Cambridge Journal of Economics 2001, 25, 809–825
CRITICAL SURVEY
This is the latest in our series of Critical Survey articles. The aim of the series is to report on recent
developments, to provide an assessment of alternative approaches and to suggest lines of future inquiry.
The intention is that the articles should be accessible not only to other academic researchers but also to
students and others more practically involved in the economy. Recent Survey articles include Ron Martin
on ‘The New “Geographical Turn in Economics”’, Sergio Cesaratto on ‘Saving and Economic Growth
in Neoclassical Theory’ and Ben Fine on ‘Endogenous Growth Theory’.
New trade theory versus old trade policy:
a continuing enigma
Sonali Deraniyagala and Ben Fine*
This paper examines the theoretical and empirical grounds for trade liberalisation.
We note that many of the conventional arguments relating to the static and dynamic
gains from liberalisation are based on fragile theoretical grounds. We also show that,
although new trade theory takes account of some of the complexities of international
trade and although the analytical thrust of many models justifies intervention, such
policy conclusions are rejected even by those at the forefront of these theories on the
grounds of political economy arguments which do not stand up to careful scrutiny.
Finally, we show that arguments favouring trade liberalisation are not supported by
existing empirical research, which generally fails to capture the complex and ambiguous
effects of liberalisation and openness.
Keywords: Trade, Trade policy, Country and industry studies of trade
JEL classifications: F12, F14, F43
Introduction
As reported in Prasch (1996), support for free trade amongst academic economists in the
USA is astonishingly high at 97%! It has enabled Anne Krueger (1997),1
Chief Economist
at the World Bank during the 1980s and chief promoter of the neoliberal Washington
consensus, to engage in a history of economic thought in which the central question
becomes one of explaining why economists should have resisted the charms of free trade
Manuscript received 9 April 1999; final version received 25 November 1999.
Address for correspondence: Professor B. Fine, Department of Economics, SOAS, University of London,
Thornhaugh Street, Russell Square, London WC1H 0XG, UK; email bf@soas.ac.uk
* SOAS, University of London. This article was completed while Ben Fine was in receipt of a Research
Fellowship from the UK Economic and Social Research Council (ESRC) under award number R000271046
to study ‘The New Revolution in Economics and Its Impact upon Social Sciences’. It draws upon Fine
(1997).
1
See also Krueger (1998) and response from Ocampo and Taylor (1998).
© Cambridge Political Economy Society 2001
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810 S. Deraniyagala and B. Fine
for so long, given both its virtues in practice and its centrality within standard theory of
comparative advantage. Her answer essentially boils down to the idea that otherwise idle
theorists have made mischief by deploying models of market imperfections without due
regard to the stylised facts. In short, for her, if the stylised (neoclassical) theory does not
support the stylised policies, it’s time to get real. However, as will be shown in much of the
discussion that follows, the recent trade literature has, within the confines of an evolving
neoclassical theory of market imperfections, made great attempts to address at least some
of the realities of trade. By doing so, from the perspective of neoliberalism, it has been
extremely mischievous, if not troublesome, in view of the extent to which its conclusions
have been over-ruled by the forward march of support for trade liberalisation.
This paper critically examines the theoretical and empirical grounds for trade liberalisation.
We note that many of the conventional arguments relating to the static and dynamic
gains from liberalisation are based on fragile theoretical grounds. We also show that,
although new trade theory takes account of some of the complexities of international trade
and although the analytical thrust of many models justifies intervention, such policy conclusions
are rejected even by those at the forefront of these theories, on the grounds of
political economy arguments which do not stand up to careful scrutiny. Finally, we show
that arguments favouring trade liberalisation are not supported by existing empirical
research, which generally fails to capture the complex and ambiguous effects of liberalisation
and openness.
Section 1 examines conventional theoretical arguments relating to trade liberalisation
and Section 2 reviews recent developments in new trade theory. Section 3 examines the
empirical research relating to liberalisation dealing with both cross-country research and
industry and firm-level studies. We close with a brief summary.
1. Conventional arguments for trade liberalisation
The literature on trade liberalisation differentiates between the static and dynamic gains
from trade policy reform. While the economic arguments relating to static gains are
straightforward, it is also generally acknowledged that the magnitude of these gains is
fairly low. Static, once-and-for-all gains arise as the misallocation of resources under protection
and import substitution is corrected, and resources shift from inefficient to
efficient sectors, activities and firms. The gains take the form of the well-known Harberger
welfare triangles. However, empirical estimates of the welfare costs of these relative-price
distortions rarely exceed 2 or 3 percentage points of GDP (Bhagwati, 1993; Pursell,
1990). The response of mainstream theorists to these negligible welfare gains has been to
extend these welfare triangles by emphasising the dynamic, long-term gains from liberalisation.
