Focus
International Trade Theory and Policy: What is Left of
the Free Trade Paradigm?
Sunanda Sen
ABSTRACT
Free trade doctrines have been questioned from the angle of their logical
validity as well as relevance. Their replacement by New Trade Theories has
been matched by important policy moves on strategic trade and industrial
policy in advanced countries. These are defended by the advanced nations,
both at inter-governmental levels and in multilateral institutions, largely in
the interest of big capital in industry and finance. However, the theoretically
discarded principles of free trade are still in use to push trade liberalization in
developing countries. An uneven power relation between the rich and poor
nations of the world has generated this asymmetric combination of policies in
the world economy. Neglect of the macroeconomic issues relating to the
national as well as the world economy has led these theories and the related
policies to ignore the concerns for growth as well as development.
INTRODUCTION
This survey is intended to provide the reader with an overall view of the
evolution of trade theory and its impact on policy. The first two sections
examine the theory of free trade, with the classical theory followed by the
further development of free trade theory which includes the neo-classical
doctrines of free trade as originally developed by Heckscher and Ohlin. An
account of the empirical and methodological critiques in the literature which
question the validity of these theories is followed, in the next two sections,
by the more recent approaches in the forms known as new trade theories
(NTTs). Although these NTT models propose modifications of the standard
neo-classical trade theories, they do not depart from the basic thrust of the
original models in terms of Pareto-optimality under free trade. Nevertheless,
the new trade theory made its own contributions to the literature by deviating
from the restrictive assumptions of the traditional trade doctrines, which
exclude increasing returns to scale, imperfect competition and product
differentiation from consideration. Introduction of these variables brings
DevelopmentandChange36(6):1011–1029(2005).#InstituteofSocialStudies2005.Published
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these models closer to the world of realities. A variant of the NTT involves
the principles of strategic trade. This theory has been behind the trade and
industrial policies which are currently being pursued in the advanced countries.
New trade doctrines also include issues connected with the flow of
foreign direct investment (FDI) and technology, and their impact on trade.
The article then turns to an examination, in the following section, of the
literature on growth and development in the context of trade. Many of these
contributions contest the notion of free trade as an ‘engine of growth’ and
development. Attempts on the part of the advanced nations to push their
national interests — through multilateral negotiations at the World Trade
Organization (WTO) and through unilaterally imposed strategic trade —
contrast with the hapless situation faced by the developing nations, unable
to resist the external pressures to further open up their domestic markets. The
final section of the article offers some concluding observations relating to the
limitations of the trade doctrines, old and new, in providing an acceptable
trade policy which is capable of generating growth as well as development.
CLASSICAL AND NEO-CLASSICAL THEORIES
The Beginnings of Free Trade Theory
Tracing back the evolution of what today is recognized as the standard
theory of free trade takes us back to the years between 1776 and 1826,
which respectively mark the publication of Adam Smith’s Wealth of
Nations and David Ricardo’s Principles of Political Economy and
Taxation. These two volumes heralded the formulation of a theory of free
trade, based on the unprecedented success of England in the fields of
industry and trade. For Smith (1776), the division of labour in the nascent
large-scale industries of England provided the base for lowering labour
costs, which ensured effective competition across countries. Possible dilemmas
such as the need for monetary adjustments for countries with a continuous
trade surplus (with absolute advantage in all traded goods) could be
set aside by relying on the principles of automatic price-specie flow mechanism,
as proposed by Smith’s contemporary, David Hume (1776).
It was left to Ricardo (1826) to sort out the basic premises of the theory of
free trade which Smith had initiated. Industrial capitalism in Ricardo’s
England was at a relatively advanced stage, with rapid growth in largescale
industries and captive markets in overseas colonies. Imports of wage
goods (corn) had the special role of cheapening those wage goods and hence
labour cost for industry. Free trade, as opposed to the mercantilist policies
of protection, was championed by both Smith and Ricardo as a route to
achieve production efficiency at a global level. Despite his concerns for the
introduction of machinery on a large scale, Ricardo’s cost calculations were
based on labour hours, treated as a single homogeneous input with
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production (in a two commodity world) subject to constant costs. It was the
comparative and not absolute advantage which was considered both necessary
and sufficient to ensure mutually gainful trade across nations, warranting
complete specialization in the specific commodity with comparative
advantage in terms of labour hours used per unit of output.
