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Re-thinking Trade Policy

Ravindra A. Yatawara's picture

Trade theory has always been lagging behind reality. From Ricardo ‘s (1817) explanation of trade based on relative productivity/technology differences among nations, it took over a century for Eli Heckscher and Bertil Ohlin (1933) to formalize a model that would explain inter- industry trade patterns based on a countries ’natural resources or factor endowments. It was almost 50 years later that Paul Krugman incorporated scale economies and imperfectly competitive markets to explain intra- industry – the observed phenomenon that countries were trading the same product- for example importing and exporting cars. In the last few years, a new paradigm is evolving that moves away from viewing trade as solely the exchange of final goods to one that incorporates the growing role of global supply chains and the international exchange of tasks or activities- off-shoring. All these theories have implications for optimal trade policy, and policy advice that nations receive from trade economists.

The question is how far is the trade field from the reality frontier? Is there sufficient general equilibrium analyses of trade policy in developing economies? How relevant is policy advice based on current models? This note is not an analysis of whether outward-orientation is valid, but instead offers some new trade and trade policy realties, and identifies some areas where more work is needed to provide policymakers with valuable guidance in thinking about trade integration.

  1. Some things change, some things stay the same.

    It continues to be useful to think of trade being based on differences in relative unit costs – be it in final goods or in tasks/activities
    A nation’s product becomes RELATIVELY competitive at home & abroad EITHER by
    i) Reducing home’s unit price/cost
    ii) Increasing foreign suppliers unit price.

    Traditionally the link between trade and industrial policy was focused on the second dimension where tariffs and other trade restricting policies were imposed to raise the prices of foreign products entering home markets, along infant industry arguments. However, this strategy has strong limitations and would produce only domestic low-quality, high- priced products. What is needed are policies that will address the first dimension - Technological progress, productivity improvements, scale economies, increasing competition, outsourcing, global supply chains, improving the environment for doing business and arguably national health care policies. Similarly we can interpret initiatives such as trade facilitation improvements and acquiring preferential market access as attempts to reduce the prices of a nation’s products in foreign markets.

    Regardless of true motivations, labor and environment standards (including those related to climate change) imposed of foreign suppliers perform a similar function to tariffs in making home products relatively more competitive, by raising the price of foreign products.

    Labelling polices - be it regarding no child labor used or the carbon footrprint -are preference shifters towards particular products. Recently implemented “Buy/hire national” policies would also fall into this category. 
  2. It’s the jobs, stupid! In the post-crisis global environment, it is clear that the focus of policymakers in developed and developing economies is generating jobs. Traditional models of trade assume full employment, and thus are not fully- equipped to address the current concerns of our time. The labor market impact of trade policy is analyzed through real wage impacts and their distributional effects across different industries or worker types (skilled versus unskilled). Adjustments costs associated with trade are also analyzed and labor market institutions and frictions have been identified as important in determining the speed and cost of adjustment. The current realities are also showing that traditional identification of labor by skill level may be insufficient- for example age of workers appears to be important ( at least in adjustment) and there has increased analysis at the occupation level instead of just education attainment.

    Policymakers are seeking advice on developing policies targeted at job creation and assisting those facing the greatest adjustment costs associated with global integration. Given the environment where government activism has gained some new support, it is important to get these polices right, and much greater research work is needed. Some progress has been in the theoretical front as in a paper on task trade by Grossman and Rossi- Hansberg (2008), and there is a small but growing empirical literature that is looking at employment outcomes in developed and developing countries ( see for example Ebenstein (2009), McMillan and Verduzco (2010). The results tend to be mixed , depending on the country under study, and in the case of task trade whether the off-shoring is in rich or poor countries. The work also looks at the impact across occupation groups, thus going beyond focusing on the industrial sector. More general equilibrium analysis of trade impacts on developing economies are much needed.
  3. Jobless growth - trade vs technology encore. Just as technology, as opposed to trade, has been cited as the dominant driver of wage inequality in the on-going debate on trade and wages, it may also be the culprit in the “jobless” growth that many economies are experiencing. The trouble is that politicians find it hard to bash technology for lack of job growth, whereas offshoring is a much more palatable target. Trade acts like a substitute for technology. Consider that a technological breakthrough reduces the number of workers needed by x people to produce a product and this reduces the cost by 50%. Now consider an offshoring arrangement that leads to the same employment and cost reduction. The public are much more likely to “blame the foreigners” and support restrictions to off-shoring , than they would argue against technological progress.
  4. Corporate and national interests. Developing countries’ share of industrial employment has risen from just under half of total employment to two-thirds (McMillan and Verduzco, 2010). Over 80 percent of this increase is attributed to the growth of industrial workers in China. One argument put forth is that this employment generation resulted from an alignment of corporate interests and national goals , where the state was focused on “exports and jobs” while suppressing wage and consumption growth. The extent to which such policies be emulated by other nations in democratic political systems appears limited. In fact, in China itself , growing inequality has been recognized and a national goal of “harmonious society’ has been added to a pure growth mantra.

