international political economy

International Political Economy Fifth Edition THOMAS OATLEY University of North Carolina Chapel Hill Longman Boston Columbus Indianapolis New York San Francisco Upper Saddle River Amsterdam Cape Town Dubai London Madrid Milan Munich Paris Montreal Toronto Delhi Mexico City São Paulo Sydney Hong Kong Seoul Singapore Taipei Tokyo ISBN-13: 978-0-205-00628-1ISBN-10: 0-205-00628-0 Senior Acquisitions Editor: Vikram MukhijaEditorial Assistant: Beverly FongSenior Marketing Manager: Lindsey PrudhommeAssociate Production Manager: Scarlett LindsayProject Coordination, Text Design, and Electronic Page Makeup: PreMediaG\ lobalSenior Cover Design Manager: Nancy DanahySenior Manufacturing Buyer: Dennis J. ParaPrinter and Binder: RR Donnelley – CrawfordsvilleCover Printer: RR Donnelley – Crawfordsville Copyright © 2012, 2010, 2008, 2006 by Pearson Education, Inc.

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If you purchased this book within the United States or Canada you should\ be aware that it has been imported without the approval of the Publisher or the Author. 2 3 4 5 6 7 8 9 10—DOC—14 13 12 BRIEF CONTENTS Preface ix CHAPTER 1 International Political Economy 1 CHAPTER 2 The World Trade Organization and the World Trade System 21 CHAPTER 3 The Political Economy of International Trade Cooperation 45 CHAPTER 4 A Society-Centered Approach to Trade Politics 69 CHAPTER 5 A State-Centered Approach to Trade Politics 89 CHAPTER 6 Trade and Development I: Import Substitution Industrialization 111 CHAPTER 7 Trade and Development II: Economic Reform 133 CHAPTER 8 Multinational Corporations in the Global Economy 158 CHAPTER 9 The Politics of Multinational Corporations 180 CHAPTER 10 The International Monetary System 202 CHAPTER 11 Cooperation, Conflict, and Crisis in the Contemporary International Monetary System 225 CHAPTER 12 A Society-Centered Approach to Monetary and Exchange-Rate Policies 249 CHAPTER 13 A State-Centered Approach to Monetary and Exchange-Rate Policies 273 CHAPTER 14 Developing Countries and International Finance I:

The Latin American Debt Crisis 298 CHAPTER 15 Developing Countries and International Finance II:

A Decade of Crises 323 CHAPTER 16 Globalization: Consequences and Controversies 346 Glossary 370 References 388 Index 401 iii iv DETAILED CONTENTS Preface ix CHAPTER 1 International Political Economy 1 What Is International Political Economy? 2 Studying International Political Economy 7 Traditional Schools of International Political Economy 8 Interests and Institutions in International Political Economy 13 The Global Economy in Historical Context 15 CHAPTER 2 The World Trade Organization and the World Trade System 21 What Is the World Trade Organization? 22 Hegemons, Public Goods, and the World Trade System 28 The Evolving World Trade Organization: New Directions, New Challenges 32 The Greatest Challenge? Regional Trade Arrangements and the World Trade Organization 36 CHAPTER 3 The Political Economy of International Trade Cooperation 45 The Economic Case for Trade 46 Trade Bargaining 53 Enforcing Agreements 58 CHAPTER 4 A Society-Centered Approach to Trade Politics 69 Trade Policy Preferences 70 Factor Incomes and Class Conflict 70 Sector Incomes and Industry Conflict 73 Organizing Interests: The Collective Action Problem and Trade Policy Demands 79 Political Institutions and the Supply of Trade Policy 81 Detailed Contents v CHAPTER 5 A State-Centered Approach to Trade Politics 89 States and Industrial Policy 90 The Infant-Industry Case for Protection 91 State Strength: The Political Foundation of Industrial Policy 95 Industrial Policy in High-Technology Industries 99 Strategic-Trade Theory 100 Strategic Rivalry in Semiconductors and Commercial Aircraft 103 CHAPTER 6 Trade and Development I: Import Substitution Industrialization 111 Domestic Interests, International Pressures, and Protectionist Coalitions 112 The Structuralist Critique: Markets, Trade, and Economic Development 118 Market Imperfections in Developing Countries 118 Market Imperfections in the International Economy 120 Domestic and International Elements of Trade and Development Strategies 121 Import Substitution Industrialization 121 Reforming the International Trade System 128 CHAPTER 7 Trade and Development II: Economic Reform 133 Emerging Problems with Import Substitution Industrialization 134 The East Asian Model 137 Structural Adjustment and the Politics of Reform 145 Developing Countries and the World Trade Organization 154 CHAPTER 8 Multinational Corporations in the Global Economy 158 Multinational Corporations in the Global Economy 159 Economic Explanations for Multinational Corporations 165 Locational Advantages 165 Market Imperfections 168 Locational Advantages, Market Imperfections, and Multinational Corporations 171 Multinational Corporations and Host Countries 173 vi Detailed Contents CHAPTER 9 The Politics of Multinational Corporations 180 Regulating Multinational Corporations 181 Regulating Multinational Corporations in the Developing World 181 Regulating Multinational Corporations in the Advanced Industrialized Countries 185 Bargaining with Multinational Corporations 188 The International Regulation of Multinational Corporations 194 CHAPTER 10 The International Monetary System 202 The Economics of the International Monetary System 203 Exchange-Rate Systems 203 The Balance of Payments 205 Balance-of-Payments Adjustment 208 The Rise and Fall of the Bretton Woods System 212 Creating the Bretton Woods System 212 Implementing Bretton Woods: From Dollar Shortage to Dollar Glut 215 The End of Bretton Woods: Crises and Collapse 219 CHAPTER 11 Cooperation, Conflict, and Crisis in the Contemporary International Monetary System 225 From the Plaza to the Louvre: Conflict and Cooperation during the 1980s 226 Global Imbalances and the Great Financial Crisis of 2007–2009 234 Exchange-Rate Cooperation in the European Union 241 CHAPTER 12 A Society-Centered Approach to Monetary and Exchange-Rate Policies 249 Electoral Politics, the Keynesian Revolution, and the Trade-Off between Domestic Autonomy and Exchange-Rate Stability 250 Society-Based Models of Monetary and Exchange-Rate Politics 255 The Electoral Model of Monetary and Exchange-Rate Politics 257 The Partisan Model of Monetary and Exchange-Rate Politics 260 The Sectoral Model of Monetary and Exchange-Rate Politics 264 Detailed Contents vii CHAPTER 13 A State-Centered Approach to Monetary and Exchange-Rate Policies 273 Monetary Policy and Unemployment 274 The Time-Consistency Problem 281 Commitment Mechanisms 283 Independent Central Banks and Exchange Rates 293 CHAPTER 14 Developing Countries and International Finance I:The Latin American Debt Crisis 298 Foreign Capital and Economic Development 299 Commercial Bank Lending and the Latin American Debt Crisis 304 Managing the Debt Crisis 309 The Domestic Politics of Economic Reform 317 CHAPTER 15 Developing Countries and International Finance II: A Decade of Crises 323 The Asian Financial Crisis 324 Bretton Woods II 332 The Heavily Indebted Poor Countries 338 CHAPTER 16 Globalization: Consequences and Controversies 346 Globalization and Global Poverty 347 Globalization and “Sweatshops” 351 Trade and the Environment 358 Glossary 370 References 388 Index 401 This page intentionally left blank ix L ocal economic developments reflect global forces. Consider the sovereign debt crisis that struck Greece in the spring of 2010. The Greek government borrowed heavily between 2006 and 2009. Greece’s ability to borrow so much was made possible by two global developments:

high savings rates in China created a large pool to draw from; the creation of the euro seemed to make Greece a low-risk borrower. German banks intermediated much of the funds that flowed to Greece in this period. When the Greek government’s financial position deteriorated sharply in the fall of 2009, financial markets began to doubt Greek solvency and sold Greek debt in massive quantities. Because German banks held such large amounts of Greek debt, a possible Greek default would possibly precipitate a severe banking crisis in Germany that could ripple across the EU and potentially undermine the euro itself. To stave off this possibility, EU governments agreed (reluctantly) to provide financial assistance to Greece in order to restore stability. Hence, global forces enabled Greece to get into financial difficulty, and once Greece encountered problems, its difficulties threatened economic stability throughout the EU. And had the crisis brought euro down, the global economy would have suffered a terrible blow. In this “era of globalization,” the factors that shape our economic lives are as likely to originate in far away places as they are to stem from local events.

Understanding the global economy requires knowledge of politics as well as economics. For globalization is not a spontaneous economic process; it is built on a political foundation. Governments share a broad consensus on core principles; core principles inform the elaboration of specific rules. Specific rules establish international institutions—the World Trade Organization, the World Bank, and the International Monetary Fund. These international institutions in turn facilitate a political process through which governments reduce barriers to global exchange and create common rules to regulate other elements of the global economy. This political system—the foundation and the process—has enabled businesses to construct the network of international economic linkages that constitute the economic dimension of globalization.

Understanding the global economy, therefore, requires a political economy approach: We must study its political as well as its economic dimensions.

Studying the political and economic dimensions of the global economy requires us to develop theory that simplifies an inherently complex world. This book develops a theoretical framework in which politics in the global economy revolve around enduring competition between the winners and the losers generated by global economic exchange. As economists since Adam Smith have told us, global exchange raises aggregate social welfare. Yet, global exchange PREFACE x Preface also creates winners and losers. For some, global exchange brings greater wealth and rising incomes; for others, however, the international economy brings job losses and lower incomes. These winners and losers compete to influence government policy. Those who profit from global exchange encourage governments to adopt policies that facilitate such exchange; those harmed by globalization encourage governments to adopt policies that restrict it. This competition is played out through domestic politics, where it is mediated by domestic political institutions, and it is played out through international politics, often within the major international institutions such as the Group of 20 and the World Trade Organization.

NEW TO THIS EDITION Although this edition maintains the basic structure of previous editions, I have adjusted the book’s discussion of substantive issues to provide extended treatment of the causes and consequences of the recent financial turmoil. I have given particular attention in this revision to a few theoretical topics and one major substantive topic. First, I have added a few new dimensions to the theoretical perspective. Chapter 2 structures the discussion of hegemonic stability theory around the concepts of public goods and free riding. Chapter 3 introduces spatial theory to analyze bargaining in the WTO and discusses the sources of bargaining power. The chapters on domestic politics introduce the concept of Veto Player and demonstrate how it shapes outcomes in trade and monetary policy making. Second, I have included substantial new content regarding the 2007–2009 financial crisis and the sovereign debt crisis in Greece. This includes a substantial reworking of Chapter 11 to focus on the global imbalances and distributional issues at the center of the crisis and a smaller reorientation of Chapter 15 to incorporate Bretton Woods II more fully into the discussion. As always, I have updated the figures and tables where appropriate to incorporate the most recent data available.

I have changed many of the “Closer Look” and “Policy Analysis and Debate” boxes. In addition to updating recurring features, I added many new topics.

Chapter 5 includes a “Policy Analysis and Debate” that asks students to consider the merits and demerits of the Obama administration’s desire to use industrial policy to promote green technology. Chapter 6 includes a “Policy Analysis and Debate” focused on the debate between Jeffrey Sachs and William Easterly over foreign aid and the Millennium Development Goals. Chapter 7 includes a “Policy Analysis and Debate” focused on whether development strategies should transition from the Washington Consensus to the Beijing Consensus. Chapter 8 includes a “Closer Look” that focuses on Hugo Chavez’s nationalization of the oil sector in Venezuela. Chapter 9 includes a “Closer Look” that examines Sovereign Wealth Funds. Preface xi Chapter 10 includes a “Closer Look” that examines how the gap between savings and investment shapes current account imbalances and relates this to the contemporary U.S.-China trade imbalance. Chapter 11 includes a “Policy Analysis and Debate” that asks students to consider whether governments should pursue additional fiscal stimulus to promote global economic recovery. Chapter 12 includes a “Policy Analysis and Debate” that asks students to discuss the merits and demerits of the Obama administration’s effort to double exports in five years in part by devaluing the dollar. Chapter 13 includes a “Closer Look” that strives to explain why the European Central Bank and the Federal Reserve have adopted such different policies in response to current economic conditions. Chapter 15 includes a “Policy Analysis and Debate” that asks students to discuss whether China’s status as a major creditor country in the global economy confers political power. Chapter 16 includes a “Closer Look” that examines how politics have created a distributive conflict that forces governments to choose between a global climate change regime or compliance with WTO obligations. FEATURES This textbook imparts a unique perspective. First, this book shows students how domestic politics shape the objectives governments pursue and how interaction between governments shapes the outcomes they achieve. In fact, I dedicate more than one-quarter of the book to the domestic politics of trade and exchange-rate policies. Second, the book shows how the objectives that governments pursue are in turn shaped by interest groups and individuals responding to the impact of the global economy on their incomes. Thus, the book highlights how political processes shape the economic system and how transactions within the global economy in turn shape political dynamics.

The book imparts this perspective by relying on four pedagogical tools.

First, each chapter elaborates the logic of the economic models relevant to each issue area in language accessible to the nonspecialist. Second, each chapter highlights how the distributional consequences of cross-border economic activity shape politics—domestic or international—within that issue area. Third, each chapter uses the models of political competition to explain important historical events. Many chapters contain “Closer Look” boxes to provide in-depth case studies. Finally, each chapter contains a “Policy Analysis and Debate” box to encourage students to relate the theoretical models— political and economic—to contemporary policy debates.

The book applies this approach to the major issue areas in international political economy. The first half of the book is devoted to international trade and production. Chapters 2 and 3 examine the political logic driving the creation and evolution of the international trade system. Chapter 2 traces the historical evolution of the General Agreement on Tariffs and Trade/World xii Preface Trade Organization. Chapter 3 examines the system through the lens of neoliberal theories of cooperation. Chapters 4 and 5 examine how domestic politics shape government trade policies. Chapter 4 presents a pluralist perspective, while Chapter 5 introduces a statist approach. Chapters 6 and 7 focus on the orientation of developing countries toward the international trade system. Chapter 6 explains why so many governments sought to insulate themselves from the system in the early postwar period. Chapter 7 examines and explains the shift in development strategies from inward to export- oriented. This section concludes with a thorough examination of the political economy of multinational corporations in Chapters 8 and 9.

The second half of the book examines the international monetary and financial systems. Chapters 10 and 11 trace the evolution of the international monetary system. Chapter 10 focuses on core issues of exchange rate systems and balance-of-payments adjustment and traces the creation and collapse of the Bretton Woods system. Chapter 11 focuses on the contemporary floating exchange-rate system, focusing on efforts to manage the system via coordination or to stabilize exchange rates via monetary union. Chapters 12 and 13 examine the domestic politics of monetary and exchange-rate policies.

Chapter 12 examines the partisan and sectoral models of macroeconomic and exchange-rate policy; Chapter 13 employs a state-centered approach to explore the impact of central banks as agents independent of governments. Chapters 14 and 15 focus on developing countries’ relationships with the international financial system. Chapter 14 examines the emergence and resolution of the Latin American debt crisis. Chapter 15 focuses on the Asian financial crisis and subsequent efforts to manage capital flows to developing countries and to reform the International Monetary Fund. Chapter 16 concludes by drawing on what we have learned to explore some of the major policy debates that have emerged surrounding the global economy.

SUPPLEMENTS Longman is pleased to offer several resources to qualified adopters of International Political Economy and their students that will make teaching and learning from this book even more effective and enjoyable. Several of the supplements for this book are available at the Instructor Resource Center (IRC), an online hub that allows instructors to quickly download book-specific supplements. Please visit the IRC welcome page atwww.pearsonhighered .com/irc to register for access.

Passport for International Relations With Passport, choose the resources you want from MyPoliSciKit and put links to them into your course-management system. If there is assessment associated with those resources, it also can be uploaded, allowing the results to feed directly Preface xiii into your course-management system’s gradebook. With over 150 MyPoliSciKit assets like video case studies, mapping exercises, comparative exercises, simulations, podcasts,Financial Times newsfeeds, current events quizzes, politics blogs, and much more, Passport is available for any Pearson introductory or upper-level political science book. Use ISBN 0-205-09290-X to order Passport with this book. To learn more, please contact your Pearson representative.

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ACKNOWLEDGMENTS No book such as this is the work of a single person. I have benefited immensely from the advice and support of many people. A few deserve special mention. Eric Stano of Longman publishers supported this project from its initial conceptualization. Vik Mukhija has been terrifically supportive through most of the subsequent editions. Roland Stephen went well beyond the call of duty as friend and colleague in entertaining my many questions, providing suggestions about how to improve the text and using early versions of the book in his class at North Carolina State University. Eric Reinhardt at Emory University and Jeffry Frieden at Harvard University each offered comments based on their experience with using this text in their courses.

Numerous reviewers provided detailed comments that vastly improved the book in so many ways. It is no light burden to write a thoughtful and constructive review of a book, and I thank them all for taking the time to do so. My thanks, therefore, go to Ali R. Abootalebi, University of Wisconsin– Eau Claire; Frances Adams, Old Dominion University; Monica Arruda de Almeida, University of California–Los Angeles; Katherine Barbieri, University of South Carolina; Charles H. Blake, James Madison University; Charles Boehmer, University of Texas–El Paso; Terry D. Clark, Creighton Preface xv University; Linda Cornett, University of North Carolina–Ashville; Charles R.

Dannehl, Bradley University; Robert A. Daley, Albertson College of Idaho; Mark Elder, Michigan State University; Matthew DiGiuseppe, Binghamton University; Richard Ganzel, Sierra Nevada College; Yoram Haftel, DePaul University; Steven Hall, Boise State University; Cullen Hendrix, University of North Texas; Michael Huelshoff, University of New Orleans; Alan Kessler, University of Texas–Austin; Douglas Lemke, Pennsylvania State University; Andrew Long, University of Mississippi; Michael Mastanduno, Dartmouth College; Sean M. McDonald, Bentley College; Phillip Meeks, Creighton University; Jeffrey S. Morton, Florida Atlantic University; Layna Mosley, University of North Carolina–Chapel Hill; Gene Mumy, Ohio State University; Clint Peinhardt, University of Texas–Dallas; Jim Peltcher, Denison University; Herman Schwartz, University of Virginia; Roger Schoenman, University of California at Santa Cruz; Cliff Staten, Indiana University Southeast; and Christianne Hardy Wohlforth, Dartmouth College.

Finally, I owe a large debt of gratitude to all of those scholars whose research made this book possible. You have taught me much, and I only hope that in writing the book I have treated your work accurately and fairly. Of course, in spite of all this support, I alone am responsible for any errors of fact or interpretation.

Thomas Oatley This page intentionally left blank 1 1 CHAPTER W e live in a global economy. How many times have you heard or read that short sentence in the last month? If you watch the cable news networks or read the major newspapers, probably more than a couple of times. What does it mean? To paraphrase the famous British economist John Maynard Keynes, I think it means in part that, from my home in North Carolina, I can order an iPod designed by an American company, but manufactured by an East Asian company, order some polo shirts produced in Bangladesh, and buy and sell stocks in British and French companies all before I have finished my morning coffee (which, by the way, was grown in Sumatra). In part, therefore, living in a global economy means the products I regularly consume are as likely to come from a distant country as from the United States.

Living in a global economy also means that global economic forces play a large role in determining many of our career opportunities. Forty years ago, for example, people in my home state could find reasonably well-paying jobs in local textile mills. Today, most of these mills and the jobs they once provided are gone, and few young North Carolinians seek, much less find, employment in this industry. During the same period, however, high-technology firms moved to North Carolina. IBM, Lockheed, GlaxoSmithKline, and many other high-technology firms all operate within a few miles of my home. Charlotte, the state’s largest city, has emerged as one of the country’s largest financial centers, home to one of the nation’s largest banks, Bank of America. High- technology companies and financial institutions today provide thousands of jobs for North Carolinians. Thus, the opportunities available to the typical North Carolinian are far different today than they were only 30 years ago. I’m sure that the state you live in has seen similar changes. The global economy has played a central role in bringing about these changes, shaped by global, rather than national (much less local), economic forces.

International political economy (IPE) studies how politics shape developments in the global economy and how the global economy shapes politics. It focuses most heavily on the enduring political battle between the winners and losers from global economic exchange. Although all societies benefit from participation in the global economy, these gains are not International Political Economy 2 CHAPTER 1 International Political Economy distributed evenly among individuals. Global economic exchange raises the income of some people and lowers the income of others. The distributive consequences of global economic exchange generate political competition in national and international arenas. The winners seek deeper links with the global economy in order to extend and consolidate their gains, whereas the losers try to erect barriers between the global and national economies in order to minimize or even reverse their losses. International political economy studies how the enduring political battle between the winners and losers from global economic exchange shapes the evolution of the global economy.

This chapter introduces IPE as a field of study. It begins by providing a broad overview of the substantive issues that IPE examines and the kinds of questions scholars ask when studying these issues. The chapter then briefly surveys a few of the theoretical frameworks that scholars have developed in order to answer the questions they pose. The chapter concludes by looking at the emergence of a global economy in the late nineteenth century in order to provide a broader context for our subsequent focus on the contemporary global economy.

WHAT IS INTERNATIONAL POLITICAL ECONOMY?

International political economy studies the political battle between the win- ners and losers of global economic exchange. Consider, for example, the deci- sion by the Bush administration to raise tariffs on imported steel in the spring of 2002. The decision to raise the steel tariff was prompted by lobbying by the owners of American steel firms and the United Steel Workers of America.

The steel industry lobbied for higher tariffs because they were losing from trade. Imported steel was capturing a large share of the American market, re- sulting in a large number of plant closings and layoffs. Thirty-four American steel mills filed for bankruptcy between 1997 and 2002, forcing about 18,000 workers from their jobs. Steel producers and steel workers recognized that higher tariffs would protect them from this competition, thereby reducing the number of American steel mills in distress and slowing the rate at which steel workers were losing their jobs.

The higher steel tariff had negative consequences for other groups in so- ciety, however. The tariff hurt American industries that use steel to produce goods, such as auto manufacturers, because these firms had to pay more for steel. The tariff also harmed foreign steel producers, who could sell less steel in the American market than before the tariff was raised. Groups that suffered from the tariff turned to the political system to try to reverse the Bush ad- ministration’s decision. In the United States, the Consuming Industries Trade Action Coalition (or CITAC), a business association that represents firms that use steel (and other imported inputs) to produce other goods, pressured the Bush administration and Congress to lower the steel tariff. Foreign steel pro- ducers lobbied their governments to pressure the United States to reverse the decision. In response, the European Union and Japan threatened to retaliate by raising tariffs on goods that the United States exports to their markets and initiated an investigation within the World Trade Organization (WTO)—the What Is International Political Economy? 3 international organization with responsibility for such disputes. The story of the steel tariff thus nicely illustrates the central focus of international political economy as a field of study: how the political battle between the winners and losers of global economic exchange shapes the economic policies that govern- ments adopt.

The steel tariff also highlights the many distinct elements that inter- national political economy must incorporate to make sense of the global economy. To fully understand the steel tariff, we need to know something about the economic interests of the businesses and workers who produce and consume steel. Understanding these interests requires us to know economic theory. Moreover, we need to know something about how political processes in the United States transform these economic interests into trade policy. This requires knowledge of the American political system and the American trade policy process. In addition, we need to know something about how a policy decision made by the United States affects businesses and workers based in other countries (more economic theory for this), and we need to know how the governments in those countries are likely to respond to these consequences (which requires knowledge about the political systems in the various coun- tries). Finally, we need to know something about the role that international economic organizations like the WTO play in regulating the foreign economic policies that governments adopt. Thus, understanding developments in the global economy requires us to draw on economic theory, explore domestic politics, examine the dynamics of political interactions between governments, and familiarize ourselves with international economic organizations. Even though such an undertaking may seem daunting, this book introduces you to each of these elements and teaches you how to use them to deepen your un- derstanding of the global economy.

One way scholars simplify the study of the global economy is to divide the substantive aspects of global economic activity into distinct issue areas.

Typically, the global economy is broken into four such issue areas: the international trade system, the international monetary system, multinational corporations (or MNCs), and economic development. Rather than studying the global economy as a whole, scholars will focus on one issue area in relative isolation from the others. Of course, it is somewhat misleading to study each issue area independently. MNCs, for example, are important actors in the international trade system. The international monetary system exists solely to enable people living in different countries to engage in economic transactions with each other. It has no purpose, therefore, outside consideration of international trade and investment. Moreover, problems arising in the international monetary system are intrinsically connected to developments in international trade and investment. Trade, MNCs, and the international monetary system in turn all play important roles in economic development.

Thus, each issue area is deeply connected to the others. In spite of these deep connections, the central characteristics of each area are sufficiently distinctive that one can study each in relative isolation from the others, as long as one remains sensitive to the connections among them when necessary. We will adopt the same approach here. 4 CHAPTER 1 International Political Economy The international trade system is centered upon the WTO, to which some 153 countries belong and through which they have created a nondiscrimina- tory international trade system. In the international trade system, each country gains access to all other WTO members’ markets on equal terms. In addition, the WTO and its predecessor, the General Agreements on Tariffs and Trade (GATT), have enabled governments to progressively eliminate tariffs and other barriers to the cross-border flow of goods and services. As these barriers have been dismantled, world trade has grown steadily. Today, goods and services worth about $7.6 trillion flow across national borders each year. During the last 10 years, however, regional trading arrangements have arisen to pose a potential challenge to the WTO–centered trade system. These regional trade arrangements, such as the North American Free Trade Agreement (NAFTA), are trading blocs composed of small number of countries who offer each other preferential access to their markets. Scholars who study the international trade system investigate how the political battle between the winners and losers of global economic exchange shapes the creation, operation, and consequences of the WTO–centered system and the emerging regional trading frameworks.

The international monetary system enables people living in different countries to conduct economic transactions with each other. People living in the United States who want to buy goods produced in Japan must be able to price these Japanese goods in dollars. In addition, Americans earn dollars, but Japanese spend yen, so somehow dollars must be converted into yen for such purchases to occur. The international monetary system facilitates in- ternational exchange by performing these functions. When it performs these functions well, international economic exchange flourishes. When it doesn’t, the global economy can slow or even collapse. Scholars who study the inter- national monetary system focus on how political battles between the winners and losers of global economic exchange shape the creation, operation, and consequences of this system.

Multinational corporations occupy a prominent and often controversial role in the global economy. A multinational corporation is a firm that controls production facilities in at least two countries. The largest of these firms are familiar names such as Ford Motor Company, General Electric, and General Motors. The United Nations estimates that there are more than 82,000 MNCs operating in the contemporary global economy. These firms collectively con- trol about 810,000 production plants and employ about 77 million people across the globe. Together, they account for about one-quarter of the world’s economic production and about one-third of the world’s trade. MNCs shape politics because they extend managerial control across national borders. Cor- porate managers based in the United States, for example, make decisions that affect economic conditions in Mexico and other Latin American countries, in Western Europe, and in Asia. Scholars who study MNCs focus on a variety of economic issues, such as why these large firms exist and what economic impact they have on the countries that host their operations. Scholars also study how the political battle between the winners and losers of MNC activity shapes government efforts to attract and regulate MNC activities. What Is International Political Economy? 5 Finally, a large body of literature studies economic development. Through- out the postwar period, developing country governments have adopted explicit development strategies that they believed would raise incomes by promoting industrialization. The success of these strategies has varied. Some countries, such as the Newly Industrializing Countries (NICs) of East Asia (Taiwan, South Korea, Singapore, and Hong Kong) have been so successful in promot- ing industrialization and raising per capita incomes that they no longer can be considered developing countries. Other countries, particularly in sub-Saharan Africa and in parts of Latin America, have been less successful. Governments in these countries adopted different development strategies than the NICs throughout much of the postwar period and realized much smaller increases in per capita incomes. Students of the politics of economic development focus on the specific strategies that developing countries’ governments adopt and at- tempt to explain why different governments adopt different strategies. In ad- dition, these students are concerned about which development strategies have been relatively more successful than others (and why) and about whether par- ticipation in the international economy facilitates or frustrates development.

In trying to make sense of these aspects of development, IPE scholars empha- size how the political battle generated by the distributive consequences of the global economy shapes the development strategies that governments adopt.

Those who study the global economy through the lens of IPE are typi- cally interested in doing more than simply describing government policies and contemporary developments in these four issue areas. Most scholars aspire to make more general statements about how politics shape the policies that governments adopt in each of these issue areas. Moreover, most scholars want to draw more general conclusions about the consequences of these policies. As a result, two abstract and considerably broader questions typically shape IPE scholarship. First, how exactly does politics shape the decisions that societies make about how to use the resources that are available to them? Second, what are the consequences of these decisions? Because these two overarching ques- tions are central to what we cover in this book, it is worth taking a closer look at each of them now.

How does politics shape societal decisions about how to allocate avail- able resources? For example, how does a society decide whether to use available labor and capital to produce semiconductors or clothing? Although this question might appear quite remote from the issue areas just discussed, the connections are actually quite close. The foreign economic policies that a government adopts—its trade policies, its exchange rate policies, and its policies toward MNCs—affect how that society’s resources are used. A deci- sion to raise tariffs, for example, will encourage business owners to invest and workers to seek employment in the industry that is protected by the tar- iff. A decision to lower tariffs will encourage business owners and workers currently employed in the newly liberalized industry to seek employment in other industries. Decisions about tariffs, therefore, affect how society’s re- sources are used. Foreign economic policies are, in turn, a product of politics, the process through which societies make collective decisions. Thus, the study 6 CHAPTER 1 International Political Economy of international political economy is in many respects the study of how the political battle between the winners and losers of global economic exchange shapes the decisions that societies make about how to allocate the resources they have available to them.

These decisions are complicated by two considerations. On the one hand, all resources are finite. As a result, choices about how to allocate resources will always be made against a backdrop of scarcity. Any choice in favor of one use therefore necessarily implies a choice to forgo another possible use. On the other hand, in every society, groups will disagree about how available re- sources should be used. Some groups will want to use the available resources to produce cars and semiconductors, for example, whereas others will prefer to use these resources to produce clothing and agricultural products. Societ- ies consequently will always confront competing demands for finite resources.

One of the important goals of IPE as a field of study is to investigate how such competing demands are aggregated, reconciled, and transformed into foreign economic policies.

The second abstract question asks what are theconsequences of the choices that societies make about resource allocation? These decisions have two very different consequences. Decisions about resource allocation havewelfare consequences—that is, they determine the level of societal well-being. Some choices will maximize social welfare—that is, they will make society as a whole as well-off as possible given existing resources. Other choices will cause social welfare to fall below its potential, in which case different choices about how to use resources would make society better off. Decisions about resource allocation also havedistributional consequences—that is, they influence how income is distributed between groups within countries and between nations in the international system.

Welfare and distributional consequences are both evident in the American steel tariff. Because the tariff makes it more profitable to produce steel in the United States than it would be otherwise, some investment capital and work- ers, who might otherwise be employed in highly efficient American industries such as information technology or biotechnology, will be used in the less ef- ficient American steel industry. The tariff thus causes the United States to use too many of its resources in economic activities that it does less well and too few resources in activities that it does better. As a consequence, the United States is poorer with a high tariff on steel than it would be without it.

The steel tariff also redistributes income. Because the tariff raises the price of steel in the United States, it redistributes income from the consumers of steel, such as American firms that use steel in the products they manufacture and the American consumers who purchase goods made out of steel, to the steel pro- ducers. In addition, because the tariff makes it more difficult for foreign steel firms to sell in the American market, it redistributes income from foreign steel producers to American steel producers. The steel tariff, like many economic policies, affects both the level and the distribution of income within a society.

These two abstract questions give rise to two very different research tra- ditions within IPE. One tradition focuses on explanation, and the second fo- cuses on evaluation.Explanatory studies, which relate most closely to our first Studying International Political Economy 7 abstract question, are oriented toward explaining the foreign economic policy choices that governments make. Such studies most often attempt to answer “why” questions. For example, why does one government choose to lower tar- iffs and open its economy to trade, whereas another government continues to protect the domestic market from imports? Why did governments create the WTO? Why do some governments maintain fixed exchange rates whereas oth- ers allow their currencies to float? Why do some governments allow MNCs to operate in their economies with few restrictions, whereas other governments attempt to regulate MNC activity? Each of these questions asks us to explain a specific economic policy choice made by a government or to explain a pattern of choices within a group of governments. In answering such questions, we are most concerned with explaining the policy choices that governments make and pay less attention to the welfare consequences of these policy choices.

Evaluative studies, which are related most closely to our second abstract question, are oriented toward assessing policy outcomes, making judgments about them, and proposing alternatives when the judgment made about a par- ticular policy is a negative one. Awelfare evaluation is interested primarily in whether a particular policy choice raises or lowers social welfare. For example, does a decision to liberalize trade raise or lower national economic welfare? Does a decision to turn to the International Monetary Fund (IMF) and accept a pack- age of economic reforms promote or retard economic growth? More broadly, do current policies encourage society to use available resources in ways that maxi- mize economic welfare, or would alternative policies that encouraged a differ- ent allocation result in higher economic welfare? Because such evaluations are concerned with the economic welfare consequences of policy outcomes, they are typically based on economic criteria and rely heavily upon economic theories.

Scholars also sometimes evaluate outcomes in terms that extend beyond narrow considerations of economic welfare. In some instances, scholars evalu- ate outcomes in terms of their distributional consequences. For example, many nongovernmental organizations are highly critical of international trade be- cause they believe that workers lose and business gains from trade liberaliza- tion. Implicit in this criticism is an evaluation of how global trade distributes income across groups within countries. Evaluations may also extend the frame of reference within which outcomes are evaluated beyond purely economic effi- ciency. For example, even those who agree that international trade raises world economic welfare might remain critical of globalization because they believe that it degrades the environment, disrupts traditional methods of production, or has other negative social consequences that outweigh the economic gains.

Explanation and evaluation both play an important role in international po- litical economy. This book, however, focuses primarily upon explanation and, secondarily, upon evaluating the welfare consequences of government policies.

STUDYING INTERNATIONAL POLITICAL ECONOMY Scholars working within the field of IPE have developed a large number of theories to answer the two questions posed earlier. Three traditional schools of political economy—the mercantilist school, the liberal school, and the 8 CHAPTER 1 International Political Economy Marxist school—have shaped the development of these theories over the last 100 years. Each of these three traditional schools offers distinctive answers to the two questions, and these differences have structured much of the scholarly and public debate about IPE.

Although the three traditional schools remain influential, more and more often students of IPE are developing theories to answer our two questions from outside the explicit confines of these traditional schools. One prominent approach, and the approach that is developed throughout this book, suggests that the foreign economic policies that governments adopt emerge from the in- teraction between societal actors’ interests and political institutions. We begin our examination of how people study IPE with a broad overview of these al- ternative approaches. We look first at the three traditional schools, highlight- ing the answers they provide to our two questions and pointing to some of the weaknesses of these schools that have led students to move away from them.

We then examine the logic of an approach based on interests and institutions in order to provide the background necessary for the more detailed theories that we develop throughout the book.

Traditional Schools of International Political Economy Historically, theories of IPE have been developed in three broad schools of thought: mercantilism (or nationalism), liberalism, and Marxism.Mercan- tilism is rooted in seventeenth- and eighteenth-century theories about the relationship between economic activity and state power. The mercantilist lit- erature is large and varied, yet mercantilists generally do adhere to three cen- tral propositions. (See, e.g., Viner 1960; Heckscher 1935.) First, the classical mercantilists argued that national power and wealth are tightly connected.

National power in the international state system is derived in large part from wealth. Wealth, in turn, is required to accumulate power. Second, the classi- cal mercantilists argued that trade provided one way for countries to acquire wealth from abroad. Wealth could be acquired through trade, however, only if the country ran a positive balance of trade, that is, if the country sold more goods to foreigners than it purchased from foreigners. Third, the classical mercantilists argued that some types of economic activity are more valuable than others. In particular, mercantilists argued that manufacturing activities should be promoted, whereas agriculture and other nonmanufacturing activi- ties should be discouraged.

“Modern” mercantilism applies these three propositions to contemporary international economic policy:

1. Economic strength is a critical component of national power.

2. Trade is to be valued for exports, but governments should discourage imports whenever possible.

3. Some forms of economic activity are more valuable than others.

Manufacturing is preferred to the production of agricultural and other primary commodities, and high-technology manufacturing industries such as Studying International Political Economy 9 computers and telecommunications are preferable to mature manufacturing industries such as steel or textiles and apparel.

The emphasis on wealth as a critical component of national power, the insistence on maintaining a positive balance of trade, and the conviction that some types of economic activity are more valuable than others leads mercantil- ists to argue that the state should play a large role in determining how society’s resources are allocated. Economic activity is too important to allow decisions about resource allocation to be made through an uncoordinated process such as the market. Uncoordinated decisions can result in an “inappropriate” eco- nomic structure. Industries and technologies that may be desirable from the perspective of national power might be neglected, whereas industries that do little to strengthen the nation in the international state system may flourish.

In addition, the country could develop an unfavorable balance of trade and become dependent on foreign countries for critical technologies. The only way to ensure that society’s resources are used appropriately is to have the state play a large role in the economy. Economic policy can be used to channel resources to those economic activities that promote and protect the national interest and away from those that fail to do so.

Liberalism, the second traditional school, emerged in Britain during the eighteenth century to challenge the dominance of mercantilism in government circles. Adam Smith and other liberal writers, such as David Ricardo (who first stated the modern concept of comparative advantage), were scholars who were attempting to alter government economic policy. The theory they developed to do so, liberalism, challenged all three central propositions of mercantilism. First, liberalism attempted to draw a strong line between politics and economics. In doing so, liberalism argued that the purpose of economic activity was to enrich individuals, not to enhance the state’s power. Second, liberalism argued that countries do not enrich themselves by running trade surpluses. Instead, countries gain from trade regardless of whether the balance of trade is positive or negative. Finally, countries are not necessarily made wealthier by producing manufactured goods rather than primary commodities.

Instead, liberalism argued, countries are made wealthier by making products that they can produce at a relatively low cost at home and trading them for goods that can be produced at home only at a relatively high cost. Thus, according to liberalism, governments should make little effort to influence the country’s trade balance or to shape the types of goods the country produces.

Government efforts to allocate resources will only reduce national welfare.

In addition to arguing against substantial state intervention as advocated by the mercantilists, liberalism argued in favor of a market-based system of resource allocation. Giving priority to the welfare of individuals, liberalism argues that social welfare will be highest when people are free to make their own decisions about how to use the resources they possess. Thus, rather than accepting the mercantilist argument that the state should guide the allocation of resources, liberals argue that resources should be allocated through volun- tary market-based transactions between individuals. Such an exchange is mutu- ally beneficial—as long as it is voluntary, both parties to any transaction will 10 CHAPTER 1 International Political Economy benefit. Moreover, in a perfectly functioning market, individuals will continue to buy and sell resources until the resulting allocation offers no further oppor- tunities for mutually beneficial exchange. The state plays an important, though limited, role in this process. The state must establish clear rights concerning ownership of property and resources. The judicial system must enforce these rights and the contracts that transfer ownership from one individual to another.

Most liberals also recognize that governments can, and should, resolvemarket failures, which are instances in which voluntary market-based transactions be- tween individuals fail to allocate resources to socially desirable activities.

Marxism, the third traditional school, originated in the work of Karl Marx as a critique of capitalism. It is impossible to characterize briefly the huge literature that has expanded on or been influenced by Marx’s ideas. Ac- cording to Marx, capitalism is characterized by two central conditions: the private ownership of the means of production (or capital) and wage labor.

Marx argued that the value of manufactured goods was determined by the amount of labor used to produce them. However, capitalists did not pay labor the full amount of the value they imparted to the goods they produced. In- stead, the capitalists who owned the factories paid workers only a subsistence wage and retained the rest as profits with which to finance additional invest- ment. Marx predicted that the dynamics of capitalism would lead eventually to a revolution that would do away with private property and with the capi- talist system that private property supported.

Three dynamics would interact to drive this revolution. First, Marx argued that there is a natural tendency toward the concentration of capital. Economic competition would force capitalists to increase their efficiency and increase their capital stock. As a consequence, capital would become increasingly concentrated in the hands of a small, wealthy elite. Second, Marx argued that capitalism is associated with a falling rate of profit. Investment leads to a growing abundance of productive capital, which in turn reduces the return to capital. As profits shrink, capitalists are forced to further reduce wages, worsening the plight of the already impoverished masses. Finally, capitalism is plagued by an imbalance between the ability to produce goods and the ability to purchase goods. Large capital investments continually augment the economy’s ability to produce goods, whereas falling wages continually reduce the ability of consumers to purchase the goods being produced. As the three dynamics interact over time, society becomes increasingly characterized by growing inequality between a small wealthy capitalist elite and a growing number of impoverished workers. These social conditions eventually cause workers (the proletariat, in Marxist terminology) to rise up, overthrow the capitalist system, and replace it with socialism.

