing countries. However, rather than examining the root causes,
he engages in moral polemics: “It would be immoral for rich countries to deprive the
poor of the world of so large an opportunity for betterment merely because they are
unable to handle sensibly and justly the distribution of the internal costs of a change
certain to be highly beneficial overall.” (170) (This alludes to suggestions of
redistribution as a way of addressing the problem of the losers under free trade.) It is
unclear what his basis is for claiming that the decline of the American manufacturing
sector, and the running of large trade deficits, is “highly beneficial overall.” He tells
industrial workers who complain of layoffs: “Only the most selfish westerners can
complain about a transformation that has brought so much to so many so quickly.” And it
is strange to hear Wolf state, in the same passage, that “the right response is.... if all else
fails, simple transfers of income” to alleviate the plight of displaced workers. Strange
because elsewhere he deplores, again and again, “predatory taxation” –by which he
means high progressive tax rates, the only means of funding such income transfers.
“Traumatized by Trade”
The second set of complaints about globalization relate to negative effects of increasing
world trade. Few objective observers would claim that international trade, in itself, is a
bad thing. Trade does generally lead to growth, and economic growth in poor countries
is, all things equal, beneficial. The real issues concern the form trade and growth should
take, what role national governments should play in producing and guiding it, and in how
its benefits should be distributed. For Wolf, there is only one right model: the free-market
model with a minimal role for government. As seen above, he takes the failure of some
other approaches, for example the Indian “pseudo-Stalinist control raj,” to vindicate the
favored free-market model. Wolf argues that increased international trade has not hurt the
citizens of high-income industrialized countries (despite his scolding of displaced union
workers for their selfishness). He claims that critics have adopted a narrow “localization”
perspective, and that complaints against the World Trade Organization are generally
wrong and always exaggerated. Again he fails to discuss the possibility that differing
policies may best serve particular countries by once more engaging in “black-white”
reasoning, contrasting “localization”—which he defines as national or regional selfsufficiency—with international trade, assumed to be the product of the free-market
policies he advocates. But surely localization means not a breakup of the international
trading system into geographically independent trading regional trading blocks but rather
30
sensitivity to the social and economic characteristics of particular countries and regions in
devising optimal trade policies.
The charge that increased international trade has hurt the industrial workers of the
advanced industrialized countries is once more addressed. Wolf considers the complaint
is that cheap Chinese labor is taking away American manufacturing jobs. Wolf claims
that “Chinese labour is cheap because it is unproductive,” (175) though he later concedes
that this is partly due to the type of industries that exist in China—labor-intensive, lowcapital manufacturing. He goes on to claim that as Chinese efficiency and capital
investment increase, wages will rise rapidly, making China less competitive. Wolf does
acknowledge that the seemingly inexhaustible pool of impoverished agricultural workers
in China could hold down the price of Chinese manufacturing labor, although he claims
that eventually wages will rise. But response fails to address the short and long term
consequences for American workers during the period of continuing industrial Chinese
industrial expansion. And it doesn’t address the effect of Chinese industrialization on
other Third World countries that are striving to raise living standards through
industrialization.
The extremely low export prices of goods produced in China are due not only to low
wage rates but also to the artificially low exchange rate of the Chinese currency. Both
factors threaten nascent industries (most notably the textile industry) throughout the
Third World. And the concomitant development of a modern managerial,
communications, and transportation infra-structure that has accompanied the growth of
Chinese industry has consolidated China’s rapidly increasing domination of international
industrial markets. Wolf’s response to these concerns is invective: “an irresistibly
competitive China is a figment of the fevered imagination, since the real cost of labour
will tend to remain in line with its productivity.” (183)
Wolf then claims that most of the decline in American manufacturing is actually due to
productivity advances rather than to foreign competition. He claims that the decline is
inevitable due to a shift of spending in high-income countries from goods to services.
Manufacturing employment in advanced economies is said to be following the path of
agricultural employment during the past century. The fear of job losses is labeled
“hysteria” resulting from what he calls the “lump of labour fallacy”—the view that there
exists a fixed number of jobs. His analysis is consistent with the claim common among
defenders of globalization that although there have been and will continue to be job
dislocations, these will be compensated for by the expansion of higher skilled jobs,
especially in the service sector. This oft-repeated claim seems less and less convincing as
more and more high technology service jobs in the computer industry and even in
medicine are moved to countries such as Ireland, India, the former Soviet Republics, and
China.
The claim by Wolf and other defenders of globalization that the growth in service jobs in
the advanced industrial countries means a great expansion of higher skilled jobs seems
wrong. Most of the new service sector jobs in advanced countries involve low pay and
irregular schedules, and often lack basic social benefits. These are the “Macjobs” referred
to by the globalization critics. In contrast to the United States, Japan, another high-wage
31
country, has, through successful targeting of key industries, preserved a strong hightechnology manufacturing sector and continues to have a far higher percentage of its
labor force engaged in manufacturing.
However, Wolf’s ultimate defense of the effects of Third World industrialization on
advanced economies appeals to the comparative advantage argument beloved by neoclassical economists:
When a developing country, such as China, sends goods to the US or to the EU, in
line with its comparative advantage, the terms of trade—and so real incomes—of
the importing countries improve. ...the importing country can buy more with what
it produces. It is better off.... trade is not a zero-sum game. It is mutually
enriching. (180)
The assumption of full employment and the free flow of labor from old to new industries
is essential to the argument (discussed in detail in the first chapter of Part II). Wolf finally
concludes, “worries about de-industrialization and global competition from pauper labor
are nonsense.” (183)
He then addresses the worry by “the prophets of doom” that Third World
industrialization threatens “global surfeit, deflation and depression.” (183) Wolf notes
that the experience of advanced industrialized countries demonstrates an insatiable
appetite for consumer goods, and that the rising income of China and other industrializing
economies should create demand sufficient to avoid a glut. But this response obscures
some fundamental issues. First, the United States maintains its level of consumer
spending by running huge adverse trade balances financed by foreign acquisition of U.S.
securities and real assets. Second, modern productive efficiency, even in the Third World,
means that only a small proportion of the population of industrializing nations actually
enjoys the allegedly rising income associated with increased production. During the
1930s, there were widespread fears of deficient aggregate demand, fears that were only
dispelled by the post-war boom associated with the reconstruction of Europe and Japan,
and the international dominance of the American economy. But absent a doctrinaire
acceptance of the full-employment assumption of neoclassical theory (“the clearing of the
labor market”), the worry about overproduction in the face of insufficient global demand
has to be taken seriously.
Third, and most serious, is the concern, grounded in science, that the rapid
industrialization occurring in China and elsewhere will vastly increase the output of
carbon dioxide and other greenhouse gasses, thereby accelerating global warming. Wolf
offers us the reader little more than the observation that socialist economies have worse
records on the environment than capitalist ones, that rich countries tend to have a better
environmental record than poor ones, that it would be a good thing to have global carbon
taxes, and that countries ought to eliminate subsidies to industries and processes that
cause environmental damage. But this brief discussion barely touches on the potential
calamity of global warming and its relation to Third World industrialization.
32
In this discussion, he once again criticizes the “selfishness” of advanced industrial
economies with respect to their trade policies towards poor undeveloped countries. He
takes the moral high ground in a long section devoted to critiquing policies allegedly
imposed on the World Trade Organization by advanced countries, including protection of
“intellectual property rights,” “anti-dumping” provisions, and especially tariff protections
and subsidies for agricultural goods. However, this moralizing belies his commitment to
the tenets of “economic science” with its core model of the purely self-interested agent.
Consistency would seem to require not moral indignation, but a reasoned argument that
such trade discrimination not only hurts Third World economies but also the interests of
the industrialized countries. On the other hand, morality is a legitimate issue for most
critics of globalization. Perhaps the greatest moral offense that critics accuse the
industrialized countries of is not selfishness (self-interest) but hypocrisy. The ongoing
subsidization of domestic agriculture in advanced countries, including export-oriented
agri-businesses, and extreme protections for the new category of products labeled
“intellectual property” that are incorporated into international trade agreements are
inconsistent with the free-market policies advocated by the industrialized countries. They
are simply imposed upon weaker countries as a condition of receiving economic
assistance.
If one rejects the one-size-fits all free-market model, then one has the burden of
evaluating each of the policies deplored by Wolf on its individual merits. For example,
agricultural production, particularly production of traditional domestically consumed
food products, is viewed by citizens of many countries as part of their national heritage
and cultural identity. Do the Japanese want their rice fields turned into housing tracts or
the French their beautiful countryside given over to developers? One has to distinguish
subsidies that preserve traditional agriculture from others that support massive production
of wheat and other grains on large modern mechanized farms. It is the latter that has the
principal adverse effect on traditional agriculture in Third World economies and on the
majority population that lives in the countryside.
“Cowed by Corporations, Sad about the State”
The third and fourth set of complaints about globalization addressed by Wolf are related,
since one of the principal charges of globalization critics is that powerful multinational
corporations subvert smaller Third World governments and encourage a “race to the
bottom” to attract foreign investment. Wolf argues that the Third World investments of
international corporations are largely beneficial to the world’s poor, that there is no “race
to the bottom” by poor countries scrambling to attract foreign investment, and that
international corporations do not undermine the independent actions of small Third
World governments.
Wolf addresses the charge that some transnational corporations exercise power that
exceeds that of national governments by focusing on a comparison, made by some
globalization critics, of the gross sales of some large transnational corporations with the
GDP of various small nations. Wolf correctly notes that GDP is measured through adding
up the value added at each stage of production and distribution, whereas the gross sales of
a corporation is a function of prices that include values added by all suppliers to the
33
corporation, rather than merely the value added by the corporation itself. Delighted that
he has caught some critics in an elementary error, he apparently believes, and expects
readers to believe, that he has thereby effectively refuted the charge of corporate
domination of Third World governments. However, comparing the sales of transnational
corporations to national income of a Third World country is quite irrelevant to the
criticism. The real issue is power exerted by international corporations, not their level of
sales. Large international corporations wield political power not as a direct result of their
sales volumes, but through their influence on Third World governments and on their
politicians—as the imposition of intellectual property protection on Third World
countries attests. Political contributions, bribes, lucrative job offers, and lobbying
activities financed by major corporations and their representatives strongly influence
national economic policy, both in advanced nations and (to an even greater degree) in
poorer nations. In poorer nations, in particular, the resources available to a few corporate
representatives to affect policy are often many times greater than the aggregate resources
of millions of poorer citizens.
Wolf sees direct foreign investment as one aspect of “free-market reforms,” as a means of
“disciplining” states. His assumption is that most Third World governments are corrupt
and incompetent; thus, like many economists, he believes that the imposition of freemarket reforms, including encouragement of foreign direct investment, is needed to limit
corruption, “predatory taxation,” and inflationary “populist” spending. And when
countries adopt free-market reforms and then suffer economic declines—for example, in
the case of the countries that emerged from the breakup of the former Soviet Union—
Wolf blames the result on corruption and incompetence (an implicit admission that that
corruption and incompetence can flourish despite the adoption of free-market reforms).
And Wolf holds, without citing any supporting evidence, that critics of globalization are
wrong to believe that one important source of corruption in Third World countries comes
from the international corporations that engage in direct investment.
In reality, the choice for governments of poor countries is never the either/or choice
between corrupt autarky (“the control raj”) and free-market reforms. There are dozens of
alternatives, and only a careful analysis of the peculiar social and economic conditions
obtaining in a particular country can provide a basis for identifying the optimal choices.
Obviously domestic corruption and the particular balance of power obtaining in a country
may well determine that the policy choices made are not merely sub-optimal, but
positively harmful. Wolf’s insistence on free-market reforms precludes exploration of
alternatives and prevents a thoughtful examination of failures such as Russia, Bolivia,
and Argentina.
“Fearful of Finance”
Of the various complaints leveled against the free-market reform program, the most
universally accepted relates to financial liberalization which generally entails opening up
a country to free in and out flows of capital. Here the usual anti-globalization critics have
been joined by distinguished economists—most notably, Joseph Stigliz, whose book
Globalization and Its Discontents, achieved best-seller status. Stigliz blamed
international agencies promoting globalization, most notably the IMF, for creating crises
34
and then making them worse with ill-advised free-market advice. Wolf’s response to such
criticism is weak, consisting of the claim that the criticisms are greatly exaggerated,
followed by a moral diatribe against the selfishness of the advanced industrial countries
in not doing more to help the poorer countries through more consistent free-market
policies
It is difficult to separate the issue of harsh financial advice and even control from more
general issues relating to the influence of international organizations on trade. The freemarket model has been promulgated for the past two decades in a particular form known
as the “Washington-consensus,” an integrated set of policies shared by the World Trade
Organization, the World Bank, and the IMF—all of whom are heavily influenced, in
some cases dominated, by the United States Treasury. Critics of globalization have
focused on the detailed activities of each of these organizations. But for Wolf, the matter
is much simpler: the purpose of the WTO is simply to help “provide the international
public good of open markets.” (207) The desired result is “a liberal, law-governed trading
system.” However, Wolf acknowledges that the largest economies dominate the WTO
and that policies counter to the liberal ideal such as “anti-dumping” and intellectual
property rights have been “enshrined in the WTO.” And although he deplores the concept
of “intellectual property,” he fails to discuss how the economic power of major
corporations has given them the political power to incorporate sweeping intellectual
property protections into international trade agreements.
Wolf focuses his discussion on the International Monetary Fund (IMF). The principal
charge against the IMF—that it imposes a simplistic one-size-fits all policy on
developing countries—is minimized by Wolf; he claims that countries must live within
their means and that the IMF has the specific single of insuring that they do so. Thus
“when a country is in the midst of a fiscal crisis, the IMF reduces the severity of the
adjustment, since it provides funds that would otherwise be unavailable.” (290) But,
according to Wolf, the IMF “has no more responsibility for the calamity than an
ambulance crew at the scene of a car crash.”
This misses the fundamental complaint of Stigliz and others—that the IMF has
encouraged the sort of capital account liberalization that produces the crises, and that,
once a crisis develops, it rigidly imposes “fiscal reforms” including currency devaluation
and tightening of credit. And these “reforms,” according to the critics, have only
exacerbated the crises. They claim that the IMF has persistently created a “moral hazard”
by encouraging large loans from Western banks to countries that present a large risk of
default (sometimes as a result of inept governments); then, when a liquidity crisis arises
and country threatens default, the IMF imposes Draconian conditions that worsen the
crisis in exchange for a large loan (often paid for by U.S. taxpayers) that effectively
repays the (American) banks that made the risky loans. The moral hazard arises from the
willingness of banks to make risky loans on the rational expectation that in the event of
default the IMF will put up the money to repay them.
Wolf acknowledges that the IMF is “a tool of the G7, particularly of the US and, more
particularly still, of Wall Street.” (294) Yet he exonerates the IMF because he claims that
the guarantees to banks that created the moral hazard were “given not by the IMF, but by
35
governments, including the governments of the G7 countries.” This is rather strange: is
Wolf suggesting that we should exonerate the IMF of blame because it is the tool of the
advanced industrial countries? In fact Wolf does (largely) exonerate the IMF of
responsibility for finances crises in South East Asia, the Soviet Union, and Latin
America. He claims that, in fact, the biggest mistake of the IMF “was failing to warn
countries adequately of the danger that confronted them.” (304) He ends his discussion
with the bland conclusion that the world needs the IMF but that the IMF can “do better.”
After a long discussion of the errors occasioned by capital account liberalization in Asia,
Latin America, and the Soviet Union, he concludes that it is nonetheless desirable that
capital account liberalization proceed with a few reforms. The principal need is for more
transparency, floating exchange rates (at least for large countries), reform of the banking
system, limitations on foreign borrowing, new international mechanisms for dealing with
sovereign defaults (e.g., Argentina), and mechanisms to avoid currency speculation.
Wolf concludes that foreign borrowing is dangerous; this conclusion reinforces his view
that foreign direct investment is the “best of all” methods of development for poor
countries or as he puts it “factories do not walk” (304) (that is, direct investment produces
permanents results). But in crises factories do close and workers do get laid off. Once
more, the entire detailed and fairly technical discussion of international finance pays little
attention differing national economic and social conditions. The one really strong
recommendation in this section—that the best modality of investment is direct private
foreign investment—is simply another facet of his one-size-fits-all laissez-faire model.
Conclusion
The final section of Wolf’s book is entitled “How to Make the World Better.” Here he
reverts to the sweeping generalizations of the first part of the book, with an emphasis on
“threats” to globalization. Wolf’s proposed answer to these threats is to commend a move
towards international political integration, with the United States as the exemplar. For
Wolf, the United States is a society of “high standards of education, health and public
services...their citizens have become better informed and more prosperous, they have
insisted on higher standards in public life.” (314) Here is Wolf’s closing paragraph:
The sight of the affluent young of the west wishing to protect the poor of the
world from the processes that delivered their own remarkable prosperity is
depressing. So too, is the return of all the old anti-capitalists clichés is (sic) as if
the collapse of Soviet communism had never happened. We must, and can, make
the world a better place to live in. But we will do so only be ignoring these siren
voices. The open society has, as always, its enemies both with in and without. Our
time is no exception. We owe it to posterity to ensure that they do not triumph.
Many of Wolf’s themes are on display here: the image of spoiled and ignorant youths as
the core of the anti-globalization movement; the view that the proper path to increased
welfare throughout the Third World is identical to that pursued by the Western
industrialized countries in the past; the assumption that the failure of the Soviet Union
somehow vindicates Wolf’s version of free-market capitalism; and the view that
globalization is a moral struggle between “open societies” and “enemies.”
36
Wolf’s book is typical of paeans in praise of globalization written by financial journalists
and popularizing economists. We now turn to the supposedly rigorous “scientific”
support for free trade and other free-market policies provided by academic economists.
37
Chapter 2
The Ideology of Orthodox Economics
Morality, it could be argued, represents the way that people would like the world
to work—whereas economics represents how it actually does work. Economics is
above all the science of measurement. It comprises an extraordinarily powerful
and flexible set of tools that can reliably assess a thicket of information to
determine the effect of any one factor, or even the whole effect.” (from
Freakanomics, by Steven D. Levitt and Stephen J. Dubner, 13)
This statement from the best-seller makes sweeping claims on behalf of modern
economics. It is not only said to be a science, but is defined so as to comprehend the
whole of statistical analysis. Moreover, the contents of Freakanomics reveal that its
subject matter is the practically the entire field of social sciences, including what is
generally thought of the subject matter of sociology. The book consists of a collection of
social observations and analyses using simple statistical methods, “the stuff and riddles of
ordinary life.” (xi) This extraordinary extension of the subject matter of economics is a
testament to the success of the academic discipline of economics in its competition for
power, prestige, and financial resources against other academic disciplines. Economics
departments routinely attract more students, pay higher salaries, and place more members
in prominent government positions than other departments. Many of the brightest and
most articulate students chose to make economics a career. As Levitt and Dubner might
say, the “incentives” (sadly lacking from hard sciences like physics) explain the students’
decisions.
Economics is the only social science that claims to be a “science” without the modifying
adjective, “social.” Much of this prestige is of recent origin. One milestone in the rising
reputation of economics occurred with a donation by the Swedish central bank to the
Nobel Foundation to endow a new prize seventy years after the science prizes were
established by Alfred Nobel’s will. According to Silvia Nasser (author of A Beautiful
Mind, the book that did much to popularize the notion that economics is a deep “real”
science),
Economics was not held in high regard by many of the natural scientists who
dominated the academy. It is not, they said, a sufficiently scientific field to
deserve equal footing with hard sciences like physics and chemistry. Ideas, they
said, slipped in and out of fashion, but one could not point to scientific progress,
to a body of theories and empirical facts about which there was certainty and
near-universal agreement. (368)
Nonetheless, the rising reputation of modern economics has led to an enormous
expansion of the scope of its activities so that today it is a sprawling collection of
specialized areas of study many of which have little to do with core economic theory. It
attracts bright and articulate scholars like Leavitt who have little interest in foundational
economic theory. In fact, in the introduction to Freakanomics we are told that co-author
38
Levitt (who was awarded the John Bates Clark metal as the best young economist under
forty), is “not good at math,” doesn’t “know how to do theory,” and doesn’t “know a lot
of econometrics.” (Freakonomics, x). By rewarding scholars like Levitt, the profession
lays claim to territory previously occupied by sociology.
The lofty status of economics coupled with its newly won scientific image has done much
to enhance the prestige of individual economists and consequently of the policy advice
they offer. This advice frequently derives from a simplified interpretation of the
fundamental economic theory that is practiced by a handful of mathematically inclined
economists. Even though most economists barely understand the core mathematical
model of neoclassical theory on a deep level, almost all of them (even Levitt) have been
indoctrinated in its basic concepts and have been inculcated with respect for the
mathematician-pioneers of the theory. Policy recommendations based on these basic
concepts and the normative meta-belief structure that accompanies them have played a
major role in moving public opinion in industrialized nations—especially in the United
States—away from the welfare-state ideas that guided political thinking in the advanced
industrialized countries from the 1930s through the 1970s.
It is often forgotten that until the Second World War economics functioned as another
problematic social science, with various contending “schools.” Neoclassical economic
theory, built around mathematical models devised from the 1870s on, was simply another
school contending with rival schools of such as historicism (in Europe) and
institutionalism (in the United States). Unlike these competitors, neoclassical theory held
that economic activities—buying, selling, investing, and earning—could be studied
mathematically without reference to human psychology. This mathematical orientation
attracted “smart” students with mathematical ability. In some cases these students were
idealistic hedgehogs, looking for the golden key to human welfare; after all, neoclassical
economics is the social science of generalization par excellence. Neoclassical theory
viewed economic activity as purely “rational,” in a peculiar technical sense of rationality.
And neoclassical theory had the advantage of being popular with the business community
because of its strong opposition to government interference in business activities and its
hostility towards labor unions and other “socialistic” concepts.
During this time, neoclassical economics remained accessible to general readers with
modest mathematical backgrounds. The most influential neoclassical economist at the
beginning of the twentieth century, Alfred Marshall, deplored the excessive use of
mathematics and presented most of his ideas in ordinary English and through simple
graphs. Critics, such as Thorstein Veblen, presented the case against neoclassical theory
and its concept of “economic man” in terms readily understandable by non-specialists.
However, the neoclassical school, now solidly ensconced in major universities, came to
attract students with ever greater mathematical ability. In the nineteen thirties, forties, and
fifties, a group of mathematically-talented young economists made a number of
theoretical (mathematical) breakthroughs that recast the non-rigorous general equilibrium
model devised by Walras in the 1870s using the tools of point-set topology and other
relatively advanced techniques. Understanding the new model required a degree of
mathematical knowledge well beyond the capability of non-specialists. In fact, most if
not all of the leading theoretical economists can be described as applied mathematicians
39
who knew little about actual economic behavior. Thus the newer generations of
(neoclassical) economists have come to think of themselves as practitioners of a deep
mathematical science almost on a par with physics.7 After the Second World War the
new gained prestige of neoclassical economic theory helped it eclipse historicism and
institutionalism, and these alternative approaches soon disappeared from economics
departments.8
This mathematical reformulation of neoclassical theory began during the Great
Depression. During this period a quite different revolution in economic theory occurred
as a result of the heretical ideas that emanated from a leading neoclassical economist,
John Maynard Keynes. In neoclassical theory, unemployment is a theoretical
impossibility. However, Keynes held that a national economy could actually be in an
equilibrium with a high level of unemployment, and that policies of government spending
and stimulation of private investment were the way to increase aggregate demand so as to
move the economy of full employment. Keynes’ ideas did much to steer reformers away
Marxist and institutionalist analyses and towards his heretical version of neoclassical
theory. However, more mainstream neoclassical economists soon incorporated Keynes’
ideas into a so-called neo-Keynesian “synthesis” which was much closer to neoclassical
orthodoxy. And three decades later, during the 1970s, the neo-Keynesian synthesis was
abandoned by the economic mainstream in the wake of the “oil shocks” and inflation of
the 1970s which seemed to contradict the Keynesian analysis. Jointly, the mathematical
reformulation of neoclassical theory, the advent of a Nobel Prize in economics, the move
away from support for the welfare-state in the United States, and the rejection of neoKeynesian theory led to ascendancy of neoclassical fundamentalism of the sort endorsed
by many of the free-market supporters of globalization. The role of the complex
mathematics in which the core theory was formulated was to give credibility to the image
of economics as a deep mathematical science akin to physics.
The currently popular free-market concepts of privatization and deregulation emerged
from this revitalized laissez-faire ideology. Once injected into the political sphere, freemarket ideas continued to gain ground and formed part of the political move to the right
experienced by many Western European countries and especially by the United States.
For example, American economists like Glen Hubbard and Larry Lindsey, who played a
prominent role in forming economic policy in the George W. Bush administration, have
advocated a radical revision of the U.S. tax code that would impose a flat income tax—
or, at least, radically reduce the taxes paid by the wealthy. There is a strong normative
undercurrent to such recommendations: Hubbard was recently quoted as saying
“...progressivity at the top? I don’t know. That just sounds like envy to me.” (Cassidy, p.
76) This is reminiscent of Wolf’s denunciation of “predatory taxation.” This thinking
arises from the conviction that markets—if only left alone—will regulate themselves to
maximize welfare. This sort of thinking also leads to condemnation of taxes on capital
gains and on interest income: investment should come from the private sector, and taxing
capital gains or interest paid on savings discourages such investment.
Perhaps the economist most identified with such thinking has been Martin Feldstein, a
Harvard professor who taught both Hubbard and Lindsey. A laudatory article about
Feldstein in Fortune magazine (June 14, 2004, p. 128) suggests that Feldstein “found
40
proof” for the proposition “that tax rates set too high over a long period will discourage
savings and investment.” Much of the article is devoted to describing Feldstein’s
academic credentials and the respect and influence his academic colleagues accord him.
This article is one of dozens in the popular business press praising conservative academic
economists, and endorsing their positions on a variety of policy issues. Of course, not all
economists share views on taxation like those propounded by Feldstein and his followers.
It seems that the views of the conservative purists have received particular prominence
because they accord so well with the self-interests of the wealthy who have
disproportionate influence over the content of the financial press.
Of course, many economists disagree, and their political ideas often conflict with laissezfaire extrapolations from fundamental theory. They take the position that economics is a
dynamic field and that modern modifications of economic theory make criticism
neoclassical theory outdated. While there is some truth in this—certainly there are
economists whose theoretical ideas and empirical research are in conflict with core
neoclassical theory—the fact is that it is the traditional core neoclassical theory that gives
rise to most policy recommendations and that colors the thinking of even “liberal”
economists. In Part III, we see that ideas drawn from core neoclassical theory exert a
strong influence even on empirically-minded development economists.
Flat taxation and similar ideas, although far from universally supported by academic
economists, emerge naturally from the formal model of an ideal economy in a state of
competitive equilibrium that lies at the core of neoclassical economic theory. Economists
habitually label deviations from the competitive ideal “market failures;” policy-minded
economists strive to suggest remedies for these “failures” that will do the least damage to
the “efficient” workings of the competitive market system.9 This way of thinking of
economic activity is not merely part of the traditional culture of economics, but is
actually grounded in the mathematical formalism of neoclassical theory.
Impatience with Critics
The doctrine of free trade has a special status among economists. Far from being
controversial in the way that a flat income tax is, free trade has the allegiance of almost
every member of the academic economic community (with the exception of a small
number of development economists). Supporters range from liberal economists like Paul
Samuelson to conservatives like Feldstein. Although the doctrine of free trade is
consistent with neoclassical theory, it is much older. The universally accepted argument
for free trade, the comparative advantage argument popularized by David Ricardo at the
beginning of the nineteenth century, was briefly discussed in the last chapter. It is not
only accepted but admired. The well-known financial journalist Martin Wolf calls it
“perhaps the cleverest [idea] in economics.” (Why Globalization Works, p. 80) It has the
advantage of being not only relatively simple but is conceptually independent of the
elaborate mathematical structure of core neoclassical theory. In addition, free trade may
be adopted independently of radical changes in the existing welfare, regulatory, or
taxation systems. On both theoretical and practical grounds, the presumed virtues of free
trade have acquired the status of a near-universal truth for academic economists. This has
led them to belittle critics of free trade in a manner reminiscent of that adopted by Wolf
41
in addressing criticisms of globalization. Academic economists act as if they know that
they’re in possession of fundamental truth, and they generally lose patience when
apparently intelligent people disagree.
For example, consider Naomi Klein who has gained fame as a social critic and writer
highly critical of globalization and free trade. Here’s what the well-known (and “liberal”)
Berkeley economist Brad DeLong writes in response to Kline’s criticism of the free-trade
policies of the World Bank and the IMF:
I rage. I rage against the failures of our educational system. Did nobody ever
teach the author—Naomi Klein—that "tumbling commodity prices in Canada" is
the same thing as "cheap food for lower-class urban consumers"?…Did nobody
ever teach the author—Naomi Klein—that for more than a generation in Africa
general tax revenues have been used to pay for schools attended overwhelmingly
by the (for Africa) relatively well off? That when the World Bank pushes for user
fees for education in Africa it does so not because it wants to discourage but
encourage education? That the real blockages to education in almost all of Africa
come not because schools are too expensive but because schools are underfunded,
and have neither materials nor teachers? That user fees—as long as they are used
to buy materials and pay real teachers, rather than as excuses for cutting other
funding sources—are not an obstacle?… Did nobody ever teach the author—
Naomi Klein—that Argentina is among the richest 10 percent of recipients of IMF
loans? That if Argentina doesn't take steps to raise taxes and reduce public
expenditures it will never pay its IMF loans back?… And here, I think, the failure
is mine and that of the estate of social science teachers to which I belong. It has
been a quarter of a millennium since Brother Secondat, Brother Hume, and
Brother Smith began the project of the serious and scientific analysis of society.
The principles—general equilibrium, cause and effect, and opportunity cost--are
well-known, simple, long-studied, and powerful in their application. Yet far too
few people use them. (posting on DELong’s website, October 11, 2002)
DeLong’s diatribe typifies the response of economists to criticism of free trade.
Dismissive condemnation of populist opposition to free trade and related free-market
policies (subsumed under the title “globalization)” by credentialed members of the
economics profession such as DeLong has been a major factor over the past several
decades in making anti-globalization and protectionism practically taboo among educated
members of the general public.
The force of DeLong’s indignant criticism derives more from his academic credentials
than from the quality of his argument. In the brief passage just quoted there is much that
should raise suspicion. First, there is the claim that there is an undisputed body of core
economic principles (“simple, long-studied, and powerful…”) that should have been
taught to any educated person. Among the names mentioned as initiating the study of
these principles is “Secondat”—far better known as Montesquieu, the eighteenth century
French political philosopher most famous for defending the role of the aristocracy in a
constitutional monarchy. Montesquieu is not known as an economist, and his name is not
42
even to be found in the the well-known dictionaries of economics such as the Penguin,
MIT, or Palgrave dictionaries.
Equally strange is DeLong’s claim that the “principles” he lists are “simple.” The first of
the so-called principles is identified as “general equilibrium”. “General equilibrium” is a
theoretical term used by economists to describe, in complex mathematical terms, a
hypothetical economy in which all markets are integrated in such a way that there is
neither excess supply nor demand in any market—all goods and services, including labor,
“clear” at stable market prices. The branch of economics known as “general equilibrium
theory” is one of the more complex, abstruse, and mathematically challenging areas of
neoclassical economics. It was only in the 1950s that new mathematical techniques led to
so-called “existence proofs” for a general equilibrium10; more recent work in general
equilibrium theory requires mathematics beyond the capability of many (perhaps most)
economics Ph.D.s. It is bizarre that DeLong calls the concept of general equilibrium a
simple principle. Moreover, most economists believe that no real economic system comes
close to meeting the requirements for a general equilibrium. Thus in the context of his
criticism of Klein, DeLong’s invocation of general equilibrium must be viewed as a
disingenuous rhetorical flourish.
DeLong’s mention of the principle of “cause and effect” is equally strange. Philosophers
of science and philosophers of language continue to struggle to understand causality and
the role of causal concepts within the natural and social sciences. This is a highly abstruse
and technical debate in which there is little agreement on fundamental questions.
The relevance of the concept of “opportunity cost” is also problematic. Opportunity cost
is “the value of that which must be given up to acquire or achieve something” (Penguin
Dictionary of Economics, 304). In this context, DeLong seems to be saying little more
than that Klein ought to recognize that there is a trade-off involved in her suggestions that
IMF policies could be improved; for example, he seems to be suggesting that the losses to
Canadian farmers are being compensated by gains to Canadian consumers. Who can
disagree that an adequate analysis of any economic policy should assess its benefits and
costs relative to those of alternative policies? If Naomi Klein failed to do this, it is
appropriate to note just which benefits of the policies she is attacking are being ignored
and to compare these with the benefits and costs of whatever alternative policies she is
arguing for. But this has absolutely nothing to do with the works of the eighteenthcentury philosophers and political economists cited by Delong or with deficiencies in
Klein’s education.11
If the specifics of DeLong’s criticism are a mystery, the overall message is clear:
professional economists are in possession of fundamental truths which, if they had been
learned by the likes of Naomi Klein, would have precluded her ignorant attacks on free
trade and on institutions managed by professional economists.12 Instead of debating the
merits of Klein’s criticisms in terms of the specific economic and social conditions in
Canada or Africa, DeLong cuts off debate through ex cathedra condemnation and ad
hominem ridicule.
43
Ex cathedra condemnation of dissenters from free trade orthodoxy reaches targets
beyond popular critics like Klein. Thus we have Paul Krugman’s ad hominem attack on
“policy entrepreneurs” (Arthur Laffer, Lester Thurow, and Robert Reich) for putting
forward ideas that are said to “horrify” academic economists. Krugman—a trade
specialist and one of the more liberal members of the academic economic
establishment—describes the emotional reaction of academic economists to unorthodox
views on trade—in this case strategic trade policy—as follows:
Like medical researchers who go wild when they are equated with
chiropractors…, or astronomers confused with astrologers, the professors were
furious to find the strategic traders taken seriously. (Peddling Prosperity, 256)
Krugman goes on to mock the title of Robert Reich’s book, The Work of Nations, for the
lese majesty of mimicking the title of Adam Smith’s The Wealth of Nations.
Occasionally criticism of orthodox views on trade policy has come from a distinguished
economist. In Wolf’s chapter on finance, he noted that the Nobel-Prize-winning
economist Joseph Stigliz attacked the IMF for policies that he claims have worsened
economic conditions in Third World countries—criticism that echoes much of what
Naomi Klein and other populist critics have been saying for years. It is hardly possible to
accuse Stigliz, a distinguished academic economist with far more credentials in the
arcane economic theory than DeLong or Krugman, of ignorance. But DeLong does
manage to criticize him, indirectly, by approvingly quoting an “open letter” to Stigliz
from Kenneth Rogoff, Economic Counselor for the IMF. Rogoff’s criticism of Stigliz’s
book Globalization and Its Discontents concludes with the following remark:
Joe, as an academic, you are a towering genius. Like your fellow Nobel Prize
winner, John Nash, you have a “beautiful mind”. As a policymaker, however, you
were just a bit less impressive.
Despite its blandly patronizing tone, this is a rather vicious ad hominem attack. In
Stigliz’s case, we are told that ignorance is not the cause of his error; rather, there is the
insinuation that he, like the Nobel Prize winner John Nash, is mentally unbalanced. (Nash
is a paranoid schizophrenic.) Underlying testy criticisms like these is the conviction that
orthodox academic economists are guardians of a body of established truths on a par with
those of the natural sciences, and that those who propose policies viewed as conflicting
with these truths are scientifically ignorant, publicity seeking, or—in the case of
renegades like Stigliz—crazy.
This criticism sends the message that discussions of international trade and
globalization—in short, many of the most important issues facing humanity—are best left
to academically-trained economic “scientists” and their admirers. Non-economists are
expected to defer to the views of these experts. Those who do not—for example,
populists and “policy entrepreneurs”—deserve to be treated with the distain that natural
scientists reserve for quack practitioners of pseudo-sciences like astrology. (See
Krugman, Peddling Prosperity, 256.)
44
I am not arguing at this point that one or another of the views on trade being ridiculed by
members of the economic establishment are, in fact, correct. My point is that the attitude
of professional economists often mirrors that of journalists like Wolf. Both not only
dismiss but ridicule analyses of international trade that conflict with the orthodox
“expert” position on free trade and related policies. The roots of this are found in the
strong normative element found in neoclassical theory.
Mathematical Economic Theory and Reality
The Meta-beliefs of Neoclassical Economics
I refer to the fundamental assumptions that underlie neoclassical theory, implicit as well
as explicit, as meta-beliefs. Some of these are value-neutral, such as the assumption that
there are laws (universal generalizations) similar to the laws of physics that are true of
economic activity. Claims that economics is a “positive science” allude to this
assumption and to the assumption that economics, like physics, chemistry, and biology, is
“value-neutral,” non-subjective, and seeks general laws. In the nineteenth century, the
German philosopher Dilthey held that there were two classes of knowledge, Natural
Science (Naturwissenschaften) and Human Science (Geisteswissenschaften), the former
seeking general laws, the later dealing with particular events. Working in this tradition,
the pioneer German sociologist Max Weber held that the appropriate methodology for
Sociology and Economics was Verstehen (generally translated as “empathetic
understanding”) which utilized the scientist’s subjective understanding of human
cognition in order to arrive at valid explanations. The school of economic analysis called
historicism (also known as the German Historical School) conformed to this way of
thinking as did the American school called institutionalism whose best-known
practitioner was Thorstein Veblen. This entire conceptual structure was rejected by the
philosophical movement known as logical positivism which arose in the 1920s in Austria
and Germany. Logical positivists held that there was only one true form of human
knowledge and that was exemplified by “positive” sciences such as physics. Although the
tenets of logical positivism have long sense been abandoned as untenable by modern
philosophers of science, its approach was embraced by influential economists such as
Milton Friedman, and the overwhelming majority of economists have been trained to
think of economics as a positive science akin to physics or chemistry.
Popular defenders of economic theory often argue that one or another policy (such as a
minimum wage law) is bound to fail because it violates “the laws of economics.”
However, empirical studies demonstrate that the alleged negative consequence (e.g.,
increased unemployment) often doesn't occur. In fact, economists even debate whether
the most universally accepted economic “law”, the law that states that the demand curve
is always downward sloping (demand decreases when the price of a good increases) is
valid.
Underlying the explicit commitment to general laws is the strong meta-belief that
economics is about discovering and applying universal generalizations of one kind or
another. When universal laws cannot be found, statistical generalizations are sought after.
The latter is especially noteworthy in the studies in development economics which are
45
discussed in Part III. Typically development economists compile statistics on the
economies of dozens of developing countries and then use standard correlation and
regression analysis to arrive at (or justify) generalizations such as “the lower the level of
corruption, the higher the level of growth.” Such generalizations are far from universal;
thus the example just cited admits many exceptions since many countries with high levels
of corruption (notably China) have experienced extremely high growth rates. Additional
generalizations are then typically invoked to explain the exceptions. (These non-universal
generalizations are equivalent to what John Sutton, in his philosophical study of
economics, calls “tendencies.”) The process of using cross-country statistics to justify
generalizations leads the implicit construction of a n-dimensional space whose axes
correspond to the property Xi in a (non-universal) generalization of the form “the more Xi
the more Y” where Y is a characteristic such as economic growth. The implicit
assumption underlying the process is that a particular country’s economy may be usefully
described by locating it as a point in this n-dimensional space, that is, as an ndimensional vector. Further, it is implicitly assumed that this point lies on an ndimensional surface of points (a few of which correspond to real countries) that share the
same growth rate. None of this is explicit, but the process and the model described reflect
the thinking of many development economists. I will discuss a particularly good example
provided by the development economist William Easterly whose works have been highly
praised by Nobel-prize winning economists. The general approach reflects, in highly
simplified form, the methodology of general equilibrium theory discussed below. Thus
instead of considering the economy of a developing country in the context of its peculiar
social, cultural, and historical characteristics in order to evaluate the potential success of
various development strategies, the majority of development economists treat a country,
for analytical purposes, as a collection of values of the n properties supposedly relevant
to economic growth as indicted by cross-country correlations.
In addition to value-neutral meta-beliefs, there are other meta-beliefs which relate to
more technical aspects of the fundamental general equilibrium model and others which
are methodological in nature. But perhaps the most important meta-beliefs are various
normative meta-beliefs which belie the claim that economics is a value-free positive
science. These will be discussed later in this chapter.
General Equilibrium Theory
At the core of neoclassical economics is a mathematical theory of economic behavior that
is supposed to describe the economic functioning of individuals, firms, and markets. The
central model of this theory is a mathematical structure labeled by economists “a
competitive general equilibrium.” This model was proposed in the late nineteenth century
by Leon Walras, but achieved its current mathematical formulation only after the Second
World War. It has since ramified into a number of variants based on slightly altering
some of the basic assumptions. The mathematics of the newer variants involves game
theory and other relatively recent branches of mathematics, although all these variant
models share the same underlying conceptual structure. Jointly this area of economics is
referred to as “General Equilibrium Theory.” A number of the recently-created Nobel
prizes in economics have been awarded for purely mathematical work on general
equilibrium theory and game theory, and the vast majority of the remaining prizes have
46
been awarded for theoretical ideas rather than for empirical research. General equilibrium
theory and its variants are represented to economics students as both difficult and
profound and its developers are practically worshipped as geniuses akin to Newton or
Einstein. Most economists consider the fundamental assumptions of general equilibrium
theory to be fundamental scientific truths.
General equilibrium theory in its classic form treats human beings as purely rational
individual “agents” who have full knowledge of the prices of every good offered for sale
in the market, who have a “utility function” that assigns a relative (ordinal) numerical
value (“utility”) to each one of these goods according to its quantity, and who then spend
their incomes in such a way as to maximize their total utilities. The formal model assigns
each of the millions of goods being sold an axis in the individual’s utility space and each
point along an axis corresponds to the quantity of the good potentially consumed. The
individual’s income determines how much of one or another good may be purchased; a
possible allocation of spending among various quantities of various goods corresponds to
a “commodity basket” and each of the billions of affordable commodity baskets available
to the individual has a utility value determined by adding up the utilities of the goods in
the basket. Among all of the baskets available to an individual, some have the maximum
possible utility available to the individual given his or her income. It is assumed that by
purchasing a little less of one good and then spending the savings realized on a little more
of one or another other good the individual will be able to purchase a different basket
with same utility value as the original basket. Moreover it is assumed that there is a
continuous surface consisting of points that correspond to baskets of equal utility (for the
individual). This conception is somewhat similar to that discussed above in connection
with the way (some) development economists approach the study of economic growth
and other key concepts.
It was a tenet of logical positivism that scientific theories are mere instruments that
facilitate links between observational data, and that, as such, theories and theoretical
concepts do not model reality. Economists, in the spirit of this outdated and refuted
philosophic analysis of the natural sciences (instrumentalism) disclaim any knowledge of
what utility is, taking it merely as a construct measured by actual and potential choices
among goods offered in the market. It is almost always assumed that the greater the
amount of any product consumed by an agent, the greater the utility achieved by the
agent. Increasing income leads to increased utility since individuals supposedly spend
their income in a completely rational manner to acquire the optimal bundle of goods—the
bundle that produces the highest possible utility given the individual’s income. Crudely
put, the model is compatible with the perverse dictum occasionally heard in the nineteeneighties: “he who dies with the most toys wins.” While it is possible that some
individuals conform to this pattern—or at least subscribe to it—most people have a
diverse range of goals and motivations which are impossible to quantify and which
utterly fail to fit to the assumptions of the model. Yet in core neoclassical theory every
single individual agent functions as a rational utility maximizer with respect to his or her
purchase of commodities—the more the better.
More generally, there is a powerful meta-belief held by most neoclassical economists: the
belief that the behavior associated with buying and selling goods is amenable to rigorous
47
analysis independently of any empirical psychological or sociological study of economic
behavior. A related meta-belief is that economic activity can be usefully modeled using
relatively simple mathematical equations.
The general equilibrium model leaves no place for impulse buying, psychological
manipulation by advertising and various other “marketing” and “merchandizing”
techniques, or for the study of outright ignorant, irrational and inconsistent buying
decisions. The theory does not allow for social and cultural influences except in so far as
these affect the hypothetical utility functions. Overall, it is committed to a simplistic
model of human psychology developed in the late eighteenth century that has long since
been abandoned by the vast majority of psychologists and sociologists.
The next step in the general equilibrium analysis is to combine the utility spaces of all
individual consumers in an economy to arrive at an aggregate demand space. The great
challenge for general equilibrium theory was to show that there exists a set of equilibrium
prices which equates this aggregate demand with the supply of the various goods so that
the market for each good “clears”—that each buyer’s demands are satisfied so as to
maximum his/her individual utility and that no goods are left unsold.
Supply is dealt with by treating producers and sellers of goods as one, as a second type of
agent generally referred to as a “firm.” These agents only function is to “rationally”
maximize profits through the purchase of raw materials which are combined (expressed
mathematically by a so-called production function) to produce goods brought to market
for sale to other firms or to individuals. It is assumed that the quantity of goods produced
is that which maximizes profit. In the model, firms never make mistakes, they always
rationally produce to realize maximum profit. It is not recognized that businesses are run
by people who are individual agents who will (according to a fundamental assumption of
neo-classical theory) strive to maximize their personal utilities. It is difficult to see why
this does not lead to a contradiction as business leaders would, according to neoclassical
theory, act both to rationally increase their own personal utilities while at the same time
“rationally” making decisions to maximize their firm’s profits.
In general equilibrium theory, the word “profit” does not refer to profit as ordinary
conceived, since it excludes any competitive return on capital invested in the business
(the latter is called “rent”). Thus according to the model, firms earn no ordinary profits at
all, even though they receive “rents” related to their investment in plant and equipment.
This arises from another strange assumption—all firms are assumed to operate in a purely
competitive market in which, individually, they have no influence on the market price;
the strive to maximize profit leads each of them to set production at a level which insures
that no ordinary profit will be earned. This is because firms are always considered to be
small in relation to the entire market; monopolies and oligopolies are excluded from the
core model.
As noted, the market for each product (and there are presumably millions of products) is
in a state of equilibrium, meaning that every product’s price is just what is required to
“clear” the market: there is neither unmet demand due to too low a price, nor unsold
goods due to too high a price. The price of each good affects the demand for every other
48
good because it affects how much money individual agents decide to spend on the good
relative to how much would be left to spend on all other goods. In the early days of
neoclassical theory it was simply assumed that there was a set of equilibrium prices that
would produce a general equilibrium. The mathematical proof that in fact, under certain
very special conditions, there is indeed such a set of equilibrium prices is considered a
milestone in mathematical economics and is a source of pride for most economists.
However, this proof did nothing to confer any degree of reality on the model which
retained unrealistic assumptions about individual psychology, business functioning, and
the nature of markets, as well as the assumption that somehow the markets in an economy
will converge to the equilibrium.
Individual human behavior and social actions outside the model are treated as
“exogenous” factors—often simply classified as “shocks.” Following a shock, it is
assumed that economic activity reverts to its normal course of convergence to the
hypothetical competitive equilibrium. This way of viewing real economies—as either
moving towards or in a state of equilibrium, or as undergoing an exogenous shock—is
even more deeply embedded in economic thinking than the general equilibrium model
itself. It will be seen in Part III that it is subscribed to even by development economists
who reject much of neoclassical theory.13
The fundamental competitive equilibrium model is static, and neoclassical theory lacks a
rigorous mathematical model to explain the dynamics of convergence of a nonequilibrium market structure to an equilibrium. In fact, there is no account at all of the
processes by which an actual economy arrives or even could arrive at the idealized
general equilibrium state. In the original formulation, Walras postulated an omniscient
auctioneer who somehow instantaneously reconciled all the buy and sell offers in such a
manner as to arrive at the general equilibrium.14 Modern theory has hardly improved on
this fuzzy idea, and economics today lacks even the beginnings of a theory of dynamics
(a mathematical theory of economic change) analogous to those of physics.15
Convergence to a general equilibrium is treated as a “timeless process” (if that term even
has meaning).
It is obvious that real economies fail to resemble the idealized model. Consumers and
businesses do not act rationally, are not in possession of full market knowledge,
unsatisfied demand and excess supply are commonplace, and anything approaching pure
competition is a rarity, characteristic of very few markets. What do mainstream
economists have to say about all of this? Very little, or at least very little that reaches the
general public. Theorists label all market activity that takes place outside of a general
equilibrium “false trading” thereby impugning almost everything that happens in real
markets. Economists who deal in international trade issues narrow their conception of
real market activity by describing it in terms of “market failures.” Thus in the debate
about protectionism, instead of looking at the complex variety of conditions that may
make one or another protectionist measure desirable, attention is often narrowed to a
focus on a few alleged “market failures”—aspects of an economy which fall short of the
competitive ideal. Next, the opponent of protectionism claims that the burden of proof is
on the defender of the protectionist measure to demonstrate the existence of a market
failure and if successful in doing so, to demonstrate that the protectionist measure being
49
defended is indeed the best way of addressing that failure. I return to this in a later
chapter.
Economic Models and Empirical Data
In contrast to work in the natural sciences, in which competing theories are constantly
being tested, in economics theoretical work is generally disconnected from empirical
work. Theoretical work proceeds without confronting empirical data and empirical
studies often make only token reference to theory. This applies not merely to the abstract
mathematical equilibrium models of neoclassical theory, but also to sophisticated
statistical models developed in the sub-field known as econometrics. The philosopher of
economics Alexander Rosenberg quotes the well-known economist Wassily Leontief as
saying, in his 1970 presidential address to the American Economics Association, “In no
other field of empirical enquiry has so massive and sophisticated a statistical machinery
been used with such indifferent results.” (Rosenberg 64) Twelve years later, writing in
Science, Leontief concluded
Year after year economic theorists continue to produce scores of mathematical
models and to explore in great detail their formal properties; and the
econometricians fit algebraic functions of all possible shapes to essentially the
same sets of data without being able to advance, in any perceptible way, a
systematic understanding of the structure and operations of a real economy. (67)
He went on to note that a content analysis of the leading journal in economics showed
that during a ten year period over 50% of the papers elaborating mathematical models
omitted data and that 22% more used only indirect statistical inferences from previously
published data.
The arcane mathematics employed in fundamental economic theory has given economists
a sense of superiority over other social scientists. It has served to enhance their scientific
credentials and to insulate economic theory from criticism by the uninitiated. Clearly,
mathematical expression is not sufficient to create a scientific theory. Undoubtedly if
there were high-paying and prestigious university chairs available to astrologers, and
Nobel prizes awarded for work in astrology, in a generation or two we might encounter
highly intelligent, articulate, and mathematically competent academic astrologers. Some
of these distinguished astrologers will have developed new astrological methods and
theories using abstruse mathematical techniques. Defenders of astrology could then cite
this work in defense of “astrological science.” The point is not that economics is a
pseudo-science (although I believe that to be the case), but that mathematical
sophistication is not, in itself, evidence that an academic discipline is a “real science.”
The principal barrier to effectively criticizing neoclassical economics is the forbidding
complexity of the mathematics used in formulating its theories. Fortunately for the
present work on free trade and globalization, the principal theoretical argument for free
trade offered by economists and economic and financial journalists is among the least
technical in modern economic theory, and the arguments for protectionism (and supposed
refutations of these arguments) are not much more difficult. In Part II, I present these
50
arguments and discuss them in a manner comprehensible to patient readers, without
recourse to anything more than arithmetic and a little elementary algebra.
The Normative Nature of Economics
One striking difference between mathematical economic theory and mathematical
theories in a natural science like physics is that many of the meta-assumptions implicit in
neoclassical economic theory are imbued with a normative valuation despite repeated
claims that economics is a “positive science.” I will refer to these assumptions,
considered as a group, as the “normative meta-belief system of orthodox economics.” I
call this a system because these shared assumptions comprise both value judgments and
factual assumptions that are shared among those indoctrinated in neoclassical theory.
For example, despite repeated claims that economics is a positive (not a normative)
science, a majority of academic economists extol “free” markets and deplore government
intervention in market activities except to correct “market failures” in a manner that
minimally departs from the laissez-faire ideal. Moreover, the core model of a competitive
general equilibrium is treated as far more than an idealized model analogous to models in
physics such as the model of an “ideal” gas. When physicists use the term “ideal” to
describe a simplified model of a gas, there is absolutely no conception of there being
anything normatively superior about the model or the “ideal” gas. In fact, the term is used
to describe something that does not exist at all, a mere mathematical construction
designed to facilitate certain kinds of calculations. But when economists speak of a
“competitive equilibrium,” they almost universally conceive of it as a normatively
superior market structure that is possible, or at least that close approximations are
possible. This explains the use of pejorative language such as “false trading” and “market
failures” to describe economic activities that fail to conform to the ideal. Of course
economists (for the most part) recognize that real economies fall short of the ideal.
However, they also believe that the closer an actual economy approaches the idea
competitive equilibrium, the better it is.16 Organizations, governments, and policies that
move economies away from the ideal are often labeled “predatory”—an adjective that
reflects the strong normative commitment to the competitive laissez-faire model. The
implicit belief in the normative superiority of a competitive equilibrium is probably the
single most important normative meta-belief of orthodox neoclassical theory. It works
powerfully (generally without acknowledgement) in support of free-market policy
recommendations for the supposed enhancement of the general welfare—thereby belying
explicit claims that economics is a positive science without normative commitments.
Normative meta-beliefs in economics are sometimes inconsistent. For example, the metabelief that purely competitive markets operating under laissez-faire governmental
policies are normatively superior has led to the condemnation of “predatory” labor union
activity and “predatory” progressive taxation. Such moral indignation is inconsistent with
the assumption of the model that individual agents rationally strive to maximize personal
utility (and often economists hold that individuals should act to maximize utility!), which
of course union members are doing in striking for higher wages and what voters (at least
some voters) are doing when they vote in favor of progressive taxation.
51
Another normative meta-belief relates to business organizations; in this case, an
underlying assumption (explicitly held by economists) is that all business activity is to be
interpreted as dedicated to the rational maximization of profit. This is not one of the
value-neutral meta-beliefs discussed earlier because it is so obviously untrue given the fct
that in addition to profit making most businesses strive to serve their employees, their
customers, and the communities in which they operate even when these goals conflict
with profit maximization. There is a normative judgment involved in the idea that that
profit maximization is what businesses should do, and that business executives who do
otherwise are somehow betraying the business’s owners. But one thing that business
executives have often done, not surprisingly, is to pay themselves exorbitant salaries that
cut into corporate profits. The general public condemns them for doing so, not so much
because they are failing to maximize profits but because they are acting selfishly.
(Business executives are seldom condemned for making charitable contributions or for
paying above-market wages.) Economists often join in the general criticism of exorbitant
executive salaries, but their concern is that the executives are failing to maximize the
firm’s profits. It was noted earlier that this reveals a seldom-acknowledged contradiction
since the psychological model of the individual agent applies to business executives as
well as union members and voters; as rational individual agents they are expected to
maximize their personal utilities. Economists have recognized the problem and give it a
name—the “agency problem”—but they have offered no solutions compatible with
fundamental neoclassical assumptions.
The normative value assigned to a competitive market structure leads to the belief that
firms should operate in a purely competitive market that consists of firms individually too
small to affect the market price. Monopolistic practices are then excoriated. All of these
normative beliefs belie the repeated claims by leading economists that economics is a
“positivistic” or value-free “science” like physics or chemistry.
Economists generally share a number of other normative meta-beliefs, such as the belief
that the less government interference in any particular market, the better from the
standpoint of general welfare. But this goes far beyond the mathematical theory which
has little to say about market structures that fall well outside the competitive equilibrium
ideal. Not all economists understand the complex mathematical models that lie at the core
of modern neoclassical economic theory, but almost all share the normative meta-belief
system. For this reason, it is plausible to maintain that the normative meta-belief system
is more central to economic orthodoxy than the mathematical models themselves.17
Finally, it should be noted that there are a number of other meta-beliefs that relate to the
methodology of economics. These include the commitment to “comparative statics,” the
analysis of economic activity in terms of a return to a (presumptive) equilibrium
following an exogenous shock; the assumption that simple graphical techniques are
useful tools of analysis; the assumption that a variety of inconsistent models are useful
tools of analysis since each provides insight into one or another aspect of economic
reality; the very basic belief that mathematical theories (not confined to traditional
general equilibrium theories) are useful devices for describing real economic activity; and
most general of all, the belief that simple universal generalizations are useful in
constructing specific economic policies. The way each of these fundamental beliefs
52
affects the work of even the best development economists will be discussed later in this
book.
Economics and General Welfare
If we take seriously what orthodox economists have said about the nature of economics
as a positive science and in particular what they have said about the impossibility of
interpersonal comparisons of utility (or welfare), then their nearly unanimous enthusiasm
for the welfare benefits of free market policies is somewhat surprising since it is a
fundamental tenet of neoclassical economic theory that the concept of general welfare is
illegitimate--at least within the context of economic science. Orthodox economists often
assert that economics is about means, not ends; this accords with their view that
economics is a value-free “positive” science. Neoclassical economic theory holds that
individuals seek to maximize their individual utility (or welfare) through “rational”
spending on commodities. An individual’s utility is known only as revealed in the
individual’s preferences—that is in the individual’s actual and potential choices among
goods offered for sale in the market. Interpersonal welfare comparisons are ruled out, and
thus there is no means of aggregating the welfare of individuals to arrive at a measure of
general welfare. It is held that only a market structure in which no one is worse off than
he or she would be in another market structure can be said to constitute an improvement
on it. This sort of ordering of market structures, which disavows interpersonal welfare
comparisons, is based on the concept of a Pareto Improvement (named after the
pioneering neoclassical economist Vilfredo Pareto).18
In the case of free trade, economists universally acknowledge that there will be losers as
well as winners when a country reduces or eliminates tariffs or other protective measures.
Since the advocacy of free trade (and related policies) is based on its purported role in
enhancing general welfare despite the creation of losers, such advocacy lacks any basis in
fundamental economic theory. Strictly speaking, policies such as free trade must be
defended from some different perspective—perhaps a sociological perspective—that is
quite alien to the conceptual foundations of neoclassical economic theory.
The concept of general welfare that economists, especially trade and development
economists, implicitly subscribe to is little more than the concept of individual utility
aggregated (in some unexplained manner that lies beyond economic theory). It subscribes
to the same assumption that is made in the case of individual utility, that an increase in
consumption of goods—by a society—represents an increase in general welfare. It tends
to impose on all societies the same welfare standard regardless of the cultural values of
the society.
A explicit statement of the acceptance of interpersonal welfare comparisons is given by
the economist Herman E. Daly in response to a letter that attacked Daly’s claim that the
marginal utility of a dollar spent on the poor is greater than that of a dollar spent on the
rich. Daly writes
Most people feel that a leg amputation hurts Jones more than a pinprick hurts
Smith. We make interpersonal comparisons of welfare or utility all the time on the
53
democratic assumption that everyone has basically the same capacity for pleasure
and pain. We do not need an objective “utilometer.” Add to that the law of
diminishing marginal utility of income (we satisfy our most pressing needs first),
and it follows logically that an extra dollar of income is of more utility to the poor
than to the rich.
Here we see the acceptance of interpersonal welfare comparisons—which justifies the
concept of general welfare—combined with acceptance of the alleged neoclassical “law”
of diminishing marginal utility which is, at best a rough generalization with many
exceptions. The reason most people feel compassion for the poor is unrelated to the
concepts of marginal utility coupled with interpersonal comparisons of utility as
understood by economists. Arguing as Daly does would seem to justify some form of
extreme egalitarian ethics such as that advocated by some philosophers. Daly’s choice of
pleasure and pain to illustrate interpersonal utility also reflects the general attitude of
economists that agents are essentially interchangeable, thereby justifying the conception
of general welfare as maximization of consumption as well as the one-size-fits all
prescriptions for improving general welfare in a variety of societies.
It is important to recognize that there is a conflict between the theoretical strictures
against interpersonal welfare comparisons and the concept of social (aggregate) welfare
on the one hand and the meta-belief structure of economics that attaches a high normative
valuation to certain kinds of economic structures on the other. In fact, some have even
viewed neoclassical theory as a kind of secular religion. Certainly the early classical
economists who fought against the English corn laws saw themselves as dealing with a
question of social welfare. William Easterly speaks of the “quest” of economists to create
growth with the end of alleviating poverty and suffering as a “moral mission:” “As long
as there are poor nations suffering from pestilence, oppression, and hunger... the quest
must go on.” (xiii)
Daly, like most other economists, shares the nearly universal compassion for those living
in serious poverty. The elimination of poverty has been perceived as an important welfare
goal by economists—a topic explored in Part III. But attempts to provide a justification
for this effort in terms of fundamental neoclassical theory are unconvincing. Fundamental
neoclassical theory rules out interpersonal welfare comparisons and relegates
distributional issues to the political sphere.
Normative Meta-beliefs and Economic Policy Recommendations
The normative meta-beliefs held by neoclassical economists have a number of
consequences in terms of policy recommendations. The belief in the superiority of a
competitive market in a state of equilibrium leads to extravagant talk of “the magic” of
the market and of “market solutions” to a host of economic problems.19 This is coupled
with a visceral contempt for almost every kind of governmental action, especially actions
involving market interventions—regulation, subsidies, tariffs and other protectionist
measures, and taxation (especially progressive taxation). An amusing illustration of the
force of this contempt of government is provided by the website of the Xavier Sala-iMartin, a well known trade economist at Columbia University. To the accompaniment of
54
music, visitors to the website are treated to a slide show of amusing government errors,
such as a variety of misspelled road signs.
One important policy consequence relates to the relative weight placed on lower
consumer prices versus decreasing unemployment in assessing welfare. The neoclassical
assumption that all normal markets clear, including the labor market, leads to a relative
neglect of unemployment which is treated—at least by hard-core neoclassical
economists—as illusory or as a temporary condition that will naturally disappear as the
economy returns to an equilibrium state. This, combined with the identification of
welfare with the consumption level has led to a consistent overvaluation of low consumer
prices and undervaluation of unemployment. Generally, there is relative neglect of the
psychological effects of unemployment and relocation, as well as a relative neglect of the
social and monetary costs of relocation, retraining, and other issues arising from
unemployment. One of the key themes of this book is that it is essential to weigh heavily
the effects of various trade policies on employment.
Free-market solutions go well beyond recommendations of deregulation and
privatization. For example, they include enthusiasm for “pollution credits” as the
appropriate means of reducing environmental pollutants. The belief in the self-regulating
nature of markets which, if only left alone, will match supply and demand, thereby
maximizing welfare, has led to neglect of the problem of chronic unemployment that
concerned the previous generation of economists influenced by unorthodox Keynesian
ideas. The belief that maximizing consumption to arrive at a higher “utility surface” is an
appropriate model of human psychology leads to an emphasis on consumption and a
relative devaluation of the psychological importance of employment and, in particular, on
the quality of work. The belief in the rationality of consumers leads to the illusion that
advertising is a means of imparting information to rational consumers (illustrated by
various policy directives of the United States Federal Trade Commission that pre-empted
state restrictions on various sorts of professional advertising; only those blinded by
ideology would contend that most television commercials contribute to rational
purchasing decisions). The belief that corporations should be single-mindedly dedicated
to maximizing profits led economists to recommend stock option plans for corporate
managers that resulted in the corporate corruption scandals of the past decade. And, I
shall argue, the dogmatic support of economists for free-market policies have resulted in
economic debacles in Russia, Bolivia, Argentina and other countries.
Adam Smith and Neoclassical Theory
The origins of the normative meta-belief in the benefits of a competitive general
equilibrium for general welfare of a competitive equilibrium predate the late nineteenth
century “neoclassical revolution” that produced the mathematical concept of a general
equilibrium. The ancestral concept is that of a free-market (or laissez-faire) economy
described in the writings of Adam Smith and other classical economists such as James
Mill and David Ricardo. Smith’s and Ricardo’s views, commingled with the formalism of
neoclassical theory that assigns a central role to the model of a competitive equilibrium,
have been inculcated into economists as part of their professional training. But the wellturned phrases of The Wealth of Nations far better serve the interests of popularizers of
55
free-market ideas than the highly abstract mathematical models of modern neoclassical
theory. As will be seen, there is a kind of intellectual dishonesty at work here. Academic
economists, for the most part, are well aware of the deficiencies of arguments taken from
the classic economists like Smith and Ricardo, yet they continue to praise these
arguments in their popular writings. The true source of their convictions is the normative
value placed on the neoclassical model of an economy in a state of competitive
equilibrium and all the related normative meta-beliefs of the profession.
“Best Practice” Institutions
Modern economics encompasses a broad range of specializations, and the meta-belief
structure of orthodox economics exhibits a number of variations according to the area of
specialization. In particular, many economists concerned with economic policy, including
trade and development policy, have moved beyond the core model of a competitive
equilibrium to embrace views on the institutional structure of superior economies. Central
to these views are normative beliefs about “best-practice” institutions: institutions such as
a judicial system that protects private property rights and that enforces contracts; a
financially transparent banking system; taxation systems that are moderate without high
marginal rates (which are held to discourage work and investment); fiscal conservatism
(to guard against inflation); minimally regulated markets free of government ownership
or interference; and a general freedom from corruption. The institutional approach gained
momentum after the striking failures of the “shock liberalization” policies recommended
by economists to the governments of the former Soviet republics in the early 1990s; the
failures were not due to neoclassical theory but to the failure of these societies to have the
appropriate institutional structures.
The concept of a unique set of “best” (or “best-practice”) institutions supposedly is
related to the idealized model of a competitive market structure. However, the model
itself has nothing to say about the role of governmental or social institutions. Rather, the
extension of the meta-belief structure of neoclassical economics to include a theory of
“best practice” institutions may be seen as an attempt to reconcile the abstract
competitive equilibrium model with the social and political realities of successful modern
industrialized economies of North America, Europe, and Japan. However, the idealized
institutions lauded by economists hardly conform to the diversity of real institutions that
exist in these varied economies; and the economies themselves hardly resemble the
underlying model. In every case, their markets are dominated by large firms with power
over pricing, their consumers are “irrationally” influenced by advertising to act contrary
to utility maximization, and their governments interfere in economic activity at all levels.
Many of the institutions in these economies differ markedly from the ideal. For example,
the banking system of Switzerland hardly exemplifies transparency; Sweden and other
successful economies impose high marginal tax rates; France and Japan (and Singapore)
exhibit a large degree of governmental interference in the economy; Germany insures that
unions have unprecedented power to affect the operation of private firms; and corruption
is rampant in Italy and various other industrialized nations. The conflict between the
theory and reality will become obvious when we examine various case studies of national
economies. Despite these studies, according to the conventional wisdom of the majority
56
of development economists, the key to economic success (i.e. growth) is the adoption of
best-practice institutions, in particular institutions that protect private property rights.20
Like the focus on so-called “market failures,” the focus on best-practice institutions
narrows the scope of inquiry into policy changes that might promote economic welfare in
a particular economy. For example, population control is surely one of the most critical
issues for a number of Third World economies, but one will look far and wide for any
mention of family planning as a best-practice institution. Economists tend to treat
population control as a passive consequence of correct economic policies. Apply our
recommended free-market reform policies, they say, and economic growth and prosperity
will ensue; and then with prosperity will come female education and family planning. But
although such changes in fertility rates may eventually occur, they may arrive very late
when the population has already reached levels that cause several social, economic, and
environmental problems. Cultures favorable to family planning did not wait for
prosperity, and examples of successful governmental intervention into family planning
such as China demonstrate that an activist policy can produce favorable economic results.
Family planning is only one example of an important factor that is omitted from the
orthodox neoclassical approach to economic policy. However, as we will see, economists
specializing in development do address social factors including family planning, female
education, the ethnic composition of a society, and traditional social arrangements. But in
doing so, they are venturing beyond the assumptions of neoclassical theory, and in many
cases their discussion is colored by the neoclassical conceptual structure.
Conclusion
In a well-regarded book analyzing the nature of economic theorizing21, John Sutton
writes that the student who comes to economics for the first time is apt to raise two
questions: first, how economists justify assuming that people rationally choose behavior
that maximizes their goals (utility) when people are so obviously inconsistent and
irrational; and second, how economists can reduce the discussion of messy and complex
issues involving the actions of millions of people to some simple mathematical model.
Sutton then notes that after students have advanced in their economic studies for a couple
of years, both questions are forgotten: “those students who remain troubled by them have
quit the field; those who remain are socialized and no longer ask about such things.”
(xv)22 Professional economists rarely question the reality of their assumptions about
individual economic behavior, about the functioning of business organizations, or about
market activity. They rarely question the welfare benefits of policies purported to move
real economies closer to the competitive ideal. And although economists involved in
practical policy issues may consider a number of relevant social factors ignored by
neoclassical theory, their manner of analyzing these factors is often distorted by
neoclassical assumptions.