While a range of arguments relating to long-term benefits have been produced,
closer scrutiny shows them to hinge on fairly arbitrary assumptions, and to be thus lacking
both theoretical consistency and empirical validity.
One way of inflating welfare triangles has been to incorporate rent seeking, with the
focus being on the calculation of welfare losses from government trade interventions,
especially the introduction of import quotas. It has been argued that the resource costs of
trade interventions are multiplied severalfold by the existence of rent seeking. Empirical
estimates have shown the magnitudes of the costs to be large (de Melo and Robinson,
1982; Gallagher, 1991; Tarr, 1992). As Ocampo and Taylor (1998) note, however, it is
difficult to accept these estimates at face value; if quotas cover only a fraction of imports
and if imports are only a fraction of GDP, rents and rent-seeking outlays cannot be
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New trade theory versus old trade policy 811
significant. It is also interesting to note that there has been little empirical research on
whether rents have actually declined following liberalisation. This is especially so of institutions
such as the research department of the World Bank, which has undertaken large
multi-country studies to establish the gains from liberalisation. Onis (1991) is a notable
exception, showing that Turkish policy moves towards export orientation gave rise to a
new type of rent seeking directed at obtaining export quotas.
Another argument relating to the dynamic gains from liberalisation centres around
X-efficiency and entrepreneurial effort. By reducing competition and increasing relative
prices in import-competing sectors, protection encourages entrepreneurial slack. Formal
representations of this argument have revealed its fragility (Tybout, 1992). It only holds
when the entrepreneurial labour supply curve is upward sloping in the relevant range and
when changes in work incentives operate in the same direction for both exporters and
import-substituting producers. As we show in Section 3, the empirical evidence relating
to trade policy and efficiency also fails to provide conclusive support for this argument.
Increasing returns to scale (IRS) are frequently cited as an important source of dynamic
gains from liberalisation. Firms in more open trade can supposedly operate at lower costs
owing to higher levels of output, available through participating in world markets. This
argument, however, is based on the assumption that liberalisation necessarily expands
IRS activities. If scale economies are mainly concentrated in protected sectors which
decline following trade reform, this type of dynamic gain will not materialise. As Rodrik
(1994, p. 159) notes, ‘whether scale effects add or subtract from resource allocation
effects depend on a variety of factors with no clear-cut presumption either way’. Another
variant of this argument is that protection increases profitability and leads to the coexistence
of too many firms producing at below minimum efficient scale. Liberalisation, therefore,
leads to industry rationalisation and allows firms to benefit from scale effects and
produce at lower average costs. Again, this argument is also questionable, as it assumes
easy and frictionless entry into and exit from markets.
Long-term productivity gains are also seen to ensue from the correction of the anticompetition,
anti-export bias of protection which will have discouraged cost-cutting technological
change. In much of the policy literature on developing countries, the precise
mechanism by which trade reform has promoted technological dynamism has never been
fully spelt out (e.g., Balassa, 1988). Increased levels of competition are taken as sufficient
to generate increased innovative activity and productivity gains across all sectors. The fact
that relative-price distortions such as tariffs may adversely affect learning and technology
development in some sectors but not in others, and the possibility that various instruments
of trade intervention may have differential consequences for innovative activity,
have not always been considered. More importantly, the simplistic notion that high levels
of competition unambiguously promote technological change ignores the well-established
body of research on market structure and innovation, which indicates that this is not
necessarily true (Evenson and Westphal, 1995). Such assertions about the beneficial
effects of trade-related competition on innovation are also found in recent analyses which
otherwise claim to question the mainstream approach to trade policy adopted by the
World Bank and the International Monetary Fund (IMF), in forming a new ‘PostWashington
Consensus’ (Stiglitz, 1998).
Overall, a general feature of conventional arguments relating to the dynamic effects of
trade liberalisation is that they are not located within a coherent theory of industrial performance.
In recent years, considerable attention has been focused on technology-related
factors in influencing firm and industry-level productivity and the fact that technology
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812 S. Deraniyagala and B. Fine
development is the outcome of a complex interaction of supply-side and demand-side
factors. That these are highly sector and country specific (such as technological skills and
institutions, scientific and technological paradigms, relative price and demand changes
and so on) has been emphasised (Evenson and Westphal, 1995). The adaptive and incremental
types of below-the-frontier type of technological activity typically undertaken by
developing country firms have also been shown to be the outcome of such processes (Bell
and Pavitt, 1992). In this context, to expect productivity improvement to be largely determined
by trade liberalisation and international competition alone is naïve. As we show
below, such notions of industrial performance are evident both in recent trade models
which incorporate increasing returns, imperfect competition and technology spillovers
and in empirical analyses of liberalisation.