In contrast to liberalism’s emphasis on the market as the principal mech- anism of resource allocation, Marxists argue that capitalists make decisions about how society’s resources are used. Moreover, because capitalist systems promote the concentration of capital, investment decisions are not typically driven by market-based competition, at least not in the classical liberal sense of this term. Instead, decisions about what to produce are made by the few firms that control the necessary investment capital. The state plays no autonomous Studying International Political Economy 11 role in the capitalist system. Instead, Marxists argue that the state operates as an agent of the capitalist class. The state enacts policies that reinforce capital- ism and therefore the capitalists’ control of resource allocation. Thus, in con- trast to the mercantilists who focus on the state and the liberals who focus on the market, Marxists focus on large corporations as the key actor determining how resources are used.

In the international economy, the concentration of capital and capital- ists’ control of the state are transformed into the systematic exploitation of the developing world by the large capitalist nations. In some instances, this exploitation takes the form of explicit colonial structures, as it did prior to World War II. In other instances, especially since World War II, exploitation is achieved through less intrusive structures of dominance and control. In all instances, however, exploitation is carried out by large firms based in the capi- talist countries that operate, in part, in the developing world. This systematic exploitation of the poor by the rich implies that the global economy does not provide benefits to all countries; all gains accrue to the capitalist countries at the top of the international hierarchy.

The three traditional schools of political economy thus offer three distinc- tive answers to our question of how politics shapes the allocation of society’s resources. Mercantilists argue that the state guides resource allocation in line with objectives shaped by the quest for national power. Liberals argue that politics ought to play little role in the process, extolling instead the role of market-based transactions among autonomous individuals. Marxists argue that the most important decisions are made by large capitalist enterprises sup- ported by a political system controlled by the capitalist class.

Each traditional school also offers a distinctive framework to evaluate the consequences of resource allocation. Mercantilists focus on the consequences of resource allocation for national power. The central question a mercantil- ist will ask is “Is there some alternative allocation of resources that would enhance the nation’s power in the international system?” Liberals rely heavily upon economic theory to focus principally upon the welfare consequences of resource allocation. The central question a liberal will ask is “Is there some alternative allocation of resources that would enable the society to improve its standard of living?” Marxists rely heavily upon theories of class conflict to focus on the distributional consequences of resource allocation. The central question a Marxist will ask is “Is there an alternative political and economic system that will promote a more equitable distribution of income?” Thus, lib- eralism emphasizes the welfare consequences of resource allocation, whereas mercantilism and Marxism each emphasize a different aspect of the distribu- tional consequences of these decisions.

These very different allocation mechanisms and unique evaluative frame- works generate three very different images of the central dynamic of IPE. (See Table 1.1.) Mercantilists argue that the IPE is characterized by distributional conflict when governments compete to attract and maintain desired industries.

Liberals argue that international economic interactions are essentially harmo- nious. Because all countries benefit from international trade, power has little 12 CHAPTER 1 International Political Economy impact on national welfare, and international economic conflicts are rare.

The central problem, from a liberal perspective, is creating the international institutional framework that will enable governments to enter into agree- ments through which they can create an international system of free trade.

Marxists argue that the international political economy is characterized by the distributional conflict between labor and capital within countries and by the distributional conflict between the advanced industrialized countries and developing countries within the international arena.

These three traditional schools have structured studies of and debate about the international political economy for a very long time. And although the pres- ence of all three will be felt in many ways throughout the pages of this book, we will spend little more time examining them directly. In their place, we will emphasize an analytical framework developed during the last 15 years or so, which focuses on how the interaction between societal interests and political institutions determines the foreign economic policies that governments adopt. TABLE 1.1 Three Traditional Schools of International Political Economy Mercantilism Liberalism Marxism Most Important ActorThe State Individuals Classes, particularly the capitalist class Role of the StateIntervene in the economy to allocate resourcesEstablish and enforce property rights to facilitate market- based exchange Instrument of the capitalist class uses state power to sustain capitalist system Image of the International Economic System Conflictual :

Countries compete for desirable industries and engage in trade conflicts as a result of this competition Harmonious: The international economy offers benefits to all countries. The challenge is to create a political framework that enables countries to realize these benefits. Exploitative :

Capitalists exploit labor within countries; rich countries exploit poor countries in the international economy Proper Objective of Economic PolicyEnhance power of the nation- state in international state system Enhance aggregate social welfare Promote an equitable distribution of wealth and income Studying International Political Economy 13 Interests and Institutions in International Political Economy To explain the policy choices made by governments, this book concentrates on the interaction between societal interests and political institutions. Such an approach suggests that to understand the foreign economic policy choices that governments make, we need to understand two aspects of politics. First, we need to understand where the interests, or economic policy preferences, of groups in society come from. Second, we need to examine how political institutions aggregate, reconcile, and ultimately transform competing interests into foreign economic policies and a particular international economic system.

Interests are the goals or policy objectives that the central actors in the political system and in the economy—individuals, firms, labor unions, other interest groups, and governments—want to use foreign economic policy to achieve. In focusing on interests, we will assume that individuals and the in- terest groups that represent them prefer foreign economic policies that raise their incomes to policies that reduce their incomes. Thus, whenever a group confronts a choice between one policy that raises its income and another that lowers its income, it will always prefer the policy that raises its income. We focus on two mechanisms to explain the formation of these policy interests.

First, people havematerial interests that arise from their position in the global economy. The essence of this approach can be summarized in a simple statement: Tell me what you do for work, and I’ll tell you what your foreign economic policy preferences are. Consider once again the American steel tariff. Whether a particular individual supports or opposes this tariff depends on where he or she works. If you are an American steelworker, you favor the tariff because it reduces the likelihood that you will lose your job. If you own an American steel mill, you also will favor the tariff, because it helps ensure a market and a relatively high price for the steel you produce. If you are an American autoworker or you own a substantial share of General Motors (GM), however, you will oppose the steel tariff. Higher steel prices mean that it costs more to produce cars. As cars become more expensive, fewer are sold and, consequently, fewer are produced. The tariff thus increases the chances that autoworkers will be laid off and it causes GM to earn smaller profits.

These are compelling reasons for autoworkers and their employers to oppose the higher steel tariff. In short, one’s position in the economy powerfully shapes one’s preferences regarding foreign economic policy. As we shall see, economic theory enables us to make some powerful statements about the foreign economic policy preferences of different groups in the economy.

Second, interests are often based on ideas.Ideas are mental models that provide a coherent set of beliefs about cause-and-effect relationships. In the context of economic policy, these mental models typically focus on the rela- tionship between government policies and economic outcomes. Not surpris- ingly, therefore, economic theory is a very important source of ideas that influence how actors perceive and formulate their interests. By providing clear statements about cause-and-effect economic relationships, economic theories can create an interest in a particular economic policy. The theory of compara- tive advantage, for example, claims that reducing tariffs raises aggregate social 14 CHAPTER 1 International Political Economy welfare. A government that believes this theory might be inclined to lower tar- iffs to realize these welfare gains. Alternatively, a government might adopt high tariffs because a different economic theory (the infant industry argument, for example) suggests that under the right conditions, tariffs can raise national in- come. What matters, therefore, is not whether a particular idea is true or not, but whether people in power, or people with influence over people with power, believe the idea to be true. Thus, ideas about how the economy operates can be a source of the preferences that groups have for particular economic policies.

Understanding where interests come from will enable us to specify with some precision the competing demands that politicians confront when making foreign economic policy decisions. It does not tell us anything about how these compet- ing interests are transformed into foreign economic policies. To understand how interests are transformed into policies, we need to examine political institutions.

Political institutions establish the rules governing the political process. By estab- lishing rules, they enable groups within countries, and groups of countries in the international state system, to reach and enforce collective decisions.

Political institutions determine which groups are empowered to make choices and establish the rules these “choosers” will use when doing so. In domestic political systems, for example, democratic institutions promote mass participation in collective choices, whereas authoritarian systems restrict participation to a narrow set of individuals. In international economic affairs, governments from the advanced industrialized countries often make decisions with little participation by developing countries.

Political institutions also provide the rules that these groups use to make decisions. In democratic systems, the usual choice rule is majority rule, and policies are supposed to reflect the preferences of a majority of voters or legislators. In international economic organizations, the choice rule is often relative bargaining power, and decisions typically reflect the preferences of the more powerful nations. Political institutions thus allow groups to make collective decisions and, in doing so, determine who gets to make these decisions and how they are to be made.

Political institutions also help enforce these collective decisions. In many instances, individuals, groups, and governments have little incentive to comply with the decisions that are produced by the political process. This is particu- larly the case for those groups whose preferences diverge from those embodied in the collective choice. And even in cases where a group or a country as a whole does benefit from a particular decision, it may believe it could do even better if it cheated a little bit. If such instances of noncompliance are wide- spread, then the political process is substantially weakened.

This problem is particularly acute in the international state system. In do- mestic political systems, the police and the judicial system are charged with enforcing individual compliance with collective decisions. The international sys- tem has neither a police force nor a judicial system through which to enforce compliance, however. Consequently, it can be very tempting for governments to attempt to “cheat” on the international economic agreements they conclude with other governments. International institutions like the WTO and the IMF can help governments enforce the international agreements that they conclude. The Global Economy in Historical Context 15 A focus on interests and institutions will allow us to develop a set of reason- ably comprehensive answers to our first question: How does politics shape so- cietal decisions about how to allocate resources? The explanations we construct almost always will begin by investigating the source of competing societal de- mands for income and then explore how political institutions aggregate, recon- cile, and ultimately transform these competing demands into foreign economic policies and a particular international economic system. This approach may not always provide a full explanation of the interactions we observe in the interna- tional political economy, but it does provide a solid point of departure. THE GLOBAL ECONOMY IN HISTORICAL CONTEXT Although we will focus on how the interaction between interests and institu- tions shapes government behavior in the post–World War II global economy, the contemporary global economy embodies a deeper historical continuity. Even though the contemporary global economy is distinctive in many ways, this system continues a trend toward deeper international economic integration that began in the nineteenth century. Because the contemporary system has deep roots in the nineteenth century, it is useful to examine the rise, fall, and reconstruction of the global economy in the years before World War II.

People have conducted long-distance trade for hundreds of years, but the first true “global” economy emerged only in the nineteenth century. This “first wave” of globalization was driven by the interaction between techno- logical change and politics. Technological innovation, in particular the inven- tion of the steam engine and the telegraph, made it profitable to trade heavy commodities across long distances. Steam engines dramatically reduced the cost and time involved in long-distance trade. The railroad made it possible to ship large volumes of heavy commodities across long distances—grain from the American plains states to the Atlantic coast, for example—quickly and at low cost. In 1830, it cost more than $30 to ship a ton of grain (or any other commodity) 300 miles; by 1900 the cost had fallen to about $5 (Frie- den 2006, 5). The use of steam to power ocean-going vessels further reduced the cost of long-distance trade. Whereas in the early nineteenth century it took a month and cost $10 to ship a ton of grain from the United States to Europe, by 1900 the Atlantic crossing took only a week and cost about $3.

Consequently, whereas throughout history high shipping costs discouraged trade of all but the lightest and highest-value commodities, technology had reduced shipping costs so sharply by the late nineteenth century that such trade became very profitable.

Although new technologies made long-distance trade possible, political structures made it a reality. Capitalizing on the new possibilities required gov- ernments to establish an infrastructure that facilitated global exchange. This infrastructure was based on a network of bilateral trade agreements and a stable international monetary system. Governments began to reduce barriers to trade in the mid-nineteenth century. Britain was the first to adopt a free- trade policy in the 1840s when it repealed its “Corn Laws” and opened its market to imported grain. The shift to free trade gained momentum in 1860, 16 CHAPTER 1 International Political Economy when Britain and France eliminated most tariffs on trade between them with the Cobden–Chevalier Treaty. The treaty triggered a wave of negotiations that quickly established a network of bilateral treaties that substantially re- duced trade barriers throughout Europe and the still-colonized developing world (see Irwin 1993, 97). The United States remained an important excep- tion to nineteenth-century trade liberalization, remaining staunchly protec- tionist until the 1930s.

Most governments also adopted gold-backed currencies. In this gold stan- dard, each government pledged to exchange its national currency for gold at a permanently fixed rate of exchange. From the late nineteenth century until 1933, for example, the U.S. government exchanged dollars for gold at the fixed price of $20.67 per ounce. Great Britain was the first to adopt the gold standard, shifting from a bimetallic system in which the pound was backed by silver and gold to a pure gold standard in the eighteenth century. Other nations embraced the gold standard during the 1870s. Germany shifted to gold in 1872, and many other governments followed. By the end of the de- cade most industrialized countries, and quite a few developing countries, had adopted the gold standard. By stabilizing international price relationships, the gold standard encouraged international trade and investment.

Technological innovation and the creation of an international political in- frastructure combined to produce a dramatic expansion of global economic ex- change in the nineteenth century. Trade grew at an average rate of 3.5 percent per year between 1815 and 1914, three and a half times more rapidly than the previous 300 years. People crossed borders in historic numbers as well. Each year between 1880 and 1900, 600,000 people left Europe to find new lives in the United States, Canada, Australia, and Argentina; the number of such migrants continued to rise, reaching one million per year in the first decade of the twentieth century (Chiswick and Hatton 2003). In all, close to 14 mil- lion people left Western Europe in this period (Maddison 2001). Although the absolute numbers are large, one gains a deeper appreciation of the scale of late nineteenth-century migration by recognizing that these migrants represented 2 to 5 percent of the total population of the home countries (Baldwin and Martin 1999, 19). Financial capital also poured across borders. In the late nineteenth century British residents invested almost 10 percent of their incomes in foreign markets, and the French, German, and Dutch invested only slightly smaller shares of their incomes. These capital flows constructed railroads and other infrastructure in the lands of recent settlement (Bordo 2002, 23).

By the late nineteenth century, therefore, it was no exaggeration to talk of a global economy. In the passage I paraphrased at the beginning of this chap- ter, John Maynard Keynes remarked on the extraordinary nature of the global economy in the early twentieth century. “The inhabitant of London could or- der by telephone, sipping his morning tea in bed, the various products of the whole earth, in such quantity as he might see fit, and reasonably expect their early delivery on his doorstep; he could at the same moment and by the same means adventure his wealth in the natural resources and new enterprise of any quarter of the world. He could secure forthwith, if he wished it, cheap and The Global Economy in Historical Context 17 comfortable means of transport to any country or climate without passport or other formality. . . . He regarded this state of affairs as normal, certain, and permanent” (Keynes 1919, 9–10).

Globalization was not permanent, however. In the first half of the twen- tieth century governments dismantled the dense international economic net- works they had created and retreated into sheltered national economies. The First World War triggered the retreat. European governments abandoned the gold standard in order to finance the war. They tightly controlled trade and financial flows in order to marshal resources for the war. Following the war, governments tried to reconstruct the global economy, but were not successful.

This failure was a consequence of many factors, a full accounting of which would require more space than we can dedicate here. One of the most critical factors, however, lay in dramatic changes in the global political structure that supported the global economy.

Throughout the nineteenth century Britain stood at the center of the world economy. British manufacturing dominated world trade, and London served as the world’s financial center. As the dominant economic power— what many political economists call the hegemon—Britain provided much of the infrastructure of the global economy. By the turn of the century Britain was ceding ground to the United States and Germany. These two rising nations industrialized rapidly in the late nineteenth century, taking advantage of science and new forms of corporate organization. By the end of the century both countries were challenging Britain’s dominance. World War I accelerated this trend. American manufacturing output expanded during the war as the United States supplied the European nations. American financial power grew as the belligerents turned to the United States to finance their war expenditures.

In contrast, 5 years of fighting weakened the British industrial capacity.

Britain borrowed heavily and sold many of its foreign assets to finance its war expenditures, and thus exited the war saddled with a heavy foreign debt.

At the war’s end, the United States stood as the world’s dominant economic power—the world’s largest manufacturing economy and its largest creditor.

This power shift meant that postwar global economic reconstruction hinged on American leadership. Yet, the United States refused to accept the responsibilities that hegemonic status carried, preferring instead to retreat into a traditional policy of isolationism. Nowhere was the lack of American leader- ship more evident than on the war debt question. France and Britain (along with smaller European nations fighting against the Triple Alliance) had bor- rowed from the United States to finance part of their war expenditures. At the war’s end, they asked the United States to forgive these debts. Britain and France had paid a heavy price, measured in terms of human suffering and eco- nomic damage, in the war. Was it not reasonable, they argued, for the United States to forgive the war debt as part of its contribution to the common ef- fort? The United States refused, insisting that European governments repay the debt. To further compound the problem, the United States raised tariffs in 1922, making it difficult for Europe to sell products in the American market in order to earn dollars needed to repay the debt. 18 CHAPTER 1 International Political Economy American war-debt policy held the key to the pace of European economic recovery, and thus had real consequences for the interwar global economy. War debt was linked (at least in the eyes of European governments) to German repa- rations payments. France insisted that Germany pay for war damages by paying reparations to the Allied powers. The amount of reparations the French sought was, in part, a function of the total demands on French financial resources. The American refusal to forgive French debt, therefore, encouraged France to de- mand more from Germany. Larger reparations payments in turn delayed eco- nomic recovery in Germany. And the delay in German recovery in turn delayed recovery throughout Europe. Had the United States forgiven the war debt, France might have demanded less from Germany. A smaller reparations burden would in turn have enabled Germany to recover more quickly, and German economic recovery would have driven European recovery. No less important, an early settlement would have enabled European governments to move past wartime animosities. Instead, the war debt–reparations mess dominated diplo- macy and soured inter-European relations throughout the 1920s.

The failure to resolve these financial issues meant that governments never placed the international economy on a firm foundation. Although govern- ments had reestablished a gold standard and had revived international trade by the mid-1920s, lingering war debts and reparations problems rendered the system quite fragile and unable to withstand the shock of the crash of the American stock market in October 1929. The financial collapse depressed eco- nomic activity. Consumer demand fell sharply, and as people stopped buying goods, factories stopped production and released their workers. Output fell and unemployment rose. The resulting Great Depression represented the largest col- lapse of production and employment the industrial world had ever experienced.

American production fell by 30 percent between 1929 and 1933; unemployment rose to 25 percent in the United States and as high as 44 percent in Germany.

Governments responded to collapsing output and rising unemployment by raising tariffs in a desperate attempt to protect the home market. The United States led the way, sharply raising tariffs in the 1930 Smoot-Hawley Tariff Act. Countries with colonial possessions created trade blocs that linked the colonial power and its possessions. Great Britain established the Imperial Pref- erence System in 1933 to insulate its trade and investment relationships with its colonies from the rest of the world. France established similar arrangements with its colonial possessions. Powerful countries that lacked colonies began us- ing force to acquire them. Japan invaded Manchuria in the early 1930s and sought to bring much of East Asia into a Japan-dominated Asian Co-prosperity Sphere. Germany exploited its power and position in Central Europe to estab- lish a network of bilateral trade relations with the region. By the mid-1930s, the world economy had disintegrated into relatively insulated regional trading blocs, and governments were moving toward the Second World War.

The failure to reconstruct the global economy after World War I and the subsequent depression and war had a dramatic impact on American policy.

American policymakers drew two lessons from the interwar period. First, they concluded that World War II was caused in part by the failure to reconstruct a stable global economy after the First World War. As a result, the construction The Global Economy in Historical Context 19 of a stable and liberal international economy would have to be a centerpiece of post–World War II planning in order to establish a lasting peace. Second, American policymakers concluded that the United States alone controlled suf- ficient power to establish a stable global economy. America’s European allies had been further weakened by World War II, and the Japanese and German economies had been destroyed. The United States, in contrast, emerged in a stronger position. These conclusions encouraged the United States to embrace an internationalist orientation. Working alongside British policymakers in the early 1940s, the United States designed international institutions to provide the infrastructure for the postwar global economy.

The resulting Bretton Woods system—so named because many of its final details were negotiated at an intergovernmental conference held in Bretton Woods, New Hampshire, in late summer of 1944—continues to provide the institutional structure at the center of the global economy. The WTO, the IMF, and the World Bank all have their origins in this concerted period of postwar planning. The contemporary global economy, therefore, was established as an explicit attempt to return to the “golden years” of the late nineteenth century to prevent a recurrence of the economic and political disasters of the interwar period. The post–World War II global economy differed from the classical liberal system of the nineteenth century in important ways. At the broadest level, the difference reflected changed public attitudes about the government’s proper economic role. In the nineteenth-century liberal system, governments eliminated trade barriers and made little effort to manage domestic economic activity. The Great Depression encouraged governments to play a more active role in the economy. Governments used macroeconomic policy to promote growth and limit unemployment, and they established safety nets to protect society’s most vulnerable from the full force of the market. This more active government role in turn required some insulation between the domestic and the international economies. The rules embodied in the Bretton Woods sys- tem provided this insulation. This important difference notwithstanding, the postwar global economy was, in effect, a restoration of the nineteenth-century global economy.

In short, the contemporary global economy continues a global trend to- ward deeper international economic integration that first emerged in the nine- teenth century. So, although we are often inclined to view our contemporary system as fundamentally new, it is not so unique. The first wave of global- ization also highlights another lesson. One often hears that globalization is inevitable, but the first wave of globalization suggests that it is not. Economic globalization is not a disembodied spirit; it is the product of multiple decisions made by governments throughout the world. Sometimes these decisions result in policies that encourage globalization, and sometimes they result in policies that discourage cross-border exchange. These decisions, in turn, are shaped by politics; that is, they are shaped by the pressures brought to bear by those who gain and those who lose in the process of international economic integration.

In the remainder of this book we will explore how this political dynamic has shaped the evolution of the global economy after World War II and how it continues to shape the contemporary global economy. 20 CHAPTER 1 International Political Economy CONCLUSION IPE studies the political battle between the winners and losers of global eco- nomic exchange. It examines how this political competition shapes the evolution of the international trade and monetary systems, affects the ability of MNCs to conduct their operations, and influences the development strategies govern- ments adopt. Thus, IPE suggests that it is hard to understand anything about the global economy without understanding how political competition unfolds.

IPE scholars traditionally have studied the global economy through the lens of three schools of thought. Each school offers a distinctive window on the global economy, and each emphasizes one aspect of global economic exchange—cooperation, competition between governments, and competition between labor and capital—as the central defining element of politics in the global economy.

This book relies on an approach that emphasizes the interaction between societal interests and political institutions. Such an approach will enable us to develop models that provide insights into how the global economy generates winners and losers, how these groups compete to influence the policies that governments adopt, and how the policies that governments adopt affect the evolution of the global economy.

KEY TERMS Distributional Consequences Evaluative Studies Explanatory Studies IdeasInterests Liberalism Market Failures Marxism Material Interests Mercantilism Political Institutions Welfare Consequences Welfare Evaluation SUGGESTIONS FOR FURTHER READING For an excellent discussion of the historical development of the global economy since the late nineteenth century, see Jeffry A. Frieden’s Global Capitalism: Its Rise and Fall in the Twentieth Century (New York: W.W. Norton & Company, 2006). The two best treatments of mercantilism can be found in Jacob Viner’sStudies in the Theory of International Trade (London: Allen & Unwin, 1960) and Eli Heckscher’s Mercantilism (London: Allen & Unwin, 1935). Adam Smith’s The Wealth of Na- tions (New York: Bantam Classics, 2003) remains the most authoritative statement of liberalism. Vladimir Il’ich Lenin’sImperialism: The Highest Stage of Capitalism (New York: International Publishers, 1933) provides the seminal Marxist approach to international political economy. For a more general treatment of the three tra- ditional schools, see Robert Gilpin’sThe Political Economy of International Rela- tions (Princeton, NJ: Princeton University Press, 1987). 21 CHAPTER 2 N ational economies are becoming deeply connected. You probably no- tice these connections most as a consumer, since many of the goods you buy are produced, either in whole or in part, in a foreign country.

This is certainly the case for me. Most of my clothes are manufactured in Ban- gladesh and other developing countries. My computer was assembled in the Philippines from components that were designed and manufactured in at least five other countries. Thus, my consumption (and yours) has become interna- tionalized. And what is true about our consumption is obviously also true about production. Although we once thought in terms of national firms, it makes less and less sense to do so. Is the iPhone, for example, an American product?

Apple designs the phone in Cupertino, California. It manufactures the phone in a plant in China. The components that go into the phone are in turn produced across the Pacific basin. Production, too, has become internationalized.

Internationalization has been brought about by the rapid growth of world trade. Global trade has grown during the last 60 years at an average rate of about 6 percent per year. As a result, annual world merchandise trade has risen from $84 billion in 1953 to $15.7 trillion in 2008 (World Trade Organization 2009). Never before in history has international trade grown so rapidly for such a long period. Even more importantly, trade has consistently grown more rapidly than the world’s economic output. Consequently, each year a greater proportion of the goods and services produced in the world are created in one country and consumed in another. Indeed, globalization is a consequence of these differential growth rates.

None of this has occurred spontaneously. Even though one could argue that the growth of trade reflects the operation of global markets, all mar- kets rest on political structures. This is certainly the case with international trade. World trade has grown so rapidly over the last 60 years because an international political structure, theWorld Trade Organization (WTO), and its predecessor, the General Agreement on Tariffs and Trade (GATT), has supported and encouraged such growth. Most political scientists who study The World Trade Organization and the World Trade System 22 CHAPTER 2 The World Trade Organization and the World Trade System the global economy believe that, had governments never created this institu- tional framework after World War II, or had they created a different one, world trade would not have grown so rapidly. Internationalization, therefore, has been brought about by the decisions governments have made about the rules and institutions that govern world trade.

Because trade plays so important a role in our lives, and because trade is made possible by the political institution that structures trade relationships, understanding the political dynamics of the world trade system is vital. This chapter begins developing that knowledge. It provides a broad overview of the WTO’s core components. It then examines how the global distribution of power shapes the creation and evolution of international trade systems. It then explores some contemporary challenges to the WTO, focusing on the rise of developing countries as a powerful bloc within the organization and the rise of civil society groups as powerful critics of the organization from the outside.

The chapter concludes by examining regional trade arrangements, considered by many the greatest current challenge to the WTO.

WHAT IS THE WORLD TRADE ORGANIZATION?

The WTO (located on the shore of the beautiful Lac Leman in Geneva, Switzerland) is the hub of an international political system under which governments negotiate, enforce, and revise rules to govern their trade policies.

Between 1947 and 1994 the GATT fulfilled the role now played by the WTO.

In 1995, governments folded the GATT into the newly established WTO where it continues to provide many of the rules governing international trade relations.

The rules at the center of the world trade system were thus established initially in 1947 and have been gradually revised, amended, and extended ever since.

The WTO is small compared with other international organizations.

Although 153 countries belong to the WTO, it has a staff of only about 635 people and a budget of roughly $170 million. The World Bank, by contrast, has a staff of about 9,300 people and an operating budget of close to $1 billion. As the center of the world trade system, the WTO provides a forum for trade negotiations, administers the trade agreements that governments conclude, and provides a mechanism through which governments can resolve trade disputes. As a political system, the WTO can be broken down into three distinct components: a set of principles and rules, an intergovernmental bargaining process, and a dispute settlement mechanism.

Two core principles stand at the base of the WTO: market liberalism and nondiscrimination.Market liberalism provides the economic rationale for the trade system. Market liberalism asserts that an open, or liberal, international trade system raises the world’s standard of living. Every country—no matter how poor or how rich—enjoys a higher standard of living with trade than it can achieve without trade. Moreover, the gains from trade are greatest—for each country and for the world as a whole—when goods can flow freely across na- tional borders unimpeded by government-imposed barriers. The claim that trade provides such gains to all countries is based on economic theory we examine in What Is the World Trade Organization? 23 detail in Chapter 3 . For our purposes here, it is sufficient to recognize that this claim provides the economic logic upon which the WTO is based.

Nondiscrimination is the second core principle of the multilateral trade system. Nondiscrimination ensures that each WTO member faces identical opportunities to trade with other WTO members. This principle takes two specific forms within the WTO. The first form, called Most-Favored Nation (MFN), prohibits governments from using trade policies to provide special advantages to some countries and not to others. MFN is found in Article I of GATT. It states, “any advantage, favour, privilege, or immunity granted by any contracting party to any product originating in or destined for any other country shall be accorded immediately and unconditionally to the like product originating in or destined for the territories of all other contracting parties.” Stripped of this legal terminology, MFN simply requires each WTO member to treat all WTO members the same. For example, the United States cannot apply lower tariffs to goods imported from Brazil (a WTO member) than it applies to goods imported from other WTO member countries. If the United States reduces tariffs on goods imported from Brazil, it must extend these same tariff rates to all other WTO members. MFN thus assures that all countries have access to foreign markets on equal terms.

WTO rules do allow some exceptions to MFN. The most important ex- ception concerns regional trade arrangements. Governments are allowed to depart from MFN if they join a free-trade area or customs union. In the North American Free Trade Agreement (NAFTA), for example, goods produced in Mexico enter the United States duty free, whereas the United States imposes tariffs on the same goods imported from other countries. In the European Union, goods produced in France enter Germany with a lower tariff than goods produced in the United States. A second exception is provided by the Generalized System of Preferences (GSP), enacted in the late 1960s. The GSP allows the advanced industrialized countries to apply lower tariffs to imports from developing countries than they apply to the same goods coming from other advanced industrialized countries. These exceptions aside, MFN ensures that all countries trade on equal terms.

National treatment is the second form of nondiscrimination found in the WTO.National treatment prohibits governments from using taxes, regulations, and other domestic policies to provide an advantage to domestic firms at the ex- pense of foreign firms. National treatment is found in Article III of the GATT, which states that “the products of the territory of any contracting party imported into the territory of any other contracting party shall be accorded treatment no less favourable than that accorded to like products of national origin in respect of all laws, regulations and requirements affecting their internal sale, offering for sale, purchase, transportation, distribution or use.” In plainer English, national treatment requires governments to treat domestic and foreign versions of the same product (“like products” in GATT terminology) identically once they enter the domestic market. For example, the U.S. govern- ment cannot establish one fuel efficiency standard for foreign cars and another for domestic cars. If the U.S. government wants to advance this environmental 24 CHAPTER 2 The World Trade Organization and the World Trade System goal, it must apply the same requirement to domestic and foreign auto produc- ers. Together, MFN and national treatment ensure that firms in every country face the same market opportunities and barriers in the global economy.

These two core principles are accompanied by hundreds of other rules.

Since 1947, governments have concluded about 60 distinct agreements that together fill about 30,000 pages. These rules jointly provide the central legal structure for international trade. As a group, these rules constrain the policies that governments can use to control the flow of goods, services, and technology into and out of their national economies. Some of these rules are proscriptive, such as prohibition against government discrimination. Others are prescriptive, such as requirements for governments to protect intellectual property. Many of these rules state instances in which governments are allowed to protect a domestic industry temporarily and then delineate the conditions under which governments can and cannot invoke this safeguard. All rules entail obligations to other WTO members that constrain the ability of governments to regulate the interaction between the national and the global economies.

All WTO rules are created by governments through intergovernmental bargaining.Intergovernmental bargaining is the WTO’s primary decision-making process, and it involves negotiating agreements that directly liberalize trade and indirectly support that goal. To liberalize trade, governments must alter policies that restrict the cross-border flow of goods and services. Such policies include tariffs, which are taxes that governments impose on foreign goods entering the country. They also include a wide range ofnontariff barriers such as health and safety regulations, government purchasing practices, and many other government regulations. Intergovernmental bargaining focuses on negotiating agreements that reduce and eliminate these government-imposed barriers to market access.

Rather than bargain continuously, governments organize their negotia- tions in bargaining rounds, each with a definite starting date and a target date for conclusion. At the beginning of each round, governments meet as the WTO Ministerial Conference, the highest level of WTO decision making. Meeting for three or four days, governments establish an agenda detailing the issues that will be the focus of negotiation and set a target date for the conclusion of the round. Once the Ministerial Conference has ended, lower-level national officials conduct detailed negotiations on the topics embodied in the agenda.

Periodic stock takings are held to reach interim agreements. Once negotiations have produced the outlines of a complete agreement, trade ministers meet at a final Ministerial Conference to conclude the round. National governments then ratify the agreement and implement it according to an agreed timetable.

To date, eight of these bargaining rounds have been concluded, and a ninth, the Doha Round, began in 2001. (See Table 2.1.) These bargaining rounds are usually extended affairs. Although the earlier rounds were typi- cally concluded relatively quickly, the trend over the last 30 years has been for multiyear rounds. Governments launched the Uruguay Round, for example, in 1986 (though they began discussing a new round in 1982) and concluded negotiations in December 1993. Governments launched the Doha Round in 2001 with plans to conclude the round by late 2005. Yet, in mid-2010, gov- ernments remain unable to reach agreement. The growing length of bargaining What Is the World Trade Organization? 25 rounds reflects the complexity of the issues at the center of negotiations and the growing diversity of interests among WTO member governments.

The rules established by intergovernmental bargaining provide a frame- work of law for international trade relations. Participation in the WTO, therefore, requires governments to accept common rules that constrain their TABLE 2.1 Trade Negotiations within the General Agreement on Tariffs and Trade (GATT)/World Trade Organization (WTO), 1947–2010 Name and Year of Round Subjects Covered Participating Countries 1947 Geneva Tariffs 23 1949 Annecy Tariffs 13 1951 Torquay Tariffs 38 1956 Geneva Tariffs 26 1960–1961 Dillon Round Tariffs 26 1964–1967 Kennedy Round Tariffs and Antidumping 62 1973–1979 Tokyo Round Tariffs 102 Nontariff Measures Framework Agreements 1986–1993 Uruguay Round Tariffs 123 Nontariff Measures Rules Services Intellectual Property Rights Textiles and Clothing Agriculture Dispute Settlement Establishment of WTO 2002–? The Doha Round Tariffs 147 Agriculture Services Intellectual Property Rights Government Procurement Rules Dispute Settlement Trade and the Environment Competition Policy Electronic Commerce Other Issues Source: World Trade Organization 1995, 9 and WTO website. 26 CHAPTER 2 The World Trade Organization and the World Trade System actions. By accepting these constraints, governments shift international trade relations from the anarchic international environment in which “might makes right” into a rule-based system in which governments have common rights and responsibilities. In this way, the multilateral trade system brings the rule of law into international trade relations. A CLOSER LOOK The Doha Round We can gain a better understanding of the WTO bargaining process by examining the evolution of negotiations in the current round. TheDoha Round was launched at the WTO’s Fourth Ministerial Conference held in Doha, Qatar, in November 2001. In Doha, governments reached agreement on the agenda for the round.

What issues would they address and which would they ignore? Governments agreed to (1) negotiate additional tariff reductions (with a specific focus on developing countries’ exports), (2) incorporate existing negotiations in services into the Doha Round, and (3) pursue meaningful liberalization of trade in agricultural products.

In agriculture, they agreed to reduce barriers to market access, to eliminate agricultural export subsidies, and to reduce domestic production subsidies. The agenda also called for negotiations on trade-related intellectual property rights, on modifications of existing WTO rules regarding antidumping and subsidies investigations, and on the rules pertaining to regional trade agreements and review of the operation of the dispute-settlement mechanism. Moreover, governments agreed to explore aspects of the relationship between trade and the environment.

Finally, members agreed to defer negotiations on trade and investment, competition policy, government procurement, and trade facilitation (four issues known collectively as “The Singapore Issues”). They agreed to treat the agenda as a “single undertaking,” meaning that everything must be agreed or nothing is agreed.

Governments would conclude the round by January 1, 2005.

The Doha Agenda was just that—an agenda for negotiations. It contained no details about the form an eventual final agreement would take. Negotiations between governments aimed at elaborating these details began at WTO headquarters in Geneva in early 2002. These initial negotiations (conducted for the most part by national delegations staffed by career civil servants or foreign service officers) were not oriented toward making final decisions, but instead explored areas of agreement and disagreement. These negotiations would set the stage for a stock- taking exercise scheduled for the WTO’s Fifth Ministerial Conference in Cancún, Mexico, in September of 2003. Even though much of the work proceeded smoothly, it quickly became evident that two issues presented the largest obstacles. First, developing countries were demanding deeper liberalization of agriculture than the United States and the European Union (EU) were willing to accept. Second, the EU was insisting that negotiations on the Singapore issues be initiated in 2004, but developing countries were unwilling to negotiate on new issues until they had What Is the World Trade Organization? 27 achieved substantial gains in agriculture. In the late summer of 2003, negotiations in Geneva paused as governments prepared for the Cancún Ministerial Conference.

As trade ministers gathered in Cancún in September 2003, they hoped to achieve two broad goals that would push the Doha Round into the home stretch.

The first was to bridge the gap concerning agriculture and the Singapore issues. It was hoped that this would be possible in Cancún because trade ministers had the political authority that lower-level officials lacked to make substantial concessions.

A simple compromise appeared possible: The United States and the EU would accept substantial liberalization in agriculture, and the developing countries would allow negotiations on some of the Singapore issues. Second, once they had removed this major obstacle, governments would agree on a broad framework for the final agreement. The Geneva-based delegations would then work out the precise details during the following year, and the final agreement would be concluded at the next Ministerial Conference scheduled for Hong Kong in December 2005. Neither goal was achieved. The EU and the United States were unwilling to meet the developing countries’ demands regarding agriculture, and the developing countries refused to allow negotiations on the Singapore issues. Unable to reach agreement, the Cancún Ministerial Conference adjourned with negotiations in complete disarray.

It took almost a year to put the negotiations back on track. Finally, on August 1, 2004, governments reached the agreement that had eluded them in Cancún. The EU and the United States accepted broad principles concerning the liberalization of trade in agriculture. In exchange, developing countries agreed to negotiating one of the Singapore issues: trade facilitation. Members hoped that this agreement would allow them to finish negotiations in time to complete the round at the Hong Kong Ministerial in December 2005. Negotiations progressed slowly during the following year and a half, however, as it proved difficult to translate these broad principles into meaningful tariff and subsidy reductions. As a consequence, when governments arrived in Hong Kong in December 2005 there was little chance they would conclude the round. Instead, governments reached a few specific agreements at the Hong Kong Ministerial (the EU agreed to eliminate agricultural export subsidies by 2013; the advanced industrialized countries agreed to eliminate 97 percent of the tariffs on exports of the least developed countries), and they accepted a work program intended to conclude the round by the end of 2006.

Presently, governments remain unwilling to reach agreement on the core issues necessary to conclude the round. American and European governments remain unwilling to liberalize their farm sectors enough to satisfy India, Brazil, and other Group of Twenty (G20) governments. For their part, G20 governments refuse to make the large concessions in the NAMA talks required to satisfy the United States and EU. Consequently, a “mini-Ministerial” held in Geneva in July 2008 collapsed in mutual recrimination. Many prominent commentators argued that the collapse in Geneva indicates that governments cannot reach a mutually beneficial agreement. Although it is easy to see the basis for such pessimism, more optimistic interpretations are possible. We will look at one such alternative, based in the logic of bargaining power, in Chapter 3 .

28 CHAPTER 2 The World Trade Organization and the World Trade System The WTO’sdispute settlement mechanism ensures that governments com- ply with the rules they establish. Individual compliance with established rules is not guaranteed. Even though most governments comply with most of their WTO obligations most of the time, there are times when some don’t. More- over, if all governments believed they could disregard WTO rules with impu- nity, they would comply less often. The dispute settlement mechanism ensures compliance by helping governments resolve disputes and by authorizing pun- ishment in the event of noncompliance.

The dispute-settlement mechanism ensures compliance by providing an independent quasi-judicial tribunal. This tribunal investigates the facts and the relevant WTO rules whenever a dispute is initiated and then reaches a finding.

A government found to be in violation is required to alter the offending policy or to compensate the country or countries that are harmed. We will examine the dispute settlement mechanism in greater detail in Chapter 3 .

The WTO, therefore, is an international political system that regulates national trade policies. It is based on rules that constrain what governments can do to restrict the flow of goods into their countries and to encourage the export of domestic goods to foreign markets. All of these rules have been cre- ated (and can be amended) through intergovernmental bargaining. Because compliance with the rules cannot be taken for granted, governments have es- tablished a dispute-settlement mechanism to help ensure that members com- ply. By creating rules, establishing a decision-making process to extend and revise them, and enforcing compliance, governments have brought the rule of law into international trade relations. HEGEMONS, PUBLIC GOODS, AND THE WORLD TRADE SYSTEM The stability of the WTO, and of international trade systems more broadly, is a function of the distribution of power in the international system. In particu- lar,hegemonic stability theory is often advanced to explain why the system shifts between periods in which it is open and liberal and periods in which it is closed and discriminatory.

Hegemonic stability theory rests on the logic of public goods provision.

Apublic good is defined by two characteristics: non-excludability and non- rivalry. Non-excludability means that once the good has been supplied, no one can be prevented from enjoying its benefits. A lighthouse, for example, warns captains away from a nearby coast. Once that beacon is lit, no captain can be prevented from observing the light and avoiding the coast. Non-rivalry means that consumption by one individual does not diminish the quantity of the good available to others. No matter how many captains have already con- sumed the light, it remains just as visible to the next captain.