For non-specialists, the really bad news is that popular discussions of globalization, like
Wolf’s, feature doctrinaire defenses of free-market policies framed in traditional
neoclassical terms. This approach suffers from three fundamental deficiencies. First, the
fundamental neoclassical models of the individual, the business organization, and the
market are artificial constructions that bear little relationship to reality. Second, these
57
models—and especially the market model—are imbued with normative values. In the
case of the market model, this leads to a strong moral commitment to policies alleged to
move real markets in the direction of the laissez-faire ideal. Third, the variety of social,
cultural, and economic factors relevant to economic development is narrowed and
distorted by the neoclassical conceptual system which limits them to what are called
“market failures” of one kind or another.
There are important case studies of economic development that venture far beyond the
doctrinaire assumptions of the doctrinaire defenders of globalization, but these are
relatively unknown to the general public. In Part II, I first discuss the alleged theoretical
support for free trade, then review in some detail orthodox economists’ “refutations” of a
number of arguments for protectionism. In Part III, I turn to the empirical data relevant to
trade policy; it is in this section that various case studies are reviewed. At the end of this
book, I make some tentative suggestions regarding trade policies for various kinds of
national economies.
58
Part II
Theoretical Arguments For and Against Free Trade
59
Chapter 3
The Comparative Advantage Argument for Free Trade
The Context of Discussion
Since economic theory is so often described as “scientific” in the same sense that theories
of physics and chemistry are, it is not surprising that a public educated to respect
scientific knowledge would give great respect to claims based on economic theory. The
mathematical difficulty of modern economic theories effectively protects them from
criticism by outsiders. This confers upon the policy recommendations of economists an
elevated status that these recommendations would lack if they came from outside the
economics profession. The pattern of deference to supposedly scientific theory may be
seen in popular defenses of free trade and other free-market policies which are discussed
in the context of globalization. However, there is one important difference between free
trade and many other free market policies advocated by economists: despite frequent
claims to the contrary, the principal theoretical argument for free trade is relatively
simple and can be formulated without the use of complex mathematics. Similarly, a
number of the arguments against free trade and for protectionist policies are only a little
more difficult. This means that arguments both for and against free trade can be presented
to educated readers and these readers can reach intelligent conclusions without relying on
the authority of economics professors. This chapter is devoted to a discussion and critique
of the principal argument for free trade, comparative advantage, and the following
chapter discusses several theoretical arguments for protectionism along with supposed
refutations. I want to make clear at the outset that I do not believe that much weight
should be given to any general theoretical argument for one or another universal
economic policy because I firmly believe that only informal common-sense reasoning
that takes account of the social, political, cultural, and economic conditions in a particular
society can lead to optimal economic policies. However, the comparative advantage
argument is presented as a slam-dunk general argument for free trade by economists and
journalists, and its deficiencies should be pointed out. It is similarly important to assess
the strengths and weakness of the much less well known arguments for various kinds of
protectionism. General arguments for or against free trade can help suggest policies
which may be suitable for one or another national economy given its unique social,
political, and economic conditions.
Free trade is the centerpiece of the liberal market ideal lauded by Wolf and others, and
the fundamental argument for free trade is called the comparative advantage argument. It
is so often referred to by economists as well as journalists in their popular writings that it
is worthwhile enduring some rather tedious examples that use arithmetic and simple
algebra to explore its assumptions and consequences in depth. If comparative advantage
fails as an argument for free trade—and it does fail—then the whole debate about trade
policy is opened up to a variety of arguments both for and against specific trade policies.
It is a central theme of this book that there is no single policy prescription for economic
success. The particular trade policy or policies that are optional for a country depends on
very specific social, cultural, geographic, and economic conditions which vary greatly
60
from country to country. Protectionism of one kind or another is an important ingredient
of many of these optimal policies. But if the arguments for this conclusion are to be taken
seriously, it is first necessary to refute the claims made on behalf of the comparative
advantage argument, since defenders of free trade have claimed that it trumps all
arguments for protectionist policies.
Before plunging into the details of the comparative advantage argument, it is important to
clarify several issues. These may be introduced through consideration of the following
questions: 1. What constitutes free trade? 2. In what ways is free trade held to be superior
to alternatives? 3. For whom is free trade held to be the best policy? And finally, 4. Why
is free trade beneficial? I’ll discuss these in turn.
What constitutes free trade? In the most general sense, free trade is trade that would take
place if there were no government policies that alter market structure from that which
would exist if there were no national boundaries. This means, at a minimum, no tariffs or
quotas on the import side and no subsidies (“bounties” was the older term), or other
policies designed to increase exports. In the past, these conditions alone have been taken
as constitutive of free trade. Under this rather narrow conception, free trade was
considered to be compatible with fixed currency exchange rates, achieved through
pegging currency values to precious metals or though international agreements on
exchange rates. When the gold standard prevailed, it was generally believed that allowing
a free flow of bullion between nations would soon alter either exchange rates or domestic
prices so as to insure a long-term trade balance within a national economy.23 In recent
years “overvalued” or “undervalued” currencies have been held to cause a “market
distortion” that is strictly incompatible with free trade, and a case has been made that free
trade requires floating exchange rates.24
A second problematic issue concerns capital flows. Since the advocacy of free trade is
part of a more general advocacy of free markets, advocacy of free trade has generally
been accompanied by advocacy of the free movement of investment capital between
national economies. The possibility of free movement of capital across national borders
was discussed by Ricardo who saw such movements as affecting trading relationships.
But Ricardo also held that such movements were unlikely to be great because of a
predilection by investors to invest in their home countries. (Principles, p. 95) This
assumption certainly does not hold today. Current discussion focuses on the type of
restriction, if any, that should be imposed on international capital movements. Naïve
endorsement of free capital flows has given way in recent years to criticism of the role of
short-term speculative investments in triggering or at least aggravating the Asian
financial crisis of 1997-8. (See the discussion in Stigliz, Chapter 4, 89-132.)
A third issue concerns the free flow of labor between industries across international
borders. Logically, freedom from immigration controls is a part of free trade since in
orthodox economic theory labor is viewed as a commodity. Some current advocates of
free trade—notably the well-known economist Jagdish Bhagwati—have extolled the
benefits of immigration, but none that I know of has endorsed unrestricted immigration.
61
Since theory would dictate absence of barriers to immigration, this is perhaps due to
political rather than economic considerations.
These three issues demonstrate that free trade is a fairly loosely defined concept which is
rarely equated with the truly open trade that would result if there were no national
boundaries. In general, modern economists associate certain free-market conditions such
as floating exchange rates and free movement of capital with free trade, while others,
such as unrestricted immigration, are generally held to be distinct.
In what sense is free trade supposed to be superior to alternatives? In considering how
free trade is superior to alternatives, one must go back to the fundamental conceptual
structure of neoclassical economic theory. According to that conceptual structure,
individual agents are seen as single-mindedly maximizing the intangible something called
“utility” through spending their resources (“endowments”) on commodities in amounts
that define what is called “an optimal commodity bundle.” Aggregating all of these
individual optimal commodity bundles gives the aggregate consumed wealth of the
economy, and under neoclassical “market-clearing” assumptions this is equivalent to the
aggregate of produced wealth (with allowance for the purchase of some commodities by
firms to use in production). Almost all arguments for free trade rely on the identification
of welfare—individual, national, or global—with the maximization of productive output
and the consumption of that output. On the other hand, arguments against free trade have
often focused on other values—national security, preservation of culture, employment,
stability, etc. In general, economists have dismissed such arguments as beyond the scope
of economics. This is one aspect of the meta-belief structure of neoclassical economics:
maximization of the production and consumption of priced goods is equated with
maximization of general welfare. Free trade is held to be superior to alternatives because
it is held to maximize (potential) consumption of priced goods.
For whom is free trade the best policy? There are a variety of possible answers. It has
rarely if ever been claimed that everyone benefits from free trade (in the sense of having
greater wealth); and this is not a position taken by serious free trade advocates, although
popularizers such as Wolf and Thomas Friedman sometimes write as if they believed this
to be true (displaced factory workers will acquire new, higher paying jobs). At the other
extreme would be the claim that overall wealth of the world is enhanced by free trade
without any claims as to the distribution of that wealth among nations or individuals. In
fact, this claim for global enhancement of wealth is often made simply as a consequence
of an increase in the division of labor under free trade. Thus Paul Samuelson, in his
famous economics text book, quotes John Stuart Mill: “The benefit of international
trade—a more efficient employment of the productive forces of the world.” (3rd edition,
p. 633)
However, the comparative advantage argument for free trade goes beyond the mere claim
of a global benefit from a maximal division of labor to conclude that each nation
participating in free trade stands to benefit in the sense that its national wealth would be
increased under free trade. More precisely, the argument holds that each nation involved
in free trade benefits in the sense that it will enjoy a higher level of national wealth under
free trade than it would under autarky (the system of producing everything domestically).
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And this immediately exposes a problem that will be discussed later, the absence of
comparisons of pure free trade with international trade under a variety of protectionist
policies that fall far short of creating autarky. Leaving this problem aside, the power
claimed for the comparative advantage argument is that it purportedly shows that even a
nation which is less efficient (in the sense of having higher unit production costs) with
respect to the production of every product can engage in mutually beneficial trade with a
nation which is universally more efficient. Thus it is held to be more powerful than the
division-of-labor argument for free trade which merely concludes that the world’s wealth
is greater under a regime of free trade because such a regime maximizes the dividiaon of
labor across national borders. The division-of-labor argument does not allay the fears of
those who fear that their own country might be a loser despite an increase in global
wealth.
What about the individuals and groups within a nation? Here economists generally agree
that there will be winners and losers when a country moves towards freer trade. In fact,
economists usually attribute agitation for protectionist measures to the self-interested
politicking of potential losers. These views were clearly seen in the great parliamentary
debates of early nineteenth-century England over revocation of the Corn Laws that
protected English agriculture from cheaper foreign grain imports. One proposed means of
addressing the problem of prospective losers was compensation. In recent years this idea
has been elaborated in an attempt to provide a somewhat technical neoclassical rationale
to deal with the problem of losers through the introduction of the doctrine of opportunity:
the greater abundance of goods and services on a national level resulting from free trade
creates the opportunity for a politically mandated redistribution of wealth, which
constitutes a “Pareto improvement” over autarky (no one is worse off, some are better
off). That is, each individual ends up with a commodity basket at least equal (in terms of
the individual’s utility function) to that received under the previous autarky, and at least
some individuals end up with baskets superior to those received under autarky. (As we
will see, this kind of argument introduces a host of other problems into the analysis.)
To summarize: free trade is claimed to benefit each nation engaging in it, but not all
individuals or groups within each nation—at least not without governmental
redistribution of goods.
Why is free trade beneficial? The simple answer is that it increases general welfare,
defined in terms of greater production and consumption of goods and services. This
incorporates the normative assumption that the presumptive increase in goods and
services actually does produce increased welfare as commonly understood. This is not
only a problem with the materialistic assumption that greater consumption means greater
happiness, although that is a valid concern. It also relates to “negative externalities”—the
graceless term used by economists to refer to all of the unfortunate byproducts of the
production and consumption of goods. These include obvious things like pollutants that
cause disease, environmental degradation, highway congestion, disruptive social changes,
and negative aesthetic effects on the human and natural environment. In general, critics
of globalization appear to place far more value on these negative externalities than do
orthodox economists, for whom it often appears that increased wealth greatly outweighs
the negative consequences of increased production and consumption.
63
David Ricardo’s Presentation of the Comparative Advantage Argument
The division-of-labor argument for free trade is generally accepted as valid. Even critics
of free trade agree that extending the division of labor across national boundaries has the
potential to increase aggregate output beyond the sum of the outputs of individual nations
functioning as isolated autarkies. It is tempting to conceive of the specialization of
nations as analogous to the specialization of persons, and this is the starting point for
Ricard. By this reasoning, nations benefit from trade by specializing in activities in which
they, by virtue of climate, natural or human resources, have an advantage over other
nations. But if a country possesses few or no advantages, can it still benefit from trade?
This question reveals a concern about winners and losers on a national level. The
mercantilist thinking that dominated discussions of trade prior to Adam Smith gave
priority to the maximization of national wealth over aggregate global wealth. It was
assumed that even if free trade contributed to global wealth, most countries would be
better off if they pursued protectionist trading policies that focused on the nation’s
accumulation of gold and silver bullion.
The classical statement of the comparative advantage argument found in Chapter VII of
David Ricardo’s Principles of Political Economy and Taxation, published in 1817
(although Ricardo was anticipated by his contemporary Robert Torrens). Ricardo’s
discussion of international trade is actually much broader than the comparative advantage
argument which occupies only a single paragraph. Among other trade issues, Ricardo
discussed dynamic factors such as technology change and economic growth, factors that
are omitted from the usual presentations of the comparative advantage argument. But the
power of the comparative advantage argument—in the version based on Ricardo’s
original presentation—lies in its simplicity. Despite claims to the contrary, it is readily
understood by beginning economics students and by many political decision-makers.
The intuitive basis of the argument can be found in an observation by Ricardo on
occupational specialization among individual workers. The idea was briefly given in a
footnote:
Two men can both make shoes and hats, and one is superior to the other in both
employments; but in making hats he can only exceed his competitor by one-fifth
or 20 percent, and in making shoes he can excel him by one-third or 33 percent;—
will it not be for the interest of both that the superior man should employ himself
exclusively in making shoes, and the inferior man in making hats? (95, footnote)
This one-sentence example gives the essence of the comparative advantage argument,
and it hardly seems to justify claims by economists that the argument “deep,” “counterintuitive”, and a “theoretical discovery of economic science.” In fact, a common way of
introducing the argument in popular presentations is by citing the “Nobel laureate Paul
Samuelson” who is alleged to have made such extravagant claims. According to a leading
text book, Samuelson is said to have proclaimed comparative advantage to be “the best
example he knows of an economic principle that is undeniably true yet not obvious to
intelligent people.” (Quoted in Krugman and Obstfeld, 11. There are several variants of
the story, all involving Samuelson.) The authors then claim that this arcane argument
64
“demonstrates” the superiority of free trade and to that it refutes “myths”—such as the
“myth” that American workers may not be able to compete internationally in any area of
production with cheap foreign workers.
Few economists (or journalists) spend much time spelling out the comparative advantage
argument in detail in their popular defenses of free trade. It is worthwhile doing so. The
argument assumes a single factor of production, labor. Early versions of the argument
relied on a labor theory of value, asserting that (for example) even if England could
produce corn a little more cheaply than Poland, it would be better off shifting labor from
corn production to cloth production where it is much more productive than Poland. Doing
so would be, in effect, to trade the additional cloth production resulting from the shift of
labor for a greater amount of Polish corn than could have been produced in England with
the labor that was shifted to cloth production. Or, as it was commonly put, the shifted
labor indirectly produces a greater amount of corn (via trade with Poland) than it would
have produced if directly employed on English farms.
Ricardo provided a specific example using hypothetical labor cost values for wine and
cloth production in England and Portugal. Suppose that one gallon of Portuguese wine is
produced with 80 units of labor whereas 120 labor units are required to produce a gallon
of English wine; and suppose that 90 Portuguese labor units are required to produce a
yard of cloth whereas 100 English labor units are required to produce a yard of cloth in
England. (We may take labor units as minutes of worker time per unit output; I will use
this interpretation in later examples.) In Ricardo’s example, Portugal is more efficient
than England in the production of both cloth and wine; because fewer labor units are
required to produce each product, Portugal is said to have an absolute advantage over
England with respect to the production of both products. But Portugal’s advantage over
England is greater in the case of wine production than it is in cloth production. This can
be seen by looking at ratios. The ratio of labor needed to produce a unit of cloth in
England compared to that needed produce a unit of wine in England is 100:120 (= 5:6)
which is less than that in Portugal (90:80 or 9:8). Relatively speaking, England is better
off producing cloth than wine even though it is still less efficient in cloth production than
Portugal. But England is even worse off with respect to wine production. Economists say
that England although England has an absolute disadvantage in cloth production
compared to Portugal, it has a comparative advantage.. Conversely Portugal has a
comparative advantage in wine production; here we look at the ratio in the other
direction: 8:9 is less than 6:5. Portugal is analogous to the “superior man” cited in
Ricardo’s footnote, the man who rationally decides to work exclusively in making shoes
because he has a comparative advantage in doing so, while the “inferior man” makes hats
exclusively because he has a comparative although not absolute advantage with respect to
hat-making. And like the shoe-maker and hat-maker, Ricardo claims that Portugal and
England are thus motivated to abandon autarky in favor of international trade, with
Portugal using its entire labor force to produce wine and England its entire labor force to
produce cloth.
A number of assumptions are required to complete the analogy between nations and
individuals. First, the argument assumes that within a country, workers can move freely
between industries, and are motivated to stay or move solely by their hourly wage rate.
65
This insures that within a country wages equalize between industries—equal wages rates
are a key assumption of the model. As noted, it is also assumed that there is only one
“factor of production,” labor, and hence that the cost of the labor used in producing wine
or cloth is the only cost associated with their production. That, plus the assumption that
firms producing products make no profit (the neoclassical assumption of pure
competition), insures that the price of a product equals its cost of production—which is
simply the cost of the labor used to make it. For example, if each labor unit is valued at
10 cents, cloth will sell for $9 a yard in Portugal and a Portuguese worker will earn $9 for
90 labor units. Given the absence of profit, we can see that he requires 90 labor units to
buy a yard of cloth. If labor units are minutes of work, then he requires 1 1/2 hours of
work to buy a yard of cloth.
The second key assumption is that there is no unemployment and that if a country decides
to specialize, all the labor in the country can be moved to the production of a single
product. Thirdly, it is assumed that the efficiency of production (the number of hours
required to produce a unit of the product) remains constant, independent of how large the
industry is, or how large the individual firms within the industry are. Thus if England
greatly enlarges its cloth industry by moving all the workers involved in wine-making to
cloth-making, it will neither gain nor lose efficiency: a yard of cloth will still require the
input of 100 labor units. (A number of other assumptions will be discussed later in the
chapter.)
Given these two assumptions, Portugal can gain more cloth by shifting all its cloth
workers over to wine production and then trading some of the additional wine that gets
produced as a result to England in exchange for English cloth. England likewise gains by
abandoning wine production, shifting all wine workers to cloth production, then trading
some of the additional cloth produced for Portuguese wine.
To better understand the argument we have to go beyond the labor-theory-of-value
framework to at examples that incorporate prices and wages. We can begin by restating
Ricardo’s example. For illustrative purposes, we arbitrarily assume that labor units are
worker-minutes of production, and that each worker-minute is paid at the rate of 10 cents,
so workers earn $6 per hour. For simplicity, we also assume that both local currencies are
freely convertible into dollars. This means that in England it costs $0.10 X 120 (labor
units) or $12 to produce a gallon of wine; under the previous simplifying assumptions
$12 will also be the selling price (in England) before trade begins. A yard of English
cloth requires 100 labor units of production (1 hour 40 minutes) so at 10 cents a minute, it
costs $10 a yard to produce and also sells for $10 a yard. In Portugal, a gallon of wine
requires 80 units of production; at 10 cents a unit, so that wine costs $8 a gallon to
produce and sells for $8. Cloth in Portugal requires 90 labor units a yard, at ten cents a
labor unit costs $9 a yard to produce, and also sells for $9 a yard. Although the nominal
wage rate in each country is $6 per hour, the higher prices in England mean that under
autarky, English workers have less purchasing power and so are poorer than Portuguese
workers. This is a consequence of the absolute advantage held by Portugal in the
production of both wine and cloth.
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Ricardo’s argument concludes that each country that engages in trade benefits. But
nothing in his argument tells us exactly how much of each product gets traded, how much
of the increase in production is consumed domestically and how much is exported.
Economists call varying ratios between the amount of a product that is exported and the
amount imported (when there is a balance of trade) “the terms of trade.” The more a
country receives in imports in exchange for its exports, the better its terms of trade. Later
economic theory analyzed a country’s terms of trade in relation to international
commodity prices set by aggregate world supply and demand. It is of the greatest
importance to realize that a number of different terms-of-trade outcomes are compatible
with international free trade and with a model specifying total specialization within each
country, and that these different outcomes can result in very different relative benefits for
the countries involved in trade. We can illustrate this by considering the effect of
differing international price levels and shipping rates.
Terms of Trade
Ricardo’s Example, Scenario I: England Gains More Than Portugal from Trade
Under international free trade, international supply and demand are supposed to
determine a single global price for each traded commodity. In fact, due to shipping and
handling costs, the final landed prices of commodities will differ from country to country.
However, in the first two scenarios to be presented, we ignore shipping costs. We assume
that Portugal, with the comparative advantage in wine production, produces all the wine
consumed in both countries, and that England, with the comparative advantage in cloth
production, produces all the cloth for both countries.
Under this scenario, we take the international price of wine to be $8.25 a gallon and the
international price of cloth to be $8.75 a yard. In Portugal, which exclusively produces
wine, wine sells for $8.25 a gallon, and Portuguese workers are paid $8.25 per gallon for
the 80 labor units needed to produce it (since there are no profits and the entire selling
price flows back to the workers). This means that under this scenario each Portuguese
labor unit is paid for at the rate of $8.25 divided by 80 labor units or 10.31 cents
($0.1031) per labor unit (i.e., $6.19 per hour compared with the nominal wage rate of 10
cents per unit or $6 per hour under autarky). At this rate in Portugal it still takes 80 labor
units to buy a gallon of wine—the same as under autarky—although the nominal price of
wine and the nominal wage rate have changed. This is a general rule: the number of labor
units required to buy a unit of the product that is produced in the home country remains
unchanged from autarky price independently of the international price. We can say that in
Portugal the “real” price of wine is unchanged from the price under autarky.
What about cloth prices? Under scenario I, cloth sells in Portugal at the international
price of $8.75 per yard rather than $9 as it did under autarky. Portuguese workers will
require $8.75 divided by the real unit labor rate of 10.31 cents or about 85 labor units to
buy a yard of cloth—compared with the 90 units required under autarky. This small cost
savings (the exact size of which depends on what proportion of Portuguese salaries are
spent on cloth) can be used by a Portuguese worker to buy either a little more wine or a
little more cloth than could be purchased during autarchy.
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In England, which now produces only cloth, a yard of cloth also sells at the international
price of $8.75. It still takes 100 labor units to produce a yard of cloth, so each English
labor unit is now paid at the rate of 8.75 cents. English workers are in the same position
with respect to cloth purchases as they were under autarky: to purchase a yard still
requires 100 labor units. Wine sells in England at the international price of $8.25 a
gallon. This is well below the $12 per gallon price during autarky. It now requires only
about 97 labor units to buy a gallon of wine in England ($8.25 divided by the labor unit
rate of 8.5 cents). This means that despite a fall in nominal wages from ten cents per unit
to 8.5 cents per unit, English workers are much better off than they were under autarky
when a gallon of wine cost 120 labor units. This large savings can be used to buy a great
deal more cloth or wine than could be purchased under autarky. Under this international
price scenario English workers see a substantial benefit from trade, whereas Portuguese
workers benefit relatively little. England has very advantageous terms of trade compared
with Portugal.
Ricardo’s Example, Scenario II: Portugal Gains More Than England from Trade
Now consider a scenario in which the dollar-denominated international price of cloth is
$8 per yard and that of wine is $9 per gallon. At $9 per gallon landed in England,
Portuguese wine is 25% cheaper than English wine produced under autarky. Similarly, at
$8 per yard landed in Portugal, English cloth sells for 11% less than the Portuguese
autarkic price of $9 per yard. English wages, per labor unit, are earned making cloth, and
are now worth $8 divided by the 100 labor units needed to produce a yard of cloth or 8
cents per unit, a 20% decline in nominal wages from the 10 cent per unit value under
autarky. But, as before, English workers are neither better nor worse off with respect to
cloth purchases since it still requires 100 labor units to buy a yard of cloth. However, it
now requires 112.5 units of labor ($9 divided the England labor unit rate of 8 cents) for
an English worker to buy a gallon of wine. This is 6.25% less than the 120 labor units
required under autarky. Thus English workers are only little better off than they were
under autarky.
Portuguese workers are neither better nor worse off with respect to wine purchases—it
still requires 80 labor units to buy a gallon of wine. Each Portuguese labor unit is equal to
11.25 cents, the $9 wine cost divided by the 80 labor units required to produce it. (This is
a 12.5% increase in the nominal Portuguese wage; the real cost of wine is unchanged.) At
the new unit wage rate, it takes $8.00 (the landed cost of cloth in Portugal) divided by the
unit wage rate of 11.25 cents, or 71 Portuguese labor units, to buy a yard of cloth. That’s
a big gain (21%) over the 90 units required under autarky. Compared to England,
Portugal is the big winner under this international price scenario; it has much more
favorable terms of trade than England.
There are many other international price (or terms of trade ) scenarios compatible with
Ricardo’s original example. Each distributes the benefits of trade differently. (However,
note that the overall benefit to each country can only be determined when the relative
consumption of each product in each country is known.) Here is the simple procedure for
evaluating the effect on the workers in each country of a given set of international
commodity prices:
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1. Take the international price of the commodity that is produced in the country
under international free trade (or the actual price paid by consumers if that is
different due to other costs, such as shipping). Divide that price by the number of
labor units used to produce it in the country to determine the country’s nominal
wage per labor unit.
2. Next take the international price of the imported commodity (or the actual price
paid by consumers if that is different due to the presence of other costs). Divide
that price by the nominal wage as calculated in step 1. This calculation gives the
number of labor units required to purchase the imported product. In the case of
the product produced in the home country, the number of labor units is unchanged
from autarky, so the gain from trade is exclusively due to the savings in labor
units required to purchase the imported product.
3. Repeat steps 1 and 2 for the other country. By comparing the relative gains, we
obtain an idea of which country has the better terms of trade.
4.
The true extent of changes in the terms of trade can only be calculated within the
model when the relative international demand and the relative local demands for
the products is known. For example, if the international demand for wine is
heavily weighted by Portuguese demand (i.e., if the English demand for wine is
relatively low) much of the increased Portuguese wine production will be
consumed in Portugal, and cloth imports may be corresponding low. In that case
Portugal would gain less from trade than it would have if the English demand for
wine had been much higher and the Portuguese demand correspondingly lower.
Relative Prices and Terms of Trade
Insight into differences in terms of trade comes from considering the relative price of
cloth to wine. The absolute prices are irrelevant to the terms of trade; only the price ratios
matter. The model assumes that under autarky, the relative prices in each country equal to
the ratio of labor units required to produce the two products in the country—since
domestic prices under autarky are a direct function of the labor unit inputs. Thus the
English relative cloth price under autarky is 100/120 or 0.83 and the Portuguese relative
cloth price is 90/80 or 1.125; cloth is relatively much more expensive than wine in
Portugal. Under Scenario I, in which England had the more favorable terms of trade, the
international relative price is 1.06 ($8.75/$8.25) which is much closer to the Portuguese
autarkic relative cloth price of 1.125 than the English autarchic price of 0.83. Under
Scenario II, in which Portugal had the more favorable terms of trade, the international
relative price is 0.89 ($8/$9) which is much closer to the English autarkic relative price of
0.83. This illustrates a general point: the closer the relative international price is to the
autarkic relative price in a country, the worse are that country’s terms of trade. (If there
are shipping costs, the ratio of landed prices must be used, so that consumers in different
countries may see different relative prices.) (Scenario II is illustrated graphically in the
Appendix to this chapter.) And if the international relative price comes to equal the
autarkic relative price, the comparative advantage model says that the country no longer
has an incentive to continue international trade; the “real” (wage—adjusted) price of the
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imported commodity now merely equals the price that would be paid under autarky and
there is longer any gain from moving to trade..
In certain circumstances, the ratio may even fall outside the range delimited by the
autarkic relative prices, an “impossible” situation according to economic theory, but
possible in the real world as later discussion will indicate. (The Appendix to this chapter
provides a graphical treatment of the extreme cases of relative prices.) If the international
relative price of the imported product were to rise above the old autarkic price, and the
country found it impossible to revive the abandoned industry (due to lack of capital or
trained labor) then the country would either have accept the highly disadvantageous terms
of trade dictated by the international relative price thereby reducing consumption below
the autarkic level, or alternatively, pay for the imported product by selling off assets
(stocks, bonds, and real property). On the other hand, if the country were to succeed in
reviving the previously abandoned industry, and if because of the lower wages now
earned in the country, the price of the home-produced products from that industry fell
below the existing international price, the comparative advantage relations would shift
and instead of importing the product, the country would find it advantageous to export it.
For example, if the international relative price of cloth rose above the Portuguese autarkic
price, Portugal might begin to export cloth to England (assuming it could revive the cloth
industry it had abandoned). Ricardo did not consider this case directly, but did foresee (in
response to Malthus’s defense of the English Corn Laws) that lower wages and
correspondingly higher potential profits could lure capital away from domestic industry
to overseas investment. (Douglas A. Irwin, Against the Tide, p. 92)
The two scenarios discussed above illustrate the incompleteness of the Ricardian model
due to failure to discuss variations in advantage related to terms of trade; the next two
scenarios, considered together, demonstrate its ineffectiveness as an argument for free
trade. These relate to the added cost of international shipping and to the imposition of a
certain kind of tariff to shift the terms of trade in favor of the country that adopts the
tariff.
Ricardo’s Example, Scenario III: The Effect of a
High Shipping Cost on Portugal’s Terms of Trade
The first two scenarios are drawn from a large number of outcomes compatible with
mutual benefit from the international trade in wine and cloth. The terms of trade can also
be affected by factors such as shipping costs. Suppose that the international price of cloth
is $8 per yard and the international price of wine is $9 per gallon, and that these costs
include a shipping cost of $1 per gallon for wine exports and 25 cents per yard for cloth
exports. This means that wine selling in England at the international price of $9 a gallon
would sell for $8 per gallon in Portugal—if it sold for more than $8 in Portugal, there
would be no incentive to export it since the after-shipping receipts would be less than $8
per gallon. On the other hand, if wine sold for less than $8 per gallon in Portugal, there
would be no reason not to export the entire quantity since the net from exportation would
be $8. Similarly, cloth selling in Portugal at the international price of $8 per yard will sell
for $7.75 per yard in England because the domestic price does not include the 25 cent
international shipping cost. As a result of the high shipping cost, Portuguese workers
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wages will fall to the autarkic rate of 10 cents per labor unit ($8 divided by 80 labor units
needed to produce a gallon of wine in Portugal).25 At 10 cents per labor unit, it would
require 80 units of labor to buy a yard of cloth in Portugal ($8 per yard divided by 10
cents). 80 units is much more than the 71 labor units needed under Scenario II in which
international prices were unaffected by transportation costs. On he other hand, the
situation in England is little changed: English cloth sells for only $7.75 per yard
domestically (there is no 25 cent shipping charge in the domestic price) and an English
labor unit is thus valued at 7.75 cents ($7.75 divided by the 100 labor units needed to
produce a yard of cloth in England). At this wage rate, it requires 116 English labor units
to buy a gallon of wine ($9 per gallon divided by 7.75 cents) which is just 3% worse than
the 112.5 units required under Scenario II but still better than the 120 units required under
autarky. Shipping costs lessen the advantages of international trade for both countries, but
the $1 per gallon cost of shipping wine to England has a large negative affect on the
Portuguese terms of trade whereas the 25 cents per yard shipping cost for cloth has a
relatively much smaller adverse affect on the English terms of trade.
Ricardo’s Example, Scenario IV: Manipulating Comparative Advantage by
Imposing a Tariff
Suppose that trade between England and Portugal conforms to the conditions of Scenario
III except that the international price of wine is $8.25 a gallon rather than $9 and wine
costs only 25 cents a gallon to ship rather than $1 in the previous scenario. Then suppose
that England—in defiance of its powerful free trade tradition—decides to impose a tariff
of 75 cents a gallon on Portuguese wine. From the Portuguese economic perspective, the
situation it faces is exactly the same as under Scenario III; its workers will earn 10 cents
per labor unit and require 80 labor units to purchase a yard of cloth. And the same holds
for English workers: they are paid 7.75 cents per labor unit and face the same prices for
wine and cloth as in Scenario III. The workers in each country face exactly the same
situation as in Scenario III because the tariff is indistinguishable from any other nonproduction cost. Both countries gain from trade as in Scenario III. However, the
Portuguese terms of trade, in particular, are much worse than they would have been in the
absence of a tariff.
Due to the tariff, the English government collects revenue of 75 cents per gallon of
imported wine. This money can be passed on to English workers through tax reductions
or public works spending. As a result of the tariff, England finds itself much better off
and Portugal much worse off than before the tariff was imposed. Scenario III illustrates
how the imposition of a tariff can affect the allocation of benefits of international trade.
Economists refer to this argument (when presented a bit more formally) as “the balanceof-trade argument.” A formal demonstration of the advantage of imposing a tariff for the
terms of trade can be given using modern neoclassical mathematical modeling. Formal
analysis calculates the optimum tariff based on supply and demand elasticities (which
measure the degree to which price is affected by changes in supply) and other details of
the international market for the two products. The key point is that economists almost all
accept as an established consequence of neoclassical economic theory that a country can
alter the terms of trade in its favor by unilaterally imposing a tariff.
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In fact, some prominent economists have argued that the beneficial effects of such a tariff
for the country imposing it could be substantial. This “valid” argument against free trade
(that is valid according to the formalism of neo-classical theory) is almost never
mentioned in popular defenses of free trade. Its existence belies the nearly universal
claim by economists and financial and economic journalists that the comparative
advantage argument “demonstrates” the superiority of free trade. At best, the comparative
advantage argument supports the general benefit of international trade over autarky–but
does not support free trade!
One objection to the balance-of-trade argument is that imposing a tariff may invite
retaliation and that such a tariff has the potential to trigger a trade war. But this objection
has nothing to do with economic theory; it is no more than a guess about political
behavior, a guess than carries little weight unless all the specific circumstances are
specified. The objection owes nothing to “economic science.” Economists who claim that
comparative advantage argument constitutes a rigorous proof for free trade over managed
trade (protectionism) are being intellectually dishonest, although financial and economic
journalists may merely be ignorant. I’ll discuss the balance-of-trade argument, along with
other arguments for protectionism, in the next chapter. Next I discuss problems that
historic changes in productive efficiency (productivity) pose for free trade. The
comparative advantage argument provides no framework for the analysis of these
problems.
Failure to Address Economic Growth
The comparative advantage argument concludes that there is a modest one-time gain for
each nation entering a trading relationship, with modern analyses showing the
distribution of gains as dependent on the relative international and national demand for
the traded products. But the enthusiastic backing for free trade by economists does not
merely spring from contemplation of this modest one-time gain. Most economists (and
journalists such as Wolf) claim that trade promotes economic growth—a factor not
involved in the comparative advantage argument. If there were no further growth in
output, population increases would soon wipe out any per capita income gain from the
new trading relationship. Thus it is misleading to present the comparative advantage
argument—even if correct within its limited set of assumptions—as the best argument for
free trade. Most contemporary economists view economic growth—taken as an unalloyed
benefit—as the ultimate justification for free trade and related free-market “reforms.”
Since the relationship between free trade and related policies and economic growth is
central to debates about globalization, I will address it at length in Chapter 5.
The more general issue is economic change: change in employment, productivity, and
capital investment under trade (not necessarily free trade).
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Comparative Advantage and Changes in Productivity
Productivity growth was a major concern of classical economists. Ricardo himself, in the
chapter of Principles in which he presented the comparative advantage argument,
discussed the consequences of an “improvement in making wine in England.” (96)
Ricardo recognized that technological improvements that alter the relative productivities
between countries must be considered before drawing conclusions about free trade. This
can be illustrated within the comparative advantage framework by a simple numerical
example.
Another Example Illustrating the Effect of a Change in International Demand
Let’s call the hypothetical countries Northland and Southland, the products Industrial and
Agricultural, and examine what happens when productivities changes over time. We will
use worker-hours as the measure of labor units. At the first stage of the analysis,
Northland is more productive than Southland with respect to both the industrial and the
agricultural product; in Northland it takes only 1 hour to produce an industrial unit and 2
hours to produce an agricultural unit versus 3 hours for an industrial unit and 4 hours for
an agricultural unit in Southland. Northland thus holds the absolute advantage in both
types of production but has a comparative advantage in the production of the industrial
good and Southland has the comparative advantage with respect to the agricultural
product. As described by Ricardo in Principles, England was in a position roughly
comparable to that of Northland.
Given that labor is the only cost involved, the relative price of the industrial good in
Northland under autarky (relative to the agricultural good) 0.5. In Southland the relative
price of the industrial good is 0.75. The international relative price normally has to be at
or between these two prices for trade to occur; if not, one or the other country will find no
advantage is abandoning autarky. Suppose trade begins with the international price of a
unit of industrial goods at $2 and the international price of a unit of agricultural goods at
$3. Then the international relative price of industrial goods is 0.667 lies between the
relative price values under autarky. Northland is now motivated to produce only the
industrial good for both domestic use and for export, and will import the agricultural
good from Southland which will produce only the agricultural good and will import the
industrial good from Northland.
As in the previous examples, Northland workers’ purchasing power with respect to
industrial goods remains unchanged from autarky: 1 hour’s work is worth $2 and this
buys one unit of industrial goods, as under autarky. Similarly Southland workers’
purchasing power remains unchanged for agricultural product produced in Southland: 1
hour’s work is worth 75 cents ($3 divided by 4 hours production time) and 4 hours of
work are still required to buy one unit of agricultural product. However, the $2 hourly
wage earned in Northland now buys 2/3 unit of $3 per unit imported agricultural product,
which is a gain over autarchy when an hour’s work only bought 1/2 unit. The 75 cents per
hour wage in Southland now buys 3/8 a unit of imported industrial product ($0.75/$2),
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versus 1/3 unit of industrial product under autarky. Both economies have benefited from
trade.
However, if the international demand for industrial products were to rise substantially
relative to the demand for agricultural products, the unit price of industrial product would
rise (ceteris paribus!) and the international relative price would approach 0.75, the
relative price of a unit of the industrial good under autarky in Southland. Suppose, for
example, it rose from 0.667 to 0.7 and also suppose that, as a result of inflation, the
international price of a unit of industrial product rose from $2 to $3.50 and that of a unit
of agricultural product to $5 in keeping with the 0.7 ratio. Northland consumers are the
winners after this increase in international demand. They now earn $3.50 per hour which
buys 7/10 ($3.50/$5) of a unit of agricultural product versus 2/3 unit before the increase
in demand. On the other hand, although Southland’s workers now earn a nominal wage of
$1.25 per hour ($5 divided by 4 hours to produce the agricultural unit), that buys only
5/14 ($1.25/$3.50) of a unit of industrial product—about 0.36 unit versus 0.385 before
the demand shift (but still a little better than the 0.333 unit under autarky). Southland’s
workers have not gained a lot from abandoning their industrial production that existed
under autarky with the loss of diversity of work and the need for retraining and
relocation. Orthodox economists who subscribe to neoclassical theory that exclusively
values the maximization of consumption, will see this as an obviously worthwhile tradeoff.
Change in International Demand and Price that Motivates Protectionism
Suppose demand for industrial product continues to increase until the international
relative price facing Southland is equal to the autarkic relative price 0.75—or even
higher. At that point, Southland is no better off (or even worse off) than it was under
autarky with respect to standard of living. To satisfy its thirst for the industrial product,
especially if Northland’s demand for agricultural product is modest, it may finance
imports through sale of assets (stocks, bonds, and real property). We assume that
Southland cannot restore its industrial capacity without incurring tremendous capital
costs, and even then the process may require decades to accomplish.
Historically, this sort of situation often resulted in a trade deficit financed by a flow of
precious metal into the industrial country. Ricardo considered this possibility, and he
recognized that eventually the bullion of the importing country would be exhausted.
(Principles, p. 97) Northland may be happy enough with this outcome; Keynes pointed
out that Great Britain enjoyed balance-of-trade surpluses during the time it was the
dominant industrial nation, so that free trade, in fact, realized a traditional mercantilist
goal. (According to Keynes, the influx of precious metals encouraged domestic
investment which had beneficial effects for employment and economic growth. (General
Theory, Chap. 23.)
To the inhabitants of Southland, in the original pre-trade condition of autarky, the
potential for a meager gain from trade with Northland may appear to be too high a price
to pay for dismantling its industrial sector and moving the displaced workers into
agriculture. If Southland fears these consequences, it may opt for protectionism rather
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free trade, hoping to garner some of the benefits of trade without abandoning its
industrial production. This involves foregoing some of the gains of trade in the short run.
It is not merely a matter of wishing to preserve jobs in the industrial sector. It could also
be part of a policy of protecting its industrial base with a view towards increasing its
productive efficiency. Thus Southland might believe that it could achieve efficiencies of
scale through growing its industry. In Ricardian terms, this means that fewer labor hours
would be required to produce a unit of industrial product.
Suppose, then, that Southland were to follow this course and that it succeeded not only in
protecting its industry but in developing its efficiency so that the hours required for a unit
of industrial product fell from 3 to 1.9. This is still considerably less efficient than
Northland’s efficiency of 1 hour per unit.
Northland now retains its absolute advantage with respect to the production of both
industrial and agricultural goods. However, the comparative advantage has changed:
Southland now has the comparative advantage in industrial production, Northland in
agricultural production. Once again both countries abandon autarky for the benefits of
trade. Southland merely waited to do so until it had the comparative advantage in
producing the industrial good. Northland, ever dominated by free traders, decides, on the
advice of its economists, to de-industrialize, shifting all its workers into agriculture; at the
same time Southland abandons its agricultural production where it has neither a
comparative nor absolute advantage.
We assume that there is far more demand for industrial products than for agricultural
products. The international price of industrial product is $2.25 and the international price
of agricultural product is $5. Southland workers, all producing industrial product, earn
$1.18 per hour ($2.25/1.9 hours to produce a unit). Northland workers, all producing
agricultural product, earn $2.50 an hour ($5/2 hours to produce a unit).26 Northland
consumers can buy 1 1/11 unit of industrial product with an hour’s work compared with 1
unit under autarky. But would this 9% increase justify dismantling it more efficient
industrial sector and shifting all former industrial workers into agriculture? Northland
economists will complain—if only we had succeeded in convincing Southland to have
abandoned its industrial sector rather than adopting protectionism and increasing
efficiency—our Northland workers would have found themselves 60% ahead of autarky
their buying power with respect to the agricultural good. Under the protectionist (and
export-oriented) strategy pursued by Southland, Northland finds itself having abandoned
industrial production in favor of agriculture, a sector which may offer little prospect of
future growth. In the meantime, Southland, with its new, larger industrial capacity, may
continue to increase productivity thereby further increasing its living standards.
This scenario is only suggestive, but it does illustrate the importance of assessing the
future likelihood of technological changes that could alter comparative advantage, and
the danger of abandoning a sector of production that may offer the possibility of
efficiency improvements that could result in gaining the comparative advantage in the
future. Several well-known theoretical arguments for protection discussed in the next
chapter rely on the purported advantages of manufacturing production over primary
goods production.
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In the next sections I discuss some other deficiencies of the comparative advantage
argument, notably its assumption of full employment, its failure to analysis other labormarket issues relating to trade, and its failure to deal with issues of capital investment.
Labor Migration and Wages
In the Context of Comparative Advantage
Labor Migration and the Assumption of Full Employment
The fundamental model of neoclassical economic theory assumes free movement of labor
from job to job according to pay level without regard to the psychological or economic
costs relocation or retraining. However, most people, given a decent job, prefer to remain
in their home community. Internal or external migration is generally the result of
hardship, and unemployment represents a common type of hardship that motivates people
to emigrate. In an economy with full employment, relatively few persons are motivated to
emigrate, at least in the absence of war or other “exogenous” hardships. Although the
model given by Ricardo assumes free internal worker migration, it implicitly assumes
that English workers remain in England and that Portuguese workers remain in Portugal,
despite different real wage rates. This assumption in turn is supported by the crucial
assumption that each country enjoys full employment before and after the changes
occasioned by the move from autarky to international trade. In the last example given
above involving Northland and Southland, it was assumed that all the labor displaced
from industrial production in Northland will come to be employed in agricultural
production. This assumption, although unrealistic, is supported by the core neoclassical
model of a competitive equilibrium which assumes that the labor market, like all other
markets, “clears” (that all product is sold). It is tantamount to the assumption that all the
labor offered in the market will be purchased at an equilibrium price that equates labor
supply and labor demand. The original Ricardian comparative advantage model, which
predated neoclassical theory, assumes that the labor market clears, that all English
workers displaced from winemaking with the advent of trade with Portugal will be
absorbed into the English cloth industry and that all displaced Portuguese cloth workers
will be absorbed into the Portuguese wine industry.
Some popular writers have mistakenly treated full employment not as a tacit but
unjustified and unrealistic assumption fundamental to the comparative advantage
argument, but rather as a consequence of that argument or as an independently
established fact. Thomas Friedman, for example, in his recent best-selling defense of
globalization (The World is Flat) offers a strikingly bad argument for his assertion that
unemployment is not an issue of concern when there are changes of comparative
advantage between trading partners. Friedman claims that worries by opponents of free
trade about unemployment are a naïve consequence of what he (like Wolf) labels “the
lump of labor theory”—“that there is a fixed lump of labor in the world and that once that
lump is gobbled up, by either Americans or Indians or Japanese, there won’t be any more
jobs to go around.” (227) Friedman is right to reject the lump of labor theory as he
describes it, but it is unclear who subscribes to it. He is correct that there is no reason to
believe that jobs will not grow with economic development. But this affords no grounds
whatever for assuming that there will not merely be job growth but job growth sufficient
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to guarantee full employment. And if there is growth, but growth insufficient to ensure
full employment, the worries of those skeptical of free trade are fully justified.
Judging by the labor statistics of dozens of countries, the assumption of full employment
is clearly unrealistic. Many advanced European nations, exemplars of Wolf’s liberal
market paradigm, have exhibited high levels underemployment for decades, with
economic distress alleviated only by a social safety net. Third World countries typically
exhibit very high rates of unemployment and underemployment most notably in the
mega-cities created by immigration from the economically-stressed agrarian sector. The
traditional answer of neoclassical economists has been to advocate reduction or even
elimination of unemployment benefits; or, more palatably phrased, to let free bargaining
over labor prices take place without outside interference. This is the formula for labor
market clearing. Under this sort of thinking, the men and women who weave through
traffic in the polluted air of Mexico City to clean windshields for a few pesos (if they’re
lucky) are a component of the labor force who should count neither as unemployed nor as
underemployed. If these street-side car window cleaners choose to work only a few hours
a day because they wish to avoid becoming ill from breathing exhaust fumes, well, that’s
their free choice—they’ve simply chosen not to work more than those few hours.
Let’s return to Ricardo’s original example to see how several implausible tacit
assumptions regarding employment play a central role in the comparative advantage
argument. Once these assumptions are rejected, the comparative advantage argument fails
independently of the problems discussed above regarding productivity changes among
trading partners.
The Assumption that All Labor Relocates to the Industry
Having the Comparative Advantage
According to the comparative advantage argument, the reason that Portugal, which has an
absolute advantage with respect both to wine and cloth production, abandons autarky is
because it can more efficiently use the labor involved in its cloth production to produce
wine for export. But if the international demand for wine, given a relative price that
permits trade (that is, a relative price between the autarkic limits), is insufficient to absorb
the quantity of wine that would be produced after a total shift of labor out of Portuguese
cloth production into wine production, Portugal will no longer have a reason to move all
the labor from cloth production and will continue to produce cloth.
In fact, a rise in the population of Portugal or technical advances in the efficiency of wine
production could result in an increase in Portuguese wine production sufficient to satisfy
world demand even with no shift of labor out of the Portuguese cloth industry. This
possibility points to the implausibility of two key assumptions of the comparative
advantage argument—that the demand for labor to produce the product having the
comparative advantage (e.g., Portuguese wine) is such that all the labor will drained from
other industries, including industries for which the country has an absolute (but not
comparative) advantage.
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The Assumption that Specialization is Cost-free
The comparative advantage model ignores the costs associated with changes in where the
labor force is employed. These changes involve both labor-related costs and the cost of
expanding productive capacity through capital spending. The latter is ignored in the
comparative advantage argument which assumes that the only cost involved in
production is the cost of labor. However, all production, and in particular manufacturing,
requires extensive investment in capital equipment and infra-structure.
Major changes in the nature of employment result arise in a number of different
situations: when an economy moves from autarky to international trade, when
comparative advantage changes as a result of technological breakthroughs, when there
are important changes in international transportation costs, and when one or another
country decides to impose a tariff or adopt some other kind of protectionist measure. The
magnitude and frequency of these kinds of changes defeats any attempt to justify the
implicit assumption of the comparative advantage model that the movement of workers
from one industry to another is a cost-free transfer; it is clear that there are major costs
involved, costs involved in relocation and retraining as well as the psychological costs
mentioned above. Changes in employment may have a strongly negative effect on
welfare as the term is generally understood—an understanding that takes account of the
psychological consequences of losing one’s job and not merely consumption levels as in
the core neoclassical model. (Another problem related to relocation costs are that the
costs of retraining and relocating displaced workers involve “economic activity” that
counts toward an increase in national income, although common sense says such costs
should instead be treated as costs deductible from gross income.)
Next I consider a relatively realistic example that illustrates just how important the
omitted concepts of employment are for an analysis of contemporary trade issues.
A Realistic Example of Comparative Advantage Affected by Labor Supply:
The United States and China
The above points can be elaborated in a hypothetical scenario involving the United States
and China. We assume that the United States has an absolute advantage over China with
respect to a small number of products—timber, wheat, oil, advanced computers, and large
jet aircraft. China has an absolute advantage over the United States with respect to a very
broad spectrum of manufactured goods due to its low labor costs. The efficiency of
production in China among these various products varies considerably, and the same is
true of the United States. Because of this variation, the United States has a comparative,
if not absolute advantage, with respect to a number of manufactured products. Under the
comparative advantage model, the United States should be exporting those products for
which it has a comparative, but not absolute, advantage, to China. But it is difficult to
think of examples of such exports.
The reason is that China has a vast pool of underemployed labor in its agrarian sector that
can be tapped to increase industrial production without significantly raising wages. This
enormous labor supply insures that China does not have to forego production of products
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for which it has an absolute but not a comparative advantage to obtain additional labor to
specialize in products for which it has a comparative advantage. If there is no scarcity of
cheap labor in China, China has nothing to gain from importing those products for which
it has an absolute, but not comparative, advantage from the United States. Here is a case
in which the analogy between countries and individuals like the hat maker and shoe
maker breaks down. The United States can only compete in the world market by
undercutting the Chinese costs—and that would mean reducing American wages below
those of China in order to counter China’s absolute advantage.
Of course, China does import a variety of products. It needs many types of raw materials
and foods. But these imported products are products in which the exporting countries
have an absolute advantage. China’s enormous export economy is not balanced by
imports of goods for which it has an absolute but not a comparative advantage; instead it
is balanced by a combination of goods it lacks (the extreme case of an absolute
disadvantage) and by capital flows. The flow of capital from the United States to China to
finance the purchase of Chinese consumer goods serves to fund China’s purchases of oil,
wood, and mineral products, machine tools from Japan, etc., as well as to construct new
factories—in short, it serves to build Chinese industry. It is worth looking at how
technological advances in China affect trade and employment there and in United States.
Wage and Pricing Issues
The Assumption that Wages and Prices are a Direct Function of Labor Productivity
There are other dubious tacit assumptions crucial to the comparative advantage argument.
In all the examples discussed earlier, it was assumed that wages are inversely
proportional to the hours required to produce a unit of the product. This derives from the
labor theory of value that dominated economic thinking (including Marxist thinking)
prior to the emergence of neoclassical theory in the latter half of the nineteenth century.
The assumption is incorrect since it leaves out the role of other factors of production,
notably, capital, that affect the labor time required to produce a unit of product. Modern
economists speak of total factor productivity. (This point will be discussed at greater
length in the next chapter in connection with the wage-differential argument.)
The significance of this omission is two-fold. First, as noted above, there are heavy
capital costs involved in the expansion of the industry in which the country has a
comparative advantage, especially in the case of manufacturing. The second issue is the
effect of an expansion of capital equipment on economies or diseconomies of scale. This
issue is addressed later.
Calculating Comparative Advantage
The omission of capital costs with exclusive focus on the cost of labor can lead to
counterintuitive decisions as to comparative advantage. For example, mid-nineteenth
century England could produce cotton cloth cheaper than any other country, but the
advantage came from its machinery not from its wage rate. The United States, at the time,
had the advantage of producing the raw material and also had cheap immigrant labor and
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low cost fuel. Yet it could not produce cloth as cheaply as England until major
investments in capital equipment had been made. If we merely look at unit pricing, we
might decide that England had the comparative advantage in cloth making. But a
common-sense analysis would say that instead of abandoning the production of cotton
cloth, the United States should support the industry because of its potential to be the lowcost producer.
Prices, Production Costs, and Exchange Rates
An equally significant limitation of the comparative advantage model is the assumption
that the price at which a product is sold is a direct function of cost of production (given
the zero profit assumption of the comparative advantage argument and of the neoclassical
competitive equilibrium model). The cost of production is inversely related to total factor
productivity (given zero profits), and the assumption is that this relation holds across
national boundaries. However, in the real world the cost of production is filtered through
international exchange rates. If a country pegs its currency at a level that undervalues its
productive factors—labor being the productive factor that is singled usual example—it
will alter absolute and perhaps comparative advantage of various products.
Wages and the Supply of Labor
There is still another problem: in economic theory, wages are taken to be the product of
supply and demand, so that a country that possesses a surplus of labor in a particular
industry (an impossibility under the assumptions of the comparative advantage model)
will (in the absence of legislation or union power) have lower wage rates in the industry
than a country with a tighter labor market (holding other factors fixed). This is the
situation assumed for China in the previous example. As a result of low wage rates,
products from the country’s industries may be offered for less than identical products
produced with fewer labor hours in other countries, and thus these products may be able
to capture international markets that would otherwise not exist. (For this to occur given
the comparative advantage conceptual framework we would have to assume a
comparative disadvantage for other products despite equally low or even lower wage
rates.)
The Question of Capital: Economies of Scale
As noted, there are significant direct capital costs involved in the expansion of industries
that enjoy a comparative advantage when a country moves from autarky to trade, or in
industries that gain a comparative advantage through technological breakthroughs, as
well as indirect costs associated with the development of infrastructure to support the
enlarged industries. Capital costs will generally be incurred whenever comparative
advantage shifts between trading partners. The move from autarky to international trade
results in the growth of industries with the comparative advantage in their respective
countries. And technological breakthroughs, (as in Ricardo’s example of the discovery of
a new process for producing wine in England), population growth, and capital spending
can also result in the growth of an industry. The comparative advantage argument ignores
these capital costs, but it also contains the implicit assumption that the efficiency of
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production—measured by output per labor unit in Ricardo’s example (and total factor
productivity in modern terms)—remains unchanged when the production for which each
country has a comparative advantage is increased to support exports. However, in
general, we do not expect changes in the size of an industry to exhibit constant returns to
scale. Manufacturing industries have been held to exhibit the opposite tendency—a
tendency towards an increase in efficiency as capital is expended to increase the volume
of production increases, referred to as increasing returns to scale. On the other hand,
Ricardo himself had noted the decreasing marginal productivity of agricultural land when
previously unproductive (marginal) land is brought under cultivation to meet an increase
in demand for agricultural produce. This illustrates decreasing (or diminishing) returns to
scale. Changes in the rate of return per unit input as production increases under trade
will, in general, alter the terms of trade from those calculated under the simplistic
assumptions of the comparative advantage argument, and the belief that manufacturing,
unlike primary goods production, generally exhibits increasing returns to scale is the
basis of several of the arguments against free trade and for protectionism considered in
detail in the next chapter.
More on the Effects of a Technology Change on Trade and Employment:
The Example of the United States and China
The comparative advantage argument concludes that there is a gain to both countries who
abandon autarchy for trade. However, the argument is silent on what happens when
comparative advantage relations change among countries already engaged in trade. This
means that the argument has nothing to say about changes in comparative advantage
between the advanced industrial nations and the industrializing economies of East Asia,
and these changes are one of the major facts underlying the debate over free trade and
globalization. Ricardo did consider a hypothetical situation something like that described
in the scenario in which Southland chose to protect and develop its less efficient
industrial sector thereby altering the comparative advantage relations with Northland. In
Ricardo’s example, the shift comes not from sheltering an infant industry to make it more
efficient, nor from a growth in population, but from the discovery in England of a new
process for producing wine that renders it even cheaper than imported Portuguese wine.
(Ricardo, 96) He argued that if this happened price of wine would fall in England,
although the English cloth price would remain unchanged. Portugal then could only
continue to sell wine to England if it lowered its export price, would mean that it would
earn less from its wine sales to England. Portugal would then have to drain down its
reserves of hard currency to maintain its previous level of importation of English cloth.
Ricardo speculated that ultimately trade between the two countries would cease, with
England ending up better off and Portugal worse off.
Although we can place little stock in Ricardo’s sketchy analysis, the situation he
discussed anticipates in some respects the situation of the United States and China, with
the United States analogous to Portugal and China to England, and manufactured goods
analogous to wine. With a lowering of manufacturing production costs in China (wine
production costs in England in Ricardo’s example), the United States (Portugal) earns
less from its manufacturing (wine) exports and begins to run a balance of payments
deficit with China (England). This is exactly what was described in the Northland-
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Southland example. One of the real concerns is not trade between the United States and
China will eventually cease (as trade between England and Portugal might cease in
Ricardo’s example), but rather that a severe devaluation of the dollar against the Chinese
Yuan might occur, lessening U.S. imports of Chinese goods which would no longer be
cheap. With the corresponding lowering of American real wages, the United States would
be left with the task of either rebuilding a low-wage manufacturing industry (quasiautarky) or (more realistically) come to depend on exports from the traditionally lowwage primary goods sectors (agriculture, forestry, mining) in which it possesses an
absolute as well as comparative advantage. And it seems quite possible that under these
conditions the United States could suffer from the high levels of unemployment or
underemployment characteristic of many resource-exporting Third World economies.
However, some pro-globalization writers have claimed that the United States will avoid
this bleak outcome because it will engage in the profitable export of services. This claim
will be addressed in the next section.
The Distribution Problem: Internal Winners and Losers
In view of the fact that a country’s labor force cannot move freely from one type of
production to another due to retraining and relocation costs, most economists
acknowledge that although comparative advantage suggests that all countries benefit
from free trade, there will be winners and losers within national economies—for
example, Portuguese cloth workers and the owners of Portuguese cloth factories would
suffer as the result of the elimination of their industry as the country specializes in wine
production. Noting that Ricardo himself was a fervent advocate of repeal of the
protectionist English Corn Laws, Krugman and Obstfeld in their popular text,
International Economics, say that Ricardo avoided the issue of winners and losers by
choosing “to present his argument in the form of a model that assumed away issues of
internal income distribution.” (p. 58)
It is important to note that in this respect the comparative advantage argument represents
only a partial advance over a simple division-of-labor argument with respect to
distribution of benefits. The division-of-labor argument claims a global gain in aggregate
wealth (which equates welfare according to orthodox theory), but leaves open the
possibility winners and losers among nations. The comparative advantage argument
claims that each country engaging in international trade experiences an increase in
welfare over autarky, but allows for winners and losers within countries. In this respect,
comparative advantage resembles mercantilism in its focus on national welfare. (This is
abetted by the assumption that there is no movement of labor between trading partners.)
The usual response of economists to the issue of winners and losers within a national
economy is to talk about the opportunity for an internal redistribution of the increased
national wealth to insure that no one is left worse off than before trade began. (This, of
course, assumes that welfare is measured in terms of commodity bundles, thereby
ignoring such things as the psychological cost associated with job losses.) Economists go
on to suggest that this distributional remedy is political in nature, and thus lies outside the
scope of economic science; as long as there is a surplus to distribute, the move to free
trade is economically justified. But why should economists, who believe in the
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dominance of self-interested behavior seeking to maximize consumption, expect that
winners would willingly part with their new-found wealth? And if the redistribution of
new-found wealth from winners to losers doesn’t occur, the neoclassical concept of a
Pareto improvement (which requires that no one be made worse off by a change)
indicates that economists should refrain from judging the new, post-trade situation
between than the previous autarkic state.
There is still another problem. The view that economics is not involved with the issue of
winners and losers and the distribution of wealth is inconsistent with the centrality
assigned to distributional issues in the debate among economists about the effect of
globalization on world poverty (a topic discussed in a later chapter. In particular, even
extreme supporters of laissez faire such as Professor Xavier Sali-i-Martin, are intent on
demonstrating that the free-market policies associated with globalization have benefited
the poor as well as increased general wealth. The whole debate over whether international
poverty has decreased or not has preoccupied academic economists and attests to an
abiding concern over distributional issues that supposedly lie outside the purview of
economic science (this is further discussed in Chapter 5).
Despite these conceptual problems, the economists’ response to the problem of winners
and losers is the claim that each national economic pie is made larger as a result of trade
and thus that there exists the possibility of enhancing everyone’s welfare through
redistribution. This answer evades the question as to whether there are alternatives to
unrestricted free trade that preclude or minimize the need for governmental redistribution
or compensation.27
There is a seldom-recognized bias implicit in the attitude of economists towards internal
winners and losers. According to Douglas Irwin, economists have accepted as legitimate
(if not always valid) various protectionist arguments that claim to show advantages for
particular national economies from imposing tariffs despite a possible lessening of
aggregate global wealth. The terms of trade argument provides a clear example, since
the aggregate production of two counties such as England and Portugal in the scenario
discussed above in which England imposed a tariff on wine imports is less than that it
before imposition of the tariff. Economists are willing to debate the merits of arguments
of this kind—arguments that claim advantages for particular national economies from
protectionist measures; such arguments are not rejected out of hand as illegitimate or
“non-economic.” In contrast, when arguments for protectionist measures are advanced
based on their alleged effect in reducing poverty, unemployment, or improving working
class wages at a potential cost to aggregate national wealth, these arguments are
routinely criticized as “non-economic.”
Economists routinely argue for free trade based on its alleged maximization of aggregate
national wealth regardless of its distributional consequences within national economies.
The national economy is thereby revealed to be the fundamental unit of analysis when
trade policy being discussed. What is the justification for assigning a central role to
national economies? If distributional issues are political, not economic, in nature why not
defend free trade simply on the basis of an increase in aggregate world output arising
from increased global division of labor? Consistency and political neutrality and would
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seem to require that economists argue that winners and losers among nations are not the
concern of economics—after all, the winner nations can redistribute some of their
winnings to the losers, just as within a nation wealth added by trade can be taken from
winners and distributed among the losers. Nations are political not economic entities, and
the usual argument about the opportunity to redistribute the gains of trade to compensate
losers equally applies to redistribution among nations as within nations. Treating nationstates as the fundamental units of welfare evaluation reveals a bias reminiscent of the old
mercantilist tradition. Or, to progressive critics of orthodox economics, it reveals a
reluctance to place a value on the alleviation of poverty within national economies.
Extolling Comparative Advantage: Thomas Friedman’s The World Is Flat
It is worth considering the effects of changes in comparative advantage on employment
as viewed by one of the most widely-read defenders of globalization and free trade,
Thomas Friedman. In his best-seller, The World Is Flat, Friedman echoes the frequently
made claim that exporting services will ensure the future welfare of the United States in
the face of globalization. Friedman is a firm believer in the comparative advantage
argument and believes that it describes future trade between the United States and India
or China. According to him, the United States will benefit from such trade because its
workers will shift to new and better jobs: “My mind just kept telling me, ‘Ricardo is
right, Ricardo is right, Ricardo is right.’” ...if all these Indian techies were doing what
was their comparative advantage and then turning around and using their income to buy
all the products from America that are our comparative advantage—from Corning Glass
to Microsoft Windows—both our countries would benefit, even if some individual
Indians or Americans might have to switch jobs in the transition.” (225-6) Friedman’s
underlying assumption is that there will be job switching that guarantees full employment
in the United States, and the new jobs will be better jobs.
Friedman notes that when he grew up in New London, Connecticut, his classmates’
parents worked for Electric Boat, or for the Navy or the Coast Guard, but that “now it is
best known for the great gambling casinos of Mohegan Sun and Foxwoods and for the
pharmaceutical researchers of Pfizer.” (20) The skeptical reader may wonder if the kinds
of jobs available at the gambling casinos are comparable to the jobs formerly available at
General Dynamics’ Electric Boat Division.
Although the usual examples of comparative advantage involve one manufactured
product and one agricultural product (representing the primary-goods sector),
globalization defenders such as Friedman substitute the so-called “service sector” for
agriculture—although rather than simply speaking of the service sector Friedman
emphasizes “high-skilled knowledge-based” jobs (such as those involved in
pharmaceutical research). The oft-repeated claim that such high-tech jobs will replace
lost manufacturing jobs arose in the “new economy” euphoria during the dot-com boom
of the late nineties. The story is that America has nothing to fear from globalization
because the “amazing American job-creation machine” is rapidly creating new higher
paid high-tech jobs to replace the factory jobs which the country has been losing for
several decades.
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Although Friedman eschews talk of the “new economy,” he presents a similar story,
writing that the loss of U.S. industry “helps because it frees up people and capital to do
different, more sophisticated work...” (21) But he never indicates how many of the
manufacturing jobs that have been lost throughout the United States have been replaced,
not by high-paid high-skilled jobs (like pharmaceutical research), but by so-called
“macjobs” that feature low pay, poor (if any) benefits, night and weekend hours, and the
need to moonlight to make ends meet. The stagnation of the income of the bottom third
of the U.S. population fails to support Friedman’s assumption that an abundance of new
highly-skilled and highly-paid service jobs have emerged to replace the loss of well-paid
manufacturing jobs.
Friedman even argues, on occasion, that off-shoring manufacturing actually creates
manufacturing jobs in the United States, although his examples are confusing. Thus he
claims that off-shoring of manufacturing by U.S. firms benefits the U.S. because “even
when production is moved offshore to save on wages, it is usually not all moved
offshore... American companies that produce at home and abroad, for both the American
market and China’s, generate more than 21 percent of U.S. economic output, produce 56
percent of U.S. exports, and employee three-fifths of all manufacturing employees, about
9 million workers. According to this account, if General Motors builds a factory in
Shanghai, it thereby ends up creating jobs in America because it requires the exportation
of a lot of goods and services to its factory in China, while at the same time benefiting
from lower parts costs in China for its factories in America.” (123) But it hardly seems
reassuring to be told that over 60% of the remaining U.S. manufacturing employees are
employed by companies already deeply engaged in off-shoring. The claim that a
company “ends up creating jobs” merely because it retains some manufacturing
operations in the United States to feed parts for use in one of its Chinese factory seems
completely without foundation.
Friedman does provide one hypothetical example that shows he is aware of a problem for
the U.S. labor force—at least for factory workers. He says suppose that the U.S. has only
100 people, 80 “well-educated knowledge workers” and 20 “less-educated low-skilled
workers.” China has 1,000 people, 80 knowledge workers and 920 low-skilled workers.
Given these assumptions, he claims that creating a single market will result in “a much
expanded and more complex market.” This claim owes nothing to comparative
advantage; it is the result of the commonly held, but quite independent, assumption that
international trade promotes economic growth. Friedman concludes that this expanded
market should be a win-win for both Chinese and American knowledge workers,
although some American knowledge workers will have to move horizontally into new
jobs. According to Friedman, the American knowledge workers won’t be hurt because
Chinese wages “will rise to American/world levels.” (228-9) His reasoning is both
ambiguous and misleading. The phrase “American/world levels” suggests that current
American levels are to be identified with “world levels” (present or future), that is, that
real wages throughout the world will rise at least to current American level; but what is
the basis for that assumption? Especially since Friedman repeatedly alludes to a seeming
infinite number of highly qualified candidates from India and China competing for these
“knowledge jobs”? We may even agree that in a “flat-world” market, wages for similar
work will ultimately reach a rough parity at some kind of “world level” (based on world
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supply and demand)—but there is no reason to believe that this world level will be
anywhere near the current U.S. pay levels for comparable jobs.
In fact, the true situation is more comparable to that described in the United States/China
example presented above. In that example, Chinese manufacturing wage levels are kept
low by a the very large supply of labor drawn from the massive Chinese agrarian sector.
The Chinese labor supply for “knowledge jobs” would seem to be extremely large
judging by Friedman’s own data, and he offers no argument that this enormous supply of
qualified knowledge workers will not lower the world wage level for so-called
“knowledge” work.