    Given the increasing role of FDI and global supply chains, much work has been done on heterogeneous firms both from a theoretical and empirical standpoint, taking off from Melitz (2003). From this dimension, it is important to look at the political economy impact of multinational firms, and their incentives vis-à-vis local firms in home and host countries. A basic first order implication suggests that MNCs are more likely to be involved in global supply chains and hence more likely to support free trade.
  5. No “locking in” comparative advantage. The dynamic nature of the global economy suggests that the time that a nation exports a particular product is likely to fall. Thus the importance of reducing adjustment costs and the accompanying institutions that allow a nation’s factors to move to new product development is key. The transformation of a car parts factory to a manufacturer of medical parts reinforces the importance of thinking in terms of “trade in tasks” instead of trade in a particular goods.
  6. Technology critical. The returns to technological innovation are rising, in a global market with numerous product varieties and qualities. For developing countries, besides their domestic innovation, the transfer of technology is important through foreign direct investment and creating linkages with their diaspora who are in the technological frontier in advanced economies. Advanced economies like the United States can try to maintain its position on the technological frontier by attracting the world’s best minds to its shores. The importance of technology may explain the rise of allegations of corporate espionage ( think low cost technology transfer) , particularly by China. The literature of foreign investment has always questioned the extent of technology transfer achieved in host developing countries, but the dynamics of much of Chinese FDI suggest little or no technology dissemination, and more likely technology absorption in natural resources from host countries . Given the importance of technology it is also important to design appropriate patent legislation that are conducive to innovation and consumer welfare. A nuanced approach needs to be taken and a recent paper (Acemoglu, 2009) finds varying levels of optimal protection based on the distance an innovator is from their closest competitor. As developing countries innovate, simplified procedures are also needed so that their innovations receive the appropriate protection. Further, as some firms in developing countries become technology leaders in their specialized field, governments need to rethink providing massive tax breaks to FDI , which would only provide to give an unfair advantage to foreign-owned firms compared to national tax-paying local firms
  7. Incorporating trade into a macro framework. The field of international economics has been artificially divided by between international macro/ finance ( exchange rate determination and capital flows) and international trade (micro-oriented and including FDI). However, in the context of the global recession it is very clear how developments in the exchange rate as well as stimulus packages were closely tied with tariff policies and other forms of protection. For example , China’s undervaluation policies have strong implications for its trade policy stance. It is no surprise then that the dollarized economy of Ecuador, with no potential for devaluation-driven competitiveness resorted to significant wide tariff increases. Clearly if Greece was not in the Euro zone, its macroeconomic difficulties would have been addressed by some greater currency depreciation (although its primary problems are not an exchange rate misalignment) or increased trade barriers.
  8. Optimal policy space. A related issue is that of optimal policy space across the range of policy instruments available to policymakers. In the face of irresponsible policymaking and lack of credible policy makers and policies, the policy prescription were basically reducing the discretion of policy makers- either through independent central banks, policy rules, fixed exchange rate regimes, international treaty commitments. Are we at a place that policymaking has matured that some loosing of the rope is appropriate? Should WTO agreements such as the Agreement on subsidies be renegotiated to allow for greater policy space?
  9. South’s relationship with China. Much has been made of the size of China’s trade surplus with the United States and the undervaluation of the yuan vis-à-vis the US dollar, and its impact on the US economy. Its implications for developing countries needs greater attention. What is the optimal relationship with and response to China- as competitor and business partner? Measurement issues plague Chinese data in general, but one of the key points on the size of the trade imbalance with the US is that it over-represents the Chinese value- added in exports because it reflects trade within East Asian supply chains where China is simply the final stage of production and hence the final exporter. Import penetration of Chinese products is often blamed for US job losses but in fact most Chinese goods are simply displacing other imports from higher-cost developing countries. Thus for developing countries not part of the supply chain, China is a goliath of a competitor, both abroad and at home. Further, even for members counties of the supply chain the undervaluation of the yuan, perpetuates the existing roles in the supply chain, and makes it harder for another country to take over China’s role. For many economies in Africa and to a lesser extent Latin America, trade with China involves imports of Chinese manufactured products and exports of raw materials to China. In some ways, this is similar to the early post WWII trade relationships between colonies and their advanced economy colonial masters !

