Cleaver Economics The Basics (Routledge, 2004)
.pdfbasic economics and it is vitally important that we analyse it fully here. To emphasise: the argument is that free trade would lead to huge welfare gains (especially for poorer nations) if it were widely implemented.
Some simple examples are necessary to explain the argument. First, take the obvious case where two counties are efficient in producing different goods (say, one in computers and one in cars). It makes sense that each specialises in what they are good at and trade for the other. Both nations clearly benefit.
Now consider the non-obvious case where one country appears to be more efficient in all its industries compared to its lessdeveloped neighbour. What do these two nations have to gain from trade? A common argument heard in the poor world is that they have everything to lose by being exploited by bigger, richer trading partners. On the other hand, a familiar cry that goes up in developed nations on these occasions is that free trade means exporting jobs to low-wage countries.
Clearly in this scenario both rich and poor cannot claim they are each losing out to the other. We have to look closer to examine the economic consequences of trade between unequal partners.
Consider an analogy: the university professor of automotive engineering who happens to be a good car mechanic. Is it worth fixing her own car when it breaks down or should she take it to the local garage?
The engineering professor may be the world s leading expert on the internal combustion engine but while she is producing a revolutionary new design that is lighter in weight, uses less fuel and comes at 10 per cent less cost, she cannot at the same time get under her own car and fix the fault. What should she do?
This is an example of comparative advantage. The local garage mechanics may not be able to redesign the future of the motor industry but they can certainly help fix problematic cars. They may not be as efficient as the engineer in diagnosing and correcting the particular fault in question but, by leaving them to get on with it, the professor can specialise in what she does best. It is simply not worth her while trying to do everything she evidently can do.
Meanwhile the local mechanics have work they can get on with that otherwise they would have been denied and, even more
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important, by starting with relatively low skill jobs they may eventually develop more exacting careers.
This analogy should help explain the economic strategies open to developed and underdeveloped industrial nations. For example, the USA may be absolutely more efficient than Mexico in both industrial engineering and in car assembly plants. Nonetheless it pays the US to specialise in that pursuit in which it has the greatest comparative advantage, engineering, and leave the car assembly plant to locate south of the Rio Grande.
Mexico meanwhile can start work on producing cars. In this example it has no ABSOLUTE ADVANTAGE but retains a comparative advantage in car assembly (i.e. compared to engineering design). It may employ more labour than would be the case in a similar factory north of the border, productivity might be lower and those employed may not develop many sophisticated skills at first, but economic development has to start somewhere and, in this example, car assembly is the place. (INFANT INDUSTRIES like this are in fact a typical way to start the process of growth and development.)
How does a country know in which industries it possesses comparative advantage? Two Swedish economists, Eli Heckscher and Bertil Ohlin, argued that a nation will have an advantage in industries which use intensively those factors of production that the country has in abundance. Thus the USA can specialise in hightech goods that require abundant supplies of highly skilled labour; Mexico can specialise in industrial goods that employ large numbers of lower skilled personnel.
One dynamic implication of the Heckscher—Ohlin theory is that, over time as specialisation occurs, the rewards will rise to the factor in production increasingly employed in trade. This has income DISTRIBUTION EFFECTS for the countries concerned. In the hypothetical example used here, it means that lower skilled workers in Mexico should gain more earnings over time; similarly, returns to technical qualifications in the USA should improve. Note that these distribution effects can have important social and political consequences for the countries concerned and any tensions that arise must be carefully managed. There is no better example of this than the case of Argentina (see Box 6.5).
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Box 6.5 Trade, specialisation and income growth – the social and political consequences
One hundred years ago, Argentina was a fast-developing country with a high per capita income equal to or better than many European states. It stood comparison with Canada and Australia as a huge, resource-rich land of recent settlement that became a world leader in the production of a staple product – beef – for overseas markets.