Friedman does concede that the “20 low-skilled Americans” mentioned in his example
will face serious competition from the 920 low-skilled and low-paid Chinese. In his view,
the relatively high American wages for those 20 American workers resulted from a
limited supply of low-skilled workers in the United States. Moreover, he states that
“those American low-skilled workers doing fungible jobs—jobs that can be easily moved
to China—will have a problem...Their wages are certain to be depressed.” (229) But his
comments conflict with his previous remarks about how off-shoring creates
manufacturing jobs in the United States. At this point in his book, he is suggesting a
different solution: rather than moving these workers into new manufacturing jobs created
by off-shoring (American General Motors workers supplying the Shanghai plant), these
workers will “have to upgrade their education and upgrade their knowledge skills so that
they can occupy one of the new jobs sure to be created...” Why “sure to be created”?
Presumably because of the full employment assumption coupled with the ethnocentric
belief in the innate superiority of American labor.
The recognition by Friedman that non-knowledge workers will see their wages depressed
(or jobs eliminated) exposes the lack of foundation for his fundamental distinction
between types of work. Why does he believe that his example—which assumes that 80%
of Americans are engaged in highly-skilled knowledge jobs—bears any resemblance to
the true situation in the United States? 80% seems ridiculously high estimate of the
percentage of highly-skilled knowledge jobs in the U.S. economy. It appears that
Friedman is conflating the entirety of service sector jobs with the relatively small
subcategory of highly-skilled knowledge jobs, lumping together $7 per hour Wal-Mart
employees with “pharmaceutical researchers.” And what is the basis for his belief that the
20 Americans in his example who currently have “low-skilled” manual-labor jobs can be
trained to be knowledge workers, whereas the 920 low-skilled Chinese workers cannot or
will not be similarly trained? All of this flies in the face of his repeated emphasis on the
work ethic, ambition, and intellectual capacity of Chinese workers. And why does
Friedman believe that only low-skilled manufacturing jobs are fungible? Why are
knowledge-work jobs not similarly fungible? Throughout the book, he provides accounts
of how almost every imaginable sort of service job is being outsourced to Bangalore—
including jobs in high skilled financial analysis, medical diagnosis, and software
development.
Friedman struggles to make a distinction between the situation facing highly-skilled
“knowledge workers” and that facing “low-skilled factory workers.” He consistently
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disparages jobs done by factory workers (“selling manual labor”) and lauds the “ideabased jobs” of the “knowledge-workers” (“consulting or financial services or music or
software or marketing or design of new drugs”). He even claims that “there is no limit to
the number of idea-generated jobs in the world.” What does this mean? Is he claiming
that there is no limit to the number of specific positions available to knowledge workers
but that there is a limit to the specific positions available to factory workers? In both
cases, the number of specific positions available will be limited by effective consumer
demand and ultimately by the earth’s resources. Consider his oft-cited example of
computer software development: software is only demanded by those with computers or
other devices that utilize it, and these computers have to be manufactured. Thus an
increased demand for knowledge-based software depends on an increased demand for
factory-produced computers. On the other hand, if he means to draw a distinction
between the number of types of new “idea-generated” jobs and types of manufacturing
jobs, the distinction is equally muddled. Manufacturing jobs are created as the result of
technology advances and will continue to be for the foreseeable future; advances in
knowledge result in advances in types of manufacturing jobs.
In speaking of “idea-based product,” Friedman claims “the bigger the market is, the more
people there are out there to whom you can sell your product. And the bigger the market,
the more new specialties and niches it will create.” (230) But how does this differ from
manufacturing? As markets for manufactured goods expand, product diversification
invariably follows and with it there is a corresponding growth in types of manufacturing
jobs.
But, as noted above, Friedman’s biggest confusion is his concept of “knowledgeworkers.” In his example, he assumes 80% of American workers to be “knowledge
workers” which suggests that he is equating the category of “knowledge-workers” with
the category of service sector workers. That means including the millions of low-level
“macjobs” in the knowledge-worker category. And even within the sub-category of highpaying service sector jobs, there is a crucial distinction between someone “who comes up
with the next Windows or Viagra” and the vast numbers of ad agency employees, high
level sales persons, consultants, financial service workers, and computer programmers
who do routine applications work. His argument requires that we ignore these crucial
distinctions.
This is again made clear when Friedman (claiming the authority of the economist Paul
Romer) contrasts “the software writer or drug inventor” who creates products that “can
be sold to everyone in the global market at once” with “the manual laborer:”—“what the
manual laborer has to sell can be bought by only one factory or consumer at a time” But
the vast majority of consultants, financial service workers, programmers, and salespeople
also sell their services to one employer or one consumer at a time. Their employers may
sell throughout the world—but so does Toyota and Hewlett-Packard.
Friedman’s empty complacency about the future of American jobs is driven not only by
the spurious distinction between knowledge-workers and factory workers, but also by
fatuous claims about the American ability to thrive in the “flat world.” In a burst of
patriotic hubris he says, “fortunately America as a whole has more idea-driven workers
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than any country in the world.” (230) But the consistently low test scores in science and
math in the United States compared with those of students in other countries, the
domination by foreign students of the graduate math, engineering, and science programs
of U.S. universities, coupled with the increasing tendency of these students to return to
their home countries—phenomena noted by Friedman elsewhere in his book—give little
support for his optimism about the future of good jobs in the U.S.
At times his optimism amounts to little more than complacency (“there always have been
new jobs to do, and there is no fundamental reason to believe the future will be
different”), cliché (“The Indians and Chinese are not racing us to the bottom. They are
racing us to the top—and that’s a good thing!”) (232-23), or anecdote (“the Chinese
operation not only has allowed Donaldson to keep making a product it no longer could
make at a profit in the United States, it also has helped boost the company’s Minnesota
employment, up by 400 people since 1990” 235)
I want to emphasize that I am not arguing (at this point) for any particular conclusion
about the result of U.S. trade with China or India. I’m arguing that the comparative
advantage argument does not shed light on the issue, that it is compatible with situations
in which one of the countries engaged in trade takes advantage of others through the
imposition of a tariff or other protectionist measures, and even with situations in which
one of the countries engaged in trade is an absolute loser. I’m also arguing that ignorant
and naïve appeals to the comparative advantage argument, such as seen in Friedman’s
recent book, are confused and contradictory. But Friedman’s bad arguments do not settle
the matter; they do not demonstrate that he could not, somehow, be correct. The
assumption that refuting a bad argument somehow affirms the negation of its conclusion
is a fallacy. Refuting Friedman’s bad arguments only justifies the conclusion that the
issue of unemployment in advanced economies in the face of the growth of economies
like those of China and India remains an open question.
Summary of Problems with the Comparative Advantage Argument
To summarize, the following problems have been discussed:
1. The argument contrasts total autarky with completely free trade, and concludes
that free trade is superior to autarky, it is the uniquely best trading system. It does
not compare free trade with the use of one or another type of protectionism under
certain circumstances. It is guilty of what philosophers call “the black and white
fallacy.”
2. The argument does not recognize the considerable differences in the benefits of
free trade between trading partners that result from differences in international
commodity prices which determine a country’s terms of trade.
3. The argument does not refute the valid formal argument for an optimal tariff
imposed by a trading nation.
4. The argument does not address, in terms of economic theory, the issue of winners
and losers within a country engaging in international trade. It ignores the failure
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of trade to achieve a Pareto-improvement in welfare (a condition in which no one
is worse off, and at least some are better off), thereby contradicting neoclassical
dogma.
5. The argument assumes full-employment despite the wide-spread presence of
unemployment and underemployment in many nations.
6. The argument assumes that unlimited labor may be freely relocated from an
industry with a comparative disadvantage into one that has a comparative
advantage.
7. The argument ignores the economic and psychological costs of relocating labor
from one industry to another.
8. The argument assumes that wages and prices are a function of labor productivity,
ignoring such factors as the effects of differences in labor supply, the role of
capital investment, monopolistic pricing practices (that engender profits, assumed
to be non-existent in the Ricardian model), international commodity prices
determined by a variety of factors, and exchange rate manipulation.
9. The argument is static in that it considers only a one time move from autarky to
free trade. In particular, it ignores the effect of economic growth, especially
growth resulting from technology changes and capital investment, in altering the
terms of trade and ultimately in shifting comparative advantage relations.
10. The argument ignores changes in efficiency as a result of expansion of those
industries with a comparative advantage. These changes in efficiency are
otherwise described as economies (or diseconomies) of scale.
These issues do not merely undermine the comparative advantage argument as a formal
argument, but demonstrate that the underlying Ricardian model is utterly inappropriate as
a heuristic for examining trade policy under specific situations. The question then arises
as to why trained professional economists are so enthusiastic about it.
Why Do Professional Economists Love Comparative Advantage?
When the well-known trade economist Jagdish Bhagwati speaks of the “Smith-Ricardo
demonstration of the gains from trade via specialization” (Free Trade Today p. 5), he is
misrepresenting economic theory. In fact, in the same section, he contradicts his claim of
a “demonstration” by claiming that “the analytically satisfactory proofs of trade’s
benefits that we modern economists demand are the handiwork of theorists working in
the twentieth century” (that is, over 100 years after the comparative advantage argument
was first presented); and in a footnote to this claim he references a paper published in
1972. (p. 4) It appears that the alleged “proofs” are not based on the Ricardian
comparative advantage argument cited in popular presentations—including his own. In
another book, In Defense of Globalization, he writes, “on both theoretical and empirical
grounds” trade “produces prosperity” (p. 82) The “theoretical grounds” are alleged
theoretical findings understood by “we modern economists” which are too complex to
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explain to the general reader. (But even this claim is false if by “trade” Bhagwati means
“free trade” which is apparently the case.)
There is a subtle kind of misdirection at work in this kind of writing. If the issue is
conceptualized as a stark choice between trade and autarky, few would dispute the
superiority of trade. Isolated societies, without meaningful foreign trade, are deprived of
the advantages of a larger division of labor and of natural resources unavailable
domestically. Such happiness as they possess is not product of modern material
abundance. However, if “trade” is construed as “free trade,” we have an example of a
“black-white” fallacy. Anti-globalization slogans such as “fair trade, not free trade,”
however vague or confused they may be, are not appeals for autarky. Trade conducted in
the context of tariffs, quotas, and subsidies is trade nonetheless, not autarky.
The best explanation for the sanctified status of the comparative advantage argument
among orthodox economists and economic and financial journalists, despite its numerous
unrealistic assumptions, is to be found in the general ideology of neoclassical economic
theory. We noted above that neoclassical economics is firmly committed to an
idealized—and normatively ideal—model of a laissez-faire market economy in a state of
competitive equilibrium. Economists assume, as part of the meta-belief structure of
neoclassic economics inculcated through their academic training, that such an idealized
economic system maximizes welfare in a peculiar technical sense (Pareto optimality), and
that somehow real market economies will, if only left undisturbed by government
meddling, converge to this ideal. For neoclassical economists, free trade is simply an
extension of this idealization to the international arena. However, strictly speaking, the
comparative advantage argument is inconsistent with the core model of neoclassical
theory. According to that model, there are no barriers to trade in any commodity—
including labor. And free trade in labor assumes free migration of labor internationally.
Leaving aside this flaw, it remains true that orthodox economists are deeply influenced
by the laissez-faire model of a competitive equilibrium and this predisposes them to
advocate free trade to a far greater degree than does the comparative advantage argument.
But professional economists do not expect lay persons either to buy into the complex
belief-structure of neoclassicism or to understand the abstract mathematical models
which they studied during years of university training. Thus they are inclined to present
their free-market ideas on the basis of well-selected quotations from Smith, Ricardo, and
other classic authors, using analogies like that of the superior man who elects to make
hats rather than shoes. Extolling the easy-to-understand comparative advantage argument
is part of this process, and claims of the argument’s supposed cleverness and even
profundity are empty rhetorical enhancements with the goal of making a very simple
argument appear to be a deep result of economic science. I suppose some readers liare
flattered to discover that they can understand this supposedly deep result. But, as seen
above, comparative advantage is not an effective argument for free trade as opposed to
trade with one or another form of protectionism. It fails to address the dynamics of
technological change, economic growth, the role of profit, employment and
unemployment, capital investment, and international flows of capital and labor.
Moreover, economists who invoke the comparative advantage argument in their popular
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writings invariably fail to mention a variety of sophisticated protectionist arguments that
have been offered by prominent economists over the years.
A final factor helps explain the apparent hypocrisy of at some professional economists
who praise the comparative advantage argument despite their awareness of its
shortcomings. This is the prevailing attitude of economists towards economic theory and
towards various “models” used in economic analysis. Economists are largely committed
to an instrumentalist interpretation of scientific theory, a position which treats theories as
neither true nor false but as more or less useful “tools” of analysis. As mentioned above,
instrumentalism was in vogue among philosophers of science of the highly influential
school of philosophy known as “logical positivism” that flourished from the 1920s to the
1940s. It soon proved itself untenable as an analysis of theories in the natural sciences.
However, many social scientists have found instrumentalism especially appealing
because it seemed to justify the confusing array of conflicting models and theories that
characterizes every social science. Instead of being an embarrassment for the would-be
“positive” science, contradictory models and theories could be viewed as a sign of
healthy fecundity: different tools for different jobs—different models for different
problems. The well known trade economists Paul Krugman and Maurice Obstfeld are
quite up-front about this in their text book. They write
Previous chapters developed three different models of international trade, each of
which makes different assumptions... each of these models leaves out aspects of
reality that the other stress....When we analyze real problems, we want to base our
insights on a mixture of models. (p. 92)
Although instrumentalism is universally rejected among contemporary philosophers of
science, its survival among economists helps explain the lack of qualms felt by
economists who offer an obviously false and inadequate model to a naïve public in
justification of free trade.
In the next chapter I’ll discuss a number of protectionist arguments. Economists’
discussions of these arguments generally revolve around one or another theoretical
formal model. However, as noted earlier, the primary reason that orthodox economists
favor free trade over protectionism is not really theoretical, but arises out of the
normative meta-belief structure of neoclassical theory. If free trade is “good,” then
opponents are often seen as ignorant or even “bad;” and protectionism is seen as the
policy of selfish parties who seek to shape trade policy to advance their narrow selfinterest. This is not simply a conservative bias. Even the economic reformer John
Maynard Keynes who (at one point in his career) defended tariffs, expressed moral
indignation, writing, “Nine times out of ten [the free trader] is speaking forth the words
of wisdom and simple truth—of peace and of goodwill also—against some little fellow
who is trying by sophistry and sometimes by corruption to sneak an advantage for
himself at the expense of his neighbor and his country. The free trader walks erect in the
light of day, speaking all passers-by fair and friendly, while the protectionist is snarling in
his corner.” 28 Certainly convinced free traders such as Jagdish Bhagwati and Martin
Wolf seem to believe that they are on the side of “wisdom and simple truth,” “peace and
goodwill.” And these writers, in fact, criticize the hypocrisy of governments of
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industrialized countries and organizations controlled by them (such as the World Bank
and IMF) whose free-trade rhetoric often conflicts an anti-competitive agenda with
respect to agricultural subsidies and the concept of “intellectual property.” But moral
rectitude and freedom from overt hypocrisy is not the issue. This book is about the
theoretical and factual support for various kinds of trade policy, not about the moral
qualities of proponents of these policies.
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Appendix: Comparative Advantage Represented Graphically
It is worthwhile looking at some simple standard graphical representations of
comparative advantage because these illustrate how “non-standard” outcomes—such as a
return to autarky—can arise from within the Ricardian model. The background for the
graphical representations discussed is the traditional neoclassical analysis known as
“partial equilibrium analysis.” A two-dimensional graph, with the vertical (y) axis
representing relative price and the horizontal (x) axis representing relative quantity, is
used to display two functional relations. The quantity of a product produced for a market
is held to be, in general, a positive function of the market price; this is the “supply curve.”
The quantity of a product that would be purchased at a given price is held to be a negative
function of price; this is the “demand curve.” Clearly, the actual quantity produced of a
product and the quantity purchased depend on a multitude of factors; hence, the alleged
supply and demand functions are held to exist only “ceteris paribus,” that is, “assuming a
fixed set of normal background conditions.” This is not the place to discuss the many
problems with partial equilibrium analysis. Rather I want to show how this standard
graphical presentation allows for various non-standard solutions that undermine the
comparative advantage argument.
The unique point of intersection of the supply curve and the demand curve is held to
determine equilibrium market relative quantity and relative price of the two traded
commodities. This graph is called the Relative Price/Relative Product Graph. There is no
claim to any empirical reality for the supply and demand curves shown on the graphs
presented; in fact, I merely represent the supply curve by a short arc generally sloping
upward to the right and the demand curve by an arc sloping downward to the right on the
assumption that a larger quantity is associated (given constant demand) with a lower
price and that a larger demand (given a constant supply is associated with a higher price.
Applied to the original Ricardian example, the vertical, or y, axis represents the relative
price of cloth (the ratio of the price of cloth to the price of wine) and the horizontal, or x,
axis represents the relative quantity of cloth (the ratio of the quantity of cloth produced to
the quantity of wine produced). As the quantity of cloth produced increases relative to the
quantity of wine, the intersection point (which determines the relative price and relative
quantity of cloth) moves further and further to the right; if 100% of the labor force is
employed in cloth production, the equilibrium relative quantity would lie at an infinite
distance from the origin. For various reasons, it is more convenient to represent relative
quantity differently, in terms of the percentage of maximum possible cloth production
which is realized. The relative quantity (x) axis then ends at a fixed distance to the right
of the origin where the end point represents 100% of available labor involved in cloth
production.
First, we use this modified Relative Price/Relative Quantity graph to depict the situation
in England and in Portugal under autarky. We represent the labor units (assumed to be
person-hours of labor) required to produce a unit of cloth in England by aC and that
required to produce a unit of wine by aW. Similarly, in Portugal we represent the labor
units required to produce a unit of cloth by a*C and to produce a unit of wine by a*W. As
before, Portugal is assumed to have an absolute advantage in producing both products
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which means that fewer production hours per unit of each product are required in
Portugal than in England (a*C < aC and a*W < aW). However, the ratio of hours required
to produce a yard of cloth in England to those required to produce a gallon of wine is
lower than in Portugal (aC /aW < a*C/ a*W) (cloth production is relatively more efficient
relative to wine production in England than in Portugal). Given the assumptions of the
argument, this suggests that both countries would gain from total specialization and from
then selling some of the additional product in which they specialize to the other country.
Portugal gains by specializing in wine production and sending wine to England in
exchange for cloth, England by giving up wine production and concentrating on cloth
production some of which is sent to Portugal in exchange for wine.
Next consider wages and prices under autarky. Let PC represent the autarkic price of cloth
in England and PW, the autarkic price of wine. In Portugal, P*C will represents the
autarkic price of cloth and P*W the autarkic price of wine. Under the assumption that the
only cost is labor and that the producing companies earn no profit, cloth workers in
England earn, per hour of work, a wage of PC/aC (the price of a unit of cloth divided by
the number of labor hours to produce it). For example, if a yard of cloth sells for $9 in
England (PC = $9), and 1 2/3 hours of work are required to produce it (aC = 100 minutes),
the hourly wage in the cloth industry is $5.40 (PC/aC = 9/1.667 = $5.40 per hour).
Similarly, the earnings per labor hour in wine making in England are represented by
PW/aW; as in Ricardo’s example, we take aW to equal 120 labor units (here assumed to be
minutes, so that aW = 2 hours). The model assumes that workers will move freely to
whatever job pays the highest hourly wage—only the wage matters to workers in
choosing where to work. So if the hourly wage for cloth making exceeds that for wine
making (PC/aC > PW/ aW) all workers will abandon the wine industry for work in the cloth
industry. In this case, if the hourly wage in the wine industry is less than $5.40, everyone
will opt to work in the cloth industry for $5.40 per hour. Under autarky, this would mean
that only cloth would be produced in England. Assuming both cloth and wine are
produced to satisfy the domestic demand, the hourly wage rates in the two industries will
be the same, hence PC/aC = PW/aW. Using simple algebra, this is equivalent to PC/PW =
aC/aW, which tells us that (under the various assumptions of the model) the relative price
of cloth (PC/PW) is equal to the relative efficiency of cloth production to wine production.
Since this ratio is determined by worker skills, equipment, and other factors held fixed in
the model, we conclude that the relative price is fixed at a specific level PC/PW which
equals aC/aW; in the original example this is 100/120 or 5/6. This means that the supply
curve has to be a horizontal line through the point 5/6 or 0.833.
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The domestic demand curve is a descending line that indicates the amount of each
product that would be purchased at each relative price (expressed as the percentage of the
maximum cloth output that gets produced). The intersection of this line with the
horizontal supply curve determines the relative quantities of each product that are
actually produced at equilibrium:
This graph represents England under autarchy as dedicating its labor to cloth production
to the extent that 40% of the total potential cloth output is actually produced. (If all of
England’s labor were devoted to cloth production, we would have 100% of potential
output.) A decrease in the relative demand for cloth (corresponding to an increase in the
relative demand for wine) would be represented by shift to the left of the demand curve
(shown as curve D2 in the graph) which would indicate a decrease in the proportion of the
workforce producing cloth, with the redundant workers now engaged in wine production..
A similar graph would represent the situation in Portugal under autarky, although the
different productivity relations in Portugal determine a different relative price. The
relative demand curve would probably differ as well. The Portuguese equilibrium relative
price, P*C/P*W is equal to a*C /a*W. But because England had the comparative advantage
in cloth production, a C/aW < a*C C/a*W, hence the Portuguese equilibrium relative cloth
price is higher than the English equilibrium relative cloth price; both are fixed. Thus the
horizontal Portuguese supply curve is higher than the English curve, corresponding to the
higher equilibrium relative cloth price. It is given by a* C C/a*W = 90/80 or 1.125 which
is larger than the English price aC/aW = 0.833. (In general, under autarky the country with
the comparative advantage in the product whose relative price and relative quantity are
being plotted is represented by the lower horizontal supply curve.) In general case, the
total potential cloth output of Portugal will differs from that of England according to the
productivity and the size of the work force; here it is represented as half that of England.
This is entirely due to a smaller workforce since by assumption Portugal is more efficient
than England in producing cloth.
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D2
Even if the Portuguese and English had similar tastes and hence identical relative demand
curves, the higher relative price of cloth in Portugal would result in a lower percentage of
cloth production in Portugal as compared with England. However, if the Portuguese
demand for cloth relative to wine were sufficiently higher than the relative demand in
England, we might actually have a proportionately larger ratio of cloth to wine
production in Portugal despite the higher relative cloth price. (As represented by demand
curve D2.)
Graphical Representation of Free Trade
To represent the situation under free trade, we have to expand the horizontal axis to
accommodate the combined maximum potential output of cloth of both countries, the
output that would result if both countries produced only cloth. By the usual assumption,
under free trade cloth is only produced, and exclusively produced, by the country with the
comparative advantage, in this case England, so the relative quantity of cloth produced is
now given by QCmax/ (QCmax+Q*Cmax) (the total potential cloth output of England, which is
the actual output under free trade, divided by the total potential cloth output of both
countries). That means that if England had a far greater productive capacity than Portugal
(due to a larger labor force, not because of higher productivity), the equilibrium relative
quantity could be larger than 50%, well to the right of the center point of the x-axis which
measures the relative quantity of cloth produced. The international relative cloth price
must lie between the lower English equilibrium relative cloth price which is equal to
aC/aW and the higher Portuguese equilibrium relative cloth price which is equal to
a*C/a*W or it may lie at one of the two extreme values. A vertical supply curve exists
between the two extreme relative price points because within that range the supply is
determined by the fixed total capacity of England to produce cloth. However, at the
extreme points, the supply curve becomes horizontal! This is because England and
Portugal will revert to the autarkic relative price values and the relative supply of cloth
(jointly) will be determined solely by the aggregate relative demand (a function of the
productive capacity of each country and the internal demand for cloth in each country at
the autarkic relative price). Surprisingly, the international relative demand curve may or
may not cross the supply curve in its vertical segment. Demand curve DI1 represents the
“standard” case which is almost always assumed in presentations of comparative
advantage. However, if the aggregate international demand is sufficiently greater or
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sufficiently less, the aggregate international demand curve will intersect one of the
horizontal segments instead (e.g., DI2 and DI3):
In the so-called “normal” case, the demand curve intersects the vertical segment to
determine an international equilibrium relative price of cloth as somewhere between the
lower relative English price under autarky (0.833) and the higher relative Portuguese
price under autarky (1.125). The curve DI1 illustrates the normal case. The closer the
international equilibrium price is to the English relative price under autarky, the better the
situation for Portugal since under the assumption of a comparative advantage in cloth
production by England, the English relative cloth price under autarky is lower than the
Portuguese price under autarky, thus insuring that the Portuguese get a big price break on
their cloth purchases. Conversely the closer the international relative cloth price is to the
Portuguese relative price under autarky, the better it is for England. This graphically
illustrates the idea that there may be more or less favorable terms of trade compatible
with the comparative advantage model. The earlier discussion provided a specific
example where England could greatly improve its terms of trade (shifting the demand
curve upwards to produce an equilibrium relative price closer to the Portuguese autarkic
relative price) with Portugal through the imposition of a tariff on Portuguese wine.
Two “abnormal” possibilities are revealed in the Figure 3. Suppose, for example, that
international demand is represented by DI2. In this situation the relative international
demand for cloth is so low (or conversely that relative international demand for wine is
so high) that the international equilibrium cloth price is equal to the English relative cloth
price under autarky (aC/aW) so that relative international wine demand will only be met if
England produces less than the maximal possible amount of cloth and uses the redundant
labor to produce wine to add to that produced by Portugal (which is exclusively
producing wine). In Figure 3, the horizontal part of the supply curve from the origin to
the DI2 equilibrium quantity DI2eq represents English (and hence world) cloth production
relative to the potential aggregate maximum, and the remainder of the segment, from the
equilibrium relative quantity to the vertical segment of the supply curve corresponds to
the English wine production for the English market. Moreover, the part of this curve that
lies between the old autarkic equilibrium x and the new equilibrium point DI2eq represents
the increase in cloth production (from autarky) that will be traded for Portuguese wine.
Under the equilibrium determined by DI2, England apparently gains nothing from trade
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since the relative prices and relative wages remain unchanged from the autarkic prices. In
fact, it is simply trading some of its cloth for Portuguese wine instead of simply
converting the remainder of the new cloth production to wine production and reverting to
autarky. Portugal, on the other hand, benefits greatly from trade because it now buys
cloth from England at the relatively low English price rather than at the much higher
relative Portuguese price so that its workers earn relatively more from the wine
production in which they are exclusively engaged than they would under autarky. In other
words, the Portuguese wine imported to England will be exchanged for a considerably
larger amount of English cloth than could be produced if the Portuguese workers moved
from domestic wine production to domestic cloth production.
English workers are indifferent as to whether they are engaged in one or the other kind of
production. Assuming that English demand is unaltered from the demand in autarky, the
international demand curve cannot cross to the left of the original equilibrium point x
(40% of potential English cloth production). The aggregate relative international demand
for cloth will determine how much wine is produced in England to supplement
Portuguese wine imports. The advantages of trade rest entirely with Portugal. English
cloth that is traded for Portuguese wine represents a one-to-one compensation for the
English wine production that was foregone when the cloth production in England
increased to meet international demand. This means that according to the model England
could return to autarky without economic loss.
The situation is just the opposite if the relative international demand for cloth increases
sufficiently as represented by curve D I3 so that the international relative cloth price rises
to a*C/a*W. In that case, Portuguese workers would resume cloth production for their
domestic use but also would supplement it with English cloth traded for Portuguese wine
at a ratio no different from that obtaining under autarky. (The Portuguese cloth
production is represented by that part of the right horizontal supply segment lying
between the vertical segment and point DI3eq. Under these conditions Portuguese workers
are no better off than during autarky and could decide to abandon trade, thereby
penalizing England which had gained greatly from trade due to the high relative
international price of cloth. Portuguese cloth production can never exceed that
represented by point y which represents the autarkic level of cloth production unless
Portuguese demand for wine falls lower than under autarky.
Of course, in the real world there are enormous costs in setting up new industries and in
moving workers. If the relative international price of cloth were high, even if not quite as
high as (a*C/a*W), both countries might be concerned about the future of international
trade. England would be concerned that if it were to totally abandon wine production,
Portugal might, if the relative cloth price rose just a bit more to the old Portuguese
autarkic level, then opt for autarky because it no would longer see any benefit from trade.
In that case, England would be forced to re-establish a wine industry with all associated
start-up costs. On the other hand, contemplating free trade from a state of autarky,
Portugal might worry that if it abandoned its capital-intensive cloth industry for reasons
of comparative advantage (of wine) it would gain very little because the international
relative cloth price is almost as high as the Portuguese autarkic relative cloth price; in
short, it would have poor terms of trade. And Portugal could foresee a future situation in
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which the relative price of cloth would rise so high that Portugal would derive no benefit
at all from trade. If that occurred, Portugal might be faced with the challenge of reviving
its cloth industry which would require a large investment. Thus countries seeing
relatively little to gain due to adverse terms of trade from trade may well seek to protect
an industry which for which it has a minimal comparative disadvantage.
It is possible to give graphical representations of a number of scenarios involving
changes in international relative prices, changes determining which country has the
comparative advantage in which product, and changes in relative supply due to growth of
the labor force in one of the two countries (discussed below). The purpose of the above
discussion is simply to demonstrate that thoughtful economists are aware of non-standard
possibilities within the context of the comparative advantage model even though in their
popular writings they ignore these when they give sweeping endorsements free trade
justified by the comparative advantage argument. The possibility that the international
relative demand curve will not cross the vertical international relative supply curve
between the autarkic relative price levels is mentioned in Krugman’s and Obstfeld’s
textbook (18-19) However, they do not pursue the matter, instead, they merely comment
that total specialization envisioned by Ricardo is the “normal result of trade.” But the
above graphs show that nothing like a “demonstration” can be claimed, even given
numerous unrealistic assumptions of the Ricardian model. I will also use a graphical
analysis to discuss a change in the level of employment in one of the two countries, but
first I want to briefly illustrate graphically some other serious deficiencies of the model.
Graphical Presentation of a Change in the Size of a National Work Force
In the so-called normal case, all English labor is devoted to cloth-making and all
Portuguese labor to wine-making. If the total hourly output of the English labor force is
represented by L and that of the Portuguese labor force by L*, then QIC = L/aC and QIW =
L* /a*W. In other words, under free trade the world-wide quantity of cloth produced per
unit period is determined by the total English labor output divided by the hours per unit
of cloth, and similarly for the world-wide quantity of wine produced per unit period.
Similarly, we English wage w under trade is equal to PIC/aC and the Portuguese wage w*
under trade is equal to PIW/a*W. That is, the international relative wage rates are equal to
the international price of the product produced exclusively in the country divided by the
labor units used to produce a unit of the product in the country. Thus PIC = (aC )(w) and
PIW = (a* W)( w*) Dividing the first identity by the second yields
PIC/PIW = (aC/a* W )(w/w*) where (aC/a* W ) is a constant in the model given the assumption
of fixed technology and worker skills. Thus we see that under trade the English wage
rate relative to Portuguese wage rate is directly proportional to the relative international
price of cloth PIC/PIW. The greater the relative international demand for cloth, the greater
the international relative price, and hence the greater the value of w/w*. Higher relative
international demand for cloth (e.g. DI1) determines a higher relative price for cloth and a
higher English wage relative to the Portuguese wage.
We can use a graphical method to depict the effects of growth of the labor force in one of
the two countries engaged in trade.
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Earlier, we considered a situation (first described by Ricardo) in which the comparative
advantage reverses. Let’s now consider the potential effect of a significant increase in the
work force of one of the two countries. We will call the countries “the United States” and
“China” since there is a kernel of reality in the situation described. Suppose that China
has an absolute advantage in both products, and has succeeded in obtaining a comparative
advantage in cloth-making—which serves as a surrogate for manufacturing in general.
(Wine-making serves as a surrogate for primary sector production.) China achieved it
comparative advantage in cloth production through protectionist measures associated
with an export-oriented trade strategy. The Relative Price/Relative Quantity Graph that
represents this situation places China below the U.S. even though China has the absolute
advantage with respect to both products, since aChina,C/aChina,W < aUS,C/aUS,W. (Note that in
the previous example, Portugal, which had the absolute advantage with respect to both
products was represented on the graph above England.) In other words, the upper
horizontal segment of the supply curve corresponds to a relative cloth price value of
aUS,C/aUS,W and the lower horizontal segment to aChina,C/aChina,W . The intersection of the
vertical solid line segment of the supply curve with demand curve DI in Figure 4 shows a
“normal” equilibrium point x:
However, according to Figure 4, China receives little benefit from trade (over autarky)
because the international relative price determined by DI is barely above what would
occur in China under autarky, whereas the U.S. apparently gains a great deal because the
price of imported cloth is relatively a lot lower in the U.S. than it would be under autarky.
(Once again we assume full employment in the United States.)
Now consider an expansion of the Chinese labor force, represented graphically in Figure
4 by the dotted line that extends the lower horizontal segment of the supply curve to the
right; this represents an expansion of potential cloth production in China. The entire
supply curve is extended to the right as indicated by the new dotted segment at the
extreme right end of the upper horizontal supply curve segment. (The new situation is
also indicated by various labels carrying the superscript P.) This expansion of potential
cloth supply results not from population growth but from the entry into the trade sector of
poor workers from the large, but relatively isolated, semi-subsistence agrarian sector that
is outside the international trade system.
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This increase in Chinese cloth manufacturing labor has the effect of shifting the
equilibrium point out of the “normal” vertical segment of the supply curve
(corresponding to relative quantity x) and onto the new extended horizontal segment
determining relative quantity z. Note that because of the increase in workers who are also
consumers, the absolute demand for cloth increases (represented by a rightward shift of
the demand curve) but the relative demand does not because it is assumed that these
workers have the same relative desires for cloth and wine as the workers formerly in the
trading system. Thus z is in the same position relative to the maximum possible postexpansion production of cloth as x was relative to the pre-expansion maximum. However,
with the increase in the Chinese workforce, the (unchanged) relative quantity of cloth to
wine now falls on the new horizontal “Chinese” segment which means that China has lost
even the marginal advantage of trade with the U.S. over autarky To induce the Chinese
to continue trade so that the U.S. can obtain the cloth (i.e., industrial goods) it wants, the
U.S. could sell something else to China—government bonds which will come due in the
future, or real estate, or shares of corporations, or other forms of property—in order to
finance cloth imports.
What happens when the U.S. runs out of assets to sell in sufficient quantity to finance
cloth (industrial) imports? The U.S. currency could then fall sufficiently relative to the
Chinese currency to insure that U.S. wine (that is, primary goods) becomes more
appealing to the Chinese than Chinese-produced wine. But because of the fall in the
dollar exchange rate, the U.S. would have to trade more wine to China than before in
exchange for the cloth it consumes thus raising the relative price of cloth. Graphically,
the vertical segment of the supply curve is now taller as shown in Figure 5, corresponding
to the new higher relative price of cloth—a relative price that creates a less favorable
situation for the U.S. than during autarky! At the same time, the international demand
curve will shift right as shown in Figure 5 as more and more Chinese cloth is consumed
internally by the now-wealthier Chinese. This seemingly paradoxical result arises from
the increased income (and greater buying power) of the Chinese who are now able to
consume more of their domestic cloth production while sending less to the U.S. in
exchange for wine.
Note that the new equilibrium relative price, point v in Figure 5, lies well above the old
U.S. autarkic equilibrium relative price, indicated by point u (=aUS,C/aUS,W). It might be
objected that this is impossible; the U.S. would never tolerate an exchange rate that
renders it worse off than during autarky. But this objection ignores the difficulty of reindustrialization. To create a new industry requires enormous capital, extensive worker
training at all levels, and probably a willingness to adopt protectionist “infant-industry”
policies. Thus reversion to autarky is less likely to occur than a decline of relative living
standards. (I stress “relative living conditions” because technological change can result in
an overall improvement in the standard of living independently of the exchange ratio.)
Although these kinds of problematic situations can be graphically represented within the
Ricardian comparative advantage model (see Chapter 1 of Krugman and Obstfeld), they
are largely ignored in popular discussions of comparative advantage. In their textbook,
Krugman and Obstfeld (in the same chapter that briefly alludes to situations that might
herald a possible return to autarky) chastise the historian Paul Kennedy for asking “What
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if there is nothing you can produce more cheaply or efficiently than anywhere else,
except by constantly cutting labor costs?” (23) Kennedy’s question is dismissed because,
according to Krugman and Obstfeld, it demonstrates Kennedy’s failure “to understand the
essential point of Ricardo’s model, that gains from trade depend on comparative rather
than absolute advantage.” The authors acknowledge that they are drawing this conclusion
from “the simplest of all models of international trade,” a model which they claim
captures the “essential points.” However, as we have just seen, graphs used to represent
the Ricardian model make clear that there are situations essentially identical to that
alluded to by Kennedy. Despite all its shortcomings, the model used by Ricardo in
arguing for free trade demonstrates the dangers of free trade under certain conditions.
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Chapter 4
Some Theoretical Arguments for Protectionism
Chapter 3 criticized the comparative advantage argument not merely as a formal
theoretical argument for free trade, but also through the use of examples of circumstances
in which free trade might be viewed as a poor choice for a particular country. One such
example was the imposition of a so-called optimal tariff to improve national welfare.
Another example dealt with the protection of a manufacturing industry even when it was
at a comparative disadvantage. And another example dealt with the effect of an increase
in the labor force in altering the terms of trade so that a competing country might impose
protectionist measures to avoid loss of an industry. Defenders of free trade typically
begin by presenting a simplified version of the comparative advantage argument, along
with the usual claims as to its profundity. But then of necessity the discussion shifts from
the empty comparison of autarky to free trade using the Ricardian model to more detailed
criticism of various protectionist proposals.
It is interesting that orthodox economists’ dislike of protectionism typically exceeds their
enthusiasm for free trade. As if sensing the weakness of comparative advantage as a tool
for attaching specific protectionist proposals, they have been intent on finding arguments
against them. The strategy, however, is largely negative and proceeds by attempting to
refute arguments that have been advanced over the past two hundred years in favor of one
or another form of protectionism. This is ultimately indecisive because refuting an
argument to a conclusion does not demonstrate that another, argument, both sound and
valid, doesn’t exist. The best strategy would be to find a general argument in favor of free
trade. But in the absence of anything better than comparative advantage, the negative
strategy prevails.
There are three types of refutation. First, there are theoretical refutations. These typically
involve the construction of a formal neoclassical model, often with assumptions about
various parameters (e.g., the elasticities of the demand or supply curves). Second, there
are political refutations that rely on the alleged impracticality of a proposed protectionist
measure, its collateral costs, or the likelihood of retaliation. Third, there are attempts at
empirical refutation using case studies to show that one or another proposed protectionist
policy, when implemented, has failed to accomplish the objectives claimed for it. In
general, neoclassical economists have used a mix of theoretical and political arguments;
case studies have played a smaller role and will be discussed in the context of a more
general discussion of empirical evidence relating to the benefits of free trade and other
free market policies.
In their popular presentations, economists defending free trade often claim that arguments
for protectionism—when not motivated by selfish self-interest—arise from economic
ignorance. This is unfair because a majority of protectionist arguments have been
advanced by leading classical economists or, more recently, by academically-trained
neoclassical economists who are outside the main-stream. The arguments offered by
these economists are rarely mentioned in popular presentations even though at least one,
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the terms-of-trade argument discussed in Chapter 3, is generally acknowledged to be
theoretically valid by orthodox defenders of free trade. In such a case, the alleged
refutation is not theoretical, but is typically political in nature when made at all. More
typically, the argument is simply ignored.
The various arguments for protectionism vary in the degree to which they lend
themselves to formulation using classical or neoclassical formalism. For example, the
terms-of-trade argument can be presented using only the simple conceptual apparatus of
the comparative advantage model, although it can be recast with greater precision using
neoclassical formalism. Other arguments, such as the increasing returns argument, the
Australian argument, the wage differential argument, and the strategic trade argument
have been debated using formal neoclassical models—although I shall argue that that has
not been a productive approach. On the other hand, the well-known infant industry
argument does not appear to lend itself to formal neoclassical analysis.
The discussion that follows suggests that casting a protectionist argument in terms of a
neoclassical model will never lead to any clear conclusion as to its validity, because the
formal models invariably omit a number of relevant variables. I shall argue that the
advantages and disadvantages of one or another protectionist measure depend on various
facts that apply in particular situations: the specific economic conditions of the industry
to be protected, both in the country and outside it, the cost and practicality of the
proposed protectionist measures, the likelihood of a successful outcome from the
application of the measures given the subject country’s social and cultural characteristics,
and the likely response to the implementation of these measures by the country’s trading
partners. This analysis requires taking account of an enormous number of economic,
social, political, and cultural factors that elude formalization. Neoclassical economists
have discussed some of these factors in recent years, notably the importance of property
rights and contract law in insuring effective market activity. But the relevant factors go
far beyond these, to include “cultural” factors such a country’s educational system, the
society’s attitude towards innovation and change, the prevalence of various types of
corruption, the cultural attitude towards poverty, the cultural value placed on economic
security, and the cultural attitude towards material improvement. At least some
economists, at some level, recognize the importance of many of these factors. But given
their general belief in the existence of universal economic laws and in the utility of
various abstract mathematical models that express them, their attention is continually
directed away from specific social, cultural, and economic conditions towards the
abstract and general. For neoclassical economists, complex real market activity is viewed
as one or another kind of “market failure” because such activity falls short of the
idealized model of a market economy in a state of competitive equilibrium.
What follows is not a scholarly discussion of various protectionist arguments that have
been proposed by economists over the past two centuries. Rather it is a brief survey of a
few of the protectionist arguments that have been taken seriously by academic
economists, with a focus on the criticisms of these arguments that has been offered by
advocates of free trade. My principal source is the excellent history of theoretical
opposition to free trade, Against the Tide, by Douglas Irwin. Irwin provides a detailed
history of various protectionist arguments and, as a strong supporter of free trade he
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spends a great deal of time discussing (and endorsing) criticisms of them. I will offer a
critique of these criticisms.
More on the Terms of Trade Argument
The expression “terms of trade” refers to the ratio at which imported and exported goods
are exchanged. The possibility of improving a country’s terms of trade though imposition
of an import tariff was illustrated in the previous chapter. In Scenario IV England was
able to alter the terms of trade in its favor by imposing a tariff on wine imports. The
possibility of altering the terms of trade through the imposition of a tariff was recognized
early on by the classical economist Robert Torrens. A country that unilaterally imposes a
tariff obtains, “in exchange for the produce of a given quantity of her labor, the produce
of a greater quantity of foreign labor.” (104) Torrens opposed unilateral free trade on the
part of a country facing such a tariff. As reported in Irwin’s history, Torrens’ criticism of
(unilateral) free trade in the 1840s provoked a strong reaction from free trade advocates
who (like Wolf) argued that a trading partner’s tariff only damaged the country imposing
it, and that other countries should continue to practice free trade despite the tariff.
However, Irwin concedes that the terms of trade argument is theoretically sound and
remains “the most durable and important exception to free trade ever conceived.” (101)
The usual criticism of the argument is political: a country imposing such a tariff would
face retaliatory tariffs by its trading partners. On the other hand, if all the trading partners
followed Wolf’s advice, the “political” argument against the terms-of-trade argument
would lose its force.
The possibility of a unilateral benefit from imposing a tariff on imports of a product for
which a country is at a comparative disadvantage was not recognized by Ricardo nor by
other early classical economists because they did not analyze the ratio at which goods
were exchanged, instead focusing on the mutual qualitative advantage to be gained by
trade over autarky. Like Wolf, most classical economists and, perhaps surprisingly, the
majority of later economists, have advocated removing all tariffs and subsidies even
when a country’s trading partners do not, asserting that trading partners who leave in
place tariffs and subsidies only damage themselves. Torren’s insight arose initially from
the argument that imposition of a tariff could result in drawing precious metals as specie
into a country, thereby raising domestic prices, wages, and profits, and increasing the
purchasing power of its labor (in terms of gold). This argument, which seems reminiscent
of certain mercantilist arguments, was not offered as a reason for imposing a tariff to
secure a more favorable balance of trade. Rather it was used to argue for a trade policy
based on reciprocity: Britain should only lower duties on goods imported from countries
that agree to import British goods on equally favorable terms.
Torrens soon improved and simplified his argument. A key insight that transcended the
Ricardian model was that the international price of an exported product is determined by
aggregate international supply and demand, not by the local costs of production as
supposed by Ricardo and most early classical economists. The price of the imported good
rises in the country imposing the tariff, demand falls, and as a consequence aggregate
international demand for the good falls (although by a proportionately lesser amount).
The decreased international demand should result in a fall in the international (pre-tariff)
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price of the good facing the tariff. Early criticisms of Torren’s reasoning led to
modifications of the argument. One such criticism was the recognition that if only one
importing country out of many imposed a tariff, the international price of the imported
product might fall very little since the decreased demand in one country might have little
effect on aggregate international demand. In addition, if a tariff were imposed on the
importation of raw materials, the manufacturing sector which provided the principal
exports in a country like Great Britain would be adversely affected by the higher prices
because of their dependence on the raw materials. (For that reason, Torrens did not
recommend retaliatory tariffs on the importation of raw materials.)
Writing a few years later, John Stuart Mill noted that another factor in determining the
effectiveness of a tariff in creating an advantage for the country imposing it is the
international elasticity of demand for the export product of the country that imposes the
tariff on imports. (Demand is elastic if it falls rapidly with a price increase; inelastic if a
price increase doesn’t decrease demand by much.) If the international demand curve for
an exported product is relatively inelastic, international demand will not decrease much
in the face of the increased prices that result from the imposition of tariffs by importers,
and thus the exporting countries will lose little in terms of total revenue from the
exported product. This situation is more likely to occur with primary sector exports (raw
materials, agricultural products) than with manufactured goods because primary sector
goods serve as essential raw materials for manufacturing (or in the case of agricultural
products, consumer demand may be relatively inelastic). In addition, production of
specific primarily goods is often confined to a limited number of countries due to
climatic, geographic, and geological conditions means that the supply curve is also
inelastic. This train of thought is the basis of an argument for protecting a domestic
manufacturing industry that coexists with a primary sector export industry: a country
imposing the tariff on (competing) imported manufactured goods may have little fear that
other countries will impose a tariff on its primary sector exports because of the reasons
just stated. Thus when a country exports primary goods with demand-curve inelasticity, it
can use a tariff on imports of manufactured goods to shift the terms of trade in its favor;
retaliatory tariffs of the primary good will do little to damage exports. Mill demonstrated
that the losses to the country whose exports are subject to a foreign tariff are greater than
the gains to the country imposing the tariff; thus the terms-of-trade argument cannot
claim that a global benefit results from the imposition of the tariff. But this fact will be
unlikely to convince a government to forgo a tariff which increases its own national
welfare. And given the maximization of utility assumption of neoclassical theory,
economists are hardly in a position to preach altruism to such governments.
Mill’s argument also suggests that governmental restrictions on exports, or restraints by
producers, could alter the terms of trade to a country’s advantage provided that the
exports face a relatively inelastic international demand curve. Restraints could also result
from exercise of monopoly power on the part of producers—examples include cartels
controlling the production and export of diamonds and petroleum. Calculations as to the
optimal size of the tariffs (or the export constraints) as a function of import and export
supply and demand elasticities have been made in the context of various formal
neoclassical models.
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Irwin concludes that “few developments have undermined [the terms of trade
argument’s] standing as a theoretically valid proposition.” (114) But he then goes on to
say that the “the conclusion to be drawn from the terms of trade controversy is not that
free trade is undesirable, but that, under certain circumstances, unilateral free trade is
undesirable.” His recommended remedy is an international agreement in which all agree
to forego the use of tariffs to alter the terms of trade. Since free trade is sacred writ
among neoclassical economists, most support Irwin’s conclusion. International
agreements are recommended to avoid what is termed a “beggar-thy-neighbor” policy—a
rare example of economists supporting global altruism instead of the narrow pursuit of
self-interest. But Irwin’s recommendation is based on political not economic
considerations, and one’s attitude towards it in a particular situation depends on the
relative weight assigned to the particular national interest versus the aggregate global
interest. And when national interests are put first, the appeal of the recommended
international agreements may depend on calculations as to the likelihood of effective
retaliation to domestic protectionist measures and also on the specific demand elasticities
facing a country’s imports and exports. A country like mid-nineteenth century England
which principally imported raw materials for its industries would hardly benefit from a
protectionist policy. On the other hand, a country which controls and exports a large part
of the world supply of an important raw material which has an inelastic demand curve
might, if rational and with minimal fear of retaliation, institute protectionist measures to
maximize its terms of trade. As long as countries act to maximize their national wealth,
and as long as economists play the role of advisors to the governments of such countries,
free trade will often appear less desirable than carefully chosen protectionist measures.
In general economists agree with Krugman and Obstfeld, who write “the terms of trade
argument against free trade, then, is intellectually impeccable but of doubtful usefulness.”
(224) Their justification for this remark has two parts, one relating to small economies
and one to large economies. They claim that small countries have little ability to affect
world prices. However, the real issue for a small country is potential retaliation. As we
saw above, the likelihood of retaliation through imposition of tariffs on a country’s
exports is entirely an empirical matter; depending on the elasticity of world demand for
the exported product. Even a small country that is in possession of a scarce resource may
have the power to gain from the restrictions on the product’s export and from imposition
of a tariff on imports of other products.
With reference to large economies, Krugman and Obstfeld write
For big countries like the United States, the problem is that the terms of trade
argument amounts to an argument for using national monopoly power to extract
gains at other countries’ expense. The United States could surely do this to some
extent, but such a predatory policy would probably bring retaliation from other
large countries. (224)
The normative meta-belief system of neoclassical economists is on display here, signaled
by phrases like “using national monopoly power to extract gains” and “predatory policy.”
But in the end their “refutation” is no more than an off-hand political prediction with no
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facts presented in support of it. And Mill’s argument demonstrates that the effectiveness
of retaliation is a function of specific factors including elasticities of supply and demand.
The Increasing Returns Argument
A number of protectionist arguments rely on the widely held belief that manufacturing
industries provide more benefits for national economies that agriculture, forestry, or
mining—industries comprising the primary sector. The increasing returns argument
provides a formal development of this idea. The principal reason for the alleged
difference between manufacturing and primary goods production relates to changes in the
cost of marginal production as output increases. Malthus, Ricardo, and other classical
economists argued that an increase in agricultural production required bringing
increasingly less productive land under cultivation, thereby raising the marginal cost of
production; in other words agriculture is subject to decreasing (or diminishing) returns to
scale. This applies also to mining where increased production often involves processing
lower-grade ores. In manufacturing industries, on the other hand, it is generally held that
growth (typically) involves an increase in the division of labor associated with the
introduction of costly specialized equipment and the development of infrastructure—
communications and transportation systems, specialized training, etc. These
developments lead to a decrease in marginal (or unit) costs of production, or equivalently,
to increasing returns to scale. It was this phenomenon that was alluded to in the previous
chapter in the discussion of the example involving Northland and Southland, and the
discussion of the growth of Chinese industry.
If primary goods production and manufacturing do generally differ in this way, the
comparative advantage argument encounters a major problem. Production levels of two
countries in a state of autarky will change when the specialization occasioned by trade
takes place, and if one country specializes in agriculture (or some other type of primary
goods production), it may experience a decrease in marginal output, whereas its trading
partner specializing in manufacturing may experience an increase in marginal output.
This shifts the balance of trade in favor of countries that export manufactured goods.
The potential consequences when the industries in different countries differ with respect
to the returns to scale they enjoy was first pointed out by the British economist J.S.
Nicholson in 1897. Nicholson presented an example in which one country has a
comparative advantage in wheat production, the other in cloth production. As the latter
shifts labor from agriculture to a growing textile industry, the average per capita output
of cloth increases; however, the wheat-producing country will experience a fall in
average per capita output of wheat as labor is shifted from textiles to wheat farming.
According to Nicholson, these combined developments could ultimately result in the
agricultural country’s consuming less of both products than it had consumed under
conditions of autarky. He concluded that protectionist measures to promote the growth of
manufacturing are warranted. Such measures would include protecting growing
manufacturing industries through the imposition of tariffs, placing quotas on competing
imports, subsidies, and investments in growth-promoting infra-structure.
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The mathematics of neoclassical theory, which lies at the heart of neoclassical analysis,
has had trouble modeling industries with increasing returns within the general
equilibrium formalism due to mathematical limitations. Historically, this caused serious
problems for economists such as Nicholson who attempted to present the increasing
returns argument using the mathematical models of neoclassical theory. Nicholson’s way
around the problem was to appeal to the concept of average cost rather than marginal
cost in analyzing the effect of increasing cloth production. But this move opened his
analysis to criticism on technical grounds and for many years the argument was largely
ignored by professional economists.
Then, in the nineteen-twenties the Princeton economist Frank Graham offered a
reformulated version of the argument. Graham wrote, “it may well be disadvantageous
for a nation to concentrate in production of commodities of increasing cost despite a
comparative advantage in those lines; it will the more probably be disadvantageous to do
so if the world demand for goods produced at decreasing cost is growing in volume more
rapidly than that for goods produced at increasing cost.” (Irwin, 142) In other words, if
the world demand for manufactured goods is growing faster than the world demand for
agricultural goods, it is probably a bad idea for a country to specialize in agricultural
exports regardless of their comparative advantage; however, if the situation is the
opposite so that international demand for the agricultural product is increasing more than
for the industrial product, then despite diminishing marginal production in agriculture, it
may be justified to export agricultural goods. The introduction of the concept of trend in
world demand led to the recognition that it is possible for an agricultural exporter
experiencing diminishing returns to gain from additional production provided the world
demand for its agricultural product increases sufficiently relative to the world demand for
the imported manufactured product. However, without such a relative increase in the
international demand (and price) of the agricultural product, specialization in agricultural
production will prove disadvantageous.
Despite Graham’s analysis, the technical problem regarding increasing returns persisted.
According to Irwin, the problem arises because standard neoclassical models in which
increasing returns are assumed for an industry yield two equilibrium points, one with zero
labor involved in production of the product, the other with 100% of the labor force
involved, and there is no stable equilibrium point between these two extremes. All the
intermediate points represent “economic inefficiency,” with either too much or little labor
dedicated to manufacturing. The formalism of neoclassical theory requires that wages
equal the marginal product of labor, an impossibility in case of increasing returns (short
of the 100% employment solution). Graham tried a move akin to Nicholson’s assuming
that wages equal to the average product of labor rather than the marginal product. But
Graham, like Nicholson before him, thereby opened himself to technical criticism from
orthodox economists. Readers unfamiliar with neoclassical theory should be aware that
the assumption that wages equal the marginal product of labor receives no support from
empirical studies; the assumption derives from the use of marginal analysis in
neoclassical formalism, and it is limited to models of pure competition.29
In addition to quibbles over formalism, a second line of criticism of the increasing returns
argument focused on the nature of the alleged efficiencies that cause the increasing
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returns to scale in manufacturing industries. Frank Knight, a well-known University of
Chicago economist, claimed that if the increasing returns result from internal efficiencies
(efficiencies within the individual firm), the industry experiencing them would
consolidate until it consisted of fewer firms, each having the optimally efficient size. The
end result might even be a single firm exercising monopoly power. Aggregate growth in
output would then only result from an increase in the total number of firms of optimal
size in the market. However, even if we grant the dubious assumption that all efficiencies
of scale are internal to firms, Knight’s argument is only effective as an argument against
permanent protection; it is not effective as an argument against protecting industries
whose firms have yet to achieve the optimally efficient size. In addition, Knight agreed
that Graham might have a case for protection if increasing returns resulted from external
efficiencies, although he was unconvinced of the existence or significance of such
external efficiencies.
Knight’s criticism together with later criticisms from the well-known economists Jacob
Viner and Jan Tinbergen focused on technical shortcomings in Graham’s analysis.
However, the conviction on the part of some economists that a country may benefit by
nurturing industries with increasing returns to scale has survived such technical
criticisms. In particular, the possibility that the increasing returns to scale arise from
external economies has been recognized by economists as providing a valid argument for
protectionism within a neoclassical conceptual framework. The simplest neoclassical
model that supports protectionism under these circumstances assumes that the industry to
be protected conforms to the model of perfect competition, meaning that there are a large
number of firms, each too small to influence the market price, each producing under
conditions of rising marginal costs to the point where price equals marginal cost. As this
competitive industry grows, efficiencies of scale arise from the creation of a more
efficient infrastructure or through other kinds of aggregate efficiencies external to the
individual competitive firms in the industry. The result is a decrease in marginal costs
throughout the industry, accompanied by a decrease in prices. Each firm sees its
equilibrium output level increase, with the increased output associated with declining
marginal costs and a lower market price. This neoclassical model has nothing to do with
the reality of modern industrial production, but it does demonstrate the possibility of a
neoclassical model that supports the increasing returns argument for protectionism.
Even through this formal model has been accepted as theoretical possibility, its existence
has had little effect on the thinking of economists regarding trade policy. The use of
government intervention (e.g., subsidies, tariffs, or quotas) to promote industrial growth
conflicts with the deeply-held laissez-faire bias inherent in the normative meta-belief
structure of economics. Economists have been quick to accept some very poor arguments
that purport to refute the increasing returns argument. For example, the highly respected
economist Dennis Robertson claimed that the concept of increasing returns in
manufacturing conflates technical progress with economies of scale. According to
Robertson, government intervention to protect industries so that they can grow to achieve
economies of scale is, at best, unnecessary since growth in efficiency will occur without
intervention because of inevitable technological progress. The obvious objection to this
claim is that such growth may well occur somewhere in the world, but not necessarily in
the home country that is contemplating protecting an industry to foster its growth.
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It has also been claimed that true external economies are difficult to identify and, even if
identified, are too difficult to measure to justify protectionist policies. It has also been
argued that even if government intervention were warranted on economic grounds, there
would be no reason to believe that the resulting external economies would not then
continue without further government support. This latter point is not really an attack on
protectionism, but rather on Graham’s advocacy of permanent protection.
Still another objection was raised by Jacob Viner. Viner questioned whether the alleged
external economies are a function of the size of the industry in a particular country or
rather they are a function of the world-wide scale of production in the industry. The latter
situation is illustrated by the supposition that increasing returns to scale in the watch
industry results from the commercial availability on the international market of better
watch-making machinery. If that’s the case, then protecting a particular country’s watchmaking industry would be unwarranted since any national industry can from the purchase
of such machinery on the international market without recourse to governmental
protection to promote the industry’s growth. But this objection is ad hoc, relying on a
hypothetical set of facts that must be tested in each specific case. In general the facts
suggest that there are very significant economies of scale that arise from the development
of a geographically concentrated infrastructure, thereby justifying protectionism.30
More recent technical work has revived Graham’s case using neoclassical formalism to
present a model of a competitive economy with two industries, one with decreasing
returns (e.g. agriculture) and one with increasing returns (some sort of manufacturing).
Then as in earlier models, it is assumed (unrealistically) that the increasing returns
industry satisfies the conditions of perfect competition, and that the increasing returns are
solely due to factors external to the firms composing it, but internal to the industry and
national in scope. In this case it is claimed that a tax to discourage an increase in output
in the decreasing returns industry (agriculture) coupled with a subsidy to encourage
production in increasing returns industry (manufacturing) will increase aggregate national
wealth under trade. (This recommendation is related to the Australian argument to be
discussed in the next section.)
Despite these neoclassical formulations that support the argument, according to Irwin
most economists focus on confusions regarding external economies of scale, in particular
the possibility that these derive from tradable goods (e.g. better watch-making equipment
available on the international market). By doing so, they find a basis for dismissing, if not
refuting, the increasing returns argument.
When one examines the history of opposition to the increasing returns argument, it is
clear that a strong bias against protectionism is at work. The various reasons given for
rejecting the argument do not form a coherent or convincing refutation. The existence of
internal efficiencies that only operate up to a certain firm size does nothing to refute the
case for government intervention to bring firms to that optimally efficient size (although
it does argue against Graham’s advocacy of permanent protection). And even though, as
critics claim, there may well be external economies that are transnational in nature, the
existence of such economies does not preclude the existence of other external economies
on a regional or national scale—such as the existence of training facilities (formal and
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informal), domestic transportation and communications infrastructure, and the
development of a conveniently-located array of specialized suppliers and sub-contractors.
Robertson’s claim of a conflation of technological progress with economies of scale is a
red herring, since it is easy enough to hold fixed the level of technology in evaluating
economies of scale. The various objections to the increasing returns argument at best
attack the argument as a general case for protectionist intervention to build up a domestic
manufacturing industry, but they hardly demonstrate that such protectionism is never
appropriate. Instead, they suggest that it is important to examine all the factors that affect
the efficiency of specific industries in a particular country before deciding if government
intervention to protect and grow the industries makes sense. The increasing returns
argument demonstrates that there is a strong prima facie case for protecting
manufacturing, at least during initial stages of growth, and that it is worthwhile looking at
specific national conditions to determine if, in fact, a protectionist policy is warranted.
Attending to the variety of empirical conditions is rare among ardent defenders of free
trade who generally seek theoretically based general conclusions. In the case of the
increasing returns argument, there is no general theoretical refutation available, and the
objections that are given immediately suggest situations in which protectionism would be
justified.
The Australian Argument
The so-called Australian argument is similar to the increasing returns argument but
focuses less on the alleged increasing returns in manufacturing industries and more on
alleged diminishing returns in the primary goods sector. It received a great deal of
attention in Australia in the nineteen-twenties and thirties. According to Irwin, the
argument was first advanced by the Australian economist J. B. Brigden. It has two
distinct forms. Initially, Brigden argued that when one of a country’s manufacturing
industries faces new competition from a foreign industry that has achieved (for example)
a technological breakthrough, a serious employment dislocation could occur due to
layoffs in the manufacturing industry. The displaced workers have only two choices: they
can emigrate or they can seek work in agriculture or other primary goods industries. This
situation was predicted for the Australian economy in the 1929 Brigden Report. It
claimed that a move towards free trade would negatively affect Australian industrial
production and direct resources towards primary commodity production—a sector that
exhibits diminishing marginal returns. Employment opportunities overall would decrease,
and the only beneficiaries would be the owners of agricultural land and of the country’s
natural resources. This first version of the argument did not argue that the aggregate
wealth of Australia would benefit from protection of manufacturing. Rather it argued that
protection would create or at least preserve manufacturing jobs, and that given the
increasing population, protectionism could maintain higher average wages by doing so.
According to Irwin, Brigden presented a second, and stronger, version of the argument a
few years later. He focused on the diminishing returns that characterize the primary
sector (agriculture and mining) in which Australia held a comparative advantage. Free
trade would divert more resources, including labor, to production in the primary sector,
thereby increasing production but decreasing per capita output. Because of Australia’s
global market power with respect to these exports, the increased Australian production
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would cause a decline in the international prices of these goods despite their higher per
unit cost in Australia. (The extent to which this is so is dependent on the international
elasticity of demand for the primary good.) An adverse change in the terms of trade
would result, real income in Australia would fall, and the gains to the primary sector
would principally benefit owners of agricultural land and natural resources. Population
increase would only aggravate the problem. Imposition of a tariff on imported
manufactured goods would not only improve the terms of trade—as suggested by the
terms-of-trade argument—but would help insure that increased income is passed on to
workers, while avoiding an influx of low-paid labor into the primary goods sector. This
second version of the Australian argument is closely related to the increasing returns
argument, although the emphasis is on diminishing returns in the primary sector rather
than on increasing returns in the manufacturing sector.
As noted earlier, international demand for primary sector products may be relatively
inelastic meaning that an increase in supply would result in sharply lower prices. For
example, demand for food products may be primarily a function of customary tastes and
less influenced by price than demand for other consumer products; thus bumper crops
result in sharply lower prices which are bad for farm income. The same is true of mined
goods as diamonds, where a relatively inelastic demand curve has fostered the formation
of an international cartel that restricts output and marketed product. Industrial raw
materials—for example, various metal ores—are often demanded in relatively fixed
quantities by manufacturers, with their aggregate demand varying directly as a function
of the demand for finished products. Since the price of a particular raw material may
determine only a small part of the price of a finished good, the demand curve facing
many raw materials will not only be inelastic, but will be relatively unstable due to
factors unrelated to its price. For all of these reasons, a country which has market power
with respect to the exportation of a primary sector good may doubly suffer from
increased production—first from diminishing marginal returns and second from a steep
fall in the unit export price produced by a relatively inelastic demand curve.
In the nineteen-thirties, the Swedish economists Eli Heckscher and Bertil Ohlin
developed a neoclassical trade model that considered the relative availability of different
factors of production in different countries and the proportions in which they are used in
producing different goods. Their model (known as the Heckscher-Ohlin or HeckscherOhlin-Samuelson model) was used by Wolfgang Stolper and Paul Samuelson in 1941 to
analyze the situation envisioned by the Australian argument. They concluded that if the
manufacturing sector of a country like Australia produced a labor-intensive good,
imposing a tariff on competing imports could raise the real income of labor and reduce
the real income of capital. If there is also a beneficial terms-of-trade effect, total national
income would increase as well.
On the other hand, it was later argued (by Lloyd Metzler) that the tariff’s impact on the
terms of trade might overwhelm its effect on income distribution. This could occur if
tariffs raised domestic prices thereby indirectly causing the prices of primary goods to
rise in the domestic market to a point where they even exceeded the tariff-induced price
increases in products from the protected industrial sector. This would mean that the
relative price of manufactured goods to primary sector goods would fall, thereby
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adversely affecting workers in the manufacturing industry—the workers supposedly
protected by the tariff. This scenario is far-fetched: in the case of a primary-goods
exporter like Australia—a country in which domestic consumption of primary-sector
goods is a relatively small proportion of total output—it seems unlikely that a
manufacturing tariff would significantly affect the internal prices of primary sector
goods. And even if such an effect occurred, it is implausible that the price increase of
primary goods would exceed the price increase of manufactured goods resulting from the
tariff. Metzler’s result is theoretical, and like other results based on formal neoclassical
models, is not very convincing, at least not to those who weren’t indoctrinated in
neoclassical analysis. Evaluation of what would really happen to prices, employment
levels, and consumption patterns under specific economic and social conditions requires
taking account of a wealth of details that transcend the conceptual tools available for
constructing neoclassical models.
In the case of agricultural exports, and exports from extractive industries like mining and
oil production, policies that involve protection of domestic manufacturing often seem to
make sense. Moreover, in the case of primary goods, it is possible for a group of
countries to form a cartel to cooperatively limit production through output quotas (or
appropriate taxation). If the cartel has the market power to raise world prices in the face
of a relatively inelastic international demand curve, then it would seem that the terms of
trade could be altered to the group’s advantage. Imposing a tariff on imports to strengthen
another sector (e.g., manufacturing) is an indirect, and generally less efficient, means of
accomplishing an improvement in the terms of trade in such a case. But tariffs or
subsidies to manufacturing industries may offer additional benefits as described in the
increasing returns argument. In fact, this compound policy was recommended by the
economist Arvind Panagariya in 1981. The interested reader should turn to Irwin’s book
for a further discussion of these issues and for extensive references.
A Pattern in Orthodox Criticism of Protectionist Arguments
Before continuing this survey of arguments for protectionism, it is worth noting that a
pattern can be seen in the neoclassical attempts to refute the terms of trade, increasing
returns, and Australian arguments. Each argument was advanced in support of
protectionist measures in specific circumstances. However, economists critical of the
various protectionist arguments rarely attempt to refute them by weighing the potential
benefits and shortcomings of the advocated protectionist measure under specific
economic conditions. That would not only be alien to the generalizing, theoretical
approach to economic reasoning favored by the neoclassical school, but it would likely
fail because it is difficult to show that under no circumstances are protectionist measures
justified. Instead, they seek to convert the protectionist argument into a neoclassical
model, and then conclude that the model does not, in fact, support protectionism unless
various assumptions are made about the market. This is held to be a serious defect, and
the protectionist argument is said to “lack generality” or to require debatable assumptions
about market conditions. This alleged shortcoming is deemed sufficient to reject the
original protectionist argument. The approach more effective when the economist who
offered the protectionist argument chose to present it in terms of a formal neoclassical
model, especially if the economist presenting the argument claims makes sweeping
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protectionist claims—for example, Graham’s claim that his version of the increasing
returns argument justified permanent protection for industry.
However, this approach to attacking protectionist arguments at best reveals that a
particular protectionist argument is incomplete, since almost all arguments for
protectionism should be seen, at best, as arguments for protectionist measures under very
specific conditions (such as those obtaining in Australia in 1930)—conditions which may
encompass a variety of social, economic, and cultural factors that elude formalization. It
is hardly surprising that such arguments fail to spell out all the relevant factors. I argue in
Part IV of this book that these arguments should be viewed a heuristic to stimulate
thinking about optimal economic policies in very specific situations rather than as
specific formulas for instituting protectionist measures under some specific set of
economic conditions.