In the first two decades of the nineteenth century, Benthamite utilitarians
rose to prominence. In their view, the Ricardian doctrine had failed to take
account of the role of demand as an explanation for terms of trade in
exchange. It was J. S. Mill who undertook the balancing act by introducing
the notion of ‘reciprocal demand’, while a few years later, Alfred Marshall
further advanced the role of demand in terms of the ‘offer curve’ construct;
according to him, this completed the Ricardian trade theory by determining
the ‘terms of trade’. However, the supply side embedded in these theories
had in the meantime changed, from the Ricardian notion of fixed labour
time inputs to ‘real costs’. These costs, for Marshall, were measured by the
subjective disutility or sacrifices of labour at the job. In addition, output
was subject to diminishing returns, with changing factor proportions rather
than constant factor (labour) coefficients as in Ricardo’s theory. Units of
‘representative bale’ — of goods offered by the respective nations in the
two-country model — bore the mark of demand as well as supply. These
were thought to settle the terms of trade at a stable equilibrium, as long as
goods exchanged were of a ‘normal’ category, facing elastic demand, and
production was not subject to increasing returns. Marshall carefully avoided
the possibilities of multiple equilibria, which arose when these conditions
were not met, by assuming that all costs are irreversible, even when subject
to increasing returns (Bharadwaj, 1989).
Neo-Classical Theories of Trade
The balancing act between forces of supply and demand was carried forward
by the Austrian school with their notion of ‘opportunity cost’, defined
in terms of the utility of foregone consumption. This provided the methodological
tools for the Heckscher-Ohlin version of the free trade doctrine
which used marginal rates, turning the classical theory on its head. At the
same time, it laid a basis for the defence of free trade as Pareto-optimum,
rather than on grounds of comparative labour costs alone. This ensured
optimization of production, consumption and exchange (trade) for the two
trading nations at equilibrium, as under Pareto-optimality.
The above version of neo-classical trade theory has continued to have a
special appeal. In particular, it has been widely used by economists championing
the cause of free trade on grounds of optimization at a global level,
of productive efficiency, consumption (and therefore welfare), and the
automatic utilization of factors of production at full capacity. Returns to
factors of production which consisted of labour and capital were in
International Trade Theory and Policy 1013
proportion to their respective material contribution, valued at market
prices. Unlike the Ricardian paradigm where the supply cost (measured in
labour hours) was the factor determining trade advantages, in these new
theories consumer preferences (with ordinal rankings) for goods was as
important as the supply factors in determining price competitiveness of
exports from the trading nations.
It is interesting to note how the Heckscher–Ohlin (and later Heckscher–
Ohlin–Samuelson, or HOS) version (see Samuelson, 1949) of free trade
doctrine played down the otherwise overwhelming role of demand on
market prices. This was to bring resource endowments of nations to centre-stage
as the determining factor for mutually gainful trade. With this
device, free trade theory moved away from the skill- or technology-based
interpretations of the Ricardian comparative cost doctrine, to an endowment-based
explanation for nations having similar access to technology.
It was a Herculean job for the neo-classical economists to arrive at the
factor-endowment based theory of free trade. Logically, consumer preferences
(or demand) in either of two trading countries could be a determining
factor for both commodity and factor prices (including those of labour) in the
pre-trade stage, independent of the impact of the disparities in factor endowments.