    China is also pioneering new forms of business partnerships in developing countries, that these nations have not seen, let alone negotiated before. For example the Democratic Republic of Congo (DRC) signed an agreement with Chinese public enterprises that involves the exchange of mining concessions for the financing of public infrastructure (Doemland et al, 2009). In this case, and much of Chinese foreign investment, the companies bring their capital and labor, providing very limited job creation and technology transfer.

    It is important for research to guide policymakers in designing optimal strategies with regard to China, and in fact other large emerging economies like India and Brazil.
  10. Trade, volatility and risk. Following the great collapse of trade at the end of 2008, trade has got a bad name for being volatile and high risk, with some initial calls for a focus on internal markets. These initial calls have faded, but volatility mitigation policies are in demand. Optimal product and market diversification is an area where there are more questions than answers.
    In the discussion of the trade collapse of 35 percent over six months, there has often been little talk of the of substantial trade expansion in the preceeding five years! It is like complaining about a morning hangover after seven days of hard partying. The diversification question may answer itself in the context of global multi-polar growth and growing South-South trade. World Bank estimates place far more optimistic growth outcomes for large developing economies than the traditionally advanced economies. As these economies are becoming sources of import demand, other developing countries will need to re-orient trade to these nations and the products demanded by their consumers.

    There is going to always be some volatility and what firms need are government agencies that are agile and flexible to offer solutions. When cargo to Europe is stuck at the airport due to volcanic ash from Iceland, exporters need a great export promotion agency that would immediately come up with solutions and prices to transport the cargo to the closest airport followed by land transport. There is no mitigation policy to stop volcanic ash ( though there is value in not sending all your exports to one country). So the requirements on government agencies are larger in supplying rapid response assistance to unanticipated trade costs.
  11. Measurement Issues. The discussion in the field on explaining the great trade collapse in the last quarter of 2008 and the first quarter of 2009, brought to the forefront the fact that trade flows are reported as gross values (as opposed to value-added) and in the context of the international division of production (global supply chains), this information may be highly misleading in terms of actual value-added exports. A focus on addressing this issue is needed.




Acemoglu, Daron and Ufuk Akcigit (2009) “State Dependent Intellectual Property Rights” (December 2009)

Doemeland D., C. Briceno-Garmendia, A. Farah and J. Herderschee (2009) “Mining concession for Infrastructure : Chinese Investment in the Democratic Republic of Congo” World Bank Policy Research Paper

Ebenstein, Avraham; Harrison, Ann; McMillan, Margaret; and Phillips, Shannon. (2009) “Estimating the Impact of Trade and Offshoring on American Workers Using the Current Population Surveys.” NBER Working Paper Series, no. 15107 (June 2009).

Grossman, Gene M., and Rossi-Hansberg. 2009. “Task Trade Between Similar Countries.” Department of Economics Working Paper, Princeton University. (July 2009).
Harrison, Ann, Rodríguez-Clare, Andrés. 2009. “Trade, Foreign Investment, and Industrial Policy for Developing Countries.” NBER Working Paper Series, no. 15261. (August 2009).
McMillan, Margaret and Inigo Verduzco (2010) “New Evidence on Trade and Employment” (May 2010)


Submitted by Simon Conesa on
With reference to the first point "Some things change, some things stay the same", I would like to add to product competitiveness is multi-dimensional, and it is not only related to price. Hence, when a company (or a country) wants to make their products more appealing to (global) customers, they may indeed decide to offer a lower price, but also more advanced features, a more attractive design, etc. This is not the same as offering just a "labelling policy", but differenciating the product.

Submitted by Dan Nita on
The Chinese/US. trade presents not only the issue of the Yuan exchange artificial support, but the pressure on buying the cheapest goods made in China. China needs to be outsourced. The Chinese barter system with developing economies around the world is not new, it has been around for decades, and is a step on securing the raw materials which they don't have.

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