The usual neoclassical approach to critiquing protectionist arguments can be viewed as
yet another example of the sort of black-and-white fallacy often found in discussions of
economic policy. Because no completely general formal neoclassical model can be found
that supports a particular protectionist argument, it is concluded that the argument is
unsound; and if all such arguments are unsound for similar reasons, then—by default—
free trade is vindicated. In reality, there is no reason to suppose that there could be a
generally valid formal neoclassical model that could settle the issue of optimal trade
policy in a particular situation because all neoclassical models abstract from critical
social, cultural, geographic, and even economic factors that obtain in one or another
specific case. The arguments that are relevant are the less formal ones that take account
of these factors which elude neoclassical formalization. As we will see later, there are
good reasons to believe that, when applied informally in the context of an analysis that
takes account of these factors, many of the protectionist arguments do contribute to the
justification of one or another type of protectionism under a variety of real-world
conditions.
The Wage Differential Argument
The wage differential argument is yet another protectionist argument based on the
presumed advantages that accrue to a national economy from protecting and building a
manufacturing industry. In the wage differential argument the advantages of
manufacturing are held to arise from wage differentials; it is claimed that since
manufacturing wages are higher than those of workers in the primary sector, a country
should use protectionist measures, if necessary, to protect its manufacturing industries.
In fact, in most countries manufacturing wages have been considerably higher than wages
of primary sector workers. This is particularly true in developing countries; in fact,
Krugman and Obstfeld discuss it as a problem, “economic dualism,” “a sign that markets
are working poorly... in an efficient economy... workers would not earn hugely different
wages in different sectors.” (262 ff) They term this a “market failure,” a concept that will
be discussed later.
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The wage differential argument holds that although these high manufacturing wages
provide an incentive for a country to maintain a manufacturing industry, the higher wages
and resulting higher prices for manufactured goods may result in a shift in comparative
advantage from manufacturing to primary goods production. The argument is important
not only for the light it sheds on comparative advantage but also because it has stimulated
a discussion about the source of higher wages in the manufacturing sector that raises a
number of important issues for free trade and other free market policies.
Irwin describes a version of the argument presented by Gottfried Haberler during the
great depression of the 1930s. I’ll change the example slightly in the interest of clarity.
Consider a country, Home, that under autarky, requires a single labor unit to produce
either a unit of agricultural output or a unit of manufactured output. Contrary to the
assumption of the comparative advantage model that wages in different industries are
equal within a single country, Haberler claims that manufacturing wages are higher than
agricultural wages. In this example, we suppose that manufacturing wages are $7 an hour
versus $3.50 an hour in agriculture. As in the comparative advantage model, we assume
that the wage differential is reflected in a price differential, so that a unit of manufactured
product sells for twice as much as a unit of agricultural product, $7 for the manufactured
unit versus $3.50 for the agricultural unit. This means that in Home one unit of
agricultural produce would exchange for 1/2 unit of manufactured product. Suppose,
however, that the international price of agricultural goods is $4 per unit and the
international price of a manufactured goods is $6 per unit so that on the international
market one unit of agricultural goods exchanges for 2/3 unit of manufactured goods.
Under these conditions it appears that Home will specialize in agricultural production
since the international exchange for a unit of agricultural goods is better than the
domestic exchange. This would be the market outcome, since a $3.50 per unit Home
agricultural good, when exported, undercuts the $4 foreign agricultural good, and in the
Home market the imported $6 a unit manufactured good undersells the Home $7 per unit
manufactured good.
However, because in Home it requires just one labor unit to produce a unit of either
agricultural product or manufactured product, each labor unit that is moved to the export
sector—agriculture—results in the loss of one unit of domestic manufacture and a gain of
one new domestic unit of agricultural production. Even though one of the newly
produced agricultural units may be exchanged internationally for 2/3 unit of
manufactured good, Home loses. If instead of moving the labor unit from manufacturing
to agriculture, if it had been retained in manufacturing, it would have produced one full
unit of manufactured product. Moving labor from manufacturing to agriculture represents
a net loss of 1/3 unit of manufactured good per labor unit moved. If Home had
specialized in manufacturing, the additional manufacturing units could have been
exchanged internationally for 1 1/2 agricultural units instead of the single unit
agricultural obtained by moving the labor to agricultural production! To avoid the
disadvantageous specialization in agriculture dictated by the Home price differential,
Haberler argued that Home should impose a tariff on manufacturing imports to
effectively alter the international exchange ratio to prevent abandoning manufacturing.
The strange situation just described arises from the divergence between the domestic
market exchange ratio (2:1 agricultural to manufacturing) and the labor substitution or
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productivity ratio (1:1). The domestic market exchange ratio is an artifact of higher
wages in manufacturing and corresponding higher prices.
The argument appears to be sound if we grant the hypothesized wage and productivity
differentials. But typical neoclassical economic models do not accept the wage
differentials assumed in the example. In orthodox theory, wage differences that are not
reflective of so-called “market failures” are explained by differences in costs of living
(e.g., city versus country), the cost of specialized training, or similar economic factors.
Moreover, labor factor productivity cannot be calculated in terms of output without
taking account of the role of capital, and in most cases the per capita capital investment
in manufacturing is higher than in agriculture, and much of the productivity differential
has been attributed to the factor productivity of capital rather than that of labor.
Nonetheless, as a matter of historical fact it appears that wage differentials between
manufacturing and agriculture exceed what would be expected from known economic
factors. The Swedish economist Bertil Ohlin claimed that actual wage differentials may
reflect “artificial” factors such as the influence of labor unions. In that case, the
imposition of a subsidy to manufacturing may serve to restore the labor allocation to
something closer to what neoclassical economists would term a “normal” by lowering the
prices of manufactured goods and, at the same time, increasing the demand for
manufacturing labor, thereby justifying the higher price of manufacturing labor.
Alternatively, a tariff could be used to raise the price of imported manufactured products
thereby justifying the higher manufacturing wages. Ohlin thought the “more natural
remedy” for the wage differential would be to increase labor mobility to bring down
manufacturing wages. Lower paid agricultural workers (and other primary sector
workers) would then find it easier to move into manufacturing jobs, thereby driving
manufacturing wages down to their “natural” level. What Ohlin presumably had in mind
was breaking labor union impediments to the free flow of cheaper labor into
manufacturing.
The well-known economist Jacob Viner took an even stronger line by arguing that free
trade itself would break the power of unions to artificially raise wages, thereby insuring
that workers would have to work in industries in which the country had a true
comparative advantage. Even Haberler supported this position, writing that “international
trade will merely be a means of breaking the monopoly power of such groups [unions]
and thus of ending their exploitation of the rest of the community.” (167) The normative
meta-language of neoclassical economics is apparent in these endorsements of free
markets and moralizing attacks on union exploitation.
The wage differential argument has been challenged in two ways. First, Haberler’s
example and similar examples offered by other supporters of the wage differential
argument describe a situation considered “abnormal” from the perspective of neoclassical
theory; the hypothesized wages are “excessive” in manufacturing due to labor market
“distortions” produced by “monopoly union power.” This departure from the idealized
neoclassical competitive model is sufficient to condemn the argument in the eyes of
many neoclassical economists.
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Second, it has been claimed that much of the apparent labor productivity advantage of
manufacturing over agriculture actually reflects the effects of costly capital investment.
Total factor productivity is a function of capital investment as well as labor skills. The
comparative advantage argument, which considers labor as the only factor of production
encourages this confusion. However, we will later examine a study of the Indian cloth
industry that indicates that at least in some cases, the efficiency of labor may be an
important variable in productivity. Moreover, industries utilizing expensive capital
equipment may require—depending on the industry—a more skilled workforce than a
labor-intensive industry. In general, skills require training, and the supply of trained
workers usually leads to high wage levels. Nevertheless, the price of labor is determined
by supply and demand, and in some cases—for example, college professors—the
resulting pay is below what might be expected given the amount of training. In addition,
high tech manufacturing industries typically produce scarce, high value products that
generate monopoly profits which may be shared with workers by granting them high
wages; this could arise from simple altruism or as a result of employee pressure (e.g.
unionization). In conclusion, Thus even if it is not always the case that manufacturing
jobs are higher paid, it is a fact that, on average, they are, and more so in highly
capitalized and high technology industries.
But even if there were no productivity effects attributable to the labor force, so that the
higher manufacturing wages were entirely due to other factors, the basic premise of the
argument would stand—pay is higher in the manufacturing sector. If the objection is that
the capital costs of establishing manufacturing industries offset the wage advantages, then
those advantages must be weighed on a case by case basis—exactly what is invariably
missing from blanket defenses of free trade. In the case of an existing manufacturing
industry faced with new foreign competition, capital investments in the industry are sunk
costs which will be lost if labor is shifted out of manufacturing as a result of foreign
competition. This suggests another reason for protection independent of the details of the
wage differential argument. Thus when a national economy has a well-developed
manufacturing industry that is threatened because it has come to operate at a comparative
disadvantage, downsizing of the industry with a shift of labor to the primary sector would
result in the abandonment of large sunk capital costs which have effectively served to
make manufacturing work more productive and higher paid than primary-sector work. I
will return to this point in a later chapter.
The harsh conservative critiques of the wage differential argument fueled by indignation
at the success of labor unions in raising wages invited the response that the laissez-faire
competitive model of neoclassical theory is unrealistic and outdated. The economist
James Meade, for example, argued that in the face of the reality of institutionalized
rigidities (such as union contracts and minimum wage laws), providing a direct
employment subsidy to a threatened domestic manufacturing industry would lower
domestic prices, and thus be more effective than the imposition of a tariff in increasing
domestic demand for manufactured goods. Meade opposed tariffs on the grounds that
they raised costs to consumers—a common complaint from orthodox economists. Meade
did concede that there was an argument for tariff protection when the industry’s problems
arose from a low volume of domestic output rather than from an outdated mode of
production, but his point appears to be a mere variation of the increasing returns
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argument. In any case, it is important to recognize that subsidies are as much part of the
protectionist repertoire as tariffs.
The Theory of Domestic Distortions
In 1963 Jagdish Bhagwati and V. K. Ramaswami made a case for an appropriately
chosen “optimal” employment subsidy to manufacturing in the case of what they referred
to as wage “distortions” (such as those induced by union contracts). Such “distortions”
(relative to the competitive market ideal) are viewed by them as “labor market failures.”
Like Meade, Bhagwati and Ramaswami argued that the import protection approach (e.g.,
tariffs) was inferior because it produced a “less efficient” mix of goods through a
“distortion” of the consumption choices through “artificially” raising the price of
industrial goods. Their analysis became known as the theory of domestic distortions.
Strangely, this theory with its endorsement of one type of protectionist measure—
employment subsidies—has achieved a reputation for defending free trade in the face of a
variety of real world market “failures” through the advocacy of limited targeted
interventions at the sources of failure. Thus in the case of the claim that labor is
inefficiently allocated, with underemployment in manufacturing due to artificially high
wages induced by union activity, it is held that the so-called “first-best” policy is to
subsidize employment in manufacturing and that the “second-best” policy is to provide a
production subsidy. An import tariff is only the “third-best” policy because of the
resulting “consumption distortion.” Subsidizing artificially high manufacturing wages is
supposed to lower the price of manufactured goods so they to approach their “natural”
price in a free labor market, thereby avoiding a distortion of consumption choices and
expanding manufacturing production and employment levels.
I have used quotation marks to highlight the normative language used by economists in
this discussion The idea is that there is natural, healthy economy is one conforming to the
neoclassical competitive equilibrium model, and that real economies are plagued with
distortions and market failures. To address these failures, Bhagwati and Ramaswami are
willing to recommend various protectionist measures, although they studiously avoid
labeling them as such. Among such measures, subsidization of employment is seen as the
least protectionist in flavor, and tariffs the most, and hence the worst. The justification for
this hierarchy is that a tariff to protect manufactured goods allegedly creates a new
distortion, (the consumption distortion). Why subsidizing employment in manufacturing
is does not create another kind of distortion is unclear as is the issue of why the alleged
distortions are bad as the word “distortion” implicitly suggests. The entire discussion
provides yet another illustration of the implicit power of the normative meta-belief
structure of neoclassical theory.
Irwin proclaims the theory of domestic distortions a “landmark” because “once and for
all the case for free trade was decoupled from the case for laissez faire.” (171) This is a
peculiar claim. Aside from the fact that the neoclassical laissez-faire model of a
competitive equilibrium is latent in the notions of “market failures” and “distortions” that
figure so prominently in the theory of domestic distortions, the ideal of free trade is
compromised by the concept of limited interventions, since the recommended “first-best”
interventions are protectionist in nature. The theory of domestic distortions illustrates the
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importance economists attach to defending free trade in name, if not in fact, by
sanctioning less familiar kinds of protectionist interventions.
It is wishful thinking for free trade advocates to assume that tariffs and other
conventional protectionist measures will, under all circumstances, fail to qualify as the
“first-best” means of attaining these goals and to ignore the protectionist nature of
subsidies. The theory of domestic distortions fails to do away with the idea that tariffs
may be beneficial since Irwin concedes that the terms-of-trade argument provides a valid
case for a tariff as a “first best” intervention. And, as the earlier discussion of the
increasing returns and Australian arguments showed, there will be, under certain specific
social, cultural, and economic conditions, a case for export restrictions (through quotas
and export taxes) for primary sector industries exhibiting diminishing returns, and for
import protections for manufacturing industries exhibiting increasing returns.
Distortions from Artificially Low Wages
In the end, the advocacy by orthodox economists of subsidies represents an implicit
qualified endorsement of the wage differential argument. As noted above, the orthodox
analysis seems narrowly focused on the case of “excessive” domestic manufacturing
wages and how to remedy that “distortion.” In fact, a similar situation may arise when the
international price ratio is lower than the international productivity ratio due to artificially
low foreign manufacturing wages. This leads to a result similar to that which occurs in
the oft-cited theoretical (theoretical) examples of high domestic manufacturing wages—
because of artificially low foreign manufacturing wages, foreign manufactured goods
undercut Home produced manufactured goods and Home loses manufacturing
employment to agriculture or in the extreme case abandons manufacturing in favor of
agriculture (or mining or services or whatever other product is under consideration). Here
there is no question of remedying any domestic distortion to remedy the situation.
To illustrate this point using a simple Ricardian model, suppose that one country, Home,
employs half its workers in agricultural production and half in manufacturing production
under autarky, and that one unit of agricultural production requires one unit of labor input
and that one manufacturing unit also requires one labor unit. Under the Ricardian
assumption that prices reflect labor costs, one agricultural unit exchanges for one
industrial unit and vice versa. Suppose that a second country, Foreign, is less efficient in
the production of each product. In Foreign it requires two labor units to produce a unit of
agricultural produce and 2.5 labor units to produce a manufactured unit, a ratio of 1:1.25
compared with 1:1 in Home. Under international trade, Home has the comparative
advantage in Manufacturing and Foreign in Agriculture. Suppose that international prices
approximate the autarkic prices that existed in Foreign (which may be much larger than
Home). That means that a manufactured unit produced in Home is worth $2.50
internationally or in Foreign and will exchange for 2.5/2 or 1.125 units of agricultural
product—which represents a gain over autarky.
Now suppose that through protectionist measures such as subsidization of manufacturing
labor in Foreign, the labor cost of a unit of manufactured good were only $2.20 rather
than $2.50. The exchange ratio of agricultural to manufactured in foreign is now 1:1.10
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which means that the comparative advantage relations would be the opposite: Foreign
would specialize in manufacturing and Home in Agriculture. We again assume that
international prices approximate the prices in Foreign. An exported agricultural unit from
Home is worth $2 and exchanges for 2/2.2 or 0.91 units of industrial product which is
worse than the autarkic exchange rate in Home. This means that Home is strongly
motivated to protect its domestic manufacturing industry when Foreign subsidizes its
manufacturing wages.
The example is grossly oversimplified as are all Ricardian and neoclassical models.
However, it illustrates the technical impossibility of arguing that protectionist measures
(including wage subsidies) are only justified when there are so-called domestic
distortions. In the example, Home suffers without experiencing “market failure” due to
“labor union exploitation” and “wage distortion.” Even though there is no “distortion” in
the domestic market, the results of the artificially low valuation placed on manufactures
internationally are equally adverse for the more efficient (and appropriately paid,
according to orthodox theory) domestic manufacturing sector.
In the last chapter, we examined hypothetical model involving Chinese manufacturing
labor. Even though Chinese labor may be relatively less efficient than American labor,
Chinese wage rates, as the result of the artificially low peg of the Yuan to the U.S. dollar,
may be lower than the lesser efficiency would dictate, and because of the enormous size
of China, these low wage rates can drive down the international price of manufactured
goods. Moreover, even though Chinese manufacturing wages may appear high compared
with Chinese agricultural wages, they may not be high compared with the productivity
differential if agriculture in China and other foreign countries is sufficiently
unproductive.
In cases like these, imposition of a tariff or provision of a subsidy to domestic
manufacturers is not a means of correcting for a domestic “distortion” caused by union
“exploitation,” but rather one possible means of protecting an efficient domestic industry
from various kinds foreign protectionist intervention (such as pegging currency at an
artificially low exchange rate). Globalization opponents sometimes call for “fair trade not
free trade.” The above example would indicate a case where that slogan may be
appropriate. It is interesting to note how supporters of free trade and globalization
ridicule such slogans as value-laden and emotional while ignoring their own use of
normative terms such as “distortions,” “market failures,” “false trading,” and even “union
monopoly exploitation.”
The Wage Differential Argument: Conclusion
In their best-selling textbook, Krugman and Obstfeld discuss, and then reject, the wagedifferential argument. (pp 262 ff) Their rejection focuses not on advanced industrialized
economies, but on the specific case of developing “dual” economies in which a “modern
sector (typically producing manufactured goods that are protected from import
competition)” has wages far higher than in a traditional agricultural sector. They attack
the concept of higher wages in manufacturing by referring to a paper published in 1970
by John Harris and Michael Todaro that claimed that the dual wage structure led to
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increased rural-urban migration that increased urban unemployment. In addition,
Krugman and Obstfeld claim that the argument is out-of-vogue because of “the general
backlash against import-substitution policies.” Import substitution refers to a policy of
subsidizing and protecting manufacturing in Third World countries that traditionally
depended on exports from the primary goods sector to finance importation of
manufactured goods. The policy has been discredited as a result of numerous cases in
which the protected manufacturing industries were highly inefficient and often afflicted
with corruption. The case studies cited in Part III and the discussion of Third World
economies in Part IV of this book tend to support the criticism of import-substitution
policies. But the wage-differential argument applies equally to advanced industrial
countries and to the relatively efficient emerging Asian economies. The failure of import
substitution in Africa and parts of Latin America is hardly a refutation of the wage
differential argument. In the last part of this book, I return to a discussion of development
strategies for Third World countries having a large proportion of their population
engaged in traditional agriculture.
What is important in the present context is the invalidity of Krugman’s and Obstfeld’s
rejection of the wage differential argument based on a single type of economic
situation—that of an underdeveloped economy that protects manufacturing as part of a
import-substitution policy. In fact, the principal application of the wage-differential
argument would seem to advanced industrial societies facing competition from emerging
export-oriented economies like those of contemporary East Asia. But as we have seen in
the case of other arguments for protection, the applicability of the argument in a specific
case will depend on specific social, cultural, and economic conditions.
Viewed in this light, the wage differential argument may be broadly viewed as an
argument for protecting an existing domestic manufacturing from a variety of adverse
conditions, foreign and domestic, that serve to decouple exchange ratios from
productivity ratios. These include not only the sort of labor market “distortions”
discussed by economists, but also factors involving currency exchange rates in multilateral trading situations (where, for example, there exists a favorable exchange rate with
trading partners in agricultural produce and an adverse exchange ratio with trading
partners in industrial produce). Again we see that the case for one or another trade policy
depends on a complex array of factors not captured in any simple model. But the theory
of domestic distortions shows that even free trade supporters, despite rhetorical bravado,
concede the benefits of protectionist intervention in markets under various conditions.
The Infant Industry Argument
The belief that manufacturing is good for national welfare predates specific arguments
like the increasing-returns, wage-differential, and Australian arguments. Mercantilist
writers emphasized the role of domestic manufacturing in increasing national wealth, and
this conviction survived the decline of mercantilism. In the nineteenth-century, the belief
in the benefits of manufacturing for national wealth was incorporated into one of the
simplest and most persistent arguments for protectionism. Unlike the arguments
discussed so far, the infant industry argument does not readily lend itself to analysis using
the neoclassical models. Like many other protectionist arguments, it assumes that
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countries are better off, in general, if their economies have a strong manufacturing sector.
This assumption is not captured by Ricardo’s static comparative advantage example
which envisioned Portugal abandoning its hypothetically efficient textile industry to
produce wine exclusively.
One version of the argument goes like this. Modern manufacturing industries develop
through the investment of large amounts of capital over time. Countries lacking a strong
manufacturing sector need to generate capital investment if manufacturing industries are
to develop. But who would want to invest in a nascent industry incapable of competing
with imports from a mature, efficient foreign industry that may enjoy economies of scale?
The way to establish and grow a domestic industry until it is capable of competing on its
own, it is claimed, is to protect it from foreign competition until it achieves sufficient
scale. Thus the infant industry argument is an argument for temporary measures to
develop an industry, rather than for permanent protectionism.
Unlike the static viewpoint implicit in the comparative advantage model, the infant
industry argument only makes sense if long-term advantages are given weight. Adam
Smith, for one, ignored such a perspective: “Whether the advantage which one country
has over another, be it natural or acquired, is in this respect of no consequence. As long
as the one country has those advantages, and the other wants them, it will always be more
advantageous for the later, rather to buy of the former than to make.” (119). Smith’s
remarks direct attention to the potential short-term losses to a country in terms of higher
prices and resource misallocation that result from protectionist measures. (WN IV,ii.1314). But his reasoning lacks a dynamic perspective, and it fails to address the claim that
the long-run gains from protection of an infant industry will outweigh the short-term
costs.
The assumed long-term gains are similar to those assumed by proponents of the
increasing returns and wage-differential arguments. In particular, much of the discussion
of the increasing returns argument earlier in this chapter is relevant to the infant
industries argument. Of course, the competitive structure of a particular industry—
whether something approximating neoclassical competition, monopolistic competition,
oligopoly, or monopoly—will depend on complex factors peculiar to the industry and to
the social and economic context in which it develops, factors hardly amenable to
treatment in terms of formal neoclassical models. For example in the case of the Swiss
watch industry there was (in the pre-electronic era) a combination of competition and
monopolistic competition; the German camera industry (again, in the pre-electronic era),
was characterized by monopolistic competition or oligopoly.
An especially relevant factor (discussed in connection with the increasing returns
argument) is the role of a scale-dependent external infrastructure (such as a skilled labor
pool, close communications networks, and training facilities) which in associated with
increasing returns to scale. Because this development of such an infrastructure is highly
dependent on the particular industry as well as on social and cultural conditions, not
every country will benefit from protecting a particular nascent industry. In the criticisms
of the increasing returns argument, one criticism focused on the concept of so called
tradeable and non-tradable goods, with the claim that many if not most external
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economies of scale involve tradeable goods therefore the scale of an industry in a
particular country is irrelevant. However, sources of intermediary goods such as
specialized components, are not easily classified as “tradeable” or “non-tradeable” as is
customary by neoclassical economists. Even if such components could be imported by an
infant industry, having sources in close proximity to the final assembly point greatly
facilitates coordination of production through customary agreements and contracts. This
is an enormous advantage to the domestic industry that has achieved a scale appropriate
to the local production of these components even when they are available internationally.
It has long been recognized, for example, that Japan’s life-time employment system was
built upon a wide-spread network of small independent suppliers that, unlike the large
“name” manufacturers, did not offer such employment guarantees. Is it reasonable to
think that a U.S. or French firm competing with Mitsubishi in the electronics market
could effectively draw upon these same small Japanese sub-contractors for parts? It is
only by looking at a particular industry, in a particular social, economic, and cultural
context, that any conclusions can be drawn as to the requisites for successful growth and
the effectiveness of one or another form of government intervention. Attempts to arrive at
a general conclusion based on neoclassical theory lead to a complex muddle. As Irwin
put it, an “understanding of the determinants and effects of external economies...[is] so
weak, both conceptually and practically, that it has yet to be established whether they
offer a reasonably clear case in which protection could enhance economic wealth.” (ATT
152) In short, the complexity of the situation is considered to argue against protection
whereas the appropriate conclusion is that it shows the impossibility of deciding on the
benefits of protecting an industry using abstract (and simplistic) neoclassical arguments.
Faced with this difficulty of dealing with the complexity using neoclassical modeling
tools, economists tend to retreat to their ingrained meta-value system and the
fundamental conviction that the “natural” way—laissez faire and free trade—is
invariably superior.
It is important to recognize that there are a wide variety of mechanisms for supporting
infant industries, many of which are not normally classified as protectionist. These
include subsidized importation of new technology, governmental creation of specialized
schools or training programs, governmental creation and subsidization of critical
infrastructure such as transportation and communication facilities, and government
purchases of output from the new industry (often justified as “defense spending.”) These
may be added to the usual protectionist repertoire of subsidies of various sorts, including
export subsidies, import quotas and tariffs, and bureaucratic barriers to imports. As noted
in the discussion of Chinese manufacturing, one important means of protecting and
growing an export industry is adoption of an artificially low fixed exchange rate.
Choosing the optimal protectionist program depends not only on the nature of the
industry and its foreign competition, but also on the particular social and cultural
conditions of the country and its competitors. Given estimates of the cost of the optimal
support package and the likelihood of success, there remains the task of determining
which (if any) nascent industries or even potential industries should receive support. The
long-term benefits accruing from more favorable terms of trade and greater national
wealth must be weighed against the short-term losses incurred during the phrase when the
growing industry requires protection. It is this manifest complexity that makes it difficult
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for neoclassical economists to evaluate the argument theoretically through the creation
and analysis of formal models.
A number of late classical and more recent neoclassical economists have acknowledged
the intuitive force of the infant industries argument which perhaps explains why there has
been much less criticism of it than of other protectionist arguments. The most influential
early supporter was John Stuart Mill, who was otherwise a strong supporter of free trade.
Mill’s endorsement, although heavily qualified, was nonetheless poorly received in
England, where it was seen as providing justification for the high tariffs faced by English
manufacturers in the United States, Canada, and Australia during the mid-nineteenth
century.
Proponents of the infant industry argument often accompanied their support by remarks
indicating a general abhorrence of protectionism and a commitment to the neoclassical
ideal of a competitive market structure. Critics, on the other hand, have cast the
discussion in neoclassical terms, focusing on the alleged “market failures” that might
create the possible need for some kind of government intervention. (Irwin, 131) The
neoclassical ideal of a pure competitive marketplace is implicit in this, only minimal
interventions that move an actual economy in the direction of this ideal are accepted. The
most commonly identified problem for industrial growth is an alleged “failure” in the
country’s capital market. According to neoclassical theory, fully rational investors will
recognize that they stand to earn a handsome future return if they invest, and continue
investing, in a nascent industry until it reaches profitable maturity. The alleged market
failure, according to writers like Krugman and Obstfeld, is the lack of institutional
infrastructure—such as an appropriate banking system and stock market—that permit the
rational investors to make long-term investments in emerging industries. Aside from this
institutional “failure,” however, there is a failure of rationality on the part of investors
that contradicts the fundamental (and completely unrealistic) neoclassical assumption of
comprehensive market knowledge on the part of agents. Economists generally choose to
focus on the institutional failure, however, claiming that “rational capital markets” will
insure industrial growth without protection. As Krugman and Obstfeld put it, “if a
developing country does not have a set of financial institutions (such as efficient stock
markets and banks) that would allow savings from traditional sectors such as agriculture)
to be used to finance investment in new sectors (such as manufacturing), then growth of
new industries will be restricted by the ability of firms in these industries to earn current
profits.” (257) However, only a naïve belief in the rationality of investors would suggest
that the needed investment will be forthcoming given a set of financial institutions. The
United States, Germany, and Japan—acknowledged by Krugman and Obstfeld as having
industrialized under the protection of trade barriers—each had such institutions yet relied
on tariffs and other protectionist measures.
Another potential “market failure” (discussed by Irwin) relates to technical knowledge.
Neoclassical economists have argued that if the so-called market failure relates to the
failure of an infant industry to acquire needed technical know-how, the appropriate
remedy is to subsidize the acquisition of the relevant technical knowledge through
spending on research and education. In short, governmental interventions short of tariffs
or quotas have been endorsed by economists as an acceptable means of growing infant
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industries. Tariffs are the principal target: it has been argued that tariffs simply shield
domestic industries from competition with imports produced with more modern
production techniques.
Krugman and Obstfeld, in their text, list several problems with the infant industries
argument. First, they claim “it is not always good to try to move today into the industries
that will have a comparative advantage in the future” because the country may lack the
capital and labor skills required for success. This is obviously true but doesn’t not
constitute a general refutation. Second, “protecting manufacturing does no good unless
the protection itself helps make industry competitive;” they then cite the failure of
protection of heavy manufacturing in India and Pakistan to produce competitive
industries. Again, it should be obvious that protecting an industry is not a guarantee of its
success.
A more interesting argument is the third. They argue that protectionism is only justified if
market failures can be proven; “...the argument for protecting an industry in its early
growth must be related to some particular set of market failures that prevent private
markets from developing the industry as rapidly as they should.” Presumably they feel
that markets not exhibiting such failures will naturally produce optimal results without
government intervention. This is an obvious expression of the meta-belief that
unregulated markets are superior to regulated markets.
Finally, they state that “in practice it is difficult to evaluate which industries really
warrant special treatment, and there are risks that a policy intended to promote
development will end up being captured by special interests. There are many stories of
infant industries that have never grown up and remain dependent on protection.” (Their
discussion is to be found on pp. 256-257) They go on to cite alleged failures of the
strategy known as import-substituting industrialization (or import substitution) that was
popular during the period from the end of the Second World War until the 1970s. This
objection was discussed above and will be looked at again in the light of empirical data
regarding such development strategies in Part III. Again, the point is that not every infant
industry should be protected—a point which all defenders of the argument would
concede. But there is no argument that it is never justified to protect infant industries.
And it is notable that neoclassical economists rarely challenge the assumption that
“grown up” manufacturing industries are economically beneficial. This is, in fact, an
important question that will be addressed in the final chapters of this book.
The neoclassical conceptual structure leads to an unfortunate narrowing of the discussion
of the development of manufacturing industries. A less doctrinaire viewpoint would
suggest that the choice among government intervention in capital markets, government
spending on technology and education, direct subsidies, tariffs, and various other
measures—including untrammeled free trade—will depend on a wealth of details that
vary from situation to situation. There is no justification for assuming, a priori, that
tariffs are invariably inferior to supposedly non-protectionist interventions such as
subsidies and government supported development of infra-structure. Moreover, to those
who have not been indoctrinated in neoclassical theory, much of the usual neoclassical
analysis of the infant industry argument is unconvincing. For example, it is assumed that
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in the absence of distortions and market failures, rational investors will direct capital so
as to maximize growth and economic success and hence government investment is both
unnecessary and harmful. But the orthodox neoclassical assumption of investor
rationality is every bit as unrealistic as the orthodox neoclassical assumption of consumer
rationality. Skepticism about investor rationality has a long history. It was discussed by
Adam Smith. And one of the central themes of Keynes’ General Theory is the
irrationality of investors whose investment decisions depend on “animal spirits.” If
individual investors often display irrational timidity or irrational herd-like exuberance, it
is reasonable to believe that no amount of institutional reform will elicit sufficient private
investment to build a capital-intensive industry from scratch; in that case, government
may play a critical role.
As in the case of other arguments for protection, economists’ opposition to the infant
industries argument is influenced by their belief in the efficiency of free markets and their
faith in free trade. This results in a skewed perception of the burden of proof. Economists
have often demanded that the proponents of the infant industry argument come up with a
general argument for protection, and that they require that the argument be expressed
using the formal conceptual structure of neoclassical theory. For example, Irwin
favorably quotes the economist Robert Baldwin, “If the infant industry argument for
tariff protection is worthy of its reputation as the major exception to the free trade case, it
should be possible to present a clear analytical case, based upon well-known and
generally accepted empirical relationships unique to infant industries, for the general
desirability and effectiveness of protective duties in these industries.” (137). This is
surely an unfair demand. Proponents of the infant argument have generally stressed the
importance of a detailed evaluation of the candidate industry in its specific social and
economic context, and an evaluation of the array of possible government interventions in
the same context. It would be foolish to claim that every infant industry should be
supported regardless of the relevant economic, social, and historical conditions. In fact,
the burden is really on advocates of free trade to show that there are never, or almost
never, circumstances in which a country could gain from protecting nascent industries.
The orthodox treatment of the infant industry argument thus exhibits the sort of blackwhite fallacy that was seen in the presentation of comparative advantage. In that case, it
was argued that autarky is inferior to international trade, therefore free trade is
vindicated. In the case of the infant industries argument, it is claimed that a policy of
protecting infant industries has often failed, therefore it is an invalid policy, and free trade
is vindicated.
Representatives of the German Historical School (commonly referred to as “historicism”)
of economists rightly argued against universal economic generalizations in favor of
analyses that take account of the specific circumstances obtaining in particular
economies. (Hodgson) It is likely that a case can be made for protecting a few infant
industries in a country given the specific historical conditions. However, protectionist
policies that succeeded in nineteenth century Germany are unlikely to be appropriate for
a country like post-independence India. Import substitution in Africa or Latin American
is very different from Japanese targeting and protecting specific export industries. The
limited forms of protection grudgingly accepted by various neoclassical economists, such
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as subsidies and support for technology development and education may not be enough.
Public investment in education and the impressive research output of England after the
Second World War did not result in a revival of its industrial strength.
The demand for a general analytic case—framed in neoclassical terms of market
failure—coupled with the selective use of examples of failed protectionist policies is not
enough. What is required is an in-depth investigation of apparently successful examples
of infant industry protection, an examination of what worked and why, and then the
application of the lessons learned to other economies with careful regard for their
particular social, historical, and economic contexts.
However, the success of Germany, Japan, the United States, and China in protecting
nascent industries suggests that conditions that justify protection of infant industries are
far from rare. These countries achieved a far higher standard of living as a result of their
support of industries that eventually grew to the point where they achieved a comparative
advantage that brought them large export markets. Lacking natural resources, what would
the standard of living in a country like Japan be today without its competitive export
industries? Had the leaders of Meiji Japan accepted the naïve comparative advantage
model, they would have been content to export hand-woven silks, woodblock prints,
clever wooden handicrafts, pottery, and lacquer ware in exchange for the manufactured
goods of Europe and the United States. It is difficult to see how a laissez-faire policy
would have led to the development of the high living standards and formidable industrial
capacity seen in present-day Japan.
Economists may point to one or another study that purports to show that protection was
not really important in determining the success of a country like Japan. But one has to be
suspicious of such studies given the strong anti-protectionist bias of the economic
establishment. As we shall see in Part III, the empirical support for free trade is far
weaker than is generally claimed. Moreover, the analysis of a specific national economy
during a specific historical period is so complicated that different scholars often arrive at
radically different conclusions. At the very least, it is hard to make a case that tariffs and
other protectionist measures damaged the economies of countries like Germany, the
United States, and Japan during their periods of rapid industrialization. Because the
validity of the infant industry argument is so dependent on the specific circumstances of a
country’s economy, I will defer further discussion until after the cases studies in Part III
have been presented.
The Strategic Trade Argument
The strategic trade argument, developed in the 1980s, is perhaps the most recent
protectionist argument. It may be viewed as a formalized variant of the infant industry
argument. The general idea is that a country may benefit economically if its government
backs certain key industries in order to gain a competitive advantage. The inspiration for
the idea was post-war Japan, in which the role of the Ministry on Trade and Industry
MITI) was credited for much of the country’s economic success. Thus—as is the case
with the infant industries argument—the inspiration comes from historical examples of
supposedly successful protectionism. Irwin looks at various neoclassical formalizations
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of the argument presented by the Canadian economists James Brander and Barbara
Spencer. One of their early models considered the case of a domestic firm and a foreign
firm competing to sell a homogeneous good in a third market under conditions of noncooperative duopolistic competition (a concept drawn from traditional neoclassical
analysis). According to their model, a government subsidy to the domestic firm would
alter the market equilibrium in its favor and would increase its profit by more than the
value of the subsidy. The real-world inspiration for this and related models is the
existence of export industries dominated by a few large firms, such as the commercial
aircraft industry.
Not surprisingly, Irwin sees the use of formal models as an asset:
The Brader and Spencer framework had one great attribute: unlike some previous
cases, most notably the infant industry argument, the theoretical structure used in
the analysis of strategic trade policies was explicit, concrete and transparent for
all to see in a formal economic model. This had the tremendous virtue of allowing
the policy implications to be checked for robustness in terms of the underlying
assumptions. These policy implications, it turned out, were highly sensitive to
simple changes in those assumptions. The combined impact of the many
qualifications to the theory of strategic trade policy erased any belief that the
theory constituted a general case for departing from free trade, confirming the
views of the skeptics. (212)
Note Irwin’s standard for judging protectionist arguments: to succeed they have to
present “a general case for departing from free trade;” it’s not enough that in one or
another set of specific circumstances protectionism is warranted. Irwin’s comments make
explicit a common strategy used by economists in critiquing protectionist arguments, a
strategy that we have seen deployed against several many of the protectionist arguments
discussed above. Economists demand that the argument for protection be formalized
through construction of a model that abstracts from particular social and cultural
contexts, and even from many of the relevant economic circumstances that may make
protectionist measures appropriate in a particular case. Next, they note that there are
many possible modifications to the model that would undermine the claim for the
benefits of protectionism. On the basis of this, they conclude that the protectionist
argument fails, or at the very least that it is so hedged with dubious assumptions that it
would be unwise to base governmental policy on it. Occasionally—as in the case of the
wage differential argument—they may concede that there is a “first best” governmental
intervention that enhances welfare, but they avoid classifying this intervention as
protectionism.
Irwin goes on to note that the models offered in support of strategic trade policy typically
involve two competing firms. He holds this to be a weakness, since according to
neoclassical theory, the optimal subsidy will vary according to the number of firms
competing in the market. Thus he writes
But as Avinash Dixit (1984) showed, the greater the number of domestic firms,
the closer the market approached perfect competition and the less an export
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subsidy was advisable. The fixed duopoly assumption also drew attention for
excluding the possibility of market entry. If there were no entry barriers, then new
competitors would begin production and eliminate the extra profits, thereby
obviating the case for profit-shifting policies. (23)
These objections are based on the presence, behind the scenes, of the competitive
equilibrium model in which firms earn no profits, and in which the market provides no
barriers to the entry of new firms (“profit” is used in the peculiar sense of earnings about
the normal-risk rated return on capital investments). Irwin cites other academic critiques
of strategic trade models that claim that when there are increasing returns to scale, tariff
and subsidy policies could “promote inefficient entry, raising average costs of production
and prices to consumers,” –criticisms again based on calculations using abstract formal
neoclassical modeling. Other objections have focused on how profits are calculated and
whether the appropriate model should be Cournot (volume) competition or Bertrand
(price) competition (these being two neoclassical formal models of duopoly). There have
also been objections to the simplified assumptions Brader and Spencer make about
production planning under duopoly. Irwin then goes on to mention a variety of alternative
models offered by critics before concluding
Each of these critiques essentially takes the basic Brander-Spencer framework as
given and considers whether a plausible but slight modification of one assumption
changes the implications for commercial policy. Almost every such modification
did change the implications in quite remarkable and often unexpected ways.
Taken together, these critiques proved devastating to any claim that strategic
considerations establish a general presumption in favor of activist trade policies of
a certain type. So many prerequisites and assumptions are required before a
definitive policy conclusion can be reached that if uncertainties exist about any
one of the prerequisites or assumptions, then the implications for commercial
policy are ambiguous. (215)
This once more displays the neoclassical strategy of criticism of protectionist arguments.
The key remark is “these critiques proved devastating to any claim that strategic
considerations establish a general presumption in favor of activist trade policies...” The
critical strategy of demanding that supporters of a protectionist argument present a formal
analysis that creates a “general presumption” in favor of protectionism loads the dice. Yet
it is effective in persuading economists of the errors of protectionist arguments, or
perhaps of justifying their prior prejudices against protectionism. For example, Paul
Krugman, coauthor of the textbook on international trade cited earlier, abandoned his
initial support for strategic trade policy based on its purported “theoretical weaknesses.”
(216)
In their text, Krugman and Obstfeld claim that none of the three reasons typically given
for cultivating specific industries hold up to scrutiny. The first reason they criticize is that
the industry to be subsidized adds high value per worker. This is held to be based on a
confusion, since they claim that high value per worker is largely a function of capital
intensity, and capital is a scarce resource whose use cannot be dictated by simplistic
notions like value added per worker. In this they may be largely correct, but it is an
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empirical matter whether capital invested in certain industries yields more value than
capital invested in others and, if so, whether the former may merit government support.
For example, steel mills may require large capital investments without yielding high
value per worker in contrast to the production of commercial aircraft, medical devices, or
computer software where the value added per unit of investment appears to be far greater.
The second reason criticized by Krugman and Olstfeld holds that wages are higher in the
manufacturing sector, the same conviction that lies behind the wage differential
argument. Here Krugman and Obstfeld reject the commonly held view that
manufacturing jobs pay much more than retail jobs, although the data they present is
sketchy and unconvincing. The third reason given for cultivating specific industries
claims that these industries yield value from technology spillovers (a positive externality
in economic jargon). Krugman and Obsfeld characterize this as a “market failure”
because high tech firms create knowledge that is appropriated by other firms without
compensation. They then minimize the magnitude of such spillovers, emphasize the
difficulty of identifying the appropriate industries, and state that government support
should be limited to direct subsidization of research and development which will be used
by others.
Their discussion is guided by the following: “a general principle is that trade and
industrial policy should be targeted specifically on the activity in which the market
failure occurs.” (280) Of course, this conceptualization—like the conceptualization that
sees the problem of securing sufficient private investment to grow an infant industry as a
“failure in capital markets”—derives from the normative jargon of neoclassical theory
which views all deviations from the competitive ideal as failures. The real problem is that
the vocabulary of neoclassical theory works to exclude discussion of social and economic
welfare based on considerations unaccounted for by neoclassical theory. Whole concept
of a market failure is based on the implicit belief that there is an ideal system—described
by the competitive equilibrium model—that maximizes welfare without government
intervention, and that only those deviations from this system that can be described using
the conceptual structure of neoclassical modeling warrant attention. Thus economists
may consider the existence of an inadequate banking system in a particular country to
warrant government intervention may be worthy of governmental action, but the fact that
investors are irrational and ignorant receives no attention because it contradicts
fundamental neoclassical dogma which assumes perfect knowledge and perfect
rationality on the part of consumers and firms.
Krugman and Obstfeld also bring up the worry about “retaliation” as a final argument for
rejecting the strategic trade argument. Their answer is support for the consensus view
about strategic trade, a view similar to that advocated in response to the terms-of-trade
argument: the best outcome is a cooperative agreement between nations that have
competing industries. According to Irwin, such agreements, “in which all agree to forgo
the use of such [protectionist] policies, could potentially make each of them better off.”
(Irwin 216)
Krugman and Obstfeld’s comments also betray a bias typical of neoclassical economists
when confronted with empirical data that seems to contradict their theoretical
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conclusions.. For example, they question post-war Japan’s apparently highly successful
infant-industry and strategic-trade policies. But their approach is quite weak; they merely
question the causal role of those policies saying “the market may have made similar
decisions if left to itself;” and “it is possible that the trade strategy may have been a
minor positive factor or even a drag on economic growth.” (286) But no evidence for the
claim is offered, since their counterfactual claim is difficult to evaluate in the context of
complex social processes. However, economists seemingly have no problem in crediting
free trade when it accompanies strong economic growth, not even considering the
counterfactual “the economy may have grown for reasons unrelated to free trade; it is
possible that free trade may have been only a minor positive factor or even a drag on
economic growth.”
In the end, the exercises in neoclassical model building tell us nothing about situations
such as the subsidies given to Airbus and its eventual rise to challenge Boeing. Would the
Europeans have been better off if twenty years ago they had reached an agreement with
the United States to forego the use of subsidies? Could Airbus ever have succeeded
without subsidies? The crucial factors to be considered in choosing which industries to
foster through subsidies will vary according to the situation; discovering them depends on
a detailed analysis of production and marketing within a particular industry, and a
detailed analysis of the country’s resources and the resources of its competitors. In fact,
Krugman and Obstfeld do not disagree with this. In discussing attempts to use formal
neoclassical models to understand Airbus and the aircraft industry in general, they
conclude “by common consensus, these models have been highly unsatisfactory in
explaining major features of the industry such as pricing policies and investment
decisions.” (292) Intelligent analysis of the multiplicity of factors relating to the potential
for a particular industry to benefit an economy has nothing to do with the use of artificial
and unrealistic neoclassical models of duopoly or other forms of imperfect competition.
Again, we have to wait for the discussion of specific economies to better understand the
issues involved in strategic trade policy.
Conclusion
The discussion in this chapter reveals a situation far removed from the view popular with
globalization proponents—that arguments for protectionism are based on elementary
fallacies and misunderstanding of “economic science.” One such argument—the termsof-trade argument—is generally acknowledged to be valid by academic economists. The
wage differential argument is countered with a semantic evasion—the implicit
assumption that subsidizing wages is not a form of protectionism. Other arguments,
notably the increasing returns argument, the Australian argument, the infant industries
argument, and the strategic trade argument resist formulation and evaluation using
neoclassical models, and only yield conclusions for or against protectionism when
particular economic, social, and cultural factors are taken into consideration. However, in
the case of these arguments, it is not difficult to construct realistic scenarios in which
various protectionist measures would prove beneficial. Irwin discusses one additional
argument for protectionism advanced by John Maynard Keynes during the nineteenthirties. Irwin treats it as a “welfare” argument, by which he means that aggregate
national wealth is held to be less important than full employment. I defer discussion of
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Keynes’ argument until the final section of this book when a variety of ideas relating to
protectionism in advanced industrial societies are discussed.
The protectionist arguments discussed in this chapter involve more sophistication and a
greater appreciation of economic reality than the comparative advantage argument. Yet in
popular presentations by proponents of free trade, the latter is continually cited and
lauded while the protectionist arguments discussed above are generally ignored. The
fundamental lesson of this chapter is that the situation facing a given country must be
analyzed in detail to determine which, if any, protectionist measures might serve to
maximize welfare. Empirical studies should be approached in this spirit, rather than with
the view that a theoretically-backed package of “free-market reforms” is almost always
the optimal choice.
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Part III
Empirical Arguments for Free Trade and Other Free-Market
Reforms
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Chapter 5
Free Trade, Economic Growth, and the Reduction of Poverty
Introduction
Part III is concerned with empirical arguments in favor of free trade and other freemarket policies in both developing countries and advanced industrialized countries.
However, the vast literature in the field of development economics reveals an especially
strong interest among economists in studying developing economies in great detail, and
contrasts with the much different treatment of advanced industrial economies. The
dominant view appears to be that since advanced industrial economies already
approximate the neoclassical ideal, the problems are mostly a matter of fine tuning—
managing interest rates, unemployment, and inflation. On the other hand, the multitude of
cross-country statistical studies and individual case studies of so-called developing
economies reveals disagreement and even perplexity among economists over what
policies can move these economies closer to the ideal market economy, stimulate growth,
and improve social welfare especially through the reduction of poverty.31 The bias is
towards solutions involving free trade and free market reforms (for example, Easterly’s
analysis discussed below), but there is, at least, an open-minded willingness on the part of
many of these economists to look at detailed features of the societies to better understand
which policies work in practice. This kind of scrutiny is much less commonly seen
among economists who deal with advanced industrialized economies.
Globalization supporters claim that economic growth spurred by free-market policies are
reducing world-wide poverty, whereas opponents claim that such reductions are nonexistent or spotty at best. Most contemporary economists debate the issue by calculating
trends in world-wide poverty rates. However, the debate cannot be settled simply on the
basis of poverty statistics. No one denies that global output is increasing, and increasing
at a rate greater than the rate of growth of world population. Most of the output is
productively consumed so it seems clear that globally average per capital consumption
has increased. But this says nothing about how the increased output is distributed. If the
increased output is exclusively consumed by the relatively well-off, an increase in output
is compatible with an increase in poverty. Some economists do support redistributive
policies, but most adopt a version of “trickle down” theory which holds that despite
inequitable distribution of gains, almost everyone benefits from economic growth.
Another fact often ignored by economists is the common-sense observation that human
welfare is determined by many factors other than consumption levels; personal security, a
healthy environment, medical care, working conditions, and social harmony are
extremely important. I return to a discussion of these other factors later in this chapter.
Three Crucial Propositions
In general, proponents of the thesis that free trade and other free-market policies are the
key to reducing poverty must argue for three distinct propositions:
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1. That there is a causal link between free trade and other free-market policies and
economic growth (that is, that free trade is more effective in promoting growth than
various kinds of managed trade or protectionism)
2. That there is a causal link between economic growth and a decline in poverty
3. That global poverty has declined.
Many of the arguments offered in support of the claim that free trade and other freemarket polices reduce poverty are based on unstated assumptions that may be challenged.
For example, many economists are so convinced of the link between free trade and
economic growth that they collapse propositions 1 and 2 into the single proposition: That
globalization reduces poverty, where globalization, as conceived of as the global
economic growth that they believe results from free trade and other free-market policies.
The propositions cited above are generally presented as statistical generalizations
supported by cross-country economic statistics. These statistical generalizations
substitute for the universal laws which are the goal of neoclassical theory (on the analogy
of physical laws). This follows from the claim that economics is a “positive science” like
physics. However, many development economists follow a different path which relies on
in-depth studies of individual developing countries to draw conclusions based on the
detailed social, economic, and cultural history of the country; this alternative approach is
discussed in the next chapter.
Definitions
Another issue is the operational definition of “free market policies.” In many cases
proponents of free market policies classify as “free” economies which are held to be
“open” or which have an “outward orientation” even though the actual policies may
involves a high level of protectionism. The result is to classify as “free” various high
growth economies which encourage exports but often protect domestic producers from
imports.
The concepts employed in statistical generalizations can be quite misleading. For
example, Bhagwati uses the concept of “EP” or “export enhancing” strategy so broadly
that it is attributed both to countries that encourage foreign investment in their economies
(such as Hong Kong and Singapore) and to countries such as Japan which is
“characterized by highly selective control on the entry of foreign investment” In fact, the
concept of an export-enhancing strategy is so broad and so vague that it would seem to
have made more sense to have defined it negatively—simply as almost any trade strategy
that is not “IS” (import substitution)! The appeal to such vague concepts results from an
underlying approach that would like to find universal economic laws but ends up settling
for vague context-free generalizations (“tendencies” in Sutton’s terminology). It is not
surprising that such vague generalizations lend themselves to interpretations that are
claimed to confirm propositions derived from core neoclassical dogma. And, as we saw
in the discussion of Wolf’s popular defense of globalization, these vague generalizations
filter down into popular journalistic defenses of free trade and globalization.
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The opposite conceptual error is made in the case of protectionism: rather than
considering countries that utilize a variety of protectionist policies (including subsidies,
infrastructure development, and quotas), defenders of free trade often focus on a single
type of protectionist economy, the so-called “import-substitution” model. Based on the
failure to achieve growth of most countries adopting this model, it is concluded that
protectionism is harmful. Examples of these sorts of fallacious reasoning will be
discussed extensively.
Since growth plays such a crucial role in arguments for free trade and free-market
policies, it is important to better understand the concept of economic growth in
contemporary economic theory.
Growth Theory
In discussing the comparative advantage argument, I noted that while the argument holds
that there is a (generally modest) one-time gain for each nation entering a trading
relationship, the comparative advantage model fails to address economic growth under
conditions of free trade despite the fact that most contemporary economists hold that
economic growth is the principal virtue of free trade. Orthodox neoclassical economic
theory encounters a serious problem at this point, since the formal theoretical apparatus
lacks any coherent theory of economic dynamics with which to handle questions
regarding change, including economic growth. Thus there have been a number of
attempts to create formal growth theories using some of the concepts of neoclassical
economics, but conceptually independent of the fundamental models of neoclassical
theory.
The first popular growth theory is known as the Harrod-Domar model. William Easterly
describes the influence of the basic idea of the model that growth is a direct function of
capital investment. (Chapter 2 of The Elusive Quest for Growth ) Acceptance of this
model led many economists to hold that by increasing capital investment by (for
example) 4% an increase of growth of (for example) 1% would occur in the following
period. It was believed that when a poor country failed to generate sufficient domestic
savings to fund such investment, foreign aid was warranted to fill the “financing gap.”
Implementation of foreign aid in accord with this idea was not wholly altruistic; it was
felt during the 1960s that the best way to combat the spread of communism in the Third
World was to jump-start development through investment aid. Easterly demonstrates that
by any measure the Harrod-Domar model failed: foreign aid didn’t result in proportionate
investment and investment didn’t result in growth. In fact, investment appears to be
neither a necessary nor sufficient condition for growth. In the heyday of the HarrodDomar model during the period during the 1960s and 1979s, relatively little attention was
paid to trade as a key factor in promoting growth. In fact, Easterly notes that in 1966,
Jagdish Bhagwati (“Mr. Free Trade”) proclaimed that the “investment to growth dogma
was ‘substantially valid’” (34) It was only with the obvious failures of the model coupled
with the success of the Japan and other East Asian export-promoting economies that the
emphasis shifted and free trade came to be seen by many economists as the key not
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merely to greater prosperity (as held by the comparative advantage argument) but also as
the key to growth.
Another popular growth model emerged forty years ago. Robert Solow introduced a
model which presents growth as dependent upon technological change which he treated
as exogenous (external to economic analysis).32 The Solow model borrowed from
neoclassical microeconomic theory the notion of a “production function” which treats
output (of a particular product) as a function of the quantities of various input factors
(including labor). He then applied the concept of a production function to the aggregate
output of an economy.33 In Solow’s model, aggregate national output is a function of
three independent variables, Labor (L), Capital (K), and Technology (T). The exogenous
technology variable, T, acts as a multiplicative factor, increasing the effectiveness of
Labor.34
Although the Solow model is consistent with fundamental neoclassical ideas, it does not
follow from neoclassical theory, and this has left room for the introduction of conflicting
variants. Some of these treat growth as a function of endogenous variables (for example,
T, technology, may be taken as endogenous—solely the result of economic factors).
There are several serious problems with Solow’s models and later variants. First, the socalled “production function” is one of the more dubious concepts of neoclassical theory
(discussed at length by Philip Mirowski in Chapter 6 of More Heat Than Light). The core
idea is that the total output of a product (in traditional microeconomic theory) or of an
entire economy (in the Solow and later models) is a mathematical function of the
quantities of the various factors of production. Various combinations of the input factors
result in maximal product output. If some factors are increased beyond their optimal
proportions, the marginal additional output will be less than at an optimal combination,
although the total output will increase. This idea has some plausibility when the factor is,
for example, a homogenous body of similarly-skilled workers since adding more than the
optimal number of workers per machine or production line will result in increased output
but decreased marginal output. But it makes little sense when applied to factors such as
parts or raw materials which are needed in precise amounts to produce units of output;
addition of a disproportionate amount of one factor will, contrary to theory, often reduce
the total quantity or quality of the output. It makes even less sense on the aggregate level
to think of capital as Capital, a homogenous substance whose increase invariably
increases aggregate output (so-called “capital deepening”), or to think of the workforce as
Labor, a homogenous substance whose increase similarly increases aggregate output.
(The latter view is encouraged by the crucial neo-classical presumption of fullemployment.) Land is a third element of the traditional analytic triad of aggregated inputs
and has similar problems.
A second problem confronting the various neoclassical growth models is the implicit
treatment of national economies as autarkies. Once we introduce international trade, the
absurdity of this treatment becomes obvious. Suppose, for example, we imagine two
economies which are exact clones—identical land, resources, labor force, buildings,
machinery, etc. Now suppose one acquires new machinery embodying superior
technology that greatly increases national output, and that much of this output is exported
in exchange for products produced elsewhere. The aggregate standard of living of the
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country would rise substantially. Now imagine that 50 years later the second (clone)
economy were to go through the process of acquiring exactly the same machinery as the
other economy had acquired 50 years earlier. Will its economy exhibit the same growth
in output? Not likely, since the machinery will by then be obsolete and there will little if
any export market for the increased production. Under conditions of international trade,
what counts is not only the technology and capital, but the technology and capital of
competing nations. This example is not as artificial as might be supposed, since much of
the support for the idea that capital investment directly produces growth is based on
extrapolating the past experience of countries like the United States, Germany, and Japan
and applying it to the present-day economies of poor countries in Africa or Latin America
who have little chance of producing capital intensive exports that can effectively compete
in international markets. The concept of an aggregate production function—assuming it
were otherwise valid—could only be relevant if the economies modeled by the aggregate
production function are autarkies. Repeated examples of this fallacy are found in the
dozens of statistical studies which attempt to test the effect of capital investment (or
investment in education conceived of as “human capital”) on economic growth. In
addition to ignoring the economies of international competitors, these studies abstract
from the social, cultural, and historical conditions of the countries in question and test for
factors that supposedly “explain” growth through “controlling” other variables. But
“explanation” requires a claim of cause and effect, and although the authors of these
studies may briefly mention the fallacy of confusing correlation with causation, they
nonetheless continue to speak of uncovering causal factors that “explain” growth.
Some newer variations of the Solow approach assume increasing marginal returns on
capital investments, and more recently some models have attempted to link free trade to
growth—although as noted above there is no generally accepted neoclassical argument
supporting such a link. The possibility of constructing a variety of formal models that
link growth to free trade merely illustrates the plasticity of neoclassical formalism, and
the ease with which models with very different underlying assumptions may be
constructed.
Capital
The treatment of capital as an undifferentiated substance whose causal role is a function
of quantity can be traced back to classical writers like Smith and Ricardo, although in fact
their treatment is more nuanced than that of many contemporary economists. Both Smith
and Ricardo discuss the relation of capital investment to the psychology of individual
investors. For example, Ricardo mentions the general reluctance of investors to invest
abroad (Principles, 95), and he alludes to the emotional element in investing, a theme that
recurs in Keynes who spoke of “animal spirits” as playing a crucial role in investment
decisions. Ricardo also speculated about the potential of low foreign wages and high
foreign profits in luring investment capital overseas. Of course, Ricardo never
contemplated the kind of large-scale transnational movements of capital that occur today,
nor did he consider the potential for large-scale movements of labor across national
borders, both of which are viewed by critics of globalization as the source of serious
problems. The international movement of investment capital, for example, is often
blamed for the East Asian financial crisis of the late nineties, and the movement of labor
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to agitation in Europe and the United States against immigration from the Middle East
and from Latin America respectively.
Today most capital investment is made by large transnational corporations or by
governments that invest public capital in educational systems, research, infra-structure,
and occasionally in specific industries through loans and subsidies. Corporations may
invest capital in mining facilities, in high-tech manufacturing, or in low-tech assembly
plants. These various types of capital investment have correspondingly different
consequences for the economic growth and the prosperity of the countries involved. This
suggests that the usual formal treatment of capital as a homogeneous factor of production,
Capital, is not helpful in analyzing real-world growth. Clearly there are complex links
between investment, in its various forms, and economic growth. Since even orthodox
economists now often acknowledge that “throwing capital” at an economy is no
guarantee of growth, it is surprising that the formal growth models that treat capital as
homogenous with a strictly quantitative effect on growth continue to dominate theoretical
discussions. Popular writers like Wolf fail to note the problems implicit in this approach,
and limit comments on the relative ineffectiveness of much capital investment to
moralizing about the corruption of “predatory” governments that mismanage capital,
rather than examining different types of investment and the social and economic
conditions that render one or another type successful.
Aside from the failure to distinguish among the various forms of investment capital,
formal growth models and much of the discussion in support of free trade as a growth
vehicle treat growth itself as a homogenous phenomenon, without distinguishing the
variety of sectors in which it may occur. In fact, as will be seen in studies of various
national economies, a country may exhibit, in a specific sector of its economy, a period of
growth that is dependent on policies related to deploying a particular array of productive
factors (including labor, infrastructure, cultural values, and capital investment), while
these same policies, related to a similar array of productive factors, may be ineffective in
promoting growth under altered global economic conditions. For example, the “green
revolution” led to substantial growth in the agrarian sector of economies that invested in
agriculture (such as Pakistan and Indonesia) but the growth was not sustainable as global
food production increased. Additional “capital deepening” in that sector did not and
would not promote further growth. Other obvious examples are provided by economies
dependent on the export of other primary sector goods such as ores, oil, or natural rubber.
A change in global demand due to technological changes or altered global economic
conditions may radically alter the international demand for such primary goods, and thus
the potential growth patterns for economies dependent upon them. Thus in assessing
whether a particular policy—whether free trade or some form of protectionism—is likely
to produce economic growth—for example, through development of a future export
industry—it is essential to go far beyond simplistic growth models that incorporate
variables representing homogenous factors such as Capital and Labor. Effective policy
assessment requires evaluation of the availability of various kinds of investment capital
and its potential uses given the economic, social, and cultural conditions that obtain in a
particular economy, as well as an analysis of international demand trends. Before
exploring this theme in depth, I want to consider a strong critique of the formal,
theoretical approach to economic growth in Third World economies that comes from a
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surprising source—“Mr. Free Trade” himself, Jagdish Bhagwati, and his colleague T.N.
Srinivasan.
The Bhagwati-Srinivasan Critique of Theoretical Arguments
For the Relation of Free Trade to Growth
In this section, I discuss the first of the three propositions listed above—that free trade
promotes growth (more effectively than alternative protectionist trade policies). Jagdish
Bhagwati, who is referred to as “Mr. Free Trade” in the popular press because of his
many books addressed to the general public in defense of free trade, co-authored an
academic paper with T. N. Srinivasan, entitled “Outward-Orientation and Development:
Are Revisionists Right?”35 This paper supports many of the above conclusions relating to
the artificiality and plasticity of neoclassical growth models and their irrelevance to
discussions of free trade and protectionism. The authors write that “there are countless
arguments, and models, that can be built, and have been built (including by us), which
show that free trade will reduce current income and even growth compared to autarky if
market failures are present.” The phrase “if market failures are present” is not much of a
qualification to the condemnation of the use neoclassical models in support of free trade,
since the phrase “market failure” in neoclassical jargon denotes almost any aspect of a
market economy that fails to conform to the neoclassical ideal of a general competitive
equilibrium—in short, to any real economy. So-called “market failures” are the hallmark
of real economies; thus Bhagwati’s and Srinivasan’s claim is tantamount to an admission
of the general irrelevancy of formal neoclassical models in supporting the case for free
trade.
The paper nevertheless goes on to discuss a number of these contradictory neoclassical
trade models. They write, “the neoclassical case for free trade (FT) is based on
institutional assumptions that include a market structure that is complete and a
government that intervenes only to correct failures, if any, of the market. Under these
assumptions, and others on technology and tastes, a competitive equilibrium (CE) under
FT [free trade] is a Pareto Optimum.” This makes manifest the implausible neoclassical
foundation for the various models discussed. The “competitive equilibrium” alluded to
assumes perfect information on the part of producers and consumers and investors, zero
profits, no monopolies or oligopolies, and producers (“firms”) without the power to
influence prices. It also assumes that all markets, including the labor market, “clear”—in
other words, that there is no unemployment. All of these assumptions are false with
respect to real economies, and models based on them so unrealistic that non-economists
may question whether they have any value at all—other than as a means by which
professional economists demonstrate proficiency and ingenuity in neoclassical modelbuilding, thereby acquiring enhanced status among their colleagues.
Bhagwati and Srinivasan consider both formal models that treat growth as exogenous
(unaffected by trade policy) such as the Solow model, and lesser-known models that treat
growth as endogenous.36 They note that different models lead to different conclusions as
to the relationship between trade and growth. Their conclusion provides an extremely
weak endorsement of the link between free trade and growth: “it would be wrong to infer
that, in all models, trade and growth will necessarily be unrelated.” In effect, they are
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rejecting the utility of neoclassical models in the debate about trade policy. After several
pages of discussion of the various conflicting theoretical growth models, Bhagwati and
Srinivasan conclude that “in practice” (the authors’ emphasis) an export-promoting
strategy promotes sustained growth. In short, their argument for an “export-promoting
strategy” (which they associate with free trade!) is based on empirical data, not on
theory. The authors even note, critically, that some economists have ignored the variety
of models with different implications for the relationship between free trade and growth:
“some proponents of trade-growth linkage write, and get amply quoted even in
magazines, as if no such [theoretical] nuances exist!” (the authors’ emphasis) Yet
Bhagwati himself is guilty of just this sort of thing in his more popular writings where,
for example, he speaks of the “Smith-Ricardo demonstration” (of the superiority of free
trade) and maintains that there are “theoretical” grounds for the claim that free trade
produces prosperity. (Free Trade Today, 4-5)
More Growth Models: Pritchett’s Attempt to Apply Economic Theory
To the Study of Growth in Third World Economies
Bhagwati’s and Srinivasan’s rejection of a formal model-theoretic approach to the
relationship of trade to growth does not rule out the use of formal neoclassical models in
treating growth itself. Nevertheless, formal growth models such as the Solow model have
proven to be of little value in analyzing economic growth (or the lack of it) in Third
World economies. A good illustration of the sort of knots economists can tie themselves
into in an attempt to accommodate the diversity of Third World growth experiences to
neoclassical formalization is provided by a discussion by the international economist
Lant Pritchett. This discussion occupies the first half of a paper entitled “A Toy
collection, A Socialist Star, and a Democratic Dud? (in Rodrik, Prosperity). (The second
half examines the economies of Vietnam and the Philippines.)
Pritchett begins by claiming that the Solow growth theory, as well as newer rivals like the
“new growth theory” that developed out of Paul Romer’s work during the 1980s, are at
best partial models which may apply only to certain national economies. (Pritchett
describes the various formal models, which he views as partial, as “toys,” thus adopting
the commonly adopted instrumentalist interpretation of neoclassical models.) He finds
that these formal growth models seem inappropriate to many Third World economies,
which he classifies using a typology of six different sorts of growth pattern. This provides
a good example of the tendency of economists to focus on generalizations at the expense
of detailed analyses of particular economies. According the Pritchett, economies are not
locked into a particular pattern (or “state” in his terminology) but may transition to
another state in accordance with a given transition probability. His analysis is presented
in terms of various traditional neoclassical concepts. He speaks of long-term growth as
occurring at an “equilibrium steady state rate” (as projected by the Solow model);
medium-term growth as “the dynamic adjustment process to a change in the level of
potential output” and short-run growth as the result of adjustments to disequilibria
produced by relatively minor transitory shocks (to be analyzed using macroeconomic
models). The changes occurring during short and medium-term periods are conceived of
as susceptible to analysis using the neoclassical methods of “comparative statics.”
Comparative statics is the closest neoclassical analysis comes to a dynamic theory—but
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it is emphatically not a dynamic analysis. The basic idea is that the system being analyzed
is considered to be either in an equilibrium state or moving towards an equilibrium state
after an exogenous shock such as the introduction of a new technology, the occurrence of
a natural disaster, war, or political disruption. Neoclassical analysis consistently treats
economic change as if it occurs in two disjointed steps: disequilibrium resulting from an
exogenous shock followed by an (undescribed) “recovery” to a new equilibrium state.
Shocks are modeled by altering one or more of the parameters that characterize the
economy in its initial equilibrium state.
For Pritchett, the most important of the three modes of analysis is the medium-term
analysis. He illustrates the sort of change he has in mind by hypothesizing a single shock,
a technological innovation (like the green revolution) that raises the productivity of a
poor country’s stable crop by 50%. This is followed by an adjustment period during
which the effects of this innovation play out over years or even decades as the increase in
agricultural production increases income and hence demand for products in other
industries, resulting in increased investment in those industries. During this adjustment
period, growth exceeds the hypothesized steady state growth rate, but eventually
converges back to it as the economy reaches a new equilibrium. Pritchett also mentions
“policy” or “institutional reform” as possible precipitating events for this kind of
medium-term change, thereby treating these as shocks.
Pritchett classifies various national economies into six categories according to their longrun growth rates and their behavior in response to shocks. These are: (1) Advanced
industrial steady growth (or AIC; examples are the U.S. and Western European countries)
(2) low-level poverty trap (Congo, Cambodia, North Korea); (3) Nonconverging steady
growth (Colombia, Pakistan); (4) Rapid growth (South Korea, Indonesia 1967-97,
Vietnam); (5) Growth implosion (countries of former Soviet Union, Venezuela 1980-,
Madagascar); and (6) Non-poverty trap stagnation (Brazil 1980-, Philippines 1993-,
Bolivia 1986-). Pritchett postulates that each country is, at any given time, in one of these
six states, and that there are occasional transitions to another state according to transition
probabilities associated with the different states.