Public goods tend to be undersupplied relative to the value society places upon them. Undersupply is a result of a phenomenon called free riding.Free riding describes situations in which individuals rely on others to pay for a Hegemons, Public Goods, and the World Trade System 29 public good (Sandler 1992, 17). My experience with public radio illustrates the logic. My local public radio station uses voluntary contributions from its listeners and businesses to finance 87 percent of its budget. Without these voluntary contributions, the station would go off the air. As a regular lis- tener, I benefit immensely from the station’s existence, and my life would be greatly diminished were the station shut down. Yet, I have never contributed to the station. Instead, I rely upon others to pay for the station’s operations.

In other words, I free ride on other listeners’ contributions. Because every- one faces the same incentive structure, contributions to the station are lower than they would be if non-contributors could be denied access to public radio.

More broadly, goods that are non-excludable and non-rivalrous tend to be undersupplied.

The severity of the free-riding problem is partly a function of the size of the group. In large groups, each individual contribution is very small relative to the total contribution, and as a result each individual has only a small im- pact on the ability of the group to achieve its objective. Consequently, each individual readily concludes that the group can succeed without his contribu- tion. In large groups, therefore, the incentive to free ride is very strong. In small groups, sometimes called “privileged groups,” each individual contribu- tion is large relative to the total contribution, and therefore each contribution has a greater impact on the group’s ability to achieve its common goal. It becomes more difficult for any individual to conclude that the group can suc- ceed without his contribution. As a result, the incentive to free ride is weaker (though not altogether absent) in small groups.

International institutions such as the WTO have public good character- istics. International rules and procedures benefit all governments (though not necessarily all benefit equally). Moreover, it is difficult (though not impos- sible) to deny a government these benefits once an institution has been estab- lished. Moreover, these benefits do not decrease as a function of the number of governments that belong to the institution. Because international institu- tions have these public good characteristics, their provision can be frustrated by free riding. All governments want global trade rules, but each wants some- one else to bear the cost of providing such rules.

Hegemonic stability theory argues that hegemons act like privileged groups and thus overcome the free-riding problem. Ahegemon is a country that produces a disproportionately large share of the world’s total output and that leads in the development of new technologies. Because it is so large and technologically advanced, the benefits that the hegemon gains from trade are so large that it is willing to bear the full cost of creating international trade rules. Moreover, the hegemon recognizes that the public good will not be pro- vided in the absence of its contribution. Hence, the free-riding problem largely disappears, and stable regimes are established, during periods of hegemonic leadership. As a hegemon declines in power, it becomes less willing to bear the cost of maintaining trade rules, and world trade becomes less open.

Historical evidence provides some support for hegemonic stability the- ory, as world trade has flourished during periods of hegemonic leadership 30 CHAPTER 2 The World Trade Organization and the World Trade System and floundered during periods without it. The two periods of rapid growth of world trade occurred under periods of clear hegemony. Great Britain was by far the world’s largest and most innovative economy throughout the nine- teenth century. Trade within Europe and between Europe and the rest of the world grew at what were then unprecedented rates. British hegemony, there- fore, created and sustained an open, liberal, and highly stable global economy in which goods, capital, and labor flowed freely across borders. The same re- lationship is evident in the twentieth century. The United States exited World War II as an undisputed hegemon. It played the leading role in creating the GATT, and it led the push for negotiations that progressively eliminated bar- riers to trade. The result was the most rapid increase in world trade in history.

Hence, the two hegemonic eras are characterized by stable trade regimes and the rapid growth of international trade.

The one instance of hegemonic transition is associated with the collapse of the world trade system. The transition from British to American hegemony occurred in the early twentieth century. In 1820, the American economy was only one-third the size of Great Britain’s. By 1870, the two economies were roughly the same size. On the eve of the First World War, the American economy was more than twice as large as Great Britain’s (Maddison 2001, 261). By the end of World War II, the United States produced almost half of the world’s manufactured goods. (See Table 2.2.) During this transition, each looked to the other to bear the cost of reconstructing the global economy after World War I. The British tried to reconstruct the world economy in the 1920s, but lacked the resources to do so (Kindleberger 1974). The United States had the ability to reestablish a liberal world economy, but wasn’t willing to ex- pend the necessary resources. Consequently, the Great Depression sparked the profusion of discriminatory and protectionist trade blocs. As protectionism rose, world trade fell sharply. (See Table 2.3.) Hence, hegemonic transition has been associated with considerable instability of international trade.

Although these episodes are suggestive, they are too few in number to support strong conclusions about the relationship between hegemony and international trade. This empirical limitation is of more than pure academic interest, given the emergence of China and India as powerful forces in the global economy. China’s emergence in particular raises questions about TABLE 2.2 Shares of World Manufacturing Production (Percent) 1880 1900 1913 1928 United States 14.7 23.6 32.0 39.3 Great Britain 22.9 18.5 13.6 9.9 Germany 8.5 13.2 14.8 11.6 France 7.8 6.8 6.1 6.0 Source: Kennedy 1988, 259. Hegemons, Public Goods, and the World Trade System 31 whether we are witnessing a hegemonic transition. Goldman Sachs estimates that China will overtake the United States in total economic production by 2027. Christopher Layne asserts that “economically, it is already doubtful that the United States is still a hegemon” (Layne 2009, 170).

These contemporary developments find parallels in the recent past. Dur- ing the 1960s, the Japanese economy grew at average annual rates of more than 10 percent, compared with average growth rates of less than 4 percent for the United States. Although Japanese growth slowed during the 1970s and 1980s, Japan continued to grow more rapidly than the United States. Faster growth allowed Japan to catch up to the United States. In the early 1960s, the United States produced 40 percent of the world’s manufactured goods, whereas Japan produced only 5.5 percent. By 1987, the United States’ share of world manufacturing production had fallen to 24 percent, whereas Japan’s share had increased to 19.4 percent (Dicken 1998, 28). In less than 30 years, therefore, Japan transformed itself from a vanquished nation into a powerful force in the world economy.

Many commentators viewed Japan’s ascent as a harbinger of hegemonic decline. The United States began running trade deficits in the 1970s, and these deficits continued to grow during the 1980s. American policymakers inter- preted these deficits as evidence of declining competitiveness, particularly in high-technology industries. Measures of the United States’ comparative ad- vantage in high-technology industries suggested that it was losing ground in critical sectors such as mechanical equipment, electronics, scientific instru- ments, and commercial aircraft. And what the United States appeared to be losing, Japan appeared to be gaining. Statistics suggested that as the American share of global high-technology markets fell (from 30 percent to 21 percent between 1970 and 1989), Japan’s share of this market rose (from 7 percent to 16 percent in the same period) (Tyson 1995, 19). Thus, the trade deficit and the apparent decline in American high-technology industries both pointed to the same conclusion: The United States was losing ground to Japan.

The United States responded to these developments by adopting a more aggressive and protectionist trade policy. The United States increasingly re- lied on bilateral initiatives and threatened to protect the American market to force changes in other countries’ trade policies (Krueger 1995). Japan was the TABLE 2.3 Collapse of World Trade (Average Monthly World Trade, $US millions) 1929 2,858 1930 2,327 1931 1,668 1932 1,122 Source: Kindleberger 1974, 140. 32 CHAPTER 2 The World Trade Organization and the World Trade System principal (though not the sole) target of American assertiveness. Many ana- lysts argued that this assertiveness reflected “the syndrome of hegemonic de- cline.” Some argued that the protectionist tendencies generated by hegemonic decline would be reinforced by the end of the Cold War, which deprived the United States of a broader purpose provided by the alliance against the Soviet threat. Robert Gilpin, a political economist at Princeton University, summa- rized this pessimistic outlook, arguing that “at the opening of the twenty-first century, all the elements that have supported an open global economy have weakened” (Gilpin 2000, 347).

Assertions of hegemonic decline proved premature, however. American unilateralism subsided in the mid-1990s as the United States entered a period of sustained robust growth and Japan struggled to recover from a financial and banking crisis. In this decade, governments strengthened and extended the multilateral trade system. They established the WTO, which enjoyed greater support and attracted a larger membership than the GATT did at the height of American hegemony. As one analyst concluded in look- ing back on the predictions of hegemonic decline, “the institutions that took hold after World War II continue to provide governance now, and the economic interests and political consensus that lie behind them are more, not less, supportive of an open world economy today than during the Cold War” (Ikenberry 2000, 151).

The open question, therefore, is whether China’s emergence today is a he- gemonic transition like that which occurred during the early twentieth century or a false alarm like that prompted by Japan during the 1980s. That is, is the global system transitioning from the American century to the Asian century, or will Asia’s ascent level off? Moreover, if we are experiencing hegemonic transition, must the global trade system weaken and collapse as it did dur- ing the 1920s and 1930s? Might the institutional structures constructed under American leadership help governments transition to a new global power struc- ture without suffering another economic “dark age”?

THE EVOLVING WORLD TRADE ORGANIZATION:

NEW DIRECTIONS, NEW CHALLENGES Although the trade system’s core principles and procedures have been sta- ble for 60 years, the past few years have brought substantial change. These changes will probably shape the evolution of the system over the next decade.

Two such changes are most important: the emergence of developing coun- tries as a powerful bloc within the organization, and the emergence of NGOs as a powerful force outside the organization. Together these developments have complicated decision making within the WTO and raised fundamental questions about the ability of governments to continue to achieve their goals through the system.

The first substantial change in the WTO arises from the growing power of developing countries within the organization. WTO membership has expanded The Evolving World Trade Organization: New Directions, New Challenges 33 dramatically since 1985. (See Table 2.4.) More than 60 countries have joined, increasing total membership to 153 countries (as of June 2010). Thirty more countries have applied for membership and are currently engaged in accession negotiations. Assuming all of these negotiations are successfully completed, WTO membership will surpass 180 countries during the next few years. Even if all governments have similar interests, more members would make the decision making harder—it is very difficult to gain consensus among 153 countries. TABLE 2.4 New Members of the General Agreement on Tariffs and Trade/World Trade Organization, 1985–2010 Albania 2000 Latvia 1999 Angola 1994Lesotho 1998 Antigua and Barbuda 1987 Liechtenstein 1994 Armenia 2003 Lithuania 2001 Bahrain 1993 Macao 1991 Botswana 1987 Mali 1993 Brunei Darussalam 1993 Mexico 1986 Bulgaria 1996 Moldova 2001 Cambodia 2004 Mongolia 1997 Cape Verde 2008 Morocco 1987 China 2001 Mozambique 1992 Chinese Taipei 2002 Namibia 1992 Costa Rica 1990 Nepal 2004 Croatia 2000 Oman 2000 Djibouti 1994 Panama 1997 Dominica 1993 Papua New Guinea 1994 Ecuador 1996 Paraguay 1994 El Salvador 1991 Qatar 1994 Estonia 1999 Saint Kitts and Nevis 1994 Fiji 1993 Saint Lucia 1993 Former Yugoslavia Republic of Macedonia 2003Saint Vincent and the Grenadines 1993 Georgia 2000Saudi Arabia 2005 Grenada 1994Slovak Republic 1993 Guatemala 1991Slovenia 1994 Guinea 1994Solomon Islands 1994 Guinea Bissau 1994Swaziland 1993 Honduras 1994Tonga 2007 Hong Kong 1986Ukraine 2008 Jordan 2000United Arab Emirates 1994 Kyrgyz Republic 1998Venezuela 1990 Vietnam 2007 Source: World Trade Organization (wto.org). 34 CHAPTER 2 The World Trade Organization and the World Trade System Membership growth reflects the dramatic reorientation of emerging mar- ket countries toward international trade. For reasons we explore in greater detail in Chapter 6 , governments in most developing countries were skeptical about the ability to foster development through trade. Consequently, most governments participated little in the GATT system. And to the extent that developing countries belonged to the GATT, the industrialized countries ac- corded them special treatment rather than demanding strict reciprocity. The GATT became, as a result, a rich-country club in which negotiations focused on the areas of interest to the United States, the EU, and Japan, and neglected liberalization in areas of interest to developing countries. Since the mid-1980s, emerging market countries have emphasized development through exports and, as a result, have placed substantially greater importance on the market access that participation in the WTO provides.

Under the leadership of the three largest emerging economies, Brazil, China, and India, developing-country members have constructed a powerful bloc within the WTO. This power is evident in the past decade. Developing countries stymied the first effort to launch the current round of negotiations in Seattle in 1999 because the proposed agenda dedicated too much attention to issues of interest to the United States and the EU and insufficient atten- tion to the issues developing countries believed important. The current round launched once developing countries were satisfied that the agenda focused suf- ficient attention on the topics of importance to them, especially liberalization of agriculture and maintaining sufficient policy space to promote develop- ment. Since 2003, cooperation among developing countries within the WTO has been institutionalized in the Group of 20.

The emergence of the developing countries as a powerful bloc in the WTO has transformed bargaining. In previous rounds countries with similar eco- nomic structures exchanged roughly equivalent concessions. With developing countries on the sidelines, the United States, the EU, and Japan defined the ne- gotiating agenda. As a result, governments liberalized industries in which they all enjoyed relative competitiveness, generally capital-intensive manufactured goods, and continued to protect industries in which they were uncompetitive.

Labor-intensive industries and farming thus remained protected in most indus- trialized countries. In essence, the United States, the EU, and Japan agreed to allow GM, Toyota, and Volkswagen to compete against each other in all three markets. Reducing these barriers challenged national producers in each country by exposing them to global competition, but because all countries were roughly similar in structure, liberalization did not impose substantial adjustment costs.

Current WTO bargaining brings together governments representing coun- tries with very different economic structures. Industrialized countries who are competitive in high-technology products and services bargain with developing countries who are competitive in labor-intensive manufactured goods, in stan- dardized capital-intensive goods such as steel, and in agriculture. For negotia- tions to succeed, governments in each group must liberalize industries that will not survive full exposure to international competition. As a result, the agree- ment that will conclude the Doha Round will impose hefty adjustment costs, The Evolving World Trade Organization: New Directions, New Challenges 35 in agriculture for many European Union countries, Japan, the United States, and other developed countries, and in services and manufactured goods for most developing countries.

Changes inside the organization are compounded by changes outside.

Of particular importance here is the growing number of non-governmental organizations (NGOs) striving to influence the organization. Few interest groups (other than businesses) paid much attention to the GATT when nego- tiations focused solely on tariffs. Since the late 1990s, however, hundreds of groups have mobilized in opposition to what they view as the unwelcome con- straints imposed by new WTO rules. In many instances, NGOs worry about how WTO rules affect the ability of governments to safeguard consumer and environmental interests.

WTO rules do not prevent governments from protecting consumers from unsafe foods or protecting the environment from clear hazards. For example, when cattle stricken by mad cow disease were discovered in the United States, nothing in the WTO prohibited other governments from banning the import of American beef. Similarly, when U.S. inspectors found toxic chemicals in toothpaste manufactured in China, WTO rules did not prohibit the United States from banning imports of the afflicted product. Problems arise when governments use health or environmental concerns as an excuse to shelter domestic producers from foreign competition. Such practices can become common in a world in which governments cannot use tariffs to protect industry.

Suppose the United States wants to protect American avocado growers from competition against cheaper Mexican avocados, they assert that Mexican avocados contain pests that harm American plants (even though they don’t) and on this basis ban Mexican avocados from the American market. This is disguised protectionism—an effort to protect a local producer against foreign competition, hidden as an attempt to protect plant health in the United States.

WTO agreements, such as the Agreement on Sanitary and Phytosani- tary Standards, attempt to strike a balance between allowing governments to protect against legitimate health risks and preventing governments from us- ing such regulations to protect domestic producers. This is a difficult balance to strike. It is not easy to determine the real motives behind a government’s decision to ban imports of a particular product. Did the EU ban the import of hormone-treated beef because of a sincere concern about potential health consequences or to protect European beef producers from American competi- tion? As a consequence, WTO rules require governments to accept current scientific conclusions about the risks to humans, animals, and plants that such products pose. Governments cannot ban imports of a product on health or safety grounds unless a preponderance of scientific evidence indicates that the product is in fact harmful. Such rules extend deeply into an aspect of national authority: the ability to determine what risks society should be exposed to and protected from.

Civil society groups argue that the balance struck by current WTO rules is too favorable to business and insufficiently protective of consumer and en- vironmental interests. Moreover, they argue that the bias toward producer 36 CHAPTER 2 The World Trade Organization and the World Trade System interests is a consequence of the nature of the WTO decision making, a pro- cess in which producer interests are heavily represented and consumer in- terests are almost entirely excluded. The mobilization of NGOs around the WTO has thus sought to bring greater attention to consumer interests in order to redress this perceived imbalance.

The growing power of developing countries within the WTO and the greater pressure by NGOs on the outside of the organization have combined to generate questions about whether the WTO can remain relevant under its current decision-making procedures. One dimension of this question concerns effectiveness: Can 153 governments at different stages of economic develop- ment reach agreements that provide meaningful trade liberalization? A second dimension concerns legitimacy: Should rules that constrain national regula- tions be negotiated without the full participation of civil society?

Both dimensions matter, but they point to contradictory conclusions.

Concerns about the effectiveness of WTO negotiations highlight the need for reform that limits the number of governments actively participating in nego- tiations. One such proposal advocates the creation of a steering committee, a WTO equivalent of the United Nations Security Council, with authority to develop consensus on trade issues. (See Schott and Watal 2000.) Such reform would make it easier to reach agreement, but only by making negotiations less inclusive. Concerns about legitimacy highlight the need for reform that opens the WTO process to NGOs. Opening the WTO in this manner, NGOs argue, would ensure that business interests are balanced against other social concerns. Although such reforms might make WTO decision making more in- clusive, they would also make it even more difficult to reach agreement within the organization.

Dissatisfaction with current decision-making procedures has yet to pro- duce a consensus about whether and how to change current procedures. The most important consequence of the current impasse, therefore, may be that governments find the WTO increasingly less useful as a forum within which to pursue their trade objectives. If governments come to that conclusion, they will begin to seek alternatives.

THE GREATEST CHALLENGE? REGIONAL TRADE ARRANGEMENTS AND THE WORLD TRADE ORGANIZATION Regionalism is one alternative that may gain particular appeal. Indeed, many observers believe that regional trade arrangements pose the single greatest challenge to the multilateral trade system. Regional trade arrangements pose a challenge to the WTO because they offer an alternative, and more discrimi- natory, way to organize world trade.

Aregional trade arrangement (RTA) is a trade agreement between two or more countries, usually located in the same region of the world, in which each country offers preferential market access to the other. RTAs come in The Greatest Challenge? Regional Trade Arrangements and the World Trade Organization 37 two basic forms: free-trade areas and customs unions. In a free-trade area , like the North American Free Trade Agreement, governments eliminate tar- iffs on other members’ goods, but each member retains independent tariffs on goods entering their market from nonmembers. In a customs union , like the EU, member governments eliminate all tariffs on trade between customs union members and impose a common tariff on goods entering the union from nonmembers.

Because RTAs provide tariff-free market access to some countries, but not to others, they are inherently discriminatory. Though such discrimination is inconsistent with the GATT’s core principle, GATT’s Article XXIV allows countries to form RTAs as long as the level of protection imposed against nonmembers is no higher than the level of protection applied by the countries prior to forming the arrangement. Nevertheless, the discriminatory aspect of RTAs makes many worry about the impact they will have on the nondiscrimi- natory trade encouraged by the WTO.

Such worries arise because of the rapid proliferation of RTAs. According to the WTO, there are currently between 190 and 250 RTAs in operation.

If all RTAs now planned are created, there may be as many as 400 RTAs in effect by the end of 2010. Free-trade agreements constitute the vast majority of these RTAs, for 86 percent of existing RTAs and for 99 percent of ar- rangements currently being negotiated. (See Figure 2.1 .) More than half of all RTAs are bilateral agreements. The others are “plurilateral” agreements that include at least three countries. RTAs are densely concentrated in Europe and the Mediterranean region. (See Figure 2.2 .) Agreements between countries in Western, Eastern, and Central Europe, and in the Mediterranean account for almost 70 percent of RTAs in operation. North and South America take sec- ond place, accounting for about 12 percent. The rest of the world seems less Free-Trade Areas, 148 Customs Unions, 24 FIGURE 2.1 Regional Trade Arrangements, 2000. Source : The World Trade Organization 2000 38 CHAPTER 2 The World Trade Organization and the World Trade System enthusiastic about RTAs, as countries in sub-Saharan Africa and Asia-Pacific participate in very few. The rapid growth of RTAs reflects a number of distinct factors. The col- lapse of the Soviet bloc and the subsequent disintegration of the Soviet Union resulted in the rapid proliferation of RTAs. Governments sought new ways to organize their trade, and they sought access to Western European markets.

Consequently, a large number of agreements were reached between coun- tries within the region and between these countries and the EU (WTO 2000).

Moldova, for example, entered RTAs with eight other newly independent countries formed from the former Soviet Union between 1992 and 1996.

Russia entered at least nine RTAs with this same set of countries. Ten Eastern and Central European countries reached bilateral RTAs with the European Union between 1991 and 1997. There were also substantial changes in devel- oping country trade policies in the late 1980s and early 1990s, which led to a greater willingness to enter RTAs (WTO 2000). Mexico, for example, negoti- ated RTAs not only with the United States and Canada (NAFTA), but also with Chile, Costa Rica, and Nicaragua. Chile negotiated RTAs with Colom- bia, Ecuador, and Peru, in addition to completing the agreement it reached with Mexico.

Although these changes help us understand why a larger number of states were willing to undertake trade liberalization, they do not fully explain why so many of these countries opted for RTAs rather than to liberalize trade solely FIGURE 2.2 Geographic Location of Regional Trade Arrangements Source : The World Trade Organization 2000 Number in Force 0 30 20 10 40 50 60 70 80 90 Asia Pacific Sub-Saharan AfricaAmericas Cross RegionalEastern Europe and Central AsiaEuro- Mediterranean Customs Unions Free-Trade Area The Greatest Challenge? Regional Trade Arrangements and the World Trade Organization 39 within the WTO. Idiosyncratic factors played an important role. Countries created out of the disintegrating Soviet Union had to find new ways to regu- late their trade relatively quickly. An RTA probably offered the quickest solu- tion. Central and Eastern European governments sought RTAs with the EU in part because they wanted better access to the EU market and in part because each planned to seek full EU membership. The EU responded by establishing free-trade agreements as the first step in the accession process. In all of these cases, RTAs emerged as expedient solutions to pressing trade problems in a rapidly changing economic environment.

Scholars have also advanced more general ideas to account for the pro- liferation of RTAs. Some emphasize a country’s desire to gain more secure access to the market of a particularly important trading partner. In the U.S.– Canada Free Trade Agreement concluded in the late 1980s, for example, Canada sought secure access to the U.S. market—the most important destina- tion for Canada’s exports. During much of the 1980s, the United States made frequent use of antidumping and countervailing duty investigations to protect American producers from Canadian imports. Such measures clearly interfered with the ability of Canadian producers to export to the American market.

The Canadian government hoped that the U.S.–Canada Free Trade Agree- ment would give Canada “some degree of exemption” from these measures (Whalley 1998, 72–73).

Other scholars emphasize a government’s need to signal a strong commit- ment to economic reform. Governments use RTAs to convince foreign part- ners that they will maintain open markets and investor-friendly policies. This argument has been applied most commonly to Mexico’s decision to seek a free-trade agreement with the United States. Mexico shifted from a highly pro- tectionist to a more liberal trade policy in the mid-1980s. The success of that strategy hinged in part on Mexico’s ability to attract foreign investment from the United States. The Mexican government feared, however, that American investors would not believe that the Mexican government was committed to its new strategy. What would prevent Mexico from shifting back to protec- tionism and nationalizing foreign investments? If American businesses didn’t believe the Mexican government was committed to this liberal strategy, they would be reluctant to invest in Mexico. Absent American investment, Mexico would be deprived of foreign capital that was critical to the success of its strategy.

A free-trade agreement with the United States allowed Mexico to signal to American investors the depth of its commitment to market liberalization.

It did so in part because NAFTA contained very clear and enforceable rules concerning the treatment of foreign investment located in Mexico. A similar argument might be used to understand at least part of the interest that Eastern and Central European governments had in signing free-trade agreements with the EU. These governments were also reorienting their economic policies and were trying to attract foreign investment. Like Mexico, they might have needed an external institution, such as an agreement with the EU, to signal to foreign investors their commitment to market reforms. Notice that these 40 CHAPTER 2 The World Trade Organization and the World Trade System arguments actually place less emphasis on the trade benefits that might result from an RTA and focus more on the need to attract foreign investment.

Other scholars argue that countries enter RTAs to increase their bargain- ing power in multilateral trade negotiations. A small country bargaining indi- vidually in the WTO lacks power because it does not have a large market to offer. By pooling a group of small countries, the market that can be offered to trade partners in WTO negotiations increases substantially. Consequently, each member might gain larger tariff concessions in WTO negotiations. Cur- rent American enthusiasm for RTAs might also be seen as an attempt to gain bargaining power in the WTO. As it has become more difficult to reach deci- sions within the WTO, the United States has explicitly threatened to rely more on free-trade agreements. By doing so, the United States denies its market to countries unwilling to make concessions in the WTO. The fear of losing access to the U.S. market could induce governments to make concessions in the WTO that they would not otherwise make. The threat to rely more on RTAs and less on the WTO, therefore, enhances American power in the organization.

Regardless of the specific motivation behind the creation of RTAs, their rapid growth raises questions about whether they challenge or complement the WTO. This is not an easy question to answer. On the one hand, RTAs liberalize trade, a mission they share with the WTO. In this regard, RTAs complement the WTO. On the other hand, RTAs institutionalize discrimina- tion within world trade. In this regard, RTAs challenge the WTO.

Economists conceptualize these competing consequences of RTAs astrade creation and trade diversion. Consider an RTA between France and Germany.

Because the RTA eliminates tariffs on trade between France and Germany, more Franco-German trade takes place. This is trade creation. Because the RTA does not eliminate tariffs on trade between France and Germany on the one hand, and the United States on the other, some trade between the United States and Germany is replaced by trade between France and Germany. This is trade diversion. An RTA’s net impact on trade is the difference between the trade it creates and the trade it diverts. If more trade is created than diverted, the RTA has liberalized trade. If more trade is diverted than created, the RTA has pushed the world toward protectionism.

Which of these effects predominates in existing RTAs? Nobody really knows, in large part because it is difficult to evaluate trade creation and trade diversion empirically. It is especially difficult once we begin to think about how RTAs evolve once created. An RTA that originally diverts more trade than it creates might over time create more trade than it diverts. Or an RTA could evolve in the opposite direction. Consider the first case. Some schol- ars have argued that RTAs exert a kind of gravitational force on countries that are not currently members. Countries that do not belong to the EU, but that engage in lots of trade with it, have a strong incentive to join. So it is no surprise, therefore, that over the last 40 years the EU has expanded from 6 to 25 member countries. Some see a similar dynamic at work in the Western Hemisphere. Mexico’s decision to seek a free-trade agreement with the United States was at least partially motivated by concerns about the cost of being The Greatest Challenge? Regional Trade Arrangements and the World Trade Organization 41 POLICY ANALYSIS AND DEBATE The United States and Free-Trade Agreements Question Should the United States pursue free-trade agreements?

Overview Until the late 1980s, the United States pursued its trade objectives exclusively through the multilateral trade system. Though American policymakers recognized that governments had the legal right to pursue regional free-trade agreements under the GATT Article XXIV, and encouraged other governments to create regional trading blocs, it did not pursue regional arrangements itself. One might argue that it believed that the hegemon should support the global trade system even at the expense of specific bilateral agreements that it might find beneficial. The U.S.–Canada Free Trade Agreement, which entered into force in 1989, changed this traditional policy.

Subsequently, the United States has negotiated 14 bilateral free-trade agreements and is pursuing regional free-trade agreements in Central and South America, Asia, and the Middle East. The change is now fully reflected in its trade policy strategy, which the Office of the U.S. Trade Representative defines as the pursuit of “multiple market-opening initiatives on a global, regional and bilateral basis.” (www.ustr.gov) America’s embrace of regionalism has been controversial, even among supporters of trade liberalization. Proponents of regionalism assert that free- trade agreements enable the United States to achieve more than it can achieve within the WTO. In the 153-member WTO, governments willing to liberalize trade effectively are prevented from doing so by governments reluctant to liberalize. The difficulty of concluding the Doha Round illustrates the point. From this perspective, free-trade agreements promote global trade liberalization better than the current WTO because willing partners can make deep cuts in trade barriers. Opponents argue that free-trade agreements threaten the multilateral trade system. Regional agreements create a complex “spaghetti bowl” of preferential arrangements that stifle, rather than expand, global trade. In addition, energy that governments devote to regional agreements is energy taken from WTO negotiations. From this perspective, free-trade agreements undermine the global trade system. Given these alternative perspectives, what policy should the United States pursue?

Policy Options • The United States should continue to negotiate free-trade agreements as the best approach to achieving its trade objectives.

• The united states should cease negotiating new free-trade agreements, consider abrogating those currently in force, and advance its trade objectives exclusively through the WTO. (Continued) 42 CHAPTER 2 The World Trade Organization and the World Trade System outside a U.S.–Canada Free Trade Area that had been negotiated in the late 1980s (Gruber 2000). The interest of many Latin American countries in a Free Trade Area of the Americas (FTAA) is at least partially a consequence of Mexico’s entry into NAFTA (Baldwin 1995). Over time, this gravitational pull attracts so many additional members that a regional RTA evolves into a global free-trade area. In this optimistic scenario, RTAs lead eventually to global free trade in which trade creation outweighs trade diversion and RTAs complement the WTO.

By contrast, the creation of a large RTA in one region could encourage the formation of rival and more protectionist RTAs in other regions. In this sce- nario, NAFTA as well as FTAA could be seen as an American response to the EU. An emerging free-trade area in Pacific Asia could be seen as a response to regionalism in Europe and the Western Hemisphere. In this view, world trade is becoming increasingly organized into three regional and rival trade blocs.

Once regional trading blocs have formed, each bloc might raise tariffs to re- strict trade with other regions. A tariff increase by one RTA could provoke re- taliation by the others, leading to a rising spiral of protection that undermines global trade liberalization (Frankel 1997, 210). In this case, trade diversion outweighs trade creation and RTAs pose an obvious challenge to the WTO.

It is impossible to predict which of these two scenarios is the more likely.

The world does seem to be moving toward three RTAs: one in Europe, one Policy Analysis • Does the United States derive benefits from free-trade agreements that it cannot derive from WTO agreements?

• Are there costs associated with creating a large network of free-trade agreements?

Take a Position • Which option do you prefer? Justify your choice.

• What criticisms of your position should you anticipate? How would you defend your recommendation against these criticisms?

Resources Online: Search online for “Free Trade Areas.” You might also visit the U.S. Trade Representative website (www.ustr.gov) for timely information about current negotiations. The WTO maintains an excellent web page dedicated to regional trade agreements and their impact on the multilateral trade system (www.wto .org and follow the links under “Trade Topics”).

In Print: For contrasting views see Jeffrey J. Schott, ed., Free Trade Agreements: U.S.

Strategies and Priorities (Washington, DC: Institute for International Economics, 2004); Jagdish Bhagwati, Termites in the Trading System: How Preferential Agreements Undermine Free Trade (New York: Oxford University Press, 2008.) Conclusion 43 in the Western Hemisphere, and one in Asia. At the same time, governments appear to be aware of the challenges RTAs pose to the WTO, as they have created a WTO committee on RTAs that is exploring the relationship between these arrangements and the multilateral system. Only time will tell, however, whether RTAs will develop into discriminatory trade blocs that engage in tar- iff wars or if instead they will pave the way for global free trade.

CONCLUSION The multilateral trade system is an international political system. It provides rules that regulate how governments can use policies to influence the cross- border flow of goods and services. It provides a decision-making process through which governments revise existing rules and create new ones. And it provides a dispute-settlement mechanism that allows governments to en- force common rules. By promoting nondiscriminatory international trade, by establishing a formal process for making and revising rules, and by allowing governments to enforce the rules they create, the WTO reduces impact of raw power on international trade relationships. In short, the WTO brings the rule of law to bear in international trade relations.

Like all political systems, the WTO reflects the interests of the powerful.

Its creation reflected the interests of a hegemonic United States; its strengthen- ing during the Cold War era reflected the growing interest of European and Japanese governments that trade liberalization promised real gains. Although one can argue that the WTO reflects only the interests of the advanced indus- trialized countries, the trends over the last 20 years suggest otherwise. The rapid growth in the number of countries joining the WTO during that period suggests that most of the world’s governments believe that they are better off with the WTO than without it. This doesn’t mean that the system is perfect. It does suggest, however, that in the contemporary global economy, the major- ity of the world’s governments believe that they do better when world trade is organized by a system based on nondiscrimination and market liberalism than they do in a discriminatory, protectionist, and rule-free environment. The WTO will weaken, and perhaps even crumble, when governments no longer believe this is true.

The largest contemporary challenges to the WTO emerge from the ability of its decision-making process to continue to produce outcomes in a changing world. On the one hand, the growth of WTO membership and the emergence of the G-20 as a powerful bloc within the organization has raised the stakes of trade negotiations and made it more difficult to find packages acceptable to the full membership. On the other hand, the emergence of a vocal NGO movement critical of the WTO’s apparent tendency to place business interests before consumer interests has made it even more difficult to reach agreements within the organization. The full consequences of these two challenges remain uncertain. Can governments reform decision making in the system in a way that simultaneously enhances the legitimacy and the efficiency? Or will con- tinued decision-making paralysis impart additional impetus to regionalism? 44 CHAPTER 2 The World Trade Organization and the World Trade System SUGGESTIONS FOR FURTHER READING For a detailed discussion of the origins and development of the rules governing international trade, see John H. Jackson, The World Trading System: Law and Policy of International Economic Relations (Cambridge, MA: MIT Press, 1997).

A recent and thorough investigation of WTO procedures is available in Kent Jones, The Doha Blues: Institutional Crisis and Reform in the WTO (New York: Oxford University Press, 2009) Unfortunately, there is no single book that provides a good overview of bargaining rounds. Detailed treatments of the political dynamics of the last three rounds of negotiations can be found in Ernest H. Preeg,Traders and Diplomats: An Analysis of the Kennedy Round of Negotiations under the General Agreement on Tariffs and Trade (Washington, DC: The Brookings Institution, 1995); Gilbert R. Winham, International Trade and the Tokyo Round Negotiation (Princeton, NJ: Princeton University Press, 1986); and Ernest H. Preeg,Traders in a Brave New World: The Uruguay Round and the Future of the International Trading System (Chicago:

University of Chicago Press, 1995). See Bernard Hoekman and Michel M. Kostecki, The Political Economy of the World Trading System: The WTO and Beyond, 2nd ed. (New York: Oxford University Press, 2001) for an extended analytical account of the politics of the world trade system.

KEY TERMS Customs Union Dispute Settlement Mechanism The Doha Round Free Riding Free-Trade Area Generalized System of Preferences HegemonHegemonic Stability Theory Intergovernmental Bargaining Market Liberalism Ministerial Conference Most-Favored Nation National Treatment NondiscriminationNontariff Barriers Public Good Regional Trade Arrangement (RTA) Tariffs Trade Creation Trade Diversion World Trade Organization (WTO) 45 The Political Economy of International Trade Cooperation W hy does the World Trade Organization (WTO) exist? There are two ways to answer this question. One approach emphasizes the partic- ular historical process that led to the WTO’s creation. As we saw in Chapter 2 , the United States had an economic interest in creating the General Agreement on Tariffs and Trade (GATT) after World War II, and it had the power required to do so. The world trade system was thus shaped by the spe- cific configuration of power and interests in place following the Second World War. An alternative approach emphasizes a more abstract logic. In this more abstract logic, the WTO exists because it helps governments work together in pursuit of mutual gain. In this approach, the world trade system is treated as a specific instance of the more general problem of cooperation.

Cooperation is not always easily achieved, even when everybody recog- nizes that they all could gain from cooperation. Cooperation is often difficult because people often have strong incentives not to cooperate. These incen- tives are driven in part by a desire to take advantage of others and in part by a desire to avoid being taken advantage of. But regardless of whether people are trying to gain advantage, or whether they are simply trying to avoid be- ing exploited, the behavior yields the same result—cooperation is stymied and people are worse off than they could be. Applied to world trade, this logic suggests that countries can gain substantially from cooperation aimed at lib- eralizing world trade. Yet, because some governments want to take advantage of others, and all governments want to avoid being exploited in this fashion, no government is willing to liberalize trade. Consequently, societies are de- prived of the benefits that trade confers. In order for cooperation to emerge in any society, therefore, people must be assured that cooperation on their part will be met by cooperation from others. 3 CHAPTER 46 CHAPTER 3 The Political Economy of International Trade Cooperation Individuals cannot easily provide these assurances to each other. If you think someone wants to take advantage of you, you will probably disregard his or her request that you trust him or her. The necessary trust can emerge gradually over time. But if you can’t cooperate with each other without trust, and if building trust requires cooperation, then you are stuck. Societies often solve this problem by creating institutions. Institutions provide the necessary assurances by punishing people who try to take advantage of others. For ex- ample, every time you enter into a contract with someone, the power of the state ensures that you and the party you contract with comply with the agree- ment. Applied to world trade, this logic suggests that trade liberalization is possible only if an international institution like the WTO can ensure that all governments comply with the agreements they make. It does so by creating conditions that help governments enforce the agreements they conclude. The WTO exists, therefore, because it enables societies to cooperate and capture the welfare gains that trade offers.

This chapter develops this abstract logic of cooperation in three essential steps. First, we examine trade theory to gain a firm understanding of why trade offers welfare gains to all countries. This examination is important in its own right, but it also highlights the gains available from international co- operation aimed at liberalizing trade. Second, we examine why cooperation to capture the welfare gains available from trade is difficult using a standard model of cooperation, the prisoners’ dilemma. Third, we examine how the WTO helps governments enforce the agreements they reach. THE ECONOMIC CASE FOR TRADE Why should countries trade? The standard answer is that countries should trade because trade makes them better off. Grasping why, exactly, trade makes societies better off, however, can be tricky. As the prominent economist Paul Krugman has argued, even many scholars and journalists who spend their lives writing about the global economy don’t fully understand why trade makes soci- eties better off (Krugman 1997, 117–125). Because understanding the rationale for trade is central to understanding the global economy but can be difficult to grasp, we develop the logic of comparative advantage in some detail.

We begin by establishing a few core concepts. The first is the production possibility frontier (PPF). Countries are endowed with factors of production in finite amounts. Consequently, any decision to use factors to produce one good necessarily means that these factors are not available to produce other goods. A decision to allocate capital and labor to the production of comput- ers, for example, necessarily requires the country to forgo the production of some number of shirts. These forgone shirts are what economists call oppor- tunity costs, and the production possibility frontier allows us to measure these opportunity costs quite precisely.

Consider an illustrative PPF for the United States. Let’s assume that the United States has a fixed stock of labor and capital that it can use in combination to produce two goods—shirts and computers. Suppose that if the United States allocates all of its labor and capital to computer production, it could produce The Economic Case for Trade 47 100 million computers (pointA in Figure 3.1) and if it allocates all labor and capital to shirts, it can produce 300 million shirts (pointB in Figure 3.1). If we connectA and B with a line, we have defined a production possibility frontier for the United States. Along it lie all combinations of shirts and computers that the United States can produce using all of its factors of production. As we move fromA to B, capital and labor are reallocated away from computer production to shirt production. The slope of the line, called the marginal rate of transfor- mation, tells us exactly how many shirts the United States forgoes for each com- puter it produces. In this example, every computer the United States produces costs three shirts. Because an autarkic country cannot consume more than it produces, the PPF also defines the limits of possible consumption.

We can draw the PPF either as a straight line, as in our example, or as a curved line. Which we select depends upon the assumption we make about the nature of the opportunity costs that the United States faces. A straight PPF embodies the assumption that the United States faces constant opportunity costs. Every additional computer always costs 3 shirts. If we assume constant opportunity costs, we also implicitly assume that the United States enjoys con- stant returns to scale in production. This means that whenever the factors employed in shirt production are increased by some factor, we will increase the amount of shirts produced by the same factor. Double the amount of labor and capital employed in shirt production and double the number of shirts pro- duced. Alternatively, we could assume that the United States facesincreasing opportunity costs and connect pointsA and B with a curved line that bends out away from the origin. The shift from producing 49,999,999 computers to 50 million computers costs 3 shirts. Yet, when the United States moves from producing 89,999,999 to 90 million computers, it costs 7 shirts. Thus, the op- portunity cost of producing each good rises as the United States dedicates a larger share of its factors to the production of a single good. If we assume the United States faces increasing opportunity costs, we are also implicitly assum- ing that factors yield diminishing marginal returns. This means that the num- ber of additional computers the United States can produce for each additional worker employed in computer production will fall as the number of workers employed in computer production rises. Most contemporary models assume that factors yield diminishing marginal returns. To keep things simple, we will assume constant marginal returns.