Assumption of identical consumer preferences between the trading
partners made factor endowments the only determining factor of the pricecompetitiveness
of the traded goods in these models. The common world
price was to settle at a level which was within the boundaries set by the pretrade
prices in the two countries. While factors of production were assumed
to be immobile (as in the classical comparative cost theory) equalization of
commodity prices was supposed to bring about a similar equalization of
factor prices across countries. The potential problem of arriving at uniform
prices in absolute terms with different national currencies was avoided by
completely ignoring the possibility of different currencies across nations. The
implicit justification for such an assumption lay in the branding of this kind
of theory as ‘pure’, as distinct from a ‘monetary’ theory of trade.
Apart from factor price equalization, theorems following from the HOS
theory of free trade doctrine include a corollary, named after Stolper and
Samuelson, which relates protection to real wages (Stolper and Samuelson,
1941). In terms of the above, the scarce factor in each trading nation would
lose out under free trade as a result of factor price equalization. Thus
labour, considered the scarce factor of production in the US, was thought
to benefit from protection and not from free trade. Attempts have been
made by a number of scholars to construct models of the old trade theories
(both comparative cost and HOS models) for multi-commodity, multi-factor
and multi-country cases. However, these models, dealing with ‘higher
dimensional issues in trade theory’ (Ethier, 1984), have not made a very
significant contribution.
In the decades that followed, the failure of the HOS model to address the
world of realities was taken up at different levels. At an empirical level, the
1014 Sunanda Sen
observed tendency for exports to be more labour intensive than imports in
the US (where capital is relatively abundant) created an anomaly for the
endowment-based explanation of trade patterns under the HOS theory.
Leontief (1956) tried to resolve this paradox with his interpretation that
one unit of US labour is equivalent to more than one unit of labour in rest
of world.
At a logical level, the HOS model needed some qualification in order to
validate its central argument relating to factor price equalization. The work
of Minhas, in particular, further restricted the model’s application to situations
of constant elasticity of substitution (CES) between factors of production:
the production function, which entailed factor intensity reversals when
elasticities of substitution are different for the two goods, thus avoided the
disruption of the factor-price commodity-price frontier with the strict ordering
of goods in terms of factor intensities (Minhas, 1962). Other assumptions
which remained in terms of the HOS model included the usual
specifications of a 2 Â 2 Â 2 model, differing endowment ratios in the
two trading countries, different factor intensities for the two goods, constant
returns to scale and diminishing returns with varying factor proportions.
Eventually it was incomplete specialization with trade in both goods which
was to ensure, under the assumptions stated above, an equalization of factor
prices as a consequence of free trade in goods. As in the Ricardian model,
prices continued to be defined in real terms and not in units of money.
Deviating from the existing supply-side theories, an alternative explanation
for the pattern of trade was offered by a Swedish economist, Staffan
Linder, in terms of ‘overlapping demand’ (Linder, 1961). Linder argued that
‘representative demand’ in the trading nations — that is, a range of goods
which are typically in demand at a given per capita income level — determines
the feasibility of trade between them. For trade to occur, there needs
to be an overlapping zone in the representative demand of the respective
countries, in terms of the range of goods which are produced and consumed
in common. With this interpretation, demand (rather than supply) returned
to centre-stage as an explanation of trade. Linder’s theory of overlapping
demand superseded the earlier emphasis in the literature on supply-based
explanations of trade via comparative cost or factor endowments. Despite
being rich with potential for explaining intra-industry trade, product differentiation
(or ‘sophistication’ as Linder calls it), and even the South–South
trade of recent years, Linder’s work has remained rather neglected in the
literature.