It is noteworthy that Pritchett’s typology abstracts from the particular characteristics of
the various economies in question by ignoring factor endowments, political systems, and
cultural traditions. In the end, since we are interested in optimal choices of trade policy
the significance of the typology must lie in claims for similar policies for countries
sharing a growth category. But it seems absurd to think that the optimal trade policy for
the Congo should be similar to that for North Korea or Cambodia, or that that for
Colombia should resemble that for Pakistan. Does Pritchett really believe that the social,
political, and economic differences between the countries he places in the same “state”
are relatively unimportant in determining future growth—that all countries that share a
state will develop in a similar fashion? That, for example, that the Venezuelan growth
pattern will closely resemble that of the countries of the former Soviet Union or that of
Madagascar? Or that Brazil, the Philippines, and (of all places) Bolivia are similar in
growth potential?
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Pritchett postulates that a different formal growth model will characterize each of the six
states; for example, he thinks that traditional models such as the Solow model or the new
growth theory models that treat innovation as endogenous may characterize state 1
(“advanced industrialized steady growth” or AIC). In the case of state 2, the low-level
poverty trap, he says “some model is necessary to explain why some countries have
essentially never had an extended period of long-range growth” (130). He does not
discuss what such a model would look like, however. He finds the third state a puzzle—
“perhaps they can be understood with a Solow model of endogenous growth with
imperfectly diffusing technological knowledge,” but he has nothing further to say about
the model. In the case of states 4 and 5—rapid growth or a growth implosion—he says
that he assumes the existence of “equations of motion of a theory of dynamics of
disequilibrium.” But neoclassical theory has no “equations of motion,” no “theory of
dynamics” at all, not for any phenomena. Prichett’s talk of “equations of motion” for
economies displaying rapid growth or economic collapse is pretentious wishful thinking.
Essentially Pritchett is engaging in rhetoric without content, although he dresses it up
using the Greek letters and subscripts of real mathematical theories. For example,
Pritchett writes, “In each state S the growth rate of a given country i in a period t would
be given by the growth model MS particular to that state. Within a given model M, growth
is determined by factors Z and parameters () expressed by gSi,t(MS(ZMi,t,M)).”
All this says, in plain English, is that the growth rate for an economy that is in a particular
state S depends on “factors” specific to the model used for the state, the country, and the
historical period being considered. This is hopelessly vague. As we just saw, Prichett has
no idea what the models are (with the possible exception of state 1, but even there he
hesitates). What are the so-called “factors” specific to the unspecified models?
Pritchett then provides a supposed example of the growth equation, that for state 1
(“advanced industrial country steady growth” or AIC) where the growth is presented as
an additive function of factors Z and parameters , and the factors and parameters are
supposedly described:
gi,tAIC = TFP + transitional dynamics
This says that the growth rate for a particular country in state 1 depends on total factor
productivity (TFP) and some kind of transitional dynamics. This is not helpful. We really
learn nothing about growth in one or another advanced industrial society by being told it
depends in part on the economy’s total factor productivity. And, as noted, neoclassical
economic theory notoriously has no theory of dynamics.37 In general equilibrium theory,
the core of neoclassical analysis, dynamic issues are dealt with by “just-so” tales about
omniscient auctioneers who match bids and offers to arrive at a set of equilibrium prices.
The analysis is even worse for the other growth states, which Pritchett goes on to say “are
more difficult to characterize, as the models of transitional dynamics are much less well
developed than of steady states.” (131) The dynamics of the other five states is a mystery
at best.
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Equally unrealistic is his assumption that there are specific transition probabilities that
govern the likelihood that an economy in one of the six states moves into one of the
others. This not only gives up on the possibility of specific causal explanations that
invoke the detailed characteristics of particular economies to explain why they change
growth patterns. In addition, the assumption of such numeric probabilities implies that
transitions occur independently of country-specific factors such as changes in global
demand for various types of products due to technological change, or war, or economic
conditions in the other countries. But if these factors account for changes in growth
patterns, the whole concept of fixed transition probabilities makes no sense.
Pritchett also assumes that some of these transitions have zero probability—meaning it is
impossible for an economy in certain states to transition into certain others. For example,
he thinks that neither an advanced industrial country nor a country in a low-level poverty
trap can move to a state of growth implosion. It is difficult to understand his reasons for
assuming the impossibility of such transitions. Might not a disastrous war or
environmental catastrophe cause the collapse of an advanced industrial economy? And
similarly couldn’t war or natural disaster cause the economy of a poverty-trap country to
collapse into mass starvation?
Pritchett represents the equation that determines the transition probabilities as follows:
S,S = (Initial conditions, History, Policies, S, S)
The probability of transitioning from state S to state S is presented as a numeric function
of parameters that seem fundamentally incapable of formalization. Are we really to
assume that “initial conditions,” “history,” and “policies” can be reduced to numbers that
can serve as arguments in a probability function? Moreover, the whole idea is incoherent
because the variables on the left side of the equation make no reference to any specific
economy, only to the initial and final states, whereas the right-hand parameters “Initial
conditions,” “History,” and “Policies” only make sense if they refer to a specific country.
If we ignore the left side of the equation, the content of the right side, shorn of unrealistic
assumptions and Greek letters, is roughly this: “the probability of a country changing
from state S to state S’ at a given time is a function of its history, current economic and
social conditions, and the policies adopted by its government. If not a truism, this comes
close, omitting only the effect of conditions in competing economies.
What remains of Pritchett’s analysis is his typology. He provides no statistical data to
support the typology and no case studies to justify it. The only alleged “test” given in his
paper is an exercise in which he assumes a set of 114 hypothetical countries, 14 “rich”
and 103 “developing.” The rich countries are assumed to continue in state 1 (AIC) with a
growth rate in each period of 1.8%. The developing countries are assigned to one of four
different growth patterns (low growth (0.5%), medium (1.8%), rapid but convergent to
1.8%, and implosive). By tinkering with the transition probabilities—no theory is
involved here—Pritchett ends up with a distribution into each of the five states roughly
like the distribution he gives for actual country economies. But this is mere playing with
a computer program to insure that the final division of countries roughly corresponds to
his intuitively-based conception as to how countries should be classified. There is no
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theory at work here beyond Pritchett’s typology and the assumption that certain
transitions are possible and others impossible. The mathematics, symbolism, and
neoclassical jargon are gratuitous. In addition, the economies are treated as autarkies with
no consideration of the effects of changes in one economy on others.
We are left to ponder just what orthodox economic theory has to contribute to the study
of economic growth, especially growth involving Third World economies. All that
remains relevant is the implicit suggestion that if we want to understand the growth (or
lack of growth) of national economies we will have to attend to their particular histories,
and the social, cultural, and political conditions that characterize them. And there are
many, many ways of bringing empirical data relating to such conditions to bear on the
issue of free trade and economic growth, most involving traditional common-sense
analysis rather than cross-country statistics used to justify generalizations.
The Link between Free Trade and Economic Growth:
Beyond the Models of Growth Theory
Economic growth has been one of the principal markers of the advance of civilization. It
is clearly related to technological discovery, and an increase in the division of labor.
Where such division of labor crosses geographical and political borders, trade occurs.
These are facts beyond dispute. However, there is an enormous difference between free
trade, which is a conception of laissez-faire economics in both its classical and
neoclassical incarnations, and trade in general. Mercantilism was a theory of trade, but
hardly of free trade, and the period of mercantilist domination saw enormous economic
growth. Protectionist periods in the history of many nations, including the United States
during much of its existence, have also been periods of rapid economic growth.
Recognizing the failure of policies like import-substitution and praising an “outward
orientation” policy as a promoter of growth does not provide evidential support for free
trade, but rather is a implicit recognition that some forms of protectionism have been
more successful in promoting growth than others under specific circumstances.
In the end, the concept of economic growth is alien to the fundamental conceptual
structure of neo-classical theory, as the various ad hoc growth models discussed earlier
demonstrate, although this failing is rarely acknowledged.
Arguments Relating to Growth and the Reduction of Poverty
Free Trade, Growth, and Income Distribution as Related to Poverty
The second proposition listed above concerned the link between economic growth and
the reduction of poverty. Two factors relating to the reduction of poverty are income
distribution and economic growth. According to the comparative advantage argument,
free trade brings an increase in national wealth compared with autarky. And because of
the assumption that everyone is employed at the same wage in the industry with the
comparative advantage, the question of how the increased wealth is distributed doesn’t
arise. However, despite their praise of the comparative advantage argument, most
defenders of free trade are quick to acknowledge that there may well be—at least in the
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short-run—both winners and losers when a country moves to free trade. Even if we were
to accept the proposition that free trade promotes economic growth, it does not follow
that economic growth reduces poverty given the frequency of adverse distributional
effects. On a global basis, despite large-scale international trade, it is recognized that a
large portion of the world population lives in extreme poverty. One fact that is not
subject to serious debate by those favoring or opposing free-market policies is that the
world economy has grown rapidly over the past 150 years (Maddison, Monitoring the
World Economy 1820-1992). Globalization proponents try to link this growth not merely
to increased world trade but to free trade. Free trade is held to strongly promote economic
growth, and it is generally claimed that any negative distributional or disruptive effects
from free trade will be more than compensated for by a general rise in per capita output
which will reduce poverty because “a rising tide lifts all boats” or some version of the
trickle down theory. The idea is that is, economic growth benefits almost everyone, and
the “losers” are only relative losers..
An abhorrence of government intervention in “free” markets makes income redistribution
anathema to most neo-classical economists. Rather than debating whether, given
economic growth, income redistribution would further contribute to the reduction of
poverty, the issue is often presented as a simple choice—either growth (without
redistribution) or redistribution (without growth). Is not surprising that defenders of free
trade focus almost exclusively on growth as a solution to poverty given their belief that
free markets result in the maximization of welfare. However, the case for causally linking
free markets to poverty reduction (a surrogate for welfare) is made only indirectly: free
trade and related free-market “reforms” are seen as a major vehicle for promoting
economic growth, and growth is seen as the direct cause of poverty reduction. This
reasoning cannot be justified through comparative advantage models which claim only a
one-time gain in the transition from autarky to free trade.
Bhagwati’s Argument
The strong bias towards growth and against governmental redistribution of wealth as a
means of reducing poverty is sometimes justified on the basis of very flimsy arguments.
For example, here is how Bhagwati claims to have become convinced that growth is the
key factor in alleviating poverty:
It fell to me to work on this problem since I had just returned from Oxford and
was the economist assigned to assist the proponents in the Indian Planning
Commission of this plan to raise the minimum incomes of the poor. I assembled
the income distribution data that were available at the time; their quality was
pretty awful because of inadequate statistical expertise in most countries, nor were
they standardized for international comparability. But a quick scan seemed to
suggest that there was no magic bullet: countries seemed to have somewhat
similar income distributions regardless of their political and economic cast. So the
primary inference I made was that if there was no way to significantly affect the
share of the pie going to the bottom 30 percent, the most important thing was to
grow the pie. In short, my advice—what I might call with some immodesty the
Bhagwati hypothesis and prescription—was that growth had to be the principal
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(but, as I argue below, not the only) strategy for raising the incomes, and hence
consumption and living standards, of the poor. (In Defense of Globalization, 54)
On reflection, this is a very strange account. Bhagwati’s assumption that countries are
similar with respect to the distribution of wealth and his conclusion that growth, not
redistribution, is the solution to poverty, are arrived at not by means of statistical analyses
or by case studies, but though a “quick scan” of “pretty awful” data from the 1960s.
There is no hint of any serious empirical investigation, either through later statistical
studies or through case studies of individual countries.
Statistical Arguments that Link Poverty Reduction to Economic Growth
Of course, economists generally offer more substantial arguments than Bhagwati’s which
I presented primarily to reveal the general bias against income redistribution. Many
development economists, perhaps due to their view of economics as a science that seeks
generalizations if not absolute laws like those of physics, prefer to use cross-country
statistical data to support generalizations which, although stated as universal
generalizations, are mere “tendencies”. This is clearly true in the case of the propositions
linking free trade and economic growth to the reduction of poverty. Economists generally
believe that poverty can be measured quantitatively (for example, by defining poverty
throughout the world in terms of income level), and thus that correlations can be run in
support of the proposition that globalization (held to be the consequence of free trade and
other free-market “reforms”) has reduced poverty and thus (by tacit agreement) has
improved human welfare.
Earlier in this chapter, I discussed how statistics have been invoked to support
proposition 1, the claim that free trade and related free-market policies are more effective
in promoting growth than protectionist policies—an argument often based on the
conflation of free trade with export promotion (an “outward orientation”) and by
identifying protectionism in Third World countries with an import substitution policy. A
further complication occurs when growth disappears as a causal link so that it is directly
claimed that free trade (or “globalization”) reduces poverty and thus enhances welfare.
And a still further complication occurs when it is recognized that the concept of welfare
improvement involves much more than poverty reduction, especially when poverty is
defined exclusively in terms of income (typically an income of less than a dollar a day).
Improvement in social welfare includes difficult-to-quantity factors such as an improved
opportunity structure (in terms of education and the role of women in the economy),
personal security, better working conditions, better health, and better environmental
protection.
The empirical data used to support the link between economic growth and reduced
poverty includes not only formal and informal statistical arguments, but also case studies
and anecdotal evidence, and this is also the case for the broader link between free trade
and reduced poverty. Typically, however, statistical correlations are invoked in support of
the generalizations expressed by these propositions. If there is a positive correlation
between, for example, free trade and the reduction of poverty (revealed either graphically
or through a positive correlation coefficient of sufficient size), the data is held to support
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the hypothesis that there is a causal link between the free trade (the independent variable
in this case) and poverty reduction (the dependent variable). Examples of this kind of
argument may be found in Bhagwati’s popular writings which are discussed below. This
approach is naïve, however, because the claim that an increase in the so-called
independent variable causes an increase in the dependent variable based on a positive
correlation between the two variables is rarely justified. One possibility is that the
direction of causation is the opposite (e.g., illegal drug use causes unemployment rather
than vice versa), or it is possible that the variables are correlated because both are effects
of some third variable (e.g., increased recreational visits to beaches do not cause forest
fires; both result from hot sunny weather); or it is possible that the apparently causal
variable is actually only an “indicator” or secondary effect of the true cause (e.g., humid
air arising from swamps doesn’t cause malaria). In many cases, the absence of sufficient
data and the inability to control for variables (as in experiments in the physical sciences)
makes it impossible to draw conclusions from statistical data.
A somewhat more sophisticated approach appeals to cross-country regression analyses in
which a variable such as “openness in trade” is plotted against economic growth. In the
paper by Bhagwati and Srinivasan discussed above, the authors criticize this approach on
a variety of technical grounds relating to stochastic error terms, proxy and dummy
variables, feedback and circular causal mechanisms, problematic parameter estimations,
and poor data quality. They conclude “we can confidently expect that there are enough de
facto degrees of freedom at an analyst’s command to reverse any “findings” that another
analysis using similar regression methods has arrived at.” (36)
Regression analysis is a statistical method that seeks to tease out correlations that
apparently matter causally by holding constant (by statistical means) other variables that
might be considered causally relevant. Bhagwati and Srinivasan’s criticism of the use
cross-country regression analyses was directed at the economist Dani Rodrik who had
used regression analyses to argue against the link between free trade and economic
growth—a link which is nearly universally accepted by orthodox economists. In
particular, Rodrik had used cross-country regression analyses to argue that an import
substitution policy (under which Third World countries attempt to develop domestic
manufacturing industries to avoid importing manufactured products from advanced
countries) may have served to promote growth just as well as a free trade policy. In
fairness to Bhagwati and Srinivasan, their rejection of such analyses explicitly applies
also to free-trade proponents who have used cross-country regression analyses in “crude
attempts at supporting trade openness...”
However, Bhagwati, in his popular writings, is guilty of the very practice he condemns in
the technical paper. For example, in his popular book In Defense of Globalization, he
attempts to refute the generally-accepted view that countries like Germany, the United
States, and Japan successfully used tariff barriers to nurture nascent domestic
manufacturing industries. He noted that the infant industry argument is endorsed in the
Cambridge Economic History of Europe, and that “recently, the economic historians
Kevin O’Rourke and Jeff Williamson have reinforced this impression by deriving a
statistical association, through running what statisticians call regressions, between
economic growth and import tariffs from 1875 to 1914.” (In Defense of Globalization,
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60) He then continues, “But the later work of Douglas Irwin has refuted that proposition.
By adding to the regression analysis several countries that were on the periphery of the
world economy but integrating into it, as one should, Irwin manages to break the positive
association between tariffs and growth.” This is a perfect example of the approach
condemned by Bhagwati and Srinivasan in their technical paper: “there are enough de
facto degrees of freedom at an analyst’s command to reverse any “findings” that another
analysis using similar regression methods has arrived at.” Obviously, Irwin didn’t
“refute” anything—he simply argued that varying the regression data leads to a different
conclusion. The phrase “managed to break the positive association between tariffs and
growth” makes clear the struggle to refute the widely-accepted conclusion that protective
tariffs were critical to the rapid growth of manufacturing in Germany, the United States,
and Japan. If regression analyses are suspect, what is the proper approach to evaluating
the infant industry argument? Wouldn’t it be to look at the details of what happened in
each of the three countries during the period of tariff protection to uncover the effects of
the tariffs? (Rather than adding countries “on the periphery of the world economy” in an
effort to “break the positive association between tariffs and growth.”) The central point
made by Srinivasan and Bhagwati in their paper agrees: “...in our view, the most
compelling evidence on this issue [of the relation of free trade to growth] can come only
from careful studies of policy regimes of individual countries, and we argue below
against the current resort (by Sachs, Rodrck and others) to cross-country regressions as a
reliable method of empirical argumentation.” They then go on to praise “systematic indepth and nuanced analyses of country experiences.” As will be seen, Bhagwati is also
guilty of appealing to even simpler statistical associations—such as two-variable
correlations—to draw causal inferences endorsing the benefits of free trade. This is
related to the technique that was discussed in Part II in connection with the meta-belief in
the centrality of generalizations of the form “the more X the more Y” for neoclassical
economists.
Although the concession Bhagwati and Srinivasan make to “nuanced analyses of country
experiences” at first seems to be a step in the right direction, their idea of what such
analyses look like is tainted with the neoclassical economist’s bias towards context-free
generalizations. They conceive of the “nuanced analyses of country experiences” as
useful not for assessing the results of specific economic polices (government investment,
taxes, tariffs, or subsidies) adopted by particular countries during particular historic
periods, but rather as part of a body of statistical data to be used for or against various
broad transnational generalizations—such as their claim that “an outward orientation
promotes growth.”
A Note on the Two Levels of Economic Presentation
It is tempting to charge Bhagwati and other economist proponents of free trade with
hypocrisy for using (in their popular writings) the very sort of statistical arguments in
favor of free trade that they deplore in academic papers. However, I suspect that there is a
kind of schizoid thinking at work whereby these economists are so deeply persuaded of
the value of free trade that even the flimsiest of arguments are considered justifiable to be
used in popular debates with “irrational” protectionists. It is only when forced to confront
the small minority of fellow academic economists who use statistical arguments to attack
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the supposed growth-enhancing effects of free trade that they analyze in detail the
deficiencies in the use of cross-country correlations and regressions to support
generalizations about trade and growth. There is hubris at work too, a conviction that as
professional economists they are scientists in possession of arcane knowledge that must
perforce be withheld from the uninitiated in favor of something simpler, even if it is
literally false.
Neoclassical economics is conducted on two levels. There is the level of technical
mathematical model-building and theorizing using both the traditional techniques of
point-set topology (general equilibrium theory) and newer mathematical techniques such
as game theory. But there is also a popular level, the presentation of economic “truths” in
plain English, usually with the claim that one or another simple “truth” is supported by
deep mathematical theory. The plain-language propositions are often selectively extracted
from writings of Adam Smith or David Ricardo without regard for the nuanced analyses
offered by Smith and Ricardo of the specific economic conditions of late eighteenth and
early nineteenth century England. A good example is found at the very end of the text
General Equilibrium Theory, An Introduction, by Ross Starr. After 238 pages of
complicated mathematical presentation, Starr concludes, “There it is in modern
mathematical form—just what Adam Smith (1776) would have said. The competitive
market can work to effectively decentralize efficient allocation decisions.” (238)
Defining Poverty
Arguments involving the relationship of growth or free trade and the reduction of poverty
require a reasonably clear conception of what is meant by “poverty.” Most economists
measure poverty in a simplistic manner as living on less than $1 per day, without
qualification with respect to time, place, or social, cultural, and economic conditions.
This is the result of the underlying view that “utility” is a function of maximizing the
contents of the agent’s commodity basket, and the size of the basket depends on income.
Orthodoxy also assumes that a small commodity basket resulting from a low income
represents a low welfare level—in ordinary language, misery and unhappiness. Todaro
and Smith, for example, begin their economic development text by painting a horrific
picture of poverty; eliminating the horrors of poverty is implicitly presented as a moral
imperative. This view is widely shared among development economists.
However, it is clearly unreasonable to assume that poverty can be measured by income,
although low income is certainly an important component of poverty. Being poor in
monetary terms is not directly correlated with unhappiness; for example, polls indicate
that some of the happiness countries are found among the poor nations of Latin America.
Even if we accept that poverty is something that should be reduced or eliminated, we also
have to recognize that poverty depends not only on income but also on “quality of life
issues” such as personal safety, economic security, opportunity for economic and social
advancement, health care, and environmental conditions, all factors difficult to measure.
The debate over poverty among economists has largely ignored these. Globalization
critics have noted the non-income aspects of poverty, but have failed to deal with the
issue in a coherent manner, instead focusing on issues such as the exploitation of native
cultures by foreign firms interested in extracting forest and mineral products from native
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environments, and the working conditions in “sweatshops” operated by American and
Europe companies. This has tended to play into the hands of pro-globalization
economists who find it relatively easy to answer this kind of criticism with statistics and
specific counter-examples. The second and third issues—the relationship between growth
and poverty (realistically defined), and between free-market policies and growth—are
often bypassed.
Nevertheless, an examination of the lively debate over the global levels of poverty
provides a good starting point. Afterwards, I will look briefly at working conditions in
factories in the Third World, and finally at the effect of globalization policies on
traditional cultures. Once more, I conclude that the only the way to gain real insight into
the causal relationship between free trade, growth, and poverty is to move from global
statistics to individual country studies.
The Statistical Debate over the Role of Globalization in Reducing Poverty
The alleged link between globalization and the reduction of poverty represents, as noted
above, a collapsing of propositions 1 and 2 (that free trade (and other free market
policies) causes growth and that growth reduces poverty) into a single claim. (As noted
above, economists view globalization as a growth process set in motion by free trade and
other free market policies.) The best-known version of the debate over this proposition
has focused on the question of whether global poverty, narrowly defined in terms of per
capita income, has actually declined in recent decades, and if so, what the geographic
distribution of that decline is. Although per capita income is easier to measure than other
factors constitutive of poverty, its measurement still presents major problems. Much of
the case for globalization’s role in reducing poverty is based on multi-nation studies by
the World Bank and by various economists, including the libertarian Xavier Sala-i-Martin
who is cited by both Wolf and Bhagwati. Sala-i-Martin claims that there was a dramatic
decline in worldwide poverty between 1970 and 1998, although he concedes that
“clearly, this reversal was caused by the very different aggregate growth performances”
between areas—poverty grew in African countries which failed to grow, but dramatically
declined in Asian countries that experienced growth.” (quoted by Bhagwati in In Defense
of Globalization, 65)
It is difficult to argue with Sala-i-Martin’s claim that poverty typically declines with
economic growth although, once again, only detailed examination of conditions in a
particular country that experiences growth can render a verdict on how much poverty was
reduced or even whether it was reduced. After all, rapid economic growth in the colonies
of the New World during the sixteenth to eighteenth centuries was accompanied by the
growth of slave labor, and since slaves are part of the societies in which they live, we
must surely count their increase as weighing on the side of increasing poverty. Even if we
were to accept the most optimistic data that suggests that poverty is rapidly declining
with global economic growth, and even if we were to accept that the cause of the
reduction in poverty is economic growth (proposition 2), the case for free trade’s causal
role (proposition 1) would still have to be made, and the above analysis suggests that
proposition 1 is false. Nor is there any generally accepted basis in neoclassical economic
theory for the widely-held belief among economists that free trade and free-market
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policies result in greater economic growth than well-chosen protectionist policies, and
neither is their any convincing statistical data. The link between free market policies and
economic growth is often simply assumed, or when made explicit, is supported by
dubious statistics or by anecdotal evidence. The comments by Bhagwati and Srinivasan
in the paper discussed above, and Wolf’s comments discussed in Chapter 1, provide
examples of how, in the context of the globalization debate, relatively clear concepts like
free trade yield to vague notions such as “outward orientation” or “export promoting
strategy” that encompass economies as diverse as Hong Kong (committed to free trade)
and Japan (committed to building export industries through protection) in an attempt to
justify the link between free trade and economic growth.
The argument that globalization reduces poverty relies on aggregate global growth data
and poverty data. In fact, the unprecedented phenomenon of Chinese growth over the past
several decades has tilted world statistics heavily towards the conclusion that world-wide
poverty is decreasing. China is clearly a prime example of a country where both
economic growth and a reduction in poverty are beyond doubt, but it is also a country
that engages in a variety of protectionist measures to boost its exports. I earlier mentioned
how the pegging of a low exchange rate for the Chinese Yuan against the dollar has been
an important protectionist tools for China. The benefit conferred on Chinese exports has
been increased as the dollar, suffering from chronic U.S. current account deficits, has
drifted downwards against a number of other currencies, notably the Yen and the Euro
making products from Japan and Europe increasingly more costly compared with
Chinese products whose price is denominated in a currency that generally has been set to
track the dollar’s fall. I will return to a discussion of China when I consider various
recent case studies.
Twenty years ago, before China’s rise to economic prominence, Japan’s economic
growth was the envy of the world. But Japan was also alternatively deplored and admired
for the way it managed its economic growth through the intervention of the Ministry of
Trade and Industry (MITI). Through a variety of means, Japan skillfully limited
competition from imported industrial goods. The apparent lesson from China and
Japan—and from the United States up until the 1950s—is that growth may be effectively
promoted through protectionist policies of one sort or another. In the case of a resourcerich exporter of primary goods like the United States, the protectionist measure of choice
was an import tariff, whereas in the case of resource-poor countries like Japan, a variety
of subtle devices were used to promote its manufacturing export industries. Most
economic historians have acknowledged the effectiveness of such methods as seen in the
widespread acceptance of the infant industry argument, despite criticism from Bhagwati
and claims by journalists like Wolf that infant industries usually “fail to grow up.” The
point is that a country’s economic success depends on specific conditions: the industry
chosen, the country’s economic, social, and political situation and that of its trading
partners. The most obvious distinction is between countries that protect industries to keep
competition out of the domestic market (e.g. an import substitution policy) and countries
that protect industries in order to build a strong export sector (Japan, China).
The examples of China and Japan suggest that even if there has been a general increase in
free-market policies throughout the world during the past several decades (at least as
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measured by international trade agreements which typically fail to reflect more subtle
means of protectionism) as well as a high level of economic growth, the global
correlation between these two factors is insufficient to establish a causal link between
free trade (as opposed to various kinds of protected trade) and economic growth
(proposition 1). Depending on how the increase in free trade is measured, the correlation
between free-market practices and global growth (and a decline in the global poverty
rates) is even compatible with hypothetical (and probably real) situations in which
countries most closely conforming with the free-market model actually experience a
lower than average growth rate than those with highly protectionist export-promotion
policies. All that is required for that to be true is that the latter countries, those which
have adopted protectionist export-promotion policies, dominate the aggregate statistics on
global economic growth and poverty rates. Because of the enormous size of China, that
appears to be what has happened. The countries most dedicated to free trade, for example
the United States, have exhibited far lower growth rates.
A misleading correlation need not arise merely from the blurring of causal relationships
because the data has been taken from a variety of different national economies. It can also
arise from selecting the criteria to measure the degree of ‘trade freedom.” Multinational
agreements to lower tariffs are hardly decisive indicators of an increase in free trade,
since there are a number of non-tariff protectionist measures that elude such agreements.
A general increase in international trade—sometimes referred to as global economic
“integration”—is also irrelevant, since (as in the case of Japan and China) exports can be
encouraged and thereby enhanced through the use of various protectionist measures.
Bhagwati’s concept of an “export-oriented” economy or one with an “open orientation”
or Wolf’s similar concepts of an “outward orientation” and “liberal trade” are compatible
with many types of protectionist measures, some quite subtle and indirect.
What is needed in lieu of cross-country correlations and regressions is specific evidence
of the relationship between free trade and growth, and between growth and the reduction
of poverty in a variety of different national economies. The importance of focusing on the
particular conditions that apply to a specific national economy is supported by the various
theoretical arguments for protectionism, which argue not for protectionism in general, but
for specific kinds of protectionism under specified circumstances. Even if it could be
shown that some countries have experienced a reduction in poverty as a result of adopting
free-trade policies, that would not constitute an argument for the universal benefit of such
policies. It would have to be shown that a very broad spectrum of very different
economies have benefited from adopting free trade and related policies. And this would
require the sort of detailed and nuanced country studies that Bhagwati and Srinivasan at
first appeared to advocate. Such studies exist, and I will discuss several from Dani
Rodrik’s recent collection in the next chapter.
Some of these issues were discussed in Chapter 1 of Wolf’s book under his section
entitled “Incensed about Inequality” which briefly discusses the debate among
economists over poverty rates. However, this discussion is something of a diversion
since, as just noted, global per capita income statistics have no bearing on the policies
individual countries should follow to alleviate poverty. China, and to a lesser extent other
industrializing Asian economies (led, historically, by Japan), have strongly biased the
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global statistics. Their success calls for a detailed examination of what occurred in these
countries, which policies and which social or cultural characteristics were responsible for
the reduction of poverty—including the role of various distributional policies. Only after
such an analysis is it appropriate to ask if these same policies are likely to succeed in the
future (after the fact of East Asian industrialization) in various African and Latin
American countries with their very different social, economic, and cultural
characteristics. These are questions that will be discussed in the following chapters.
More on the Non-Income Components of Welfare
Poverty is typically conceived of as a condition of life that encompasses far more than
absolute income level. If poverty is to be defined narrowly in terms of income level (e.g.
less than $1 per day) then it should be recognized that the key concept is not poverty sodefined, but social welfare. Thus the debate over world-wide poverty levels defined by
per capita income ignores the negative welfare effects of the sub-standard labor
conditions that exist in many export-oriented manufacturing facilities in developing
countries. Bhagwati’s claim of a positive connection between labor standards and
globalization is largely based on anecdotal evidence, as are most of anti-globalization
claims. Of course, if one looks exclusively at wage rates and working conditions,
ignoring cultural and social factors, Bhagwati presents a fairly persuasive case that in
general multi-national corporations tend to provide better wages and working conditions
than the average in the economies in which they function. Whelan, in his defense of
globalization (Naked Economics), takes a similar position in a section entitled “The Good
News about Asian Sweat Shops.” But factors other than wages are relevant; for example,
the relative lack of job security at factories operated by multi-national corporations and
the social disruptions that occur when workers migrate from their rural home
communities to the large urban centers where the new factories are typically located.
These factors vary between countries and can only be addressed in the context of
particular national conditions. One only has to think of the well-organized export zone of
a small country like Mauritius in comparison with the conditions obtaining in various
Latin American sweat-shops. Recognition of these differences suggests that in looking at
specific national conditions, income levels are merely one of many factors that should be
considered in judging the welfare effects of alternative economic policies.
Globalization proponents have often answered concerns about working conditions and
cultural disruption by claiming that critics are elitist and paternalistic, and that sweatshop workers freely chose to leave the rural economy to take the jobs, freely chose to eat
fast food at McDonalds, and freely choose to purchase icons of American culture. Wolf’s
book exemplified how globalization proponents often emphasize the negative and
exploitative aspects of traditional cultures, and then praise globalization not only as
economically beneficial but as spiritually liberating. It is true that many opponents of
globalization have focused on the destruction of traditional cultures and the spread of a
homogenous “American culture.” But such critics also exist within the countries subject
to globalization. In the face of intuitively repugnant aspects of globalization—such as the
construction of a garish McDonald’s in the midst of an historic district in Singapore—
globalization supporters say that critics must respect the “choice” of the local populace.
But the presence of a sufficient number of consumers to make the McDonald’s a financial
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success hardly settles the matter, if large numbers of other citizens are appalled by its
existence. “Local choice” in these discussions is typically measured by the economic
power of consumers rather than in democratic terms.38 Moreover, the libertarian or
laissez-faire defense of local choice over the alleged “paternalistic elitism” of the antiglobalization movement exemplifies the unfortunate tendency of globalization
proponents to engage in rhetorical rather than substantive argument. Rather than openly
defending the proposition that unrestrained markets are best, globalization defenders
invoke a normative argument that lies outside the scope of economic theory in extolling
individual choice and “freedom”—even through they rarely advocate legalizing
prostitution or drug dealing wherever the market dictates these activities.
The debate over the cultural effects of globalization obscures a deeper issue which is the
optimal choice of governmental policies, including economic policies, to maximize social
welfare, broadly construed. The orthodox economic conception of welfare derives from
an outdated and invalid psychological model in which individual utility is maximized
through spending income on goods and services; the higher the income, the greater the
potential individual utility. This model assigns no value to those aspects of life that
cannot be measured in terms of consumption levels. In particular, the value of various
aspects of traditional culture with respect to social welfare is not quantifiable in economic
terms—nor is the jolt to the sensibilities of local (not foreign) passersby upon seeing an
ugly McDonald’s in an historic quarter. Such changes in traditional culture can contribute
to a generalized malaise that diminishes the quality of life. However, some aspects of
social welfare that are unrelated to direct consumption of marketable goods can be
measured. Among these are health care and educational levels. And both can become
decoupled from economic growth. Pakistan provides a good illustration that will be
discussed in the next chapter.
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Chapter 6
Case Studies of National Economies
The previous chapter suggested that real insight into the relationship between various
trade policies and economic growth, and between economic growth and social welfare,
will have to come from detailed country studies. Neither neoclassical growth theory with
its array of implausible and contradictory formal models nor cross-country statistical
generalizations cast much light on the selection of optimal trade policies.
The orientation of these country studies is historical. It is worthwhile looking at some
general features of them before turning to specific studies. In their excellent book on
development economics, Todaro and Smith make several important points about the
difference between the conditions obtaining during the early growth stages of the
advanced industrial economies and conditions facing Third World economies today.
These are (1) fewer physical and human resource endowments in currently developing
countries; (2) a lower level of per capita income than the developed countries had during
the nineteenth century; (3) currently developing countries are predominantly located in
tropical or subtropical climatic zones; (4) currently developing countries have much
higher rates of population growth; (5) today there are greatly lessened opportunities for
international migration (thus reducing population pressures on developing countries); (6)
currently developing countries have adverse terms of trade compared with the terms of
trade developed countries had during the nineteenth century; and (7) currently developing
countries have a relative lack of scientific and technical research; (8) currently
developing countries have less stable and less flexible political and social institutions;
and (9) currently developing countries have less efficient domestic economic institutions.
(Economic Development, 71-83). The important point is not that all of these problems
afflict every developing country. Rather I think Todaro and Smith’s list provides a
caution; economists should not assume that policies that worked for the currently
developed economies during their early developmental stages will work for a currently
undeveloped country. And my position will be that the specific economic, social, cultural,
and geographic conditions obtaining in a particular economy are crucial in determining
the most effective development policies.
Consider free trade. Free trade was promoted by English social reformers at a time when
England was the most advanced economy in the world and its manufactured goods faced
little serious competition in foreign markets. English workers were forced to pay
artificially high prices for bread due to the Corn Laws that protected the English gentry
that controlled agricultural output from grain imports. Adoption of free trade policies in
the early nineteenth century meant increased profits for the emerging English
manufacturing class from expanded exports and cheaper raw material imports, and also
cheaper food for English workers from grain imports. However, the second generation of
countries that experienced the industrial revolution, most notably Germany and the
United States, relied heavily on protectionism to protect and develop their infant
industries. In addition, these countries had a large domestic market for goods
manufactured domestically goods. In the case of England, its colonies provided a
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protected market for its manufactures. The conditions under which the advanced
industrial countries developed, and in which some favored free trade, are quite different
from the conditions facing developing Third World countries today.
Three Approaches to Development Economics
Development economists have been socialized in neoclassical theory which forms the
basis for contemporary economic education. However, most have been forced to modify
neoclassical orthodoxy in one way or another as a result of their studies of developing
economies. Nonetheless, when an economist wanders too far from orthodoxy, reaction
can be severe as we saw in the case of Joseph Stigliz. It is worth looking at three different
responses to the problems for neoclassical orthodoxy posed by developing economies.
The first response is illustrated by William Easterly’s work. Easterly claims to discover
confirmation of a key element of contemporary neoclassical theorizing, the power of
incentives. He arrives at this conclusion through a study of the failure of various
development models of the past few decades to produce the predicted growth. The second
response is illustrated by Michael Todaro and Stephen Smith, authors of a well-received
textbook on development economics. Todaro and Smith declare that although
neoclassical theory applies to advanced industrial economies, it does not apply to
developing economies. A third response is illustrated by Dani Rodrik. Rodrik who seeks
to modify orthodox free-market thinking about development without abandoning core
neoclassical tenets. None of these three positions is in accord with the “Washington
Consesus” associated with the World Bank and IMF, but nonetheless all three are
burdened to one degree or another by the effects of indoctrination into the meta-belief
system of neoclassical theory. The same will be seen to be true of most of the authors of
the individual country studies that will be considered later in this chapter. I now consider
each of the three responses in more detail.
William Easterly
Easterly authored a highly-praised survey of policies directed towards increasing
economic growth in the Third World, The Elusive Quest for Growth, Economists’
Adventures and Misadventures in the Tropics. As the title suggests, the book exhibits a
rather condescending attitude towards poor countries (reflected even more strongly in the
title of his latest book, The White Man’s Burden). Easterly surveys the failures of foreign
aid inspired by the Harrod-Domar growth model and its later modifications, and the
limitations of the emphasis on exogenous technology (as in the Solow model) as well as
failures of policies based on increasing funding for education and birth control. However,
rather than drawing the conclusion that achieving economic growth (along with an
improvement in social welfare) is an extremely complicated process that requires
different strategies according to the specific economic, social, cultural, and geographic
conditions of the country under consideration, he arrives at the conclusion that there is a
single key to growth:
The problem was not the failure of economics, but the failure to apply the principles
of economics in practical policy work. What is the basic principle of economics? As a
wise elder once told me, “People do what they get paid to do; what they don’t get paid
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to do, they don’t do.” A wonderful book by Steven Landsburg, The Armchair
Economist, distills the principle more concisely: “People respond to incentives; all
the rest is commentary.” (xii)
At one point Easterly states that the centrality of incentives in the motto of his book. He
writes, “This effect on growth is a big change from the Solow framework in which the
technological progress that occurred for noneconomic reasons always determined growth
in the long run. Now changes in incentives would permanently change the rate of
economic growth.” (146) Easterly’s simplistic generalization illustrates the tendency of
contemporary neoclassical economists to substitute sweeping generalizations for detailed
analyses of the complexity of empirical reality. “Incentives” as the explanation of
development success is another example of the “one big idea” characteristic of
“hedgehog” analysts (discussed in Chapter 1).
The concept of incentives in itself is hopelessly vague since incentives may be invoked to
explain almost any behavior. However, as used by economists, the concept of incentives
is based on the conception of human beings as mere “utility maximizers,” coupled with
the notion that utility is a function of consumption levels and hence of disposable income.
If “agents” attempt to maximize utility, they will attempt to maximize income, hence the
power of monetary incentives. The idea that incentives are central to economic
explanations derives from the work of the University of Chicago economist Gary Becker,
a winner of the Nobel Prize for Economics, who attempted to analyze behavior such as
criminality, normally thought to be in the domain of sociology, in terms of response to
incentives.
Easterly’s book provides example after example of bad economic reasoning; not bad in
the sense that it contrasts with “good” economic reasoning but bad in that it relies on
simplistic and unrealistic neoclassical assumptions to reach its conclusions. Easterly uses
cross-country statistics to support a variety of generalizations of the form “X promotes
growth.” The various characteristics that can replace “X” can be thought of as an ndimensional property space in which each particular country may be located, a process
that represents a methodological meta-belief. This is not an idiosyncratic process utilized
only by Easterly; first book has been highly praised by such prominent economists as
Robert Solow and Paul Romer (who states on the back cover) “Easterly presents both the
power of simple economic models of the development process and the painfully
disappointing track record of official development assistance.” Certainly Easterly does a
good job of demonstrating the failure of development policies based on conventional
models. But he leaps from concrete data demonstrating these failures to simplistic
conclusions by way of unrealistic hypothetical models that incorporate many of the false
assumptions of neoclassical theory.
His use of such reasoning reflects a more general truth about neoclassical economics: that
simplistic arguments are used to arrive at standard laissez-faire conclusions without any
reference to, or reliance on, the arcane mathematical apparatus of core neoclassical
theory. This is quite unlike natural science where deep conclusions come from arcane
theory which popularizers struggle to describe in ordinary language. In economics,
mathematical theory principally serves to give weight to bad arguments, by surrounding
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them with the mystic of deep mathematical theory created by “brilliant” minds and
understood only by trained economists.
This is not the place to look at these bad arguments in any detail. However, among the
false premises are the following: the assumption that an aggregate production function is
a meaningful way to describe national output; the implicit assumption of full
employment39; the assumption that diminishing returns applies to the factors involved in
aggregate national output, the assumption that the specifics of culture, geography, social
organization, political organization, and cultural, geographic, can be ignored in
comparing countries’ economic growth; the assumption that the analysis of growth in a
country can ignore the historic global economic environment of the country (tantamount
to assuming autarkic economies); and the loose use of the concept of incentives, applying
it even to entire countries (poor countries are said to have every incentive to grow).
However, there is one bad argument whose assumptions I haven’t previously discussed
that is worth examining. Easterly argues that since income from capital (that is, income to
direct and indirect owners of capital) is only half as great as wage income, capital
“accounts for” only one-third of total production and workers “account for” two-thirds of
total production. (50-51) He then goes on to use this implicit aggregate production
function to argue (citing Robert Lucas) that more capital goods (machines) can’t explain
the fact that American per capital income is 15 times larger than Indian per capita
income. Why not? Because “machinery is not very important as an ingredient of
production;” capital has only “a slight role in production,” and “capital accounts for only
about a third of all production.” (56-57)
Why should the payments to owners of capital as compared with wages have anything
much to do with the role of capital goods in determining economic output? Wonderfully
efficient new machines or techniques that vastly increased production might cost very
little and yield relatively little profit to its producers or owners; and very costly
machinery might make only a marginal difference in the level of output. Easterly’s
reasoning is indeed typical of the reasoning of economists who take capital as some kind
of undifferentiated substance. The income difference between India and the United States
obviously does not merely reflect the difference in the quality of machinery—a myriad of
social, cultural and historical factors are of great importance. But if the Indian capital
base—machinery, communications and transportation infrastructure, human capital,
etc.—is far less efficient than the American capital base, that difference would be
significant independently of the relative payments received by owners of the capital. In
fact, relatively higher payments to the owners of Indian capital would be perfectly
compatible with that situation. In short, the payments to owners of capital goods have
relatively little to do with the productivity of these capital goods. Rather than concluding
that investment in capital goods is a waste of money when the goal is increasing growth,
the conclusion ought to be that everything depends on which capital goods effectively
promote growth for a particular economy, and that depends on the country’s natural
resources, labor skills, infra-structure, ability to create a sufficiently large domestic or
domestic and international market to realize economies of scale, etc., etc. The existence
of one or another kind of incentive will be part of this analysis, but the orthodox
assumption that the laissez-faire program of low taxes is the best, if not the only viable
incentive package, is totally unwarranted.
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Easterly looks at a variety of developing economies and everywhere finds governmental
incompetence and corruption. He bemoans the fact “that some governments interfered
with the returns to skill by not letting their citizens keep all their income” and then notes
that “governments that safeguarded property rights and let free markets work (most of the
time) did move to intensive growth…” In short, after surveying a variety of failures in
developing countries, he leaps to the conclusion that the usual package of free market
reforms coupled with incentives (“letting their citizens keep all their income”) is the key
to creating growth.
If the fundamental problem with unsuccessful developing economies is lack of
incentives, we would certainly expect to hear a good deal of discussion of incentives in
the case histories of particular countries written by academic economists. But as we shall
see they are scarcely mentioned. A preoccupation with material incentives (pay and
profits) coupled with a neglect of cultural and social values is characteristic of
neoclassical analyses. But as an explanation of why Bangladesh has done better than
Pakistan, or China better than India, or Vietnam better than the Philippines, or to explain
what went wrong in Venezuela, it this approach is so general as to be vacuous.
Todaro and Smith’s Textbook
Another approach to dealing with the dissonance between the reality revealed in case
studies of Third World economies and economic orthodoxy is exhibited in the textbook
on development economics authored by Michael P. Todaro and Stephen C. Smith.
Todaro and Smith take the position that “traditional neoclassical economics deals with an
advanced capitalist world of perfect markets; consumer sovereignty; automatic price
adjustments; decisions made on the basis of marginal , private-profit, and utility
calculations; and equilibrium outcomes in all product and resource markets. It assumes
economic “rationality” and a purely materialistic, individualistic, self-interested
orientation toward economic decision making.” (9) They continue, “Unlike the more
developed countries (MDCs), in the less developed countries (LDCs), most commodity
and resource markets are highly imperfect, consumers and producers have limited
information,... the potential for multiple equilibria rather than a single equilibrium are
common, and disequilibrium situations often prevail (prices do not equate supply and
demand.” According to them, development economics has greater scope than traditional
economics because it deals “with economic, social, political, and institutional
mechanisms, both public and private, necessary to bring about rapid... improvements in
levels of living...” In short, rather than rejecting neoclassical orthodoxy outright, they
seek to restrict its application to advanced industrial societies while still continuing to use
neoclassical jargon (“multiple equilibria”) in speaking of developing economies. Despite
the continued, if limited, use of neoclassical vocabulary, their position is somewhat
reminiscent of a criticism of classical laissez-faire economic theory in the mid-nineteenth
century by the then emerging school of historicist economists. This school originated in
Germany, but also had support in Ireland. Early critics such as T. E. Cliffe Leslie
attacked the view that there were universal economic laws of the sort proposed by
Ricardo, Bentham and other classical economists; rather, they claimed that the conditions
presumed by these laws applied at best to an advanced economy such as that existing in
England. (Hodgson, Chap. 5)
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Although their approach frees Todaro and Smith from the constraints of neoclassical
dogma when studying development in the Third World, it is patently absurd to claim that
modern advanced economies any in way resemble the neoclassical model of a general
competitive equilibrium with its assumption of pure rationality on the part of producers
and consumers, and all markets matching supply and demand. Issues of free trade and
free market policies relate to both developing countries and to advanced countries, and
both types of economies, although different in many respects, function in the context of
specific social and cultural factors, and the inhabitants of both types of countries function
in a manner at variance with the assumptions of neoclassical theory, a fact recognized by
Adam Smith himself. Neoclassical theory converted the qualified generalizations of
classical economics into putative “laws” ossified in a mathematical structure that purports
to model economic reality. The Todaro-Smith position can best be viewed as a way of
paying lip-service to the fundamental dogmas of the profession without being bound by
them in studying developing economies.
Dani Rodrik’s Collection of Case Studies
The well-known trade economist Dani Rodrik (whose statistical argument in defense of
the oft-maligned “import-substitution” policy was criticized by Bhagwati and Srinivasan
in the paper discussed in the last chapter) is representative of a small but growing group
of orthodox economists who have distanced themselves from the free-market policies of
the World Bank and IMF. These economists no longer reflexively reject the criticisms of
globalization critics nor do they ridicule protectionism; rather they believe in examining
detailed case studies of various national economies, studies which focus on the social and
cultural aspects of the economies being studied as well as economic factors. I’ll discuss
in some detail many of the studies found in Rodrik’s collection of case studies. All are by
academic economists, and although all to one degree or another adopt the jargon of
neoclassical theory, they vary greatly in the influence such theory has on their
presentations (the Pritchett study discussed in the last chapter represents an extreme
example of neoclassical influence). In most cases, these economists’ tentative attempts to
apply neoclassical orthodoxy give way in the face of resilient facts about the social and
cultural context in which the economies function. This creates some awkward writing
because in many instances their dissenting analyses remain couched in neoclassical
jargon.
Rodrik himself, in his introduction to the collection, offers a number of conclusions that
are sharply at variance with the usual claim of a causal link between free-market policies
and economic growth. He begins by noting that the gap between rich and poor nations
has increased enormously since the beginning of the industrial revolution, with very poor
nations like Sierra Leone now having an average income 100 times lower than that of
some rich nations. Moreover, two-thirds of the world’s population lives in countries
where the average income is only one-tenth of that in the United States. These
differentials resulted from different long-term growth rates.
As noted in the previous chapter, extensions of orthodox economic theory, including the
Solow growth model and later variants, take the proximate factors affecting growth as the
growth of Capital (“capital deepening”), increase in Human Capital, and growth of Total
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Factor Productivity (TFP) through technological advances. According to Rodrick, the
most widely discussed indirect causes that work through these proximate factors are
“geography” (proximity to navigable waters, climate, and natural resources); “trade”
viewed as integration into the world economy; and “quality of social institutions” that
affect economic performance. Rodrik presents scatter plots of national income versus
each of these factors in attempting to show that a positive correlation exists in each case.
But he notes that these correlations obscure complex feed-back effects (e.g., a higher
income fosters more trade and “better” institutions). In addition, he notes that it is
difficult to find indices that measure more complex factors such as geographical
advantage or institutional quality.
Of the three indirect factors listed by Rodrik, “trade” (or “integration”) has been
traditionally identified by economists as the principal cause of national income growth.
This corresponds to Bhagwati’s notion of an “outward orientation” and Wolf’s notion of
“economic integration.” Free trade is the dominant concept discussed in connection with
trade, but most economists, including Rodrik and Bhagwati, have in mind a complex of
factors and policies that go well beyond free trade. A particular set of such policies, those
I have labeled “free trade and related free-market policies” (one variant of which has
been labeled “the Washington consensus”) has been widely claimed by globalization
proponents to promote economic growth through extended integration into the world
economy with income-enhancing effects. The degree of unqualified support for this
position varies. As Rodrik comments, “An influential article by Jeffrey Sachs and
Andrew Warner (1995) went so far as to argue that countries that are open to trade (by
the authors’ definition) experience unconditional convergence to the income levels of the
rich countries;” Rodrik goes on to note that this purist position is held by the International
Monetary Fund, World Bank, World Trade Organization, and Organization for Economic
Cooperation and Development. He terms this supposed causal link between “trade
openness” (as defined by these economists) and economic growth as (or was until very
recently) the “new” economic orthodoxy. In fact, this is what was labeled “globalization”
at the very beginning of this book.
Rodrik is a dissenter from the purist position, and he makes some of the same points that
were made in the discussion of the comparative advantage argument in Chapter 4: “The
traditional theory of trade does not support such extravagant claims, as trade yields
relatively small income gains that do not translate into persistently higher growth.” (8) He
claims that the only way to support the alleged link between free trade and growth is to
“tweak” endogenous growth models so they yield general large dynamic benefits from
trade openness, “provided technological externalities and learning effects go in the right
direction” and capital flows go from rich to poor countries. (8) (This tweaking of growth
models was just what Bhagwati and Srinivasan warned against in their paper.)
Rodrik then notes that the thinking of some economists has evolved to a nuanced position
over the past few years. First came a recognition of the importance for economic growth
of institutions—a view that became codified as “the new institutional economics.”40
Rodrik mentions, in particular, “property rights, appropriate regulatory structures, the
quality and independence of the judiciary, and bureaucratic capacity.” The critical
importance of such institutions was brought home by the disastrous imposition of free-
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market policies on the states that composed the former Soviet Union, many of which
experienced an absolute fall in per capita national income after adopting free-market
“reforms.” According to Rodrik (perhaps a bit optimistically), “the profession’s priors
have moved from an implicit assumption that these institutions arise endogenously and
effortlessly as a by-product of economic growth to the view that they are essential
preconditions and determinants of growth.” (p.8) The influence of the new institutional
economics can be seen in Wolf’s discussions and in other recent writings in support of
globalization.
Rodrik then notes that that there are complex feedbacks between trade and institutional
structure: “better institutions foster trade and more openness to trade begets higherquality institutions.” (9) His remarks, though departing from the purist position of a few
years ago, continue to reflect the normative meta-belief structure of neoclassical theory:
“trade” is assumed to be good, and the “goodness” of institutions is measured by the
extent to which they facilitate efficient markets of the sort hypothesized in the core
neoclassical competitive equilibrium model. Neoclassical economists have labeled
institutions as “good” or “best practice” when they are associated with judicial
protections of property rights and contracts and other aspects of the political system that
help insure “effective” (competitive) markets. Under this orthodox conception, the role of
government is minimal beyond this protective and regulatory institutional role.
Rodrik, like Bhagwati and Srinivasan, stresses that the complex relationship between
institutional quality and trade “makes simple minded empirical exercises” of the kind
shown in correlation analyses “highly suspect.” And he agrees with Bhagwati and
Srinivasan that “econometric results can be found to support any and all of these
categories of arguments,” that is arguments offered by those who wish to demonstrate
that either trade, or institutional quality, or geography is the primary factor in promoting
growth. According to Rodrik, “very little in this econometric work survives close
scrutiny... or is able to sway the priors of anyone with strong convictions in other
directions.” (9)
Bhagwati and Srinivasan held the narrow view that role of case studies is to support
broad generalizations such as “an outward orientation leads to growth.” Rodrik is more
guarded about the possibility of such generalizations, asserting “there is little reason to
believe that the primary causal channels are invariant to time period, initial conditions, or
other aspects of a country’s circumstances.” He acknowledges that “there may not be
universal rules about what makes countries grow.” (9-10) Nevertheless, he sees a role for
more limited generalizations, and advocates a combination of case studies and crossnational regressions to test such generalizations. In the end, his views on free trade are
not as far from the conventional neoclassical position as at first appears. The position
taken in his book Has Free Trade Gone Too Far? might be characterized as orthodox
economic doctrine tempered by appreciation of local conditions, a position similar to that
of Joseph Stigliz. But his opinion that “government policy toward trade does not play
nearly as important a role as the institutional setting” puts him at the extreme edge of
orthodox opinion. (11-12)
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Conclusion
Of the three approaches taken by development economists, that of Todaro and Smith
provides the greatest scope for a consideration of specific cultural, social, and economic
factors untainted by neoclassical theory. Their assumption that neoclassical theory holds
for developed economies, although clearly false, does nothing to undermine an openminded approach to the study of developing economies. Rodrik’s position is also
revisionist in that he does not let orthodox theory distort a realistic look at the specific
conditions affecting economic development in a variety of different economies. These
two approaches contrast with the dogmatic adherence to neoclassical orthodoxy exhibited
by Easterly—an economist whose work has drawn the most praise from the economic
mainstream. We now turn to look at specific case studies to see what they can teach about
the analysis of economic development.
Case Studies
The principal concern of this section is to explore the relationship between trade policy
and economic growth in Third World countries through the examination of some case
studies. These will help determine to what extent free trade and related polices actually
promote the institutions responsible for growth, and the extent to which such policies can
promote growth independently of local cultural and social conditions. Obviously, there is
an inexhaustible literature of case studies developed since the Second World War. I focus
on the 13 studies in Rodrik’s recent compilation; these provide a good cross section of
recent approaches and deal with 15 varied economies. They have the advantage of being
authored by a number of well-known development economists, almost all relatively
orthodox in their fundamental views, who approach their work with preconceived beliefs
about the importance of free-market policies and institutions (like private property) that
are traditionally associated with them, beliefs that form part of the extended normative
meta-belief structure of neoclassical theory. Thus unlike works by a single author (such
as the important text book by Todaro and Smith), one can get a better idea of the variety
of ways that academically-trained economists attempt to reconcile the facts to the metabelief structure of neoclassical theory. When, as is generally the case, the facts don’t fit
the theory, the actual situation is nevertheless frequently conceptualized using the
vocabulary of technical neoclassical theory or of its meta-belief structure. Interested
readers should also look at works by Todaro and Smith, Smith’s collection of case
studies, the recent work by Meir and Stigliz, and Easterly’s highly-praised studies of
growth policies.
Introduction
The term “globalization” suggests a world-wide phenomenon that belies the enormous
diversity in economic progress among various national economies. Many Third World
countries, particularly those in Africa, Latin America, and the Middle East, have shown
little or no economic growth over the past several decades. Others enjoyed long periods
of steady growth followed by a collapse into stagnation or economic decline. Very few
Third World countries conform to anything approaching the laissez-faire model
commended by most economists. Nonetheless, even countries that fall far short of the
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ideal have been praised when they institute “reforms”—which generally means that they
followed the advice of the World Trade Organization, IMF, or native “technocrats”
educated in the economic faculties of American universities. So-called free-market
reforms such as elimination of protectionist policies, privatization, deregulation, opening
domestic markets to free flows of foreign capital, and letting exchange rates float are
often lumped with political reforms aimed at reducing corruption and inefficiency. Few
would dispute the use of the word “reform” in the case of political reforms that reduce
corruption and inefficiency, but the conflation of free-market policies with political
reforms that occurs when the label “institutional reform” is used contributes to the
polemical force of the argument for globalization. When countries succeed in achieving
economic growth, their success is often attributed to their adoption of economic reforms,
although a closer examination of the specific changes involved often reveals that various
types of government intervention in the economy were strongly associated with the
growth. When such intervention promotes exports—when the country adopts an
“outward orientation”—the increase in exports is often taken as a argument for freemarket policies (“reforms”) when, in fact, the reality is that the government intervened in
ways contrary to neoclassical orthodoxy. On the other hand, when a country stumbles,
when its economy ceases to grow or even experiences contraction (“negative growth”) it
is easy for economists to blame “bad institutions” which fail to conform to “best practice”
models.
The obvious negative effects on growth of wide-spread corruption, political instability,
communal violence, and foolish government policies has led to the growth of what is
known as “the new institutional economics” that stresses “institutional reform” and
macroeconomic stability as preconditions for the successful application of free-market
policies. In recent years, both the IMF and World Bank have imposed a fairly rigid set of
institutionalization and stabilization policies on a variety of Third World economies as a
precondition for their receiving economic assistance. Control of inflation has been a
centerpiece of the Washington Consensus for the past two decades. This means insistence
in many cases on high interest rates in countries receiving IMF loans, credit restrictions,
cuts in government services to balance budgets, and floating exchange rates—all without
much regard for the consequences in terms of unemployment, reduced public services,
and lack of government investment in infrastructure. Countries such as Bolivia and
Argentina which have carried out IMF-mandated “reforms” were singled out for praise—
until their economies crashed. A scathing critique of IMF policies (in particular) in found
in Joseph Stigliz’s Globalization and Its Discontents.
An examination of a variety of case studies of developing economies fails to support the
purported link between free-market policies and economic growth (although it does
support a link between skillful export-oriented policies and growth). Jonathan Temple,
the author of the study of Indonesia in the Rodrik volume, comments on “the common
tendency of observers of relative performance to exaggerate the role played by
fundamentals, and underestimate the role played by chance.” (162) (By “fundamentals”
he means free-market policies.) Perhaps the most important lesson to be drawn from the
case studies, however, is that success or failure depends not on chance so much as on a
complex variety of local social, cultural, and political conditions that can tip the delicate
balance between success and failure, conditions that are difficult to reduce to the
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generalizations favored by orthodox economists. The example of Pakistan illustrates this
complexity: a country that exhibited respectable growth despite acute institutional
instability, a corrupt judicial system, crony capitalism, and the failure to develop human
capital.
Pakistan: A Case Study of Growth without Improvement in Poverty
Pakistan is especially interesting because it provides an example of a country that has
experienced per capita growth rates well above average in the decades since colonial rule
ended yet by a number of social measures life in Pakistan has hardly improved for the
impoverished majority of the population. The author of the study, William Easterly (the
author of The Elusive Quest for Growth), speaks of a “great divide” between the poor
majority and the elite, but claims that this divide is not reflected in exceptional levels of
economic inequality for a country with Pakistan’s per capita income. Instead, the failure
of the quality of life of the poor to advance with economic growth illustrates the
importance of components of poverty which are not reflected in per capita income
statistics.
Easterly writes that it may be “that the skewed distribution of education (the near worldrecord gap of nine years of schooling between the richest 20 percent and the poorest 40
percent...) is a more important dimension of inequality than income.” (66) “The typical
member of the poorest 40% has no schooling.” (450) Easterly is not alluding to some sort
of fuzzy “cultural” value placed on education, but to associated factors that would
generally be accepted as indicators of poverty and a low level of social welfare, factors
such as infant mortality and general morbidity. Internationally, and in particular in
Pakistan, one finds a negative association between mothers’ education and the mortality
rate of their children. (462) Over the period 1950 to 1999, Pakistan tripled per capita
income to a level that was higher than a third of the world’s countries. Yet at the end of
the period of the study (1999) social indicators like infant mortality and female primary
and secondary school enrollment in Pakistan were among the worst in the world. In
Baluchistan, female literacy was only 3%. The image is that of growth without
development, of a wealthy “elite that does not support human capital development in the
masses.” (440).
Some of the health statistics are equally disturbing: compared to other countries at its per
capita income level, Pakistan has 36% lower births attended by trained personnel, 11%
more babies born with low birth weight, 42% less per capita spending on health, 27 more
infant deaths per thousand, and 23% less of its population with access to sanitation. It
also has 20% fewer of its elementary age children enrolled in school. 24% more of the
Pakistani population is illiterate as compared with the average of countries of its income
level. Excess fertility is 0.6 births per woman. Socially relevant institutions are weak:
there is more graft, more violence, less rule of law, and less accountability. Despite its
low level of spending on health and education, the government has spent lavishly on
military weaponry. It spent $1.2 billion on a six-lane expressway between Lahore and
Islamabad, with traffic use at less than 10% of capacity. (440)
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Easterly investigated and rejected the possibility that Pakistan’s backwardness with
respect to indicators of social welfare reflected initial conditions inherited from its
colonial past. He found that although Pakistan grew much more rapidly than other lowincome countries, it achieved less social progress than they did. Countries that grew only
moderately displayed a faster rate of social progress, as measured by the indicators just
discussed, than Pakistan. (451-2)
Pakistan illustraes why growth in per capita GDP is not an appropriate indicator of
poverty reduction or more general improvement in social welfare, despite the near
universal acceptance of the relation between growth and the reduction of poverty on the
part of most economists. As Easterly noted, “Pakistan’s lack of social progress did not
prevent the World Bank’s touting Pakistan as a success story in 1985 in a publication
entitled Pakistan and the World Bank: Partners in Progress. Easterly attributes the
failure of Pakistan to make social progress to specific cultural and political factors,
notably ethnolinguistic diversity and rule by alternation between feuding factions of an
elite drawn from the landowning class and the military leadership. In the case of Pakistan,
Easterly speculates that growth in Pakistan resulted from a skilled managerial elite and a
mass of unskilled workers, and because of “the landlord elite taking advantage of the
immense potential of the irrigation network and the green revolution, using only
unskilled agricultural laborers.” (469-470) Pakistan is hardly unique in illustrating how
economic growth can occur under conditions that do little to improve the living
conditions of the impoverished majority.
A possible example of the opposite situation may be found in the Indian state of Kerala.
Kerala is one of the poorer states in India, and has showed little economic growth. Yet
Kerala has a highly educated population with good social services, low infant mortality,
and relatively high levels of social welfare.41 Examples like that of Pakistan and Kerala
indicate that attempts to dismiss criticisms of globalization through statistics that indicate
an increase in per capita income are bound to fail. Poverty—and social welfare in
general—is a function of far more than per capita income. The examples of Pakistan and
Kerala support the view that the effect of free trade and other free-market policies can
only be evaluated on country-by-country basis taking full account of local cultural, social,
and political conditions.
Even where growth has resulted in a decrease in poverty defined using measures boarder
than per capital income, it is important to recognize that different patterns of growth can
have very different consequences for national welfare, and in particular, for the welfare
of the poor. Advocates of globalization often assume that a single set of free trade and
related policies constitute the best, and probably the only, road to growth and to an
increase in social welfare. In the case of Pakistan, policies praised by the World Bank
contributed to growth, but not to the reduction of poverty. In other cases, these policies
have not even contributed to growth.
The Philippines and Indonesia
In the second half of his paper in the Rodrick collection (the first half, on theory, was
discussed in the previous chapter), Pritchett contrasts the economies of the Philippines
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and Indonesia. Under the dictator Ferdinand Marcos, the Philippine economy was marked
by a high level of corruption and a regime of crony capitalism, yet the economy grew at a
respectable 2.6% annual rate from 1970 to 1982. After the post-Marcos transition to
democratic institutions, the per capita GDP actually fell (to 92% of its 1982 level). In
contrast, the GDP of Thailand doubled in the same period. During the post-Marcos period
of economic decline, the Philippines had an open economy with an education rate far
above that of its more rapidly growing East Asian neighbors, and despite some ups and
downs in physical capital growth, “growth in capital has been faster and steadier than
growth in output.” Pritchett says that neither “the raw numbers” for budget deficits nor
real exchange rates “suggest for either of these indicators a policy deterioration in the
democratic period versus the previous period capable of explaining the significant growth
slowdown.” (146) Moreover, institutional structures improved in the post-Marcos period
with a decline in the “blatant crony corruption of the Marcos days,” and “more civil
rights and a freer press.”
Pritchett’s “conjecture” to explain the lack of correlation between institutional reform and
growth is an increase in “institutional uncertainty—the reliability with which economic
actors can anticipate the rules of the game (no matter how good or bad those rules might
be.)” He explains the relatively greater success of the Philippines under Marcos, of
Indonesia under Suharto, and of Vietnam under Communist Party rule, as due to
predictability—“the supportable level of output is potentially substantially lower in the
new “better” but uncertain regime than in the bad old days.” (148). Pritchett’s conclusion
is not based on any detailed analysis of the historical and cultural context of the
Philippine economy nor of that of the other countries he discussed. It is no more than an
ad hoc explanation which justifies Pritchett’s classification of the Philippines within his
taxonomy as a “non-poverty trap, low or zero growth state,” and his view that it is an
exemplar of the generalization that “institutional uncertainty stymies economic growth.”
Moreover, the generalization is contradicted by the economy of Pakistan which
experienced respectable growth with institutions even more unstable than those of the
Philippines. Pritchett’s general approach is in keeping with the tendency of economists to
seek broad generalizations. However, his conclusion is adverse to the orthodox view: “if
the problem is systematic uncertainty... it is not clear than individual, piecemeal
economic reforms, even cumulated, can shift the growth state.” (149)
Although Pritchett treats Indonesia as an example of successful growth in contrast to the
Philippines, a more detailed examination of the Indonesian economy by Jonathan
Temple, an English economist, shows a far more complex situation, but one that is
equally troubling for the orthodox view that links growth to the adoption of free-market
policies. Temple does not discuss the early post-colonial period under Sukarno, a period
that terminated in political and economic collapse in the early 1960s; instead he focuses
on the decades-long period of rule by General Suharto in which Indonesia showed steady
growth which and was considered a success story by the orthodox economic community.
In 1965, at the end of the Sukarno period, inflation in Indonesia had reached almost
600% and by year-end the country could not longer meet its debt service obligations. In
March 1966 the military under General Suharto took control, instituting what was
referred to as “the New Order,” a regime that was to last more than thirty years. At the
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beginning of this period, Indonesia was one of the poorest economies in the world. Its per
capita GNP was less than 60% of other East Asian countries, lower than the regional
median for Sub-Saharan Africa, and far lower than the Latin American median. From
1961 to 1997, GDP per capita grew more than four-fold, infant mortality rates dropped,
average years of schooling went from 1.5 to 5, and illiteracy dropped from 40% in 1970
to 15% in 1997. Gross domestic investment as a share of GDP rose from under 10% to
almost 30%. Agricultural employment fell from 75% to close to 50%, and the share of
the population living in urban areas rose from 16% to 40%.