Staple theory explains the way in which specialisation in the export of a key primary product can create a network of linkages in the developing country – the spread of transport and commercial INFRASTRUCTURE and the development of port facilities that typifies what occurred in and around Buenos Aires and the Argentine Pampas. Note, however, that modern export-led development is not just determined by advantageous overseas demand conditions – it is crucially dependent on supply-side factors. The fact that Argentina became a world leader in the export of beef, rather than wheat which it could also produce, was because the enterprise, investment and expertise that it developed in cattle ranching was far more innovative and dynamic than any other farming or industrial practice at the time. It thus spawned complementary investment in the latest techniques of stock breeding, refrigerated transport and modern banking and financial facilities and attracted great inflows of European capital and immigration in the three decades running up to the First World War.
Argentina was the leading Latin American economy for most of the twentieth century in terms of its national income and national income per capita but the Great Depression of the 1930s resulted in a sudden collapse in overseas markets. The political consequences were immense. The land-owning, liberal aristocracy that favoured export led policies now lost out to urban-based, nationalist, populist opinion that demanded policies favouring industrial development.
Argentina entered the post-Second World War period with a well-established, domestically-owned industrial sector, a
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well-integrated economy with efficient export-orientated agriculture, little persistent unemployment, wide access to education and, relative to the region, less inequality. It came closer to the standard neoclassical ideal, with all factors of production scarce and valuable in market terms, than almost any other less developed country. It was not a less developed country.
Juan Domingo Peron was elected Argentine President in 1946, principally by urban voters. He immediately set about implementing an economic strategy that was industrialist, protectionist, based on government direction and subsidy and designed to transfer resources from agriculture and the landowning elite towards industrial working classes. The policy stance was extreme: reducing farm export incomes by a half of their real value by insisting all sales went through government marketing boards at fixed low prices. (See monopsony, Chapter 1.) Meanwhile urban real wages increased by around 62 per cent between 1946 and 1949.
As a strategy to redistribute incomes, these policies were outstandingly successful but their extremism built in to Argentine society major long-term problems: bitter division of industry against agriculture; government as patron and provider rather than market policeman, and increasing fiscal deficits and external trade imbalances. The country was set on a post-war path of sluggish inefficiency and contradictory objectives.
An economy that was based on export agriculture but which protects industry, depresses agricultural incomes and inflates urban ones is bound on the one hand to reduce export revenues while on the other promote increased expenditure on foreign consumer goods. Further, when the main exports are meat and wheat then increased urban incomes and consumption tend to divert these potential exports into the domestic market.
The post-war Peron government thus ran into inevitable balance of payments difficulties and stop-go growth. The only way to stop trade deficits was to stop growth in spending. As soon as spending resumed the deficits came back. Efforts to restore incentives to primary exporters by devaluing the currency only promoted demonstrations from well-organised urban workers and
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industrialists. Trying to buy off both sides then resulted in fiscal deficits and inflation. A spiral of inflation, devaluations, increased wage demands, increased public spending, inflation etc was thus institutionalised: the economic consequences of domestic social conflict. The military forced Peron into exile in 1955 but the basic fault-lines in Argentine society, polity and economy remained and, to this day, they still hamstring attempts to secure economic growth and development.
The Argentine experience shows that international trade can bring immense rewards – and the market may distribute these in ways that are not always popular. Government management of the gains from trade can then be fraught with difficulty (though see Box 6.7 on Korea).
A R G U M E N T S F O R T R A D E P R O T E C T I O N
In all countries there are likely to be winners and losers as trade expands. The most common argument against free trade is that it creates unemployment in those domestic industries that cannot compete against cheap imports. While this is undoubtedly true, it is nonetheless argued that there are sufficient welfare gains to be made by unrestricted trading to compensate the losers and still leave a net gain for the country as a whole. The principle is as true for individuals as it is true for communities: by specialising in certain employments you can earn more than if you try to produce everything yourself.