2. New trade theory
New trade theory is now entering its middle age, having been established in the 1980s
(Ethier, 1982; Krugman, 1984,1986; Brander and Spencer, 1985; Eaton and Grossman,
1986; Grossman and Horn, 1988; Grossman and Helpman, 1991). In general, its models
attempt to address the shortcomings of standard trade theory by dealing with some of the
realities of trade in a more complex and sophisticated manner by incorporating a fuller
range of factors. However, they provide few, if any, unambiguous conclusions.
New trade models incorporate four innovations within neoclassical economics: market
imperfections, strategic behaviour and the new industrial economics, new growth theory
and political economy arguments. Many of the models based on market imperfections
and strategic behaviour justify interventionist trade policy. While much of the literature
linking trade and new growth theory favours trade liberalisation (mainly on the grounds of
knowledge spillovers), here too the possibility that free trade may be detrimental to economic
growth is allowed for. Overall, however, interventionist trade policies are rejected
even by those at the forefront of these theories, mainly on the basis of political economy
arguments (such as rent seeking). Below, we examine the fragility of these political economy
arguments when we discuss the four innovations linked to new trade theory in
detail.
2.1 Market imperfections and strategic behaviour
First, the IRS conventionally used to justify protection have been complemented by a
range of other market imperfections. These include informational asymmetries and
imperfections which inform so much of recent innovation within mainstream microeconomics,
which is itself usually seamlessly transformed into understandings of the
economy as a whole. Second, new trade theory also draws upon the new industrial economics,
with models incorporating the strategic behaviour of all agents, firms as well as
governments. This involves game theory, intertemporal optimisation, and issues of time
consistency, especially for government policy (the possibility of changing policy commitments
after the private sector has invested, of which the latter can be aware).1
We shall
address the literature around these two sets of innovations together.
Informational asymmetries and adjustment costs are dealt with in models which consider
optimal technology choice over time. Ohyama and Jones (1995) allow for one
1
See McKay and Milner (1997) for problems in the design of policy so that ex post outcomes coincide with
ex ante intent.
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New trade theory versus old trade policy 813
country deliberately to fall behind another so that, with adjustment costs, leaping ahead in
the future becomes less expensive. It becomes possible to explain both falling behind,
catch-up and leapfrogging. Leahy and Neary (1996) consider such issues in the context of
R&D rivalry, although Durkin (1997) shows that pursuit of comparative advantage in
producing technological progress itself can lead to inefficiency (home country may be
better at producing innovation in the factor-rich sector of the other country!).
In models involving strategic behaviour, results differ depending upon stylised assumptions.
Various assumptions about the sorts of competition and oligopolistic behaviour
considered are made. Thus, Bhattacharjea (1995) finds that both strategic industrial
policy (on entry/exit) and tariffs are necessary under imperfect competition at home and
abroad and endogenous market structure. Fuerst and Kim (1997) and van Long and
Soubeyran (1997) take account of heterogeneity in costs functions, with trade policy
affecting the distribution of production across (more or less efficient) firms within countries
as well as across countries. The effect of vertical integration is modelled by Bernhofen
(1997), Ziss (1997), Holm (1997) and Jie-A-Joen (1997). Pal and White (1998) incorporate
considerations of privatisation (the removal of a firm that acts strategically to
maximise domestic welfare rather than profit), and Devereux and Lee (1999) address
interaction with internationalisation of financial markets and extent of trading in productive
assets across countries.
Strategic trade models also involve consideration of the policy instruments that governments
are allowed to deploy and the sequencing of decision-making. Sleuwagen et al.
(1998) examine the issue of cascading protection—to what extent and in what circumstances
is protection passed on and how are its costs and benefits distributed. Karp and
Perloff (1995) find differential effects of protection when policy instruments are targeted
at investment as opposed to output (not affecting or affecting long-term outcomes, res-
pectively).
The relevance of these new trade models to developing countries has been debated
(Lucas, 1988; Bardhan, 1995; Ruttan, 1998). While some strategic models with oligopolistic
players dominating world markets may be of limited relevance to low-income
developing countries (Stewart, 1991), arguments for intervention based on scale economies
and imperfect competition are widespread in developing countries, rendering these
theories especially relevant for them (Helleiner, 1992). Empirical evidence indicates that
imperfect competition is indeed rampant (Lee, 1992), although the evidence on scale
economies is much more limited.
Thus, models based on strategic behaviour are highly diverse, given the underlying
factors and assumptions over which they range. But, what they all tend to have in common
is the result that strategic trade policy is justified and, in addition, that it should be
complemented by other forms of policy (or take a variety of forms). Such a conclusion
should not come as a surprise, for it is presumably only by accident that free trade will be
optimal in the presence of market imperfections and, further, the more numerous the
imperfections, the more instruments we need to deal with them. Further, given the diversity
of the models, it also follows that interventions will need to be selective and country/
sector specific depending upon the type and strength of market imperfections involved.