NEW TRADE THEORY (NTT)
By the early 1980s, the rigid framework of the neo-classical models of free
trade was being questioned from different quarters. The major efforts to
restructure the free trade doctrine were made in the NTT literature. The key
International Trade Theory and Policy 1015
contribution of the NTT was to discard the limiting assumptions of the
traditional trade theory: the absence of scale economies in production, and
the assumptions of homogeneous products and perfectly competitive markets
in exchange. These three aspects (scale economies, imperfect markets
and product differentiation) which differentiate the NTT from the old trade
models, effectively challenge the capacity of the HOS model as a predictor
of the trade pattern across nations on the basis of pre-trade commodity and
factor prices as determined by relative endowments.1
The introduction of returns to scale, which was a major departure of the
NTT, influenced both the predictability of trade patterns as well as the
benefits from trade to the trading countries. The theory of increasing
returns, if related to economies of scale which are internal to the firm, is
incompatible with competitive equilibrium, a problem recognized earlier in
the literature (Sraffa, 1926; Young, 1928). This is because producers enjoying
internal economies of scale are usually in a position to influence the
market by exercising control over prices as well as the market share. A
related point concerns the size of firms and the market structure, both
intricately linked to possible economies of scale, which could lead to market
imperfections with monopolistic competition, oligopoly or monopoly. These
possibilities — especially the oligopolistic sharing of the market — led to the
application of strategic trade principles which emerged as an alternative
with strong policy overtones. We will deal later with these developments in
the area of strategic theory. To appreciate the implications of scale economies,
it is also important to note that products, especially under monopolistic
competition, are likely to be differentiated, generating further
deviations from the traditional competitive models. By incorporating these
possibilities of product diversifications, the NTT added an important
dimension to trade theory.
The new trade theories affected the basic assumptions underlying the
HOS model, and as such its major conclusions, including the corollaries
relating to factor price equalization, protection and real wages (the StolperSamuelson
theorem), and effects of changes in proportions of factor endowments
(the Rybczynski theorem) (see Darity and Davis, 2005; Deraniyagala
and Fine, 2001). Efforts from within NTT circles to reinstate the HOS
theorems by introducing a set of restrictive assumptions did not help
much (for example, Helpman, 1981). Use has sometimes been made of
‘Dixit-Stiglitz preferences (represented by a utility function in which utility
increases with the varieties consumed, not just the quantity of each variety)’
to conclude that the welfare effect of the variegated consumption basket
outweighs the losses to the nation, if any, from the movement from autarky
1. Some NTT theorists attempted, rather unsuccessfully, to validate the HOS predictors
within the framework of the new theory.
1016 Sunanda Sen
to free trade. These losses may affect the small producers who are unable to
reap the economies of scale.
In its work on scale economies and the gains from trade, the NTT
literature also showed that with economies which are external to the firm
but internal to industry, production achieves a global span in terms of
location. This permits cost reduction on a global scale while relocating
production away from areas/countries where it is not cost-efficient (Ethier,
1982; Krugman, 1981). Implicit in this is an argument for free trade with
potential gains to all trading nations by achieving increasing returns on a
global scale (Krugman, 1981). A further distinction in scale economies is
drawn in the NTT literature between scale economies which are external to
the firm but are of ‘national’ origin, as distinct from those which are
‘international’ — the latter arising from developments at the level of the
global industry. The distinction is relevant for identifying situations in
which the trading nations can gain from trade. Thus gains from trade
arise for countries with increased output in industries which enjoy
national-level scale economies. Gains from trade are also possible for
industries with scale economies arising at an international level: in particular,
small economies which otherwise cannot access such economies are
supposed to gain by opening up (Bhattacharjea, 2004: 111). Thus trade can
be beneficial with external economies at an international level, for nations
with opportunities of accessing economies and avoiding diseconomies of
scale in integrated markets. This applies even for countries with identical
resource endowments and therefore with similar pre-trade prices. In this case,
a small country has more to gain as markets are opened up and external
economies of scale become available at an international level (Ethier, 1979;
Helpman, 1984). It can be argued, however, that the validity of this argument
would depend on the prevailing state of trade restrictions in the world
economy.2
In retrospect, the major contribution of the NTT was its work on product
differentiation and intra-industry trade. As with economies of scale and
market imperfection, product differentiation also distorts the basic properties
of the HOS trade model. Thus, with demand generated in either country
for individual varieties produced by the same industry, the process makes
space for intra-sectoral (intra-industry) trade across nations. Intra-industry
trade is possible in both directions across countries when global markets are
segmented and firms adopt price discrimination/dumping. The goal is to
2. There were also earlier attempts to address issues relating to increasing returns. Alfred
Marshall sought to avoid the problem of possible multiple equilibria under increasing
returns by assuming that costs are historical and hence irreversible over time. At one
stroke, Marshall thus avoided the Pigouvian proposal for taxes and bounties for
respectively increasing and decreasing cost industries. A similar issue was also raised by
Graham and Knight who dealt with increasing returns and its effects on trade; for both of
these, see Viner (1937).