Our second core concept, consumption indifference curves, helps us under- stand the specific combination of computers and shirts American consumers will purchase. Consumers will acquire shirts and computers in the combina- tion that maximizes their collective utility. Economists conceptualize consumer utility with indifference curves. We assume that consumers prefer more to less, and therefore consumer utility increases as we move away from the origin.

Some combinations of shirts and computers, such as those at pointsa, b, and c on Figure 3.1, yield the same amount of utility. If asked to choose between these three, our consumer will say, “I like them all the same.” If we connect ev- ery combination of shirts and computers that provides our consumer with the same amount of utility with a curved line such asU a, we have drawn an indif- ference curve. Our consumer enjoys identical utility from every combination of 48 CHAPTER 3 The Political Economy of International Trade Cooperation shirts and computers that falls onU a. We can draw a second indifference curve that links the combinationsd, e, and f. Each of these combinations yield more utility thana, b, or c, and are thus said to lie on a higher indifference curve.

But, our consumer is indifferent betweend, e, and f. We can connect these three combinations with a second indifference curve,U b. Were we to repeat this exercise for every possible combination of shirts and consumers within this two-dimensional space, we would have a complete indifference map.

Three additional characteristics of indifference curves are important. First, indifference curves typically slope downwards. This slope, called the marginal rate of substitution, tells us how much of one good the consumer is willing to give up to acquire an additional unit of the second good. Second, indifference curves typically bend in toward the origin. This reflects the assumption of di- minishing marginal utility. The first computer provides a large improvement in utility. Each successive computer, however, provides a smaller increase of utility. Consequently, even though the consumer might be willing to give up a large number of shirts to acquire her first computer, she will be willing to give up fewer shirts to acquire her sixth computer. Finally, when we focus on production and consumption for an entire country, we construct community indifference curves rather than individual indifference curves. Community in- difference curves aggregate utility for all consumers in that society. In this example, then, our community indifference curves embody the aggregated preferences of all American consumers.

Together, the PPF and indifference curves allow us to define equilib- rium production and consumption of shirts and computers in this autarkic American economy. Production and consumption will occur at the point where the marginal rate of transformation (the slope of the PPF) is equal to the marginal rate of substitution (the slope of the indifference curve). That is, production and consumption will occur where the PPF and the indifference curve are tangent. This is pointe on Figure 3.1.

Why must production and consumption occur only at this point? Sup- pose the United States initially produced and consumed atG. Society can gain greater utility than atG (consumers can shift to a higher indifference curve) by consuming fewer shirts and more computers. We would therefore expect consumers to demand fewer shirts and more computers and we would ex- pect production to shift in response, producing more computers and fewer shirts. Beyonde, consuming additional computers and fewer shirts decreases consumer utility. Consequently, consumers will begin to demand more shirts and fewer computers. Only ate is it impossible to achieve higher utility from a different combination of shirts and computers. Consumer utility is thus maximized by producing and consuming ate. Under autarky, therefore, equi- librium production and consumption in the United States equals 60 million computers and 120 million shirts.

To see how trade changes this equilibrium, we must introduce a country for the United States to trade with. We will assume that the only other country in the world is China. We construct China’s PPF just as we did for the United States (see Figure 3.2). Let’s suppose that if China dedicates all of its labor The Economic Case for Trade 49 Shirts (millions) 0246 1218 3036 788472 90 96 66 Computers (millions)42 48 54 60 1020 80 60 40 20 100 120 140 160 180 200 220 240 260 280 300 320 B A d aG b c e f U b Ua FIGURE 3.1 U.S. Production Possibility Frontier Shirts (millions) 0164 8 12 20 24 52 5648 60 64 44 Computers (millions)28 32 36 40 680 50 100 150 200 250 300 350 400 Uc FIGURE 3.2 China’s Production Possibility Frontier 50 CHAPTER 3 The Political Economy of International Trade Cooperation and capital to computers, it can produce 20 million computers. If it dedicates all of its labor and capital to shirt production, it can produce 400 million shirts. Connecting these two points yields China’s PPF. Given our assump- tions, China’s marginal rate of transformation is 20: Every computer China produces carries opportunity costs of 20 shirts. We then find the point of tangency between China’s consumer indifference curves and the PPF to iden- tify equilibrium production and consumption in an autarkic China. Based on our assumptions, equilibrium production and consumption in autarkic China yields 13 million computers and 140 million shirts under autarky.

We can now see how trade between the United States and China affects equilibrium production and consumption in both countries (see Figure 3.3).

Trade changes equilibrium production by causing each country to specialize in the production of one good. The United States specializes in computer produc- tion and stops producing shirts. China specializes in shirt production and stops producing computers. Specialization arises from the conclusions each draws from a simple price comparison. The United States acquires more shirts per computer when it buys them from China than when it produces them at home.

A computer buys 20 shirts in China whereas at home it buys only 3 shirts. Why should the United States produce shirts at home when it can acquire them for substantially less in China? The United States thus stops producing shirts, pro- duces only computers, and acquires the shirts it wants from China.

Similarly, China acquires more computers per shirt when it buys them from the United States than when it produces them at home. China can ac- quire a computer from the United States for only 3 shirts whereas if it produces computers at home each computer costs 20 shirts. Why should China produce computers when it can acquire them much less expensively from the United States? China therefore stops producing computers, specializes in shirts, and acquires the computers it wants through trade with the United States. Trade thus changes equilibrium production in both countries: the United States spe- cializes in computer production and China specializes in shirt production.

To see how trade affects equilibrium consumption in both countries, we need to know the price at which the United States and China will exchange shirts for computers. We know that this price must fall somewhere between 3 and 20 shirts per computer. We could solve for the exact price that will arise, but we’ll simply assume that the two agree to trade at 6 shirts per com- puter. This new price is depicted in Figure 3.3 as the dashed line labeled p t.

Now we must find the combination of shirts and computers that maximizes consumer welfare in each country at this new price. To do so, we find the point of tangency between the new price line and our consumer indifference curves. These points are labeledC US andC C, respectively.

Equilibrium consumption in both countries has thus expanded beyond what was possible under autarky. American consumption expands from 60 million computers and 120 million shirts under autarky to 75 million com- puters and 150 million shirts. Chinese consumption expands from 13 million computers and 140 million shirts under autarky to 25 million computers and 250 million shirts. At this new equilibrium, both countries consume more The Economic Case for Trade 51 shirts and computers than they could under autarky. Consequently, consum- ers achieve greater utility, which is reflected in the move to higher indifference curves ( U US and U C , respectively). This additional consumer utility is the gain from trade. Trade between the United States and China is thus beneficial for both countries. Shirts (millions) 0246 1218 3036 788472 90 96 66 Computers (millions)42 48 54 60 1020 80 60 40 20 100 120 140 160 180 200 220 240 260 280 300 320 UUS pt U US CUS Shirts (millions) 0164 8 12 20 24 52 5648 60 64 44 Computers (millions)28 32 36 40 680 50 100 150 200 250 300 350 400 UC CC pt U C FIGURE 3.3 Equilibrium with Free Trade and Complete Specialization 52 CHAPTER 3 The Political Economy of International Trade Cooperation This specific example illustrates the broader claim thatevery country gains by specializing in goods it produces relatively well and trading them for the goods it produces relatively less well. This is the principle of compara- tive advantage. These gains are not dependent upon having an absolute cost advantage in a particular industry. The United States does not gain because it produces computers more cheaply than China. It gains because it can acquire more shirts per computer in China than it can at home. And these gains exist even if shirts cost more to produce in China than in the United States. Thus, even countries that produce every good at a higher cost than all other coun- tries gain from trade by specializing in the goods they produce best. This is the logic of comparative advantage.

What determines which goods a particular country will produce relatively well and which it will produce relatively less well? The Hecksher-Ohlin (or H-O)model, (named after the two Swedish economists, Eli Hecksher and Ber- til Ohlin who developed it) provides the standard answer. The H-O model argues that comparative advantage arises from differences infactor endow- ments.Factors are the basic tools of production. When firms produce goods, they employ labor and capital in order to transform raw materials into fin- ished goods. Labor obviously refers to workers. Capital encompasses the entire physical plant that is used in production, including the buildings that house factories and the machines on the assembly lines inside these factories.

Countries possess these factors of production in different amounts. Some countries, like the United States, have a lot of capital but relatively little labor.

Other countries, such as China, have a lot of labor but relatively little capital.

These different factor endowments in turn shape the cost of production. A country’s abundant factor will be cheaper to employ than its scarce factor. In the United States and other advanced industrialized countries, capital is rela- tively cheap and labor is relatively expensive. In developing countries, labor is relatively cheap and capital is relatively expensive.

Because countries have different factor endowments and face different factor prices, countries will hold a comparative advantage in different goods.

A country will have a comparative advantage in goods produced using a lot of their abundant factor and a comparative disadvantage in goods produced us- ing a lot of their scarce factor. In the auto industry, for example, payments to labor account for between 25 and 30 percent of the total cost of production.

The much larger share of the costs of production arise from capital expendi- tures, that is, expenditures on the machines, assembly lines, and buildings re- quired to build cars (Dicken 1998). In contrast, in the apparel industry wages paid to workers account for the largest share of production costs, whereas capital expenditures account for a much smaller share of the costs of produc- tion. It follows that countries like the United States and Japan with a lot of capital and little labor will have a comparative advantage in producing cars and a comparative disadvantage in producing clothing. By the same logic, developing countries with a lot of labor and little capital will have a com- parative advantage in producing clothing and a comparative disadvantage in producing cars. Trade Bargaining 53 Thus, in our example, the United States has a comparative advantage in computers and not in shirts because the United States is abundantly endowed with physical and human capital and poorly endowed with low-skill labor.

China has a comparative advantage in shirts and not in computers because China is abundantly endowed with labor and poorly endowed with human and physical capital. Comparative advantage tells us, therefore, that all coun- tries gain from trade by specializing in the goods that rely heavily on the fac- tors of production that they hold in abundance and exchanging them for goods that make intensive use of the factors of production that are scarce in their economy. TRADE BARGAINING Although trade liberalization raises the standard of living, governments don’t often liberalize trade unilaterally. Instead, governments strive to open foreign markets to the exports of competitive domestic industries and continue to pro- tect less competitive industries from imports. As a result, trade liberalization generally occurs through tradebargaining in which governments exchange market access commitments.

We can model trade bargaining using basic spatial theory. To keep things concrete, we will model the central bargaining problem in the Doha Round.

We begin by defining the bargaining space. The two issues at the center of the Doha Round are the reduction of barriers to trade in agriculture products that governments in the advanced industrialized countries impose and the reduc- tion of barriers to trade in manufactured goods that governments in devel- oping countries impose. We can depict each of these as a policy dimension (see Figure 3.4a). The horizontal axis depicts all possible levels of agriculture protection in the advanced industrialized countries. Protection of agriculture is zero at the origin and barriers to trade rise as we move out toward the right.

The vertical axis captures all possible levels of protection of manufactured goods in developing countries. Again, protection is zero at the origin and in- creases as we move up from the origin. Each point within the two-dimensional bargaining space represents a combination of trade barriers in industrialized country agriculture and developing country manufactured goods.

We can locate the current levels of protection, the status quo, in this bar- gaining space. The status quo is characterized by a fairly high level of protec- tion in both sectors. The United States, the EU, and Japan excluded agriculture from multilateral trade negotiations until quite recently. Consequently, trade barriers in this sector remain quite high. Similarly, developing country govern- ments did not participate much in bargaining rounds prior to the Uruguay Round. As a result, they retain high tariffs on manufactured goods. Hence, the status quo, labeled SQ in Figure 3.4a, falls in the northeast quadrant of the bargaining space.

In our next step we locate government ideal points in the bargaining space. An actor’s ideal point is its best possible outcome, in this instance the SQ Group of 20 US/EU G-20 Goods Markets US/EU Market for Agriculture Unilateral US/EU Agriculture Liberalization SQ Group of 20 US/EU G-20 Goods Markets US/EU Market for AgricultureJoint Gains SQ Group of 20 US/EU g m e Contract Curve US/EU Market for Agriculture G-20 Goods Markets FIGURE 3.4 Tariff Bargaining in the Doha Roun d (a) (b) (c) Trade Bargaining 55 specific combination of barriers to trade in agriculture and manufactured goods that each actor prefers to all other combinations. Rather than depict ideal points for each of the 153 WTO members, we focus on two coalitions at the center of bargaining, the United States/EU and the Group of 20. We locate these ideal points using a simple rule—governments liberalize com- paratively advantaged sectors and protect disadvantaged sectors. The United States/EU is relatively poorly endowed with land and relatively abundantly endowed with capital. The ideal outcome from their perspective is a sharp reduction of tariffs on G-20 goods markets and continued protection of their agriculture sector. Their ideal point therefore lies in the southeast quadrant of the bargaining space. Governments in the Group of 20 are abundantly endowed with land and poorly endowed with capital. The ideal outcome for these governments combines low barriers on agricultural markets in the EU and the United States with high barriers on their goods markets. The ideal point for the Group of 20 thus lies in the northwest quadrant of the bargain- ing space.

Notice that given these ideal points and the status quo, neither group can improve its utility relative to the status quo from unilateral liberalization. As- sume that utility for each actor is a linear function of distance; that is, utility decreases as we move away from the ideal points in any direction. Unilateral reduction of protectionist barriers on United States/EU agriculture shifts the outcome from SQ toward the left along a line parallel to the horizontal axis.

Every point on this line is further from the United States/EU ideal point than SQ and thus offers less utility than the SQ. Similarly, any unilateral reduction of tariffs on manufactured goods shifts the SQ down along a line parallel to the vertical axis (not drawn). Every point on this line is further from the G-20 ideal point than SQ. Hence, neither group can realize higher utility by engag- ing in unilateral liberalization.

What neither is willing to do unilaterally, both are willing to do through international bargaining. To see why, we must first identify all outcomes that each group prefers to the status quo. We can see these outcomes by drawing circular indifference curves centered upon each group’s ideal point with a radius equal to the distance between this ideal point and the status quo (see Figure 3.4b). Each group prefers all outcomes interior to this indifference curve to the status quo. The combinations within the “lens” created by the intersection of the two indifference curves are thus outcomes that the G-20 and the United States/EU both prefer to the status quo. And in the vast ma- jority of these outcomes, each group has liberalized the sector it wishes to protect quite substantially. International bargaining, therefore, enables gov- ernments to liberalize domestic sectors that they are unwilling to liberalize unilaterally.

The selection of one outcome from all of those that offer joint gains car- ries distributional consequences. Some agreements benefit the United States/ EU more than the G-20, and some agreements benefit the G-20 more than the United States/EU. We can see this by drawing a series of indifference curves for each group (see Figure 3.4c). We then connect all of the points at which 56 CHAPTER 3 The Political Economy of International Trade Cooperation the United States/EU and Group of 20 indifference curves are tangent to one another. The result is acontract curve—the set of mutually-beneficial agree- ments that exhaust available joint gains. We assume that governments will select an agreement from that set. Now, each agreement on this contract curve carries a different distribution of the joint gains. If the Group of 20 and the United States/EU select the outcome represented bym they divide avail- able joint gains evenly. If they select an outcome betweenm and e the United States/EU realizes larger gains than the Group of 20. If instead they choose an outcome betweenm and g the Group of 20 realizes larger gains than the United States/EU. Hence, governments are not just realizing joint gains, they are also deciding how to distribute these gains between them.

Bargaining power determines which distribution of gains governments ul- timately select. Although we often think of power as brute force, bargaining power derives from an array of much subtler characteristics such as patience and outside options. Patience refers to the fact that both parties to the nego- tiation would prefer to settle today rather than tomorrow. Because each side gains from agreement, delaying agreement sacrifices utility for both. But if one government is more patient than another, it can use its willingness to wait to insist on an outcome closer to its ideal point, and thereby capture more of the joint gains for itself. A government may be less patient, and thus willing to concede some of the surplus to other government in exchange for a quick deal, if it is relatively poor (since economic gains have greater marginal utility for poorer states), or if it has a low tolerance for risking a breakdown in ne- gotiations. Patience seems to be an important element of bargaining power in the Doha Round (see A Closer Look: Distributive Bargaining and the Geneva Mini-Ministerial). A CLOSER LOOK Distributive Bargaining and the Geneva Mini-Ministerial Doha Round negotiations collapsed (again) at the end of July, 2008. After reaching agreement on multiple issues during a “mini-Ministerial” in Geneva, India, China, and the United States failed to bridge their differences on a rather obscure special safeguard mechanism (SSM). The SSM would allow developing countries to raise tariffs (temporarily) to protect local farmers from import surges. India and China demanded SSM rules that would make it relatively easy to protect farmers, whereas the United States insisted on rules that made it more difficult to do so.

Unable to find rules that satisfied both, trade ministers abandoned the negotiations.

Major media outlets across the world pronounced the Doha Round dead, while some even speculated that the WTO itself was doomed.

Although it is tempting to conclude from the collapse that the Doha Round is in peril, one might also suggest, less obviously, that the collapse brings governments Trade Bargaining 57 one step closer to agreement. To understand this apparent paradox we need to think about bargaining strategy. The best deal for each government is the one that combines maximum concessions from other members in exchange for minimal concessions. Group of Twenty (G20) governments want large reductions in American and European agricultural protection in exchange for minimal liberalization of their manufacturing and service sectors. American and European governments seek the opposite—maximum G20 cuts in manufacturing and services in exchange for minimal cuts in farm tariffs and subsidies. In bargaining, therefore, governments are tussling over the distribution of the available joint gains, and the agreement best for a G20 government is necessarily less good for the United States and the European Union (EU).

Each government’s ability to negotiate the best possible deal for itself is complicated by private information. G20 governments do not know how much American and European governments are willing to reduce farm tariffs and subsidies. Nor do they know how much they must offer in exchange for such liberalization. Each government holds these critical pieces of information about its negotiating position privately, and has no incentive to reveal them to others. If American negotiators tell the G20 the maximum cuts in farm tariffs and subsidies the United States will make, then G20 governments will accept nothing less. If the United States tells G20 governments the minimal amount of service and NAMA liberalization it expects, G20 governments will offer only this minimal amount.

Revealing private information about their negotiating positions thus condemns governments to their worst possible deal—minimal gains and maximal concessions.

Negotiating the best deal possible thus requires governments to force each other to reveal information they do not wish to reveal. This is exactly the situation governments faced in Geneva in July, 2008. Trade ministers had negotiated for nine days. By Tuesday, they had reached the point at which each government had to decide whether the resulting package was the best deal it could get. China and India had to decide whether the United States and the EU had made their maximum concessions. Yet, they knew that asking for additional concessions was pointless— they had been asking for nine days, and asking for more now would simply elicit a quick “no, this is my best offer.” China and India could learn if, in fact, the offer on the table was the best offer only by walking away from the negotiations.

Walking away from the table served a strategic purpose. Walking away constituted a “costly signal”: it transformed cheap talk (can we have additional concessions) into costly action (we’ll forgo this agreement now to get additional concessions). This costly action, which demonstrates that India and China are not impatient, makes American policymakers more likely to believe that additional concessions are necessary to get a deal. Walking away also imposes costs on the United States by denying it an agreement it wants. By walking away, therefore, India and China are trying to gain information about the U.S. bargaining position. If the United States offers additional concessions, India and China get a better deal and their gamble has paid off. But even if the United States fails to offer additional concessions, China and (Continued) 58 CHAPTER 3 The Political Economy of International Trade Cooperation India still gain valuable information that the United States has offered all that it will offer. They can then accept the deal on the table.

The collapse of negotiations thus might bring governments one step closer to agreement by revealing information about each government’s negotiating position.

The better information enables governments to believe they have achieved the best deal possible. Of course, the collapse might also indicate that the Doha Round is dead. The problem, of course, is that we cannot know which of these is correct. To know which is correct we need private information about government negotiating positions that we cannot get. Thus, although we cannot know whether the collapse does, in fact, bring governments closer to agreement, we should not be surprised if governments conclude a deal not fundamentally different from the one India and China walked away from in July of 2008.

If governments are equally patient, one government may gain bargaining power if it has an attractive outside option. An outside option is a government’s next-best alternative to agreement. For example, if the EU can strike a similar bargain with the United States, then it has little need to make large concessions to the Group of 20; it can leverage its potential deal with the United States to extract concessions from the Groups of 20. If the Group of 20 knows this, it will be willing to allow the EU to capture a larger share of the gains than it would if the outside option of a deal with the United States did not exist. Somewhat para- doxically, therefore, giving one side a good reason to not reach agreement often enables governments to find common ground. The U.S. strategy of negotiating regional trade agreements, for example, might be an attempt to demonstrate an outside option in order to gain greater power within WTO negotiations.

In short, governments liberalize trade via trade agreements because they are unwilling to liberalize unilaterally. Given their focus on export expansion, trade negotiations enable governments to exchange market access commit- ments. Although the resulting trade agreements yield benefits to all parties, they also carry distributional consequences. Some governments will realize smaller gains in market access opportunities in exchange for larger conces- sions of their own. These distributional consequences reflect differences in bargaining power. Governments that are most willing to wait, that are willing to risk a breakdown of negotiations, and that have outside options are likely to capture a larger share of the available gains from agreement. ENFORCING AGREEMENTS The ability of governments to conclude trade agreements is additionally frus- trated by the second intervention of politics: the enforcement problem. The enforcement problem refers to the fact that governments cannot be certain that other governments will comply with the trade agreements that they con- clude (Conybeare 1984; Keohane 1984; Oye 1986). As a result, governments will be reluctant to enter into trade agreements, even when they recognize that Enforcing Agreements 59 they would benefit from doing so. Even though this might seem counterint\ ui- tive, we can use a simple game theory model, called the prisoners’ di\ lemma, to see how the enforcement problem can frustrate the efforts of governments\ to conclude mutually beneficial trade agreements. Suppose that the Group of 20 and the EU manage to identify an outcome that each prefer to the status quo. In the absence of a mechanism to enf\ orce the agreement, would they be able to conclude the agreement? The prisone\ rs’ dilemma tells us that they will be unable to do so. In the prisoners’\ dilemma, the Group of 20 and the EU each have two strategy choices: Each can open\ its market to the other’s exports, which we will call liberalize, or each can use tariffs to keep the other’s products out of its domestic market, whic\ h we will call protect . Two governments with two strategy choices each generates the two-by-two matrix depicted in Figure 3.5. Each cell in this matrix corresponds to a strategy combination, and thes\ e strategy combinations produce outcomes. We can describe these outcomes starting in the top left cell and moving clockwise. One word about the n\ ota- tion we use before we proceed. It is conventional to list the strategy c\ hoice of the row player (the player who selects its strategy from the rows of th\ e matrix) first and the strategy choice of the column player (the player who sele\ cts its strategy from the columns of the matrix) second. Thus, the strategy com\ bina- tion referred to as “liberalize/protect” means that the row player, which in this case is Group of 20, has played the strategy liberalize and the column player, which is the EU, has played the strategy protect . We can now describe the four outcomes. Liberalize/Liberalize: Both eliminate tariffs. Group of 20 exports agri- cultural products to the EU, and the EU exports manufactured goods to Group of 20 countries. Liberalize/Protect: The Group of 20 eliminates tariffs, but the EU does not. The EU thus exports goods to the Group of 20, but the Group of 20 cannot export farm goods to the EU. G-20 European Union Liberalize L,LI L,PII Liberalize Protect Protect P,LIV P,PIII Preference Orders: G-20: P,L L,L P,P L,P European Union: L,P L,L P,P P,L FIGURE 3.5 The Prisoner’s Dilemma and Trade Liberalization 60 CHAPTER 3 The Political Economy of International Trade Cooperation Protect/Protect:Both retain their tariffs. No trade takes place. Protect/Liberalize:The EU eliminates tariffs, and the Group of 20 does not. The Group of 20 exports farm goods to the EU, but the EU cannot export manufactured goods to the Group of 20.

Now we must determine how each government ranks these four out- comes. How much utility do they realize from each outcome? The Group of 20 ranks them in the following order: protect/liberalize liberalize/liberalize protect/protect liberalize/protect where the “greater than” sign means “is preferred to.” It is not hard to justify this ranking.

The Group of 20 gains the most utility from protect/liberalize. Here the Group of 20 exports to the EU and protects its producers from EU competition.

The Group of 20 gains less utility fromliberalize/liberalize than from protect/liberalize. Here the Group of 20 can export to the EU, but must open its market to EU imports. The Group of 20 gains still less utility from protect/protect than from liberalize/liberalize. Here the Group of 20 protects its domestic market, but cannot export to the EU.

The Group of 20 gains less utility fromliberalize/protect than from protect/protect. Here the Group of 20 opens its market to the EU but does not get access to the EU market.

In other words, the Group of 20’s most preferred outcome is unrecipro- cated access to the EU market. Its second-best outcome is reciprocal tariff re- ductions, which is in turn better than reciprocal protection. The Group of 20’s worst outcome is a unilateral tariff reduction.

The prisoners’ dilemma is a symmetric game. This means that the EU faces the exact same situation as the Group of 20. Consequently, the EU’s payoff order is identical to the Group of 20’s payoff order. The only difference arises from the notation we use. Like the Group of 20, the EU’s most preferred out- come is unreciprocated access to the other’s market, but for the EU this is the outcomeliberalize/protect. Also like the Group of 20, the EU’s least preferred outcome is granting the other unreciprocated access to its market, which for the EU is the outcomeprotect/liberalize. Thus, the EU’s payoff order is identi- cal to the the Group of 20’s payoff order, but the position of the most and least preferred outcomes are reversed: liberalize/protect liberalize/liberalize protect/protect protect/liberalize We can now see how the Group of 20 and the EU will play this game and what outcome will result. The Group of 20 and the EU both have a dominant strategy—a single strategy that always returns a higher payoff than all other strategy choices.Protect is this dominant strategy. Protect dominates liberal- ize as a strategy choice because each government will always realize higher utility by playingprotect than by playingliberalize. Enforcing Agreements 61 We can see whyprotect is a dominant strategy by working through the Group of 20’s best responses to the EU’s strategy choices. Suppose the EU plays the strategyliberalize. If the Group of 20 playsliberalize in response, the Group of 20 receives its second most preferred outcome ( liberalize/liberalize).

If the Group of 20 plays protect in response, the Group of 20 receives its most preferred outcome ( protect/liberalize). Thus, if the EU plays liberalize, the Group of 20’s best response—the strategy that returns the highest utility— isprotect.

Now suppose the EU playsprotect. If the Group of 20 responds withlib- eralize, it receives its least preferred outcome ( liberalize/protect). If the Group of 20 responds withprotect, however, it receives its second least preferred outcome ( protect/protect). Thus, if the EU playsprotect, the Group of 20’s best response is to playprotect.

Protect, therefore, “dominates” liberalize as a strategy choice—that is, protect yields more utility for the Group of 20 than liberalize regardless of the strategy that the EU plays. Because the prisoners’ dilemma is symmetric, protect is also the EU’s dominant strategy. Because both governments have dominant strategies to playprotect, the game always yields the same out- come: The Group of 20 and the EU both playprotect and the game ends at theprotect/protect outcome. Governments in both groups retain tariffs and no trade occurs.

This outcome has two important characteristics. First, it isPareto sub- optimal. Pareto optimality is a way to conceptualize social welfare. An out- come is Pareto optimal when no single actor can be made better off without at the same time making another actor worse off. Pareto suboptimal refers to outcomes in which it is possible for at least one actor to improve its position without any other actor being made worse off. In the prisoners’ dilemma the protect/protect outcome is Pareto suboptimal because both governments real- ize higher payoffs atliberalize/liberalize than at protect/protect. Thus, rational behavior on the part of each individual government, each playing its dominant strategyprotect, produces a suboptimal collective outcome. The Group of 20 and the EU are both poorer than they would be if they liberalized trade.

Second, the protect/protect outcome is a Nash equilibrium. A Nash equi- librium is an outcome at which neither player has an incentive to change strategies unilaterally. If the Group of 20 changes its strategy from protect toliberalize, the outcome shifts to liberalize/protect, the Group of 20’s least preferred outcome. Thus, the Group of 20 has no incentive to change its strat- egy unilaterally. If the EU changes its strategy fromprotect to liberalize, the outcome moves to protect/liberalize, the EU’s least preferred outcome. Thus, the EU has no incentive to change its strategy unilaterally either. Putting these two points together reveals the prisoners’ dilemma’s central conclusion:

Even though the Group of 20 and the EU would both gain from reciprocal tariff reductions, neither has an incentive to reduce tariffs. More broadly, the prisoners’ dilemma suggests that even when all countries would clearly benefit from trade liberalization, political dynamics trap governments in a protectionist world. 62 CHAPTER 3 The Political Economy of International Trade Cooperation Governments are unable to conclude agreements that make them all bet- ter off because each fears getting the “sucker payoff.” If the Group of 20 and the EU agree to liberalize trade and then the Group of 20 complies with this agreement but the EU does not, the EU has exploited the Group of 20.

The Group of 20 suffers the “costs” of rising imports without getting the “benefit” of increased exports. The gains from trade liberalization could be achieved, of course, if governments could enforce international trade agree- ments. Governments could agree in advan ce to play strategies if they were confident that cheating would be caught and punished. Moreover, because cheating would be punished, both would comply with the agreement. The in- ternational system provides no enforcement mechanism, however. Domestic political systems rely upon the police and the judicial system to enforce laws, but the international system does not have an authoritative and effective judi- cial system. Instead, the international system is anarchic; that is, it is a politi- cal system without an overarching political authority capable of enforcing the rules of the game.

Although the prisoners’ dilemma is pessimistic about the prospect for international trade cooperation, cooperation in a prisoners’ dilemma is not impossible. Cooperation can emerge if three specific conditions are met. First, cooperation can emerge in an iterated prisoners’ dilemma, that is, in a game played repeatedly by the same governments (see Taylor 1976; Axelrod 1984; Keohane 1984; Oye 1986). Iteration changes the nature of the reward struc- ture that governments face. In a one-shot play of the prisoners’ dilemma, countries make a one-time choice and receive a one-time payoff. In an iter- ated game, however, governments make repeated choices and receive a stream of payoffs over time. Assuming that the two other necessary conditions are met, governments will prefer the stream of payments they receive from coop- erating over time to the payoff they receive from cheating on an agreement.

Iterating the game can therefore make it rational for a government to play the liberalize strategy.

Second, governments must use reciprocity strategies to enforce the liberalize/liberalize outcome. Although many reciprocity strategies exist, the most well known is calledtit-for-tat (Axelrod 1984). In tit-for-tat, each gov- ernment plays the strategy that its partner played in the previous round of the game. Trade liberalization by one government in one round of play is met by trade liberalization from the other government in the next round. Should one government playprotect in one round (that is, cheat on an existing trade agreement), the other government must playprotect in the next round of play.

Playing such tit-for-tat strategies allows governments to reward each other for cooperation and punish each other for cheating.

Finally, governments must care about the payoffs they will receive in future rounds of the game. If governments fully discount future payoffs, the iterated game essentially reverts back to a single play of the prisoners’ dilemma; when it does, the threat of punishment in the next round of play can hardly be expected to promote cooperation in this round. But if governments care about the future and if they use a reciprocity strategy such as tit-for-tat, then cooperation in an Enforcing Agreements 63 iterated prisoners’ dilemma becomes rational; each government can realize a larger stream of payoffs by cooperating than it can realize by defecting.

The WTO provides the first two of these three necessary conditions. The WTO helps iterate the game by creating expectations of repeated interaction.

Membership in the WTO has been relatively stable. The number of countries that belong to the WTO has increased over time, and very few countries have left the organization after joining. As a consequence, WTO members know that the governments with which they negotiate today will be the governments with which they negotiate tomorrow, next year, and on into the future. In addition, WTO members interact regularly within the organization. Govern- ments have already concluded eight formal bargaining rounds and are now engaged in the ninth such round. In addition to these formal rounds of nego- tiations, the WTO draws governments together for annual and semiannual reviews of national trade policies. By bringing the same set of governments together in a regularized pattern of interaction, the WTO iterates intergovern- mental trade interactions.

The WTO also provides the information that governments need in order to use reciprocity strategies. In order to use a tit-for-tat strategy effectively, governments must know when their partners are complying with trade agree- ments and when they are cheating. The WTO makes this easier by collect- ing and disseminating information on its members’ trade policies. Moreover, WTO rules provide clear standards against which governments’ trade policies can be evaluated. The WTO’s most-favored nation clause, for example, pro- hibits discriminatory practices except under a set of well-defined exceptions.

To give another example, the WTO’s rules governing domestic safeguards de- fine the conditions that must be met in order for governments to temporarily opt out of commitments. These detailed rules increase transparency. Trans- parency means that it is easier for governments to determine whether a spe- cific trade measure adopted by a particular government is or is not consistent with WTO rules. The high-quality information and the transparency provided by the WTO allow governments to monitor the behavior of other WTO mem- bers. This in turn makes it easier for governments to use reciprocity strategies to enforce trade agreements.

The ability of governments to use the WTO to enforce trade agreements is most clearly evident in the WTO’sdispute settlement mechanism. The dispute settlement mechanism follows a standard procedure that was agreed to by all members of the WTO during the Uruguay Round. (See Figure 3.6.) A dispute is initiated when a government brings an alleged violation of WTO rules to the WTO Dispute Settlement Body (DSB, consisting of all WTO members).

The DSB initially encourages the governments involved in the dispute to try to resolve the conflict through direct consultations. If such consultations are unsuccessful, the DSB creates a formal panel to investigate the complaint.

This panel is typically composed of three experts in trade law who are selected by the DSB in consultation with the governments involved in the dis- pute. The panel reviews the evidence in the case, meets with the parties to the dispute and outside experts if necessary, and prepares a final report that … 30 days for appellate report Consultations (Art. 4) Panel established by Dispute Settlement Body (DSB)(Art. 6) Panel examination Normally 2 meetings with parties (Art. 12), 1 meeting with third parties (Art. 10) DSB adopts panel/appellate report(s) including any changes to panel report made by appellate report (Art. 16.1, 16.4, and 17.14) In cases of nonimplementation,parties negotiate compensation pending full implementation (Art. 22.2) Retaliation If no agreement on compensation, DSB authorizes retaliation pending full implementation (Art. 22) Cross retaliation: same sector, other sectors, other agreements (Art. 22.3) Possibility of arbitration on level of suspension, procedures, and principles of retalitation (Art. 22.6 and 22.7) Dispute over implementation Proceedings possible, including referral to initial panel on implementation (Art. 21.5) Review meeting with panel upon request (Art. 15.2) Expert review group (Art. 13; Appendix 4) During all stagesgood offices, conciliation, or mediation (Art. 5) Appellate review(Art. 16.4 and 17) Implementation Report by losing party of proposed implementation within “reasonable period of time” (Art. 21.3) Interim review stage Descriptive part of report sent to parties for comment (Art. 15.1) Interim report sent to parties for comment (Art. 15.2) Terms of reference (Art. 7) Composition (Art. 8) Panel report issued to parties (Art. 12.8; Appendix 3 par. 12( j)) Panel report issued to DSB (Art. 12.9; Appendix 3 par. 12( k)) 60 days by 2nd DSB meeting 20 days (+10 if Director- General asked to pick panel) 6 months from panel’s composition, 3 months if urgent up to 9 months from panel’s establishment 60 days for panel report unless appealed … 30 days after “reasonable period” expires “REASONABLE PERIOD OF TIME”:

determined by:

member proposes, DSB agrees; or parties in dispute agree; or arbitrator (approx. 15 months if by arbitrator)NOTE: a panel can be “composed” (i.e., panelists chosen) up to about 30 days after its “establishment” (i.e., after DSB’s decision to have a panel) TOTAL FOR REPORT ADOPTION:

Usually up to 9 months (no appeal) or 12 months (with appeal) from establishment of panel to adoption of report (Art. 20) max. 90 days 90 days 0–20 days FIGURE 3.6 The Dispute Settlement Mechanism Enforcing Agreements 65 it submits to the DSB. The DSB must accept the panel’s final report unless all WTO members, including the government that initially brought the com- plaint, vote against its adoption.

Both governments can appeal the panel’s decision. If an appeal is re- quested, the DSB creates an appellate body composed of three to five people drawn from a list of seven permanent members. The appellate body can up- hold, reverse, or modify the panel’s findings, conclusions, and recommenda- tions. The appellate report is given to the DSB for approval, and as with the panel report, the DSB can reject the report only with the consent of all mem- ber governments. If at the end of this process it is determined that the disputed trade measure is inconsistent with WTO rules, the government must alter its policy to conform to the rule in question or compensate the injured parties.

The entire dispute settlement process, from initiation to appellate report, is supposed to take no longer than 15 months.

An ongoing dispute involving American cotton subsidies illustrates how governments use the dispute-settlement mechanism to enforce compliance with trade agreements (see Schnepf 2010). The cotton subsidy case began in 2002. The Brazilian government complained to the WTO that subsidies paid by the U.S. government to American cotton farmers provided an advantage in global markets that harmed Brazil’s cotton growers and violated WTO rules.

The Bush administration defended the measures on the grounds that the sub- sidies represented a “safety net” that protected American cotton growers from volatile global commodity markets. Because the two governments could not settle the dispute through initial discussions, the WTO established a panel in early 2003.

The panel found that American subsidies violated several WTO rules. In particular, the panel ruled that the American cotton policy constituted an ex- port subsidy and domestic production support that harmed Brazilian cotton growers. Although the United States appealed the ruling, the appellate panel upheld the original ruling. As a result, the United States modified its policy in an attempt to bring it in line with its WTO obligations. These changes failed to satisfy the Brazilian government, however. They requested that a WTO compliance panel evaluate whether the American adjustment brought the sub- sidies regime in line with WTO rules. The compliance panel sided with Brazil; it found that the U.S. policy change was insufficient, a finding upheld by the appellate panel. As a consequence, the WTO authorized Brazil to retaliate against the United States by imposing tariffs on imports of U.S. goods into Brazil up to as much as $823 million per year, the amount the American cot- ton policy cost Brazil.

Brazil’s threatened imposition of these retaliatory tariffs induced the U.S.

government to negotiate a less-costly solution to the dispute. In April 2010 the two governments announced the results of these negotiations. Arguing that cotton subsidies form part of its larger agricultural policy, the United States agreed to reform its cotton subsidies regime only as part of the 2012 Farm Bill. Second, until the subsidies regime is reformed, the United States agreed to pay to Brazil $147 million per year for capacity-building and technical 66 CHAPTER 3 The Political Economy of International Trade Cooperation improvement in Brazilian agribusiness. In exchange, Brazil agreed to not im- pose retaliatory tariffs against U.S. goods, services, or intellectual property. In other words, Brazil accepted current American policy, even though it violates WTO rules, and the United States agreed to compensate Brazil for doing so.

The cotton case illustrates how governments can use tit-for-tat strate- gies to enforce trade agreements. An alleged defection by the United States prompted a WTO investigation. This investigation indicated that U.S. policy violated WTO rules, and when the United States failed to bring its policies into line with its obligations, Brazil was allowed to retaliate by withdraw- ing concessions it had made previously to the Americans. In the language of the iterated prisoners’ dilemma, the United States defected and Brazil, playing a tit-for-tat strategy, defected in response. Moreover, Brazilian retaliation came only after the WTO had determined that it was justified and the scale of the retaliation was proportionate to the injury suffered.

Although the WTO’s dispute resolution mechanism focuses our attention on a legalistic version of tit-for-tat, it also allows us to see in a very detailed way how the WTO can promote trade cooperation by helping governments enforce trade agreements.

The WTO thus helps governments gain the assurances they need in order to conclude the trade agreements required to capture the gains from trade.

The WTO provides this assurance by allowing governments to monitor the behavior of their trade partners and to enforce the trade agreements they reach. By doing so, the WTO enables societies to capture the welfare gains the trade provides. In the absence of the WTO, or an institution that performed similar functions, it is unlikely that governments would be able to reach the agreements required to liberalize trade. Each society, and thus the world as a whole, would be poorer as a result.

CONCLUSION The WTO exists, therefore, because it facilitates international cooperation, thereby enabling societies to capture the welfare gains available from trade.

Trade raises social welfare by enabling consumers to enjoy a higher level of utility than if they could consume only goods produced at home. The principle of comparative advantage tells us that these welfare gains do not require a country to have an absolute advantage in anything. As long as a country is better at doing some things than others, it gains by specializing in what it does relatively well and trading for everything else.

Politics, however, makes it difficult for societies to realize these gains from trade. For reasons we examine in greater detail in the next chapter, gov- ernments often neglect consumer interests in favor of producer interests. Con- sequently, governments can capture the gains from trade only by negotiating agreements in which they exchange market access commitments. In such bar- gaining, governments strive to gain access to foreign markets for their compar- atively advantaged industries in exchange for granting access to their markets in their comparatively disadvantaged industries. Consequently, governments Suggestions for Further Reading 67 employ bargaining power in an attempt to gain maximum access in exchange for minimal concessions. By providing a forum for bargaining, the WTO en- ables governments to liberalize trade more than they would be willing to do unilaterally.