Of course, the standard neoliberal response to these models is to claim that government
has neither the knowledge nor the ability to be selective in its policy interventions. The
supposedly large informational requirements are one reason why the analytical thrust of
trade theory in justifying interventionist trade policy has been rejected even by those at the
forefront of the theory. Yet, the literature is itself well suited to handle such issues, since it
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814 S. Deraniyagala and B. Fine
has drawn upon the economics of imperfect and asymmetric information. If governments
are less well-informed than the private sector (and less able), does it follow they should do
nothing? The answer is resoundingly in the negative and should not come as a surprise.
For the implication is that we should leave the generals and the military industrial complex
to make defence policy since they know more about waging war and the true costs
and capabilities of weapons.1
Clearly, as in any principal–agent problem, there is a trade-off between (lesser) knowledge
and (others’) motives. Brainard and Martimort (1997) address the issue directly as
suggested by the title of their paper.2
Their conclusion is striking:
Attainment of the informationally constrained social optimum requires a complicated menu of contracts
combining per-unit subsidies and lump-sum transfers. (p. 56)
Even more remarkable is the conclusion reached by Creane (1998) to the effect that
policymakers may be better off, and justified in using trade policy, the less information
that they have. It is not, however, necessary to engage in trade theory to see why this
conclusion arises in the context of imperfect competition. For, consider a monopolist who
wishes to exercise product discrimination. To do so, customers (including countries
contemplating trade policy) must have the knowledge to discriminate between products
(as is recognised in practice by advertising irrespective of whether ‘genuine’ differences
are created). Without this, monopolists may be forced to rely upon a more Pareto-efficient
but less profitable strategy and be unable to exploit product discrimination. Nor is this
some esoteric point in the context of development where, both for welfare and growth,
economies may be better served by supplying a cheap mass market than in targeting a
more profitable elite.
2.2 Links with new growth theory
Apart from strategic behaviour and market imperfections, the new trade theory is integrated
with the new growth theory, which is also essentially based upon market imperfections
(translated into variable growth rates rather than deadweight loss).3
In endogenous
growth theory, the long-run growth rate can be improved by government policy to induce
a higher saving rate and/or to incorporate externalities. Models linking trade and endogenous
growth have examined the various channels through which trade can influence
growth, but provide few generalisable conclusions.
Technology and knowledge spillovers are key mechanisms which link international
trade and endogenous growth.4
In their classic work, Grossman and Helpman (1991)
show how international trade can boost a country’s Research and Development (R&D)
sector (the sector which drives economic growth) by transmitting technological information,
increasing competition and entrepreneurial effort and expanding the size of the
market in which innovative firms operate. But, trade can also have negative effects on the
R&D sector by displacing innovative activities, making the overall effects of trade openness
ambiguous.
Other technology-based models emphasise the positive effects of openness by focusing
on the role of capital goods imports in promoting economic growth (Coe et al., 1995; Lee,
1995; Pissarides, 1997). In these models, technology spillovers are generally proportional
1
Alternatively, to be topical, chemical companies should be allowed to make policy on genetic engineering.
2
See also Wong and Chow (1997) and Wright (1998).
3
For a critical account, see Fine (1999).
4
For an overview of trade, growth and knowledge, see Zhang (1994).
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New trade theory versus old trade policy 815
to capital goods imports. Imported capital goods embody information about new technologies,
and producers who are exposed to this information are seen as more likely to
innovate. Romer (1992) describes this as ‘using ideas’ (as opposed to ‘producing ideas’)
and Pack (1992) sees them essentially as a free dividend for being a latecomer. Many of
these models imply that increased amounts of resources will be devoted to R&D following
trade liberalisation.
The positive conclusions about openness in these models are largely dependent on
specific assumptions about the nature of technology and technology transfer and can be
reversed when the definition of technology is refined. Most models assume that technology
can be perfectly codified and easily transferred. If, however, we acknowledge that
learning by importing capital goods is partly dependent on the absorptive capacity of
countries, the gains from trade (especially for poorer countries) may be more limited.
Keller (1996) presents a model which differentiates between technology embodied in
capital goods and capabilities (or ‘absorptive capacity’). Using a Rivera-Batiz and Romer
(1991) type endogenous growth model, he shows that the productivity and growth effects
of increased access to foreign capital goods will be short lived unless absorptive capacity
increases at a more rapid rate than during the period prior to trade reform. In the long run,
the rate of growth of output is forced down to the rate of human capital growth. Similarly,
Van de Klundert and Smulders (1996) allow for technology spillovers between North and
South, but the latter’s low level of high-tech production limits learning by doing.1
In the
light of recent evidence, that increased openness leads to less investment in human capital
at the secondary and tertiary levels (Wood and Ridao-Cano, 1999), this all implies that
the gains for poor countries from access to technology imports can be limited.