Indonesia achieved this growth in spite of the presence of factors generally held to be
negative to growth—such as a high level of ethnolinguistic diversity with recurrent ethnic
conflicts. Moreover Indonesia possessed extensive oil reserves, what economists refer to
as “a resource-rich tradable sector.” However, far from being a blessing with respect to
economic growth, economists have generally treated this as negative factor because of
the so-called “the Dutch disease effect”—the claim is that when a resource-rich tradable
sector like oil experiences a boom due to rising international demand, resources will be
diverted from non-resource-based tradable sectors (most importantly, manufacturing),
and output from these sectors will fall. Since manufacturing is generally held to promote
sustainable endogenous economic growth, an oil boom is assumed to inhibit growth.
Indonesia defied conventional wisdom by growing relatively rapidly both during the oilboom decade of the 1970s and afterwards despite these supposed disadvantages.
The period of Suharto’s rule is not one of uniform growth as various neoclassical growth
models project. The initial success of the Suharto regime lay in controlling hyperinflation
without incurring a sustained contraction in output; by 1969 the inflation rate had
declined to a manageable 15%. This is attributed by Temple to good macroeconomic
management that generally maintained price stability. This management, though labeled
“orthodox” by Temple, hardly conformed to the hand-off injunctions of free-market
advocates, since it relied on heavy government intervention to stabilize price levels and
the exchange rate. In addition, there was a high level of spending on public goods,
especially for the dominant agricultural sector. The Suharto regime was notoriously
brutal and corrupt; what Temple describes is not a laissez-faire economy but a highly
controlled and corrupt economy which, however, fell short of engaging in the worst sort
of predatory behavior seen in some African nations.
A major factor in Indonesia’s growth during the 1970s was the green revolution in
agriculture, and the priority the government gave to agricultural production through large
subsidies for fertilizers and pesticides, stabilization of rice prices, and investment in rural
infrastructure, including schools and clinics. This spending was financed by the large
revenues that accrued to the government from the oil boom of the 1970s. The windfall
began in 1973 when a quadrupling of world oil prices increased real national income
and—as predicted by the Dutch disease argument—contracted the non-oil traded sector,
inhibiting industrialization. However, the potential negative consequences for growth
were largely offset by the direct government investment in the agrarian sector.
The end of the oil boom in the early 1980s led to major problems in most oil-producing
nations, but Indonesia responded quickly when its current account moved into deficit
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with a combination of expenditure reduction and exchange rate adjustments. Then during
the late 1980s and 1990s, labor-intensive manufacturing rapidly grew as Indonesia
benefited from its proximity to the rapidly industrializing economies of East and
Southeast Asia. These changes are attributed by Temple not only to regional growth but
also to administrative reform of the notoriously corrupt customs service and the banking
sector, selective import liberalization with respect to raw materials and intermediate
goods used by exporters, and a shift towards tariffs as the preferred tool of trade policy.
Together these changes represent a shift not to free trade but to an outward orientation
that favors manufacturing exports. Between 1983 and 1992, the share of manufacturers in
total merchandise exports rose from 7% to almost 50%. This was partly due to the
“reforms,” partly due to falling international prices for oil and natural rubber, and partly
due to specific protectionist policies such as a ban on the export of unprocessed logs that
raised plywood exports.
The government’s economic policies during the 1960s and 1970s are labeled
“macroeconomic reforms” by Temple. As noted, these involved fiscal and monetary
policy, and targeted government investment in agriculture. Such policies, although
administered by U.S. trained economic technocrats, hardly fit the free-market model.
Temple labels the cleaning up of the customs service and banking sectors, as well as the
shift to policies favoring labor-intensive manufacturing exports, as “microeconomic”
reforms thereby suggesting (somewhat misleadingly) conformity to orthodox neoliberal
economic recommendations. In fact, Indonesia shifted from a reliance on oil exports to an
export orientation based on labor-intensive manufacturing through a variety of
government interventions that were far from the laissez-faire model. The more important
reforms involved cleaning up corruption and facilitating exports. A “shift towards tariffs
as the preferred tool of trade policy” is labeled a “reform” although this is in direct
opposition to the advice of Bhagwati, Wolf, and others who take tariffs to be the worse of
protectionist measures.
Temple also claims that Indonesia was simply lucky. Governments in most other oil rich
countries squandered much of their oil revenues on over-ambitious and risky investments
in oil-based industries, investments that were difficult to postpone or cancel when oil
prices declined. Indonesia did not fall into this trap because the oil industry had been
discredited by a major scandal that enveloped the giant state-owned energy company
Pertamina in the mid-1970s. Moreover, the rapid growth of neighboring Asian economies
during the 1980s, at the very time the effects of the oil crisis were being experienced,
provided an exogenous spur to an export-oriented approach, an instance in which
geography played a key role in promoting growth. Temple also sees historical accident at
work in the influence of technocrats who had gained prestige from their success in
controlling inflation in the late 1960s and once again from dealing with the problems
associated with the corruption scandal at Pertamina in the 1970s. These same technocrats
were able to implement the export-orientation policies that were responsible for the
country’s successful move into manufacturing exports.
Close examination of Indonesia’s three-plus decades of relative economic success does
not support the case for free-market policies. But a whole new set of conditions arose
from the Asian currency crisis of 1997. As Temple notes, “the financial crisis led to
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astonishingly steep declines in investment and output, and Indonesia’s economic miracle
unraveled amidst growing social disorder and internal tensions.” (174) The explanations
he provides for the change are vague and laced with orthodox jargon. Temple speaks of
“institutional weaknesses” and says that “the effects of corruption, and the politicization
of economic activity, started to threaten the security of the financial system... These
institutional weaknesses suggest that, by the late 1990s, Indonesia may have lacked
resilience in the face of shocks.” The notion of an economy operating in a state of general
equilibrium until disturbed by an exogenous “shock” is fundamental to the conceptual
structure of neoclassical economic theory (as is the related use of comparative statics as a
primary analytical tool). However, in view of Indonesia’s ability to handle the “shocks”
associated with hyperinflation, followed by the oil boom of the 1970s (without suffering
from the “Dutch disease”), as well as the shock occasioned by the end of the oil boom
early in the 1980s without experiencing the severe fall-out of other oil-based economies,
the reference to “lack of resilience” seems puzzling. Nor does it explain anything to say
that Indonesia was “destined for trouble” or that “bad luck played a role.”
Other knowledgeable economists have drawn different conclusions from the economic
collapse of 1997. Where Temple speaks of “a new awareness of exchange rate risk” and
of “a series of policy mistakes, particularly the sudden closure of sixteen failing banks”
as responsible for the economic collapse, (174) Joseph Stigliz, the well-known economist
who served as the Chief Economist for the World Bank during the period, lays the blame
squarely with the neoliberal dogmatism of the IMF. According to Stigliz, the IMF
encouraged lifting of controls on the flow of capital, thereby creating the preconditions
for the run on the Thai baht that precipitated the crisis which then spread throughout the
Asian economies. And far from being the result of faulty Indonesian policy, Stigliz
blames the closing of the Indonesian banks on IMF. According to Stigliz:
Nowhere was the IMF’s lack of understanding of financial markets so evident as
in its policies toward closing banks in Indonesia. There, some sixteen private
banks were closed down, and notice was given that other banks might be
subsequently shut down as well; but depositors, except for those with very small
accounts, would be left to fend for themselves. Not surprisingly, this engendered a
run on the remaining private banks, and deposits were quickly shifted to state
banks, which were thought to have an implicit government guarantee. The effects
on the Indonesia banking system, and economy, were disastrous, compounding
the mistakes in fiscal and monetary policy already discussed, and almost sealing
that country’s fate: a depression had become inevidable. In contrast, South Korea
ignored outside advice, and re-capitalized its two largest banks rather than closing
them down. This is part of why Korea recovered relatively quickly.
(Globalization and Its Discontents, 117)
Stigliz claims that the successful East Asian economies shared only one principle with
the neoliberal “Washington Consensus”—macroeconomic stability. “As in the
Washington Consensus, trade was important, but the emphasis was on promoting exports,
not removing impediments to imports.... While the Washington Consensus policies
emphasized privatization, government at the national and local levels helped create
efficient enterprises that played a key role in the success of several of the countries.” (92)
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His concluded that “while the Washington Consensus policies emphasized a minimalist
role for government, in East Asia, the governments helped shape and direct markets.” In
the case of Indonesia, the stability of the Suharto dictatorship coupled with the
interventionist actions of technocrats succeeded in overcoming the negative effects of a
corrupt crony capitalist system. And the early emphasis on investment in agricultural
infrastructure vastly improved the quality of life for the majority of the population. The
problems that spelled to an end of the period of growth were not of Indonesia’s making—
they were indeed a kind of external shock, magnified by the faulty free-market dogma of
the IMF. Various underlying social and political problems in Indonesia did re-emerge in
the wake of the shock that resulted from the closing of the banks, and the subsequent
political instability undoubtedly hindered Indonesia’s recovery. However, none of this is
explained by orthodox economic analysis and certainly has nothing to do with the
simplistic generalizations about development favored by economists—much less with
free trade and other free-market policies. A look at some other Third World economies
confirms this judgment.
Latin America
The Latin American countries as a group present a problem for proponents of the view
that the key to economic growth is adoption of free-market policies. Not a single Latin
American country has achieved a solid record of economic growth (with the very recent
exception of Chile), despite the fact that a number have adopted free-market policies
recommended by the IMF and similar institutions, and despite the fact that many of their
economies have been directed by U.S.-educated economists steeped in free-market
dogma. Up until twenty years ago, Venezuela appeared to be the exception, but since that
time its economy has been stagnant and it is now considered a failed economy. The Latin
American countries benefit from geographical proximity to the large North American
market and to long-standing cultural and economic ties that facilitate trading relations. A
large part of the governing elite were educated in American universities, and many
“technocrats” in Latin American governments have earned advanced degrees in
economics. Several of the countries are rich in natural resources. So what went wrong?
Bolivia
Bolivia provides a clear lesson that free-market policies are insufficient to produce
economic success. In 1985, a democratically-elected center-right coalition introduced a
bold package of economic and political “reforms” that liberalized trade, smoothed market
mechanisms, and ended government subsidies. (348) These reforms were followed by
privatization of first small, and then large, state-owned enterprises, the creation of private
pension funds, and finally banking and judicial “reforms.” As a result of these changes,
Bolivia was characterized as “virtually a private economy” (352) In particular, Bolivia
brought trade barriers down to the point where they were lower than those in the United
States. The country also exhibited remarkable economic stability since the mid-1980s.
(359) Yet annual per capita growth rates have averaged near zero since the reforms
began and have had no effect on the severe poverty that afflicts the country, with half the
population living on less than $2 per day. (350)). The inability of economic reforms to
produce growth is one of the principal conclusions of an in-depth study of Bolivia’s
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economy by Daniel Kaufman, Massimo Mastruzzi, and Diego Zaveleta, all economists
with the World Bank (“Sustained Macroeconomic Reforms, Tepid Grow, A Governance
Puzzle in Bolivia?”, in Rodrik, Prosperity) Their analysis is of particular interest because
it attempts to understand why Bolivia has failed to grow through a detailed examination
of the country’s institutions and culture. The authors use a multifaceted approach,
combining an historical narrative that focuses on institutional change, an “econometric”
analysis based on a survey of almost 10,000 business firms in 80 countries, including
Bolivia, a statistical analysis of factors making for success of business firms in Bolivia,
and finally a statistical analysis of data from in-depth surveys of 1,250 public officials in
Bolivia.
The sophisticated statistical analyses presented are labeled “econometric” thereby
preserving a nominal link to traditional academic economics, but they are, in fact,
essentially the same type of analyses that are commonly found in sociological literature.
Models are developed that postulate various sorts of causal relations between levels of
corruption, transparency, values, politicization, etc., then statistical methods are used to
estimate parameter size and hence direction and strength of influence. This type of
analysis is certainly part of the sprawling enterprise that forms modern academic
economics, but is more closely related to contemporary sociological analysis than to
neoclassical theory.
This complex formal exercise produced some rather commonsense conclusions that
reinforce the case for context-sensitive analyses of individual economies in their
particular cultural, social, and political settings. We are told, not surprisingly, that “it is
important to transcend generalities and point to the particular dimensions of governance
that are an acute challenge within Bolivia” (374); that “there is enormous variance in
governance quality and performance across institutions within the country, backstopping
the “localization of knowledge” notion emphasized in the previous empirical section on
enterprise” (386) Moreover, there is a need for “unbundling the generic notions of policymaking, governance, and institutional quality, and of localizing knowledge.” (386) The
authors question the value of inter-country comparisons based on country aggregates
(such as measures of stability, corruption, transparency, and politicization), concluding
that “the empirical evidence attests to the large variance in performance and governance
across institutions, and also to the variance across policy and institutional factors within a
country. This challenges the tendency to rank (or “grade”) countries as if the withincountry variance were low, obscuring the strengths and weakness that institutions the
country may have—in turn clouding our ability to provide properly prioritized and
focused policy advice at the country level.” (389)
More concretely, (and here the authors speak through an imaginary Bolivian analyst)
...none of us can tell for sure what the optimal recipe is for Bolivia to grow
stronger—not even the experts from the international financial institutions!
Indeed, our review of the overall development field suggests that this not specific
to our country; there is simply no universally accepted truth on what are the most
important factors in making a country grow. In part, the answers vary from setting
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to setting; in part, there are imponderable mysteries however deeply we study
them. (389)
The reference to “imponderable mysteries” goes beyond what I claim about the need to
look at specific aspects of the culture, society, and economy, but the notion of answers
varying from setting to setting expresses it exactly. These conclusions come in the wake
of the rejection of simplistic hypotheses advanced in some of the studies previously
discussed. The authors find no support for the view that democracy (combined with
various economic reforms) is the key to growth; nor—as argued by Temple in his study
of Indonesia—that macroeconomic stability is the key; no support for the “grease
hypothesis” that views bribery as a sort of de facto efficiency-enhancing privatization
mechanism in an over-regulated environment (370, 374); and no support for the
generalization that corruption per se is not a problem but only unpredictable corruption
(370, 374) Their fundamental conclusion is that it is the particular variety of corruption
that exists in Bolivia that has resulted in economic stagnation.
Nonetheless, the study also makes it is clear that opening Bolivian financial markets in
accordance with conventional free-market thinking contributed to instability. Thus in
2001, when the economy was suffering from falling international commodity prices, a
foreign bank that played a major role in the Bolivian economy suddenly decided to pull
back on lending, greatly aggravating the situation. In the case of Bolivia, apologists for
free-market policies can find a number of excuses for the lack of growth in the
institutional structure. But the conclusion is clear: free trade and associated free-market
policies, in and of themselves, did not result in economic growth in Bolivia; in fact, these
policies appear to have contributed to the instability that brought the country to nearcollapse in 2005. And, as the East Asian financial crisis demonstrated, free-market
policies with respect to banking and capital flows can be destabilizing and precipitate
economic instability and “negative growth.”
Argentina
Argentina is another interesting case because, unlike Bolivia, it had a history of
prosperity during the first decades of the twentieth century, but since the nineteen
twenties has progressively lost ground, and experienced serious economic and political
problems under the populist regime of Peron and his successors. Thus to orthodox
economists it seemed a country with the potential to benefit from the standard
prescription of economic reforms which were applied during the nineteen eighties and
nineties. Indeed, according to Joseph Stigliz, Argentina was long held up as a “poster
child of reform” by the IMF because of its success in controlling inflation (Globalization
and Its Discontents, 98). But Stigliz notes that the monetary and fiscal policies
implemented at the IMF’s behest led to social and political disorder which created a
hostile climate for investment. And ultimately the country found itself on the verge of
economic insolvency. Stigliz claims that this illustrates that economic policies need to
take account of the specific social, cultural, and political situation of the country adopting
them. The effects of new economic policies are usually difficult to predict and simple
panaceas almost never work out as predicted. And the free trade and free-market policies
advocated by most academic economists are just that—simple panaceas sanctioned by the
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meta-belief structure of neoclassical economic theory. Of course, it is generally accepted
that Argentina’s defiance of the World Bank after its economic collapse paid off, and the
country experienced an subsequent unexpectedly strong recovery.
Venezuela
One of the most interesting examples, and one dealt with in detail in a study by Ricardo
Hausmann in Rodrik’s collection, is Venezuela (“Venezuela’s Growth Implosion”).
Venezuela grew at the phenomenal rate of 6.4% per annum between 1920 and 1980,
making it by far the fastest growing Latin American economy. The non-oil part of
economy grew at almost 4%, in defiance of the “Dutch disease” hypothesis. Between
1950 and 1980, output per worker grew at an annual rate of 2%, or 80% cumulatively;
During an almost 60 year period, Venezuela conformed to Pritchett’s category “rapid
growth.” However, after many years of rapid growth, Venezuela experienced a rather
sudden “growth implosion,” with output per worker in the non-oil economy dropping by
almost half over the next twenty years. Output per worker fell at the rate of 3% per year,
eventually regressing to the level of the early 1950s. During its sixty years of growth,
Venezuelan institutions met the criteria that the “new institutional” economists claim are
necessary for growth: absence of war and civil disturbances, a democratic government
with broadly-based competitive political parties, strong independent labor and business
institutions to negotiate social conflict, a free press, the world’s lowest inflation rate
between 1950 and 1980, and a triple-A international credit rating as recently as 1980.
According to Hausmann, explaining what went wrong requires a complex analysis in
contrast to more simplistic analyses which generally seek to blame one or more factor. To
illustrate the tendency to seek simple analyses of this sort, he begins with a parable in
which villagers search for witches to explain crop failures: “If witches actually do not
exist, or if, while existing, they do not deal in crops, the village will never find out. There
are too few observations and too much fluctuation from year to year for the village
scientist to prove the proposition one way or the other.” (245) He continues, “The
Venezuelan public is convinced that the core explanation is corruption and has been
kicking out whoever is in power... International agencies favor the assumption of
insufficient structural reforms or poor institutions. Whichever explanation one chooses
needs to account for the fact that the past 20 years were preceded by 60 remarkable years
of growth, with probably similar institutions and degrees of corruption.” (246)
Among the explanations Hausmann considers (and rejects) are the “Dutch disease”
hypothesis—which predicts growth problems during the oil boom, not later as actually
happened; the effects of a political economy based on oil rents—which fails to explain
the timing of the collapse; and the claim that the collapse is linked to long-term declines
in oil reserves—which is inconsistent with the discovery of new reserves. Still another
explanation postulates weak institutions that were incapable of handling the shock
associated with declining oil revenues in the early eighties; however, as Hausmann notes,
Venezuelan institutions were not considered weak in 1980; they weakened later, as a
consequence of the economic decline. Yet another explanation claims that the decline in
output per worker since 1980 reflects inadequate accumulation of human capital. But
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according to Hausmann, “On the contrary, Venezuela exhibited very rapid improvements
in social indicators,” notably increases in life expectancy and years of schooling. (249)
One salient statistic is a steady decline in capital per worker after 1980. Based on a
complex statistical analysis, Hausmann concludes that there may be a common factor that
caused a severe reversal of the previous capital deepening and also a decline in total
factor productivity despite the rising quality of human capital. He makes three additional
points (called, after the usual practice of economists, “stylized facts”): (1) in the 1960s,
the non-oil economy continued to grow despite a decline in oil revenues, (2) the growth
collapse in the non-oil economy began in 1978, four years before the collapse in oil
revenues, and (3) private sector investment has been the key to the dynamics of
investment and disinvestment in Venezuela—hence arguments about wasteful public
investment cannot be central to a valid explanation of the collapse.
Hausmann first attempts to account for these stylized facts using a neoclassical model
based on the simplified assumptions that 1) all non-oil production is essentially
nontradable (i.e., wholly for domestic consumption) and 2) the return in this sector is
equal to the world interest rate. A decline in oil income is assumed to cause a decline in
the demand for the nontradable good (there’s only one in the model), hence to a price
decline for the good, hence to a decline in the rate of return on capital invested in the
nontradable sector causing it to fall below the international rate of return thereby leading
to a decline in domestic investment. This is typical neoclassical models with unrealistic
simplifications. As Hausmann notes, the model grossly underpredicts the actual fall in
output (almost 67%). He goes on to note that if we assume a significant increase in
interest rates in Venezuela, the model could generate a decline of the appropriate
magnitude. And, in fact, interest rates did experience a major increase after 1983.
However, given the unrealistic assumptions of the model, it is unclear that it tells us
anything that cannot be stated more clearly in ordinary language: that a decline in oil
revenues coupled with a steep rise in domestic interest rates discouraged domestic
investment, leading to a deterioration of capital stock and a decline in output. To
Hausmann’s credit, after his obligatory exercise in what he refers to as “Greek-letter
economics,” he concedes the inability of neoclassical models to deal with the rise of
domestic interest rates, the critical factor in the economic decline. At best, neoclassical
analysis would predict a short-term increase in interest rates resulting from defaults on
contractual obligations due to the decline in the rate of return in the nontradable sector
following the fall in demand when oil income declined. According to Hausmann,
political-economic considerations that transcend neoclassical theory are required to
explain the steep rise in domestic interest rates. Normally such a rise is associated with an
international perception of country risk. Venezuela, however, has enjoyed much stronger
financial ratios than countries which possess even better international credit ratings.
After considering various alternatives, Hausmann settles on what he refers to as a
“political-economic” explanation that postulates an inability to settle the distributional
conflicts that arose in the wake of the decline of oil revenues. These conflicts were
associated with a series of currency crises which eroded the real value of monetary assets,
led to inflationary episodes and to negative real domestic interest rates. In conclusion, he
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writes, “the intermediate variable through which the political economy effects may take
place is the external interest rate, which is relevant even if the country is not dependent
on attracting foreign capital. This rate affects the required marginal product of capital,
determining declines in output and capital per worker over and above those caused by the
loss of external income.” (268) The “political economy effects” are alluded to in the
context of a reference to Rodrik’s theory that growth collapses are related to “the quality
of the conflict management institutions.” A deeper analysis would examine Venezuelan
society and culture, examining the historical roots of the institutional weaknesses that led
to monetary instability and high interest rates. Perhaps there are socio-historic factors
common to Latin American countries (and possibility the former Spanish colony of the
Philippines) that play a central role in explaining the economic problems which have
confronted most of these countries.
Such social and cultural differences may help explain the very different performances of
the Venezuelan and Indonesian economies in the 1980s in the wake of the sharp decline
in international oil prices. It is difficult to see what neoclassical economic theory could
offer in explanation of the different performance of the two economies.
The Role of Cultural Factors
The generalizations scattered through the various country case studies tend to focus on
institutional arrangements, and in particular, on institutional arrangements held to
facilitate the workings of free markets rather than on more diffuse social and cultural
factors. Although there are occasional hints that underlying social and cultural factors are
important, there is little direct discussion of them. Recognition that social and cultural
factors are important determinants of economic performance is hardly new—it was, for
example, the central theme of Max Weber’s studies of the effects of religious beliefs on
economic behavior. In his best-known work, Weber argued that the ascetic Protestantism
of Northern Europe was far more conducive to savings and investment (and hence to
economic development) than the more worldly culture of Catholic Spain or Italy. Robert
Bellah argued, in his widely discussed book Tokugawa Religion, that the religious culture
of pre-modern Japan had much to do with Japan’s later economic success, and his views
have been extended to other East Asian countries that share a Confucian tradition. A
study of the Indian cloth industry illustrates the point that cultural norms may be critical
for economic success quite independently of the institutions discussed by the new
institutional economists.
The Indian Cloth Industry
The economists Gregory Clark and Susan Wolcott studied the relation of per capita
income in India to the efficiency of utilization of technology. Their work challenges the
conventional assumption that capital per worker is exdogenous, and functions uniformly
with respect to growth. In their view it is, in part, endogenous, since capital will be
rationally allocated internationally according to differences in efficiency of utilization, or
differences in TFP (total factor productivity). They note that for many decades there has
been no significant difference in the types of machinery employed in the production of
cotton textiles in India and in England, the United States, and Japan. They state, “The
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problem that limited the growth of the Indian industry was not machinery, but the low
profits made by cotton mills in India, because of their inability to employ technology
effectively.”(59) For example, they note that if we begin with a common output per
worker index of 100 in the period 1905-9 for the Japanese cotton industry and the
Bombay cotton industry, the Japanese index had risen to 281 in the 1935-39 period
compared with only 106 for the Bombay industry. The inefficient operation of the Indian
mills arises from low output per worker rather than from low output per machine hour. In
1978, output per worker-hour in cotton spinning was 7.4 times greater in the United
States than in Indian mills using substantially the same equipment. (60)
The hypothesis they ultimately endorse is that the key difference between India and the
other countries lies in the employment relationship, “the bargain by which a worker sells
his or her labor power for a set time to an employer.” (69) It is their contention that this
factor—which is cultural in nature—transcends economic incentives or monitoring which
are the economic factors traditionally held to affect worker efficiency. At least as
important as these economic factors is “the complex human interplay among workers and
bosses, and workers and workers, involving pride, notions of fairness, and gift
exchanges.” They claim that these cultural factors cannot be reduced to self-enforcing
equilibria between rational self-interested agents: “the relationship sustained between
employers and workers...depends not just on a rational calculus between self-interested
agents... but on a general attitude toward gift giving.” Indian workers are unwilling to
give the gift of extra labor to their employers since they expect other workers to take
advantage of opportunities to shirk. The employees are unwilling to give voluntarily what
is costly to monitor.
We need not accept all the details of the specific hypothesis to recognize that two
orthodox economists were led by the data to conclude that a cultural, rather than
institutional, difference explains the relative failure of an important Indian manufacturing
industry. This conclusion is relevant to decisions about when to protect infant industries
and when such protection is unwarranted. It also provides a partial explanation for the
relative lack of private capital investment in certain countries: capital will be invested
(ceteris paribus) in countries where there is an appropriate “work ethic.”
Other case studies also turn on the importance of cultural factors for economic success—
Botswana, an African success story, and relative success of post-Soviet Poland in contrast
to post-Soviet Romania. In the case of Botswana, the authors of the study in Rodrick’s
collection conclude that the key was having the right institutions. However, behind these
lay unique historical and political conditions which did not exist in other African nations.
(Acemogulu, Johnson, and Robinson, An African Success Story, Botswana, 80-119) In
the case of Poland and Romania, the authors of the study in Rodrik’s collection conclude,
after noting that political differences proved crucial, “Answers to those questions [about
political differences] lie perhaps in the legacy of geography, culture, and earlier history.”
(Menil, History, Policy, and Performance in Two Transition Economies, Poland and
Romania, 271-294 )
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China and India: Two Contrasting Success Stories
China: Economic Success Through Adaptive Institutions
Perhaps the most important study in Rodrik’s collection is a long study of the institutional
changes responsible for China’s remarkable growth during the past several decades. Over
period 1980-2000, China grew at an average annual rate of 9%, more than quadrupling its
gross domestic product. The number of people living in absolute poverty fell from about
a third of the population to approximately 4%. Even though China’s population is almost
three times that of Japan, South Korea, Taiwan, Hong Kong, Singapore, Malaysia,
Thailand, and Indonesia combined, it has matched or exceeded the growth record of these
economies during their best years. A revealing contrast is with Russia: in 1988 the
Chinese GDP was less than half that of Russia, but ten years later, it was more than twice
as large.
In the study entitled “How Reform Worked in China” (and subtitled “A Puzzling Reform
that Worked”), Yingyi Qian, a Berkeley economist, notes that this phenomenal growth
record was achieved without following standard economic prescriptions for economic
and institutional reforms. There has been neither privatization nor democratization, and
market liberalization is limited. Private property rights are not secure. Qian notes that the
World Bank’s 1996 development report “gave China short shrift because it couldn’t
figure out where to put China on the various measurement parameters.” (299) In
particular, foreign direct investment, trumpeted by Wolf and considered a key to
economic growth, has been very small. Although China has adopted an policy and has
benefited from a rapid expansion of its exports, this has primarily benefited the coastal
provinces. However, the inland provinces have also experienced a major growth and
prosperity boom. Qian notes that “if each of China’s provinces were counted as a distinct
economy, about 20 out of the top 30 growth regions in the world in the past two decades
would be provinces in China, many of which did not receive much foreign investment
and did not depend on exports.” (299)
I earlier noted how Wolf, Bhagwati and other proponents of globalization often shift from
making specific claims about the causal benefits of free trade to something much weaker,
lauding the vague idea of an “open orientation” as the key to economic growth. But
China fails to support even this weakened claim—at least without major qualification.
According to Qian, “Russia became very open after reform, more so than China, but
neither higher growth nor more FDI [foreign direct investment] ensued.” (300)
The Chinese experience challenges the traditional neoclassical view that treats growth as
a function of Capital (human and physical), Labor, and Total Factor Productivity. It also
challenges the “new institutional economics” that assumes a “best practice” set of
institutions as critical for growth—institutions for the protection of private property
rights, for the impartial enforcement of contracts, and transparent financial systems. In
many studies of unsuccessful economies, identification of institutions that fail to meet the
best-practice standard is advanced to explain the lack of success despite the
implementation of the standard package of free-market reforms (stabilization, market
liberalization, free trade, and privatization). China presents a powerful counterexample to
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this analysis: a country that has grown at a phenomenal rate without possessing the “best
practice” institutions or even attempting to create them. Qian notes that during recent
years neither China nor Russia has had the rule of law, secure property rights, effective
corporate governance, or a strong financial system, yet China prospered while Russia
regressed.
Qian hypothesizes that the key to China’s success is adoption of policies designed to
modify the institutions of the centralized state economy so as to build a novel marketresponse system at the margins, on top of the old socialist allocation system. These
policies produced institutions which continued to serve the interests of those benefiting
from the previous institutional arrangements (the Communist hierarchy) while capturing
the efficiencies of market-response pricing and production. In short, the policies were
sensitive to the unique set of socio-historic facts characterizing China. Qian describes
these mixed institutions in detail and shows how they have contributed to China’s
economic growth. However, he retains, in his discussion, the standard orthodox view that
there are, in fact, “best-practice” institutions (“rule of law, private ownership of firms,
and transparent government”), and he characterizes the Chinese institutions as
“transitional” on the assumption that they are a stage on the road to these best-practice
models. This truth or falsity of this assumption is quite independent of his analysis. The
key issue in the globalization controversy is not whether there is some unique set of bestpractice institutions for advanced industrial economies—evaluation of that claim
requires examination of the economic functioning of the older advanced industrial
societies which have (to a greater or lesser degree) adopted these institutions or served as
models for them. Rather the key issue in the globalization controversy is what set of
policies, “reforms,” and institutions are optimal to put a particular Third World economy
on a path towards improved living standards. And Qian’s analysis provides a strong case
for policies and institutions differing from the usual list of best-practice institutions
regardless of whether these are labeled “transitional” or not. China’s unprecedented
success under a quite different institutional regime provides no support for the view that
institutions on the best-practice list provide a superior institutional framework for
economic progress, especially when progress is measured not merely in terms of growth
but in terms of a reduction in poverty.42
According to Qian, the path to development does not lie with adoption of conventional
free-market “reforms” either in terms of policies (liberalization, free trade, privatization,
stabilization) nor in terms of “best-practice” institutions but rather lies with a choice of
policies and institutions that can accommodate economic growth without creating
political and economic losers or, as he puts it, institutions that are “efficiency-enhancing
and interest-compatible.” (330) This focus on continuity and accommodation of various
economic and political sectors during change is an important clue to why it is so
important to take account of the social, political, and cultural conditions obtaining in the
country in selecting growth policies and in altering institutions.
One reason Qian’s paper is so important is that he describes in some detail the institutions
that have propelled China’s growth. Unlike many of the other studies of successful
growth, explanations lie not so much in the in the antecedent institutional structure, but in
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the intelligent (or lucky) choice of policies that created new institutions or transformed
existing ones.
TVEs and the Dual-Track System
According to Qian, the key institution responsible for China’s growth has been the
township-village enterprise or TVE. Neither privatization of state enterprises nor new
private firms played the dominant role in Chinas growth during the crucial initial 15 years
(between 1979 and 1993). New firms did enter the market, but these were local
government firms, of which TVEs are the most important. In 1993, local government
firms constituted 42% of national industrial output, in compared with only 15% for
private firms and 43% for large state firms (so-called state owned enterprises or SOEs).
The trends are revealing: in 1978 the SOEs comprised 78% of industrial output and local
government firms 22%, but by 1993, the output of the two was roughly equal. The TVEs
are the most important segment of local government firms, responsible for the majority of
rural output and employment. It is true that during the later phase, by the late nineties,
they were increasingly giving way to private firms—but this in no way diminishes their
key-role in the crucial take-off phase.
The Chinese national government depends on local governments to maintain order, build
infrastructure such as roads, water and irrigation systems, and implement family
planning. Thus the national government has been far more tolerant of the ownership
rights of TVEs than it has been of private property rights. Moreover, given Chinese
conditions, it proved far easier for the national government to tax TVEs than to tax
private firms. As Qian notes, a common institutional problem in developing countries is
the lack of an adequate system for generating tax revenues, and the lack of an effective
fiscal system for using tax revenues. (313) The Chinese national government addressed
these problems by stipulating that TVE after-tax profits either be reinvested or used for
the provision of local public goods. In 1992, 59% of the after-tax profits of local
government firms was reinvested and 40% used for local public expenditures. This
arrangement compensated for weak tax and fiscal systems. It also provided a way of
avoiding a bias often seen in developing countries—disproportionate revenue expenditure
in favor of urban areas. The bias results from the greater effectiveness of political
lobbying by urban groups.
TVEs exhibit the benefit of a dual-track approach to market liberalization. Both SOEs
and TVEs are required to deliver a planned quantity of output at planned prices, but
production in excess of the planned quantity may be freely sold in the market. Qian
comments that this has proved advantageous in avoiding “losers”: “in contrast, the singletrack approach to liberalization in general has distributional consequences that cannot
guarantee an outcome without losers.” (308) A good example is provided by agricultural
market liberalization, where communes and households were obliged to sell a fixed
quantity of output to the state procurement agency at predetermined planned prices and to
pay a fixed tax to the government. They also had the right to receive a fixed quantity of
agricultural inputs—principally chemical fertilizers—at predetermined plan prices. But
beyond these conditions, communes were free to produce more and to sell the excess
production at whatever prices they chose and then retain the profits from such sales.
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Communes could also engage in non-agricultural production, and use the revenue from
its sale to purchase grain or other agricultural produce required under the plan and resell
it to the state at plan prices. This arrangement resulted in the reliable production of planmandated agricultural goods over a fifteen-year period, together with an increase of
approximately one-third in total production.
Another example of the success of the dual-track system is provided by coal output (coal
is China’s principal source of energy). TVEs contributed to a very large increase in coal
production. Planned delivery of coal grew from 329 million tons in 1981 to 427 million
tons in 1989, but the market track production (mainly from small rural coal mines run by
individuals and TVEs) increased even more, from 293 million tons to 628 million tons.
Fiscal Federalism
Qian explicitly recognizes the critical role of government for economic development, a
factor not addressed in what he refers to as “the trilogy of stabilization, liberalization, and
privatization.” It is common for economists, when they speak of government, to focus on
role of corruption. Qian examines the Chinese fiscal system, and in particular on the
relation between the central government and local governments. The central revenue
principally derives from customs duties and direct taxes or profit remittances from the
SOEs. Local revenue is divided between central and provincial governments according to
pre-determined revenue schemes. Provinces retain marginal revenue, and in the early
1990s provinces retained, on average, nearly 90% of local revenue. This provided a
strong incentive for provinces to build their local economies to enhance their revenue
bases. This so-called “fiscal contracting system” resulted in a great proportional increase
in expenditure on local services. Under the earlier system, only 20% of any increase in
provincial revenue was to be retained locally, while 80% was to be remitted to the central
government; afterwards, between 75% and 100% was retained locally. This is in sharp
contrast to the situation in Russia where almost all of any increase in local revenue is
remitted to the central government thereby providing almost no incentive for local
governments to increase their revenue base.
The economic effects can be measured statistically: an increase in the marginal fiscal
revenue retention rate in a province of 10% is associated with an increase of 1% in the
growth rate of employment in non-state (TVE or private) enterprises in the province. This
represents a significant proportion of the mean growth rate of 6% in rural enterprise
employment and 9% in non-agriculture non-state employment. Other statistics confirm
the beneficial effects of what Qian refers to as “fiscal federalism.”
Constraints on State Intervention: Anonymous Banking
The belief among economists that a powerful centralized state authority is inimical to
economic growth is supported by ample examples from recent history, especially from
countries following the Soviet model. In general, economists see “the rule of law” as the
only effective way of constraining an all-powerful state and thereby enabling successful
growth. China challenges this view, since not only does it have centralized state
authority, but it lacks an effective rule of law. Among the alleged negative factors listed
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by economists (and by journalists like Wolf) are “excessive” margin tax rates held to be
“detrimental to private incentives.” Certainly private incentives are important to private
investment, and Qian describes institutionalized mechanisms that have been created in
China to avoid undermining private investment incentives. The usual belief is that if a
state has perfect information and discretionary power, it can impose a post-marginal tax
rate of 100% which would destroy any private incentive to work or invest. The Chinese
have avoided this problem. Instead of income taxes, the government collects “quasifiscal” revenues from the state banking system which limits potential government
“predation” by imposing an upper bound on the taxation of anonymous assets (as
permitted in China).
Real government revenue almost doubled over 20 years, although as a result of economic
growth total fiscal revenue as a percentage of GDP declined from 40% to 17%. The
principal reason for this decline was the inability of government to collect taxes on
hidden private revenue. The government has an indirect source of revenue through the
state banking system as the result of its ability to set interest rates on savings accounts
below market rates. This represents an implicit tax of about 2% of GDP per year. In
addition what is known as currency “seigniorage”—the gain to government through
control of foreign exchange, inflation, and the expansion of real money balances—
represented an additional implicit tax of 3%. These implicit taxes, coupled with fixed
revenues from the provinces, revenues from customs duties, and revenues from SOEs
brought the total government revenue to approximately 22% in the mid-1990s—still a
relatively high level, although far below the 40% at the beginning of the growth period.
In Russia, despite high inflation, the government collected only a low level of seigniorage
because of the extensive use of U.S. dollars in trade and free international capital flows.
Qian comments: “China learned about anonymous bank deposits from the Soviet Unioin.
But unlike China, Russia abandoned them after the reform in order to follow international
“common practice.” In short, international pressure to adopt “best-practice” institutions
led to a collapse of government revenues in Russia. Moreover, according to Qian, the
Russian mafia, in collusion with the banks, was able to obtain information about the
depositors’ wealth.” (322)
Problems with Large State-Owned Enterprises (SOEs)
At the beginning of the growth period, state-owned enterprises were responsible for about
80% of total output. Contrary to what occurred in the Soviet Union and Eastern Europe,
the SOEs (for the most part) were not privatized. Instead, they were left in place, but their
share of total national has declined to about 25%. Employment in SOEs peaked as late as
1995, but declined in the late nineties to below 100 million, about the level of the late
eighties. Profits and taxes per unit have fallen from 24.2% in 1978 to 6.5% in 1996, and
more than one-third of SOEs lost money in 1996. According to Qian, the primary
problem facing SOEs is not state ownership, but the Communist Party’s control over
appointment of SOE managers. The appointment process is secretive and complex,
information is obtained through bureaucratic rather than market channels (such as stock
prices, rating services, and investment banks), and the party bureaucrats making the
personnel decisions lack the background required. A number of reforms have been tried,
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with the latest ones moving towards narrowing the scope of SOEs and allowing multiple
ownership with participation by both domestic and foreign private investors. As an
example of the changes, PetroChina is now listed on the New York Stock Exchange.
Clearly the SOEs are the least successful of the institutions propelling China’s growth.
Although they have not performed at the level of the TVEs and private enterprises, it is
also clear that they not undermined overall growth in China despite their dominant role.
They have been a major revenue source for the national government, and because they
produced many of the core products required during the growth period, they have
provided an effective framework on which the more vibrant TVE and private sectors
could develop. Thus the SOEs have not been a total failure by any means, and one key to
their qualified success has been the same dual-track system that has benefited the TVEs.
For example, steel production, which is the responsibility of large SOEs, experienced a
reduction in the percentage of planned production from 52% in 1981 to 30% in 1990,
accompanied by a corresponding growth of market-directed output—a change paralleling
that of the TVEs.
China: Conclusion
Qian qualifies his report by adopting the conventional view that the Chinese institutions
that did so much to foster China’s economic growth are only “transitional” in the sense
that they “incur higher costs and generate lower benefits” than hypothetical “best
practice” institutions. He mentions “the costs of dual-track liberalization” such as the cost
of enforcing the planned track, the consequences of failed enforcement such as supply
diversion, and the possibility of ratcheting up the scope of the planned track.” He also
claims that “weak managerial incentives” together with costly government intervention”
“make them uncompetitive in the market place in the long run.” Information opaqueness
resulting from anomalous transactions and banking “facilitates corruption, detrimental to
corporate governance, and makes it harder to introduce modern taxation.” He thus
believes that “these institutions should not be viewed as permanent and should eventually
be replaced by more conventional, best-practice institutions when the underlying
environment improves.” (323)
This commentary, offered as an afterthought to his detailed analysis which is so
thoroughly subversive of orthodox economic thinking, represents a nod to neoclassical
ideology—or rather a modified form of neoclassical orthodoxy that has been adopted by
policy-oriented economists under the name “the new institutional economics.” This
modification idealizes the institutions of advanced industrial economies, and assumes that
such an idealized institutional structure of “best practice institutions” is uniquely superior
to other institutional arrangements. However, the concept of “best-practice” institutions
requires considerable idealization in the face of the large variety of institutions that
actually exist in these advanced industrial economies. These economies have
experienced, and continue to experience, problems of corruption, corporate misgovernance, high levels of unemployment, high levels of criminal activity, and increasing
levels of income inequality. China, through use of institutions responsive to its peculiar
social, cultural, and economic conditions, has experienced sustained growth rates well
above those of the advanced industrial economies during their earlier growth phases.
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Qian strongly argues for the appropriateness of these Chinese institutions given the initial
conditions, and argues that under these conditions they are superior to what economists
consider to be “best-practice” institutions and he stresses that China was fortunate to have
hit upon a combination of institutions that served it well in promoting economic growth.
Rather than criticizing these institutions for falling short of some hypothetical idealized
“best practice” model, they might better be faulted for not being more responsive to
distributional or quality-of-life needs or to protection of the environment.
Despite the residual ideological bias, Qian’s study supports the principal conclusion that
emerges from detailed case studies: countries would be well-advised to ignore the advice
of economists who recommend the standard policy “reform” menu of free trade, market
liberalization (including privatization and deregulation), and the “best-practice”
institutional recommendations (“rule of law, private ownership of firms, and transparent
government”) in favor of policies derived from a thoroughgoing study of their unique
social, political, and economic conditions. And one of the key factors in China’s success,
according to Qian, was modification of existing institutions in such a manner that
previous beneficiaries did not become losers.
Economists in general have been skeptical of Chinese growth due to its non-conformity
with neoclassical doctrine. In the fifth edition of their international economics text,
published in 2000, Krugman and Obstfeld write of China “...some of the growth is is a
statistical illusion... There is evidence that Chinese statistics understate inflation and
overstate real growth; the actual growth rates have been at least 2 percentage points
below the official numbers...this still leaves a very impressive growth of 7% or more a
year.” (269) They then claim that Chinese growth is unlikely to continue at the current
rate due to inefficiency of the state-owned sector. However, events have confounded
these predictions. In fact, a recent BBC news report (December 20, 2005) revealed that
due to past statistical errors, China’s economy was 16.8% larger in 2004 than previously
calculated—$284 billion larger, approximately the size of the total economy of Australia.
By the end of 2005 China was expected to be the fourth largest economy in the world,
ahead of France, Italy, and the UK. The story points out that “the World Bank had
welcomed the new figures as a major improvement.” According to the story, “economists
have long said that China’s official annual growth figure of 9% understates the size of its
economy.” The “economists” referred to obviously do not include Krugman and
Obstfeld. China thus continues to confound the mainstream view that the secret of growth
are free-market policies and “best-practice institutions.” In fact, all too often imposition
of the standard package of free-market reforms has created large constituencies of losers
who have successfully subverted the new system or rebelled against it resulting in
economic stagnation or decline.
India: A Confused Picture
India is often touted as a “second China” or “the next China” by globalization
proponents. The image is of two giants awakening from years of government control to
embrace free-market policies and institutions as the means to achieve dramatic growth.
The image is false for China, and it is false for India, although the reasons are different.
Of the two countries, India has, in many respects, been more appealing to Western
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enthusiasts than China. Indians, at least educated Indians, speak English and have been
steeped in Western cultural norms as the result of the almost two-hundred years of British
colonial rule. The recent Indian success stories come from high technology industries
(computers, medicine) not from low-wage sweat shops. The successful enterprises in
these sectors are private, frequently led by articulate English-speaking managers who
make good interview subjects. There is no negative image of “India Inc” of the sort that
plagued Japan in the past and currently plagues China.
I shall deal with India far more briefly than I dealt with China, but I want to make two
key points. First, the Indian economy experienced a growth upsurge in the 1980s in the
wake of relatively minor modifications in the rigid structure of government controls
(Wolf’s “control raj”) that characterized the post-war decades. These changes did not
involve implementation of free-market policies. There is evidence that these changes
were, in fact, more important for India’s growth than the more thorough-going “reforms”
introduced in the 1990s. Second, the arrival of “free enterprise” in India through the use
of modern technology to support outsourcing of medium and high skilled service jobs
from the West has not helped large sectors of Indian society. A successful, articulate elite
thrives in the midst of continuing extreme poverty and stagnation in many sectors. This is
the principal contrast with the Chinese success story. In China, gains have been unevenly
distributed, but nevertheless there has been an overall increase in prosperity for most
sectors of society and most regions of the country. This is not the case in India.
These conclusions are based on two studies of India found in the Rodrik collection. The
first (by Clark and Wolcott) provided the material for the earlier discussion of the role of
cultural factors on textile worker productivity. The second is a study of India’ recent
growth by Brad DeLong—the economist who lashed out at Naomi Klein’s alleged
ignorance of economics. Although the two papers agree on a number of points, they
disagree on others. Clark and Wolcott stress India’s lack of economic progress despite a
legacy of British institutions, including a judicial system that enforces contracts and
protects private property, and relatively low taxation rates. They also note the absence of
the sort of ethnic strife in India that has afflicted various African countries. Their focus
on cultural factors makes them less optimistic than DeLong about India’s economic
future. DeLong, despite his defense of orthodox economics in his criticism of Naomi
Klein, nevertheless concedes that growth under what he refers to as the post-war “license
raj” was not particularly low; in fact, it was average despite near autarkic policies that
conflict with almost every recommendation of orthodox economists. (185, 189)
The usual story told by free-market enthusiasts is that India was in a state of stagnation
(“the control raj”) until 1991 when, quite suddenly, free-market reforms were introduced
causing the economy to experience rapid growth. For example, Thomas Friedman,
quoting Tarun Das the head of the Confederation of Indian Industry, says that Manmohan
Singh, the finance minister in the early nineties, “decided that India had to open its
economy.” “...it was like unleasing a caged tiger. Trade controls were abolished. We
were always at 3 percent growth... three years later (after the 1991 reforms) we were at 7
percent rate of growth. To hell with poverty!” (The World is Flat, 50).
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Perhaps the most surprising conclusion reached by DeLong is his rejection of the
consensus view among economists that India’s growth spurt occurred only after India
adopted structural free-market reforms in the early 1990s. (He cites Bhagwati as a leading
proponent of this view.) According to DeLong the key break occurred years earlier, in the
mid-1980s, under Rajiv Gandhi who made relatively minor changes that encouraged
capital imports and commodity exports, instituted a modest degree of industrial
deregulation and rationalization of the tax system. Tariffs were reduced on imports of
capital goods, but not eliminated; taxes on exports were halved, and subsidies were
reduced. But according to DeLong the changes were modest; there was no process of
rapid structural reform. However, these modest changes resulted in a sustained economic
boom during the late 1980s. (196-199) Subsequently, in the 1990s, the government of
Narashimha Rao and Manmohan Singh instituted the extensive changes that conformed
to the usual free-market reform package (market liberalization, free trade, liberal capital
markets, inflation controls, etc.)—the changes that have been praised by Friedman,
Bhagwati and others who hold them responsible for India’s relatively rapid growth in
GNP in recent years. Yet according to DeLong, these later “reforms” “had effects on the
country’s long-run steady-state growth path between two-thirds and five-sixths as large
as those of the first wave of reforms,” a fact he finds “both interesting and puzzling.”
(199) But it is only puzzling to those steeped in the ideology of neoclassical theory. A
multitude of case studies makes clear that free-market reforms have little to do with
growth, that the key factors vary greatly from country to country, and that they often
involve various sorts of protectionist measures.
DeLong suggests that either “simple growth theory is in fact not very useful” or that the
Rajiv Gandhi reforms were “strategic.” (200-201) The first suggestion (the uselessness of
growth theory) is supported in the paper by Bhagwati and Srinivasan discussed above.
The second seems largely rhetorical; it seems to say no more than that some tinkering
with existing institutions and policies can produce big returns in terms of growth—a
conclusion fully consistent with the Chinese experience with the TCOs.
The principal difference between DeLong’s view of India and Clark and Wolcott’s view
relates to India’s potential for successful industrialization. As we saw in the discussion of
the Indian textile industry, there are social norms at work in India that limit worker
productivity. Given its low rate of growth from the period 1873 (when statistics were first
kept) until 1998, it is not surprising that recent policies that encourage exports would
produce an impressive growth rate. But the starting base was low; Indian income levels
relative to those of the United States in 1998 were, at 8%, below those of the early 1960s.
(53) Given that the principal opportunity for sustained long-term growth in a country
with a very large and very poor population has historically been exports based on lowwage manufacturing, it is difficult to see how India can in the long-run compete with the
much more productive economies of East Asia. Of course, continuing expansion of offshored information service industries might sustain growth for some time, but it is
unclear that these could ever provide the motor for sustained long-term growth that
manufacturing has provided to other Third World economies. The expansion of the
information service sector has created a wealthy educated class of service-industry
professionals (Friedman’s “Bangalore”). But the conspicuous success of this class
contrasts to the abiding poverty of the overwhelming majority of the population, a
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situation at variance to that of East Asia where the benefits of growth have been far more
equitably distributed.
A second issue that Clark and Wolcott highlight is the extremely low rate of internal
migration in India despite the absence of legal impediments to movement. Levels of per
capita income between states in India have been diverging at least since 1961, and
income levels in a wealthy state like the Punjab are now over three times larger than
those in a poor state like Bihar. Despite these differences, there has been little migration
from poor states to rich states despite the very large disparities in income. (73) The
internal migration rates are not only far lower than those in countries like the United
States but are also considerably less than the migration rates between the different
sovereign states of Western Europe.
This phenomenon points to the extreme social conservatism of India, and to the certainly
of increasing future divergence in incomes—a divergence that is guaranteed in any case
by the relative growth in a service sector that draws from small an educated minority. All
this indicates the need for policies that democratize education, distribute wealth from the
wealthier to the poor regions of the country, and that work to modify traditional attitudes
toward work. These are not policies which form any part of the free-market programs
advocated by orthodox economists.
If the standard free-market program supplemented by the new institutional economics
were the key to economic growth, India would be more successful than China. Its
institutions fit the “best practice” pattern far better than China’s; the government is far
less intrusive in the economy, and free-market reforms have been implemented to a far
greater degree. Yet China’s growth rate is far higher and the benefits of growth have been
distributed far more widely. There is no disagreeing that a number of the free-market
policies have contributed to Indian growth, but without extensive government
intervention in the economy, and especially in the educational system and the welfare
system, India will not only continue to lag in growth, but may become a world model for
injustice and inequality.
The Search for Generalizations
Despite being indoctrinated in neoclassical theory, when they undertake the study of
specific national economies, their dogmatism softens in the face of recalcitrant facts. But
their retreat is partial and tentative as illustrated by Easterly’s and Pritchett’s approach to
development. Pritchett’s proposed an elaborate typology of growth models; Easterly
focused on the vague neo-classical concept of incentives. One common approach is to
focus on specific institutional factors held to be preconditions to successful
implementation of free-market policies. Sometimes economists, or more typically
economic journalists, abandon the vaunted value-neutral stance and attribute
development problems to moral deficiencies (such as corruption). One common feature
of almost all these discussions is the endorsement of simplistic generalizations such as
“stability promotes growth” or “the higher the level of formal economic relations, the
higher the growth rate.” The brief discussion of various national economies reveals that
in most cases the complexity of economic, cultural, geographic, and historical factors
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renders such generalizations virtually useless. At best, they provide a preliminary to a
detailed examination of a particular country’s historical situation. A good example is
provided by generalizations about the relation of income distribution to growth and
welfare.
Income Distribution
Income distribution deserves special treatment because there does, indeed, seem to be a
serious difference of opinion among economists regarding its significance for economic
development. On the one hand there are economists such as Bhagwati and Wolf who
minimize its importance. As noted, Bhagwati arrived early on at the conclusion that the
only way to help the poor was through an increase in aggregate national income.
Although he took the view that there are little differences in intra-country income
distributions, he is clearly in error. Other economists acknowledge the existence of major
inequalities, even increases in inequality with development, but are unmoved by them on
moral grounds. They claim that a growing economy benefits all its participants, even if
the gap between rich and poor increases. To this is added the argument that it is always
available to countries to decide to redistribute the wealth resulting from growth to the
poor, although this is a political decision that they hold economists should not involve
themselves in.
On the other hand, many economists are disturbed by extremes of income inequality, in
particular when (as is typical) countries with great inequality have a large population
living in absolute poverty. But again many of these economists believe that economic
growth is the only way to help the poor.
In fact, case studies do support the existence of a negative relation between income
inequality and economic growth. It is very much against the spirit of this book to make
too much of this sort of generalization which is comes with a strong ceteris paribus
clause; it will always be necessary to examine the totality of social, cultural, and
economic conditions characterizing a country to decide on a development policy.
However, there is a commonsense logic to the generalization. Great income disparities
are typically mirrored by great disparities in power. The poor are generally politically
weak, the rich politically strong, and the causal relationship flows in both directions in a
self-reinforcing cycle. Wealth buys influence or, more crudely, military and police force,
and these often lead in turn to suppression of wages and working conditions, land
appropriation, favored contracts, etc. Those who are on top in a society with such
inequalities will typically attempt to preserve the status quo. Since growth often disturbs
the status quo, ruling cliques may oppose it, or limit its expression to forms that
perpetuate the existing power structure. Pakistan, India, the Gulf States, and various Latin
American countries provide examples.
Rapid growth may increase inequality. In this case, it may well be true that the poor
benefit, although less than the rich. But the situation is typically quite different from that
of inequality in traditional societies, since the concentration of wealth at the top is in the
hands of a newly emergent entrepreneurial class. If this class seizes control of political
power, it may then use that power to exploit the poor—even though those poor will have,
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in absolute terms, gained from the growth. Here is where a second generalization may
come into play—the generalization that ethnically diverse societies often have more
problems with growth than more homogenous ones. Countries with greater homogeneity
are more likely to have controlling elites sympathetic to their poor and those elites are
less likely to use political power to perpetrate poverty and extreme inequality. In part this
explains the greater egalitarianism of Japan or Scandinavia compared with Brazil or
India. It does not, however, explain the high degree of inequality in pre-war England or
pre-revolutionary Russia.
The conclusion is that a factor such as inequality should be interpreted in the context of
the total social and cultural conditions obtaining in a particular country. Even fairly good
generalizations provide are insufficient guides for policy-making.
Policy Generalizations
Generalizations of the sort just discussed should be distinguished from generalizations
about the policies to be followed by international institutions involved in development.
The latter can be useful correctives to the naïve assumptions of the traditional free-market
models of these institutions (e.g. the Washington consensus model) or to the
programmatic recommendations of the new institutional economists. Among the most
interesting are generalizations pertaining to crisis management. These relate to an
underlying theme that runs through the various case studies: the precariousness of
economic growth. Clearly, specific events trigger a change from growth to stagnation or
decline. What occurs in these cases is not a matter of unanalyzable chance as might be
suggested by Pritchett’s “transition probabilities.” For example, these changes are often
associated with financial crises (for example, as occurred in Indonesia). Joseph Stigliz
made a number of recommendations in his book, Globalization and Its Discontents.
These can be viewed as policy generalizations. They are, briefly summarized, (1) Shortterm capital flows impose huge externalities, and thus interventions in financial crises by
the banking and tax systems are fully justified; (2) Bankruptcies that result from
macroeconomic disturbances should be dealt with in new ways, not through IMF
bailouts; (3) Governments should limit short-term speculative borrowing; (4) There
should be international insurance to prevent crises resulting from currency exchange
fluctuations; (5) Countries should develop extensive social safety nets to protect against
unemployment and small business and agricultural bankruptcy; (6) Funds must be
available to sustain or restore aggregate demand in countries facing economic crises.
Most of these suggestions advocate intervention in the marketplace, by government or by
international agencies—a conception at odds with a dogmatic belief in self-regulating
markets.
I now turn to a discussion of some specific ideas about the sorts of policies that may be
beneficial for various sorts of economies.
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Part IV: Reflections and Recommendations
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Chapter 7
Trade Policy in Developing Countries
“Non-economic” Arguments for Protectionism
In this chapter and the following chapter I will discuss a number of arguments for
protecting industries, particularly manufacturing industries. Some of these are what Irwin
labels “non-economic” arguments in the sense that they advocate protectionism on
grounds other than maximization of national income. For example, the argument that a
diverse economic base is good for an economy because it promotes greater stability or
greater choice of employment would be considered non-economic in this sense.
However, the alleged dangers of overspecialization pertain not just to potential
exogenous threats like climate change but also to technological advances which are
related to economic growth and hence are arguably endogenous. More familiar examples
of non-economic arguments are national defense—the need to guarantee access to certain
crucial types of products in the event imports are cut off by war—and culture—the
desirability of maintaining certain traditional economic activities, ranging from
handicrafts to traditional agriculture.
In fact, it is somewhat inconsistent for economists to claim that protectionist arguments
based on these goals should be separated from the economic arguments for protectionism,
and therefore to be accorded an inferior status. The reason is that any argument for free
trade or for one or another kind of government intervention in international trade involves
claims of national welfare enhancement, and from the standpoint of orthodox economic
theory arguments based on aggregating individual utilities are no more legitimate than
arguments based on cultural or political concerns. Economists can, indeed, argue that one
or another arrangement will increase the total output of goods and services over an
alternative, and that this expands the consumption possibilities. Or, as economists say, a
Pareto-improvement is possible because a greater abundance of goods and services
makes possible a redistribution in which every individual can be given a commodity
basket at least equal to that in the alternative distribution, and some can be given baskets
that are superior from the perspective of their individual utility functions. Thus
economists have argued against versions of the Australian argument that advocate
protecting manufacturing industries to reduce income inequalities because they claim that
the appropriate alternative is free trade to maximize national income, possibly followed
by rectification of a skewed distribution of wealth through politically-mandated
redistribution.
However this response implicitly assumes that the welfare value of a more equitable
distribution is much less important than the total volume of output. Moreover, any
realistic weighing of alternative policies has to take account of the likelihood of
successful implementation of the policy as well as its transaction cost. The practicality
and likelihood of success of a massive tax on the “winners” under free trade (e.g., the
Australian landowners) is so small that it is not a serious contender with the argument for
imposing a tariff to achieve the desired distribution of wealth. It seems a bit disingenuous
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for those economists who advocate lowering taxes on profits, interest, and capital gains—
purportedly to stimulate investment and growth—to then brush aside concerns over the
distributional consequences of trade policies based on the theoretical possibility of taxing
the winners to make payments to losers. Once it is acknowledged that aggregate social
welfare depends on a variety of factors beyond the aggregate value of goods consumed,
considerations of practicality have to enter into the evaluation of alternatives. Moreover,
once we pass beyond measuring welfare in terms of material goods, we will have to
consider the difference between the personal satisfaction obtained by a worker who earns
a certain wage to support a family and that obtained by a worker who as a result of free
trade is compelled to work at a lower paying job but who then receives a welfare check
by mail to help restore his previous earning power.
Distributional concerns are only one of a number of “non-economic” reasons for
advocating government intervention in international trade. Encouraging technology with
perceived social benefit and discouraging that causing perceived social harm are very
important. It is easy to ridicule the latter through citing sumptuary laws of the past (which
usually failed). But the prohibition of the drug trade, prostitution, and gambling are better
examples. Even libertarian opponents of prohibition generally advocate controls in terms
of requiring prescriptions for drugs, banning child prostitution, prohibiting private
importation of weapons, and restricting gambling to certain specified locations. But other
examples abound. A country with serious air pollution problems might bar or impose a
high tariff on dirty two-stroke engine vehicles, or even those which are fuel inefficient,
while allowing relatively clean and fuel efficient vehicles to be imported without paying
duty.
If a country, perhaps for cultural reasons, wished to maintain an industry, such as
traditional manufacturing of handicrafts or traditional agriculture, it might subsidize it.
Such decisions, ideally, would be made through democratic debate facilitated by expert
analysis and input. Economists might be expected to play a major role in this process.
Unfortunately, their analyses are often counterproductive due to the latent bias in favor of
maximization of national wealth regardless of distributional consequences and negative
externalities and blind adherence to the doctrine of free trade as the universal means of
maximization.
In discussing both developing and advanced industrial economies, these “non-economic”
arguments play a crucial role. Aside from the diversity argument and cultural arguments,
there are arguments relating to employment (both quantity and quality of jobs). In the
final chapter, I consider arguments for strong government policies to redirect production
and consumption based on realistic fears of environmental catastrophe arising from
global warming resulting from the carbon dioxide emissions associated with economic
growth.
Welfare Concerns in Developing Countries
Most of the discussion of globalization has focused on the countries of the Third World,
optimistically referred to as “developing nations.” The comparative advantage argument
is offered as a justification for a world-wide reduction of tariffs as a step towards
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completely free trade. Arguments for protecting various industries offered by political
leaders of Third World countries are routinely criticized, and specific protectionist
policies such as import substitution have been condemned on both theoretical and
empirical grounds. In this chapter I will discuss a number of issues relating to the
economies of these countries utilizing insights derived from earlier chapters. The goal is
not to arrive at an alternative blueprint for these economies but rather to survey some of
the issues that should be considered when weighing possible development strategies for a
particular country. In many cases my suggestions are biased towards various forms of
protectionism because I wish to offset the bias of professional economists towards free
trade. I also give greater weight to employment than to consumption since the meta-belief
system of neoclassical theory places supreme value on maximizing consumption as the
means of raising aggregate welfare, while underestimating the costs of unemployment in
both psychological terms and in terms of the costs of retraining and relocation of laid-off
or chronically under-employed workers. However, these are only general reflections
since the choice of trade policy and development policy should ultimately be determined
by the specific social, cultural, and economic conditions of the country.
As noted in the discussion of neoclassical theory, the concept of general welfare, though
theoretically incompatible with neoclassical dogma, is universally employed by
economists concerned with development issues. But this concept is little more than
individual utility aggregated, with the assumption that the greater the per capita
consumption of material goods in a society, the greater the welfare. This imposes a onesize-fits all standard on countries that have varying social and cultural norms. As a result,
the debate over development strategies is generally narrowed to a debate over the best
means of increasing the production and consumption of goods. According to the metabelief structure of neoclassical economics, these goals are best accomplished through
laissez faire, with minimal government interference in economic activities. The “magic”
of free markets is assumed to represent the optimal development strategy, although in the
case of occasional “market failures” minimal government interference may be tolerated
or even recommended. However, when discussion is broadened to include cultural issues,
the role of government is expanded to include not merely questions of how to maximize
material wealth but to questions about the effect of various kinds of development on
cultural and social values. Ideally, each national entity will arrive at decisions sensitive
not only to economic conditions and possibilities, but to its cultural and social values. It
is highly unlikely that many governments will see maximization of individual utility
through the consumption of goods as the unique goal of development.
Economists often mock government involvement in development issues, claiming that
such involvement limits the freedom of individuals to make buying decisions that
maximize their personal utilities. In popular presentations, this may come across as little
more than moral indignation that government is infringing on personal choice. A more
serious argument is that markets make better decisions than governments—a position
deeply embedded in the meta-belief structure of neoclassical theory. But why should we
expect the aggregated individual actions involved in purchasing goods and services to
produce better results for social welfare than the considered opinions of voters and their
elected representatives? First, the model of individual decision making is fatally flawed
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because it is universally acknowledge that buying decisions are irrational and
manipulated by advertising and branding. On the other hand, voters often place a high
value on cultural preservation and elect representatives who make and enforce policies
that fulfill these cultural goals. Ideological commitment drives economists to claim, for
example, that beneficial welfare results will derive from the aggregated decisions of
teenagers patronizing a McDonald’s in an historic zone in Singapore over the decisions
of the electorate to enact and enforce policies that prevent that kind of development. For
example, Wolf wrote that relying on government “to do a sensible job of remedying socalled market failures when it busily introduces so many failures of its own is absurd.”
(70) Economists are generally inconsistent on this point, since many oppose commerce in
various drugs and sex (at least sex involving minors). Unfortunately, it sometimes seems
that defenders of McDonald’s and similar fast-food restaurants are advocates for the
expansion of American firms catering to American consumption patterns into developing
markets.
Development decisions concern a variety of factors. One set of these are the cultural and
social effects of various sorts of development, including employment and income
distribution, and another, emphasized by economists, concerns the strategy for
maximizing production and consumption (so-called “economic welfare”). Many of the
most critical decisions concern the development of manufacturing industries, and I will
discuss this topic at length.
Throughout the discussions in this book, I have opposed generalizations in favor of
country-specific and situation-specific policy analysis. However, in this chapter, and the
following chapter, I will engage in quite a lot of generalizing. What I offer, merely in the
way of suggestions or heuristics, are reflections on which sorts of policies might be
effective in various sorts of economies. These are not presented as universal
generalizations. In the end, specific development policies should be arrived at by
focusing on specific economic, social, cultural, and historical factors. The generalizations
offered below merely indicate a general direction of such policies for certain types of
economies.
Manufacturing Industries in Developing Countries
The infant industry argument assumes that development of successful manufacturing
industries increases economic welfare. Even neoclassical economists who attack the
argument (along with all the other arguments for protection) implicitly accept this
assumption, although there is nothing in the comparative advantage argument or in
fundamental neoclassical theory to support it. In the earlier discussion of the infant
industry argument, we noted Adam Smith’s rejection of any attempt to alter comparative
advantage to build manufacturing. However, modern economists are firm believers in the
link between free-market policies and the dynamics of growth, and they also tend to
assume a link between the development of manufacturing industries and economic
prosperity. Manufacturing industries are generally assumed to offer potentially higher
wages than primary sector industries (although many economists would attribute that to a
higher level of employee skill or to capital-induced productivity advantages). Certainly
the wealthiest countries are those with a strongly developed manufacturing sector, and
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historically countries with the most rapid growth in per capita income have been those
that were rapidly developing manufacturing industries. The correlation is so strong that it
is difficult to argue that a developing country should ignore the possibility of developing
a healthy manufacturing sector. This explains, in part, the assumption shared by orthodox
economists and proponents of the infant industries argument that greater industrialization
means greater welfare, the chief difference being that orthodox economists believe that
industrial development will occur naturally if only markets are left alone, except for
possible minimal interference to address a “market failure.”
However, the shared assumption that manufacturing is beneficial to national welfare
tends to overlook examples in which the purported welfare benefits of manufacturing
have not been forthcoming, even when the industry achieves a scale that renders it
competitive internationally. Developing economies have to consider the type of industry,
the cost of its development, the nature and volume of resulting employment, and the
long-term viability of the industry. These factors, discussed in greater detail below,
provide an additional reason for governmental guidance of the development process.
Thus the decision as to which industries (if any) should be protected is at least as
important as the protection process itself. Before looking more closely at these issues, I
want to discuss criticisms of the infant industry argument based on historical examples.
Despite the theoretical criticisms of the infant industry argument discussed in Chapter 4,
the argument has continued to be widely accepted by economic historians, if not by
orthodox theorists. One of the principal reasons is the conclusion that Germany and the
United States in the late nineteenth and early twentieth centuries, and Japan in the
twentieth century, developed into wealthy advanced industrial economies by protecting
their nascent manufacturing industries through a variety of protectionist measures,
including tariffs, subsidies, and a various subtle impediments to competing imports. For
example, Bhagwati notes that the Cambridge Economic History of Europe claims that
protectionism went with economic growth and the expansion of trade and that this result
has been confirmed by recent statistical studies. (In Defense of Globalization, 60).
However, he then goes on to argue against the prevailing view:
“..the later work of Douglas Irwin has refuted that proposition. By adding to the
regression analysis several countries that were on the periphery of the world
economy but integrating into it, as one should, Irwin manages to break the
positive association between tariffs and growth.