Yet, concluding trade agreements is also complicated by the enforcement problem. Governments must believe that cooperation on their part will be re- ciprocated by cooperation from their partners. They must believe that their partners will not try to take advantage of them. And as the prisoners’ dilemma highlights, unless such assurances are provided, governments have little in- centive to cooperate. The international trade system lacks the equivalent of a state to enforce agreements, and thus governments face a pervasive enforce- ment problem when they try to cooperate for mutual gain. Consequently, it is difficult for governments to conclude mutually beneficial agreements, and as a result, societies have lower standards of living.

The WTO helps governments solve this enforcement problem. By en- abling governments to feel reasonably secure that their partners will comply with the agreements they enter, the WTO provides the assurances necessary to achieve cooperation. Strictly speaking, the WTO is not an international equivalent of a state because the WTO does not have the authority or the capacity to punish governments that fail to comply with trade agreements.

Instead, the WTO facilitates international cooperation by providing an infrastructure that allows governments to enforce agreements themselves.

By providing a set of mutually agreed on rules, by helping governments monitor the extent to which their partners comply with these rules, and by providing a dispute-settlement mechanism that helps governments resolve those issues of compliance that do arise, the WTO enables governments to enforce effectively the trade agreements that they reach. The WTO thus provides enough assurance that all governments will live up to the agree- ments that they enter into and that no government will be able to take advantage of the others. By providing this infrastructure, the WTO enables governments to conclude the trade agreements necessary to capture the wel- fare gains from trade.

KEY TERMS Bargaining Contract Curve Dispute Settlement MechanismEnforcement Problem Factor Endowments Hecksher-Ohlin Model Nash Equilibrium Outside Option Pareto Suboptimal Patience Reciprocity SUGGESTIONS FOR FURTHER READING For an approach that emphasizes the intuition of the theory of comparative advantage and downplays explicit theory, see Russell D. Roberts,The Choice: A Fable of Free Trade and Protectionism (Upper Saddle River, NJ: Prentice Hall, 1994). For an 68 CHAPTER 3 The Political Economy of International Trade Cooperation excellent account of the historical development of the theory of comparative advan- tage and of those theories that have challenged the central claim of this theory, see Douglas Irwin,Against the Tide: An Intellectual History of Free Trade (Princeton, NJ: Princeton University Press, 1996).

To delve more deeply into the logic of international cooperation and the role inter- national institutions play in facilitating such cooperation, see Robert O. Keohane, After Hegemony: Cooperation and Discord in the Global Economy (Princeton, NJ: Princeton University Press, 1984) and Robert Axelrod, The Evolution of Cooperation (New York: Basic Books, 1984). 69 A Society-Centered Approach to Trade Politics O ur focus on the international politics of trade has bracketed an impor- tant question—what determines the specific trade objectives that gov- ernments pursue when bargaining within the WTO, when negotiating regional trade arrangements, or when making unilateral trade-policy decisions?

We take up this question in this chapter and the next by examining two ap- proaches to trade politics rooted in domestic politics. This chapter examines a society-centered approach to trade politics. A society-centered approach argues that a government’s trade policy objectives are shaped by politicians’ responses to interest groups’ demands. The European Union’s (EU) reluctance to liberal- ize European agriculture reflects EU policymakers’ responses to the demands of European farmers. The Japanese government’s commitment to high tariffs on imported rice reflects the Japanese government’s need to respond to the de- mands of Japanese rice growers. The American effort to open foreign markets to American high technology and service exports while continuing to protect the American textile, apparel, and steel industries reflects the influence that industry-based interest groups exert on American trade policy.

To understand the political dynamics of this competition, the society- centered approach emphasizes the interplay between organized interests and political institutions. The approach is based on the recognition that trade has distributional consequences. In my home state, people employed in the textile and apparel industry—traditionally a large employer in North Carolina—have been hit hard by trade liberalization. Between 2000 and 2004, 207 textile and apparel factories closed, and about 44,000 people lost their jobs. In contrast, North Carolinians employed in the pharmaceutical industry or in finance have benefited from trade liberalization. The average wage earned by people em- ployed in these industries rose in the first half of this decade, as did the to- tal number of jobs available in these industries. In North Carolina, therefore, some people have gained from trade, whereas others have lost.

These distributional consequences generate political competition as the winners and losers from trade turn to the political arena to advance and 4 CHAPTER 70 CHAPTER 4 A Society-Centered Approach to Trade Politics defend their economic interests. The American Textile Manufacturers Insti- tute and the National Council of Textile Organizations, business associations representing textile and apparel firms, pressure American politicians for more stringent controls on textile and apparel imports. They are joined by other business associations representing businesses harmed by trade liberalization.

A protectionist coalition gradually begins to form. The Coalition of Service Industries, a business association that represents American financial-services firms (and many other service industry firms), pressures the U.S. government to conclude WTO negotiations aimed at liberalizing world trade in services. As other groups that benefit from expanded trade join them, a pro- liberalization coalition begins to form. Exactly how this competition unfolds—which groups organize to lobby, what coalitions arise, how politicians respond to interest-group demands, which groups’ interests are reflected in trade policy and which groups’ interests are not—is shaped by the political institutions within which it takes place.

This chapter develops the analytical tools central to a society-centered approach. We focus first on interest-group preferences—which groups prefer protectionism, which groups prefer liberalization, and why? We use trade the- ory to develop some systematic expectations about trade policy preferences, and we use collective action theory to understand which groups will organize to pursue their interests. We then turn our attention to political institutions, looking at how different institutional frameworks create different kinds of in- terest representation. We conclude by discussing some of the weaknesses of this approach.

TRADE POLICY PREFERENCES Because a society-centered approach argues that trade policy reflects interest- group demands, it devotes considerable attention to the source, content, and organization of these demands. Here we examine two standard models of trade policy preferences: the factor model and the sector model. The two models agree that raising and lowering tariffs redistributes income, and they agree that these income consequences are the source of trade policy preferences. The two models offer distinctive conceptions of how trade’s income consequences divide society. We examine both models and then turn our attention to the collective action problem that shapes the ability of groups with common interests to organize in order to lobby the government on behalf of their desired policies.

Factor Incomes and Class Conflict The factor model argues that trade politics are driven by competition between factors of production—that is, by competition between labor and capital, be- tween workers and capitalists. Labor and capital have distinct trade policy preference because trade’s income effects divide society along factor lines.

Whenever tariffs are lowered and trade expanded (or tariffs raised and trade Trade Policy Preferences 71 restricted), one factor will experience rising income, whereas the other will see its income fall. Trade, therefore, places labor and capital in direct compe- tition with each other over the distribution of national income. To fully un- derstand the reason for this competition, we need to look at how trade affects factor incomes.

To do so, we are going to make some assumptions. First, we will assume that there are only two countries in the world: the United States and China.

Second, we will assume that both countries produce two goods: shirts and computers. Third, we will assume that each country uses two factors of pro- duction, labor and capital, to produce both goods. Fourth, we will assume that shirt production relies heavily on labor and less heavily on capital, whereas computer production requires a lot of capital and little labor. Finally, we will assume that the United States is endowed with a lot of capital and little labor, whereas China is endowed with a lot of labor and little capital. These assump- tions merely restate the standard trade model that we learned in Chapter 3.

These assumptions establish who produces what. First, capital will be relatively cheap and labor will be relatively expensive in the United States, whereas the opposite will be the case in China. Consequently, the United States will export the capital-intensive good (computers) and will import the labor-intensive good (shirts). China will export the labor-intensive good and import the capital-intensive good.

We can now see what happens to factor incomes in the United States and China as they engage in trade. We look first at the United States. When the United States begins to import shirts from China, demand for American-made shirts falls. As demand for American shirts falls, American firms manufacture fewer of them. As shirt production falls, apparel firms liquidate the capital they had invested in shirt factories, and they lay off their employees. At the same time, American computer firms are expanding production in response to the growing Chinese demand for American computers. As American com- puter production expands, computer firms demand more capital and labor, and they begin to employ capital and labor released by the shirt industry.

There is an imbalance, however, between the amount of labor and capital being released by the shirt industry and the amount being absorbed into the computer industry. The imbalance arises because the two industries use labor and capital in different proportions. The labor-intensive shirt industry uses a lot of labor and little capital, and so as it shrinks, it releases a lot of labor and less capital. The capital-intensive computer industry employs lots of capital and less labor, and so as it expands it demands more capital and less labor than the shirt industry is releasing.

Consequently, the price of capital and labor will change. More capital is being demanded than is being released, causing the price of capital to rise.

People who own capital, therefore, now earn a higher return than they did prior to trade with China. Less labor is being demanded than is being released, causing the price of labor to fall. Workers, therefore, now earn less than they did prior to trade with China. For the United States, then, trade with China causes the return to capital to rise and wages to fall. 72 CHAPTER 4 A Society-Centered Approach to Trade Politics The same dynamic is taking place in China, but in the opposite direction.

As demand for Chinese computers falls, Chinese firms manufacture fewer computers. As computer production falls, Chinese computer manufacturers liquidate the capital they have invested in computer factories and they lay off their employees. Chinese shirt firms are expanding in response to the growing demand in the United States and they demand more capital and labor. The Chinese shirt industry thus absorbs capital and labor released from the com- puter industry.

Again, however, there is an imbalance between the factors being released and those being demanded. The computer industry uses lots of capital and lit- tle labor, and so as it shrinks, it releases lots of capital and only a little labor.

Yet, the shirt industry employs a lot of labor and relatively little capital. So as it expands, it is demanding more labor and less capital than the computer industry is releasing.

Consequently, the relative prices of capital and labor change. More labor is being demanded than is being released, causing the price of labor to rise.

Less capital is demanded than is being released, causing the price of capital to fall. Trade with the United States has caused the wages earned by Chinese workers to rise and the return to Chinese capital to fall.

Trade between the United States and China has thus caused changes in the incomes earned by workers and capitalists in both countries. Abundant American capital and abundant Chinese labor both gained from trade. Scarce American labor and scarce Chinese capital both lost. More generally, therefore, trade raises the income of society’s abundant factor and reduces the income of society’s scarce factor. If we allow this trade to continue uninterrupted, then over time, factor incomes in the United States and China will equalize. That is, wages for American workers will fall and wages for Chinese workers will rise until wages in the two countries are the same. The return to capital in the two countries will also equalize. The return to Chinese capital will fall and the return to American capital will rise until the return to capital in the two coun- tries is the same. The tendency for trade to cause factor prices to converge is known asfactor-price equalization (or theStolper-Samuelson Theorem).

Trade policy preferences follow directly from these income effects. Be- cause trade causes the scarce factor’s income to fall, scarce factors want to minimize trade. Scarce factors thus demand high tariffs in order to keep for- eign products out of the home market. Because trade causes the abundant factor’s income to rise, abundant factors want to maximize trade. Abundant factors thus prefer low tariffs in order to capture the gains from trade. In the United States and other capital abundant countries, the factor model predicts that owners of capital (the abundant factor) will prefer liberal trade policies, whereas workers (the scarce factor) will prefer protectionist trade policies. In developing countries, the factor model predicts that labor will prefer liberal trade policies, whereas owners of capital will prefer protection. Trade politics are thus driven by conflict between labor and business (or capital). Because this competition pits workers against capitalists, the factor model is often called a class-based model of trade politics. Trade Policy Preferences 73 Thefactor model suggests that the debate over trade policy is a conflict over the distribution of national income between American labor and American business. Because trade reduces the income of American workers, these workers, and the organizations that represent them, have an incentive to oppose further liberalization and to advocate more protectionist policies. And indeed, American labor unions have been very critical of globalization. The AFL-CIO, a federation of 64 labor unions representing 13 million American workers, has been among the most prominent critics of globalization.

Although the AFL-CIO does not consider itself protectionist, it has fought consistently to prevent passage of fast-track authority. It is also highly criti- cal of the North American Free Trade Agreement (NAFTA) and the proposed Free Trade Area of the Americas (FTAA).

Conversely, because trade raises the return to American capital, American businesses should be strong supporters of globalization. And American busi- ness has been very supportive of globalization. The Business Roundtable, a business association composed of the chief executives of the largest American corporations, strongly supports globalization. It has been an active lobbyist for fast-track authority, it supports NAFTA and the FTAA, and it strongly supported China’s entry into the WTO. The National Association of Manu- facturers, which represents about 14,000 American manufacturing firms, also supports the WTO and regional trade arrangements. Trade policy demands from American labor and capital thus reflect the income consequences that the factor model highlights. American trade politics does seem to be shaped by competition over national income between workers and capitalists.

We conclude with an important qualification. The emergence of conflict between workers and capitalists is based on the assumption, embodied in our simple two-factor model, that American labor is homogeneous—all workers are identical. Workers are not homogeneous, however, and at a minimum, we need to divide labor into distinct skill categories, such as low- and high- skill, and treat each category as a distinct factor of production. A model that allows for different skill categories among workers yields different con- clusions about trade’s impact on the incomes of American workers. Trade still reduces the income of low-skill American workers; high-skill workers, however, which are an abundant factor in the United States, would see their incomes rise. Sector Incomes and Industry Conflict Thesector model argues that trade politics are driven by competition be- tween industries. Industries have distinct preferences because trade’s income effects divide society along industry lines. Whenever tariffs are raised or lowered, wages and the return to capital employed in some industries both rise, whereas wages and the return to capital employed in other industries both fall. Trade, therefore, pits the workers and capitalists employed in one industry against the workers and capitalists employed in another industry in the conflict over the distribution of national income. 74 CHAPTER 4 A Society-Centered Approach to Trade Politics POLICY ANALYSIS AND DEBATE Trade Adjustment Question How should governments respond to the economic dislocation caused by trade?

Overview Most economists believe that trade does not change thenumber of jobs in the local economy. Instead, trade changes thekinds of jobs that are available. Jobs in import-competing industries disappear as firms shut down or move offshore. In the meantime, jobs are created in export-oriented industries. The jobs created offset the jobs lost. The jobs being created are quite different from the ones that are eliminated. In North Carolina, for example, trade has eliminated low-skilled jobs in the apparel industry while creating high-skilled jobs in high-technology industries.

Society as a whole is much better off over the long run with these high-paying jobs than it is with low-paying jobs.

In the short run, however, the inevitable adjustment creates some real policy dilemmas. It is difficult for workers to move from low-skilled to high-skilled jobs.

Typically, low-skilled workers have a high school education at best and in many instances are 40 years old or older. This segment of the population finds it very difficult to become employed in high-technology industries. Moreover, even if it weren’t so difficult, many would find it necessary to abandon the communities in which they were born and raised to take a job in a new town. What policies should governments use to manage this trade adjustment problem?

Policy Options •Protectionism: Governments should raise tariffs or use other means to protect industries threatened by import competition. By protecting industries from import competition, this policy would protect the most vulnerable from the forces of economic dislocation.

•Adjustment Assistance: Governments should establish programs to retrain workers.

by offering such programs, this policy would help workers move from declining to expanding industries with less difficulty.

Policy Analysis • What are the costs and the benefits of each policy?

• Who pays the costs for each policy?

• Is one policy more feasible politically than the other? If so, why?

What Do You Think?

• Which policy do you advocate? Justify your choice.

• What criticisms of your position would you anticipate? How would you defend your recommendation against those criticisms? Trade Policy Preferences 75 The sector model argues that trade divides society across industry rather than factor lines because the assumptions it makes about factor mobility are different from the assumptions embodied in the factor model.Factor mobility refers to the ease with which labor and capital can move from one industry to another. The factor model assumes that factors are highly mobile; labor and capital can move easily from one industry to another. Thus, capital currently employed in the apparel industry can be quickly shifted to the computer in- dustry. Similarly, workers currently engaged in apparel production can easily shift to computer production. When factors are mobile, people’s economic interests are determined by their factor ownership. Workers care about what happens to labor, whereas capitalists care about the return to capital.

The sector model assumes that factors are not easily moved from one in- dustry to another. Instead, factors are tied, orspecific, to the sector in which they are currently employed. Capital currently employed in apparel produc- tion cannot easily move to the computer industry. What use does a loom or a spinning machine have in the computer industry? Workers also often have industry-specific skills that do not transfer easily from one sector to another.

A worker who has spent 15 years maintaining sophisticated automated looms and spinning machines in an apparel plant cannot easily transfer these skills to computer production. In addition, the geography of industry location often means that quitting a job in one industry to take a job in another requires workers to physically relocate. Shifting from apparel production to auto- mobile production might require a worker to move from North Carolina to Michigan. Logistical obstacles to physical relocation can be insurmountable.

A worker may not be able to sell his house because the decline of the local in- dustry has contributed to a more general economic decline in his community.

Complex social and psychological factors also intervene, as it is difficult to abandon the network of social relations that one has developed over many years. The combination of specific skills, logistical problems, and attachments Resources Online: Do an online search for U.S. government trade adjustment policy. Compare the U.S. approach with that of another country. (Sweden provides a strong con- trast.) Search for the terms trade adjustment assistance Sweden andlabor market policy Sweden.

In Print: Alan V. Deardorff and Robert Stern, The Social Dimensions of U.S. Trade Policy (Ann Arbor: University of Michigan Press, 2000); Kenneth F. Scheve and Mat- thew J. Slaughter, “A New Deal for Globalization,” Foreign Affairs 86 (July/August 2007); Howard F. Rosen, “Designing a National Strategy for Responding to Economic Dislocation,” Testimony before the Subcommittee on Investigation and Oversight House Science and Technology Committee, June 24, 2008. www .petersoninstitute.org/publications/papers/print.cfm?doc=pub&ResearchID=967. 76 CHAPTER 4 A Society-Centered Approach to Trade Politics to an established community mean that labor cannot always move from one industry to another.

When factors are immobile, trade affects the incomes of all factors em- ployed in a given industry in the same way. We can see why by returning to our U.S.–China example. Consider the apparel industry first. Shirt imports from China lead to less shirt production in the United States. Factories are closed and workers are laid off. As in the factor model, apparel workers see their incomes fall. In contrast to the factor model, however, the owners of capital employed in apparel production also see their incomes fall. Why? Be- cause capital is immobile and therefore capital employed in apparel produc- tion cannot move into the computer industry. As demand for American shirts falls, demand for capital employed in the American shirt industry must also fall. As it does, the return to this capital must also fall. Workers and business owners in the apparel sector thus both suffer from trade.

The opposite consequences are evident in the computer industry. Trade’s impact on the return to capital employed in the computer industry is similar to the factor model. As computer production expands, increasing demand for capital raises the return to capital employed in the computer industry. Trade’s impact on the incomes of workers employed in the computer industry is quite different from the factor model’s prediction. The factor model tells us that computer workers see their incomes fall as they compete against the work- ers released by the apparel industry. With more people chasing fewer jobs, all workers’ incomes fall. The sector model argues that computer workers’ incomes rise. Because labor is immobile, the workers released by the apparel industry cannot move into the computer industry. Greater demand for labor in the computer industry increases the wages paid to workers already employed in the industry. Thus, capital and labor employed in the American computer industry both gain from trade.

When factors are immobile, it makes little sense to speak of the interests of a unified labor or capital class. The apparel worker loses from trade; the computer worker gains. Roger Milliken (owner of the world’s largest privately owned textile firm, Milliken & Company) loses from trade while Michael Dell (founder of Dell Computers) gains. Consequently, trade policy interests are defined in terms of the industry in which people work or have invested their capital. Apparel workers and Roger Milliken will have a common interest in trade policy. Computer workers and Michael Dell will have a common inter- est in trade policy. Trade politics is then driven by competition between the workers and capitalists who gain from trade and the workers and capitalists who lose. The result is not class conflict, but conflict between industries.

We can be very precise about which industries gain and which lose from trade. Labor and capital employed in industries that rely intensively on society’s abundant factor (that is, the country’s comparatively advantaged industries) both gain from trade. In the advanced industrialized countries, this means that labor and capital employed in capital-intensive and high-technology in- dustries, such as computers, pharmaceuticals, and biotechnology, gain from trade. As a group, these industries are referred to as theexport-oriented sector. Trade Policy Preferences 77 Conversely, labor and capital employed in industries that rely intensively on society’s scarce factor (that is, the country’s comparatively disadvantaged in- dustries) lose from trade. In the advanced industrialized countries, this means that the incomes of owners of capital and workers employed in labor-intensive sectors such as apparel and footwear will fall as a result of trade. As a group, these industries are commonly referred to as theimport-competing sector.

Thus, the sector model argues that trade politics is driven by competition be- tween the import-competing and export-oriented sectors.

The sector model adds nuance to our understanding of the political de- bate over globalization. The factor model suggests that the debate over glo- balization pits labor against capital, and the sector model suggests that this political debate often pits capital and labor in import-competing industries against capital and labor in export-oriented industries. We might expect there- fore that UNITE (the Union of Needletrades, Industrial and Textile Employ- ees), the principal union in the American apparel industry, and the American Textile Manufacturers Institute (ATMI), a business association representing American textile firms, would both oppose globalization. Indeed, this is what we find. UNITE has been a vocal opponent of NAFTA, of the FTAA, and of fast-track authority. For its part, the ATMI has not been critical of all trade agreements, but it has opposed free-trade agreements with South Korea and Singapore, has been very critical of the American decision to grant China per- manent normal trade status, and does not support further opening of the U.S.

market to foreign textiles through multilateral trade negotiations (American Textile Manufactures Institute 2001). In general, labor and capital employed in textile and apparel are both skeptical of globalization.

Conversely, the sector model predicts that capital and labor employed in export-oriented industries will both support globalization. It is relatively easy to document such support among American export-oriented firms. A coalition of business associations representing American high-tech firms—including the Consumer Electronics Association, Electronic Industries Alliance, Information Technology Industry Council, MultiMedia Telecommunications Association, and The Semiconductor Industry Association—has supported fast-track au- thority, the approval of normal trade relations with China, NAFTA, and the FTAA. It is more difficult to document attitudes of workers employed in these industries, in large part because workers in high-technology sectors are not unionized to the same extent as workers in many manufacturing industries.

However, workers in high-tech industries are predominantly high skilled, and on average, high-skilled workers are more supportive of trade liberalization than low-skilled workers (Scheve and Slaughter 2001). Although this is indi- rect evidence, it is consistent with the prediction that both labor and capital employed in American high-technology industries will support globalization.

The factor and sector models thus both argue that trade policy prefer- ences are determined by the income consequences of trade. Trade raises the incomes of some groups and lowers the incomes of others. Those who gain from trade prefer trade liberalization, whereas those who lose prefer pro- tectionism. Each model offers a distinct pattern of trade policy preferences, 78 CHAPTER 4 A Society-Centered Approach to Trade Politics however, based on distinct conceptions of how the income effects of trade di- vide society (see Table 4.1). The factor model states that trade divides society across factor lines and that, consequently, trade politics is driven by conflict between labor and capital. The sector model states that trade divides society along sector lines and that, consequently trade politics is driven by conflict between import-competing and export-oriented industries. These distinct pat- terns are based on the assumptions each model makes about factor mobility.

The factor model assumes that factors are highly mobile, and therefore people define their interests in terms of factor ownership. The sector model assumes that factors are immobile, and thus people define their interests in terms of the industry in which they earn their living. Recent research challenges the assumption that trade policy preferences are based on the impact of trade on individual incomes (Mansfield and Mutz 2009). Rather than base their trade policy preferences on their factor ownership or on the sector in which they are employed, this research suggests that people base their trade policy prefer- ences on perceptions or beliefs about what is good for the country as a whole.

Such “sociotropic” concerns might focus on or revolve around attitudes to- ward out-groups (e.g., foreigners), foreign policy (i.e., isolationism or inter- ventionism), or beliefs about the impact of trade on the national economy rather than specific sectors. As a consequence, people might hold complicated trade policy preferences that change over time. For instance, a person might support trade during economic booms but oppose trade during recessions. If citizens believe that trade enriches their country as a whole, they will be more TABLE 4.1 Two Models of Interest-Group Competition over Trade Policy The Factor Model The Sector Model The principal actors Factors of production or classes Industries or sectors How mobile are factors of production?Perfectly mobile across sectors of the economy Immobile across sectors of the economy Who wins and who loses from international trade? Winner: abundant factor—capital in the advanced industrialized countriesWinner: labor and capital employed in export- oriented industries Loser: scarce factor— labor in the advanced industrialized countries Loser: labor and capital employed in import- competing sectors Central dimension of competition over trade policyProtectionist labor versus liberalizing capitalProtectionist import- competing industries versus liberalizing export- oriented industries Organizing Interests: The Collective Action Problem and Trade Policy Demands 79 likely to support open trade. Conversely, if citizens believe that trade causes a loss of jobs to other countries they will be more likely to oppose open trade policies.

ORGANIZING INTERESTS: THE COLLECTIVE ACTION PROBLEM AND TRADE POLICY DEMANDS Individuals’ preferences are not transformed automatically into political pres- sure for specific trade policies. Transforming individual preferences into po- litical demands requires that the individuals who share a common preference organize in order to exert influence on the policy-making process. Organizing can be so difficult that individuals with common interests may not organize at all. This might seem counterintuitive. If trade affects incomes in predictable ways, and if people are rational, then why wouldn’t people with common in- terests join forces to lobby for their desired policy?

Groups often can’t organize because they confront a public goods prob- lem or collective action problem (Olson 1965). Collective action problems are similar to the problem of public goods provision. Consider consumers and trade policy. As a group, the 200 million or so consumers who live in the United States would all gain from free trade. These 200 million people thus have a common interest in unilateral trade liberalization. To achieve this goal, however, consumers will have to lobby the government. Such lobbying is costly—money is required to create an organization, to pay for a lobby- ist, and to contribute to politicians’ campaigns, and time must be dedicated to fundraising and organization. Consequently, most consumers will perform the following very simple calculation: My contribution to this campaign will make no perceptible difference to the group’s ability to achieve free trade.

Moreover, I will benefit from free trade if the group is successful regardless of whether I have contributed or not. Therefore, I will let other consumers spend their money and time; that is, I will free ride. Because all consumers have an incentive to free ride, no one contributes time and money, no one lobbies, and consumer interests fail to influence trade policy. Thus, even though consum- ers share a common goal, the collective action problem prevents them from exerting pressure on politicians to achieve this goal. The incentive to free ride makes collective action in pursuit of a common goal very difficult.

The logic of collective action helps us understand three important char- acteristics of trade politics. First, it helps us understand why producers rather than consumers dominate trade politics. Consumers are a large and homoge- neous group, and each individual consumer faces a strong incentive to free ride. Consequently, contributions to a “Consumers for Free Trade” interest group are substantially less than the underlying common interest in free trade would seem to dictate. In contrast, most industries are made up of a relatively small number of firms. Producer groups can thus more readily organize to lobby the government in pursuit of their desired trade policy. The logic of collective action helps us understand why producers’ interests dominate trade politics, whereas consumer interests are often neglected. 80 CHAPTER 4 A Society-Centered Approach to Trade Politics Second, the logic of collective action suggests that trade politics will exhibit a bias toward protectionism. A tariff provides large benefits to the few firms producing in the protected industry. The costs of a tariff, however, are distributed across a large number of individuals and firms. A higher tariff on steel, for example, provides large benefits to the relatively small number of American steel producers and their workers. The costs of a steel tariff fall on everyone who consumes steel, a group that includes most American consumers as well as all firms that use steel as an input in their production processes. The small group of steel producers that benefits from the higher tariff can fairly easily overcome the collective action problem to lobby for protection. The large and heterogeneous group that bears the costs of the tariff finds it much more difficult to organize for collective ac- tion. Consequently, trade politics is dominated by import-competing indus- tries demanding protection.

Finally, the logic of collective action helps us understand why govern- ments rarely liberalize trade unilaterally, but have been willing to do so through negotiated agreements. Reciprocal trade agreements make it easier for export-oriented industries to overcome the collective action problem (see Bailey, Goldstein, and Weingast 1997; Gilligan 1997; Milner 1988). Recipro- cal trade agreements provide large benefits in the form of access to foreign markets to small groups of export-oriented firms. Reducing foreign tariffs on microprocessors for personal computers, for example, provides substantial gains to the three American firms that dominate this industry (Intel, Advanced Micro Devices [AMD], and Motorola). These three firms will solve the col- lective action problem they face and lobby for trade liberalization at home in exchange for the removal of foreign barriers to their exports.

Many scholars argue that exactly this effect lies behind postwar trade lib- eralization in the United States. The Roosevelt administration proposed and Congress passed the Reciprocal Trade Agreements Act (RTAA) of 1934. This legislation has continued to structure U.S. trade policy ever since. Under its terms, Congress delegates to the president the authority to reduce tariffs in exchange for equivalent concessions from foreign governments. By linking re- ductions of American tariffs to the opening of foreign markets to American exporters, the RTAA transformed the large and heterogeneous group favoring liberalization into small groups of export-oriented industries that could more easily organize to pursue common goals. This in turn altered the balance of interest-group pressure that politicians faced. More balanced political pres- sure made politicians more willing to liberalize trade.

In a society-centered approach, therefore, trade politics are shaped by competition between organized interest groups. This competition sometimes revolves around class conflict that pits workers against business owners and at other times revolves around industry conflict that pits import-competing industries against export-oriented industries. In all cases, however, the core conflict in, and the ultimate stakes of, this competition remain the same: the distribution of national income. The winners of this political competition are rewarded with rising incomes. The losers become poorer. Political Institutions and the Supply of Trade Policy 81 POLITICAL INSTITUTIONS AND THE SUPPLY OF TRADE POLICY While scholars have devoted considerable attention to developing conceptual models of the demand side of trade politics, they have focused less on the sup- ply side of trade politics. Supply-side models strive to say something systematic about who wins the competition over trade policy. Here we find considerable agreement that political institutions play an important role in transforming interest-group demands into actual policies, but substantially less agreement about how exactly they do so.

Political institutions shape how competition between organized interests unfolds. They do so by establishing rules that influence the strategies people adopt in pursuit of their policy objectives. These rules influence how people organize and thus determine whether interests organize around factor or sec- toral interests. Rules influence how organized interests exert pressure on the political process and thus determine whether interest groups lobby the legisla- ture or whether they exert influence through political parties. Rules influence which interests politicians must respond to and thus determine which interests gain representation and which do not. Because political institutions shape the way people behave, they have an important impact on who ultimately wins the battle over national income.

The electoral system is one institution that most political economists agree has an important impact on trade politics. Electoral systems can be classified into two broad categories: majoritarian and proportional. The critical dimension on which the two types are distinguished is the number of legislative seats selected in each constituency. Majoritarian electoral systems combine single member districts and first-past-the-post elections. Great Britain, for example, is divided into 650 constituencies, each of which elects a single member of parliament.

First-past-the-post voting means that a candidate need only attract a plurality of the vote to win in each district. As a result, British political parties can capture a majority in the House of Commons with only a plurality of the popular vote.

In the 2005 election, for example, the Labour Party received 35 percent of the popular vote but won 55 percent of the seats in the House of Commons. In 2010, the Conservative Party captured 47 percent of the seats in the House with only 36 percent of the popular vote. Majoritarian systems also disadvantage smaller third parties. The British Liberal Democrats, for example, earned 23 percent of the popular vote in the 2010 election, but only 9 percent of the seats in parliament.

Proportional representation (PR) electoral systems employ multi-member districts to distribute legislative representation in proportion to the share of the popular vote each party attracts. Norway, for example, is divided into 19 constituencies, each of which elects between 4 and 17 representatives to the Norwegian parliament. Legislators from each district are selected from the political parties in proportion to the party’s share of the popular vote in the district. In the 2009 election, the Norwegian Labor Party gained 33 percent of the seats in parliament based on 35 percent of the popular vote, while the second largest party, the Progress Party, captured 22 percent of the seats on 82 CHAPTER 4 A Society-Centered Approach to Trade Politics 23 percent of the popular vote. In PR systems, therefore, a party’s importance in the legislature closely tracks its share of the popular vote.

Electoral systems can affect trade politics in two ways. First, electoral sys- tems may play an important role in shaping how groups organize to pursue their trade policy objectives. In particular, majoritarian systems may encour- age organization around the common sector-based interests while PR systems may encourage organization around factors. Consider the incentives created by majoritarian electoral systems. To win elections in such systems, candidates must satisfy the demands of their districts’ residents. Each electoral district is relatively small and likely to be dominated by one or two major industries.

The wages paid in these industries will in turn play a large role in support- ing the rest of the district economy—the retail and service-sector businesses that provide jobs for many other people in the community. Such electoral systems create incentives for elected officials to represent the interests of the owners of and workers in the industries that dominate economic activity in their districts. We expect legislators from Detroit, Michigan, to advance and defend the interests of the auto industry and its employees. Because elected representatives have incentive to reward demands from the industries in their districts, industries have incentive to pursue their narrow interests rather than seek to construct broader coalitions. Consequently, majoritarian electoral institutions may create strong incentives for individuals to organize around narrow industry-specific interests.

In contrast, PR systems do not link political representation tightly to the interests of small and undiversified electoral districts. In the extreme case, for example, a PR system has a single national constituency. In such systems, elec- toral success requires the construction of electoral coalitions that appeal to broad rather than narrow interests. Consequently, PR systems seem to pro- duce political parties based on class or factor interests. In Norway, for ex- ample, the three largest political parties in postwar politics are closely tied to factor-based interests. The labor party is closely linked to Norwegian labor unions, the agrarian party evolved out of the farm movement of the 1920s, and the conservative party has represented the business or capital interest. And with the electoral system creating an incentive to represent factor-based inter- ests, economic actors gain an incentive to pursue their trade policy goals by organizing around factor-based interests. Thus, PR systems may create incen- tives for individuals to organize for political action around factoral interests.

Electoral systems may also affect the level of protection adopted by gov- ernments in the two systems. In particular, we might expect governments in countries with PR systems to maintain lower tariffs (and other trade barriers) than governments in countries with majoritarian electoral systems. The logic behind this hypothesis asserts that the small groups that benefit from pro- tection can more easily influence policy in majoritarian than in proportional systems. As one advocate of this hypothesis explains, “When automakers or dairy farmers entirely dominate twenty small constituencies and are a power- ful minority in fifty more, their voice will certainly be heard in the nation’s Political Institutions and the Supply of Trade Policy 83 councils. Where they constitute but one or two percent of an enormous dis- trict’s electorate, representatives may defy them more freely” (Rogowski 1987, 208). Such a logic may help us understand why farmers, who constitute well less than 5 percent of the American population, are able to gain such favorable legislation from Congress. In other words, minority interests can construct legislative majorities more easily in majoritarian than in PR systems.

It has proven difficult to tease out unambiguous empirical support for this electoral system hypothesis. The most recent empirical investigation reports substantial evidence that tariffs are higher in countries with majoritarian elec- toral systems than they are in countries with proportional systems (see Evans 2009). Analyzing the experience of as many as 147 countries (and as few as 30) between 1981 and 2004, this study finds that the average tariff in majori- tarian countries stood at 17 percent, while the average tariff in countries with PR systems reached only 12 percent. This five-percentage point difference per- sists even when the relationship between electoral systems and tariff rates is evaluated with more demanding statistical techniques that control for a large number of possible alternative explanations.

Other research reaches very different conclusions. A study that focuses on the experience of Latin American countries in the 1980s and 1990s finds that tariffs are higher in countries with PR systems than they are in countries with majoritarian electoral systems (Hatfield and Hauk 2004). A study based on variation in non-tariff forms of protection in fourteen industrial coun- tries during the 1980s also finds that protectionism was higher in countries with PR systems than in countries with majoritarian systems (Mansfield and Busch 1995). Both of these studies thus find exactly the opposite of what the electoral system hypothesis suggests we should observe. Consistent evidence about how electoral systems shape the level of protection has thus proven dif- ficult to find.

One final political institution, the number of veto players present in the political system, may also affect trade policy. Aveto player is a political actor whose agreement is necessary in order to enact policy (Tsebelis 2002). In the U.S. context, each branch of government might be a veto player. Whether each branch is a veto player in fact depends upon the preferences of the in- dividuals that control each branch. We might count situations of divided government, where one party controls Congress and the other party controls the White House, as two-veto player systems and count unified government as one-veto player systems. Coalition governments in parliamentary systems such as Germany, where two or more parties almost always make up the majority within the legislature and hold cabinet posts, are multi-veto player systems. Britain is perhaps the simplest system (until quite recently). With its majoritarian electoral system and parliamentary government, it has been ruled by single-party majority governments for most the postwar era. It is typically, therefore, a political system with a single veto player.

The central expectation of veto player theory is that the difficulty of moving policy from the status quo increases in line with the number of veto 84 CHAPTER 4 A Society-Centered Approach to Trade Politics A CLOSER LOOK The Politics of American Agricultural Policy Agricultural policy presents a compelling political economy puzzle. Congress passed the 2007 Farm Bill, which allocated billions of dollars to fund a variety of agriculture and related programs for 5 years. Current legislation in turn builds on a longer history of government support for agriculture. The Environmental Working Group documents that, as a group, American farmers received more than $177 billion from American taxpayers between 1995 and 2007 (Environmental Working Group). Yet, the beneficiaries of these programs, farmers and farm workers especially, constitute a small fraction of the American population. The U.S. Census Bureau estimates that only slightly more than 2 million farms are currently in operation, employing fewer than 3 million hired farm workers (U.S. Department of Agriculture 2002). How does such a small minority of the population manage to attract such large sums from the federal government?

Farmers, and their representatives in Congress, have passed legislation that provides these payments by creating legislative coalitions with other minority interests. Rather than handle each farm commodity through independent legislation, the Farm Bill combines all commodities into a single piece of legislation. As a consequence, producers of individual commodities gain a common interest in the bundle rather than a narrow interest in commodity-specific legislation. Wheat growers have a common interest with corn farmers, and both in turn have incentive to support cotton farmers, sugar beet producers, soybean growers, and so forth. Moreover, bundling farm commodities into a single bill expands the number of states that support the farm bill. Indeed, farms in all 50 states (even Alaska) receive some financial assistance via the subsidies the Farm Bill provides.

Legislators from farm states also link agricultural policy to other issues.

Traditionally, for example, the Farm Bill is linked to Food Stamps, a program designed to enhance the nutritional standards of low-income individuals, and to some school lunch programs. Linking farm subsidies to these consumer programs helps draw in support from legislators who represent those urban districts most harmed by higher food prices generated by a protected farm sector. The specific link to school lunch programs, by financing fresh fruit and vegetable consumptions, garnered support from producers of fresh produce, who are not typically supported by direct subsidies. Legislators also linked the 2007 Farm Bill to the issue of energy security by funding biofuel research, to environmental issues by funding clean up of the Chesapeake Bay, as well as to water and land conservation. Linking these issues expands the legislative coalition beyond farm interests.

This broad-based coalition in turn reflects the institutional imperatives of the American political system. On the one hand, the Senate, which confers two votes to each state, overrepresents rural relative to urban residents. Senators from rural states can thus build a majority for the Farm Bill so long as they can spread the gains across a sufficient number of states. Getting the measure through the House, Political Institutions and the Supply of Trade Policy 85 players in the political system. Applied to trade policy, this suggests that po- litical systems with many veto players will find it difficult to alter tariffs in response to societal pressure for change (Henisz and Mansfield 2006). In con- trast, tariffs will be relatively easy to change in political systems with few veto players. Some research that explores how protectionism reacts to changes in macroeconomic conditions supports this expectation. We might expect, for example, that protectionism would rise during recessions and fall during eco- nomic booms. This is surely what occurred during the 1930s as well as to a lesser degree in the 1970s. More recently, policymakers have feared that the however, requires that the bill provide some clear benefit to (or at least impose no obvious costs on) the more densely populated urban areas that are more heavily represented in the House. Building a House majority, therefore, required measures like Food Stamps to ensure that higher prices paid to the farmers represented by Senators from rural states did not worsen the plight of low-income groups represented by Representatives from urban districts.

Finally, the Senate and House committees that wrote the Farm Bill are composed of legislators from the states that are the principal beneficiaries of the agricultural policy. Tom Harkin, a Democrat from Iowa, currently chairs the Senate Committee on Agriculture, Nutrition, and Forestry. Moreover, more than two-thirds of the committee members represent states with important agricultural sectors. Similar characteristics are evident in the House Committee on Agriculture.

More than four-fifths of the House Committee’s current members come from farm states, while Collin Peterson, who represents Minnesota’s Seventh Congressional District (which attracted half of all subsidies paid to Minnesotan farmers between 1995 and 2006), chairs the committee. Legislators from farm states thus exert considerable control over agricultural trade policy by controlling the committees with direct responsibility for the relevant legislation in both houses of Congress.

Seeing how domestic politics shape American agricultural policy helps us understand why the Doha Round is both an important source of policy change and yet also is limited in what it can achieve. The Doha Round’s importance lies in large part in agenda setting. In the absence of international pressure, congressional committees would be unlikely to consider dramatic changes in agricultural policy.