A negative conclusion about the effects of openness is also reached by a few recent
endogenous trade models which revisit infant industry arguments by explicitly dealing
with the role of learning under protection in countries with low levels of industrialisation.
In these models, poor countries are shown to specialise in low technology products if free
trade is allowed, but trade restrictions allow them to develop complex industries (see
Reddy, 1999).
These ambiguous results of endogenous growth/trade models are complicated further
by the fact that growth-enhancing trade policies do not always improve welfare. Thus,
Westerhout (1995) focuses on consumer variety and allows firms to exit and enter. With
trade liberalisation, consumer prices and costs of production are lower but so can be
product variety, as domestic producers are eliminated, and this can outweigh the other
effects on consumer welfare. For a small open economy, Osang and Pereira (1996) find
that all tariffs are damaging to long-run growth but there can be increases in welfare in the
short run.2
In addition, there is no reason to presume that tariffs should be uniform across
goods in maximising intertemporal welfare.
Models linking growth and trade also deal with the issue of convergence. Again, they
provide few robust conclusions, with convergence or divergence depending upon how
openly competitive is international trade. Boileau’s (1996) model allows for international
externalities, but with non-traded and non-market production within countries. He is
able to generate growth and cycles in which, contrary to most models and in conformity
with received wisdom, cross-country correlations on output exceed those of consumption
1
See also Walde (1996), who suggests that, with perfect international technical spill-over, convergence will
depend upon conditions of competition.
2
See also Kaneda (1995) who shows in presence of increasing returns that the one country of two with
lower time preference is liable to industrialise first.
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816 S. Deraniyagala and B. Fine
and productivity. Lau and Wan (1994) argue that trade is necessary but not sufficient for
poorer countries to converge. For middle-income countries will be able to accrue the
benefits of catch-up since the costs of doing so declines with growth, whereas the poorest
countries will experience a widening income gap. A complex model is provided by Fischer
and Serra (1996) in which the domestic economy grows faster the greater the level of
equality because of higher incentives and returns to investment in human capital.1
As
growth rises, unskilled labour may be rewarded more as it becomes scarcer, but inequality
may also increase as the wealthier invest more in human capital. With a world economy of
rich and poor countries, free trade is in part disadvantageous for the former in raising
inequality at once (skilled labour is immediately worth more in opening up to trade) and
over time, and in lowering the growth rate as poorer countries converge. Poor countries
unambiguously gain from each of these effects. The implication is free trade for poor
countries and subsidised education for the worse-off in rich countries.
2.3 Political economy arguments
In short, the marriage between new trade and growth theories serves to render each more
complex. In addition, they also tend to share a particularly underdeveloped notion of what
constitutes a nation. Indeed, in conformity with longstanding traditions in trade theory,
the nation is simply a special individual, usually with both benevolent goals (social welfare)
and special powers (policy).2
A simple step is taken to progress beyond such
simplicity once account is taken of internal influences upon government policy, thereby
incorporating a fourth factor in new trade theory, that of political economy in general and
rent seeking in particular. Rodrik and Fouroutan (1998), for example, debate whether
trade liberalisation has stalled in Africa because of a combination of distributional and
informational problems (who knows consequences and who gets compensated for them).3
Fung (1995) examines the redistribution between capital and labour as rents are shifted
and shared with change in trade policy in the presence of oligopoly. In a model of electoral
competition, Riezman and Wilson (1997) find that limits on number of donors and
amounts of donations by interest groups can lead to inefficiency in the making of trade
policy.
Most important, though, in the political economy of trade policy have been the rentseeking
arguments. It is as if all of the above can be set aside, since to act upon their
prescriptions is to solicit unproductive rent seeking through trade policy. Here, however,
there is a major problem. If there are underlying economic and political interests in favour
of trade policy, why would they allow trade liberalisation to proceed? And, if they have no
choice, might they not engage in even more costly forms of pursuing their advantage? This
is exactly what is perceived to have happened, if not anticipated, in the wake of the
Uruguay Round, with trade policy pursued by other means and, most notably, through
antidumping measures which have become the new form of (privatised) trade policy in
the WTO era.4
1
See also Gould and Ruffin (1995) for the case that human capital is crucial to growth and trade.
2
Hence the capacity for the theory to move effortlessly between lower and higher levels than the nation. See
Krugman and Elizondo (1996) for the idea that third world cities are too large because of economies of
linkages accruing out of ISI. See also Lall (1998). For new trade theory and regional integration (and idea that
this can even intensify internal protection), see Bilal (1998).
3
See also Edwards (1997).