International Trade Theory and Policy 1017
maximize revenue by taking advantage of the different demand elasticities
for the same good in different countries, which can be described as a
strategic trade deal.3
The notion of ‘strategic trade’ was forumated by Brander and Spencer
(1985) in the context of the widely prevalent practice of reciprocal dumping
within the industrial policies of advanced nations (see also Krugman and
Obstfeld, 1992). This relates to situations in which demand curves are
subject to elasticities which are different in the two countries. Using the
famous example of Airbus and Boeing in the aeronautics industry, the
strategy was one of aggressive pre-emption by creating a market niche
through subsidized dumping of exports. A parallel possibility also exists
with internal economies of scale at a national level: countries which are
historically ahead of others in producing a good clearly have an advantage,
with the capacity to produce at lower costs experienced by the starting
countries. As with ‘infant industries’, this situation justifies a strategic
trade policy, with subsidies offered to the high-cost country in order to
enable its industries to benefit from scale economies. Paradoxically, however,
this has often provided the basis for aggressive strategic trade on the
part of industrially advanced nations.
The strategic trade component of the NTT gained currency, especially in
the US, in public policy debates during the 1980s. It was generally recognized
that the ‘vagaries of history’, rather than resources, determine what a
country produces and exports. Thus the role of ‘history and accident’ were
both considered crucial in determining the location of an industry on the
world map (Krugman, 1994: 201).4
By the early 1980s, influential people,
including Robert Reich and Lester Thurow, were recommending governmental
intervention to shift resources from ‘sun-set’ to ‘sun-rise’ industries,
thus generating ‘high value added products’ (ibid.: 248). Around the same
time, the Berkeley Roundtable, an influential thinktank at the University
of California, drew attention to what they saw as tendencies towards
de-industrialization in the US, and recommended active state intervention,
advocating industrial policy along the above lines (ibid.: 249).
The NTT also encompasses new theories of FDI and technology, which
are seen as conditioning factors for trade flows and trade patterns.
Although the role of these factors was also recognized in the earlier trade
theory literature, NTT drew attention to the ‘product-life-cycle’ (PLC) of
technology-driven foreign investment and trade flows (see Hufbauer, 1966;
3. The efforts of NTT to re-validate the ‘predictive power’ of trade theory, and the related
problems of incorporating increasing returns to scale, have been rather complex, especially
when the point of departure of these theories continued to be defined in the neo-classical
HOS tradition, and when the theorists concerned tried to rehabilitate the HOS theory (see
Helpman, 1981, 1984).
4. This is what Krugman calls the economics of QWERTY or path-dependence, as in the
age-old typewriter keyboard which continues in the latest models of computers.
1018 Sunanda Sen
Posner, 1961; Vernon, 1970). According to the NTT, innovations which led
to the adoption of new technology in advanced countries, introduced new
products which were made, consumed and exported to the rest of world.
With the ‘maturing’ of product innovation, both technology and capital
(FDI) are supposed to move to other advanced countries, to produce similar
goods, which in turn are exported back to the lead nation. Less developed
countries import these goods from the advanced country/countries during
the new/maturing stages of the PLC. Production starts in the less developed
countries only when the product is ‘standardized’, thus completing the life
cycle of the product. Thus, technology and capital travel first from the most
advanced to other advanced nations, and eventually to the developing
countries which now export the product to the advanced nations. With
product specifications (new, maturing, standardized) and the initial control
over the market by advanced countries, the PLC theory of technologydriven
trade incorporates both product differentiation and market imperfections.