There are simply too few people on congressional agriculture committees who have an incentive to press for such reforms. Hence, placing agriculture on the WTO agenda also forces the issue onto the congressional agenda. Yet, international pressure is insufficient by itself to produce substantial policy change. The Farm Bill enjoys widespread support within Congress (Congress voted to override President George W. Bush’s veto of the 2007 Farm Bill). One cannot readily imagine the construction of a majority willing to dismantle this program in a single act.

Consequently, one might suspect that domestic politics will cause the liberalization of trade in agriculture to proceed gradually, much as tariffs on manufactured goods came down slowly.

86 CHAPTER 4 A Society-Centered Approach to Trade Politics recession sparked by the financial crisis would spark a surge of protectionism.

However, the extent to which protectionism rises during recessions appears strongly shaped by veto players. Protection rises sharply during recessions in countries with few veto players but rises substantially less in countries with fewer veto players.

Political institutions thus shape how private sector trade policy demands are transformed into trade policy outcomes. The rules governing elections can influence whether private sector groups organize around factors or sectors.

These same rules can also shape the level of protectionism. The number of veto players in the political system shapes the government’s ability to raise or lower tariffs in response to changes in the relative power of protectionist and liberalizing demands emanating from organized groups. These features of in- stitutions thus play an important role in determining which groups prevail in the distributive competition over trade policy.

CONCLUSION Although a society-centered approach helps us understand how the interac- tion between societal interests and political institutions shapes trade politics, it does have weaknesses. We conclude our discussion of this approach by looking at the three most significant weaknesses. First, a society-centered approach does not explain trade policy outcomes. It tells us that trade poli- tics will be characterized by conflict between the winners and losers from international trade, and it does a fine job telling us who the winners and losers will be. It does not help us explain which of these groups will win the political battle. Presumably, a country’s trade policy will embody the prefer- ences of society’s most powerful interests. To explain trade policy outcomes, therefore, we need to be able to evaluate the relative power of the competing groups. The society-centered approach provides little guidance about how to measure this balance of power. The temptation is to look at trade policy outcomes and deduce that the most powerful groups are those whose prefer- ences are reflected in this policy. Yet, looking at outcomes renders this ap- proach tautological; we assume that the preferences of powerful groups are embodied in trade policy and then infer the power of individual groups from the content of trade policy. Thus, the society-centered approach is better at explaining why trade politics are characterized by competition between organized interests than at telling us why one group outperforms another in this competition for influence.

Second, the society-centered approach implicitly assumes that politicians have no independent trade policy objectives and play no autonomous role in trade politics. This assumption is probably misleading. Politicians are not simply passive recorders of interest-group pressures. As Ikenberry, Lake, and Mastanduno (1988, 8) note, politicians and political institutions “can play a critical role in shaping the manner and the extent to which social forces can exert influence” on trade policy. Politicians do have independent trade policy Conclusion 87 objectives, and the constellation of interest groups that politicians confront is not fixed. Indeed, politicians can actively attempt to shape the configuration of interest-group pressures that they face. They can, for example, mobilize la- tent interest groups with a preference for liberalization or protection by help- ing them overcome their collective action problem. By doing so, politicians can create coalitions of interest groups that support their own trade policy objectives. Political institutions also affect the extent to which societal groups can influence policy. In some countries, political institutions insulate politi- cians from interest group pressures, thereby allowing politicians to pursue their trade policy objectives independent of interest group demands. We will examine this in greater detail when we look at the state-centered approach in the next chapter.

Finally, the society-centered approach does not address the motivations of noneconomic actors in trade politics. Societal interest groups other than firms, business associations, and labor unions do attempt to influence trade policy. In the United States, for example, environmental groups have played a prominent role in trade politics, shaping the specific content of NAFTA and attempting to shape the negotiating agenda of the Doha Round. Human rights groups have also become active participants in American trade politics. This has been particularly important in America’s relationship with China. Human rights groups have consistently sought to deny Chinese producers access to the U.S. market in order to encourage the Chinese government to show greater respect for human rights. The assumption that trade politics are driven by the reactions of interest groups to the impact of international trade on their in- comes provides little insight into the motivations of noneconomic groups. The society-centered approach tells us nothing about why groups that focus on the environment or on human rights spend resources attempting to influence trade policy. Nor does it provide any basis with which to make sense of such groups’ trade policy preferences. In the past, such a weakness could perhaps be neglected because noneconomic groups played only a small role in trade politics. The contemporary backlash against globalization suggests, however, that these groups must increasingly be incorporated into society-centered models of trade politics.

Although recognizing these weaknesses of the society-centered approach is important, these weaknesses are not reasons to reject the approach. The appropriate measure of any theory or approach is not whether it incorporates everything that matters, nor even whether it explains every outcome that we observe. All theories abstract from reality in order to focus more sharply on a number of key aspects. Consequently, the appropriate measure of any theory or approach is whether it is useful—that is, does it provide us with a deeper understanding of the enduring features of the phenomenon of interest? On this measure, the society-centered approach scores high. By focusing on how trade shapes the fortunes of different groups in society, it forces us to recog- nize that the enduring features of trade politics revolve around a continual struggle for income between the winners and losers from international trade. 88 CHAPTER 4 A Society-Centered Approach to Trade Politics KEY TERMS Collective Action Problem Export-Oriented Sector Factor Mobility Factor Model Factor-Price Equalization Import-Competing Sector Majoritarian Proportional Representation Reciprocal Trade Agreements Act Sector Model Specific Factors Stolper-Samuelson Theorem Veto Player SUGGESTIONS FOR FURTHER READING For an excellent introduction to and an interesting attempt to resolve the debate over the factor and sector models of trade policy preferences, see Michael Hiscox, International Trade and Political Conflict: Commerce, Coalitions, and Mobility (Princeton, NJ: Princeton University Press, 2002). For a deeper understanding of the collective action problem, it is hard to do better than the classic by Mancur Olson,The Logic of Collective Action: Public Goods and the Theory of Groups (Cambridge, MA: Harvard University Press, 1965).

The literature on U.S. trade politics is enormous. The best available introduction is probably I. M. Destler,American Trade Politics, 3rd ed. (Washington, DC: Insti- tute for International Economics, 1992). Unfortunately, there has been much less written in English on the trade policy process in the EU and Japan. For the EU, see John P. Hayes,Making Trade Policy in the European Community (London: The MacMillan Press, 1993). For Japan, see Chikara Higashi,Japanese Trade Policy Formulation (New York: Praeger, 1983). 89 A State-Centered Approach to Trade Politics I n October of 2004, the United States lodged a complaint with the World Trade Organization (WTO)’s dispute-settlement mechanism in which it alleged that France, Great Britain, Germany, and Spain were illegally subsidizing the European commercial aircraft manufacturer, Airbus SAS.

The American move punctuated a decade during which Airbus successfully challenged the American firm Boeing for dominance in the global market for commercial aircraft. Only 20 years ago Airbus appeared to pose little threat to Boeing; Boeing jets commanded almost two-thirds of global commercial aircraft sales, whereas Airbus airliners captured only slightly more than 15 percent. As each year passed, however, Airbus drew closer, until early in the current decade it finally caught up with Boeing, with each firm capturing roughly half of the global market. Within this changing market context, U.S.

Trade Representative Robert Zoellick argued that although there may once have been justification for subsidies to Airbus, that time had long since passed.

The European Union (EU) quickly responded to the American complaint. As- serting that the American move was “obviously an attempt to divert attention from Boeing’s self-inflicted decline,” the EU initiated a counter-dispute with the WTO in which it alleged that Boeing receives “massive subsidies” of its own from the U.S. government (Pae 2004).

How do we make sense of this trade conflict? A society-centered ap- proach suggests that we should look at the political influence of the indus- tries concerned. And indeed, there is little doubt that Boeing has substantial influence in American politics. Former President George W. Bush explicitly acknowledged this influence during the 2004 campaign when he promised Boeing workers during a campaign stop in Seattle in August that he would end EU subsidies to Airbus even if he had to initiate a WTO dispute to do so. Yet, the conflict also raises issues that are not readily incorporated into the society- centered approach. In particular, this isn’t an instance of conflict between an American import-competing industry and a foreign export-oriented industry.

Instead, the conflict is between two export-oriented firms battling over global 5 CHAPTER 90 CHAPTER 5 A State-Centered Approach to Trade Politics market share. Moreover, the conflict does not revolve around one govern- ment’s use of tariffs to protect domestic producers from foreign competition, but instead focuses on the use of government subsidies to support the domes- tic firm as it competes for global market share.

There is also a difference hinted at by the Robert Zoellick statement— although there once may have been a justification for EU subsidies to Air- bus, that time has now long passed. This suggests that there may be instances in which government intervention can raise social welfare and may thus be justified. Yet, the standard model of trade, which provides the basis for the society-centered approach, pretty much rules out such welfare-improving in- tervention. To fully understand the U.S.–EU trade conflict in the commercial aircraft industry, therefore, we have to broaden our understanding of the eco- nomics, and perhaps also the politics, of international trade.

We gain this broader understanding in this chapter by developing a state-centered approach to trade politics. A state-centered approach argues that national policymakers intervene in the economy in pursuit of objectives that are determined independent from domestic interest groups’ narrow self- interested concerns. Moreover, this approach suggests that such intervention may (but need not necessarily) raise aggregate social welfare. We examine the state- centered approach with a specific focus on government intervention designed to promote the development of specific national industries. We look first at the broader economic justification for protectionism aimed at creat- ing internationally competitive industries, then narrow our focus to the use of such measures by the advanced industrialized countries in high-technology industries, and then apply the logic of this approach to the current U.S.–EU conflict in the commercial aircraft industry. We conclude the chapter by look- ing briefly at some of the weaknesses of this approach.

STATES AND INDUSTRIAL POLICY A state-centered approach is based on two central assumptions, both of which contrast sharply with the assumptions embodied in the society-centered ap- proach. The first assumption concerns the impact of protectionism on aggre- gate social welfare. The society-centered approach argues that protectionism reduces social welfare by depriving society of the gains from trade and by employing society’s resources in comparatively disadvantaged industries, but the state-centered approach argues that under certain circumstances trade pro- tection can raise social welfare.

The second assumption concerns whether governments can operate inde- pendently of interest group pressures. The society-centered approach argues that national policy reflects the balance of power among competing interest groups, but the state-centered approach argues that under specific circum- stances governments are relatively unconstrained by interest-group demands.

As a consequence, a government’s trade and economic policies embody the goals of national policymakers rather than the demands of domestic inter- est groups. The state-centered approach combines these two assumptions to States and Industrial Policy 91 suggest that under a specific set of circumstances, governments will intervene in the domestic economy with tariffs, production subsidies, and other policy instruments in ways that raise aggregate social welfare.

To fully understand this approach, we need to understand the conditions under which such intervention may raise social welfare. We then can examine the institutional characteristics that enable national policymakers to act au- tonomously from interest groups to capture these welfare gains.

The Infant-Industry Case for Protection The economic justification for the state-centered approach rests on the claim that targeted government intervention can increase aggregate social wel- fare. This claim stands in stark contrast to the conclusions drawn from the standard model of trade that we examined in Chapter 3 and extended in our discussion of the domestic adjustments to trade in Chapter 4. The standard model rules out such welfare-increasing government intervention by assump- tion. In the standard model, society does best by removing all forms of trade protection and by specializing in its comparatively advantaged industry. Main- taining protection merely deprives society of the welfare gains from trade.

Moreover, in the standard trade model, nothing makes it difficult for fac- tors currently employed in comparatively disadvantaged industries to move into the comparatively advantaged sector. Factors of production will move into comparatively advantaged industries because it is profitable to do so—the returns in these industries are higher than the returns in the comparatively disadvantaged industries. Such movement will take time, there will be adjust- ment costs, and there is a case to be made for government policies that help individuals manage these costs, but such policies are oriented toward shift- ing workers and resources into sectors where they would go anyway. In this model, tariffs and other forms of protection can only make society worse off by preventing factors from moving out of low-return and into high-return in- dustries. In the world depicted by the standard trade models, therefore, gov- ernment intervention cannot raise social welfare.

In order to claim that a tariff and other forms of government intervention raise social welfare, one must be able to demonstrate that something prevents factors from shifting into industries that yield higher returns than are available in other sectors of the economy. Historically, this justification has been pro- vided by the infant-industry case for protection. Theinfant-industry case for protection argues that there are cases in which newly created firms (infants, so to speak) will not be efficientinitially but could be efficient in the long run if they are given time to mature. Consequently, a short period of tariff protec- tion will enable these industries to become efficient and begin to export. Once this point has been reached, the tariff can be removed. The long-run welfare gains created by the now-established industry will be greater than the short- run losses of social welfare imposed by the tariff.

There are two reasons why an industry may not be efficient in the short run, but could be efficient in the long run: economies of scale and economies 92 CHAPTER 5 A State-Centered Approach to Trade Politics of experience (Kenen 1994, 279–281).Economies of scale arise when the cost of production varies with the size of output, that is, when the unit cost of producing falls as the number of units produced rises. For example, it is quite costly to develop a new commercial aircraft. Estimates put the cost of develop- ing Boeing’s new 777 at around $3 billion. The unit cost of production will be very high if Boeing produces only a few of these planes, as we must divide this fixed cost by a small number of final goods. The unit cost falls substantially, however, if Boeing produces 1,000 of these new planes. What we see, then, is that the average cost of each unit falls as the number of units produced rises.

Firms in industries with such scale economies face a dilemma, however. They can produce efficiently and begin to export once they produce enough output to achieve the available scale economies. In an open economy, however, these firms must compete immediately against established foreign producers that have already achieved economies of scale. Consequently, a new firm will have a hard time selling its higher-average-cost output in the face of competition from lower-cost firms. Consequently, the new firm will never reach the level of output necessary to achieve economies of scale.

In such cases, a tariff might be welfare improving. By imposing a tariff, the government could effectively deliver the domestic market to the infant do- mestic firm. With a guaranteed market, the domestic firm could sell its early high-cost output to domestic consumers and eventually produce enough to achieve economies of scale. Once it had done so, it could then compete against foreign producers without the need for tariff protection. The tariff would then be removed.

Economies of experience arise when efficient production requires specific skills that can only be acquired through production in the industry. In many industries, efficient production requires “seasoned managers, skilled work- ers, and reliable suppliers of equipment and materials” (Kenen 1994, 280).

Because these skills are lacking by definition in an infant industry, it will be costly to produce the early units of output. Over time, however, management skills improve, workers learn how to do their tasks efficiently, and reliable suppliers are found and supported. Costs of production fall as experience is gained. For example, when Airbus built its first jet, it took 340,000 person- hours to assemble the fuselage. As Airbus gained experience, however, the time required to assemble the jets fell rapidly. By the time that Airbus had produced 75 aircraft, only 85,000 person-hours were required to assemble the fuselage, and eventually this number fell to 43,000 person-hours (Mc- Intyre 1992, 36). The efficiency gains realized as a result of these dynamics are often called “moving down the learning curve.” Again, however, the new firm faces a dilemma. In an unprotected market, it won’t be cost competi- tive in the face of established foreign producers. Consequently, it will never be able to produce enough output to realize these economies of experience.

As with economies of scale, a tariff can allow the infant industry to realize the cost savings available from economies of experience and achieve greater efficiency. Once it has done so, it can begin to export, and the tariff can be removed. States and Industrial Policy 93 A CLOSER LOOK Criticism of the Infant-Industry Case for Protection Many economists are skeptical about the claim that government intervention is the best response to the problems highlighted by the infant-industry argument (see Kenen 1994, 281). First of all, a tariff is rarely the best policy response to the central problem the infant industry confronts. Economists argue that a subsidy is a much better approach because it is more efficient. Subsidies are a more efficient policy than a tariff because they target the same policy goal—helping the domestic industry cover the gap between its production costs and established foreign producers’ costs—but they don’t reduce consumer welfare like tariffs do (Kenen 1994, 281). Thus, a subsidy is more efficient.

However, a government subsidy may not improve social welfare either. The case against a subsidy arises from the fact that a firm that will be profitable in the long run but must operate at a loss in the short run should be able to borrow from private capital markets to cover its short-run losses. Such borrowing obviates the need for a subsidy because it enables the firm to sell its goods at the world price and cover its short-term losses with the borrowed funds. Thus, as long as capital markets are efficient and not “strongly averse to risk,” infant industries should be able to borrow at an interest rate that reflects the social rate of return on capital.

If a firm can’t borrow at an interest rate that reflects the social rate of return to capital, then the market is essentially saying that this industry is not the best place to invest society’s scarce resources. Consequently, the firm shouldn’t be supported with subsidies or tariffs (Kenen 1994, 281). In other words, when capital markets are efficient, the firm should borrow rather than rely on the government; if it can’t borrow, the government shouldn’t help it either.

This critique of government intervention fails to hold in two circumstances.

First, a firm may be reluctant to borrow from private markets when the problem it faces arises from economies of experience. In such instances, borrowed funds yield long-run efficiency by allowing workers employed at a particular firm to gain the skills required to operate efficiently. Yet, once workers have acquired these skills, they may go to work for other firms. If they do, the firm that has paid for their training will be unable to achieve economies of experience and cannot repay the loan. In this instance, government support for the industry might be helpful, but economists argue that government assistance in such cases should take the form of broad government-funded training programs rather than narrow subsidies to a specific firm.

The criticism of subsidies also fails to hold if the private capital market is inefficient and therefore won’t loan to a firm entering an infant industry. If this is the case, the firm will have little capacity to gain the financial resources it needs to cover its short-term losses. Even here, however, economists argue that a subsidy or (Continued) 94 CHAPTER 5 A State-Centered Approach to Trade Politics Therefore, tariffs and other forms of government intervention may some- times improve social welfare, because a disjuncture between the social and private returns from a particular industry may prevent the shift of factors out of relatively low-return industries and into relatively high-return industries (Balassa and Associates 1971, 93). In other worlds, certain industries may offer high social returns over the long run (that is, they will provide large benefits to society as a whole), but the short-run private returns (that is, the profits realized by the person or firm making the investment) are likely to be negative. Consequently, factors don’t move automatically into the potentially high-return industry. A tariff, or another form of government intervention, may encourage factors to move into this industry by raising the short-run return above what it would be without a tariff.

The logic of the infant-industry case for protection has been adopted by governments in many late-industrializing countries. A late-industrializing country is one that is trying to develop manufacturing industries in competition with established manufacturing industries in other countries. This term obvi- ously describes most developing countries in the contemporary international economic system. But it once described many of today’s advanced industrial- ized countries, including the United States, as they attempted to develop manu- facturing industries in the face of dominant British manufacturing power in the nineteenth century. Indeed, the infant-industry argument was first developed by an American, Alexander Hamilton, in 1791 as an explicit policy for the development of manufacturing industry in the United States. Hamilton’s argu- ment was further developed by the Germany political economist Fredrick List in the mid-nineteenth century. Like Hamilton, List was primarily interested in thinking about how the German government could encourage the growth of manufacturing industries in the face of established British dominance. The infant-industry argument continued to have an important impact on govern- ment trade policies throughout the twentieth century. Many argue that Japan’s postwar trade policies reflect the logic of the infant-industry argument as the Japanese government used a variety of policy instruments to encourage the development of advanced manufacturing industries in the face of American a tariff may not be the right response. If the government is determined to support the development of a specific industry, then it should do what the private capital market won’t and extend loans to firms in this industry rather than provide a subsidy. If the government is primarily interested in raising social welfare, however, economists argue that the best thing it can do in this circumstance is strengthen the private capital market so it does operate efficiently (Baldwin 1969). Thus, even though most economists agree that there will be instances in which firms that are not efficient in the short run can become efficient in the long run, there is considerable skepticism about the extent to which government intervention is the only, or the best, solution to this dilemma.

State Strength: The Political Foundation of Industrial Policy 95 competitive advantages. Many developing-country governments also em- braced the logic of the infant-industry argument throughout the early postwar periods, as we will see in greater detail in Chapter 6.

The policies that governments have adopted to promote the development of infant industries are known collectively as industrial policy.Industrial pol- icy can be defined as the use of a broad assortment of instruments, includ- ing tax policy, subsidies (including the provision of state credit and finance), traditional protectionism, and government procurement practices, in order to channel resources away from some industries and direct them toward those industries that the state wishes to promote. The use of such policies is typi- cally based on long-term economic development objectives defined in terms of boosting economic growth, improving productivity, and enhancing inter- national competitiveness. The specific goals that governments pursue often are determined by explicit comparisons to other countries’ economic achieve- ments (Wade 1990, 25–26). In postwar Japan, for example, the explicit goal of Japanese industrial policy was to catch up with the United States in high- technology industries. In much of the developing world, industrial policy was oriented toward creating economic structures that paralleled those of the ad- vanced industrialized countries.

STATE STRENGTH: THE POLITICAL FOUNDATION OF INDUSTRIAL POLICY The ability of any government to effectively design and implement an indus- trial policy is dependent on the political institutions within which it oper- ates. The various institutional characteristics that make some states more and others less able to design and implement coherent industrial policies can be summarized by the concept of state strength.State strength is the degree to which national policymakers, a category that includes elected and appointed officials, are insulated from domestic interest-group pressures.

Strong states are states in which policymakers are highly insulated from such pressure, whereas weak states are those in which policymakers are fully exposed to such pressures. Strong states are characterized by a high degree of centralization of authority, a high degree of coordination among state agencies, and a limited number of channels through which societal actors can attempt to influence policy. In contrast, weak states are characterized by decentralized authority, a lack of coordination among agencies, and a large number of channels through which domestic interest groups can influence economic policy.

These characteristics of political institutions make it easier for strong states to formulate long-term plans embodying the national interest. In weak states, policymakers must respond to the particularistic and often short- run demands of interest groups. Strong states also may be more able than a weak state to remove protection once an infant industry has matured. In ad- dition, strong states may be more able to implement industrial policies that 96 CHAPTER 5 A State-Centered Approach to Trade Politics redistribute societal resources, because policymakers need worry less that poli- cies that redistribute resources from one domestic group to another will have a negative impact on their position in power.

Japan is often depicted as the preeminent example of a strong state that has been able and willing to use industrial policy to promote economic de- velopment (see, for example, Johnson 1982). The Japanese state centralizes power and provides limited channels of access to domestic interest groups.

Because of this highly centralized state, Japan has been able to pursue a coher- ent industrial policy throughout the postwar period. The Ministry of Interna- tional Trade and Industry (MITI: now called the Ministry of Economy, Trade, and Industry or METI) and the Ministry of Finance (MoF) were the principal agencies involved in developing and implementing industrial policy. In the im- mediate postwar period, these agencies gave priority to economic reconstruc- tion and to improving the prewar industrial economy. Since the 1960s, greater emphasis has been placed on promoting rapid economic growth and devel- oping internationally competitive high-technology industries (Pempel 1977, 732).

With this goal firmly in mind, the Japanese state pursued an active indus- trial policy (called administrative guidance) through which it channeled re- sources to those industries it determined critical to Japanese success. Together, the MITI and MoF targeted specific industries for development, starting with heavy industries (steel, shipbuilding, automobiles) in the early postwar period and then shifting to high-technology industries during the 1970s. The state pressured firms to invest in the industries targeted for development, and those that made such investments benefited from tariff and nontariff forms of protection, tax credits, low-cost financing, and other government subsidies.

Some scholars suggest that Japan’s remarkable postwar economic performance was a direct result of this state-centered approach to economic development (Johnson 1982).

France also relied heavily upon industrial policies throughout much of the postwar period (Hart 1992). The French state is highly centralized, and French bureaucracies are tightly insulated from societal group pressures, as in Japan. This structure allowed the French government to pursue an industrial policy aimed at developing key industries with little direct influence from do- mestic interest groups. A former director of the Ministry of Industry described the policy-making process: “First, we make out a report or draw up a text, then we pass it around discreetly within the administration. Once everyone concerned within the administration is agreed on the final version, then we pass this version around outside the administration. Of course, by then it is afait accompli and pressure cannot have any effect” (quoted in Katzenstein 1977, 18).

In the early postwar period, the French state formulated development plans to “establish a competitive economy as an essential base for political independence, economic growth, and social progress” (Katzenstein 1977, 22).

French industrial policy in this period was based on a strategy of “National Champions,” under which specific firms in industries deemed by the French State Strength: The Political Foundation of Industrial Policy 97 state to be critical to French economic development received support. In the 1950s and 1960s, for example, two French steel companies and a small num- ber of French auto producers (Renault, Simca, Peugeot) received state sup- port. During the 1960s and 1970s, the French state attempted to develop a domestic computer industry by channeling resources to specific French com- puter companies such as Machines Bull. Most regard this strategy as relatively unsuccessful, because French national champions failed to become competi- tive in international markets (Hart 1992). However, the current French gov- ernment seems poised to revive this approach, announcing in early 2005 the creation of a new industrial policy oriented toward promoting national cham- pions in high-technology industries.

In contrast to Japan and France, the United States typically is character- ized as a weak state (Katzenstein 1977; Ikenberry et al. 1988). Political power in the United States is decentralized through federalism, through the division of powers within the federal government, and through independent bureau- cratic agencies. This decentralization of power in turn provides multiple chan- nels through which domestic interest groups can attempt to influence policy.

Consequently, “American state officials find it difficult to act purposefully and coherently, to realize their preferences in the face of significant opposi- tion, and to manipulate or restructure their domestic environment” (Ikenberry et al. 1988, 11). American trade and economic policy therefore more often reflects the interests of societal pressure groups than the “national interest” defined by state policymakers.

This does not mean that the United States has been unable to support crit- ical industries. American national security and defense policies have channeled substantial resources to maintaining technological leadership over potential rivals. To maintain this lead, the U.S. government has financed the basic re- search that underlies many high-technology products, including computers, telecommunications, lasers, advanced materials, and even the Internet. In ad- dition, Department of Defense contracts have supported firms that produce both military and civilian items. Thus, even though the United States is a weak state, we do see a form of industrial policy in the U.S. government’s support for basic research and in its defense-related procurement practices designed to meet national security objectives.

The state-centered approach therefore argues that state policymakers can use industrial policy to improve social welfare. In contrast to the standard model of trade, this approach argues that factors may not move automati- cally from relatively low-return industries into relatively high-return indus- tries. In such instances, targeted government intervention, in the form of a tariff or a production subsidy, can encourage movement into these industries.

Over the long run, the welfare gains generated by this industry are substan- tially larger than the welfare losses incurred during the period of protection.

The ability of policymakers to effectively pursue such policies, however, is strongly influenced by the institutional structure of the state in which they operate. In strong states, such as Japan and France, policymakers are insulated from domestic interest groups and are therefore able to use industrial policy 98 CHAPTER 5 A State-Centered Approach to Trade Politics POLICY ANALYSIS AND DEBATE Green Industrial Policy in the U.S.?

Question Should the U.S. government employ industrial policy to encourage the development of green technology?

Overview During the 2008 presidential campaign, Barack Obama pledged to spend $150 billion over 10 years developing new green technologies, and another $60 billion improving energy-related infrastructure. In January 2010, President Obama began a new program that provided $2.3 billion in funding to 183 firms engaged in clean-energy manufacturing, arguing that such programs boost employment while benefiting the environment. At the same time, President Obama has indicated that he will be hesitant to approve of any new trade agreements that do not include environmental protections. On several dimensions, in other words, the Obama administration is attempting to reorient the U.S. economy and trade around environmentally friendly manufacturing and infrastructure. This has generated debate over the government’s role in shaping the national economy.

Why is the use of industrial policy controversial? Advocates of green industrial policies—including former Secretary of Labor Robert Reich, the AFL-CIO, and political commentators like Thomas Friedman—claim that government investment is needed to overcome high start-up costs for new industry, boost productivity in high-growth technologies, and maintain competitiveness in globalized markets.

Without government involvement, advocates say, the United States will sacrifice the gains from early development of new technologies to other countries. Opponents of green industrial policies—including many economists, business groups, and free-trade advocates—claim that government intervention misdirects investment to less productive industries, that choosing economic winners and losers in the political arena leads to corruption, and that American industry will have an unfair advantage over their foreign competitors. Both sides can point to examples of industrial policies that provide evidence for their claims.

Policy Options • Use the power of the U.S. government to promote the development of new green technologies by shifting resources into sectors through taxation and redistribution.

• Allow technological development to occur through the market, and resist government interference.

Policy Analysis • What interest, if any, do other states have in the U.S. industrial policy? Why is this the case? Industrial Policy in High-Technology Industries 99 to promote economic development. In weak states, such as the United States, policymakers cannot easily escape interest-group pressures. As a consequence, trade and economic policy is more likely to reflect the particularistic demands of these groups than any broader conceptions of social welfare.

INDUSTRIAL POLICY IN HIGH-TECHNOLOGY INDUSTRIES High-technology industries have been one area in which governments in many advanced industrialized countries have relied heavily on industrial policies.

Boosting the international competitiveness of such industries has been the principal goal of such policies. High-technology industries are highly valued for the contribution they make to national income. These industries tend to earnrents; that is, they earn a higher-than-normal return on an investment, and they pay higher wages to workers than do standard manufacturing in- dustries. In addition, relatively recent developments in economic theory that build on the basic insight of the infant-industry case for protection suggest that governments can use industrial policy to create internationally competi- tive domestic high-technology industries. We examine these issues here, focus- ing first on the economic theories that justify the use of industrial policy in high-technology industries and then examining two cases in which industrial • How might U.S. trading partners react to greater U.S. government involvement? Is this optimal?

• What role does domestic politics play in determining international outcomes in trade and environmental policies?

Take A Position • What option do you prefer? Justify your choice.

• What criticisms of your position should you anticipate? How would you defend your recommendations against these criticisms?

Resources Online:Online searches for “industrial policy” and “green jobs.” In Print: For a less rigorous, but best-selling, discussion of this topic see Thomas L.

Friedman, Hot, Flat, and Crowded: Why We Need a Green Revolution – And How It Can Renew America (New York: Farrar, Straus, & Giroux, 2008). For a more academic treatment of development and industrial policy, see Dani Rodrik, One Economics, Many Recipes: Globalization, Institutions, and Economic Growth (Princeton, NJ: Princeton University Press, 2008). 100 CHAPTER 5 A State-Centered Approach to Trade Politics policy appears to have enabled high-technology firms based in Japan and the EU to become internationally competitive at the apparent expense of high- technology firms based in the United States. We conclude by returning to the current U.S.–EU dispute in commercial aircraft.

Strategic-Trade Theory Strategic-trade theory provides the theoretical justification for industrial pol- icy in high-technology industries.Strategic-trade theory expands on the basic insight of the infant-industry case for protection. Like the infant-industry case, strategic-trade theory asserts that government intervention can help domestic firms achieve economies of scale and experience in order to become efficient and competitive in global markets. In contrast to the classical infant-industry argument, which assumes that markets are perfectly competitive, strategic- trade theory asserts that many high-tech industries are characterized by oli- gopolistic competition; that is, they feature competition between only a few firms. The combination of economies of scale and experience on the one hand and oligopolistic competition on the other creates a theoretical rationale for government intervention to raise national income.

Anoligopoly is an industry dominated by a small number of firms. The world auto industry, for example, is dominated by only about eight firms.

The world market for long-distance commercial aircraft is dominated by only two firms. Such industries are clearly different from, say, agriculture, in which thousands of farms produce for the world market. Economic dynamics in oli- gopolistic market structures are quite different from the dynamics we see in perfectly competitive markets. The economic analysis of oligopolistic competi- tion can be quite complex, however, and a detailed analysis of such competi- tion would take us far from our primary concern. Consequently, we will leave a detailed analysis of such competition to the side and simply state that firms operating in oligopolistic markets earn excess returns—profits greater than could be earned in equally risky investments in other sectors of the economy (Krugman and Obstfeld 1994, 282).

Suppose an American firm dominates the world market for commercial aircraft. The United States captures the excess returns available in this indus- try. As a result, American workers employed in this industry, as well as the people who have invested their savings in this industry, earn higher incomes than they would earn in the next-best use of their labor or savings. Ameri- can national income is higher than it would be otherwise. If a European firm dominates the world market for commercial aircraft, Europe captures the ex- cess returns and enjoys the higher “national” income. And because an oli- gopolistic industry is one in which only a limited number of firms can operate, only a small number of countries can capture the available excess returns. It is certainly reasonable to suppose, therefore, that societies would compete over these industries. Strategic-trade theory thus suggests that in some industries global economic interaction gives rise to zero-sum competition over the excess returns available in oligopolistic high-tech industries. Industrial Policy in High-Technology Industries 101 Who is likely to win this competition? In the absence of intervention by any government, the firm that is the first to enter a particular industry will win, and in doing so effectively deter subsequent entry by potential rivals.

Thus, such industries offer a first-mover advantage. This first-mover advan- tage arises from economies of scale and experience. Suppose an American high-tech firm is the first to produce and market a product such as commercial jet aircraft. Because achieving economies of scale and experience is central to the ability to produce commercial jets efficiently, the United States, by virtue of being first into the market, has a production cost advantage over rivals who may want to enter the market at a later time. As a consequence, a European firm that could be competitive once it achieved economies of scale and experi- ence is deterred from entering the industry because the cost advantage enjoyed by the established American firm makes it very difficult to sell enough aircraft to achieve these economies. After all, who will buy the new entrant’s higher- cost output? Absent such sales the new firm will never realize the economies of scale and experience essential to long-term success. The U.S. firm, therefore, has an advantage in the industry only because it is the first into the market.

Consequently, the United States will enjoy the higher national income yielded by the excess returns in the commercial aircraft industry. Other countries are denied these excess returns, even though were they able to achieve the neces- sary economies of scale and experience, they would be every bit as successful as the American first mover.

Government intervention may have a powerful effect on the willingness of a latecomer to enter the industry. That is, targeted government interven- tion may enable late entrants to successfully challenge first movers. By doing so, government intervention shifts the excess returns available in a particular industry from a foreign country to the national economy. The logic of this argument can be illustrated using some fairly simple game theory (Krugman 1987). Let’s assume that there are two firms, one American and one European, interacting in a high-tech industry, say commercial aircraft, which will sup- port only one producer. Each firm has two strategies: to produce commercial aircraft or to not produce. The payoffs that each firm gains from the four possible outcomes are depicted in Figure 5.1a. There are two possible equi- librium outcomes in this game, one in which the American firm produces and the European firm does not (cell II), and one in which the European firm pro- duces and the American firm does not (cell IV). Thus, this particular high-tech industry will be based in the United States or in Europe, but never in both.

Whichever country hosts the firm earns 100 units in income.

Which country captures the industry depends upon which firm is first to enter the market. Let’s suppose that the American firm is first to enter the industry and has realized economies of scale and experience. In this case, the European firm has no incentive to enter the industry, because, by doing so, it would earn a profit of 25. If we assume that the European firm is first to enter the market, then it realizes economies of scale and experience. In this case, the American firm has no incentive to enter the market. Thus, even though both firms could produce the product equally well, the firm that enters first 102 CHAPTER 5 A State-Centered Approach to Trade Politics European Firm American Firm ProduceProduce Not Produce 5, 5 (I) 100, 0 (II) 0, 100 (IV) 0, 0 (III) Not Produce European Firm American Firm ProduceProduce Not Produce 5, 5 (I) 100, 0 (II) 0, 110 (IV) 0, 0 (III) Not Produce FIGURE 5.1 The Impact of Industrial Policy in High-Technology Industries (a) Payoff Matrix with no Subsidy (b) Payoff Matrix with European Subsidy dominates the industry. According to strategic-trade theory, therefore, the firm that is first to enter a particular high-technology industry will hold a competitive advantage, and the country that is home to this firm will capture the rents available in this industry.

Against this backdrop, we can examine how governments can use indus- trial policy to help domestic high-technology firms. Government intervention can help new firms enter an established high-technology industry to challenge, and eventually compete with, established firms. Government assistance to these new firms can come in many forms. Governments may provide financial assistance to help their new firms pay for the costs of research and develop- ment. Such subsidies help reduce the costs that private firms must bear in the early stages of product development, thereby reducing the up-front investment a firm must make to enter the industry. European governments participating in the Airbus consortium, for example, have subsidized the development of Airbus aircraft. Governments also may guarantee a market for the early and more expensive versions of the firm’s products. Tariffs and quotas can be used to keep foreign goods out, and government purchasing decisions can favor do- mestic producers over imports. The Japanese government, for example, pur- chased most of its supercomputers from Japanese suppliers in the 1980s, even though the supercomputers produced by the American firm Cray Industries were cheaper and performed at a higher level. The guaranteed market allows domestic firms to sell their high-cost output from early stages of production at high prices. The combination of financial support and guaranteed markets allows domestic firms to enter the market and move down the learning curve.

Once the new firms have realized economies of scale, they can compete against established firms in international markets. Strategic Rivalry in Semiconductors and Commercial Aircraft 103 We can see the impact of such policies on firms’ production decisions by returning to our simple game (see Figure 5.1b). Suppose that the American firm is the first to enter and dominates the industry. Suppose now that European governments provide a subsidy of 10 units to the European firm. The subsidy changes the payoffs the European firm receives if it produces. In contrast to the no-subsidy case, the European firm now makes a profit of 5 units when it produces, even if the American firm stays in the market. The subsidy therefore makes it rational for the European firm to start producing. Government sup- port for domestic high-technology firms has a second consequence that stems from the oligopolistic nature of high-tech industries. Because such industries support only a small number of firms at profitable levels of output, the entry of new firms into the sector must eventually cause other firms to exit. Thus, government policies that promote the creation of a successful industry in one country undermine the established industry in other countries.

This outcome is also clear in our simple game. Once the European firm be- gins producing, the American firm earns a profit of 25 if it continues to produce and a profit of 0 if it exits the industry. Exit, therefore, is the American firm’s rational response to the entry of the European firm. Thus, the small 10-unit sub- sidy provided by European governments enables the European firm to eliminate the first-mover advantage enjoyed by the American firm, but ultimately drive the American firm out of the industry. As a consequence, Europe’s national income rises by 100 units (the 110-unit profit realized by the European firm minus the 10-unit subsidy from European governments), whereas America’s national income falls by 100 units. A small government subsidy has allowed Europe to increase its national income at the expense of the United States.

Strategic-trade theory suggests, therefore, that the location of high- technology industries has little to do with cross-national differences in factor endowments and a lot to do with market structure and the assumptions we make about how production costs vary with the quantity of output. This is a world in which the classical model of comparative advantage doesn’t hold.

International competitiveness and the pattern of international specialization in high-technology industries are attributed as much to the timing of market entry as to underlying factor endowments. STRATEGIC RIVALRY IN SEMICONDUCTORS AND COMMERCIAL AIRCRAFT The semiconductor industry and the commercial aircraft industry illustrate these kinds of strategic trade rivalries between the United States, Japan, and the EU in the contemporary global economy. In the semiconductor industry, American producers enjoyed first-mover advantages and dominated the world market until the early 1980s. The semiconductor industry prospered in the United States in part due to government support in the form of funding for research and development (R&D) and for defense-related purchases. The U.S.

government financed a large portion of the basic research in electronics—as 104 CHAPTER 5 A State-Centered Approach to Trade Politics much as 85 percent of all R&D prior to 1958, and as much as 50 percent dur- ing the 1960s. At the same time, the U.S. defense industry provided a critical market for semiconductors. Defense-related purchases by the U.S. government absorbed as much as 100 percent of total production in the early years. Even in the late 1960s, the government continued to purchase as much as 40 per- cent of production. These policies allowed American semiconductor firms to move down the learning curve and realize economies of scale. This first-mover advantage was transformed into a dominant position in the global market. In the early 1970s, U.S. semiconductor producers controlled 98 percent of the American market and 78 percent of the European market.

Beginning in the 1970s, the Japanese government targeted semiconduc- tors as a sector for priority development and used two policy measures to foster a Japanese semiconductor industry. First and most importantly, the Japanese government used a variety of measures to protect Japanese semi- conductor producers from American competition. Tariffs and quotas kept American chips out of the Japanese market. The Japanese government also approved very few applications for investment by foreign semiconductor firms and restricted the ability of American semiconductor firms to purchase exist- ing Japanese firms. As a direct result, American semiconductor firms were un- able to jump over trade barriers by building semiconductor production plants in Japan. The Japanese industrial structure—a structure in which producers develop long-term relationships with input suppliers—helped ensure that Japanese firms that used semiconductors as inputs purchased from Japanese rather than American suppliers. Finally, government purchases of computer equipment discriminated against products that used American chips in favor of computers that used Japanese semiconductors. Second, the Japanese gov- ernment provided financial assistance to more than 60 projects connected to the semiconductor and computer industry. Such financial assistance helped cover many of the R&D costs Japanese producers faced.

The extent of Japanese protectionism can be appreciated by comparing U.S. market shares in the EU, and Japanese markets. Whereas American semi- conductor firms controlled 98 percent of the American market and 78 percent of the EU market in the mid-1970s, they held only 20 percent of the Japanese market (Tyson 1995, 93). By 1976, Japanese firms were producing highly so- phisticated chips and had displaced American products from all but the most sophisticated applications in the Japanese market. Success in the Japanese market was followed by success in the global market. Japan exported more semiconductors than it imported for the first time in 1979. By 1986 Japanese firms had captured about 46 percent of global semiconductor revenues, whereas the American firms’ share had fallen to 40 percent (Tyson 1995, 104–105). By protecting domestic producers and subsidizing R&D costs, the Japanese government helped Japanese firms successfully challenge American dominance of the semiconductor industry.