P o l i t i c a l A r g u m e n t s
While the economic equation is clearly weighted in favour of trade, however, the political argument may not be. Try convincing the farmers in industrial countries that they have no comparative advantage. Inefficient (in world terms) farmers in Europe have been blocking reforms to the COMMON AGRICULTURAL POLICY (the CAP) for years —much to the chagrin and cost of both poor country producers and rich country consumers. While it is true that, in theory, a country
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Box 6.6 Protecting the farmers
Agriculture is subsidised in many rich-world countries for a variety of reasons. Farming is liable to large swings in output as unpredictable weather, disease and other misfortunes have their impact. Agricultural prices are thus very variable in free market conditions
– hence the demand for government intervention to stabilise prices and farm incomes. In many countries, also, the agricultural lobby is a powerful political force – partly as a result of strong emotional attachment to the countryside and the historic (now redundant?) strategic need to guarantee domestic food supplies.
Government subsidies to farmers in the developed world, however, act against the interests of poorer countries who have little else to export. Far from free trade, we have a global system that fixes the rules to keep rich farmers’ incomes up and poor countries’ incomes down. In the last round of world trade discussions (The Uruguay Round, 1986–93) between rich and poor nations, agriculture was deliberately kept off the agenda. The World Trade Organisation has insisted that in the present round of negotiations (The Doha Round, supposed to be concluded in 2005) agriculture is kept very firmly in centre focus. Unfortunately, the European Union is unlikely to make any sizeable concession to modify its system of farm subsidies in the CAP and the USA, in response, is therefore unlikely to move much either. It seems that free trade in agricultural products – which would be the single most important measure to improve developing country incomes – is still a long way off.
Source: see www.wto.org for a record of past and up-to-date news on agricultural trade negotiations.
can compensate losers in trade this does not mean that all people who stand to lose out will trust their governments to actually do that.
I n f a n t I n d u s t r i e s
The fastest growing economies in the world, in East Asia, have not pursued blanket free trade policies as a means of raising their
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incomes. They have, in fact, been careful to protect their infant industries as a means of developing their potential.
Consider the case of car production. Korea had no comparative advantage in this industry, at first. Enormous US, European and Japanese car giants could exploit economies of scale to keep costs of production down and — with product names and logos wellrecognised all round the world —there were considerable barriers to entry into this global market place. Nonetheless, the South Korean government realised that comparative advantage is a dynamic, not a static concept. What seems impossible today might not be so tomorrow. Policies were therefore implemented to raise levels of general education and to support management training. Similarly, the growing capital markets (domestic banks and money traders) were instructed to give low cost access to finance to certain chosen sectors, and the government gave tax breaks, subsidised investment and, directly and indirectly, encouraged the growth of fledgling export industries that would otherwise have been unable to compete in world markets. The strategy worked. Korea now has a highly skilled and hard-working urban, industrial workforce and a capital market structure that gives its motor industry a competitive advantage.
Infant industries need protection from world competition until they have grown up enough to cope with it. Free trade may be the best policy in the long run but in the short term there are sound economic arguments to grant protection as a means to that end. (Note, however, that all involved must accept that government protection is short term only. Dependent infants have no incentive to grow up otherwise.)
‘ E x t e r n a l ’ E f f e c t s
The Korean example given previously introduces the concept of EXTERNALITIES. Markets will fail to allocate resources efficiently if their prices do not reflect all the external costs and benefits involved in both production and consumption. If many of the rewards for a certain enterprise are all external (e.g. workers receive excellent training in accountancy then leave to set up their own businesses) then it profits the entrepreneur little to start up. Government must take a lead in these circumstances (Box 6.7).
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Box 6.7 Korean steel and administrative guidance
The case of POSCO, Korea’s state-owned integrated steel industry, is an excellent example of how governments can overcome MARKET FAILURE. In the early 1970s the Korean government applied for a concessionary loan (i.e. at a lower than market rate of interest) from the World Bank to build a steel mill. The application was rejected on the grounds that Korea possessed no comparative advantage in steel. The World Bank, using standard market valuation, was correct in its decision. There are enormous economies of scale in building such capital equipment, (see Chapter 3) which implies a long gestation period before output is large enough to be efficient. And where was the market for all the steel that was proposed? World markets were glutted and domestic steel demands in this developing country were not great. Thus returns on any investment in Korean steel seemed to be way below market rates for the foreseeable future.