A similar emphasis was laid on technology-driven trade flows in
models which looked at the ‘technology gap’ among nations. The explanations
for this gap included a ‘demand-lag’ on the part of consumers and a
‘reaction-lag’ on the part of producers in the home country, along with an
‘imitation-lag’ on the part of producers in the foreign country (Posner,
1961).
While the basic premise of PLC and other neo-technology models rested
on diffusion (or transfer) of technology across nations, the process by which
this would happen remained unclear, with no reference to multinational
corporation (MNC) practices relating to parent companies and subsidiaries.
This opened up new areas of research in the branch of economics known as
Industrial Organization theory, with models which, again, seem rather
remote from the world of realities. A somewhat more realistic approach to
the FDI–trade nexus was provided by Ozawa’s ‘Flying Geese’ paradigm,
which sought to explain the relocation of production and the shifting export
platforms in Asia since the 1980s (see UN, 1995: 246). Overall, the PLC
literature provided a platform for an integrated approach to trade, technology
and FDI, incorporating product differentiation and market imperfection.
Compared to the earlier approaches to trade, which were primarily
location-specific (comparative cost, resource endowments), PLC theory
introduced product-specific (new, mature, standardized) characterizations
and organization-specific factors.
How far has the NTT departed from the old models of free trade doctrine?
Notwithstanding its innovative critique of the traditional trade theories,
it has been pointed out that the NTT has remained ‘fully consonant
with ‘‘traditional theory’’. It explores creatively and extensively the exceptions
that the ‘‘traditional theory’’ would admit to its standard results’
(Darity and Davis, 2005: 142; see also Deraniyagala and Fine, 2001). An
exhaustive analysis and critique of NTT claims that ‘limitations remain
embedded in the new theory because of its excessive fidelity to the old’
International Trade Theory and Policy 1019
(Bhattacharjea, 2004: 117). Indeed, the free-trade doctrines, both of the
traditional and the new variety, with their positive approach to world
trade, have failed to address the dynamic implications of trade opening in
terms of growth and development of the trading nations, especially concerning
developing countries.
It is interesting to note that the static theories of optimal resource allocation
in neo-classical trade theory do not share the awareness demonstrated by
both Smith and Ricardo of the uneven development of nations (Darity and
Davis, 2005: 143). Smith analysed increasing returns, innovation and market
size, while Ricardo explored technical progress and the Corn Law debate as
possible hindrances to industrialization. Smith, in particular, was aware of the
‘marked differences’ in economic development of nations: ‘he refers to
‘‘nations of savages’’ coexisting with ‘‘civilized nations’’’ (ibid.: 146). Both
Smith and Ricardo, despite their basic differences on increasing as distinct
from diminishing returns to scale, ‘provide a framework for directly addressing
the phenomenon of divergent economic development’ (ibid.: 149).
TRADE, GROWTH, DEVELOPMENT, DEPENDENCE
On balance, the neo-classical HOS trade theories and the more realistic
models introduced as NTT have both failed to address the issue of growth
and development. They view ‘change by comparing static equilibrium states,
rather than as a process occurring in irreversible historical time’
(Bhattacharjea, 2004: 121). The agenda the NTT theorists had set for
themselves clearly excluded situations in which changes can happen in
resource endowments, technological possibilities or consumer preferences
(see Ruttan, 1998; Stewart, 1991). Furthermore, neither set of theories paid
much attention to issues of changing income distribution, as is usual with
free or even restricted trade.
Early attempts to capture the relation between trade and growth include
Johnson’s (1956) ‘trade-cum-growth’ and Bhagwati’s (1958) ‘immiserizing
growth’ models. Despite limiting assumptions, Bhagwati was able to pinpoint
the relevance of terms of trade movements as a factor related to
growth rates for trading countries. It is, however, rather paradoxical that
Bhagwati’s ‘immiserizing growth’ through deteriorating terms of trade
seemed to prevail in a country growing faster than its trade partner, or
even growing in isolation.