A similar dynamic is evident in U.S.–European competition in the com- mercial aircraft sector. Two American firms, Boeing and Douglas (later McDonnell Douglas), dominated the global market for commercial aircraft Strategic Rivalry in Semiconductors and Commercial Aircraft 105 throughout the postwar period, in part because of U.S. government support to the industry provided through the procurement of military aircraft (Newhouse 1982; United States Office of Technology Assessment 1991, 345). Work on military contracts enabled the two major American producers to achieve econ- omies of scale in their commercial aircraft operations. Boeing, for example, developed one of its most successful commercial airliners, the 707, as a modi- fied version of a military tanker craft, the KC-135. This allowed Boeing to re- duce the cost of developing the commercial airliner. Both jets in turn benefited from the experience Boeing had gained in developing the B-47 and the B-52 bombers (OTA 1991, 345). As Joseph Sutter, a Boeing executive vice presi- dent, noted, “We are good . . . partly because we build so many airplanes.

We learn from our mistakes, and each of our airplanes embodies everything we have learned from our other airplanes” (quoted in Newhouse 1982, 7).

The accumulated knowledge from military and commercial production gave the two American producers a first-mover advantage in the global market for commercial airliners sufficient to deter new entrants.

In 1967, the French, German, and British governments launched Air- bus Industrie to challenge the global dominance of Boeing and McDonnell Douglas. Between 1970 and 1991, these three European governments provided between $10 billion and $18 billion of financial support to Airbus Industrie, an amount equal to about 75 percent of the cost of developing Airbus airliners (OTA 1991, 354). As a consequence, by the early 1990s Airbus Industrie had developed a family of commercial aircraft capable of serving the long-range, medium-range, large passenger, and smaller passenger routes. Airbus’s entry into the commercial aircraft industry had a dramatic impact on global market share. As Table 5.1 makes clear, in the mid-1970s Boeing and McDonnell Douglas dominated the market for large commercial airliners. Airbus began to capture market share in the 1980s, however, and by 1990 it had gained control of 30 percent of the market for large commercial airliners. In 1994 Airbus sold more airliners than Boeing for the first time. And the ensuing 10 years indicates that 1994 was no fluke, as Airbus has firmly established itself as a dominant force in the global market for long-range commercial jets. TABLE 5.1 Market Share in Global Commercial Aircraft Boeing McDonnell Douglas* Airbus 1975 67% 33% 0 1985 63% 20% 17% 1990 54% 16% 30% 2005–2007 50.8% n.a. † 49.2% *Merged with Boeing in 1997; its commercial aircraft fleet is no longer produced. †n.a., not available.

Source: Data for 1975–1990 are calculated from Tyson 1995, 158–159. Data for 2005–2007 are from Boeing and Airbus. 106 CHAPTER 5 A State-Centered Approach to Trade Politics As a consequence of Airbus’s success, a substantial portion of the rents avail- able from the production and sale of commercial airliners has been transferred from the United States to Europe. Thus, by subsidizing the initial costs of air- craft development, European governments have been able to capture a sig- nificant share of the global market for commercial aircraft and the income generated in this sector, at the expense of the United States.

Strategic-trade rivalries of this kind have been a source of conflict in the international trade system. Countries losing high-technology industries as a consequence of the industrial policies pursued by other countries can respond by supporting their own firms to offset the advantages enjoyed by foreign firms or by attempting to prevent foreign governments from using industrial policy. In the United States, which considered itself a victim of the industrial policies adopted by Japan and the EU, the national debate has focused on both responses. Considerable pressure emerged during the 1980s and early 1990s for a national technology policy. Proposals were advanced for the creation of a government agency charged with reviewing global technology and “evalu- ating the likely course of key American industries; comparing these baseline projections with visions of industry paths that would be compatible with a prosperous and competitive economy; and monitoring the activities of foreign governments and firms in these industries to provide an early warning of po- tential competitive problems in the future” (Tyson 1995, 289). Many recom- mended that the U.S. government reduce its R&D support for military and dual-use projects ( dual use refers to projects with military and commercial ap- plications) and increase the amount of support provided to strictly commercial applications. Proponents of a national technology strategy also encouraged greater cooperation between the public and private sector on precompetitive research in a wide range of advanced technologies. Such proposals played an important role in the first Clinton administration’s thinking about interna- tional trade, a role reflected in Clinton’s selection of Laura D’Andrea Tyson, an economist and one of the most prominent proponents of such policies, to be the chair of his Council of Economic Advisors.

The United States also put considerable pressure on other governments to stop their support of high-technology industries. A series of negotiations with Japan that was conducted during the 1980s and early 1990s were designed to pry open the Japanese market to internationally competitive American high-technology industries. Such negotiations took place in semiconduc- tors, computers, telecommunications, and other sectors. The rationale for these negotiations is evident from the previous discussion about first-mover advantages. If Japanese firms could be denied a protected market for their early production runs, they would never realize the scale economies re- quired to compete in international markets. Opening the Japanese market to American high-technology producers would prevent the emergence of com- petitive Japanese high-technology firms and thereby help maintain American high-technology leadership. During the 1980s and early 1990s, therefore, the United States responded strategically to the use of industrial policies by Japan and, to a lesser extent, the EU and adopted policies designed to counter them. Conclusion 107 It is within this context that we can understand the current U.S.–EU con- flict in the commercial aircraft industry. Boeing has long been concerned about the gains Airbus has made in the global market and has long pressured the U.S. government to try to limit the subsidies that European governments offer.

In 1992 the United States and the European Union reached agreement that both would not provide subsidies greater than one-third of the total cost of de- veloping a new airliner or greater than 3 percent of the firm’s annual revenue.

In early summer of 2004 the Bush administration, facing considerable pressure from Boeing, informed the EU that it was time to renegotiate this agreement.

The time for such a move looked right, at least to Boeing, for both companies were beginning to develop new aircraft, and Boeing argued that each should do so without government support. As Boeing CEO Henry Stonecipher said, the 1992 agreement “no longer reflected market realities” and had “outlived its usefulness” (King 2004). Given Airbus’s current market position, it should stop expecting European governments to give it “truckloads” of money to cover a portion of new aircraft development. “We’re saying enough is enough.

You’re very successful, you’re delivering and selling more airplanes than Boeing. . . . Why don’t you go to the bank and borrow money?” It was, Boeing argued, “time for Airbus to accept the financial and marketplace risks that true commercial companies experience” (Casert 2004, p. E.03).

Efforts to renegotiate the 1992 agreement proved unsuccessful. Although EU officials seemed willing to accept the American claim that Airbus had re- ceived government support (though they denied that such support amounted to more than a token), they asserted that Boeing had itself been the beneficiary of $23 billion of government subsidies since 1992. These subsidies had come, the EU argued, from U.S. government R&D contracts and from $3.2 billion in tax reductions, tax exemptions, and infrastructure improvements provided by the state of Washington. Consequently, the EU was willing to discuss a reduc- tion of European assistance to Airbus only in conjunction with an American willingness to accept a reduction of such assistance for Boeing. When the United States proved unwilling to either accept the EU claim or to provide information that would dispute the claim, the negotiations broke down. Days later, the United States announced that it was withdrawing from the 1992 agreement and filed a dispute with the WTO alleging that the EU was in viola- tion of its WTO obligations concerning the use of subsidies that cause harm to foreign competitors. The EU responded immediately by initiating its own WTO dispute in which it alleged the same thing of the United States. The stakes are high, as estimates suggest that over the next 20 years sales of large commercial aircraft will generate $2 trillion (Blustein 2004b). It remains to be seen whether American or European producers will capture this income. CONCLUSION Even though a state-centered approach directs our attention to the impor- tant role that states play in shaping the structure of their domestic econo- mies, it does have some important weaknesses. Three such weaknesses are 108 CHAPTER 5 A State-Centered Approach to Trade Politics perhaps most important. First, the state-centered approach lacks explicit mi- crofoundations. The approach asserts that states act in ways that enhance national welfare. A critical student must respond to this assertion by ask- ing one simple question: What incentive does the state have to act in ways that do in fact enhance national welfare? Anyone who has visited the Pal- ace of Versailles in France or has spent any time reading about the expe- rience of other autonomous rulers knows that autonomous states have as much (if not more) incentive to act in the private interests of state officials as they have to act in the interest of society as a whole. Why then would autonomous state actors enrich society when they might just as easily enrich themselves? Answering this question requires us to think about how state actors are rewarded for promoting policies that enhance national welfare and are punished for failing to do so. In answering this question, we develop microfoundations—an explanation that sets out the incentive structure that encourages state officials to adopt policies that promote national welfare.

But the state-centered approach currently does not offer a good answer to this question. The reward structure that state policymakers face cannot be elections, for that pushes us back toward a society-centered approach. The reward structure might be security related; one could reasonably argue that states intervene to enhance the power and position of the nation in the in- ternational system. We must still explain, however, how these broad con- cerns about national security create incentives for individual policymakers to make specific decisions about resource allocation. The point is not that such microfoundations could not be developed, but rather, as far as I am aware, that no one has yet done so. As a result, the state-centered approach provides little justification for its central assertion that states will regularly act in ways that enhance national welfare.

Second, the assumption that states make policy independent of domestic interest-group pressure is misleading. Even highly autonomous states do not stand aboveall societal interests. Interest groups need not dictate policy, as the society-centered approach claims, but they do establish the parameters in which policy must be made. Even in Japan, which probably comes closest to the ideal autonomous state, the Liberal Democrat Party’s (LDP) position in government was based in part on the support of big business. Is it merely a co- incidence that Japanese industrial policy channeled resources to big business, or did the Japanese state adopt such policies because they were in the interest of one of the LDP’s principal supporters? Thus, whereas the society-centered approach assumes too little room for autonomous state action, the state- centered approach assumes too much state autonomy. We may learn more by fitting the two approaches together. This would lead us to expect governments to intervene in the economy to promote specific economic outcomes, but often such policies are consistent with and shaped by the interests of the coalition of societal groups upon which the government’s power rests.

Finally, strategic-trade theory itself, which provides the intellectual jus- tification for government intervention in high-technology industries, has considerable weaknesses. Strategic-trade theory is as much a prescriptive Conclusion 109 theory—one used to derive policy proposals—as it is an explanatory theory.

As such, it has some important limitations. The claim that government inter- vention can improve national welfare is not particularly robust. The conclu- sions one derives from any theory are sensitive to the assumptions one makes when building the theory. If the conclusions change greatly when one alters some of the underlying assumptions, then the confidence one has in the ac- curacy of the theory must be greatly diminished. Strategic-trade theory has been criticized for producing strong conclusions only under a relatively re- strictive set of assumptions. Although the specific criticisms are too detailed to consider here, the bottom line is that altering the assumptions about how one country’s established firms respond to a foreign government’s subsidy of its firms, about how many firms are in the sector in question, and about where firms sell their products can either weaken the central claim considerably or introduce so much complexity into the model that the policy implications be- come opaque.

Thus, strategic-trade theory does not provide unambiguous support for the claim that government intervention in high-technology industries can raise national income. In addition, even if we assume that strategic-trade theory is correct, it is not easy for governments to identify sectors in which interven- tion will raise national income. It is difficult to identify sectors that offer such gains and then to calculate the correct subsidy that will shift this activity to domestic producers at a net gain to social welfare. If governments choose the wrong sectors or provide too little or too much support, intervention can re- duce rather than raise national welfare. Thus, the precise policy implications of strategic-trade theory are unclear, in part because the theory itself is weak and in part because it is not easy to translate the theory’s simpler conclusions into effective policies.

In spite of these weaknesses, the state-centered approach provides a useful check on the tendency of the society-centered approach to focus exclusively on the interests of societal interest groups. The state-centered approach points our attention to the interests of government officials and underscores the need to think about the ability of these officials to act in- dependent from, and even against, the interests of domestic interest groups.

By doing so, it suggests that trade policy may not always reflect the balance of power between interest groups and tells us that we might need to take into account how state interests intervene in this competition in ways that produce outcomes that no interest groups desire. Yet, in spite of these use- ful insights, I believe that the absence of clearly specified microfoundations in this approach represents a fatal flaw. Without such foundations, the ap- proach can tell us that autonomous state officials will act, but it cannot tell ushow they will act. Adding such microfoundations, perhaps by combining the dynamics highlighted by the society-centered approach with the rich in- stitutional environment emphasized by the state-centered approach, would enable us to begin thinking about the conditions under which state officials have the capacity for autonomous action and about the ends to which such autonomous officials will direct their energies. 110 CHAPTER 5 A State-Centered Approach to Trade Politics KEY TERMS Economies of Experience Economies of Scale Industrial Policy Infant-Industry Case for Protection OligopolyRents State Strength Strategic-Trade Theory SUGGESTIONS FOR FURTHER READING Douglas Irwin provides an excellent discussion of the historical development of the infant-industry case for protection in hisAgainst the Tide: An Intellectual History of Free Trade (Princeton, NJ: Princeton University Press, 1996). The original formulation can be found in Alexander Hamilton, Secretary of the Treasury,Report on Manufactures, communicated to the House of Representatives, December 5, 1791, inPapers on Public Credit, Commerce and Finance, S. Mckee, Jr., ed., pp. 175–276 (New York: Columbia University Press, 1934).

On the issues posed by industrial policy in high-technology industries, see Laura D’Andrea Tyson,Who’s Bashing Whom? Trade Conflict in High Technology In- dustry (Washington, DC: Institute for International Economics, 1995). For a more polemical discussion written by a former trade negotiator in the Reagan administra- tion, see Clyde V. Prestowitz,Trading Places: How We Are Giving Our Future to Japan and How to Reclaim It (New York: Basic Books, 1988). For a more technical treatment, see Paul R. Krugman, ed.,Strategic Trade Policy and the New Interna- tional Economics (Cambridge, UK: Cambridge University Press, 1986). 111 Trade and Development I:

Import Substitution Industrialization M exico has experienced an economic revolution during the last 20 years. Until the mid-1980s, Mexico was one of the most heavily protected and highly directed nonsocialist economies in the world.

Importing anything into the country required formal government approval.

Even with such approval, tariffs were very high, averaging over 25 percent and rising as high as 100 percent for many goods. Moreover, Mexico did not belong to the General Agreement on Tariffs and Trade (GATT), and it was hard to imagine any conditions under which Mexico would seek a free-trade agreement with the United States. Behind these high tariff walls, the Mexican government intervened deeply in the domestic economy. Government-owned financial institutions channeled investment capital to favored private indus- tries and projects. The government created state-owned enterprises in many sectors of the economy (about 1,200 of them by 1982) that together attracted more than one-third of all industrial investment (La Porta and López de Silanes 1997). Today, by contrast, Mexico is one of the most open develop- ing countries in the world. Mexico entered the GATT in 1987 and the North American Free Trade Agreement (NAFTA) in the early 1990s. The Mexican government has retreated sharply from involvement in the domestic economy.

It has sold state-owned enterprises, liberalized a wide variety of market- restricting regulations, and begun to integrate Mexico deeply into the global economy. In less than 10 years, the Mexican government opened Mexico to foreign competition and drastically scaled back its role in managing Mexican economic activity.

Mexico’s experience is hardly unique. Governments in India, China, much of Latin America, and most of sub-Saharan Africa opted out of the global trade system following World War II. Most governments erected very high trade barriers, and to the extent that they participated at all in the GATT, 6 CHAPTER 112 CHAPTER 6 Trade and Development I: Import Substitution Industrialization they sought to alter the rules governing international trade. Convinced that the GATT was biased against their interests, developing countries worked through the United Nations to create international trade rules that they be- lieved would be more favorable toward industrialization in the developing world. Like Mexico, most governments intervened extensively in their econo- mies in an attempt to promote rapid industrialization. Drawing on the logic of the infant-industry case for protection, governments used the power of the state to pull resources out of agriculture and push them into manufacturing.

And, like Mexico, these policy orientations have changed fundamentally since the late 1980s. Most developing countries have dismantled the protectionist systems they maintained in the first 30 years of the postwar period, have be- come active participants in the World Trade Organization (WTO), and have abandoned the quest to institute far-reaching changes to international trade rules. Most have greatly reduced the degree of government intervention in the domestic economy.

This chapter and the next examine how political and economic forces have shaped the adoption and evolution of these new trade and development poli- cies. This chapter examines why governments in so many developing countries intervened deeply in their domestic economies, insulated themselves from in- ternational trade, and sought changes in international trade rules. The next chapter focuses on why so many governments have dismantled these policies during the last 30 years. We look first at how economic and political change throughout the developing world brought to power governments supported by import-competing interests. We then examine the economic theory that guided policy during those times. As we shall see, this theory provided governments with a compelling justification for transforming the protectionism sought by the import-competing producers that supported them into policies that em- phasized industrialization through state leadership. Having built this base, we turn our attention to the specific policies that governments pursued during that period, looking first at their domestic strategy for industrialization and then examining their efforts to reform the international trade system.

DOMESTIC INTERESTS, INTERNATIONAL PRESSURES, AND PROTECTIONIST COALITIONS Developing countries’ trade policies underwent a sea change in the first half of the twentieth century. Until the First World War, those developing coun- tries that were independent, as well as those regions of the world held in co- lonial empires, adopted liberal trade policies. They produced and exported agricultural goods and other primary commodities to the advanced industrial- ized countries and imported most of the manufactured goods they consumed.

Governments and colonial rulers made little effort to restrict this trade. But by the late 1950s, these liberal trade policies had been replaced by a protection- ist approach that dominated the developing countries’ trade policies until the late 1980s and whose remnants remain important in many countries today. Domestic Interests, International Pressures, and Protectionist Coalitions 113 We begin our investigation of developing countries’ trade and development policies by looking at this initial shift to protectionism.

Trade and development policies in developing countries have been strongly shaped by political competition between rural-based agriculture and urban-based manufacturing. Developing countries pursued liberal trade poli- cies prior to World War I because export-oriented agricultural interests domi- nated politics. In general, developing countries are abundantly endowed with land and poorly endowed with capital (Lal and Myint 1996, 104–110).

The relative importance of land and capital in developing countries’ econ- omies can be appreciated by examining the structure of those economies, to- gether with exports, as presented in Table 6.1 and Table 6.2. For the time being, we will focus on 1960, as this will allow us to put to the side the con- sequences of the development policies that governments adopted during the postwar period. With a few exceptions (particularly in Latin America), be- tween one-third and one-half of all economic activity in developing countries in 1960 was based in agriculture, whereas less than 15 percent was based in manufacturing. By contrast, agriculture accounted for only 5 percent of gross domestic product (GDP) in the advanced industrial economies. If we include the “other industry” category, which incorporates mining, then in all regions of the developing world other than Latin America, agriculture and nonmanu- facturing industries accounted for more than half of all economic activity.

A similar pattern is evident in the commodity composition of developing countries’ exports ( Table 6.2). In 1962, developing countries’ exports were TABLE 6.1 Economic Structure in Developing Countries (Sector as a Percent of Gross Domestic Product) Agriculture Manufacturing Other Industry* Services 1960 1980 1995 1960 1980 1995 1960 1980 1995 1960 1980 1995 Sub- Saharan Africa36 24 20 12 12 15 18 24 15 40 38 48 East Asia and the Pacific46 27 18 16 27 32 7 12 12 31 32 38 South Asia 49 39 30 13 15 17 6 9 10 33 35 41 Latin America16 10 10 21 25 21 10 12 12 53 51 55 Figures may not sum to 100 because of rounding.

*Includes mining, construction, gas, and water.

Sources: Data for 1960 from World Bank, World Tables, 3rd ed. (Washington, DC: The World Bank, 1983). Data for 1980 and 1995 from World Bank, World Development Indicators(Washington, DC: The World Bank, 1997). 114 CHAPTER 6 Trade and Development I: Import Substitution Industrialization TABLE 6.2 Developing Countries’ Export Composition (Sector as a Percent of Total Exports) Fuels, Minerals,and Metals Other Primary Commodities Manufactures 1962 1980 1993 1962 1980 1993 1962 1980 1993 Sub-Saharan Africa Cameroon 21 33 51 75 64 35 4 414 Ghana 73 17 25 31 82 52 1 123 Kenya 23616 895266 91319 Nigeria 11 97 94 81 2 4 8 0 2 South Africa 23 33 16 47 28 11 26 40 74 Zaire 16 56 69 75 14 13 10 31 18 East Asia and the Pacific Hong Kong 2 2 2 3 5 3939396 Indonesia 37 76 32 63 22 15 0 353 Malaysia n.a. 35 14 n.a. 46 21 n.a. 20 65 Singapore 52 31 14 18 18 6305180 South Korea 24 1 3 57 9 4209094 Taiwan n.a. 2 2 n.a. 10 5 n.a. 88 93 South Asia India 9 8 7 473318 445975 Pakistan 0 8 1 754414 254885 Latin America Argentina 2 6 11 95 71 57 32332 Bolivia 91 86 56 4 11 25 5319 Brazil 9 11 12 88 50 28 33960 Chile 87 65 43 8 25 38 41019 Mexico 24 73 17 60 15 9161275 n.a., not available.

Sources: Data for 1962 from World Bank,World Tables, 3rd ed. (Washington, DC: The World Bank, 1983). Data for 1980 and 1993 from World Bank,World Development Indicators (Washington, DC: The World Bank, 1997). heavily concentrated in primary commodities: agricultural products, miner- als, and other raw materials. Roughly speaking, in each developing country, primary commodities accounted for more than 50 percent of exports, and in more than half of the listed countries primary commodities accounted for more than 80 percent of exports. In addition, each country exported a narrow range of primary commodities. Some countries weremonoexporters; that is, Domestic Interests, International Pressures, and Protectionist Coalitions 115 their exports were almost fully accounted for by one product. For example, more than 80 percent of Burundi’s export earnings came from coffee, and cocoa accounted for 75 percent of Ghana’s export earnings (Cypher and Di- etz 1997, 339). Similar patterns were evident in Latin America: In 1950, cof- fee and cocoa made up about 69 percent of Brazil’s exports, and copper and nitrates constituted about 74 percent of Chile’s exports (Thorp 1999, 346).

The structure of their economies and the composition of their exports thus un- derline the central point: Developing countries are abundantly endowed with land and have little capital.

The precise form through which landowners dominated politics prior to World War II differed considerably across regions. In Latin America, an indig- enous landowning elite dominated domestic politics. In Argentina and Chile, for example, the landowners controlled government, often in an alliance with the military. Even though these political systems were constitutionally demo- cratic, participation was restricted to the elite, a group that amounted to about 5 percent of the population, in a system that has been characterized as “oli- garchic democracy” (Skidmore and Smith 1989, 47). In other Latin American countries such as Mexico, Venezuela, and Peru, dictatorial and often military governments ruled, but they pursued policies that protected the interests of the landowners (Skidmore and Smith 1989, 47). With landowners dominating domestic politics, Latin American governments pursued liberal trade policies that favored agricultural production and export at the expense of manufac- tured goods (Rogowski 1989, 47). As a result, most Latin American countries were highly open to international trade, producing and exporting agricultural goods and other primary commodities and importing manufactured goods from Great Britain, Europe, and the United States.

In Asia and in Africa, export-oriented agricultural interests dominated local politics through colonial structures. In Taiwan and Korea, for example, Japanese colonization led to the development ofenclave agriculture—that is, export-oriented agricultural sectors that had few linkages to other parts of the local economy (Haggard 1990). Agricultural producers bought little from local suppliers and exported most of their production. In both coun- tries, agricultural production centered on the production and export of rice; in Taiwan, sugarcane was a staple crop as well. India produced and exported a range of primary commodities, including cotton, jute, wheat, tea, and rice.

In exchange, India imported most of the manufactured goods it consumed from Britain. In Africa, colonial powers encouraged the production of cash crops and raw materials that could be exported to the mother country (Hop- kins 1979; Ake 1981, 1996). In the Gold Coast (now Ghana), the cocoa in- dustry was a small part of the economy in 1870. Under British rule, Ghana became the world’s largest cocoa producer by 1910, and cocoa accounted for 80 percent of its exports. In Senegal, France promoted groundnut (the American peanut) production, and by 1937 close to half of all cultivated land was dedicated to this single product (Ka and Van de Walle 1994, 296). Simi- lar patterns with other commodities were evident in other African colonies (Hopkins 1979). 116 CHAPTER 6 Trade and Development I: Import Substitution Industrialization These political arrangements began to change in the early twentieth century. As they did, the dominance of export-oriented interests gave way to the interests of import-competing manufacturers. In many instances, the most important triggers for this change originated outside of developing so- cieties. In Latin America, international economic shocks beginning with the First World War and extending into the Second World War played a central role (Thorp 1999, Chapter 4 ). Government-mandated rationing of goods and primary commodities in the United States and Europe during the two World Wars made it difficult for Latin American countries to import many of the consumer goods they had previously purchased from the industrial- ized countries. In addition, falling commodity prices associated with the Great Depression and the disruption of normal trade patterns arising from the Second World War reduced export revenues. The interruption of “nor- mal” Latin American trade patterns led governments in many countries to introduce trade barriers and to begin producing many of the manufactured goods that they had previously imported. The rise of domestic manufactur- ing in turn produced a growing urban middle class as workers and industri- alists began to move out of agricultural production and into manufacturing industries.

The emergence of manufacturing industries gave rise to interest groups, industry-based associations, and labor unions that pressured the government to adopt economic policies favorable to people working in the import-com- peting sector. The creation of organized groups to represent the interests of import-competing manufacturing generated its own political logic. On the one hand, the groups that saw their incomes rise from protection had a strong incentive to see protectionist policies continued in the postwar period (see Rogowski 1989; Haggard 1990). On the other hand, the emergence of new organized interests and a growing urban middle class created an opportunity for politicians to construct new political coalitions based on the support of the urban sectors. In Argentina, for example, Juan Peron rose to power in the late 1940s with the support of labor, industrialists, and the military. A similar pattern was evident in Brazil, where Getulio Vargas was elected to the presi- dency in 1950 with the support of industrialists, government civil servants, and urban labor. Nor were Argentina and Brazil unique: Throughout Latin America, postwar governments were much less tightly linked to landed inter- ests than governments had been before World War I. Instead, governments rose to power on the basis of political support from interest groups whose incomes were derived from import-competing manufacturing (Cardoso and Faletto 1979). Such governments had a clear incentive to maintain trade poli- cies that protected those incomes.

A similar dynamic is evident in India. The global economic collapse of the 1930s forced India to become increasingly self-reliant. Markets for Indian ex- ports constricted sharply, thereby greatly constraining Indian export revenues.

Unable to earn foreign exchange, India had to reduce imports of manufac- tured goods as well. Under this forced self-reliance, India began to create an indigenous manufacturing sector. By the end of the Second World War, India Domestic Interests, International Pressures, and Protectionist Coalitions 117 had emerged as “the tenth largest producer of manufactured goods in the world” (Tomlinson 1979, 31). The indigenous urban manufacturing sector then fused with the burgeoning nationalist movement during the late 1930s to lead the push for Indian independence and to supplant the predominantly foreign-owned export sector at the center of the Indian political system. By the time India achieved independence in 1947, it was committed to a strategy of autonomous industrialization.

In Pacific Asia, the shift in political power came about as a product of de- colonization. In Korea and Taiwan political change resulted from the defeat of Imperial Japan in World War II (see Haggard 1990). In South Korea, Japan’s defeat transferred power from a foreign colonizer to indigenous groups.

Although the landowners initially dominated postwar politics, the Korean War of the early 1950s and a series of land reforms implemented during that same decade greatly reduced the landowners’ power and increased the rela- tive power of the emerging urban sector. On mainland China, Japan’s defeat was followed by the defeat of the nationalist Chinese government and the migration of the Chinese nationalists to the island of Taiwan. Once installed in Taiwan, the Chinese nationalists instituted land reforms to assert their au- thority over indigenous landowners and to prevent a repeat of their experience on the mainland, where the rural sector had supported the Communists. As in South Korea, land reforms reduced the power of landowners and increased the power of the urban–industrial sector.

Africa’s transition came later, as decolonization began only in the 1950s, and it took a slightly different form. The push toward decoloni- zation was led by a coalition of indigenous professionals who had been educated by the colonial powers and had then acquired positions in the ad- ministration of colonial economic and political rule. One factor motivating Africa’s push for independence was dissatisfaction with the discriminatory practices of colonial administration. Colonies were run for the profit of the colonists, with colonial economic enterprises staffed and managed by men from the colonial power. The local population had limited opportunities to participate in these economic arrangements other than as workers. The nationalist struggles for independence that emerged in the 1950s sought to transfer control over existing economic practices from the colonial govern- ments to indigenous elites.

The period demarcated by the start of the First World War and the end of decolonization in sub-Saharan Africa thus brought a fundamental change to patterns of political influence in developing countries. Political structures once dominated by export-oriented agricultural interests were now largely un- der the control of import-competing manufacturing interests. Consequently, governments beholden to the import-competing sector had a clear incentive to abandon liberal trade policies and to continue the protectionist arrange- ments they had built during the 1930s. As we will see, the political interest in protectionism was reinforced by an elaborate theoretical structure that argued that protectionism was the only path to the establishment of industrialized economies. 118 CHAPTER 6 Trade and Development I: Import Substitution Industrialization THE STRUCTURALIST CRITIQUE: MARKETS, TRADE, AND ECONOMIC DEVELOPMENT Although protectionism reflected the interests of the politically influential import-competing manufacturing sector, it did not represent a coherent eco- nomic development strategy. And most governments were committed, at least rhetorically, to the adoption of policies that would promote economic devel- opment. Most governments wanted to shift resources out of agricultural pro- duction and into manufacturing industries because they believed that poverty resulted from too heavy a concentration on agricultural production. Higher standards of living could be achieved only through industrialization, and ac- cording to what was then the dominant branch of development economics, calledstructuralism, the shift of resources from agriculture to manufacturing would not occur unless the state adopted policies to bring it about (see Lal 1983; Little 1982).

The belief that the market would not promote industrialization provided the intellectual and theoretical justification for the two central aspects of the development strategies adopted by most governments throughout much of the postwar era. Because structuralism played such an important role in shaping developing countries’ trade and development policies, understanding the poli- cies governments adopted requires us to understand the structuralist critique.

Market Imperfections in Developing Countries Structuralists argued that market imperfections inside developing countries posed serious obstacles to the reallocation of resources from agriculture to manufacturing industries. Structuralists argued that markets would not bring about the necessary shift of resources because developing economies were too inflexible.

Most important, according to the structuralists, was the belief that the market would not promote investment in manufacturing industries (Scitovsky 1954). The structuralists pointed to two coordination problems that would limit investment in manufacturing industries. The first problem, calledcomple- mentary demand, arose in the initial transformation from an economy based largely on subsistence agriculture to a manufacturing economy (Rosenstein- Rodan 1943). In an economy in which few people earned a money wage, no single manufacturing firm would be able to sell its products unless a large num- ber of other manufacturing industries were started simultaneously. Suppose, for example, that 100 people are taken out of subsistence agriculture and paid a wage to manufacture shoes, whereas the rest of the population remains in non- wage agriculture. To whom will the new factory sell its shoes? The only workers earning money are those producing shoes, and these 100 workers are unlikely to purchase all of the shoes that they make. In order for this shoe factory to suc- ceed, other factories employing other people must be created at the same time.

Suppose instead, that five hundred thousand workers are taken out of subsistence agriculture and simultaneously employed in a large number of The Structuralist Critique: Markets, Trade, and Economic Development 119 factories producing a variety of different goods; some make shoes, others make clothing, and still others produce refrigerators or processed foods. With this larger number of wage earners, manufacturing enterprises can easily sell their goods. Shoe workers can buy refrigerators and clothes, workers in the clothing factory can purchase shoes, and so on. Thus, a manufacturing enter- prise will be successful only if many manufacturing industries began produc- tion simultaneously.

Structuralists doubted that uncoordinated market behavior would pro- duce simultaneous investment in multiple manufacturing industries. No single entrepreneur has an incentive to invest in a manufacturing enterprise unless she is certain that others will invest simultaneously in other industries. People willing to invest will thus wait until others invest and, as a consequence, no one will invest in manufacturing unless all potential investors could somehow coordinate their behavior to ensure that all will invest in manufacturing at the same time. The problem of complementary demand thus meant that if invest- ment were left to the market, there would be little investment in manufactur- ing industries.

The second coordination problem, calledpecuniary external economies, arose from interdependencies among market processes (Scitovsky 1954).

Think about the economic relationship between a steel plant and an auto- mobile factory. Suppose that the owners of a steel factory invest to increase the amount of steel they can produce. As steel production increases, steel prices begin to fall. The automobile factory, which uses a lot of steel, be- gins to realize rising profits as the price of one of its most important inputs falls. These increasing profits in the automobile industry could induce the owners of the car plant to invest to expand their own production capacity.

Such a simultaneous expansion of the steel and auto industries would raise national income.

The two firms face a coordination problem, however. The owners of the steel plant will not increase steel production unless they are sure that the auto industry will increase car production. Yet, the owners of the auto plant will not increase auto production unless they are certain that the steel producer will make the investments needed to expand steel output. Thus, unless invest- ment decisions in the steel and auto industry are coordinated, neither firm will invest to increase the amount it can produce. Once again, structuralists argued, the market could not be expected to solve this coordination problem.

The structuralists’ assertion that coordination problems would prevent investment in manufacturing was a serious problem for governments intent on industrialization. Fortunately, the structuralists offered a solution to the problem. Structuralists argued that the way to overcome these coordination problems was with a state-ledbig push. The state would engage in economic planning and either make necessary investments itself or help coordinate the investments of private economic actors. Thus, what the market could not bring about, the state could achieve through intervening in the economy. The structuralist critique of the market therefore provided a compelling theoretical justification for state-led strategies of industrialization. 120 CHAPTER 6 Trade and Development I: Import Substitution Industrialization Market Imperfections in the International Economy Structuralists also argued that international trade provided few benefits to de- veloping countries. This argument was formulated during the 1950s, princi- pally by Raul Prebisch, an Argentinean economist who worked for the United Nations Economic Commission for Latin America (ECLA), and Hans Singer, an academic development economist. According to theSinger-Prebisch the- ory, participation in the GATT–based trade system would actually make it harder for developing countries to industrialize by depriving them of critical resources.

The Singer-Prebisch theory divides the world into two distinct blocks— the advanced-industrialized core and the developing-world periphery—and focuses on the terms of trade between them. Theterms of trade relate the price of a country’s exports to the price of its imports. An improvement in a country’s terms of trade means that the price of its exports is rising relative to the price of its imports, but a decline in a country’s terms of trade means that export prices are falling relative to its import prices. As a country’s terms of trade improve, it can acquire a given amount of imports for a smaller quantity of exports. Thus, an improvement in its terms of trade makes a country richer, but a decline in its terms of trade makes it poorer.

The Singer-Prebisch theory argues that developing countries’ terms of trade deteriorate steadily over time. When they developed this theory, devel- oping countries exported primary commodities and imported manufactured goods. Singer and Prebisch argued that primary commodity prices steadily fell relative to manufactured goods prices, thereby steadily reducing the incomes of developing countries. The periphery’s terms of trade deteriorate, according to this theory, in large part as a result of differences in the income elasticity of demand for primary commodities versus industrial goods (see Lewis 1954; United Nations 1964; Gilpin 1987, 275–276).

The income elasticity of demand is the degree to which a change in in- come alters demand for a particular product. For a product with a low income elasticity of demand, a large increase in income produces little change in de- mand for the good. For a product with a high income elasticity of demand, a small increase in income produces a large change in demand for a particular good. Structuralists argued that the income elasticity of demand for primary commodities was quite low, but income elasticity of demand for manufac- tured goods was relatively high. Thus, as incomes rise in the core countries, a smaller and smaller percentage of those countries’ income will be spent on im- ports of primary commodities. But as incomes rise in the periphery countries, a larger percentage ofthose countries’ income will be spent on manufactured imports from the core. Falling demand for primary commodities will cause the periphery countries’ export prices to fall, whereas rising demand for manufac- tured goods will cause the periphery countries’ import prices to rise. Rising import prices relative to export prices yields deteriorating terms of trade.

Most research disputes the claim that developing countries face a continu- ous decline in their terms of trade (see, for example, Borensztein et al. 1994; Domestic and International Elements of Trade and Development Strategies 121 see also Bloch and Sapsford 2000). Yet, the objective validity of the Singer- Prebisch hypothesis is not the central consideration. What mattered was that governments in developing countriesbelieved the hypothesis. Governments of developing countries were convinced that industrialization would not occur if they participated in the GATT–based international trade system. This convic- tion played an important role in shaping the trade and development policies that developing countries adopted.

DOMESTIC AND INTERNATIONAL ELEMENTS OF TRADE AND DEVELOPMENT STRATEGIES Structuralism enabled governments to transform the protectionist trade poli- cies that benefited their principal political supporters into comprehensive state-led development strategies. The trade and development policies that most governments adopted following World War II had both a domestic and an in- ternational dimension. At home, the desire to promote rapid industrialization led governments to adopt state-led development strategies that were sheltered by high protectionist barriers. In the international arena, concern about the distributional implications of international trade led developing countries to seek far-reaching changes to the GATT–based trade system. We examine each dimension in turn.

Import Substitution Industrialization Structuralism provided the intellectual justification for a state-led develop- ment strategy. Confidence that the state could achieve what markets would not was based in part on evidence of the dramatic industrialization that the Soviet Union had achieved between 1930 and 1950 with an approach based on centralized planning and state ownership of industry. In developing so- cieties outside the Soviet bloc, this state-centered approach to development came to be calledimport substitution industrialization, or ISI. The strategy of ISI was based on a simple logic: Countries would industrialize by substitut- ing domestically produced goods for manufactured items they had previously imported.

Governments conceptualized ISI as a two-stage strategy. (See Table 6.3.) Its initial stage was “wholly a matter of imitation and importation of tried and tested procedures” (Hirschman 1968, 7).Easy ISI, as this first stage was of- ten called, focused on developing domestic manufacturing of relatively simple consumer goods, such as soda, beer, apparel, shoes, and furniture. The ratio- nale behind the focus on simple consumer goods was threefold. First, there was a large domestic demand currently satisfied by imports. Second, because these items were mature products, the technology and machines necessary to produce them could be acquired easily from the advanced industrialized coun- tries. Third, the production of relatively simple consumer goods relies heavily on low-skilled labor, allowing developing societies to draw their populations 122 CHAPTER 6 Trade and Development I: Import Substitution Industrialization into manufacturing activities without making large investments to upgrade their skills.

Governments expected to realize two broad benefits from easy ISI. Ini- tially, the expansion of manufacturing activities would increase wage-based employment as underutilized labor was drawn out of agriculture and into manufacturing. In addition, the experience gained in these manufacturing in- dustries would allow domestic workers to develop skills, collectively referred to as general human capital, that could be applied subsequently to other manufacturing businesses. Of particular importance were the management and entrepreneurial skills that would be gained by people who worked in and managed the manufacturing enterprises established in this stage. Success in the easy stage would therefore create many of the ingredients necessary to make the transition to the second stage of ISI.

Easy ISI would eventually cease to bear fruit. The domestic market’s ca- pacity to absorb simple consumer goods would be exhausted, and the range of such goods that could be produced would be limited. At some point, there- fore, governments would need to shift from easy ISI to a second-stage strategy characterized by the development of more complex manufacturing activities.

One possibility would be to shift to what some have called anexport substi- tution strategy, in which the labor-intensive manufactured goods industries TABLE 6.3 Stages of Industrialization in Mexico and Brazil, 1880-1968* Commodity Exports, 1880–1930 Primary ISI, 1930–1955 Secondary ISI, 1955–1968 Main IndustriesMexico: Precious metals, minerals, oil Brazil: Coffee, rubber, cocoa, cottonMexico and Brazil:

Textiles, food, cement, iron and steel, paper, chemicals, machineryMexico and Brazil:

Automobiles, electrical and nonelectrical machinery, petrochemicals, pharmaceuticals Major Economic ActorsMexico: Foreign investors Brazil: National private firms Mexico and Brazil: National private firms Mexico and Brazil:

State-owned enterprises, transnational corporations, and national private firms Orientation of the Economy World market Domestic market Domestic market *ISI, import substitution industrialization.

Source: Gereffi 1990, 19. Domestic and International Elements of Trade and Development Strategies 123 developed in easy ISI begin to export rather than continue to produce exclu- sively for the domestic market. Many East Asian governments adopted this approach, as we shall see in Chapter 7 .