This sounds very much like the sort of statistical jiggering that Bhagwati deplores when it
is engaged in by other economists. Bhagwati then cites another study by Irwin in which
the effect of a protective tariff imposed on tinplate in the late nineteenth century in the
U.S. did not pass a cost-benefit test. According to this study, U.S. iron and steel prices
were converging to those of Britain, and the U.S. production of tin plate was becoming
profitable in any event. The conclusion he draws (from this single example) is that
protection is at best unavailing. But it is difficult to see how even a convincing
demonstration of negative effects of a single instance of tariff protection could serve to
demonstrate the general error of protecting infant industries.
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Bhagwati then addresses evidence that “an inward-looking or import substitution trade
strategy” is harmful. Based on his (and Srivivasan’s) arguments against the use of
statistical analyses (such as Rodrik’s) to shed light on important substitution, it is clear
that he should be offering evidence from case studies rather than from regression
analyses. But there is a difficulty with the case study approach since the failure of one or
another example of an unsuccessful import substitution policy doesn’t demonstrate that
an infant industry policy can never be effective; after all, no one would claim that every
infant industry should be protected. The wrong industries might be chosen for protection
given the social and economic conditions in the country, or the wrong sorts of protection
used, or the policy might be mismanaged or corrupted. It would be foolish for anyone to
claim that an import substitution policy (or, more generally, the protection of an infant
industry) is always or even usually successful. A loose generalization was suggested
earlier: the protection of potential export industries has generally proven more successful
than the protection of industries whose production is exclusively directed at the domestic
market (as was the case with most of the import substitution policy failures).
There really are two distinct issues. First, whether there are examples where protection of
an infant industry has been accompanied by successful development, and if such
successes are causally related to the protectionist measures adopted. Second, whether a
successful industrial development really benefits the economy. If examples exist, we
should examine in detail the specific circumstances that are associated with success.
As noted in Chapter 4, in the nineteenth century a number of leading economists,
including John Stuart Mill and Alfred Marshall, accepted the infant industry model as
valid in certain cases. Bhawati’s empirical argument against infant industry protection
represents a minority view, and he acknowledges that the prevailing opinion is that
Germany, the United States, and Japan provide examples of the successful use of
protection to build manufacturing industries. But each national economy presents a
different set of circumstances and the external economic environment facing developing
countries today is vastly different from that facing Germany and the United States one
hundred years ago or Japan in the decades following the Second World War. In each
case, the circumstances associated with success will include the availability in the
country of appropriate human, capital, and natural resources to build the manufacturing
industry, and a potential domestic market large to support it at a large enough scale to
make it competitive against similar products produced elsewhere. Given the appropriate
circumstances, the role of government would be to protect the industry from international
competition long enough to permit it to reach a size where economies of scale enable it to
compete without continued protection. In addition, government may have to provide the
capital required for the industry’s growth to the critical size or otherwise support capital
investment to the extent needed for such growth.
Theoretical Neoclassical Objections
As we saw in Chapter 4, neoclassical economists, with their belief in the natural
efficiency of markets, often responded to the infant industries argument by challenging
proponents of protection to identify the “market failures” that necessitate government
intervention. Frequently mentioned market failures such as a deficient capital market
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(insufficient private investment) or insufficient technical knowledge to develop a
particular industry hardly exhaust the list of relevant factors, and limiting attention to
them seriously distorts the evaluation of industries in terms of suitability for protection.
For example, one of the most important factors is the degree of capitalization required to
develop the productive capacity to compete without protection. And another critical
factor is the size of the protected domestic market.
The discussion in Chapter 4 also addressed worries by neoclassical economists about how
to analyze internal economies of scale (on either the industry or firm level). As noted in
that discussion, these worries are the product of a rigid adherence to neoclassical
formalism. The supposed serious issue of whether internal economies of scale ultimately
lead to unlimited growth or growth to a monopoly market position are mere technical
questions that derive from an unrealistic neoclassical competitive model. A real issue is
the degree to which the absence of such economies of scale due to insufficient size of an
infant industry increases the cost of an infant industry policy for that industry, and
perhaps lessens the probability of eventual success in the face of competition from
mature foreign competitors that already benefit from such economies of scale. The
greater the difficulty in achieving critical size, the greater the level of government support
required for effective development of the industry, whether in the form of direct capital
investment, subsidies, or incentives for private investors. And if the difficulties are
sufficiently great, the rational decision will be to not support the industry in question.
The Level of Foreign Competition
One critical factor in evaluating the probability of a successful infant industry program is
the level of competition from products produced in other countries. For example, it is
obvious that in the nineteenth century the level of competition for most manufactured
goods was far lower than today. At that time, many industries developed within a
particular country not by virtue of any natural advantage with respect to natural
resources, but simply because they had a head start as a result of diverse social and
cultural factors. The German camera industry and the Swiss watch industry provide
examples. If a country is the first to develop an industry that then achieves significant the
external economies of scale associated with the development of a skilled labor force and
a supporting infrastructure, it may be costly for another country to develop a competing
industry. This type of “path dependency” conflicts with the notion that natural
comparative advantage is critical in determining industry success. Being first is not
always decisive; if the industry undergoes a change in technology, or if a foreign country
with a large domestic market for the product undertakes a sufficient aggressive protective
program, or if some exogenous factor (such as war) disrupts the dominant industry, a new
competing industry in another country may eventually grow to be competitive. The
Japanese camera and watch industries afford examples of this kind of success.
Protecting an Infant Industry: the Relevance of Market Size and Complexity
We would expect—at least in conditions of autarky or limited international trade—a
direct relation between the relative size of the domestic market for a product and the
relative size of the domestic industry producing that product. And in industries where
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internal economies of scale lead to the emergence of a few relatively large producers, the
firms that emerge in large economies will be larger than firms producing similar products
in smaller economies, and the firms operating in the larger economies will be, ceteris
paribus, more efficient than those operating in smaller economies.
Nevertheless, selling into international markets may offer a means by which firms in
smaller economies can grow to a size that would enable them to function as efficiently as
firms producing similar products that operate in larger economies; or, alternatively, to
enable firms in large economies that currently lack a significant export market for their
products to grow to be competitive with foreign firms that already have achieved a larger
(and more efficient) size through international sales. Because there are significant barriers
to expansion into foreign markets, the period of protection required for growing the firms
to a competitive size may be relatively long. Countries committed to this course are said
to have an “outward orientation” to use Bhagwati’s term. These countries have used a
variety of protectionist policies to build industries whose products compete in
international markets, including artificially low exchange rates and direct and indirect
subsidies.
Nevertheless, larger firms operating in larger economies will find it easier to extend their
dominance into international markets. An export-oriented protectionist policy is more
difficult for smaller economies. The lack of a large domestic market makes the growth
path longer and more costly with a lower probability of ultimate success. This varies, of
course, with the industry since a complex high-tech, capital-intensive industry will be far
more difficult to develop to an appropriate scale than a less capital-intensive light
manufacturing industry. Additionally, selling into international markets generally
requires sufficient firm size to deal with complex marketing issues arising from the
variation in tastes and market conditions in different foreign markets, a variety of
governmental regulations, and the need for multi-country distribution networks. Even
relatively efficient firms operating in smaller economies may lack the size to effectively
develop these marketing skills.
These factors help explain why a relatively large country such as China, Brazil, or Japan
may find it easier to succeed with an infant-industry policy than a smaller country. Of
course, there are well-known exceptions such as Nokia in Finland, but in general the
exceptions will involve products where comparative (and absolute) advantage is gained
through technological superiority rather than pure economies of scale.
The same points can be made in historical terms. If we envision a situation of general
autarky or a low level of international trade followed by a period of general trade
expansion, it can be seen that industries and firms existing in larger economies have a
considerable advantage, especially when such industries are technically complex or
capital intensive. Firms which have the advantage of selling into a large domestic market
will typically achieve a scale that enables them to develop specialized departments
capable of handling the complexities of international trade whereas firms operating in
smaller economies may often have difficulty in doing so even if they are relatively
efficient producers for their domestic markets.
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One especially negative possibility for smaller economies is that an increase in
international trade accompanied by a general lowering of protectionism may have the
effect of damaging or even destroying even relatively efficient domestic industries in
smaller economies as a result of the marketing expertise of large foreign producers. For
example, a developing country with relatively efficient domestic clothing and food
products industries may see these decline or collapse under free trade due to sophisticated
marketing techniques including brand advertising even if the imported products possess
no intrinsic advantages over the domestically produced products. This outcome can arise
even if the smaller economy would have had an absolute advantage in the production of a
product were a domestic industry to achieve sufficient scale through exports. This
suggests one reason why smaller economies, including developing economies with
relatively efficient light manufacturing industries, should be wary of eliminating
protectionist policies that would lead to a destruction of these industries. Everything
depends on specific national, however, and this is not a recommendation for a blanket
protection of light manufacturing, but rather a plea for an open-minded and thorough
examination of the industries in question.
The Value of Tariffs as a Protectionist Tool
Orthodox economists dislike protectionism, but among protectionist measures, tariffs
seem to be especially hated. Tariffs are almost always placed far down the list of
measures to correct alleged “market failures”—typically ranking no higher than a “third
best” status. However, historically tariffs have been one of the most popular tools of
protecting infant industries. The above reflections suggest that this is not merely an
irrational blunder or historical accident, but rather because the application of relatively
high tariffs on various imported goods offers advantages over more complex kinds of
government intervention. These advantages go beyond simple protection to encompass
more complex sorts of social planning. An example would be influencing consumer
behavior by encouraging consumption of products that can be efficiently produced
domestically. This may have social or cultural benefits as well as creating employment
outside the primary sector. For example, a country whose citizens place a high value on
the preservation of a traditional agrarian lifestyle might impose high tariffs on products
considered detrimental to such a lifestyle. Such a country might decide that a large
increase in the number of automobiles is not in the interest of national welfare. By
imposing a tariff on automobile imports, the government would indirectly be encouraging
the use of domestically-produced bicycles and perhaps imported public transport products
(assuming tariffs on buses and railroad equipment were eliminated or set at low levels).
This may be held to be a social benefit and would additionally encourage the domestic
production of bicycles, a product whose technology is compatible with efficient
production at a scale compatible with the relatively small domestic market.
The imposition of a tariff in such a case is quite different from an import-substitution
policy which seeks to develop whole new industries to produce products previously
imported. An import-substitution policy typically requires a large degree of direct
government intervention which may result in corruption and inefficiency. Selective tariffs
have the advantage of simplicity and transparency. They were also the primary means by
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which large emerging economies (such as that of the United States in the nineteenth
century) protected and nurtured their manufacturing sectors.
Problems Associated with Industrialization in Third World Countries
Because of the wide-spread belief that manufacturing is the key to growth and prosperity,
and because the wealthiest and most powerful countries have been those with mature
manufacturing industries, manufacturing, and heavy manufacturing in particular,
developed an almost irrational appeal to political leaders in many developing countries.
This helps explain the popularity of import substitution policies that are generally derided
by orthodox economists. In many cases, these involved investments in inefficient steel
production facilities and other forms of heavy industry. The priority placed on the
development of manufacturing not only led to the development of inefficient industries,
but often produced disappointing employment results.43
Developing countries have to consider which manufacturing industries are capable of
being developed to a competitive size with cost effective protectionist measures, direct or
indirect. Indirect measures are those that discourage the import of products which may
substitute for the products of the industry being developed, as in the above example of a
tariff on automobile imports to encourage a domestic bicycle industry.
Factors relevant to the choice of manufacturing industry may be divided into two groups,
those that are relevant to the success of the industry given various protectionist measures,
and those that are relevant to the benefits or negative consequences of the industry. The
decision process involves weighing these various factors and the costs of protecting the
industry until it matures. The first group of factors would include 1) the level of
technology required; 2) the amount of capital needed to purchase modern machinery and
to grow the industry to a competitive size, 3) the existence of a sufficiently skilled labor
force, or an effective means of training such a labor force; 4) natural advantages such as
cheap electric power, proximity to needed raw materials and a supply of other
components of production; 5) the cost of domestic labor for the industry; 6) the potential
size of the domestic market for the industry’s products; 7) the potential size of the export
market, and 8) the vulnerability of the industry to technological change or shifts in
demand. The second group of factors includes 9) compatibility of the industry with the
cultural values of the society; 10) the existence of negative externalities, such as air or
water pollution; 11) the degree to which the industry complements other sectors of the
economy through shared infrastructure, development of a skilled labor pool, etc.; and 12)
the flexibility of the industry to convert to the production of other products in the event
that demand for the products declines.
Obviously a country would be ill-advised to develop an industry when it lacks the
technological, capital, or skilled labor force likely to be needed for competitive success.
On the other hand, proximity of foreign markets for the products, relevant natural
resources, and a qualified labor force would be positive factors. Relevant social and
cultural factors lying outside the purview of orthodox economic theory are often more
relevant to service industries than to manufacturing. Obviously examples of culturally
sensitive development industries are tourism and casino gambling, but there are examples
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in manufacturing as well, such as state-subsidized or state-monopoly cigarette
production, production of alcoholic beverages, and production of firearms and other
weaponry. Well-known negative externalities such as air and water pollution arising from
certain kinds of manufacturing operations should be taken into account in deciding which
industries should be encouraged. The potential for industrial accidents or even disasters
such as that that occurred in Bhopal, India, are clear cases. Another negative factor would
be the requirement of heavy capital investment in an industry with the potential for rapid
technological change.
The need for a careful weighing of these complex factors creates a high potential for
error, a problem compounded when there is a culture of corruption in government
decision-making. Proponents of free-market policies are fond of citing examples of
foolish or corrupt governmental decisions in making their case for free-market reforms,
claiming that the “wisdom of the market” is vastly superior to governmental decisionmaking. However, free-market “reforms” are not implemented by divine fiat, but by
governments, and corrupt or incompetent governments have an equally bad track record
in implementing free-market policies as in implementing (for example) an infant industry
policy. This was vividly demonstrated in the case of the nations that arose from the
breakup of the Soviet Union.
Unfortunately, the preponderance of intellectual resources dedicated to economic policy
implementation has come from economists deeply committed to the neoclassical model.
Relatively few intellectual resources have been devoted to in-depth analyses of how the
various factors listed above should be weighed in the context of the specific social,
cultural, and economic conditions facing a particular national economy. Instead, the
opposition to neoclassical free-market orthodoxy (known to its opponents as “neoliberalism”) has been left to leftist activists who often subscribe to simplistic doctrines
derived from nineteenth century Marxist thinking, or to an unreflective amalgam of freemarket and populist programs. Typically such programs are biased towards urban
workers in the “modern” sphere of manufacturing rather than in the agricultural sector in
which the majority work. The development of intellectual resources alternative to
neoclassical economics would have the beneficial effect of correcting many of the errors
of populist leftist regimes, and in so far as alternative ideas, such as those presented in
this book, come to influence public opinion they could provide a check on policy errors
resulting from governmental corruption. At present, however, opponents of free-market
ideas, when they take power, often implement programs without informed intellectual
oversight. When they do attend to “informed advice” they often end up with some diluted
version of free-market programs.
Light Industry in Developing Economies
In general, all but the largest developing economies lack the conditions for successful
development of capital intensive and high technology industries. Most developing
economies have a large proportion of the population engaged in traditional agriculture,
and suffer from severe rural poverty which has resulted in migration to metropolitan
areas. Light industry associated with the processing of food stuffs, production of farming
implements, fertilizer, and agriculture-related products may well satisfy many of the
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above criteria for successful industrialization. In so far as government undertakes
programs of rural development (such as occurred in Indonesia in the nineteen seventies
and eighties) direct government purchases of many products from these light
manufacturing industries will provide an important indirect means of nurturing them.
In addition, light industry associated with the production of apparel, household products,
toys, etc. will often meet the criteria for potential successful infant industries. These
industries may require protection for two reasons. First, as noted above, branded foreign
products of (at best) negligible superior value selling for a higher price may come to
dominate an unprotected market due to the effectiveness of sophisticated advertising
techniques. Second, imported light manufactured goods of various sorts may undersell
domestic goods not because of absolute or comparative advantage related to relative
productive efficiency, but solely due to low foreign labor costs. The comparative
advantage argument which sees labor costs as an inverse function of productivity fails to
address this issue. For example, lower labor costs may be due not to lower worker
productivity but rather to an artificially low international valuation of the exporting
country’s currency, or an artificially high valuation of the importing country’s currency).
Or they may be due to labor supply factors (surplus labor) in the exporting country.
Whatever the reason, it is doubtful that a country with significant unemployment would
want to lose an industry that offers substantial employment simply because a competing
foreign industry has lower labor costs rendering the imported products cheaper. So, for
example, it is probably not a good idea for Latin American countries to allow their
domestic clothing industries to collapse in the face of cheaper imports of clothing from
China.
Investment Modalities
Direct Foreign Investment
In Chapter 1, we saw how Wolf strongly argued for direct foreign investment. His
principal reasons were worries about the “debt crises” that have plagued countries that
received large foreign development loans. Wolf attributes these problems to
governmental incompetence, but international organizations must share the blame for
urging loans on countries which lack the capacity to effectively invest the funds or which
are so afflicted by corruption that the funds are poorly utilized or diverted to private
accounts. As Joseph Stigliz observed, many of these loans are made by private banks
with governmental guarantees, or knowledge of a history of government bailouts of bad
loans. This creates a “moral hazard” that encourages risky loans (Globalization and Its
Discontents, 237-8).
However, direct foreign investment has its own set of problems. First, there is the
problem of “hot money” invested in quick money schemes during an economic boom.
Real estate investments, including investments in residential housing and resort facilities,
provide a clear example. When the boom ends, hot money can flee the country leading to
financial crisis, a collapse of business activity, and unemployment. The example of the
East Asian financial crisis of 1997 is discussed at length by Stigliz (Globalization and Its
Discontents, Chapter 4).
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Second, foreign direct investment in recent years has been concentrated in low-skilled
manufacturing, often of relatively capital-light consumer goods such as apparel and
recreational products. The principal motivation for the investment is low-cost labor. The
products manufactured are almost exclusively for export to wealthy industrialized
countries. These manufacturing industries typically satisfy few of the criteria listed
above. They exist largely outside the existing economy, even their facilities are typically
located in isolated enclaves that are not integrated with the rest of the economy. They
create a separate higher wage elite whose employment, however, is largely at the whim of
a foreign employer insensitive to the cultural values of the society. This situation
contrasts to the sort of direct investment that occurred in the nineteenth century when
England invested heavily in United States industry through the purchase of corporate
shares in American-run companies selling principally to the American market.
However, a second type of direct foreign investment has the potential to play a role in a
beneficial mix of manufacturing industries in developing countries. That is investment in
plants manufacturing automobiles, machinery, and consumer appliances. In an economy
too small to support a viable domestic automobile industry, for example—and that
includes most developing countries—it is reasonable for countries with sufficiently large
domestic markets to negotiate with large foreign automobile companies for investments
in a manufacturing plants in the country. The negotiations would concern the type of
vehicles produced, labor guarantees, assurances of a long-term commitment with
flexibility to convert to newer models, use of domestic parts supply sources, etc. For
example, requiring that a large proportion of the parts be manufactured by local suppliers
can lead to the development of a skilled labor pool that facilitates the development of
domestic light manufacturing industries. The choice of the foreign investor may depend
also on bilateral trade agreements, with the choice of the automobile manufacturer, for
example, depending in part on the ability and willingness of its home country to import
products from the developing country in which the plant will be located.
Domestic Private Investment and Government Investment
The domestic private investment market is often quite weak in developing countries, and
is often distorted by cultural factors that are not necessarily conducive to overall
economic welfare. For example, the traditional status accorded cattle raising in much of
Latin America does little to alleviate rural poverty and may cause environmental damage
through deforestation. Similarly, there is frequently a pattern of excessive investment in
real property, including apartment and office buildings, and resorts. Government is a
frequent offender, with bribery for construction contracts playing a role, but private
investors unfamiliar with manufacturing operations and modern technology often feel
more comfortable with real estate investments. One role of government would be to
encourage private investment in light industry that fits the criteria chosen for national
development.
The pattern that has characterized the successful industrializing economies of East Asia
since the Second World War is different. These economies have exhibited very high rates
of private savings. In the case of Japan, the internal savings rate provided funds for bankfinanced capital development. For many years, low Japanese wages were attacked as
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giving the country an unfair trade advantage. Similar charges are now being made with
respect to China, although as noted earlier, the Chinese advantage derives in large part
from undervaluation of its currency. Thirty years ago, Europeans were fond of saying that
Japanese workers were willing to live in “rabbit warrens”—remarks reminiscent of those
made about Chinese immigrant workers in nineteenth century America. These remarks
point out, in exaggerated form, the effect life-style (a cultural value) plays in what is
considered an acceptable salary in a particularly society. A modest life-style is conducive
to higher monopoly profits (and monopoly profits are the rule not the exception, contrary
to neoclassical assumptions). Higher profits permit companies to invest heavily in new
plant and equipment, and thereby to take a long-term view of success.
In the case of China, the fastest growing economy ever seen, a high savings rate has been
achieved not merely through life-style factors but also through the ability of a command
economy to limit the availability of various consumer goods. China has had a very high
rate of capital formation as a share of GDP by international standards, (between 32 and
44 percent). This is in part due to a high savings/consumption ratio atypical of economies
with low per capita income. This is largely the result of government taxation policies as
described by Qian in the previous chapter.
High rates of savings, high monopoly profits, and high rates of government investment
(in managed economies) only translate to meaningful investment when the conditions for
effective industrial development are present and wise investment decisions are made. In
the case of government investment, the countries of the Soviet block, in general, invested
unwisely. In the case of Japan, China, and other successful developing East Asian
economies, a combination of technological know-how and a skilled and disciplined labor
force has been crucial. (And timing was also crucial: the immediate post-war decades
offered opportunities for industrialization superior to those existing today because of the
relative lack of competition resulting from wartime destruction of industry.)
Cultural attitudes towards various sorts of work are also critical. Recall the comparisons
of worker efficiency in the Indian cloth industry compared with the Japanese cloth
industry running similar equipment. A Japanese automobile executive working in Mexico
remarked to me that the productivity levels achieved in China considerably exceed those
achieved in Mexico using the same equipment. A culture-neutral perspective will find
nothing morally superior about a strong “work ethic”—Japan has coined the word
“karoshi” or death from overwork for a real phenomenon. An economy with a culture
that encourages hard, focused work may indeed succeed in achieving a higher level of
per capita income and wealth than an economy whose cultural context has a different
attitude (“work to live” rather than “live to work”). But welfare is not a simple function
of material wealth, and cultures which emphasize other values should choose different
development strategies from those which place a stronger emphasis on material wealth.
Certainly cultural differences in attitudes toward work should be taken account of in
making investment decisions and in negotiating trade agreements.
Wolf contrasted direct foreign investment with international-loan financed government
investment, while generally ignoring domestic private investment (as seen in Japan) and
government investment derived from taxation or state ownership (as seen in China). Wolf
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attacked international-loan financed government investment based on a history of unwise
or corrupt use of loan funds by Third World governments. Of course not all Third World
governments are incompetent or corrupt. In general, however, successful direct
government investment is most successful when it is restricted to the development of
infra-structure: schools, universities, health care, family planning, rural development,
low-income housing assistance, roads, light transit, and telecommunications. These
investments contribute to general social welfare, lower birth rates, a decrease in crime
and corruption, and in general create an environment favorable to private investment and
the development of a diverse economy. The previously discussed example of rural
investment in Indonesia demonstrates the potential of this sort of investment by even a
relatively corrupt government. The success of the Chinese local government firms
(especially the TVEs) also attests to the importance of rural development in economic
development.
Exports: Natural Advantages and Low-Cost Labor
The comparative advantage model holds that contrary to intuition, absolute advantage in
production costs counts for little. However, the examples provided in Chapter 3
demonstrate that absolute advantage may gained through governmental intervention, and
that such intervention may indirectly produce improvements in comparative advantage
and thereby alter international trading patterns. In real world trade, where full
employment is the exception rather than the rule, and where labor is not easily transferred
from industry to industry, absolute advantage generally translates into export success.
Thus in considering which industries are worth developing for the export market—
whether in the manufacturing sector or in the primary sector—countries will pay careful
attention to products for which they possess an absolute advantage, or which rank
relatively higher in terms of natural productivity advantages. These could consist of
favorable growing conditions for certain agricultural products, natural resources, and
proximity to markets incapable of producing the products as efficiently. Low-cost labor,
as normally understood, means lower pay for performing the same job. In other words,
low-cost labor is an advantage in terms of final product cost or in terms of profits.
“Low Cost Labor”
Countries with low-cost labor have an absolute advantage in certain sorts of international
competition, and arouse ire among workers in higher-wage countries. Low-cost labor is
often labeled “sweat-shop labor” by unions and their supporters in advanced industrial
countries. However, the comparative advantage model, with its implicit labor theory of
value, does not allow for the concept of low-cost (or “cheap”) labor (as normally
understood) since the model assumes that the cost of labor is always proportional to its
productivity. Thus Wheelan demonstrates ignorance of economic theory when he states
“the comparative advantage of workers in poor countries is cheap labor.” (201) However,
a few sentences later he seems to accept the assumption of a rigid link between
productivity and wages when he states “they are paid very little by Western standards
because they accomplish very little by Western standards.” Then a few sentences further
on he says, “sweatshops do not cause low wages in poor countries; rather, they pay low
pages because those countries offer workers so few other alternatives.” His final
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comment is closer to the truth: wages are determined by supply and demand, and with
few opportunities for immigration (none in the comparative advantage model) wages in
poor countries are determined by domestic supply and demand. His last remark suggests
that wages are low in Third World countries because there is a low level of demand
relative to supply (“those countries offer workers so few other alternatives”).
The term “low-wage labor” as normally used merely states a fact about wages paid per
hour (or week, or year) without addressing productivity. A country with unproductive
low-cost labor is unlikely to attract investment in manufacturing, and when investment
occurs it is unlikely to lead to success. On the other hand when cultural and social
conditions in a country are conducive to creation of a labor force that is highly productive
in terms of the labor cost per unit output (holding fixed other productive factors), the
country has an advantage that may well attract successful investment. It is absurd to
claim that Chinese factory workers are less efficient than American factory workers in
the ratio of their pay differentials. If we take seriously the peons of praise Friedman
lavishes on the Chinese, we might even conclude that they are more productive. And
were Japanese workers in the decades immediately after the Second World War less
productive than American workers to the degree indicated by the difference in pay levels
at that time? The reason that Japan grew to be a manufacturing giant had much to do with
its highly productive low-cost labor (as noted in the study of the Indian textile industry).
In the case of light manufacturing in developing countries, I argued that low import
prices resulting from very low-cost foreign labor (either as a result of the structure of the
foreign labor market or currency undervaluation) should not be a reason for abandoning a
domestic manufacturing industry when underlying productivity values (labor hours per
unit output) are comparable, unless there are better ways of employing the labor that
would be displaced by the imports. However, an advanced country with high wages and
relatively full employment may well decide to abandon certain light manufacturing
industries such as apparel production in the face of low-cost imports produced with lowcost labor. This situation has provided opportunities for relatively poor countries with
reasonable productivity rates to develop export industries on the basis of the low export
prices that result from a relatively productive low-cost labor force. However, unlike other
advantages (natural resources, geography), low-cost labor is a highly unstable resource.
The reality of global poverty is such that any increase in the prosperity of a developing
country exporting goods which are competitive primarily to low-cost labor will typically
result in an increase in wage levels and prices of the exported goods so that they no
longer compete effectively in the international market.
Of course, there are cases where (productive) low-cost labor may be the only advantage a
country possesses, and there is little choice but to exploit it. An excellent example is the
Indian Ocean island nation of Mauritius. (A thorough discussion of factors conducive to
Mauritius’ successful exploitation of its low-cost labor is found in “Who Can Explain the
Mauritian Miracle?” by Arvind Subramanian and Devesh Roy in Rodrik’s collection.)
Mauritius was a typical African economy: monocrop, prone to terms-of-trade shocks,
with a rapidly growing population. Nobel-prize winning economists had predicted a dire
fate for Mauritius in 1961. Yet by exploiting its low-cost labor through establishment of
an export processing zone in 1973, it succeeded in achieving an envious rate of growth
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through exports of textiles and clothing. Between 1973 and 1999, real GDP in Mauritius
grew on average 5.9 percent per year compared with 2.4 percent in Africa. Per capita
income increased 350% compared with 32% in Africa. (209). It is important to note that
throughout this period Mauritius had a highly protected economy, in fact, the IMF ranked
Mauritius as one of the most protected economies in the world in the early 1990s. Yet the
policy was intelligent in that exceptions to generally high tariffs were made for imported
inputs to manufacturing in the export processing zones. An important form of protection
was the granting of subsidies (tax incentives) to firms operating in the export processing
zones. Outside these zones, import-substituting domestic industry remained highly
protected. In other cases, a developing country may accept the necessity of exporting
products based on low-cost labor as a first step towards a different export regime based
on development of industries (primary or manufacturing) utilizing additional favorable
productive factors. Or the country may invest in education and training to create a skilled
labor force to staff higher value-added industries.
In general, a developing country would be ill-advised to accept tariff-free imports of
products whose sole or chief advantage over domestically produced products is low-cost
labor. Only when the country achieves an economic status that involves full employment
in higher paying industries would that make sense. And almost no developing countries
meet that criterion.
The Advantages of Diversification
Many developing economies are dependent on the exportation of primary-goods. This has
subjected them to boom-bust cycles as demand for their exports has waxed or waned in
the wake of fluctuations in international supply and demand occasioned by technology
changes, wars, discoveries of new natural resources, new cultivation of agricultural
products, world-wide economic slowdowns, and a host of other factors. Perhaps the most
severe effects have come from technological discoveries that vastly reduce the demand
for such traditional products as sisal and natural rubber. Agriculture is also prone to
weather-related, pest-related, and disease-related natural shocks that can devastate an
entire national economy. Mineral resources may become exhausted or decline in quality,
sometimes without much forewarning. Given these potential threats, national economies
are rational to hedge their bets by developing and maintaining a diversity of
manufacturing industries to supplement primary production. An additional benefit is that
when manufacturing industries suffer as the result of technological change, it will
typically be found that the displaced industrial work force is more readily retrained for
employment in other industries than a displaced agricultural work force. Though
diversification will rarely provide justification in itself for protectionist policies, it
provides additional weight to what other reasons may exist for protecting or incubating a
manufacturing industry.
These reflections should be contrasted with the case for an import substitution strategy—
an approach which free trade advocates claim has generally failed. There is ongoing
debate regarding the evidence for such failures (see the discussion in the BhagwatiSrinivasan paper discussed earlier). In most cases, the failures can be attributed to
misguided goals, to a failure to analyze the potential of an industry given national
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conditions, and in many cases to rampant corruption. For example, developing a domestic
steel industry—a common goal of many countries influenced by the old Soviet model—
proved to be a waste of valuable resources. A world-wide surplus of steel production
resulted, and few of the domestic steel industries achieved the scale of production or
technical level to be internationally competitive. Import substitution is radically different
from the protectionist policies pursued by various Asian countries. In the latter cases, the
countries chose to encourage highly competitive export industries and experienced
enormous success by doing so.
International Trade Agreements
The orthodox position on free trade holds that in a world of completely free trade, market
forces will lead to the best possible situation for all trading nations. The problems of how
to distribute the largesse of free international trade are left to the politicians of the various
countries. We have seen this is a fallacious model and that careful planning based on the
social, cultural, and economic factors affecting each country is critical for discovering its
optimal trade policy.
One consequence of this general conclusion is to raise doubts about the benefits of global
trade agreements. Not only are such agreements subject to manipulation by the large
industrialized nations—a fact acknowledged by free-market advocates such as Wolf—but
they are generally insensitive to the specific needs of developing nations.
One alternative, deplored by many free-trade advocates, are regional trade agreements
such as the European Common Market, The North American Free Trade Agreement
(NAFTA), and Mercosur in South America. The usual argument against these agreements
is that they protect relatively inefficient industries thereby depriving consumers of the
benefits of superior or lower priced products produced elsewhere. However, when a
critical goal is full employment, it may not be beneficial for the countries in question to
allow a viable protected manufacturing industry to decline or disappear in the face of
international competition. For example, the Brazilian automotive industry may be less
efficient than the European or Japanese industries, but if the difference in vehicle quality
and productive efficiency is relatively small, the cultural and employment benefits of
maintaining the industry may outweigh the small advantage to consumers of owning a
marginally superior Japanese or European automobile.
The obvious fact that some regional groupings will, as a group, have a lower per capita
income than others is hardly surprising. International trade does not confer uniform
benefits among countries participating, regardless of whether there are or are not
protectionist barriers. Regional grouping allow may allow greater attention to be paid to
the consequences for employment. In addition, regional groupings can allow small and
medium sized economies to specialize in the production of products that suit the cultural
values and lifestyles of members of the grouping. For example, an automobile
manufacturer situated in a medium-sized country that participates in a regional trade pact
may be able to specialize in the production of vehicles designed to suit the needs and
demands of the populations of member countries. In the event of unfettered international
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competition, such a manufacturer, if it survived at all, might well be limited to a small
number of vehicle types with sales scattered over a number of countries.
Bilateral Agreements
Bilateral agreements also offer possibilities for developing economies. A country with
certain natural resources, perhaps including climatic conditions favorable for certain
types of agricultural production, may seek preferential markets for these products through
a bilateral trade agreement with an advanced industrial country that can provide
manufactured products beyond the capacity of the developing country at internationally
competitive prices. One advantage of such a bilateral arrangement is that the
underdeveloped country can far more easily develop the marketing skills, including
branding, to sell effectively into a limited number of foreign markets than it can develop
the skills to compete in a much larger number of markets. The two countries thus develop
a kind of symbiotic relationship that may even involve cultural exchanges of mutual
benefit, from tourism to advanced training. These arrangements may offer more longterm stability for the developing country than unrestricted international trade where new
competitors sometimes appear suddenly, capturing markets that are based on the lowest
commodity price. What is lost in terms of marginal utility for consumers is more than
compensated for by stability of unemployment and profits. The pattern is somewhat like
an enlightened version of the colonial arrangements of the past, with the principal
difference being that decisions relevant to the economy of the developing country are
made by its own government.
Limitations of Industrial Development
The factors listed as relevant to decisions relating to the support of infant industries
included a number of negative factors including environmental pollution, undesirable
social or cultural consequences, and disappointing results in reducing unemployment.
Krugman and Obstfeld address some of these problems from an orthodox neoclassical
perspective. For example, they cite a paper by Harris and Tudaro that argued that
industrialization in developing countries may lead to increased unemployment as the
rural poor are attracted to large metropolitan areas in search of scare manufacturing jobs.
(265) They then take this observation as a confirmation of the negative effects of import
substitution policies. However, it is apparent that the problem alluded to is not restricted
to manufacturing industries created under an import substitution policy, but rather relates
to the location of certain sorts of manufacturing industries in large metropolitan areas. It
makes no difference whether these industries were developed under government
protection or through private investment. This is equally true of the putative negative
effects of higher manufacturing wages; as defenders of globalization are fond of pointing
out, “sweatshop wages” paid by suppliers to companies like Nike are considerably above
the market rate in developing countries. The appropriate response to these problems is
careful selection of industries and measures to mitigate the problems of industrialization.
But this has nothing to do with import substitution as a general policy.
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Global Overproduction
It is easy to see the difficulty of assuming that industrialization within an autarchous
economy may be inhibited by insufficient consumer demand. Suppose the total
productive capacity of the widget industry permits the production of 10 million widgets a
year with one hundred thousand full-time workers out of a total population of 7 million.
Widgets are like washing machines—almost no one needs more than one. The hundred
thousand workers buy a new widget every year, so if there is full production, there
remain 9.9 million widgets to be sold elsewhere. Each of the widget workers can buy the
one widget he needs. But for the industry to sell its production, it needs consumers who
can afford its products. There are lots of other workers out there—suppose they are
relatively low income farmers making $3,000 per year. Where is the demand to purchase
the remaining potential 9.9 million widgets? Even if the price of a widget is at its
marginal cost it may still may be too high for those farmers, and in any case there aren’t
enough potential consumers to clear the supply since each farmer needs only one.
Modern technology can result in potential production, with a relatively small labor force,
of far more products than are demanded in the market place. And the demand curves for
these products may be sufficiently inelastic beyond certain production levels that
aggregate demand, even with full employment at “good” jobs, is insufficient to absorb
the potential production. (For example, how many consumers want, for their personal
consumption, six automobiles, three barbecues grills, or 100 pairs of shoes?) This
technology-related problem is quite apart from the negative externalities associated with
the high-volume production in terms of environmental damage. The traditional
neoclassical assumption is that at a low enough price, every market will clear, regardless
of the supply of products. But owners, managers, and investors in manufacturing firms
make guesses about future demand and about the supply of competing products and these
guesses are often wrong. They may (and often do) over-invest in plant and equipment
leading to excess capacity. The Keynesian problem was how to get money into the hands
of consumers to consume potential output, a problem aggravated when it takes very few
workers to generate large-scale output. But inelastic demand curves at high output levels
and the negative externalities associated with large-scale production go beyond the
Keynesian analysis.
Exports may provide a solution for some industries in some countries, but on a global
scale the problem recurs. Manufacturing is not merely empirically untenable as a
universal solution for unemployment, but is theoretically untenable as well, at least in the
context of highly productive modern equipment.
The Role of Traditional Agriculture
Market Decisions Versus Governmental Decisions
Economists typically deride subsidies to farmers (recall DeLong’s comments on Naomi
Klein). They argue is that consumers are deprived of lower prices for agricultural goods,
so general welfare suffers. However, a broader view of general welfare that includes
cultural values, including the value placed on preservation of traditional agricultural
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activity within many societies, leads to a different conclusion. A consumer purchasing a
traditional food stuff, such as rice in many Asian countries, is making a small decision,
and probably does not reflect on the cultural value of local rice production in doing so. If
the consumer does reflect that purchasing imported rice may be damaging local farmers,
the thought is soon dismissed because that single small purchase has no effect on survival
of the domestic industry. The situation is analogous to an individual decision to turn on a
home air conditioner in a heat wave when the aggregate decisions of tens of thousands of
people to do the same thing lead to a power black-out.
Voters or their representatives who support protecting domestic agriculture are making a
considered decision about their culture. Of course, such decisions may be made on
emotional grounds or may be corrupted by political contributions, but it is no more than
ideological bias to assume, as most economists do, that the consequences of the aggregate
decisions of millions of consumers in making small purchases are invariably welfareenhancing—that is that the consequences of market activity are invariably superior from
a welfare perspective to the consequences of political decision-making.
Supporters of free trade are fond of citing the popularity of McDonald’s or Kentucky
Fried Chicken in poor Third World countries as evidence that globalization is simply
extending people’s freedom—even if the fast food restaurant is located in an historic
zone. Free-trade advocates like Charles Wheelan blur the issue by making statements
such as “free trade is consistent with one of our most fundamental liberal values: the right
to make our own private decisions.” (Naked Economics, 200) In addition to McDonald’s
customers, Wheelan does mention neighbors “who may have fast-food wrappers blown in
their gutters,” but he does not consider national governments, which should represent the
cultural values of the society. Wheelan says that “people eat there because they want
to...and if no one eats there, the restaurant will lose money and close.” But once a
McDonald’s has been built in an historic area (perhaps through bribes to local officials),
individual consumers will rationally conclude (if they reflect on the issue at all) that their
individual decision to buy a hamburger is inconsequential in maintaining the
McDonald’s, no matter how much they may dislike its cultural and aesthetic effects.
The Importance of the Traditional Agricultural Sector in Third-World Economies
A pattern may be perceived in the economies of many Third World countries, most of
which have a large proportion of their populations engaged in traditional agriculture. The
spread of modern technology to these countries and their integration into the world
economy has resulted in the rapid growth of urban areas as workers have migrated from
an increasing depressed agricultural sector. Wages are higher in urban areas—at least for
those who succeed in finding employment—and income inequality both within urban
areas and between urban areas and rural areas has increased. On the level of global
statistics, this increase in income inequality has been accompanied by a rise in per capita
income, and arguably (as seen in Chapter 5) in a decrease in poverty if one measures
poverty by having an income of less than $1 or $2 per day. The amazing growth of the
Chinese economy is the principal cause since its enormous population has dominated
global statistics on both growth and poverty. This is not the pattern claimed by Bhagwati,
however; as noted he believed that inequality is roughly constant throughout the world.
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One pattern that emerges relates to the effect of a growth in trade in manufactured goods
on the agricultural sector in a large number of Third World economies. In the advanced
industrialized countries, industrialization was accompanied by a progressive shrinking of
the agricultural sector as populations moved to industrialized urban areas, and this
movement was a crucial part of the reduction of aggregate poverty. It has been suggested
that “trade” (or integration into the global economy) will effect a similar change,
reducing overall poverty in those countries that open their doors to free trade. Note,
however, that many economists (including Bhagwati in his defenses of globalization)
claim that the primary reason for the shrinking percentage of jobs in the industrial sector
in the United States in recent years is technology change: modern manufacturing no
longer provides the level of highly-paid skilled work that it did in the past. If this is true
in the United States today, the claim that will be true throughout the world in the future,
for technological change is a world-wide phenomenon in an integrated global economy.
But how plausible is this projection? Why should we suppose that modern highly
productive factories with their relatively small labor forces will be able to absorb the vast
Third World agrarian labor force? As noted in the discussion of the Harris-Tudaro paper,
Third World industrialization has often resulted in high urban unemployment levels.
Unlike the farm labor of America and Europe, most Third World farmers are not working
the most productive land with modern machinery and farming techniques. They are, for
the most part, peasant farmers working small plots of often marginal land. The push of
rural poverty (and often insecurity) is perhaps stronger than the pull of the possibility of
finding high paying urban factory jobs. When they migrate to burgeoning Third World
mega-cities like Jakarta, Lagos, or Sao Paulo they are likely to end up unemployed, or
under-employed, or employed in criminal activities. In effect, they trade rural poverty for
urban squalor.
Keynes once argued for tariffs to protect English agriculture, and his reasons parallel the
later protectionist policies of the European common market and Japan. Agriculture is an
important part of the cultural identity of many countries, and protection of agriculture is
deemed of value beyond its economic return. However, in the case of many Third World
countries, the reasons for protecting agriculture goes far beyond cultural preservation,
although cultural preservation is as important for these countries as it is for the advanced
industrial countries. The principal reason is that suffering occasioned deterioration of
rural economic conditions under pressure of imports from the efficient mechanized farms
of Canada, Australia, the United States and other advanced nations cannot be alleviated
by migration to cities; there simply are not enough manufacturing and service jobs.
Unrestricted economic integration, accompanied by free trade in agricultural produce,
encouraged by the IMF and World Bank and supported by the academic economic
community, may well worsen the condition of Third World farmers. Of course, free-trade
proponents have argued for reduction of agricultural production as a means to help Third
World agricultural exports. But the more serious Third World problem is rural poverty
among farmers who produce traditional foodstuffs for local consumption. Free trade in
agricultural goods almost always leads to a decline in the prices of these traditional crops.
Except in times of crop failure when imports are needed, this price competition can exact
an enormous human toll in the agrarian sector, driving many of the rural poor to large
metropolitan areas where crime, substandard housing, and air and water pollution are
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endemic. Poverty in rural areas is also generally associated with large family size, and
when there are even small improvements in medical care, in rapid population growth.
An important component of social welfare is per capita income, and population control is
essential to raising per capita income in much of the Third World. Economists maintain,
with justification, that the best means of lowering birthrates is to raise living standards
and increase social security. As education and income increase in rural areas, birthrates
fall. Increasing the welfare of the traditional agrarian sector through subsidies or other
protectionist measures, improved farming methods and social services including
education, development of rural infrastructure (social and economic), and development of
agricultural processing industries on a local level discourages emigration to large urban
areas, encourages family planning in rural areas, and leads to a decrease in population
growth. This is not to say, however, that governmental policy is ineffectual and that only
privately-induced economic growth results in effective birth control. Cultural attitudes,
availability of inexpensive contraception, and government subsidies and investment in
infrastructure can all have a strong effect on family size and population growth.
It is clear from case studies, that economic development and in particular economic
development that leads to an increase in welfare as culturally defined, requires policies
that protect all major social groups in the face of economic change—a point emphasized
by Qian in his study of the success of recent Chinese development policies. In many
developing countries, one of the most important groups consists of the rural poor. The
experience of Indonesia illustrates how a heavy investment in agricultural infrastructure,
including provision of schools and health facilities (as opposed, for example, to the
failure to invest in the rural infrastructure in Pakistan) did much to raise the standard of
living, and the improved educational standards in Indonesia thereby contributed to the
later shift to an emphasis on the export of manufactured goods. Third-world countries
that have ignored this lesson through a doctrinaire application of “free-market reforms”
have seen an increase in both social and economic problems.
Primary Sector Exports
Exports from most developing economies are dominated by primary sector goods:
agricultural produce, both food stuffs such as grains, coffee, sugar, and fruits; forestry
and fishery products; fibers (sisal, hemp) and natural rubber (mostly in the past); and
perhaps most important, fossil fuels and ores. The trade consequences for the exporting
country vary according to the product and the other sectors of the national economy.
Recent trade negotiations have focused on agricultural exports, with free trade proponents
claiming that both advanced countries and Third World countries should reduce subsidies
to domestic agricultural producers to encourage freer international trade in these
products. It is generally held that reducing protection will benefit Third World countries.
However, as noted, protection for traditional agriculture in Third World countries forms
part of a program for enhancing rural welfare and restraining the continuing growth of the
mega-cities that have arisen throughout the Third World. It is doubtful that the lower
food prices resulting from eliminating protection for traditional agriculture will produce a
net benefit for these countries.
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The agricultural exports of these countries are generally not from the traditional sector,
but from crops produced on large holdings with low-wage hired labor. Many of the
exporting countries are located in tropical or subtropical areas, and their agricultural
exports do not, in many cases, compete with products such as grains produced by the
advanced countries. Thus reducing agricultural subsidies in the Third World may increase
the agricultural exports of advanced countries like the United States and Canada while
damaging the economies of Third World countries, specifically in the agrarian sector
which already suffers from chronic poverty.
Primary sector exports from developing countries resemble low-wage manufacturing
exports in several respects. Wages are low and working conditions are poor. Control is
generally in the hands of politically-connected cliques. Environmental degradation is
common. (For example, the egregious consequences on the Aral Sea of irrigated cottongrowing in Uzbekistan.) Moreover, like exports based on low-wage labor, the export
market for agricultural goods, in particular, is often precarious because of the large
number of alternative countries which offer locations favorable for cultivation of many of
the products. This has led to gluts of coffee, sugar, and citrus fruits with disastrous effects
for countries that formerly prospered from exports of these products. One obvious
example is the effect of the collapse of world-wide coffee prices on a country such as
Colombia that depended heavily on the industry. It will often be wiser for countries
dependent on agricultural exports to try to regulate them within the context of regional
trade agreements. It is unlikely that completely free trade in these products will prove
beneficial for an exporting nation unless conditions are such that it is difficult to
economically produce the product in other countries.
Fishery and forest products are less subject to foreign competition because these
resources are harvested rather than cultivated, for the most parts (fish farming in Asia
being the exception). Nevertheless, these industries have proven fragile since resources
rarely last more than a few decades under modern conditions of extraction. So even
though countries with access to rich fisheries or high-demand forest products may favor
free trade in these products, they should consider limiting their exports in order to
minimize environmental damage, allow for regeneration, and avoid over-reliance on
export revenues which may impede longer-term development in other sectors.
The third, and most important category, consists of fossil fuels and mineral deposits. Like
fishery and forestry products, these are generally scarce commodities which may
command high prices on international markets. The extreme case where exports of a
given product command high international prices and revenues from the product
dominate the domestic economy, has been studied at length. Economists have been
sensitive to the potentially negative effects of this situation and the expression “Dutch
Disease” is widely used suggesting a common set of causal factors. Oil and natural gas
are the exports usually associated with the Dutch disease hypothesis. Certainly the special
place that oil and natural gas occupy in the world economy distinguishes them from other
fossil fuels and mineral products. The Dutch Disease is discussed in the next section.
Most fossil fuel and mineral industries follow a pattern similar to that of forestry: the
industries are generally controlled by large corporations, often foreign owned. Wages are
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low and workers generally have few freedoms or cultural advantages, although some
social services provided privately by the employers, such as medical care, may be
superior to those typically available. There is often a high level of environmental
degradation, with government control compromised by corruption. Instead of government
capturing maximal revenues through taxation, partnership or nationalization, it often
happens that bribery of officials results in sub-standard benefits for the national economy.
An egregious example was recently documented in a long investigative story in the New
York Times on the disastrous history of Freeport-McMoRan, an American company that
runs the world’s largest gold mine and mines the world’s third-largest copper deposit. A
pristine wilderness area in New Guinea has been badly polluted by the company’s mining
activities.. Corrupt payments made to the Indonesian army and police have kept local
protesters at bay. (NY Times, December 27, 2005, article by Jane Perlez and Raymond
Bonner.) This is a pattern that dates back to Spanish colonial mining practices in Central
and South America and to later exploitation of mineral deposits in many Third World
countries.
Free trade and free market policies hardly seem relevant here, since the issue is really the
ability of Third World governments to tax and regulate these enterprises. Advanced
industrial nations need these products as raw materials for their manufacturing industries
and are generally not going to impose protectionist barriers to their imports. The crucial
decisions are made at the outset of development. If a country is fortunate, it will have a
government that negotiates a contract that provides extensive government oversight,
environmental protections, worker protections, and a plan for sharing revenues through
taxation, partnership, or outright nationalization. The national culture, especially the
potential for corruption, will have much to do with the choice of an effective policy, since
some types of agreements lend themselves to greater transparency. For example,
nationalization is problematic for a country with a history of corruption, whereas various
forms of joint ownership may lead to healthy competition and scrutiny.
The Dutch Disease
Oil and natural gas exports have often (but not always) resulted in greater benefits for the
producing countries than the export of other mineral resources. There are exceptions
(such as Nigeria) where the bulk of the population has failed to benefit from large
petroleum production, or Chile where copper exports have helped the wider economy in
various ways.44 But when an extractive industry such as oil dominates a domestic market,
economists have perceived a cluster of problems which jointly are referred to as the
“Dutch disease effect.” The idea is that countries that are richly endowed with scarce
natural resources commanding a high price on world markets may suffer from
exportation of these resources, a phenomenon also sometimes referred to as the “resource
curse.” Although there is little evidence to support the view that natural resource booms
lower GNP, they have been held to retard industrialization which is considered by most
economists as crucial for long-term growth. Oil has provided the most-discussed
examples. High international prices for the exported resource, especially during booms,
lead to higher returns from investments in the resource sector than in other sectors, and
consequently there is a movement of labor into it from other sectors, particularly the
manufacturing sector. Wages go up in the resource export sector and demand for non-
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tradable services and goods (including real property) rise, resulting in price increases; this
has the effect of draining additional labor from the domestic manufacturing sector. The
price increases in the non-tradable sector contrast with the internationally determined
prices of manufactured goods, resulting in an increase in the real exchange rate.45 Imports
of foreign manufactured goods increase, and exports of domestic manufactured goods
(from the shrinking domestic manufacturing sector) decrease. The increased spending on
services and non-tradables (such as construction projects) may come from private
spending or from government spending of increased tax revenues from resource exports.
All of this (and much more) has been presented in formal, simplified three-sector
neoclassical models. (as reviewed in Stijns) The predicted consequences are an
appreciation of the real exchange rate, an increase in the output of the non-traded sector
(usually, though not always), a fall in domestic manufacturing output, and a fall in
manufacturing exports.
Since it is generally believed that growth of manufacturing, and especially of
manufacturing exports, promotes long-term national income, the supposed consequences
of possessing a natural resource for which there is a high international demand are
deemed so negative as to deserve being labeled a “disease” or “curse.” The disease is
often seen as being triggered by the discovery of new natural resources in the country or
more commonly by an increase in international demand and international resource prices.
It does not apply to countries with undeveloped natural resources—a common Third
World situation—or to exports from the primary sector that are either too small in scale
or that fail to command sufficiently high prices on the international market—exports of
the sort discussed in the previous section.
The term “Dutch disease” was apparently coined based on observations of the results of
large discoveries of natural gas in the North Sea on the economy of the Netherlands in the
1960s. In the case of developing nations, the most common examples concern the effects
of oil booms on investment in domestic manufacturing. As we saw, Wolf claimed that
Venezuela and Nigeria were afflicted by the Dutch disease due to their oil resources.
However, the alleged phenomenon is really no more than an hypothesis of the sort
economists are fond of offering. At best, we can say that the existence of high-value
exports resulting from country-specific advantages—most commonly natural resources—
may tend to skew labor and investment away from manufacturing. The case studies of
Indonesia and Venezuela rejected the Dutch disease hypothesis. In the case of Indonesia,
the Suharto government, despite its corruption, carefully controlled the currency
exchange rate during the oil boom, and chose to invest income from oil exports in rural
development, which had generally beneficial results for the economy and laid the basis
for the export of labor-intensive light manufactured products. In the case of Venezuela,
the economic problems arose not during the oil boom years but subsequently, and the
best hypothesis attributed the decline in domestic investment in manufacturing to the
currency volatility and artificially high interest rates that followed the oil boom years.
Nor does the original example of the Netherlands stand detailed scrutiny since the decline
in manufacturing output during the nineteen seventies in the Netherlands was similar to
that of its resource-poor neighbor Germany and less than that of its equally resource-poor
neighbor France. In the case of developing countries, a 1997 World Bank study
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concluded that where problems arose they were not the result of the resource export
boom per se but rather of faulty economic policies or inadequate policy responses to a
resource boom.46 In Kuwait, Nigeria, Indonesia, and Mexico, the growth rate of the
manufacturing sector was actually greater than or equal to that of the non-tradable sector
during the oil boom. The general conclusion of a number of case studies is that the
primary danger of resource booms comes from inappropriate government policy, rather
than from the market effects predicted by neoclassical models.47
An interesting but anomalous example is Colombia where the export in question is not
oil, or even a mineral deposit, but cocaine. The exportation of cocaine in the nineteen
eighties and nineties produced classic Dutch disease effects, with a real appreciation of
the Colombian peso, accelerated growth in the nontradable sector, and a decline in
tradable output from other sectors as they were drained of resources.48 But one reason for
the problem was the inability of the government to control the drug trade or to capture its
profits for compensatory spending such as occurred in Indonesia. In the case of
developing countries such as Colombia, uncontrolled Dutch disease affects agriculture
even more than manufacturing, and one of the chief victims of the drug exportation boom
was the coffee industry.
Several conclusions are possible. First, resource rich developing countries cannot expect
laissez-faire free market policies to produce favorable long-term results. It is likely that
under laissez-faire conditions valuable exports such as petroleum will experience boombust cycles detrimental to development, and that during boom times human and
investment resources will be drained out of manufacturing, and especially out of export
manufacturing. Government intervention can remedy these defects, but only if
government uses the resource revenues wisely. One such use would be rural development
to stabilize the large agricultural sector for the reasons discussed in the previous section.
Another would be to protect domestic manufacturing from low cost imports—providing
that an infant industry policy is justified for the industries in question. Protected
manufacturing thereby becomes a non-tradable sector. This is akin to what occurred in
Mauritius where exports from the special manufacturing zones assumed, in the context of
the small island economy, the role of a typical Dutch disease industry. Mauritius avoided
Dutch Disease problems with other industries by strong protectionist measures.
Historically, many governments have failed in these tasks and have actually contributed
to the problem through unwise spending of resource-derived tax revenues. But laissez
faire is hardly the solution, since the Dutch disease effect is real, though hardly
inescapable.49
In keeping with a major theme of this book that local conditions are critical in arriving at
optimal economic policies, I think the preponderance of evidence is that whether the
“disease” actually manifests itself will depend on a complex array of country specific
conditions. In some cases, cultural factors are relevant. For example, exports of precious
metals from the American colonies to Spain during the sixteenth and seventeenth
centuries has been said to exemplify the Dutch disease. But according to Max Weber’s
thesis, the key factor distinguishing the development of the Protestant countries of
Northern Europe from Catholic countries such as Spain was the cultural attitude towards
consumption of luxuries. Countries with a culture favorable to higher education may
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resist the Dutch disease through the development of specialized high-tech industries.
Such may well be the case with England, which saw a decline in its industrial base
greater than that of its European neighbors after the development of North Sea oil, but
whose economy nonetheless boomed (until recently!) as a result of high tech industry.
The United States during the nineteenth and early twentieth centuries provides an
example of the role of protection converting the manufacturing sector in a non-tradable
sector, thereby avoiding the predicted decline despite the large-scale export of primary
sector goods. That is, during the nineteenth and twentieth centuries the United States
rapidly developed its manufacturing sector under the protection of high tariffs despite
high exports of its rich endowment of natural resources.50
Large and Small Resource-Rich Developing Countries
The United States exemplifies the possibilities open to a large country with extensive
natural resources. Depending on the exact nature of these resources and the nature of the
country’s labor force, the revenues and profits generated from the export of natural
resources can be used to finance the development of appropriately chosen manufacturing
industries, often of a medium to large scale capable of being supported by the large
domestic market. These revenues and profits can also be used to raise general welfare
through the expansion of social services and infrastructure in both rural and metropolitan
areas. The potentially harmful effects of the Dutch disease can be mitigated by exchange
controls and use of tariff barriers to convert the products of protected manufacturing
industries into non-tradable goods. This policy is easiest to implement through the
establishment of regional or bilateral agreements which enable sale of manufactured
products at negotiated prices (in some cases below those obtaining in the domestic
market). The choice of manufacturing would depend on political and geographical
factors; a large country such as Brazil might successfully undertake automobile
manufacturing with domestic distribution and exports to the other members of Mercosur
(Argentina, Paraguay, and Uruguay), whereas an even larger country, Indonesia (over
240 million), would be better off serving as a supplier to the neighboring Asian advanced
manufacturing countries.
In any case, a primary goal is full employment through an expanded non-tradable sector
(implemented in part through the government infrastructure programs), protected
manufacturing, and a rejuvenated agrarian sector in which relatively low income is
compensated for by governmentally supplied infrastructure and crop subsidies. Ideally,
such a country would import labor-intensive products (for example, textiles and many
other consumer goods) manufactured by other, poorer members of a regional trade
agreement or in some cases at low world market prices, but that decision would depend
on the domestic standard of living and level of unemployment.
Smaller developing countries richly endowed with exportable natural resources will have
more difficulty in developing sustainable manufacturing industries that require a large
market to grow to an efficient size. Avoiding the Dutch disease effect by using
protectionist measures to convert manufacturing output to a non-tradable product is
difficult where the domestic market is too small to sustain a manufacturing industry at an
efficient size. However, the resource-export revenues can be used to raise general welfare
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through infrastructure and social service programs, especially in the agrarian sector, very
sorts of light manufacturing primarily aimed at the domestic market, and (depending on
geography) the development of a tourism industry. Light labor-intensive industries such
as food processing, textiles, and other consumer products that require a relatively small
market for optimal operation can be protected from low-priced imports which might
dominate the market due to an increase in the real value of the currency. In the long run,
small resource-rich countries should consider large investments in education and
development of a high-value skilled labor market that can lay the groundwork for future
industries that require highly skilled workers but not a high level of capitalization, and
which do not require a large domestic market to enjoy competitive economies of scale.
Each resource-rich Third World country will have to study the successes and failures of
other countries, and try to apply the lessons learned to decisions regarding control of
exchange rates, protection of manufacturing and agriculture, and wise use of government
revenues arising from resource exports. Citizens will have to be vigilant to minimize the
corruption that is common in these situations. But laissez faire is not really an option for
these countries which face an especially complex set of challenges regarding economic
management.
Resource-Poor Third-World Countries
These are the countries whose principal asset is their labor force. They will not have not
enjoyed the historical benefits of the resource-poor (by current international standards)
European countries. Unless they have a favorable geographical location (for example,
Singapore and Hong Kong as entrepots), they are unlikely to develop a significant
manufacturing sector. However, their poverty provides a basis for low-wage, labor
intensive exports, and government expenditures should be directed towards training an
efficient work force to leverage this advantage. They should also be able to develop, and
if necessary, protect low-capital light industry whose products as destined for domestic
consumption. They should not allow the importation of products whose principal price
advantage derives from an artificially low exchange rate as is currently the case with
China.
Expenditures on education can result in a large number of trained doctors, teachers,
engineers, and technicians who can do much to successfully satisfy country-specific
social and economic needs. In general, these countries should concentrate on maximizing
welfare through development of infrastructure and social services that alleviate poverty
and realize non-monetary cultural values. Such support applied to the rural economy is
critical as these countries often struggle to provide their people with an adequate diet. In
one sense, their plight is often not as bad as economists represent it, since there is
certainly ample evidence that consumption of material goods, beyond a point, is far less
conducive to human happiness than cultural opportunities and social arrangements. By
raising their people above the poverty level, they may succeed in achieving much of the
happiness that comes from the possession of material goods, and by cultivating other
cultural and social values they may, in fact, achieve subjective levels of well-being
superior to those of much wealthier nations.51
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Other Factors
Some social and cultural factors create special problems for developing countries. Firm
opposition to birth control on the part of the Church hierarchy in Catholic countries has
hardly proven decisive in limiting the move towards smaller families and a lower birth
rate as attested by the low birth rates in the traditionally Catholic countries of Europe and
the recent fall in birthrates in Mexico and elsewhere in Latin America. However, the
Church’s attitude has surely slowed the movement towards population control in Latin
America as compared to historically poor countries such as China. Unless Third World
governments take strong measures to reduce population growth through female
education, availability of contraceptives, and social security that supports and protects the
elderly without reliance on support from their children, the prospects for improving social
welfare are poor.
A second difficult issue is the effect of ethnic diversity on economic growth. Several of
the country studies in Rodrick’s collection found that ethnic diversity was negatively
correlated with economic welfare, presumably because of the tendency for different
ethnic groups to contend for control of government resources, and having gained control,
to adopt policies which, often through corruption and discrimination, favor the group in
control. This is a political, rather than economic issue, and many governments are
struggling to resolve it. But it is essential that development plans be created and
implemented with full awareness of the potential effects of the plans on all sectors of the
population, and with awareness of the negative effects of policies which favor one or
another group.
Conclusion
Developing countries should consider four areas where some form of protection may
benefit national welfare. First, there is the possibility that given the social, cultural, and
economic characteristics of the country it may successfully develop certain
manufacturing industries to a competitively efficient size though cost-effective
protectionist measures (the infant industry argument). Second, when there is
unemployment, or potential unemployment resulting from imports of products of labor
intensive industries, it makes sense to protect domestic industries producing those
products. This is especially true when imports undersell domestic produce due to
distortions in exchange rates or in foreign wage rates that do not reflect genuine
productivity advantages. Third, it will often make sense to protect traditional (nonexport) agriculture both for reasons of national culture and to prevent rural poverty and
uncontrolled migration to burgeoning metropolises of the sort found throughout the Third
World. Tariff revenues can be used to enhance rural infrastructure. Fourth, when a
country is blessed with a high-value natural resource whose exportation causes economic
distortions of the sort identified with the Dutch disease, it reasonable to protect domestic
manufacturing to convert a threatened tradable industry that was previously healthy into a
non-tradable industry to ensure its continuation. This preserves jobs and mitigates the
boom-bust pattern common in natural-resource rich economies. A final reason for
protectionism—diversification in the interest of economic stability—is common to both
developing and advanced industrial societies.
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Chapter 8
Trade Policy in Advanced Industrialized Countries
The United States has been a leading proponent of global free trade for the past several
decades. With a few notorious exceptions—such as the quotas imposed on imported
automobiles in the 1980s—the United States has embraced free trade in manufactured
goods. Thus consideration of the effects of free trade in the United States lacks many of
the complications that characterize the debate over the effects of free trade in the Third
World. It is indisputable that American industrial production has sharply declined in the
past three decades, along with industrial employment, that working class wages have
remained relatively stagnant, that there is far less job security than in the past, and that
income differentials have increased. In the face of these changes, which have distressed
many liberal economists, it is not an easy matter to make a strong case for the benefits of
free trade in the United States. The usual response of economists is to argue that
protectionism would have made matters worse.
It is worth beginning the discussion by evaluating a number of arguments by Jagdish
Bhagwati in defense of free trade in advanced industrial economies. Bhagwati presents
his case indirectly through a critique of propositions claiming that free trade has had
various negative effects. This risks falling into the “debating points” trap that
characterized Wolf’s discussion. A good example is Bhagwati’s extended discussion of
the claim expressed by the political slogan “globalization results in a race to the bottom.”
His discussion does nothing to shed light on the complex effects on working conditions
and wages of occupational changes. Instead, he quickly moves from the vague notion of
a “race to the bottom” to a discussion of the effect of free trade on the production of
“labor-intensive goods” such as “textiles and shoes” in the United States. This poses an
immediate problem, because of his assumption that labor-intensive production only
involves unskilled labor. Ignored are teaching, scientific research, computer
programming, medical technology, and any number of other higher level labor-intensive
“new economy” jobs. These are the kind of jobs which have recently become the focus of
concerns about outsourcing.
Bhagwati’s focus on labor-intensive goods creates a “straw-man” argument: the concern
of globalization opponents who talk about a race to the bottom has little to do with the
loss in the United States of low-skilled labor intensive jobs. The lost manufacturing jobs
that concern critics of globalization involve highly skilled and well-paid work in the
electronics, automotive, and machine tool industries. In a recent critique of American deindustrialization by Eamonn Fingleton, this distinction is made clear:
...postindustrialists implicitly define manufacturing to mean merely laborintensive work of the assembly type. In so doing, they set up a straw man—for
there is no question that, in an increasingly integrated world economy, many
kinds of consumer products can no longer be assembled economically in highwage nations. Overlooked by the postindustrialists, however, assembly is only the
final, and generally by far least sophisticated, step in the making of modern
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consumer goods. Earlier steps such as the making components and materials are
typically highly sophisticated. And even before the making of such components
and materials, there is a still more sophisticated level—the manufacture of the
production machines that make the world’s components and materials.
(Unsustainable, 5)
Bhagwati, like Friedman and other cheerleaders for the “new economy,” focuses on the
loss of low-skill jobs in labor-intensive industries. His stated goal is to refute the alleged
“fear” that “follows from the fact that the poor countries export labor-intensive goods
such as textiles, garments, shoes, and toys to us.” (In Defense of Globalization, 124) The
real and widespread concern over the loss of skilled manufacturing jobs is thus
misinterpreted as the concern that “if the prices of these goods fall in trade because of
increasing supplies from the poor countries, this will trigger a decline in the reward to
unskilled workers; an intuitive effect, as explained earlier, going from lower prices of the
goods produced to lower real wages of the workers producing them.” Bhagwati then
claims that this alleged fear is not supported by the evidence. Thus he has constructed a
classic straw-man argument.
Moreover, even his critique of the reformulated claim is questionable. The evidence he
cites to refute the alleged link between declining prices of labor intensive goods and
declining American wages may be summarized as follows: in the 1970s, even though the
prices of labor-intensive goods fell, American real wages rose; however, in the 1980s, the
real wages of American workers were stagnant although the prices of labor-intensive
goods as a group actually rose relative to the prices of the set of all other goods in world
trade. Thus the alleged causal link is invalid.
But the evidence cited would only be relevant if the real wages of all American workers
correlate with the real wages of unskilled workers. Moreover, the relative increase in the
cost of labor-intensive goods claimed for the 1980s likely reflects not an absolute
increase in the prices of these goods but a fall in the price of more capital-intensive
manufactured goods (e.g. electronic goods) as an ever-greater share of such goods sold
domestically was produced in lower-wage emerging economies. It was the fall in the
prices of these capital-intensive, skilled-labor goods as a result of foreign imports of
these goods and the associated shift of the labor force from higher paid skilled
manufacturing jobs to lower paying service jobs that caused the stagnation in real wages
during the 1980s. In the 1970s the situation was rather different. In that decade, it is
reasonable to assume that there were far few imports of low-cost capital-intensive goods,
and thus relatively little effect on higher paid domestic manufacturing jobs in the
industries that produced these products; this permitted a continuing rise, overall, in real
wages in the United States. On the other hand, during the 1970s many jobs in laborintensive industries (such as the textile and toy industries) had already been lost to
foreign production, and prices for these labor-intensive products had declined as a result
of cheaper imports. In short, Bhagwati’s “evidence” is explained by a two-stage process:
in the first stage (the 1970s), many unskilled labor-intensive jobs moved overseas, but the
better paid skilled manufacturing sector remained relatively intact; this change in the
composition of the labor force raised the average real wage. In the second stage (the
1980s), large numbers of highly-paid, skilled manufacturing jobs were lost, and the goods
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formerly produced by workers in such jobs were now being produced in low-wage
countries at a much lower cost. Importations of these goods (electronics, automobiles,
etc.) lowered average prices, but also raised the relative prices of labor intensive goods.