The government went ahead with the investment anyway and found its own finance. Additionally, the government provided essential infrastructure such as water supplies, port facilities, power stations, road and rail communications. Manufacturing in chosen sectors – like the motor industry – was also subsidised so that steel production when it eventually came on-stream had a ready-made market. Current market signals were, in effect, ignored and producers were responding to government commands – a system in East Asia known as ADMINISTRATIVE GUIDANCE. Some years later, POSCO eventually won the World Bank accolade of being ‘the world’s most efficient producer of steel’, out-competing many other producers around the globe. Moreover, its success stimulated a host of domestic supply industries to set up which could now sell a range of products to the steel mills: the fraction of local content in POSCO’s output increased from 44 to 75 per cent between 1977 and 1984.
Source: Rodrik, D. (1995) ‘Getting Interventions Right: How South Korea and Taiwan Grew Rich’ Economic Policy 20.
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Direct government allocation can thus lead to greater efficiency than free markets are able to secure on their own. Countries learn by doing. Management skills improve in coping with developing industries. Technology (like skills) can be expensive to develop but quick to disperse. Linkages between industries can be exploited — both forward and backward. A cement plant provides construction materials for office blocks (a forward linkage), whilst pulp and paper industries set up to produce sacks for cement (a backward linkage). No one industry would contemplate starting on their own but if all set up more or less together the costs for all would be reduced. Coordinating such decisions and implementing them requires the hand of government.
There are negative externalities that markets omit also. Free trade and specialisation can promote the exploitation of exhaustible natural resources. For example, Borneo in East Malaysia has a wealth of tropical rainforest which supports irreplaceable ecologies — yet the profits received by private logging companies for selling hardwoods to customers overseas do nothing to compensate for the loss of precious eco-diversity. Similarly, tourism is frequently cited as an industry that many poor countries can develop but this too can bring problems. Cultural pollution occurs —a superficial materialism that begins to erode a rich cultural and spiritual heritage.
As a general aim, therefore, free trade has much to commend it but arguments given in this section show that it must be carefully managed. There are a variety of private and social costs and benefits involved in opening up sectors of an economy to trade. National income and welfare may be enhanced by trade in the long run but development takes time and governments may need to give guidance, support and, indeed, protection to certain natural and cultural assets whose values are not recognised in the short term. Getting the policy mix right in all circumstances is not easy.
M U LT I N AT I O N A L C O M P A N I E S
The dilemma of how best to secure free trade but not to lose out in the process is central to the relationship between MULTINATIONAL CORPORATIONS (MNCs) and host governments in the developing world.
Two thirds of international trade nowadays is handled by businesses that own assets in more than one country. For example,
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much internal firm trade now crosses borders: a firm producing raw materials in one country sells supplies to a manufacturing affiliate in another and the finished product may be marketed by a sales office of the same corporate family located in yet another part of the world.
There is no doubt that one of the major economic trends of the last fifty years or so has been the phenomenal growth and global reach of MNCs. Business empires have built up all over the world such that companies like the Swiss-based Nestle SA own assets worth US$37.7 billion (1997), 93 per cent of which are held overseas and which are more highly valued than the GDP of many poor nations (e.g. Ghana US$5.4 billion; Guatemala US$19.0 billion; Morocco US$33.3 billion and Romania US$36.7 billion).
The concentration of economic power in the hands of profitseeking global enterprises has become a source of much controversy. The huge flows of FDI into and out of different countries is potentially very unsettling for any national economy. What represents a good business decision for any one MNC may not be good business for the country that hosts its operations. At the same time, nations can benefit greatly from the resources and technology that foreign firms can bring into (particularly) developing countries. There are therefore arguments both for and against opening borders to international business and governments, academics, journalists and many members of the public have all expressed concerns over the issue (see Box 6.8).
Box 6.8 Multinationals at bay?
Some high-profile MNCs make easy targets for anti-globalisation critics. There are many arguments to be found in books, articles and websites protesting about the injustices perpetrated by global capitalism. It is the responsibility of all students to examine the economic issues for and against these criticisms. Here are two well-known examples.
In the Indonesian financial crisis of 1998, rioters in Jakarta demonstrated outside a local McDonalds hamburger bar, protesting about alleged US cultural imperialism. The owner of
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