The second alternative, and the one adopted by most governments out- side of East Asia, was secondary ISI. In secondary ISI, emphasis shifts from the manufacture of simple consumer goods to consumer durable goods, intermediate inputs, and the capital goods needed to produce consumer du- rables. In Argentina, Brazil, and Chile, for example, governments decided to promote domestic automobile production as a central component of secondary ISI. Each country imported cars in pieces, called complete knockdowns, and assembled the pieces into a car for sale in the domestic market. Domestic auto firms were required to gradually increase the percentage of locally- produced parts used in the cars they assembled. In Chile, for example, 27 percent of a locally produced car’s components had to be manufactured domestically in 1964. The percentage rose to 32 percent in 1965 and then to 45 percent in 1966 (Johnson 1967).

By increasing the percentage of local components of cars and other goods in this manner, governments hoped to promote the development of backward linkages throughout the economy (Hirschman 1958).Backward linkages arise when the production of one good, such as a car, increases demand in indus- tries that supply components for that good. Thus, increasing the percentage of locally produced components of cars, by increasing the demand for indi- vidual car parts, would increase domestic part production. The latter would in turn increase demand for inputs into part production: steel, glass, and rubber, for example. Industrialization, therefore, would spread backwards from final goods to intermediate inputs to capital goods as backward linkages multiplied.

Governments promoted secondary ISI with three policy instruments: gov- ernment planning, investment policy, and trade barriers. Most governments structured their efforts around five-year plans (Little 1982, 35). Planning was used to determine which industries would be targeted for development and which would not, to figure out how much should be invested in a particular industry, and to evaluate how investment in one industry would influence the rest of the economy. India’s second Five Year Plan (1957–1962), for example, sought to generate ambitious growth in manufacturing by targeting the devel- opment of capital goods production (Srinivasan and Tendulkar 2003, 8). The plan thus served as the coordination device that governments thought neces- sary, given their belief that the market itself could not coordinate investment decisions.

With a plan in place, governments used investment policies to promote tar- geted industries. Most governments either nationalized or heavily controlled the financial sector in order to direct financial resources to targeted industries. Gov- ernments also invested directly in those economic activities in which they thought the private sector would not invest. Much of the infrastructure necessary for in- dustrialization—things such as roads and other transportation networks, elec- tricity, and telecommunications systems—it was argued, would not be created by the private sector. In addition, the private sector lacked access to the large sums 124 CHAPTER 6 Trade and Development I: Import Substitution Industrialization of financial support needed to make huge investments in a steel or auto plant.

Moreover, it was claimed that private-sector actors lacked the technical sophis- tication required for the large-scale industrial activity involved in secondary ISI.

Governments invested in these industries by creating state-owned and mixed-ownership enterprises. In Brazil, for example, state-owned enterprises controlled more than 50 percent of total productive assets in the chemical, telecommunications, electricity, and railways industries and slightly more than one-third of all productive assets in metal fabrication (Trebat 1983). Indian state-owned enterprises provided 27 percent of total employment and 62 per- cent of all productive capital (Krueger 1993a, 24–25). In Africa, governments in Ghana, Mozambique, Nigeria, and Tanzania each created more than 300 state-owned enterprises, and in many African countries, state-owned enter- prises accounted for 20 percent of total wage-based employment (World Bank 1994b, 101). Throughout developing societies, therefore, the shift to second- ary ISI was accompanied by the emergence of the state as a principal, and in many instances the largest, owner of productive capacity.

Finally, governments used trade barriers to control foreign exchange and protect infant industries. Because export earnings were limited, governments controlled foreign trade to ensure that foreign exchange supported their devel- opment objectives (Bhagwati 1978, 20–33). After all, many elements critical to industrialization, including intermediate inputs and capital goods, had to be imported. Protection also allowed infant industries to gain experience needed to compete against established producers. In Brazil and India, for instance, the state prohibited imports of any good for which there was a domestic substi- tute, regardless of price and quality differences.

The scale and the structure of protection that governments used to pro- mote industrialization are illustrated in Table 6.4, which focuses on Latin America in 1960. In all but two of the listed countries, nominal protection on TABLE 6.4 Nominal Protection in Latin America, circa 1960 (percent) Nondurable Consumer Goods Durable Consumer Goods Semi- Manufactured Goods Industrial Raw Materials Capital Goods Argentina 176 266 95 55 98 Brazil 260 328 80 106 84 Chile 328 90 98 111 45 Colombia 247 108 28 57 18 Mexico 114 147 28 38 14 Uruguay 23 24 23 14 27 European Economic Community17 19 7 113 Source: Bulmer-Thomas 1994, 280, Table 9.1. Domestic and International Elements of Trade and Development Strategies 125 nondurable consumer goods was well over 100 percent, and for all but three countries, tariffs on consumer durables also were over 100 percent. Mexico and Uruguay stand out as clear exceptions to this pattern, which has more to do with those countries’ extensive use of import quotas in place of tariffs than with an unwillingness to protect domestic producers (Bulmer-Thomas 1994, 279). It is also clear that tariffs were lower for semi-manufactured goods, in- dustrial raw materials, and capital goods (all of which were items that devel- oping countries needed to import in connection with industrialization) than they were for consumer goods. This pattern of tariff escalation was common in much of the developing world (Balassa and Associates 1971).

The costs of ISI were borne by agriculture (see Krueger 1993a; Krueger, Schiff, and Valdes 1992; Binswanger and Deininger 1997). Governments taxed agricultural exports through marketing boards that controlled the purchase and export of agricultural commodities (Krueger et al. 1992, 16). Often estab- lished as the sole entity with the legal right to purchase, transport, and export agricultural products, marketing boards set the price that farmers received for their crops. In the typical arrangement, the marketing board would purchase crops from domestic farmers at prices well below the world price and then would sell the commodities in the world market at the world price. The dif- ference between the price paid to domestic farmers and the world price rep- resented a tax on agricultural incomes that the state could use to finance industrial projects (Amsden 1979; Bates 1988; Krueger 1993a). The trade bar- riers that protected domestic manufacturing firms from foreign competition also taxed agriculture. Tariffs and quantitative restrictions raised the domestic price of manufactured goods well above the world price. People employed in the agricultural sector, who consumed these manufactured goods, therefore paid more for them than they would have in the absence of tariffs and quanti- tative restrictions (Krueger 1993a, 9).

Such government policies transferred income from rural agriculture to the urban manufacturing and nontraded-goods sectors. The size of the income transfers was substantial. As a World Bank study summarized, the total impact of interventions . . . on relative prices [between agri- culture and manufacturing] was in some countries very large. In Ghana . . . farmers received only about 40 percent of what they would have received under free trade. Stated in another way, the real incomes of farmers would have increased by 2.5 times had farmers been able to buy and sell under free trade prices given the commodities they in fact produced. While Ghanaian total discrimination against agriculture was huge, Argentina, Cote d’Ivoire, the Dominican Republic, Egypt, Pakistan, Sri Lanka, Thailand, and Zambia also had total discrimination against agriculture in excess of 33 percent, implying that in all those cases, farm incomes in real terms could have been increased by more than 50 percent by removal of these interventions. (Krueger 1993a, 63) Thus, ISI redistributed income. The incomes of export-oriented producers fell while those of import-competing producers rose. 126 CHAPTER 6 Trade and Development I: Import Substitution Industrialization A CLOSER LOOK Import Substitution Industrialization in Brazil In the late nineteenth and early twentieth centuries, Brazil was the classic case of a country that exported primary commodities. Its principal crop, coffee, accounted for a large share of its production and the overwhelming majority of its export earnings. This economic structure was supported by a political system dominated by the interests of coffee producers and other agricultural exporters (Bates 1997). Political authority in Brazil was decentralized, and the states used their power in the country’s federal system to influence government policy. As a result, Brazil pursued a liberal trade policy throughout the late nineteeth and early twentieth centuries. The First World War and the Great Depression disrupted these arrangements. The world price for coffee fell sharply in the late 1920s and early 1930s, generating declining terms of trade and rising trade deficits. The government responded to this crisis by adopting protectionist measures to limit imports. The initial turn to protectionism was accompanied by political change. A military coup in 1930 handed power to Getulio Vargas, who centralized power by shifting political authority from the states to the federal government. Even though Vargas did not adopt an ISI strategy, this period represented in many respects the easy stage of ISI (Haggard 1990, 165–166). Protectionism promoted the growth of light manufacturing industries at a rate of 6 percent per year between 1929 and 1945 (Thorp 1999, 322). Concurrently, the centralization of power created a state that could intervene effectively in the Brazilian economy. Although the export-oriented interests did not lose all political influence in this new political climate, the balance of power had clearly shifted toward new groups emerging in urban centers: the professionals, managers, and bureaucrats who constituted the emerging middle class and the nascent manufacturing interests. As Brazil moved into the post–World War II period, therefore, the stage was set for the transition to secondary ISI.

A full-blown ISI strategy emerged in the 1950s. The government restricted imports tightly with the so-called law of similars, which effectively prohibited the import of goods similar to those produced in Brazil. In 1952, the Brazilian government created the National Economic Development Bank (BNDE), an important instrument for industrial policy through which the Brazilian state could finance industrial projects. In the late 1950s, the government created a new agency, the National Development Council, to coordinate and plan its industrialization strategy. In taking up its task, the council was heavily influenced by structuralist ideas (Haggard 1990, 174). Studies conducted within these agencies—and, in some instances, in collaboration with international agencies such as the United Nations (UN) Economic Commission on Latin America—focused on how best to promote industrialization (Leff 1969, 46). Most of these studies came to similar conclusions: Industrialization in Brazil would quickly run into constraints caused by inadequate transportation networks (road, rail, and sea), shortages Domestic and International Elements of Trade and Development Strategies 127 of electric power, and the underdevelopment of basic heavy industries such as steel, petroleum, chemicals, and nonferrous metals. Building up those industries thus became the focus of the government’s development policies. The Brazilian government had little faith that the private sector would create and expand these critically important industries. Instead, policymakers determined that the state would have to play a leading role. In the early 1950s, the state nationalized the oil and electricity industries and began investing heavily in the expansion of capacity in both. A similar approach was adopted in the transportation sector (in which the government owned the railways and other infrastructure), in the steel industry, and in telecommunications. By the end of the 1950s, the state accounted for 37 percent of all investment made in the Brazilian economy. As a result, the number of state- owned enterprises grew rapidly, from fewer than 35 in 1950 to more than 600 by 1980.

Beyond creating these basic industries, the Brazilian government also sought to create domestic capacity to produce complex consumer goods. To achieve this objective, Brazil, in contrast to many other developing countries, drew heavily upon foreign investment to promote the development of certain industries. The auto industry is an excellent example. In 1956, the Brazilian government prohibited all imports of cars. Any foreign producer that wanted to sell cars in the Brazilian market would have to set up production facilities in the country. To ensure that such foreign investments were not simple assembly operations in which the foreign company imported all parts from its suppliers at home, the Brazilian government instituted local rules that required the foreign automakers operating in the country to purchase 90 percent of their parts from Brazilian firms. In order to induce foreign automakers to invest in Brazil under these conditions, the government offered subsidies; by one account, the subsidies offset about 87 percent of the total investment between 1956 and 1969. Relying on this strategy, Brazilian auto production rose from close to zero in 1950 to almost 200,000 cars in 1962.

Brazil’s ISI strategy helped transform the country’s economy in a remarkably short time. Imported consumer nondurable goods (the products targeted during easy ISI) had been almost completely replaced with domestic production by the early 1950s (Bergsman and Candal 1969, 37). Imported consumer durables, the final goods targeted in secondary ISI, fell from 60 percent of total consumption to less than 10 percent of total consumption by 1959. Imports of capital goods also fell, from 60 percent of total domestic consumption in 1949, to about 35 percent of consumption in 1959, and then to only 10 percent by 1964. Finally, imports of intermediate goods, the inputs used in producing final goods, also fell continually throughout the decade, to less than 10 percent of total consumption by 1964.

Thus, as imports were barred and domestic industries created, Brazilian consumers and producers purchased a much larger percentage of the goods they used from domestic producers and a much smaller percentage from foreign producers. As a consequence, the importance of manufacturing in the Brazilian economy increased sharply: Whereas manufacturing accounted for only 26 percent of total Brazilian production in 1949, by 1964 it accounted for 34 percent.

128 CHAPTER 6 Trade and Development I: Import Substitution Industrialization The strategy of ISI promoted rapid economic growth in the 1960s and 1970s: Developing countries’ economies grew at annual average rates of between 6 percent and 7.6 percent during this period. In many countries, it was the manu- facturing sector that drove economic growth. Argentina, Brazil, Chile, Mexico, Mozambique, Nigeria, Pakistan, and India, to select only a few examples, all enjoyed average annual rates of manufacturing growth between 5 percent and 10 percent during the 1960s. A glimpse back at Table 6.1 indicates that, in Latin America, manufacturing’s share of the total economy increased substantially be- tween 1960 and 1980. Thus, although the policies that governments adopted had important effects on the distribution of income, they also appeared to be transforming developing societies into industrialized economies. Reforming the International Trade System Developing countries also tried to alter the rules governing international trade.

For many developing-country governments, these efforts reflected their experi- ence with colonialism. India’s perspective was not unique: International trade was “a whirlpool of economic imperialism rather than a positive instrument for achieving economic growth” (Srinivasan and Tendulkar 2003, 13). Conse- quently, as early as 1947, India, Brazil, and Chile were arguing that the multi- lateral rules the United States and Great Britain were writing failed to address the economic problems that developing countries faced (Kock 1969, 38–42).

Advancing the infant-industry justification for protection, many developing countries argued that their firms could not compete with established producers in the United States and Europe. Yet, GATT rules not only made no provi- sion for the infant-industry justification for protection but indeed, explicitly prohibited the use of quantitative restrictions and tightly restricted the use of tariffs.Developing countries insisted that they be given a relatively free hand in the use of trade restrictions to promote economic development, because the GATT failed to do so.

Developing countries continued to press for GATT reforms throughout the 1950s (see Kock 1969, 238; Finger 1991). By the early 1960s, a coalition of developing countries dedicated to far-reaching reform had emerged. Its first im- portant success was achieved with the formation of theUnited Nations Confer- ence on Trade and Development (UNCTAD) in March of 1964. The UNCTAD was established as a body dedicated to promoting the interests of developing countries in the world trade system. At the conclusion of this first UNCTAD conference, 77 developing-country governments signed a joint declaration call- ing for reform of the international trade system. Thus was born theGroup of 77, the leading force in the campaign for systemic reform. During the next 20 years, trade relations between the developing world and the advanced industri- alized countries revolved almost wholly around competing conceptions of inter- national trade rules embodied in the GATT and UNCTAD.

During the 1960s, the Group of 77 used UNCTAD to pursue three inter- national mechanisms that would increase their share of the gains from trade (Kock 1969; UNCTAD 1964; Williams 1991). First, the Group of 77 sought Domestic and International Elements of Trade and Development Strategies 129 commodity price stabilization schemes. Commodity price stabilization was to be achieved by setting a floor below which commodity prices would not be allowed to fall and by creating a finance mechanism, funded largely by the advanced industrialized countries, to purchase commodities when prices fell below the floor. Stabilizing commodity prices would be an important step toward stabilizing developing countries’ terms of trade (recall the Singer- Prebisch hypothesis). The Group of 77 also sought direct financial transfers from the advanced industrialized countries to compensate them for the pur- chasing power they were losing from declining terms of trade (UNCTAD 1964, 80). Developing countries also sought greater access to core-country markets, pressuring the advanced industrialized countries to eliminate trade barriers on primary commodities and to provide manufactured exports from developing countries with preferential access to the core countries’ markets.

These reform efforts yielded few concrete results. Core countries agreed to incorporate concerns specific to developing countries into the GATT char- ter. In 1964, three articles focusing on developing countries were included in theGATT Part IV. Part IV called upon core countries to improve market ac- cess for commodity exporters, to refrain from raising barriers to the import of products of special interest to the developing world, and to engage in “joint action to promote trade and development” (Kock 1969, 242). In the absence of meaningful changes in the trade policies pursued by the advanced industrial- ized countries, however, Part IV provided few concrete gains. The advanced in- dustrialized countries also allowed the developing countries to opt out of strict reciprocity during GATT tariff negotiations. The developing countries that belonged to the GATT were therefore able to benefit from tariff reductions without having to offer concessions in return. Benefits from this concession were more apparent than real, however; GATT negotiations focused primarily on manufactured goods produced by the advanced industrialized countries and excluded agriculture, textiles, and many other labor-intensive goods. Develop- ing countries were therefore exporting few of the goods on which the advanced industrialized countries were actually reducing tariffs. In the late 1960s, the ad- vanced industrialized countries agreed to theGeneralized System of Preferences (GSP), under which manufactured exports from developing countries gained preferential access to advanced industrialized countries’ markets. This conces- sion, too, was of limited importance, because advanced industrialized countries often limited the quantity of goods that could enter under preferential tariff rates and excluded some manufacturing sectors from the arrangement entirely.

Even though their efforts during the 1960s had achieved few concrete gains, the Group of 77 escalated its demands in the early 1970s. Escalated demands were sparked by the 1973 oil shock. The oil shock was a clear illus- tration of the potential for commodity power. The world’s major oil-produc- ing countries, working together in the Organization of Petroleum Exporting Countries (OPEC), used their control of oil to improve their terms of trade.

OPEC’s ability to use commodity power to extract income from the core coun- tries strengthened the belief within the Group of 77 that commodity power could be exploited to force fundamental systemic change. 130 CHAPTER 6 Trade and Development I: Import Substitution Industrialization Greater confidence in the possibilities that their control of commodities offered led the Group of 77 to develop a set of radical demands dubbed the New International Economic Order (NIEO). The NIEO represented an at- tempt to create an international trade system whose operation would promote development (see Krasner 1985). The NIEO, which the UN General Assem- bly adopted in December 1974, embodied a set of reforms that would have radically altered the operation of the international economy. In addition to the three mechanisms that developing countries had demanded during the 1960s, the NIEO included rules that would grant developing countries greater con- trol over multinational corporations operating in their countries, easier and cheaper access to northern technology, a reduction in foreign debt, increased foreign aid flows, and a larger role in the decision-making processes of the World Bank and International Monetary Fund (IMF).

Governments in the advanced industrialized countries refused to make significant concessions, and by the mid-1980s the NIEO had disappeared from the international agenda. The failure of the NIEO has been attributed to a number of factors. First, developing countries were unable to establish and maintain a cohesive coalition. The heterogeneity of developing countries’ interests made it relatively easy for the advanced industrialized countries to divide the Group of 77 by offering limited concessions to a small number of governments in exchange for defection from the broader group. In addition, the Group of 77 had hoped that OPEC would assist it by linking access to oil to acceptance of the NIEO. But OPEC governments were unwilling to use their oil power to help other developing countries achieve broader trade and development objectives.

Most importantly, however, by the early 1980s, many developing coun- tries were facing serious balance-of-payments problems and turned to the IMF and the World Bank for financial support. The need to obtain IMF and World Bank assistance altered the balance of power in favor of the advanced indus- trialized countries. This power shift sparked a reform process that changed fundamentally development strategies throughout the developing world.

POLICY ANALYSIS AND DEBATE The Millennium Development Goals Question Can the Millennium Development Goals eradicate extreme poverty?

Overview Members of the UN agreed in 2000 to focus their development policies around the eight Millennium Development Goals (MDGs). The MDGs are ambitious, and include (among other things) cutting extreme poverty (measured as living on less Domestic and International Elements of Trade and Development Strategies 131 than one dollar per day) in half by 2015. Governments are to achieve these goals through extensive planning at the domestic and international levels. Policies based on these plans will in turn be supported by foreign aid offered by the international community. For that purpose, the UN has called upon rich countries to increase foreign aid expenditures to 0.7 percent of GDP by 2015 (from the then current average of about 0.25 percent).

The logic upon which MDGs rest is similar to the thinking that shaped ISI. The MDGs rest on a diagnosis of poverty that emphasizes structural factors. Rather than emphasize market failure, however, contemporary thinking emphasizes a “poverty trap.” “When poverty is extreme, the poor do not have the ability—by themselves—to get out of the mess . . . When [people] are utterly destitute, they need their entire income, or more, to survive . . . There is no margin of income above survival that can be invested for the future” (Sachs 2005, 56). People can escape the poverty trap only with the help of the contemporary analogue of the “big push.” The international community must provide “a leg up” through well-funded and well-conceived government policy initiatives. Given the logic upon which they are based, do you think the MDGs will cut extreme poverty by 50 percent?

Policy Options • An MDG-like strategy is necessary if the world is to eradicate extreme poverty.

Governments must embrace these goals.

• The MDGs rest on faulty logic and thus cannot reduce extreme poverty.

Governments should reevaluate their approach to the problem of global poverty.

Policy Analysis • Do developing-country governments have incentives to implement the policies called for by the MDG strategy? Why or why not?

• Do advanced industrialized countries have incentives to provide the foreign aid that is required to support MDG policies? Why or why not?

Take a Position • Which option do you prefer? Justify your choice.

• What criticisms of your position should you anticipate? How would you defend your recommendation against these criticisms?

Resources Online: To learn more about the MDGs and current progress toward achieving them, conduct an online search for the keywords UN andMDGs. Look especially for the UN’s annual progress reports.

In Print: Read the alternative perspectives embodied in Jeffrey Sachs’ Ending Poverty:

Economic Possibilities of Our Time (New York: Penguin Press, 2005), and William Easterly’s The White Man’s Burden: Why the West’s Efforts to Aid the Rest Have Done So Much Ill and So Little Good (New York: Penguin Publishers, 2006). 132 CHAPTER 6 Trade and Development I: Import Substitution Industrialization CONCLUSION Throughout much of the postwar period, developing countries insulated them- selves from the world trade system. The interaction between domestic poli- tics on the one hand, and economic shocks and decolonization on the other, generated governments that were highly responsive to the interests of import- competing manufacturing industries and a growing class of urban workers.

Influenced greatly by structuralism, most governments transformed the political incentive to protect these domestic industries into ambitious state-led development strategies. Structuralism’s critique of the ability of domestic and international markets to promote industrialization led governments to inter- vene in domestic markets to overcome the market imperfections that reduced private incentives to invest in manufacturing activities.

To the extent that developing countries participated in the global trade sys- tem, they sought to achieve far-reaching reform of the rules governing the system.

Again, the structuralist critique served an important role in this effort, as it suggested that developing countries could not expect to gain from trade with the advanced industrialized countries until they themselves had industrialized. More- over, structuralism claimed that trade based on GATT rules would only make industrialization harder to achieve. Rather than accept participation in the global economy on what they viewed as vastly unequal terms, developing countries bat- tled to change the rules governing international trade in order to capture a larger share of the available gains. Thus, an international struggle over the distribution of the gains from trade arose as an important counterpart of the domestic strategy of redistributing resources from agriculture to industry embodied in ISI.

KEY TERMS Backward Linkages Big Push Complementary Demand Easy ISI Enclave Agriculture Export Substitution Strategy GATT Part IV Generalized System of PreferencesGroup of 77 Import Substitution Industrialization Monoexporters New International Economic Order Pecuniary External Economies Secondary ISI Singer-Prebisch Theory Structuralism Terms of Trade United Nations Conference on Trade and Development SUGGESTIONS FOR FURTHER READING For a readable introduction to structuralism and development strategies more generally, see Ian Little,Economic Development (New York: Basic Books, 1982).

For an in-depth look at Latin America, see Victor Bulmer-Thomas,The Economic History of Latin American since Independence (Cambridge: Cambridge University Press, 2003). For a comparative study of the role of the state in development, see Atul Kohli,State-Directed Development: Political Power and Industrialization in the Global Periphery (Cambridge: Cambridge University Press, 2004).

For a detailed examination of the New International Economic Order, see Stephen Krasner,Structural Conflict: The Third World against Global Liberalism (Berkeley:

University of California Press, 1985). 133 Trade and Development II:

Economic Reform W hereas structuralism and import substitution industrialization (ISI) shaped development strategies during the first 35 years of the post- war period, the last 30 years have been dominated by neoliberal- ism and export-oriented industrialization. In contrast to structuralism, with its skepticism about the market and faith in the state, neoliberalism is highly skeptical of the state’s ability to allocate resources efficiently and places great faith in the market’s ability to do so. And in contrast to structuralism’s ad- vocacy of protectionism and state intervention, neoliberalism advocates the state’s withdrawal from the economy, the reduction (ideally, elimination) of trade barriers, and reliance on the market to generate industries that produce for the world market.

Like structuralism, neoliberalism has dramatically affected policy. Across the developing world, governments have reduced tariffs and removed other trade barriers, thereby opening their economies to imports. They have sold state-owned enterprises to private groups. They have deregulated their econo- mies to allow prices to reflect the underlying scarcity of resources. They have shifted their emphasis from producing for the domestic market to producing for the global market. Countries that had never joined the General Agreement on Tariffs and Trade (GATT) sought membership in the World Trade Orga- nization (WTO). Thus, the last 30 years have brought a complete reversal of the development strategies that most governments had adopted. Belief in the power of states has been replaced by belief in the efficacy of the market; skep- ticism about trade has been replaced by concerted efforts to integrate deeply into the world trade system. Neoliberalism has replaced structuralism as the guiding philosophy of economic development.

The shift from structuralism to neoliberalism emerged from the interplay between three developments in the global economy. First, by the early 1970s, ISI was generating economic imbalances. The emergence of these imbalances suggested that economic reform of some type was required, although it did not point to a specific solution. Second, at about the same time, it 7 CHAPTER 134 CHAPTER 7 Trade and Development II: Economic Reform was becoming apparent that a small group of East Asian economies were outperforming all other developing countries based on what many viewed as a neoliberal strategy. Third, a severe economic crisis in the early 1980s forced governments to embark on reform, and as they did, the International Monetary Fund (IMF) and World Bank strongly encouraged them to base reform on the neoliberal model.

We examine each of these three developments. We look first at the factors that caused ISI to generate economic imbalances. This examination allows us to understand the problems ISI created and the reasons that reform of some type was necessary. We then turn our attention to the East Asian countries.

We briefly compare their performance with that of the rest of the develop- ing world. We next examine two contrasting explanations for this remarkable performance, one that emphasizes the neoliberal elements of those countries’ strategies and one that emphasizes the role East Asian states played in the development process. We then turn to economic crisis and reform. We look at how the crisis pushed developing countries to the World Bank and the IMF and at how these two institutions shaped the content of the reforms govern- ments adopted. The chapter concludes by examining the challenges that devel- oping countries now confront as active participants in the WTO.

EMERGING PROBLEMS WITH IMPORT SUBSTITUTION INDUSTRIALIZATION By the late 1960s, ISI was generating two important economic imbalances, which together suggested that it had reached the limits of its utility as a de- velopment strategy. The first imbalance lay in government budgets. ISI tended to generate persistent budget deficits because it prescribed heavy government involvement in the economy. Since governments believed that the private sector would not invest in industries that were important for the success of secondary ISI, governments themselves often made the investments, either in partnership with private-sector groups or alone by creating state-owned enterprises.

Yet, many of these state-owned enterprises never became profitable. By the late 1970s, state-owned enterprises in developing countries were running combined operating deficits that averaged 4 percent of gross domestic product (GDP) (Waterbury 1992, 190). Governments kept these enterprises afloat by using funds from the state budget. Government investment and the subsequent need to cover the losses of state-owned enterprises combined to generate large and persistent budget deficits throughout the developing world.

Domestic politics aggravated the budget deficits generated by ISI. For many governments, urban residents provided critical political support.

Governments maintained this support by subsidizing essential items.

Electricity, water and sewer, transportation, telephone service, and food were all made available to urban residents at below-market prices. This was possible only by using government revenues to cover the difference between the true cost and the price charged. In addition, many governments expanded Emerging Problems with Import Substitution Industrialization 135 the civil service to employ urban dwellers. In Benin, for example, the civil service tripled in size between 1960 and 1980, not because the government needed so many civil servants, but because the government used it to employ urban residents in order to maintain support. Such practices added to government expenditures and added nothing to government revenues, thereby worsening the budget deficit.

ISI also generated a second important imbalance: persistent current- account deficits. Thecurrent account registers a country’s imports and exports of both goods and services. A current-account deficit means that a country is importing more than it is exporting. Import substitution gave rise to current-account deficits because it generated a considerable demand for imports while simultaneously reducing the economy’s ability to export.

Somewhat ironically, ISI depended on imports. Industrialization required countries to import the necessary machines, and once these machines were in place, production required continued import of parts that were not produced in the domestic economy.

Exports declined for two reasons. First, the manufacturing industries created through import substitution were not competitive in international markets. Production in many of the heavy industries that governments tar- geted in secondary ISI is characterized by economies of scale. The domes- tic market in most developing countries, however, was too small to allow domestic producers to realize economies of scale. These inefficiencies were compounded by excess capacity—the creation of more production capacity than the domestic market could absorb (see Little, Scitovsky, and Scott 1970, 98). Consequently, the newly created manufacturing industries could not export to the world market.

Second, the policies that governments used to promote industrializa- tion weakened agriculture. The decline in agricultural production was most severe in sub-Saharan African countries, which, as a region, taxed farmers heavily (Schiff and Valdés 1992). Heavy tax burdens reduced farmers’ incen- tives to produce, hence the rate of growth of agriculture declined. In Ghana, for example, the real value of the payments that cocoa farmers received from the government marketing board fell by about two-thirds between 1960 and 1965. Falling prices gave cocoa farmers little incentive to invest in order to maintain, let alone increase, cocoa output (Killick 1978, 119). In addition, cocoa farmers smuggled much of what they did produce into the Ivory Coast, where they could sell cocoa at world prices (Herbst 1993, 40).

These microeconomic inefficiencies were reinforced by the tendency of most governments to maintain overvalued exchange rates. Ideally, a govern- ment should maintain an exchange rate that equalizes the prices of goods in the domestic and foreign markets. However, under ISI, many governments set the exchange rate higher than that, and as a result, foreign goods were cheaper in the home market than they should have been and domestic goods were more expensive in foreign markets than they should have been. Because foreign goods were underpriced in the domestic market, capital goods and intermediate inputs could be acquired from abroad at a lower cost than they 136 CHAPTER 7 Trade and Development II: Economic Reform could be produced at home. This difference in price created a strong incentive to import, rather than creating the capacity to produce the goods locally. The result was rising imports. Because domestic goods were overpriced in foreign markets, domestic producers, even when efficient, found it difficult to export.

The emergence of budget deficits and current-account deficits indicated that ISI was creating an economic structure that couldn’t pay for itself. Many of the manufacturing industries created during secondary ISI could not sell their products at prices that covered their costs of production. Many develop- ing countries could not export enough to pay for the imports demanded by the manufacturing industries they were creating. Such imbalances could not persist forever; some reform was clearly necessary.

Yet, the domestic politics of ISI greatly constrained the ability of govern- ments to implement reforms. The balance of power among domestic interest groups created multiple veto players that limited the ability of governments to alter policies. Because governments depended so heavily on urban residents for political support, they could not easily reduce benefits provided to that group (Waterbury 1992, 192). In 1971, for example, the Ghanaian prime minister devalued the exchange rate in an attempt to correct Ghana’s current- account deficit. Concern that devaluation would raise the prices of many im- ported goods consumed by urban residents contributed to a coup against the government a few days later. Once in power, the new regime quickly restored the currency to its previous rate (Herbst 1993, 22–23). What message did that send to politicians who might be contemplating measures to address the eco- nomic imbalances they were facing?

In addition, the administration of ISI had created opportunities for rent seeking and other corrupt practices. Those who engaged in these activities had a vested interest in the continuation of the system. On the one hand, government intervention had established an environment conducive torent seeking (Krueger 1974; Bhagwati 1982)—efforts by private actors to use the political system to achieve a higher-than-market return on an economic activity. Consider, for example, the consequences of government controls on imports. Governments controlled imports by requiring all residents who wanted to import something to first gain the permission of government authorities. Such restrictions meant that imported goods were scarce, thus imports purchased at the world price could be sold at a much higher price in the domestic market. The difference between the world price and the domestic price provided a rent to the person who imported the good. A government license to import, therefore, was valuable. Consequently, people had incentives to pay government civil servants to acquire licenses, and government civil servants had incentives to sell them.

Such behavior was extraordinarily costly. It has been estimated, for exam- ple, that rent seeking cost India about 7 percent and Turkey about 15 percent of their national incomes during the 1960s (Krueger 1974, 294). Because so many people inside the government and in the economy were benefiting from the opportunities for rent seeking, they had a very strong incentive to resist any efforts by the government to dismantle the system. The East Asian Model 137 Finally, even if governments could overcome these obstacles, it was un- clear what model they should shift to. Far-reaching reforms would require them to reevaluate the underlying strategy they were using to industrialize.

The only available alternative to ISI was a market-oriented development strat- egy (one we will look at in detail in the next section). In the 1970s, how- ever, it was precisely this strategy that the Group of 77 was fighting against in the UNCTAD and with the NIEO. Even moderate reforms held little appeal.

Most governments were unwilling to scale back their industrialization strate- gies. Instead, they looked for a way to cover the twin deficits without having to scale back their ambitious plans.

Facing economic imbalances, unable and unwilling to change policy, many governments sustained ISI by borrowing from abroad. Yet foreign loans could provide only a temporary solution; foreign lenders would eventually question whether loans could be repaid. When they concluded that they couldn’t, they would be unwilling to lend more, and governments would be forced to cor- rect budget and current-account deficits. This point arrived in the early 1980s and ushered in a period of crisis and reform. Before we examine this period, however, we must look at economic developments in East Asia, as these devel- opments played a critical role in shaping the content of the reforms adopted throughout the developing world after 1985. THE EAST ASIAN MODEL Whereas ISI was generating imbalances in Latin America and sub-Saharan Africa, four East Asian economies—Hong Kong, Singapore, South Korea, and Taiwan—were realizing dramatic gains on the basis of a very different devel- opment strategy. The dramatic performance gap is evident in three economic indicators. (See Table 7.1.) Per capita income in East Asia grew almost three times faster than in Latin America and South Asia and more than twenty-six times higher than in sub-Saharan Africa. Manufacturing output grew by 10.3 percent per year between 1965 and 1990. No other developing country came close to this growth for the period as a whole Exports from East Asia grew 8.5 percent per year between 1965 and 1990 while exports from Latin America shrank by 1 percent per year.

As a consequence, manufacturing grew in importance in East Asia, while the importance of agriculture diminished. This differed substantially from ISI countries, where agriculture’s importance fell but manufacturing failed to grow. (See Table 6.1.) The growing manufacturing sector transformed the composition of East Asia’s exports. (See Table 6.2.) By the mid-1990s, manu- factured goods accounted for more than 80 percent of East Asian exports. By contrast, only in Brazil, Mexico, India, and Pakistan did manufactured goods account for more than 50 percent of total exports by the 1990s, and most of these gains were realized after 1980. Finally, per capita incomes in East 138 CHAPTER 7 Trade and Development II: Economic Reform TABLE 7.1 Comparative Economic Performance, Selected Developing Countries (Average Annual Rates of Change)* 1965–1990 1985–1995 Growth of per Capita GNP East Asia and the Pacific 5.3 7.2 Sub-Saharan Africa 0.2 1.1 South Asia 1.9 2.9 Latin America and the Caribbean 1.8 0.3 Growth of Manufacturing East Asia and the Pacific 10.3 15.0 Sub-Saharan Africa n.a. 0.2 South Asia 4.5 5.3 Latin America and the Caribbean 8.3 2.5 Growth of Exports East Asia and the Pacific 8.5 9.3 Sub-Saharan Africa 6.1 0.9 South Asia 1.8 6.6 Latin America and the Caribbean 2.1 5.2 *n.a., not available; GNP, gross national product.

Source: World Bank, World Development Report, various issues. Asia soared above those in other developing countries ( Table 7.2). In 1960, per capita incomes in East Asia were lower than per capita incomes in Latin America; by 1990, East Asian incomes were higher than—in some cases twice as large as—per capita incomes in Latin America.

Why did East Asian countries outperform other developing countries by such a large margin? Most who study East Asian development agree that the countries in the region distinguished themselves from other developing coun- tries by pursuing export-oriented development. In anexport-oriented strat- egy, emphasis is placed on producing manufactured goods that can be sold in international markets. Scholars disagree about the relative importance of the market and the state in creating export-oriented industries. One position, the neoliberal interpretation, is articulated most forcefully by the IMF and the World Bank. This thesis argues that East Asia’s success was a consequence of market-friendly development strategies. In contrast, the state-oriented inter- pretation, advanced by many specialists in East Asian political economy ar- gues that East Asia’s success is due in large part to state-led industrial policies.

The IMF and the World Bank contend that East Asia’s economic success derived from the adoption of a neoliberal approach to development. This in- terpretation places particular emphasis on the willingness of East Asian gov- ernments to embrace of international markets and their ability to maintain The East Asian Model 139 TABLE 7.2 Gross National Product per Capita, Selected Developing Countries (1996 U.S. Dollars) 1960 1990 2000 Percent Change 1960–2000 Hong Kong 3,090 20,827 26,699 764 Singapore 2,161 17,933 24,939* 1,054 Taiwan 1,430 10,981 17,056** 1,093 South Korea 1,495 9,952 15,876 962 Mexico 3,980 7,334 8,762 120 Malaysia 2,119 6,525 9,919 368 Argentina 7,371 7,219 11,006 49 Chile 3,853 6,148 9,926 158 Brazil 2,371 6,218 7,190 203 Thailand 1,091 4,833 6,857 528 Zaire/Congo 980 572 281*** – 71 Indonesia 936 2,851 3,642 289 Pakistan 633 1,747 2,008 217 India 847 1,675 2,479 193 Nigeria 1,033 1,095 707 – 32 Kenya 796 1,336 1,244 56 Zambia 1,207 1,021 892 – 26 Tanzania 382 494 482 26 *Data for 1996; **data for 1998; ***data for 1997.

Source: Penn World Tables. stable macroeconomic environments. (See World Bank 1989, 1991, 1993; Little 1982; Lal 1983; for critiques, see Toye 1994 and Rodrik 1999.) Most East Asian governments adopted ISI strategies in the immediate postwar period. Unlike governments in Latin America and Africa, however, East Asian governments shifted to export-oriented substitution once they had exhausted the gains from easy ISI. In Taiwan, for example, the government shifted in 1958 from production for the domestic market to a strategy that emphasized production for export markets. South Korea adopted similar reforms in the early 1960s. A second wave of newly industrializing countries (NICs)—a group that includes Indonesia, Malaysia, and Thailand—followed the same path starting in the late 1960s (World Bank 1993). The emphasis on exports forced Asian manufacturing firms to worry about international competitive- ness. As a result, the World Bank and the IMF argue, Asian societies invested their resources in domestic industries profitable in world markets.

The shift to export-oriented strategies was followed by selective import liberalization. Asian governments did not engage in wholesale import liber- alization. The Taiwanese and South Korean governments continued to rely heavily on tariff and nontariff barriers to protect domestic markets. In Taiwan, 140 CHAPTER 7 Trade and Development II: Economic Reform for example, approximately two-thirds of imports were subject to some form of tariff or nontariff barrier greater than 30 percent, and as late as 1980 more than 40 percent of imports faced protection greater than 30 percent (World Bank 1993, 297). A similar pattern appeared in South Korea, where, as late as 1983, “most sectors were still protected by some combination of tariffs and nontariff barriers” (World Bank 1993, 297). However, selective liberalization helped promote exports by reducing the cost of critical inputs. Reducing tar- iffs on key intermediate goods, such as looms and yarn in the textile industry, enabled domestic producers to acquire inputs at world prices. This kept ex- ports competitive in international markets.

East Asian governments also maintained stable macroeconomic environ- ments. Three elements of the macroeconomic environment were particularly important. First, inflation was much lower in East Asia than in other devel- oping countries. Between 1961 and 1991, inflation averaged only 7.5 percent in the East Asian economies. By contrast, annual inflation rates in the rest of the developing world averaged 62 percent (World Bank 1993, 110). Second, because governments kept inflation under control, they could maintain appro- priately valued exchange rates. In many developing countries, high inflation caused the domestic currency to rise in value against foreign currencies, making exporting difficult. In the East Asian countries, by contrast, governments were able to maintain exchange rates that allowed domestic firms to remain compet- itive in foreign markets. Third, East Asian governments pursued relatively con- servative fiscal policies. They borrowed little, and when they did borrow, they tapped domestic savings rather than turning to international financial markets.

This approach was in stark contrast to Latin American governments, which ac- cumulated large public-sector deficits financed with foreign capital.

This stable macroeconomic environment had beneficial consequences for Asian economic performance. Low inflation promoted high savings rates and investment (World Bank 1993, 12). Savings rates in the Asian NICs averaged more than 20 percent of GDP per year, almost twice the level attained in other developing countries, whereas investment rates were 7 percentage points of GDP higher, on average, than in other developing countries (World Bank 1993, 16, 221). A stable macroeconomic environment also made it easier to open the economy to international trade. Because inflation was low and ex- change rates were maintained at appropriate levels, trade liberalization did not generate large current-account deficits. Finally, the ability to maintain rel- atively stable and appropriately valued real exchange rates encouraged private actors to invest in export-oriented industries.

The interaction between the export orientation, the relatively liberal im- port policy, and the stable macroeconomic environment promoted economic deve