Modern Trade Agreements: its implications for long-run development policy
Development is a long-run process of transforming the economy from concentrated primary product-based economy to diversified set of assets based on knowledge. This has been achieved in the developed nations through the process of investing in human, physical and natural capital in manufacturing and services while stripping inefficient sectors, rent-seeking etc. As the nation develops, the sectoral production and employment concentration also diversify as well.
Traditional trade theories are limited in saying about long-run growth for developing countries. This is because they assume static technological change and no market failures, which are unrealistic in developing countries context. Therefore, in an ideal world, as our theories suggest free trade would be beneficial on aggregate and even if it creates some losers, the winners can compensate them to benefit as a whole.
Static comparative advantage (CA) is problematic because it might be the case that a country has CA in the industry at an instance of time but losses it in the long run due to say decreasing relative price of that industrial good. This would create long-run growth difficulties. If the developed world has CA in innovation then it can continuously remain ahead of developing world in the long run.
Therefore, what matters in the long-run is the dynamic comparative advantage - "the ability to follow one success with another, to build on one industry by launching another and continue."
Unlike neo-classical suggestions, there exists mainly four forms of market failure:
1. Co-ordination failure - This happens when multiple equilibria are possible in an economy. Basically, firms might end up at the bad equilibria because they fail to coordinate. For example, if one firm is pessimistic about the economy and fires its workers, it would suppress demands for other firms and eventually, the economy would end up in the bad equilibrium. Coordination failures can occur due to sunspots or animal spirits as well. Policy instruments used to tackle these: export subsidies, tariff sequencing, tax drawbacks, clustering, infrastructure provision.
Under export subsidies, government policies are such that encourages exports and discourages domestic trade of those goods. Along with export subsidies, clustering also attracts firms to enter the market. Along with these, infrastructure provision, tax breaks and drawbacks (rebates) encourage foreign firms to enter the market in this country.
2. Informational externalities - Information obtained or extracted from one firm or individual is utilized by the others to make decisions. This creates a free-riding problem. Innovator through its innovation creates enormous social value, however, the bears the entire risk of failures themselves. This may result in a lower level of innovation. For example, in the credit markets, a lender may inhibit lending to a consumer who has been rejected by other lenders. This might create economic slowdown because of the decrease in lending activity by one transforms into reduction by other lenders as well. Policy instruments used to tackle these: Administrative guidance, subsidized credit, tariff sequencing, subsidized entrepreneurship, selective permission for patents.
The static models of trade do not account for co-ordination failures or information externalities and therefore would suggest developing countries to say dismantle industrial sector and invest in labour-intensive like textile production. This clearly would not have enabled such nations to sustain long-run growth.
3. Technological dynamism and economies of scale - Markets may fail to investments into technologies as under high and uncertain learning costs and high pecuniary externalities, markets do not give correct investment signals. Policy instruments used to tackle these: Tariff sequencing, technology transfer requirements, joint ventures, public R&D, compulsory licensing, selective permission for patents, government procurement.
4. Human capital formation - Private markets may invest less than society optional levels in human capital due to costs involved. Private firms may under-invest in the training of workers due to higher turnover rates. Policy instruments used to tackle these: Public education, employment of locals, movement of people.
Some developing countries, however, have been successful in deploying policies to generate dynamic CA and corrected their market failures. East Asian miracle is said to be the result of mainly four policies:
1. Targeted industrial policy
2. Loosen IP rules
3. Mobility of people
4. Investment in human capital and public infrastructure
Role of IP policy? IP has become an important part of modern economies and trade. So much so that WTO had created agreement on Trade-Related Aspects of IP (TRIPS) to harmonize standards of IP. Impact of IP protection on trade is not clear.
It has a positive effect on trade because it of protection of the rights creating higher transactions - this is the market expansion effect. Strong IPP is also argued to encourage vertical separation by encouraging technology-intensive entrants. Developing countries are said to be benefitted by stronger IP rules if the technology transfers take place through MNCs channel. If FDI is the channel of transfer, then strong IPP also is a better policy.
However, it also has a negative effect on trade because it may increase the market power of right owners, who would then reduce supply to increase the price - market power effect. So, strong IPPs may reduce transactions on the net as well. Another possible channel is that of infringement. Strong IPP may cause infringement suits on entrants products on other available products. Firms in developing countries mainly arise through imitation of technologies. Strong IP may impact this and increase the technology gap between developed and developing. This therefore would deter market entry if new firms.
So, although the extent to which each policy contributed to the growth of East Asian tigers is debatable there's an agreement that they had a positive effect on economic performance. Having said that, economists do not generally suggest other developing economies adapt their approach because governments may be big failures in picking winning sectors to focus on. In addition, government involvement might proliferate rent-seeking behaviour.
The important underlying point from the development stories seen is that they got the political economy of industrialization correctly. In presence of market failures, the government may fail to take the right decisions for sectors as well. Political economists proposed - embedded diagnostics - forming public-private partnerships help both of them to discover market failures, other hurdles and plans towards development. This bypasses the problem of picking winning sectors by the government. PPP, however, can also become a hub for corruption and rent-seeking. To prevent this, good discipline and accountability are required. It has been called has - reciprocal control mechanism. A control mechanism is a set of institutions that discipline economic behavior based on the feedback of information that has been sensed and assessed. For East Asian success, reciprocity based control mechanism was the key. Reciprocity disciplined subsidy recipients and minimized government failure. Subsidies were given to make manufacturing profitable and therefore they were subjected to monitoring. When the required performance conditions were not met, subsidies were stopped. Thus reciprocal control mechanism in this transformed the system towards efficiency.
> Based on Rachel Denaie Thrasher and Kevin P. Gallagher paper, Boston University, September 2008, The Pardee Papers,-No.2
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