4
This is the subject of a separate paper in preparation. But for a comprehensive empirical overview, see
Miranda et al. (1998).
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New trade theory versus old trade policy 817
3. Empirical evidence
Empirical research has examined the effects of trade liberalisation on growth, productivity
and efficiency at cross-country, industry and firm level. Below, we discuss each of them in
turn.
3.1 Cross-country research
The country-level research on liberalisation and growth consists of cross-section ‘before
and after’ studies (Greenaway et al., 1997), and ‘with and without’ studies (Mosley et al.,
1991; World Bank, 1990) as well as of country-specific time-series analysis (Papageorgiou
et al., 1991; Greenaway and Sapsford, 1994; Onafowora et al., 1996). In general, many of
these studies suggest that the effects of liberalisation on growth are ambiguous and complex:
while some groups of countries show an improvement in growth (as well as other
indicators such as investment), others show a marked deterioration. Here again, however,
the alternative models provide very different estimates of the long-run effects on growth
(with the pay-off ranging from 2% to 46% !), indicating the limitations of capturing complicated
growth effects using cross-country single-equation growth regressions (discussed
below).
At best, most of the literature seeking to investigate the effects of shifts in trade policy
(towards liberalisation) develops a model from which a reduced form is estimated. At
worst, simple regressions are run on some index of economic performance against some
index of openness (although the best and worst often coincide in practice). Here, we leave
aside perennial problems (like much of the literature!) concerning the data, and how we
measure openness,1
the value for an individual country’s development over time for what
are often cross-section studies, the fallacy of composition—if all liberalise, export prices
may fall2
—and the direction of causation between variables.
Consider, however, two problems that are generally overlooked. The first is that only a
single equation tends to be estimated rather than a model. However, even if a significant
and desired result is obtained, this is not a proper test of the theory. For, within the model,
there will be implicit mechanisms through which trade policy has affected trade performance.
These include both shifts in composition of output and in capital–labour ratios
as well as shifts in domestic prices, factor rewards and composition of consumption.
These usually remain unexamined. If, as is to be expected,3
such empirical regularities do
not hold, to what extent is the theory properly tested? To be more concrete, if trade
liberalisation in a labour-rich economy is associated with growth in capital-intensive
exports, there will be an apparent connection between trade reform and export growth,
but not for the reasons posited.
The second point is a more developed form of the first and is to be learnt from the more
sophisticated treatments of the endogenous growth literature.4
The models involved in
1
See Greenaway et al. (1998) for a discussion. Note that the problems in measuring openness are recognised
theoretically by the wish to construct sensible indices, as in the notion of a uniform-tariff welfareequivalent
to any existing level of protection. See Anderson (1995, 1998) and Anderson and Neary (1996).
These measures, however, depend upon genuine equilibrium comparative statistics and cannot eliminate the
problem of perverse prices, that increases in a tariff may be equivalent to a decrease in (effective) protection.
In addition, in the absence of perfect competition, as is well-known, export subsidies and tariff reductions (or
other trade measures) are not equivalent to one another for a variety of reasons for both partial and general
equilibrium. See Chen and Devereux (1997) and Okawa (1997), for example.
2
See Bandyopadhyay (1996).
3
Not least from the theory itself in view of the discussion above!
4
These points are discussed at length in Fine (1999) and carry over, if less observed in the literature, from
statistical investigation of growth to trade performance.
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818 S. Deraniyagala and B. Fine
the new trade theory, even with a few factors, are extremely complicated in terms of their
outcomes—potentially generating multiple equilibria and complex patterns of adjustment
to or around them. For a single economy, this raises issues of what exactly we are estimating—comparison
of static equilibria or paths between equilibria. For a cross-section
of economies, trade performances cannot be taken to be independent of one another.
Countries serve the same world market, one country’s exports are another’s imports, and
economic variables are not independent of one another, given flows of capital, labour and
technology, quite apart from strategic behaviour of firms and governments, etc.
Ideally, of course, the dynamics of trade performance would be properly modelled, and
models fully estimated across panel data. The literature generally falls far short. Even so, it
is far from supportive of the trade liberalisation hypothesis. Neatly illustrating some of
these observations is the study of Greenaway et al. (1998), who use panel data across
liberalisers and non-liberalisers (with/without and before/after) to come to a negative conclusion
on the effect of trade reform on growth but then suggest this may be due to a
shorter-run J-curve impact of liberalisation.