Terms of trade resurfaced in the literature as a powerful tool to demonstrate
the inequities of trade for developing countries. Raul Prebisch (1963)
and Hans Singer (1950) both advanced the much celebrated thesis relating
to a secular decline in terms of trade experienced by the primary producing
and exporting countries. Supplementary material, which supported the
hypothesis, was provided in the Haberler report from GATT (1958), spelling
out the factors responsible for the lack of demand for exportables from
1020 Sunanda Sen
the semi-industrialized countries in advanced country markets (see also
Haberler, 1968). The reasons included the falling or low import content of
production in advanced nations as a consequence of technological changes.
It was argued that ‘industrialization is a significant factor in the long term
tendency for exports of the semi-industrialised countries to rise even more
slowly than those of non-industrial countries’ (Theberg, 1968: 42). The low
price and income elasticity of demand for exports from developing countries
in the advanced country markets was another contributing factor.
Further support to the trade and underdevelopment thesis was lent by
Nurkse (1959), Singer (1950) and by Myrdal (1957). Nurkse stressed the role
of agricultural protectionism in advanced economies, along with lagging
demand for imported inputs (both primary and intermediate) from the less
developed countries, as factors contributing to under-development. Looking
at foreign investment flows to developing counties, Singer (1950) documented
the damage done, not only from falling export prices and the declining
terms of trade for the primary producing countries, but also from the
outflow of funds to service and repay foreign investment. Singer held that
foreign investments indirectly foster a base for export-oriented primary
production, thus ruling out the prospects of an alternative path of development
based on industrialization. Myrdal (1957) argued that similar ‘backwash
effects’ of investments in open economies often over-ruled the ‘spread
effects’ if any. Many of these arguments are of relevance today.
A variant of the alternative approaches to trade and underdevelopment
can be found in the neo-Marxist literature. Inequities resulting from trade
was one of the main themes in the Marxist literature dealing with trade.
Using the labour theory of value, Arrighi (1972) pointed out the asymmetry
in exchange across countries, with productivity gains in the developing
countries appropriated by the rest of world. The result is equivalent to a
drop in the double factoral terms of trade, independent of the assumptions
of the labour theory of value. Other studies in this tradition, which reject the
mainstream neo-classical theories of optimal trade and growth, offer a
picture of inequitous and exploitative world trade. The literature includes
the classics on imperialism, and especially, the under-consumption thesis of
Rosa Luxemburg (see Luxemburg, 1968). It signifies an inevitable crisis for
capitalism which could be remedied only by having access to pre-capitalist
markets within the nation state or overseas. Trade thus had a major role in
the process, providing access to markets hitherto unexploited.
The emphasis on trade continued in the debates on related themes on
capitalism, with Sweezy (1976) highlighting the primacy of ‘circulation’ (or
exchange) as against ‘production relations’ which was emphasized by Dobb
(1962). Borrowing from Sweezy, Wallerstein (1979) dwelt on commerce as a
major tool in the ‘peripheralization’ of new territories and the transfer of
resources to ‘core areas’. This generated the widely known core–periphery
distinction in the literature. ‘De-industrialization’ via trade, and transfers of
surpluses from colonies also remain important elements in the analysis and
International Trade Theory and Policy 1021
documentation of the colonial past of developing countries (see, for example,
Bagchi, 1982; Sen, 1992). Trade and investment are used even more
effectively in Frank’s analysis of the ‘development of under-development’,
which explains much of neo-colonial expropriation of surpluses from the
developing areas (Frank, 1967). Such theories have influenced the ‘dependencia’
school of thought which dwells on the inequities of the world
trading and financial order (Amin, 1972; Amin et al., 1981; Braun, 1983).
WHAT THEN REMAINS OF THE FREE TRADE PARADIGM?
