Trade & Growth

Bakuriani, July 2008

Outline

Trade and wealth creation

The costs of openness to trade?

The race to the bottom?

Adam Smith and trade

Smith: pin’s factoryDivision of labor, division of

knowledge, enlargement of markets generates wealth

What if you have no talent?

Ricardo’s comparative advantage

Production in an hour

Of wool(kilograms)

Of wine(liters)

England 2 2

Portugal 3 6

Wealth creationWool (kg)

200

E (100,100)

P(180, 210)200 E’

E*(110,100)

P’(300, 150)

P*(190, 250)

600

The costs of trade

Against trade

National independence (sovereign funds, national champions)

Others are not liberalizing (electricity, Airbus and Boeing)

Regional trade is preferableA plane without pilotRace to the bottom

An illustration: the race to the bottom argument

Mentioned in many fields:

• Tax competition• Labor standards and free trade• Environmental standards and free trade

Race to the bottom scenario

Starting with two jurisdictions Jurisdiction A has “high standards” Jurisdiction

B has “low standards” As trade opens, capital moves from A to B Jurisdiction A cannot sustain “high standards” Both jurisdictions end up with low standards

First impressions about the argument

Simple Plausible:

at the start of the 20th century, trade in primary products accounted for 2/3 of world trade, and by the end of the century the fraction had dropped to ¼

foreign direct investments were about 25 times larger in 1996 than they were in 1970

Theoretical support to RTB

Hecksher-Ohlin, Stopler-Samuelson: equalization of factor prices across trading partners

Important theoretical literature “In sum, for all the reasons mentioned above,

although economic integration may be expected to improve labour standards overall, the possibility of social dumping because of stronger international competition needs to be taken into account, and there is, in principle, ambiguity on the predicted sign and magnitude of the effect.” Dehejia and Samy (2006)

Empirical evidence?

Mixed evidence:“Overall, the results are not as grim as

the conventional wisdom would have it. Even though integration may impose constraints on domestic policy, they are evidently not as severe as the pessimists would have predicted.” Dehejia and Samy (2006)

OECD (1996) no evidence that low standards perform better

Brueckner (2000): “social shopping” taking place in the US

Theoretical arguments against the possibility of a

race to the bottom To the extent that free trade combined

with ‘market failures’ leads to inefficiency, suppress market failures and keep free trade (Bhagwati-Ramaswami)

Harmonization is not efficient Quality of standards is a superior good

(“one size fits all” is inefficient) Competition among standards helps reveal

the most appropriate standard

Arguing with new (basic) tools…

Freedom to trade is also freedom not to trade True, as trading opportunities change, some

might trade because they are “forced to,” or because they lose their trading partners

But, at least two people will be better off after the expansion of trade opportunities

A race to the bottom is logically impossible

The reality behind the race to the bottom

In a dynamic, entrepreneurial process of discovery, some will lose in the short run

Some might even lose in the long run… But this is the case with any change. The change might

be due to enlargement of the market or any “national” technological improvement

Why does the same government which promotes spending public money on R&D also oppose free trade? Why are ‘we’ sometimes promoting entrepreneurial spirit and sometimes raising barriers against it?

Who will have to adjust? When you promote R&D you know that this will

require adjustments, but you don’t know exactly who…

When you promote free trade, the groups who will have to adjust are more easily identifiable (privileged ones)

“[E]ven if they are globally limited, the costs related to that opening are quite visible, tangible and concentrated in space and time; while its benefits—much higher but spread much more uniformly—are difficult to perceive in our day-to-day life and in the short run.” (Pascal Lamy, WTO)

To summarize:

The claim that free trade will lead to a race to the bottom has no validity

It is a fancy name for a well-known reality: change (and in particular, new opportunities) calls for adjustment

One may reject the enlargement of the market, but at least economists should be unanimous about the analysis of the process

(Free market) economists