3.2 Industry and firm-level studies
A substantial body of empirical literature has focused on the dynamic effects of trade
liberalisation and has investigated the effects of trade policy and openness on total factor
productivity and efficiency at the industry level. Evidence from these studies, however, is
inconclusive. Some early empirical exercises found a negative (but weak) correlation
between import substitution and productivity growth (Nishimuzu and Robinson, 1984),
others showed TFP growth rates to be high in highly protected industrial sectors
(Waverman and Murphy, 1992), while continued and accelerating TFP growth rates in
both periods of high and low protection have also been reported (Aswicahyono et al.,
1996). High levels of import penetration have also been found to be associated with low
rates of productivity growth (Nishimuzu and Page, 1991). Given the varying country
coverage of these studies, the different industrial sectors included and the varying definitions
of liberalisation and openness used, attempting to provide a rigorous net balance
of the evidence would serve little purpose. Some key weaknesses of these industry-level
studies, however, must be noted. None of them discriminates between the effects of trade
policy and macro policy choices and it is, therefore, difficult to attribute causality to trade
policy itself. Many of them also fail to control adequately for other influences on productivity
growth. In particular, the failure to control for industry effects is especially
problematic.
The firm-level literature circumvents the need to control for industry effects, but still
fails to establish a direct causal link between trade liberalisation and improved economic
performance. Much of this literature examines the link between trade liberalisation, openness
and firm-level efficiency estimated using frontier-production-functions. Some
studies find support for the conjecture that efficiency levels are highest among industries
experiencing the largest declines in protection (Tybout et al., 1991). The firm-level
literature also examines the relationship between export-orientation and productivity/
efficiency, although the link between trade liberalisation and exporting is not empirically
investigated. Several studies have found exporting firms to be more efficient than their
domestically oriented counterparts (Chen and Tang, 1987; Haddad, 1993; Aw and
Hwang, 1994; Tybout and Westbrook, 1995; Aw and Batra, 1998), and have attributed
this result to the positive learning effects which accrue from contact with foreign buyers.
There are three major weaknesses with this firm-level literature. First, most studies
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New trade theory versus old trade policy 819
examine one-time changes in the level of efficiency and their findings are consistent with
the claim that trade liberalisation generates static gains. They, do not however, provide
conclusive evidence relating to long-term, dynamic improvements in firm-level efficiency.
Secondly, the indicator of firm performance used by many of the studies, total factor
productivity, is characterised by theoretical inconsistencies and estimation problems
(with Nelson, 1981, providing a critical discussion of these issues). Thirdly, they fail to
establish the causal links between trade policy, export orientation and efficiency. For
instance, the literature on exporting generally does not ask whether the direction of
causality runs from exporting to efficiency or vice versa. The latter is a strong possibility,
as more efficient firms are more likely to be competitive in export markets. A study of
exporters in Colombia and Morocco attempted to address the causality issue by plotting
long-term cost and productivity trajectories (Clerides et al., 1998). They found that entry
into export markets does not significantly shift the cost and productivity functions of firms
and conclude that the association between exporting and efficiency is most plausibly
explained by low-cost producers choosing to become exporters.
Finally, much of the firm-level research fails to shed light on the various channels
through which trade liberalisation might affect productivity and efficiency in changing
populations of heterogeneous firms. A few studies have attempted to do so, focusing on
the effects of trade policy on industry rationalisation and entry and exit patterns and costprice
ratios (Tybout, 1992; Roberts and Tybout, 1991). Overall, however, no strong conclusions
emerge. There is little evidence of an association between import penetration and
entry and exit patterns, contrary to predictions that import liberalisation is likely to result
in the exit of inefficient firms and the entry of low-cost ones. There is also little support for
the argument that liberalisation allows firms to benefit from scale economies. Positive
firm-level effects of liberalisation are reported by Steel and Webster (1992) in their study
of small firms in Ghana; they found new firms (i.e., those entering after liberalisation) to
have faster growth rates than older firms and concluded that this demonstrated that
liberalisation brings forth dynamic new entrants. This, however, is highly misleading as
the negative relationship between the age of a firm and growth is well established empirically
(McPherson, 1995), having little to do with trade policy.
The dynamic gains from liberalisation are supposed to accrue largely from technology
upgrading but few empirical studies have directly examined the technological response to
liberalisation at firm-level. One group of studies has examined the relationship between
technology imports and domestic technology development. Both Basant (1993) and
Fikkert (1993) found that domestic R&D and foreign technology were substitutes in the
case of India. Braga and Wilmore (1991) and Katrak (1997) examine whether improved
access to imports increased the extent of R&D at firm-level. They report a positive but
weak association between measures of technology imports and R&D. In general, the
evidence indicates that the extent to which foreign technology can stimulate R&D depends
on factors such as availability of necessary skills and expertise (Evenson and Westphal,
1995).
In the context of developing countries, informal technological effort (mainly to modify
and adapt foreign technologies) is more relevant than formal R&D, but the links between
trade policy and such informal technological activity have rarely been explicitly examined.
Some exceptions are Deraniyagala and Semboja (1999) and Latsch and Robinson (1999),
who examine the technological response to liberalisation in sub-Saharan African countries.