The loss of skilled manufacturing jobs and corresponding increase in low-paid service
sector jobs produced wage stagnation. These are only conjectures; testing them would
require separating components of the labor market. But the underlying dynamics are
obscured by Bhagwati’s misleading focus on labor-intensive products such as textiles and
toys when, at the same time, he uses “American real wages” as a surrogate for the real
wages of unskilled workers in these labor-intensive industries.
A second part of Bhagwati’s argument involves the claim that the price of labor-intensive
goods increased in the 1980s because the poorer countries were getting rich and enjoying
technical advances that resulted in a shift to capital-intensive goods. As a result, he
claims that there was a rise in the price of low-capital, labor-intensive goods as the supply
of labor to the labor-intensive sectors fell in these “rapidly growing erstwhile poor
countries.” (In Defense of Globalization, 125) But this is an attempt to explain a
phenomenon—the supposed absolute (not relative) rise in the prices of labor-intensive
goods—that may never have occurred, or if it did occur, may have arisen from different
causes. The alleged rise in the absolute price of labor-intensive goods in the 1980s is not
supported by Bhagwati’s claim that the relative price of labor-intensive manufactured
goods rose in the 1980s. A better explanation of the relative price rise is the fall in the
(absolute) average price of capital-intensive manufactured goods as cheaper imports of
automobiles and electronic goods entered the US market. Even if there were an absolute
increase in the prices of labor intensive products like textiles, shoes, and toys during the
1980s, that price rise could be explained by increases in quality, fashion, or brand-name
promotion due to changing social, cultural and economic conditions. Again, the issue is
not the actual facts—I have not independently researched these—but the fallacy of
Bhagwati’s argument as presented.
Bhagwati next displays a graph showing that East Asia exclusive of Japan and China (but
including South Korea, Taiwan, Singapore, and Malaysia) steadily increased net exports
of labor-intensive manufactures during the 1970s, while Japan reduced them; whereas in
the 1980s, these countries also reduced their proportion of trade in labor-intensive goods.
(DG 126) The graph is offered in support of the claim that “rapidly growing erstwhile
poor countries” shifted away from labor-intensive production from the 1970s to the
1980s. Bhagwati’s argument is a good example of a crude correlation being used to
support a causal claim—a far more serious abuse of statistics than that associated with the
regression analyses attacked by Bhagwati and Srinivasan in the paper discussed in
Chapter 5. The correlation shown on Bhagwati’s graph is entirely consistent with importinduced downward pressure on average wages in the United States and other older
industrialized countries during the 1980s. The fact that these East Asian countries were in
the process of decreasing the relative level of labor-intensive manufacturing exports
(textiles, shoes, and toys)—ceding their production to poorer countries like China and
Bangladesh—hardly supports the claim that the prices of labor-intensive goods rose in
absolute terms. In fact, since their production in even poorer countries occurred at wage
rates as low or lower than those that obtained when these products were being made in
Japan or in the listed East Asian countries during the 1970s, it is reasonable to believe
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that (aside from product changes resulting from quality improvements or more
demanding tastes)—the absolute prices of these labor-intensive goods fell.
Bhagwati also cites a study that purports to show that outsourcing of components of
labor-intensive products for assembly in the U.S. during the period 1972-90 was
associated with a rise in the wages of unskilled labor. But this study relates to wages in
one small sector of the total labor market—assembly plants—which, as Fingleton noted,
employ relatively unskilled labor. The correlation between increasing imports through
free trade and a rise of wages in this limited sector hardly supports a causal link between
free trade and a rise in overall wage rates in rich countries. In fact, wage statistics
overwhelmingly demonstrate that working-class wages in the United States have
stagnated during the past three decades. Bhagwati’s argument obscures the underlying
reality.
At one point in his discussion, Bhagwati claims that the principal cause of the decline in
the wages of unskilled labor was technological change that economized on the use of
such labor. This has been a common refrain of defenders of globalization: job loss and
wage declines are to be explained almost entirely by technological change rather than by
free trade. Indeed, technological change may explain part of the decline in employment
levels in all areas of manufacturing, skilled and unskilled. But it hardly explains a decline
in the wages of unskilled labor in the United States. We cannot identify, for example, a
group of new and efficient American textile or toy factories producing an equal or greater
volume than earlier factories did with a reduced and lower-paid labor force; rather we
find a collapse of the domestic textile and toy industries in the face of massive low-cost
imports.
Bhagwati goes on to claim that the supposed technologically-induced decline in the
manufacturing labor force has been largely offset by the new and better paying jobs
created by free trade, a claim similar to that made by Friedman and other defenders of the
new service economy. But the claim that the benefits of free trade have succeeded in
offsetting a technologically-induced wage and job decline is not supported by Bhagwati’s
confused arguments. In fact, there is good reason to believe that free trade has aggravated
the problem of the loss of good jobs because it has created an incentive for the export of
investment capital to relatively low-wage Asian countries. And it is the loss of “good
jobs” in manufacturing that is a major reason for the sharp increase in income inequality
in the United States.
Of course, none of these criticisms of Bhagwati’s arguments demonstrates that one or
another protectionist measure would have produced a better result. However, his
arguments ignore the well-known fact that many of the successful Asian economies,
including Japan and China, have developed healthy manufacturing sectors largely as a
result of government intervention. These countries did not champion unrestricted free
trade in the belief that wealth would invariably trickle down as Bhagwati and other
neoclassical economists maintain. Successful Asian economies have utilized a variety of
interventionist policies to protect and grow their export industries. And unlike the United
States, Japan, the oldest success story, has continued to maintain a successful
manufacturing-based economy despite high wages and benefits. And in spite of its highly
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publicized banking crisis, it has continued to dominate the world market for high-wage
capital-intensive manufacturing products. The so-called “new-economy” plays a
decidedly secondary role. If Bhagwati were correct, Japan should have adopted far more
open trade policies, like those of the United States. Although Japan did lose laborintensive industries to other Asian countries, it did not experience a decline in
manufacturing at all comparable to what occurred in the United States. According to
Fingelton, Japan has passed the United States in total manufacturing output with a
workforce less than half that of the United States, and Japan’s output of advanced
manufactured products now exceeds that of the United States by a factor of five. Japan’s
current account surpluses in the 1990s ran 2.37 times their total in the 1980s. Despite the
banking crisis, unemployment averaged less than 3.1 percent during the 1990s, far less
than the average of 5.7 percent in the U.S.
Bhagwati ignores these facts, instead offering the absurd statement that “today the
country [Japan] is almost an economic wasteland, mired in recession and paralyzed into
inaction.” (In Defense of Globalization, 73) This absurd statement comes from an
economist who advocated “nuanced” empirical case studies.
Protectionism and Employment
The central model of neoclassical theory is that of an economy in a state of competitive
equilibrium, with prices in each market perfectly matching supply to demand. Real
markets, of course, do not always match supply and demand, and conditions of perfect
competition among firms selling common “commodity” type products at prices
determined by the market are very rare. When real markets fail to conform to the
competitive model, economists speak of “market failures.” Among the long list of socalled “market-failures” that characterize real economies unemployment stands out.
When there is unemployment, economists generally hold that something unnatural is
preventing the price of labor from falling to a level that would clear the market; the price
of labor is so high that companies are unwilling to buy enough labor to clear the market.
This is called a market failure. Thus unions that negotiate higher wages and minimumwage laws have been denounced with a moral vehemence that derives from the normative
meta-belief structure of neoclassical theory.
In fact, when economic conditions are favorable—such as in the United States in the
decades following the Second World War—a high level of unionization has been
accompanied by historically low unemployment rates. Rather than unions causing
unemployment, the reverse seems the case, unemployment leads to a weakening of
unions because a labor surplus creates an opportunity for companies to “break” unions or
expand in a union-free environment.
Economists have also claimed that unions create wage differentials that contribute to
unemployment. However, in the United States a decline in union membership has been
accompanied by a higher average rate of unemployment (on or off the books) than during
the immediate post-war decades. Nor is there evidence that the high wages gained
through union bargaining have contributed to income inequality. As union wages
declined, income and wealth inequality in the United States increased. Much of this is
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due to an increase in profits and capital gains, two items left out of the fundamental
models of neoclassical theory (and the comparative advantage model).
Keynes, who was more attuned to the Marshallian tradition of neoclassicism which drew
heavily on the work of classical economists, referred to the neoclassical belief in market
clearing as “Say’s Law” because Jean-Baptiste Say, an early nineteenth century classical
economist was the first to defend it. Rejection of Say’s Law as applied to the labor
market, was one of the foundations of Keynes’ new “general theory” which contemplated
the possibility of economic equilibria at less than full employment—an impossibility in
conventional neoclassical theory.52 Based on his view that England had fallen into such
an equilibrium state during the Great Depression, he formulated an argument for tariffs as
a means of raising industrial employment levels.
Several years before he published his General Theory, Keynes had advocated the use of
tariffs as one of several means of raising employment. In A Treatise on Money (1930) he
had criticized the British return to the gold standard at the prewar rate as overvaluing the
pound, which had the effect of increasing English investment abroad and harming both
exporters and producers who competed with imports. To counter the resulting outflow of
gold, the British government had chosen to raise domestic interest rates. But high interest
rates depressed domestic investment, output, and employment. Moreover, under modern
social and political conditions, the unemployment seen in the Great Depression did not
lead to a sufficient lowering of wage rates to restore full employment as projected by
neoclassical theory. (Of course, traditional economists denounced these politically
imposed conditions as selfishly interfering with the benevolent unfettered actions of the
market.)
A few years later, Keynes came to see the potential virtue of a tariff policy along lines
reminiscent of mercantilist thinking, holding that a tariff would shift the balance of trade
in favor of Great Britain, thereby encouraging domestic industry and increasing
employment. He no longer believed that there would be an automatic movement towards
a neutral (or zero) balance of payments as assumed by conventional theory (what he
referred to as the “classic theory”). However, although he saw the potential benefit of
tariffs, they were not his first choice for addressing unemployment. The preferred
mechanism for achieving greater output and increased employment was investment
occasioned by cheap money (lower interest rates). And he felt that in the conditions
existing in England at the time, government investment would be needed to raise
aggregate domestic demand. This would avoid the dangers of a unilateralist protectionist
trade policy. But undoubtedly an equally powerful motivation was the traditional
reluctance on the part of English economists to abandon the doctrine of free trade which
had played such an historically significant role.
Keynes’ argument for a tariff as a possible solution to unemployment was reconstructed
in a neoclassical framework by Gottfried Haberler, who showed that if there were factor
immobility (e.g., labor immobility) and factor price rigidity (e.g., union opposition to
nominal wage cuts), free trade could lead to unemployment and inferior resource
allocation. (Irwin, 200). Irwin commented that economists ultimately came to favor
exchange rate flexibility over import restrictions as a means of cheapening the factor cost
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of labor, thereby increasing production for export and employment in export industries. If
“flexibility” means the possibility of setting an exchange rate below the level that would
result from a free-float, we have merely another type of protectionist measure—as noted
in the discussion of China. On the other hand, if flexibility means no more than moving
from a high pegged exchange rate to a floating exchange rate, then there is no reason to
suppose that this would always be enough to restore employment in export industries. It
has also been argued—for example by the Nobel-Prize winning economist Robert
Mundell—that a floating exchange rate increases risks for exporters and importers and
thus discourages international trade.
Moreover, the advocacy of exchange rate flexibility as a solution for unemployment
ignores that both the balance of payments argument and the increasing returns argument
provide additional reasons for favoring protectionist restrictions on the importation of
foreign manufactured goods. If these arguments apply in a particular case, the effect of a
tariff (for example) in increasing aggregate demand through an increase in employment
must be considered as a further benefit. Flexible exchanges rates may, for a variety of
reasons, be ineffective in preventing the decline of industries or fostering the growth of
industries. It seems obvious that generating investment in industries requiring a high
degree of capitalization will generally require more stimulus than can be provided by
floating exchange rates, or even artificially low pegs, although the latter is far more likely
to produce the desired result. Relatively low unemployment levels in the advanced
industrialized nations after the Second World War, coupled with an emphasis in the first
two and one half decades on neo-Keynesian fiscal policy and subsequently on monetary
policy, led economists to forget Keynes’s protectionist arguments which, even in their
heyday, were contrary to the well-established tradition favoring free trade.
Mature Industries
Irwin presents the Keynesian argument for tariffs as a type of “welfare argument.”
Keynes’ argument is a rare case where an economist explicitly separates the notion of
social welfare from the (technical) notion of utility, with the latter defined in terms of
consumption (and production when the economy is in equilibrium) which can be roughly
correlated with national income. Because he distinguishes welfare from income, Irwin
holds that Keynes’ argument differs from typical protectionist arguments which advocate
one or another form of protection as a means of raising national income.
More generally, economists have granted that protecting mature industries—such as
those of Great Britain during the nineteen thirties—may serve to maintain a high level of
employment, although at the cost of national income. Commonsense views assign a much
more significant role to maintaining full employment as contributing to social welfare
than does economic theory which sees unemployment as a an unusual market failure.”
Unemployment, even with a generous monthly unemployment check, is viewed as
detrimental to self-respect, familial happiness, and general social health. Since
neoclassical theory measures welfare solely by the level of consumption of commodities,
for it the source of the income is irrelevant. Thus consumer savings on imported
television sets will trump saving jobs in the domestic electronics industry.
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The employment situation in the United States and Western Europe in recent decades has
raised welfare issues that go beyond worries about the unemployment rate. In the United
States a major concern has been the loss of relatively skilled high-paying manufacturing
jobs. Those advocating protectionism often claim that competition from foreign imports
has been responsible for the loss of these skilled jobs. This claim has been criticized by
supporters of free trade who assert that empirical data demonstrate that most of the
manufacturing job loss has been caused by technological advances rather than by
competition from foreign imports—an assertion that was discussed earlier.53 However,
free trade supporters do generally acknowledge that at least some of the industrial job
loss has come from foreign competition. This seems clear when entire industries—
textiles, light-manufacturing, ship-building—have vanished in the face of foreign
competition.54
The fact that mature manufacturing industries have disappeared from the United States
over the past few decades at first appears to conflict with a basic premise of the infant
industries argument—that mature industries are highly resilient due to having achieved a
size that realizes economies of scale can deter competition. If economies of scale are
really so significant in manufacturing, how could this situation arise?
The answer is that the newer foreign industries that compete not only have the advantage,
in many cases, of the sort of protection recommended by advocates of the infant
industries argument, but also have other advantages that, at some point, result in an
absolute competitive advantage. Among these are inexpensive labor and, many cases,
newer capital equipment. It is highly unlikely that a heavily capitalized export-oriented
automobile industry could have arisen in a country like Japan without significant
protectionist measures (of one kind or another) to nurture it during its early years, but it is
also highly unlikely that Japanese producers could have achieved the success they have
without new, high technology capital equipment and associated production methods. In
the case of the newer industries arising in China, capital has been supplied not only from
domestic (typically government) investment, but by multi-national corporations attracted
by relatively-skilled low-wage labor and political stability.
Once a new industry reaches a critical size, its success will depend on the efficiency of
production, and in a differentiated, branded market (what economists call “monopolistic
competition”) it will also depend on the quality of engineering, design, and
manufacturing. Japanese automobiles only became a competitive threat to domestic sales
of American-made cars after the Japanese automobile industry had matured under a
variety of protectionist measures. In other cases, notably textiles, the required capital
investment is far lower, and the critical factor has been the cost of labor. Thus the decline
of mature industries in the United States does not contradict the assumptions of the infant
industry argument.
Most economists view the demands for protection from workers in mature industries in
advanced industrial nations as the understandable but misguided protest of losers in the
course of dynamic market activity arising from free international trade—misguided
because under trade national wealth as a whole has supposedly grown in accord with the
predictions of the comparative advantage model. Economists may grant that there are
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“non-economic” reasons why countries may wish to protect declining industries—such as
national security or preservation of traditional culture. Thus European Union countries
have defended traditional domestic agriculture as part of their national identity, and a
number of countries have subsidized production of military aircraft. Clearly, there was an
element of national pride in Keynes’ call for tariffs to protect the British steel and
automotive industries. But are there also arguments which claim an economic benefit
from protecting mature industries?
In the case of unemployment, especially as observed in Western Europe, there is little
doubt that the so-called “monopoly power” of labor unions deplored by Viner and other
orthodox economists has contributed to the high cost of labor and to the relatively high
levels of chronic unemployment there as compared with the United States. Although in
the United States the neoclassical assumption of a “clearing” labor market is just slightly
closer to reality, the enormous prison population, the large standing military, and the
millions of “discouraged workers” who fail to appear in unemployment statistics, obscure
a major “failure” in the employment market. But the primary issue in the United States
until recently has not been full employment but rather the quality of jobs. This is in part
due to the near universal belief that for the working class manufacturing jobs are better
than kinds of jobs, although today the contrast is not between manufacturing and primary
sector jobs, but between manufacturing jobs and jobs in the heterogeneous category
known as “the service sector”—an issue explored in the discussion of Thomas
Friedman’s optimistic views about the future of “knowledge jobs.” The specific concern
is over the relatively low wages (and scanty benefits) paid to a majority of service sector
workers. The shift of jobs from manufacturing to the service sector has been associated
with static or declining incomes, increasing inequality in income and wealth in the United
States, a decline in the savings rate, and large chronic trade deficits experienced by the
United States over the past two decades. A boom in the consumption of low-priced
imported goods—largely paid for by the sale of financial and real assets to foreigners and
an increase in private credit-card debt—has contributed to the vast increase in retail sales
employment.
Given these facts—chronic, but hidden unemployment; the replacement of relatively
high-paying manufacturing jobs with low-paying service sector jobs (a primary cause of
increasing income inequity); and the ongoing liquidation of national wealth to finance
low-cost imports—it seems that there ought to be “economic” arguments for protecting
mature industries. However, it should be recognized at the outset that there is an apparent
conflict of goals in determining which protectionist policy to adopt. If fostering exports to
restore the balance of payments is the goal, there may well be an emphasis on subsidizing
industries in which economies of scale are such that continuing success in world markets
is likely. The example generally cited in discussions of the strategic trade argument is the
production of commercial aircraft. Production of high-tech weaponry is another example.
But if the goal is to foster employment in manufacturing, the favored industries would be
those that are relatively labor intensive, the usual examples being textiles and light
manufacturing—and these are not industries in which the United States can easily
compete in international markets with low-wage countries. This would seem to pose a
dilemma for proponents of protection for mature industries. However, there may be an
alternative that serves both ends.
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Intermediate Industries
During the Great Depression, J. M. Keynes expressed the opinion that, “in the case of
most manufactured articles I doubt whether today there is any great advantage to be
gained by a high degree of specialization between different countries...Any
manufacturing country is probably just as about as well fitted as any other to manufacture
the great majority of articles...” (Irwin, Against the Tide, 198). This is mentioned casually
by Irwin as exhibiting a deeply conservative tendency toward inward-looking policies
arising from Keynes’ sense of England’s heritage. But there is a deeper truth in Keynes’
remarks.
When one considers the varieties of types of industrial production, one can identify three
obvious factors that contribute to acquisition of a comparative advantage. First, there are
some kinds of production which uniquely benefit from some peculiar feature of a given
geographical area. These would be exemplified by industries that depend heavily on
expensive-to-transport raw materials or particular climatic conditions. Thus it may be
advantageous to produce steel in countries with plentiful deposits of iron ore and coal,
and to produce goods whose manufacture requires large amounts of electrical power in
regions with an abundance of low-cost hydroelectric power.
Second, there may be industries which are only efficient at very large production levels
due to internal and external economies of scale. When the economies of scale are
internal, or when the external economies of scale depend on local infrastructure, only a
few regions of the world can successfully support these industries at their optimally
efficient size, and those countries that first develop such industries will have a strong
competitive advantage over newer competitors. The location of such industries
throughout the world may be largely the result of historical accident, but once
established, such industries tend to maintain their competitive advantage (so-called “path
dependence”) provided there is no radical shift in technology. As noted earlier, the
existence of a large domestic market is undoubtedly helpful in initiating and maintaining
such dominance.
Third, there are industries that are labor-intensive to a degree that confers an advantage to
low-wage countries—providing they can nurture the industries to the size required for
international competitiveness.
However, these three categories of advantage do not exhaust the possibilities for a viable
industry. Many industries are relatively unaffected by the first and third factors; they
neither depend heavily on local resources nor does labor constitute such a significant cost
factor that low-wage countries derive any significant advantage from the low cost of
labor. And the second advantage—economies of scale that provide an advantage to early
entrants—is not, in the case of most industries, so significant as to reduce the level of
international competition to that seen in an industry like commercial aircraft production.
Many types of industry may coexist in different countries without any significant
advantage accruing to firms in any particular national economy. I shall refer to such
industries as “intermediate industries.” This in accord with Keynes’ assertion that there
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are many industries for which there is no obvious comparative advantage associated with
production in one or another country. These industries lie between the extremes of
industries with enormous efficiencies of scale that allow for only a very few global
competitors, industries that have such dependence on a developed local infra-structure
that it is difficult for newcomers to compete even with intelligent government protection,
and industries that are so labor-intensive (and capital-poor) that low-wage countries have
an unchallengeable advantage. (In the latter case, a government may still decide on
protectionist measures where there would otherwise be unemployment.) Intermediate
industries comprise a large proportion of the mature industries in the older industrialized
countries. Their significance lies not only in the social and cultural value of retaining
them, but also in the large numbers of good jobs they provide. It is also important to note
that there are advantages to the diversification of industry within domestic economies—
diversification mitigates market shocks resulting from natural disasters and minimizes the
effects of changes in technology.
For example, there may well be subtle differences in comparative advantage between
Japanese, Korean, American, or German automobile industries, but the differences are
sufficiently minor that all coexist and compete internationally. In general, labor costs are
not important enough to provide a decisive advantage to lower labor-cost producers.55 In
addition to automobiles, the products of such industries include durable goods such as
home appliances, certain kinds of machine tools, and construction equipment. While not
as labor intensive as, for example, the textile industry, such industries do afford largescale industrial employment. The number of national economies which can support a
particular intermediate industry depends on a variety of factors related to optimal
operating scale, technological level, and domestic market size. For example, it is difficult
to argue that Japan has a significant wage advantage over the United States in the
production of automobiles, construction equipment, printing presses, or machine tools.
Any competitive advantage enjoyed by Japan for such goods on international markets
relates to the quality of design, engineering, and manufacturing, manufacturing
technique, and worker skills—all factors which, with well-planned government
intervention, can plausibly be realized in the United States.
There are considerations relating to the preservation of pre-existing intermediate
industries parallel to those used in deciding whether to protect an infant industry. Since
the threat of retaliatory protectionist measures is a real political possibility—illustrated by
how a number of countries have used indirect protectionist measures to maintain their
domestic automobile industries—a government will have to consider whether the
country’s domestic demand is sufficient to maintain an intermediate industry at an
optimal, or near optimal, size. The potential export market must be gauged with respect
to the number of competing foreign producers of the product present or potentially
present. (Failure to take this into account was one of the principal causes of the worldwide surplus of steel production.)
Paralleling the considerations used in evaluating support for infant industries, it is
necessary to carefully evaluate the available and potentially available human and capital
resources required to maintain the industry at a viable size, and the cultural and political
climate must be considered to insure that corruption or inefficiency does not undermine
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such efforts. A national economy wishing to protect a mature intermediate industry must
invest to assure that it possesses the technological skills, as well as the managerial skills
and incentives to compete—something that the United States has failed to do for a
number of industries which otherwise might have remained competitive in world
markets. Much of the responsibility for this neglect lies with the acceptance of a naïve
comparative advantage model that views unrestricted free trade as leading to
enhancement of national welfare everywhere.
More on Diversification
Much of the case for protecting intermediate industries depends on the value attached to a
diverse economic base. Certainly, in the case of developing economies with a few key
primary sector export products, the benefits of diversification are obvious through the
contribution to economic stability that derives from smoothing out the boom-bust cycles
that are characteristic of primary sector markets. The comparative advantage argument
ignores the advantages of diversification in assuming that a country is better off by
moving all resources to the types of production for which it has a comparative advantage.
As noted earlier there is a cost, perhaps prohibitive, to retraining and moving workers,
and to shifting capital investment between industries as international demand ebbs and
flows altering the comparative advantage relations between nations. Moreover, there is a
danger that at least in the short run a setback to one or two key industries could devastate
an economy that lacked other strong industries.
Thus, ceteris paribus, there is an advantage in developing and maintaining a variety of
industries, in particular mature manufacturing industries which are less likely to
experience future disruptions through changes in domestic and international demand. In
the case of advanced economies, this lends weight to the argument for protecting viable
intermediate industries, quite aside from the employment advantages of doing so. Of
course, both primary goods and manufactured goods are subject to changes in demand
resulting from technological changes. But technological changes generally (but not
always) affect manufactured products incrementally. For example, many of the same
companies are producing automobiles and durable goods today as were 50 years ago,
even though the products produced are radically different.
In the case of the mature economies of the advanced industrialized countries, with the
exception of labor-intensive light manufacturing, most of the larger manufacturing
industries have reached a highly competitive level of development and have been
successful in the international marketplace. These industries are hardly to be compared
with the failures of startups in developing economies that adopted an import substitution
strategy. Both diversification and employment support the case for advanced industrial
societies with mature industries to identify intermediate industries that can be preserved
in the face of lower-cost imports through the use of relatively modest protectionist
measures. This requires that their voting publics recognize that such preservation
contributes to national welfare through the maintenance of good manufacturing jobs and
through the continuation of a diverse economic base that contributes to economic
stability. However, economists generally argue that that most job losses in manufacturing
has come from technological advances, not from the decline of manufacturing in the face
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of foreign competition. If this is so, is it really worth the effort to support these
industries?
Technology and Employment
Ever since the mid-1930s when Keynes introduced the radical idea of an economy in
“equilibrium” but with chronic unemployment (an impossibility in neoclassical theory),
economists have struggled to accommodate it to fundamental neoclassical assumptions.
At one extreme are hard-core neoclassical fundamentalists like (Nobel Prize winner)
Robert Lucas who completely reject Keynes’ views, claiming that real economies
actually are at (or very near) a general equilibrium; they hold that the labor market does
clear, and apparent involuntary unemployment is actually voluntary. But the more
common (and common-sense) response to the reality of unemployment is to appeal to
Alfred Marshall’s notion of “the long-run”: economies are held to always to be tending
towards a long-term market-clearing equilibrium—although various barriers prevent a
rapid convergence. In the case of the labor market, economists identify as the likely
causes of unemployment “sticky wages” resulting from “monopolistic union power,”
labor contracts, and several more technically-expressed structural problems.
These explanations of unemployment ignore various phenomena that lie completely
outside the neoclassical conceptual framework. It is a fundamental neoclassical
assumption that every “good”—including labor—has a price at which it will sell (thus
clearing the market). This is trivially and obviously false. No normal business will hire an
infant, a chronic invalid, a dangerous madman, or an habitual criminal. These people are
not what economists refer to as “goods” but would have to be classified (from the
prospective of economic utility) as “bads” like industrial waste that is assigned a negative
utility value.
These are considered borderline cases. But consider the elimination of jobs through
technological advance; this is not generally held to lead to unemployability. Once a
“good” (an employable worker), always a “good.” Goods do not turn into “bads.” But
jobs involve specific skills, and job categories which existed in the past (such as elevator
operator) disappear; in fact, hundreds of job categories have vanished over the past few
decades. But economists assume that displaced workers will invariably be re-employed—
perhaps not at the same wage—but re-employed somewhere in the economy. In the long
run, the labor market is supposed to clear. But is it possible that given the advance of
technology, the ranks of the unemployable—the “bads”—will swell? Will many
displaced workers, lacking skills for the “new” economy, come to resemble the infant,
invalid, madman, or habitual criminal in terms of employment opportunities?
Consider a hypothetical economy with a thousand industries, including agricultural
production, various sorts of mineral extraction, and various sorts of industrial production.
(We assume that the hypothetical economy is a self-sufficient autarky.) There are a
hundred million inhabitants, and seventy million workers (for an average of seventy
thousand workers per industry). The remaining thirty million inhabitants are mostly
familial dependents of the workers, although there are also ten million non-workers
dependent on public assistance.
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Now suppose that through a series of rapid technical advances, four hundred of these
industries are able to achieve the same output with only 50% of the previous work force,
and that they reduce their employment by half, displacing 14 million workers. The
resulting 20% unemployment rate creates a Keynesian nightmare of insufficient
aggregate demand leading to further layoffs. Under the neoclassical market-clearing
assumption, these 14 million workers will find employment (probably at a lower wage)
elsewhere in the economy. At worst, this could lead to the Malthusian condition of
workers accepting subsistence wages. Keynes and others thought this to be impossible
due to social and political factors. But let’s ignore these and focus on job skills. What if
half of the 14 million discharged workers not only lack the ability to work with the newer
technology of their industries, but are also unqualified for any jobs in the remaining 600
industries—that they are unemployable as miners, farm hands, commercial fisherman,
etc. Where are they to obtain income to support themselves and their dependents?
Malthus only considered simple industries in which the question was not employability,
but the wages of employment. For most economists who recognize the power of
technological change, however, it is an article of faith that new industries will appear to
employ displaced workers thereby restoring aggregate demand. This belief does not flow
from the theoretical structure of neoclassical economics which has nothing to say about
the creation of new industries, merely asserting that if the price of a commodity—e.g.,
labor—is low enough, it will be consumed. In other words, “goods” remain “goods.”56
The service sector is often held out as the source of new jobs (a claim made repeatedly by
Thomas Friedman). But even lower-level service sector jobs are selective, with social
stereotypes limiting employment opportunities for those deviating from the norm in terms
of race, ethnicity, age, and language skills. And there is no reason to suppose that the
service sector can expand indefinitely. Some limiting factors are already apparent. For
example, internet retailing will increasingly limit growth in traditional retailing, the
largest segment of the service sector. What about the acclaimed high-skilled, technical
service sector jobs—the software engineers, medical technicians, consultants, and
financial experts (Friedman’s knowledge workers)? In fact, only a limited number of
displaced workers are qualified for these relatively scarce higher-level service sector jobs,
and these jobs are some of the easiest to outsource to low-wage nations like India.
The hypothetical example suggests that although national wealth is potentially increased
through technical advances, there is no automatic mechanism for absorbing displaced
workers, and unemployment or underemployment or employment in low-wage service
sector jobs will severely limit aggregate demand. Short of major government intervention
to encourage production and to redistribute its proceeds, a significant proportion of the
population is unlikely to benefit from these technological advances. Temporary
palliatives, such as that seen in the United States where an increase in consumer debt and
financing of imports through sale of domestic assets (government bonds, corporate
shares, and real property) to nations whose products are being sold to American
consumers on a massive scale, only postpone the inevitable consequences. .
This gloomy picture may seem to support, at least hypothetically, the free traders’
assertion that most of the manufacturing job loss that has occurred in recent decades is
the result of technical advances rather than from foreign competition. Such job loss is a
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real possibility, but this does not mean that every country has to suffer. Countries such as
Japan have maintained a healthy industrial sector despite high wages and foreign
competition. They have maintained relatively low unemployment rates, including high
rates of industrial employment. Japan has not seen an explosion of low-end service jobs
and (as seen in the United States) increasing numbers of persons off the employment rolls
because they are in prison, the military, or simply discouraged. This is not to say that
Japan has not suffered problems as a result of competition from China and other
developing Asian countries. But it continues to maintain a high level of good-paying
skilled industrial jobs though an emphasis on education, skilled engineering, and
targeting of high-tech industries. Japan has been committed to an export-oriented policy
for many decades, but it has not sincerely committed itself to unrestricted free trade. It
has fostered selected industries even when its wage rates were far higher than those of
potential competitors. Unlike the United States over the past thirty years, it has not
looked with complacency upon the decline of its industrial sector. In contrast, it is
worthwhile looking at what has happened in the United States during these decades.
The Deindustrialization of the United States
In the two decades following the Second World War the United States, while hardly an
autarky, was largely self-sufficient with respect to manufacturing. Less than 5% of the
economy involved foreign trade. During this period major industries exhibited sustained
growth, inflation was low and employment high, and the country experienced relatively
minor recessions. The first significant increase in imports occurred in the early nineteen
seventies, and was associated with a fall in the exchange rate of the dollar and domestic
inflation which made imports of manufactured goods from Europe and Japan—now fully
recovered from the effects of the war—more competitive in United States markets. The
nineteen-seventies saw a decline in the U.S. textile industry in the face of imports from
France, Italy, and East Asia. These changes were triggered by a further fall in the value of
the dollar, but were ultimately due to a combination of rapid industrial growth in Europe
and Asia and complacency on the part of American manufacturers who had been selling
in a relatively closed market. Because of its commitment to the doctrine of free trade and
distaste for government spending to protect or promote key industries, little was done to
counter increasing imports. A crucial turning point was reached when capital-rich
American corporations, attracted by cheap foreign labor and lack of foreign governmental
controls on working conditions and benefits, began to contact manufacturing outside the
United States or to directly invest capital in foreign enterprises; the laissez-faire attitude
adopted by the government under the influence of professional economists supported this
free flow of investment capital overseas. (These changes are discussed at length in
Fingleton)
Entire industries were allowed to wither away—consumer electronics, textiles, and an
array of light manufacturing (sporting goods, hand tools, plastic goods, etc.) During this
period the United States continued to press for a reduction in tariffs through GATT. The
trade deficit began its steady rise. These trade deficits were paid for with the sale of
American assets, including real property and financial securities—transactions that are
the modern equivalent of the outward flow of precious metals discussed by Ricardo when
precious metals backed currency (or were currency in the form of coinage).
237
Despite the decline of American industry, national income (GDP) has continued to grow.
Demand has been stimulated by government spending, primarily on military goods, and
on strong consumer demand stimulated by advertising, the expansion of retail shopping
malls, and an array of relatively low priced new consumer products (primarily electronic
goods) imported from abroad and financed by consumer borrowing. Credit cards have
facilitated the growth in consumer debt and the savings rate has decreased. In addition, a
rapid rise in home prices and a ten-fold increase in stock prices over the past 25 years
(aided by publicity touting stock ownership, foreign investment in American stocks, and
401K individual retirement accounts), have created a sense of greater wealth among
middle and upper income consumers that has led to a higher rate of consumption. And the
boom in consumer spending coupled with the expansion of retail locations has led to a
great increase in lower-level service jobs that has kept “on-the-books” unemployment
statistics at a relatively low level (until recently!).
When unemployment reached very low levels during the mid to late nineteen nineties,
inflation was expected to follow in accord with the “natural rate” hypothesis. The
assumption was that there was a natural unemployment rate (often put at 5%) and that
when unemployment fell below this rate wages would be bid up leading to price increases
and general price inflation. However, this did not happen because much of the new
employment was in low paying non-union service jobs. During the same period, higherpaid manufacturing employment continued to decline, and the ideology of “shareholder”
value led to continued cost-trimming by large corporations which, in effect, often meant
discharging better paid employees. On the product side, intense retail competition
together with downward price pressure from cheap imports countered any wage-push
effect on prices. The natural rate hypothesis failed.
The so-called service sector which provided the new jobs is claimed to provide new
export products to replace declining manufacturing exports. But this seems illusory.
Software exports are severely limited by “piracy” (copyright violations), and generic
“shareware” is increasingly available. Entertainment media including video tapes and
various sorts of disks are also widely copied. Moreover, the entertainment industry in
Europe and East and South Asia is increasingly sophisticated and less dependent upon
products produced in the United States. Finally, the outsourcing of higher-level service
sector jobs threatens not only the exports of the products of these jobs but the jobs
themselves.
Had the United States implemented policies for protecting a wide-range of intermediate
industries in the nineteen seventies and eighties, the current employment, income, and
trade situation would be far healthier. Large-scale importation of manufactured goods
greatly exacerbated the employment loss resulting from technological change by
accelerating the displacement of workers from highly paid industrial jobs. In many cases
lower foreign labor costs, even if not a large factor in determining consumer prices,
created a critical competitive edge for imports in a near zero-trade barrier environment.
An important feature of such an environment is the flow of capital accumulated over
decades in the United States to countries with lower labor costs, thus further weakening
American industry in terms of capital improvements. Appropriate protectionist measures
would have included the same sort of subtle barriers to entry that have been used
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successfully in the European Union and in Japan, measures to weaken the dollar,
increased government support for technical education and training, and investments in
advanced manufacturing technology through grants and tax write-offs. The result would
have been retention of millions of manufacturing jobs, thereby greatly reducing the cost
to national welfare occasioned by layoffs, unemployment, and displacement of workers
to low-paying retail and similar service sector jobs.
The long-term manufacturing job loss that invariably results from technological advance
would have continued, but at a much slower pace, allowing more time for researching
and testing long-term solutions to technologically-induced unemployment. Unlike the
sudden layoffs assumed by the hypothetical example, technical change is incremental,
and over time, advanced industrial societies not facing the additional shock of free-tradeinduced competition from low-wage countries have time to work out methods of
distributing goods and services to maximize welfare in the face of employment declines.
There is no natural market-clearing mechanism that will automatically solve the problems
posed by technological progress tending towards automation. Older models of central
planning are not helpful guides, but they have nonetheless served as a bogey men used by
those benefiting from free trade to frighten politicians and members of the general public
away from considering intelligent and innovative protectionist solutions.
Protectionism and Beggar-Thy-Neighbor Polices
Protectionism has continued at a relatively high level in developing countries, although
under the influence of the IMF, World Bank, and World Trade Organization (WTO),
tariffs have been gradually reduced. The largest reductions in tariffs have occurred in the
United States and other industrialized nations. One of the arguments against
protectionism discussed in Chapter 4 is not economic, but political: the fear of a spiral of
retaliatory protectionist measures leading to a trade war. Alarmists like Wolf see this as
portending the collapse of the world economic order. This is presumably primarily an
issue for the advanced industrial economies; it is fear of protectionism among these
economies that elicits fears of a “beggar-they-neighbor” trade war.
It is true that certain sorts of protectionist measures, such as the imposition of selective
tariffs in response to political agitation, may result in retaliation or the threat of
retaliation. In part the current worries result from the sets of rules and complaint
procedures that have been implemented to make deviations from free trade especially
salient. A few decades ago, when tariffs were more common, world-wide economic
growth continued unabated, and there were relatively few cries of unfair trading
practices. Even today protectionism continues in many subtler forms than imposition of
tariffs or quotas. For example, both European and American agriculture is highly
subsidized, and in the United States, Europe, and Japan, there are a number of indirect
barriers to imports, including subsidies, complex requirements relating to the production
and composition of imports, quotas, etc.
None of the suggestions offered in this book favor a world of self-sufficient autarkies.
However, there is an enormous variety of international trading arrangements other than
universal free trade. For example, a country that wished to maintain certain industries in
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the face of international competition that benefits from low wages or major efficiencies
of scale may form a symbiotic trading alliance with one or more other countries which
offer non-competing products (e.g. a country that wishes to export tropical agricultural
products and a country that imports these products and that exports motor vehicles or
sophistical capital equipment). What is commended is pragmatism, with policies decided
on the basis of local conditions, without imposition of the rigid principles that are part of
the meta-belief structure of neoclassical economic theory. This would result in a mixed
global economy in which free trade coexists with protectionism of various kinds. To
achieve this requires an evolution of attitudes towards protectionism that frees it from the
orthodox stereotypes that hold that those advocating protectionism are either misguided
or selfish (recall Keynes image of “some little fellow who is trying by sophistry and
sometimes by corruption to sneak an advantage for himself at the expense of his neighbor
and his country.”) Given a thoughtful examination of the costs and benefits of various
sorts of protectionism, it should be possible to arrive at policies that avoid setting off a
trade war. Certainly a variety of protectionist measures have been adopted by trading
nations without serious consequences, and even the post-war decades of relatively high
tariffs were free of trade wars. The ideas in this book suggest that some industries—
notably traditional agriculture—would be protected for cultural reasons, a few industries
for reasons of national security or to insure sufficient diversity to withstand boom-bust
cycles, while others—the intermediate industries discussed earlier—because of a desire
to insure full employment, preferably in good jobs. Some industries will exist in only a
very few countries either because a true geographically based strategic advantage exists
or because the industry enjoys such a advantage of scale that it is able to maintain a
dominant position with respect to its exports. In the case of any particular industry in any
particular country, more than one of these factors may coexist. Another factor that
mandates consideration of large-scale governmental intervention in economic policy is
the impending crisis in resource throughput that requires sustainable industry if we are to
avoid economic and environmental disaster.
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Chapter 9
Economic Growth and the Environment
The Challenge
Environmental threats, as conceived by leading scientists, trump economic growth from
the standpoint of human welfare. If the consensus opinion on global warming is accepted,
only a drastic reduction in the emission of greenhouse gases, notably carbon dioxide
released by the burning of fossil fuels, can mitigate ecological catastrophe. Since growth
using current manufacturing technology involves levels of carbon dioxide emissions that
will result in severe climatic change, only a decrease in the rate of growth, possibly even
a contraction of global production, or a major change in the technologies of production,
offers even the possibility of avoiding disaster. Technological change requires time,
perhaps decades, and will require incentives currently lacking in the marketplace.
Reducing growth would require extensive government intervention, and this in turn
requires a high level of public support which thus far has been lacking. In the meantime,
the world is in an overshoot situation where even the most radical measures being
discussed will prove ineffective in altering warming patterns for a minimum of decades.
And given the unanticipated rapid industrialization of China, the prospects for avoiding
catastrophe are not at all good. But clearly what is called for—either the development of
new technologies or a reduction in the release of greenhouse gases using current
technologies—will require extensive government intervention in the economy of almost
every country—in conflict with the economic meta-belief that government should play a
minimal role in the marketplace.
There is a second concern that indicates a need for governmental intervention—the
impending exhaustion of various natural resources, including petroleum. This threat is
often derided by economists because the gloomy short-term prophesies of doom offered
by the “Club of Rome” during the nineteen seventies have not materialized. But with the
unanticipated rapid economic growth of China and India creating greatly increased
demand for raw materials, resource exhaustion seems once again to present a real threat.
These two problems, resource exhaustion and global warming, jointly suggest the
urgency of government-financed or subsidized research programs relating to new
industrial technologies. The harder issue of reducing the growth of production and
consumption, and perhaps even reducing the level of global production and consumption
in absolute terms, poses major issues for aggregate welfare. Each society has its
particular cultural values. One value is associated with the consumption of products sold
in the marketplace—this is the only value recognized by fundamental economic theory.
With the necessity of reducing production, and hence consumption, to avoid
environmental catastrophe, there must be increased emphasis on non-economic values
such as personal security (including unemployment, retirement, and medical benefits), art
of various sorts, social development, intellectual and religious activities, sports and
recreation, and on and on. It has been long recognized that happiness is poorly correlated
with the accumulation of material goods, and this recognition must be extended to
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societal planning for a world far less consumption-oriented that at present. But that will
require a radical change in the voices governments and voters attend to.
How Economists Have Responded to Environmental Critics
Neoclassical economists who defend free trade typically act as if any concession to their
critics will lead them down a “slippery slope” to some sort of protectionism. This attitude
has led them to defend free trade—and the economic growth they believe it creates—as
unequivocally beneficial. One of the most serious challenges to this uncompromising
position is the obvious and extensive environmental degradation (independent of the
claimed and projected effects of global warming) that has occurred in the wake of postWorld War II economic development. Economists have struggled to come up with
arguments defending growth—which they attribute to free trade and other free market
reforms—from the charge that it has created serious environmental problems. Growth
itself is clearly the principal factor in environmental degradation, but because economists
typically attribute growth to free trade, their defense focuses on details involving trade
policies rather than the broader issue of growth.
Some of the defenses merely question the claim that there is an invariable link between
free trade and environmental damage. For example, it has been claimed that removal of
trade barriers for agricultural products would create a shift from agricultural production
in Europe, which is pesticide-intensive, to “lower-cost, manure-using agriculture in poor
countries.” (Bhagwati DG 138) Again it has been claimed that protectionist measures in
the United States that involved “voluntary” quotas on Japanese car exports resulted in a
shift to exports of more expensive luxury cars that were less fuel efficient.
The examples offered are ultimately unconvincing. It’s clear that the effect of free trade,
overall, has been to favor modern chemical-intensive large-scale agriculture over
traditional manure-based agriculture. In the case of the example of the alleged negative
environmental effect of quotas on Japanese auto imports, it is clearly inappropriate to
consider the decrease in fuel efficiency of Japanese imports without looking at the overall
American car market in terms of the replacement of low-efficiency American cars during
the 1980s with more efficient Japanese imports, the end of the oil-shock mentality of the
1970s with its associated energy conservation ethic, a rise in income among the wealthy,
etc.—all factors which played a far more important role with respect to automobile
energy consumption than anything associated the quotas. And there can be no doubt at all
that economic growth leads to more industrial byproducts which contribute to
environmental degradation. Thus if the linkage between free trade and growth holds, as
neoclassical economists believe, free trade itself contributes to environmental
degradation.
It has also been claimed that there is generally a bell-shaped curve with the highest levels
of pollution, on a national basis, occurring for countries whose income lies in the midrange. It is claimed that increasing national wealth leads to less pollution as wealthier
countries shift from primary production to cleaner types of production; for example, there
is less smog in the United States today than 75 years ago. But this seems wrongheaded on
several counts. First, it focuses only on the most-obvious kind of point-source industrial
242
pollution such as factory smoke-stack emissions or discharges of chemicals into the water
system. The key issue is the global effect of economic growth, not local effects with
respect to certain specific types of pollution. Smog may be lower in Pittsburgh, but the
overall level of greenhouse gas emissions has risen considerably in the United States over
the past 75 years, and the rate of deforestation and air and water pollution throughout the
world have shown steady increases. Few environmentalists would argue that each and
every type of pollutant has increased with increased growth. Arguments that claim a
decline in one or another specific type of pollution within particular economies do
nothing to answer critics.
A more plausible strategy for free traders has been to recommend an “economic
valuation” approach that requires that environmental damage be assigned a cost and that
that cost be weighed against offsetting welfare benefits. Thus, for example, Bhagwati
proposes that a “pollutor-pay” tax be imposed on shrimp farms to cover the
environmental social costs imposed by spillover effects from water contamination. The
idea is that free trade has both favorable (e.g. removal of agricultural subsidies) and
unfavorable (e.g. shrimp farms) effects, but that assigning specific costs to the damage
that results certain cases will resolve the problem.
A crucial move in this strategy is the claim (by Bhagwati) that if environmentalists reject
this approach, they are thereby placing an infinite value on environmental protection.
This response assumes that environmentalists accept the underlying premises of the
standard economic valuation approach which most do not. First, many of the negative
environmental effects transcend national borders, and may affect other countries more
than the country in which the damage originates. In these cases, a tax which reflected the
relative value of employment and increased national income in the country doing the
emitting against domestic environmental damage might well be insufficient to deter
negative environmental effects outside the national borders. Moreover, governments
would be unlikely to transfer tax revenues abroad to compensate for environmental
damage caused by economic activity within their national territories. Bhagwati’s answer
to this problem is to recommend international treaties that feature “efficient design” and
distributional fairness, and that are “packaged” to gain assent. Efficient design would be
realized by charging each country for its net emissions of carbons minus its absorption of
carbon, a solution related to the internal taxes proposed in the case of domestic pollution.
The prospect of effective treaties of this sort seems remote, however.
Another problem is that environmental tax proposals assume some kind of extra-market
means of evaluating the cost of pollution since, by definition, pollution is a negative
externality without a natural market valuation. As Bhagwati notes, different societies will
place different negative values on avoiding pollution. A very poor country, whose
citizens depend on a given industry to maintain a minimum standard of living, may place
a far lower cost on noxious waste discharges into rivers or into the atmosphere than a
wealthy country with a more diverse economy. The preservation of endangered species
may seem of little value in a country with a substantial hunger problem. The problem is
magnified when the issue is pollution that affects other countries, perhaps even the entire
global biosphere such as greenhouse gas emissions.
243
The usual neoclassical reverence for market mechanisms leads to a narrowing of the
scope of potential solutions and an attempt to represent as a market solution what is, at
root, a political solution. Market supply and demand do not determine the size of the
proposed taxes or how they are spent. And establishing a market for buying and selling
pollution credits—a solution commonly advocated by economists and currently before
the U.S. Congress—does not alter the essential role of political decision-making in
defining the “products” being bought and sold, the thresholds at which penalties apply, or
the size of the penalties. Recent European experience throws doubt on the effectiveness
of this approach.
Environmentalists are not claiming an infinite value for environmental protection because
they object to the “solution” of using pollution taxes and credits; their position is little
different from the commonsense position that would object to a proposal to replace all
jail sentences with fines. What is the price of a mugging? A rape? A murder? Is the
refusal by society to set a price on these crimes, to require that criminals pay taxes to
compensate the damage caused by their crimes in lieu of jail sentences, evidence that
society holds such criminal acts to be infinitely damaging?
The social goal of criminal penalties, at least from a utilitarian prospective, is to deter
crime. The severity of the penalty depends on the crime and its circumstances; in contrast
to a tax or fine, the subjective severity is unrelated to the wealth of the perpetrator.
Similarly, environmentalists are not generally comfortable with a world in which large
highly profitable polluters pay penalties (or buy credits) that enable them to continue
polluting, whereas poorer or low-profit polluters who cannot afford the taxes or penalties
have little choice but to forego production however beneficial such production may be in
terms of sustaining life or providing for basic human needs. Of course it is obvious in the
case of criminal acts that the wealthy have an easier time of it than the poor. They can
pay for a better legal defense and prisons for the crimes they commit are often (relatively)
much more comfortable. But would we wish to vastly extend this imbalance by
substituting fines for jail terms for those who can afford to pay?
Bhagwati is not completely doctrinaire on the issue; he does suggest, for example, nonmarket solutions such as supplying fishermen in poor countries with TED’s (turtleexcluding devices) to replace the purse seine nets that trap and kill rare sea turtles. But
this suggestion is offered in the context of seeking alternatives to trade-linked sanctions.
Once one abandons the economist’s preoccupation with trying to find a “market” solution
by assigning prices to pollution or by creating a markets (or pseudo-market) for trading
pollution credits, the way is open to a variety of solutions akin to the supplying of new
fishing nets. These solutions would have little to do with nominal market solutions or
other neoclassical fixes. Hefty pollution taxes or fines in wealthy countries could be
devoted funding research and production of relatively non-polluting technologies,
including technologies which would be principally used in poorer countries. It would be
worthwhile forming, by international treaty, international research institutions to do the
same. These institutions could be supported internationally by such pollution taxes.
Moreover, at this point there is an argument for trade sanctions against countries that
refused to collect such taxes. Again, each case is different and each proposal has to be
244
evaluated within its specific social, economic, and cultural context. This is quite different
from the usual economist’s approach which sees free trade as essentially untouchable,
and sees problems associated with free trade as properly addressed only through market
mechanisms.
Final Note
Unlike the authors of many books that discuss the looming environmental problems
resulting from economic growth, I am not an optimist, certainly not the habitual “cautious
optimist” that such authors frequently claim themselves to be in their concluding
remarks. I fully expect an environmental disaster that will cause incalculable suffering
and mark a regression in civilization. However, I cannot tolerate the ongoing obfuscation
that springs from the unrealistic theory that lies at the core of modern economics and that
inspires much of the destructive advice offered to government leaders and voters by
professional economists. Still there are greater and lesser potential disasters, and the
sooner opinion-makers free themselves of their ill-founded reverence for self-styled
economic “scientists” who see free trade and free market policies in general as universal
blessings, the more likely we are to avoid the worst of the potential disasters. Will this
happen in time? I seriously doubt it, but human action is never entirely predictable, and
surprising turns in collective thinking have happened periodically in human history.
Perhaps we’ll get lucky and experience such a change that will enable the painful
adjustments needed to mitigate the impending disaster.
245
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Jeffrey D. Sachs, The End of Poverty, Penguin Press, New York, 2005.
Jeffrey Sach et. al., Ending Africa’s Poverty Trap, Brookings Institute, 2004.
Frank Safford and Marco Palacios, Colombia, Fragmented Land, Divided Society,
Oxford University Press, New York, 2002.
Paul Samuelson, Economics, Third Edition, McGraw-Hill, New York, 1955.
Barry Schwartz, The Paradox of Choice, Harper Collins, New York, 2004.
Adam Smith, Wealth of Nations, Prometheus Books, New York, 1991.
Stephen C. Smith, Case Studies in Economic Development, Second Edition, AddisonWesley-Longman, Reading, Massachusetts, 1997.
Brian Snowdon, Howard Vane and Peter Wynarczyk, A Modern Guide to
Macroeconomis, Edward Elgar, Cheltenham, UK, 1994.
George Soros, On Globalization, Public Affairs, Perseus Books Group, 2002.
Ross M. Starr, General Equilibrium Theory, An Introduction, Cambridge University
Press, Cambridge, 1997.
248
Joseph E. Stiglitz, Globalization and Its Discontents, W.W. Norton, New York, 2002.
Jean-Philippe Stijns, An Empirical Test of the Dutch Disease Hypothesis Using a Gravity
Model of Trade, Accepted for presentation at the 2003 Congress of the EEA, Stockholm,
August 20 to August 24. Found at: http://129.3.20.41/eps/it/papers/0305/0305001.pdf
Philip E. Tetlock, et al., eds, Behavior, Society, and International Conflict, Vol. III,
Oxford University Press, New York, 1993.
Philip E. Tetlock, Expert Political Judgment: How Good is It? How Can We Know?,
Princeton University Press, Princeton, 2005.
Michael P. Todaro and Stephen C. Smith, Economic Development, Ninth Edition, 2006,
Addison-Wesley, Boston.
Hal R. Varian, Microeconomic Analysis, Third Edition, Norton, New York, 1992.
Hal R. Varian, Intermediate Microeconomics, Fifth Edition, Norton, New York, 1999.
Charles Wheelan, Naked Economics, W. W. Norton, New York, 2002.
E. Roy Weintraub, General Equilibrium Analysis, Cambridge University Press,
Cambridge, 1985.
E. Roy Weintraub, Stabilizing Dynamics, Cambridge University Press, Cambridge, 1991.
Martin Wolf, Why Globalization Works, Yale University Press, New Haven, 2004.
249
Endnotes
1
For example, the front-page story in the November 18, 2005, Christian Science
Monitor entitled “Free Trade Losing Steam” begins “When leaders of Asian and
American nations meet today at an economic summit in South Korea, they have an
ambitious goal: revive negotiations on a new global agreement to reduce trade barriers—
a move that experts say could add some $300 billion a year to the global economy and
help lift millions of people out of poverty.” The article continues, “History suggests that
trade helps much more than it hurts... High tariffs, by contrast, were a hallmark of the
Great Depression.”
2
For example, Dani Rodrik, In Search of Prosperity, Dwight Perkins et al.,
Economics of Development, Michael Todaro and Stephen Smith, Economic Development,
William Easterly, The Elusive Quest for Growth, and Joseph Stigliz, Globalization and
Its Discontents.
3
For example Charles Wheelan in Naked Economics; but this is a very common
refrain among pro-globalization journalists.
The Economics Nobel Prize is indeed unique. It was not part of Alfred Nobel’s
bequest but resulted from a grant by the Bank of Sweden in 1968. Thus it is not properly
a “Nobel Prize” but rather a prize “in honor of Alfred Nobel.” The medal even differs
from the other medals. However, journalists and the general public treat the economics
prize as on a par with the other prizes. This has had the undeniable effect of helping to
elevate the status of economics in the popular imagination to that of a “real science” like
physics, chemistry, or biology. This is attested to by a recent “News Scan” in Scientific
American (Dec. 2005, p. 34), which describes the winners of various prizes (including
economics) after an introductory paragraph that begins “almost 110 years ago Alfred
Nobel left a will...” There is no mention of the parvenu status of the economics prize; it is
listed along with the prizes for physics, chemistry, and medicine. Scientific American
now regularly features articles by economists.
4
5
In a concession to social critics of modern capitalism, Wolf notes that when there
are great inequalities in wealth and income, a society may became unstable and
democracy may prove inconsistent with sustained economic liberalism. (29)
6
The economist Jeffrey Sachs has noted that one finds corruption everywhere, but
only a few places where it is so massive as to preclude development. See The End of
Poverty: An Interview with Jeffrey Sachs, Mother Jones, May 6, 2005. Also Sachs, et. al.,
“Ending Africa’s Poverty Trap,” Brookings Institute, 2004.
7
For an account of this period, with emphasis on the relationship of economics to
the militarization of the United States after the Second World War, see Mirowski,
Machine Dreams.
8
John Kenneth Galbraith, the only influential institutionalist economist in the postwar period, was regarded by his neoclassical colleagues as an intellectual lightweight.
(Krugman, pp. 13-14)
250
9
For example, Krugman and Obstfeld in their text International Economics write
“The problem with many arguments for strategic trade policy is precisely that they do not
link the case for government intervention to any particular failure of the assumptions on
which the case for laissez-faire rests.” (279)
10
This is mere mathematical existence: among the infinity of mathematicallyformalized models that meet the axioms of neoclassical theory, it can be shown
mathematically that at least one such model is in a state of general equilibrium. But even
if some real economy were to satisfy the assumptions of an equilibrium model,
neoclassical theory provides no dynamics; that is, there is no theoretical explanation of
how it could have evolved to its equilibrium state. See Richter and Wong.
11
It is interesting to note that DeLong, in a different context, takes a rather different
view of Smith’s benevolent “invisible hand”: “Adam Smith’s case for the invisible hand
so briefly summarized above will be familiar to almost all readers: it is one of the
foundation-stones of our civilization’s social thought. Our purpose in this chapter is to
shake these foundations…” (November 14, 1999 draft of his book The Next Economy,
Section A found on his website.)
12
DeLong is more circumspect in his discussion of globalization in other contexts.
For example, he writes (in a review of William Easterly, The Elusive Quest for Growth:
Economists’ Adventures and Misadventures in the Tropics, Cambridge, MIT Press,
2001), “The hope is that privatization and world economic integration will in the long
run help create the rest of the preconditions for successful development. But we are
playing this card not because we think it is a winner, but because it is the last one in our
hand.” (On DeLong’s website)
13
For example, see Chapter Four of the textbook by Todaro and Smith. Developing
economies are said by them to have “multiple equilibria” in contrast to the single
equilibrium state of advanced industrial economies.
The proof of the “existence” of a general equilibrium is what is known in
mathematics as a “non-constructive” proof, meaning that the competitive equilibrium
model is never presented. More importantly, it has been shown that there is no algorithm
or set of procedures (no matter how long or how impractical they might be) that can
move from a non-equilibrium set of prices to a set of equilibrium prices through stepwise price adjustments. In fact, even the most powerful conceivable computer (called a
Turing machine) can be programmed to ensure the convergence of a set of nonequilibrium prices to a set of equilibrium prices. (Richter and Wong)
14
15
The failure of various attempts to produce a theory of dynamics within
neoclassical theory is described in Weintraub, Stabilizing Dynamics.
16
There are exceptions: the Nobel Prize winning economist Robert Lucas actually
believes that the United States economy is in a state of competitive equilibrium and that
unemployment—the failure of the labor market to clear—is illusory. Unemployment,
according to Lucas, results from rational decision-making by individual agents, hence it
is voluntary. See Marilu McCarty’s book The Nobel Laureates, p. 155.
251
17
The extent to which this normative meta-belief structure has contaminated
everyday educated thinking is illustrated by a remark by Jared Diamond in his book
Collapse that deals with economically-induced environmental disasters. Diamond can
hardly be labeled a doctrinaire supporter of neoclassical economics, yet he writes “If
Chevron were to spend money on environmental policies that ultimately decreased its
profits from its oil operations, its shareholders would and should sue it.” (446) The word
“should” suggests a commitment to the view that the maximization of profit is a moral
responsibility of a corporation. Yet we would normally praise an individual owner who
chose to use company funds for a laudatory purpose that reduces the company’s profit;
why should shareholders who jointly own a large corporation be treated differently?
18
Discussed in microeconomics texts such as those by Varian.
A good illustration is Chapter 4 of Wolf’s Why Globalization Works, entitled
“The ‘Magic’ of the Market.”
19
20
For example, this quotation from Mark Rosenzweig of the Kennedy School, in a
news report about antipoverty programs: “Growth depends more on institutions, such as
the status of property rights, which affect how people respond to interventions.”
(Scientific American, December 2005, p. 20)
Marshall’s Tendencies: What Can Economists Know? An entire issue of the
academic journal Economics and Philosophy was devoted to a discussion of Sutton’s
book (Vol. 18, 1, April 2002).
21
Eichner writes “Students who evidence difficulty in accepting a neoclassical
framework inevitably receive lower grades in their courses, are less likely to pass their
qualifying exams, can expect more criticism and other forms of resistance to the research
they want to carry out, and in every other way will find their progress as a student
impeded.” p. 234. It should be noted that acceptance of the manifestly false assumptions
of neoclassical theory is akin to acceptance of religious principles or Marxist principles;
in each case, there is conviction that the neophyte is being inducted into a privileged elite
that seeks to solve the world’s big problems through application of arcane knowledge.
22
23
This species-flow analysis was first presented by David Hume in his 1752 essay
Of the Balance of Trade. See the discussion on p. 693 of Volume 2 of the New Palgrave
Dictionary of Economics, and on pp. 431-432 of Volume 4.
24
There is a good discussion of the modern support for floating exchange rates in
Irwin, Against the Tide, 202-203.
25
This decline might result from a fall in nominal wages (denominated in the local
currency) or, more likely, from a decline in the exchange rate for the Portuguese
currency.
26
In order to isolate the direct effects of free trade according to the Ricardian
model, we have (unrealistically) assumed no productivity increase in Northland over a
period of perhaps decades. Perhaps free trade does promote technological advances and
productivity increases, but that is not the argument under analysis, and that is certainly
not the argument economists have in mind when they scold skeptics for their ignorance of
economic theory.
252
27
The neoclassical insistence that interpersonal welfare comparisons lie outside the
purview of economic science can be traced back to classical economists such as Nassau
Senior and John Stuart Mill. This, plus the view that welfare is measurable only in terms
of consumption led to the view that one equilibrium solution was superior to another if
there is some redistribution that insures that everyone is at least as well off (in terms of
goods consumed) in the superior solution as in the other and that at least some agents are
better off. This runs into technical problems since there are at least two different sorts of
distribution possible: (1) potential losers effectively bribing the potential winners from
free trade to maintain the (protectionist) status quo and (2) future winners compensating
future losers out of their gains. But from a commonsense perspective, the biggest
problems are the practicality and likelihood of winners compensating losers and the
unrealistic assumption that human welfare is determined by the level of consumption of
commodities. A discussion of the first of these issues is found in Against the Tide, by
Douglas Irwin, Chapter 12.
Irwin, 198. Surprisingly, Keynes’ polemic was produced in the context of a
discussion of the advantages for Britain of certain protectionist policies.
28
29
Undergraduate economics textbooks offer simple presentations of the
neoclassical concepts of marginal cost and marginal revenue. See for, example,
Nicholson, Microeconomic Theory, Chapter 11, or Varian, Intermediate Microeconomics,
Chapter 21. A good critical discussion is found in Hausman, Chapter 3 and also on 158-9.
30
An elementary discussion is found in Krugman, Peddling Prosperity, Chapter 9,
“The Economics of Qwerty.”
31
One of the best-known books on development economics expresses the
frustration with developing economies in its title The Elusive Quest for Growth:
Economists’ Adventures and Misadventures in the Tropics by William Easterly. His latest
book on the same subject is entitled (apparently with tongue-in-cheek) The White Man’s
Burden. Easterly’s viewpoint is briefly discussed in the next chapter.
32
For a summary, see Jones, Introduction to Economic Growth.
33
The concept of a production function is a questionable means of dealing with
production in economic theory in any case. See the extensive criticism in More Heat
Than Light.
The reasoning behind Solow’s thinking is discussed in Chapter 3 of Easterly’s
The Elusive Quest for Growth. Easterly notes that economic theory would limit growth
based on simply increasing capital because the increase of a single factor ultimately leads
to diminishing returns. Technology advances render capital more efficient thereby
escaping this trap. Of course, this reasoning is simply another example of treating the
neoclassical meta-assumptions as if they actually described (a context-free) economic
reality.
34
35
The introductory selection in Lal and Snape; page references are to the PDF
version appearing on Bhagwati’s website.
36
Various models are discussed in Jones.
253
37
For a history of the failure of general equilibrium theory to discover such a
theory, see E. Roy Weintraub, Stabilizing Dynamics.
Wheelan writes, “These are local decisions that ought to be made by the people
affected—those who might eat in the safe, clean environment of a McDonald’s restaurant
as well as those who may have fast-food wrappers blown in their gutters. Free trade is
consistent with one of our most fundamental liberal values: the right to make our own
private decisions.” (p. 200). Food wrappers in the gutter and the effect on an historic
district of a McDonald’s are what economists refer to as “negative externalities.” These
pose a major problem with welfare claims made for a completely free market.
38
39
In rejecting claims that excess population in undeveloped countries leads to
unemployment, Easterly writes “An additional person has the incentive to find productive
employment to subsist. The real wage will adjust until the demand for workers equals
their supply.” (93)
To be distinguished from “institutionalism” the school of economics that
competed with neoclassicism early in the twentieth century.
40
41
A very positive picture of Kerala is given in Hope, Human and Wild, by Bill
McKibben.,
42
In fact, China is not unique in adopting non-standard institutions—Quian briefly
mentions the case of Germany which, as a relatively late-comer to the industrial
revolution, also adopted various special institutions to catch up with and eventually to
pass England and France. He also mentions two successful small Third World economies,
Botswana (a conspicuous exception in sub-Saharan Africa) and Mauritius.
43
For example, see the discussion of industrialization program in Colombia in the
1960s and 1970s in Safford and Palacios, pp. 312-314.
Stijns, p. 13, citing Spilimbergo, A. (1999), “Copper and the Chilean Economy:
1960-1998,” IMF Working Paper 99/57, April: 1-33.
44
45
The effect of a newly valuable export on exchange rates and inflation in the
exporting country was discussed by Ricardo (Principles, pp. 100 ff.)
McMahon, G (1997), “The Natural Resource Curse: Myth or Reality?” Economic
Development Institute, World Bank, Washington, D.C.
46
47
A number of studies are reviewed and cited in the paper by Stijns. Stijns also
offers a typical neoclassical model (“a gravity model of trade”).
48
Discussed in Safford and Palacios, pp. 308; 315-316 and by Stijns, p. 13.
49
This is the main conclusion of Stijns paper, at least concerning exports of
manufactures. His “gravity model” predicts that overall that a one percent increase in an
energy country’s net energy exports decreased its real manufacturing exports by eight
percent. But the variety of outcomes shown in case studies undermines the credibility of
the model and its predictions.
50
In his discussion, Stijns writes that it is not plausible that domestic manufacturing
increases while manufacturing exports fall because exports are too strongly affected by
254
resource booms. However, this assumes that the export market for manufactured goods is
proportionately large, and this was not the case in the United States in the nineteenth
century when tariffs were high. (8-9)
51
Even left-leaning economists like Todaro and Smith portray the poor inhabitants
of Third World countries as uniformly miserable and inhabitants of wealthier countries as
relatively happier. This is really a psychological question, and surveys of personal
attitudes show little correlation between national wealth and self-perceived levels of
happiness. The assumption that happiness somehow correlates to material wealth is
fundamental to the meta-belief structure of neoclassical theory and is, in fact, more
universally accepted among economists than many of the explicit assumptions of the
theory. See Argyle, especially Chapter 9.
52
A good discussion is found in Snowdon et al., Chapter 2.
53
Of course, better manufacturing methods mean that television sets produced in
countries like United States today could be, relatively speaking, cheaper than television
sets produced in the United States thirty years ago. Falling consumer prices are not
merely the result of cheap foreign imports but also of technological progress.
54
Krugman and Obstfeld attempt to minimize the frequently-made claim about the
loss of high paying manufacturing jobs. They estimate the loss of high income
manufacturing jobs and their replacement with service jobs amounts to only 0.1 percent
of American national income, although they provide neither arguments nor references;
they merely call it “a typical estimate.” (278)
The frequently discussed disadvantage of the (former) “Big Three” American vehicle
manufacturers—legacy commitments to pension funds—is the result of the anomalous
situation in the United States where medical and retirement benefits are largely the
responsibility of private companies. From an operational perspective, there is relatively
little difference between an American and a Japanese automobile manufacturer.
55
56
A related neoclassical belief holds that total satiation never sets in; consumers
value increasing amounts of every good, although their marginal valuations continue to
decrease.