They find very little evidence of widespread technology development following import
liberalisation, with most firms being hesitant or unable to invest in new technologies in the
CJE 25/6 pps. FINAL 809-825 19/9/01 9:54 am Page 819
820 S. Deraniyagala and B. Fine
face of very intense import competition. Well-known qualitative studies of interventionist
trade and industrial policies in East Asia have demonstrated in detail their impact on
technology strategies, learning effects, entry and exit dynamics and the micro-level
aspects of industrial performance, and have highlighted the point that these effects vary
considerably according to the type of trade policy and according to the specificities of
industrial sectors (Amsden, 1989; Wade, 1990). It is important that empirical research on
the effects of trade liberalisation also examines such factors and provides an in-depth
analysis of the manner in which various policy instruments affect aspects of performance
in specific sectors and in countries at specific levels of development.
In general terms, then, existing empirical research on trade liberalisation allows us to
make the following observations. First, there is little to suggest that trade policy is itself an
important determinant of industrial performance and, even so, a positive role will derive
from export expansion (through export performing requirements, for example) rather
than from import liberalisation.1
As Helleiner (1994, p. 31) concludes:
On the basis of currently available evidence, it is difficult to escape the conclusion that trade policy
has not been the major influence on productivity growth in manufacturing that many analysts have
said that it should be. Such associations as there have been between productivity growth and trade
phenomena relate to the probable positive role of manufactured export expansion, and not to import
liberalization.
Secondly, at least as important as trade policy have been the other elements of industrial
policy, such as R&D, and the impact of technology transfer and the scale and growth of
domestic markets. Also important has been the macroeconomic environment, especially
the level and stability of the exchange rate, the level of domestic demand and real wage
restraint. At a more detailed level of targeting, favourable access to credit can be used to
promote exports, especially to complement low levels of domestic demand relative to
scale economies. Given the significance of stability in the macroeconomic environment
and the structure of incentives to industry, it is hardly surprising that liberalisation beyond
trade, to capital markets, has not been favourable to industrial performance. The impact
of speculative movements of capital can discourage long-term investment; and attempts
to stabilise capital movements and the exchange rate can lead to high interest rates further
discouraging domestic economic activity.
Thirdly, trade policy involves a very wide variety of complex instruments with an
equally varied set of outcomes depending upon how the trade policies interact with other
policies and factors in the specific economic conditions in which they operate. Consequently,
trade policy should not be seen in isolation from other policies and as a bias in
one direction or another. Rather, it needs to be situated carefully in a sectoral context [see,
for example, Agosin and Ffrench-Davis (1995) for Latin America and Soludo (1998) for
Africa]. But, even more important, the process of restructuring industries, both vertically
and horizontally, needs to range far beyond considerations of trade policy alone and to
recognise how the structure and functioning of sectors are very different from one to
1
See also the review provided by Edwards (1993, p. 1389), who concludes on the mixed results in favour of
trade liberalisation:
Much of the cross-country regression based studies have been plagued by empirical and conceptual shortcomings.
The theoretical frameworks used have been increasingly simplistic, failing to address important
questions such as the exact mechanism through which export expansion affects GDP growth, and ignoring
important potential determinants of growth such as educational attainment. All of this has resulted . . . in
unconvincing results whose fragility has been exposed by subsequent work.
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New trade theory versus old trade policy 821
another—by virtue of technology, markets, sources of finance and ownership, vertical
integration with other sectors as well as established historical patterns.
In short, the factors underlying appropriate trade policy are not only varied and complex
but require trade-offs to be made. Macroeconomic conservatism, for example, in
order to provide stability for potential investors and exporters, could prove to be a selfdefeating
exercise if the level of domestic demand is insufficient to support scale economies.
Certainly, however, there is no rationale for accepting the general case in favour of
trade liberalisation, and the merits of trade policy need to be examined at a detailed and
specific level. Given infant industry considerations, the sequencing as well as the content
of policy is crucial, especially as trade, macroeconomic or other policy could kill off infants
or even adolescents before they have the opportunity to attain maturity.
5. Concluding remarks
A number of conclusions follow from our review. First, free or freer trade is heavily
favoured by the economics profession and is gathering momentum under the WTO
regime. Secondly, the thrust of theoretical and empirical literature is far from supportive
of such postures.1
Thirdly, it is totally inappropriate to address trade theory and policy
separately from other aspects of industrial policy and performance and macroeconomic
considerations. Fourthly, crude dichotomies such as those between free trade and protection
should be rejected and the need recognised for sophisticated, sector- and countryspecific
trade and industrial policy and, lastly, in this respect, to the extent that the neoliberal
consensus has promoted trade liberalisation, it has done a double disservice both
by undermining interventionist trade policy and its integration with other policy areas.
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