The wave of liberalization, which has swept the developing world in the
process of globalization, also generated some specific tools for policymakers
to justify moves towards deregulation. Trade barriers employed by
import-substituting or Quantitative Regulation (QR) regimes were identified
as ‘social costs of protection’, often measured by ‘effective rate of
protection’, popularly known as ERP (see Corden, 1957, 1966). Such costs
could also be identified as the ‘domestic resource cost’ (DRC), providing a
measure of the cost efficiency of domestic industries in comparison to
international standards. For developing countries which were on the move
from an import-substituting regime to one of export promotion during the
1980s, the tool could be used to identify potential exportables from a
country (Bhagwati, 1978; Helleiner, 1992; Krueger, 1978). To compute
‘shadow prices’ which reflect ‘dynamic comparative advantage’ (Chenery,
1961), the cif (cost, insurance and freight) prices of importables (in the
absence of programming exercises) was used to arrive at the ERP and
DRC calculations. These were used extensively by the free-trade lobby in
developing countries as tools to question the controlled trade regimes.
Limitations, conceptual as well as operational, can easily be detected in
the approaches to trade efficiency which underlie these concepts. These
problems limit the validity of the ERP/DRC indices as guidelines for
resource allocation in developing countries. Three main issues give an idea
of the related problems. First, the restrictive assumption of fixed input
coefficients as used in these calculations fails to measure the gains in
efficiency through factor substitution. The assumption reduces to triviality
all prescriptive claims of such models on issues relating to efficiency gains
within the economy. Second, by using international (cif) prices as a surrogate
for ‘shadow prices’, calculations of these indices often lead to serious
anomalies with negative ERP/DRC values, which are meaningless for allocational
purposes. Third, the possibilities of monopoly power enjoyed by
different protected units may generate a ranking of industries by ERP/DRC
criteria, which does not necessarily reflect inefficiencies under protection
(see Sen, 1982).
This brings to mind the developmental agenda for open economies which
had rather limited success under neo-colonialism. However, despite their
1022 Sunanda Sen
subordinate economic and political status in relation to the advanced
industrial nations, the developing countries have been able to draw attention
to the ongoing inequality of the world economic order — albeit rather
unsuccessfully in terms of remedial steps. These include the voice raised by
the Group of 77 developing nations in the 1960s, which culminated later in
the United Nations Conference on Trade and Development (UNCTAD).
At another level, the Non-Aligned Nations tried, over the limited period for
which the movement was active, to demand fair deals on trade and investment.
More recently, developing countries have been active (although again
with limited success) in defending their national interests against the aggressive
unilateralism of the powerful industrialized countries at the level of the
multilateral trading institutions like the WTO. We will return to this below,
in the context of the asymmetry and inequity of the current international
trading system.
Let us now draw attention to the fact that not much has remained of the
predictions of a conflict-free, harmonious world of free trade. Advances in
trade theory and policy have not kept pace with the issues which concern the
majority of nations in the developing areas. Trade policies prescribed by
mainstream neo-classical economists for the developing region have focused
exclusively on the Pareto-optimality conditions in multiple markets which
are achievable under free trade. In the literature dealing with sub-optimal
conditions, all deviations from competitive equilibrium are treated as ‘distortions’
in terms of the favoured Pareto-optima. It is not surprising that
policy conclusions emerging from such formulations have failed to address
the problems of the real world.
In the advanced nations, where theories of free trade are nurtured even
today, rising unemployment as well as over-supply of domestic goods are
often related to labour market distortions (trade union militancy and wage
rigidity, in-migration, lack of skills), cheap foreign goods (produced abroad
with cheap labour, outsourcing) or even an overvalued foreign currency
(such as the Chinese yuan). Little attention, if any, is paid to deficiencies of
demand at home, which remains a major source of the malaise in the
advanced economies.
In this context, rather anomalous usages of trade theory are appearing in
the policies advanced by industrialized nations, which seem to rely on two
distinct strands of theory. For developing countries the recommendation is to
liberalize and open up as much as possible, in order to avail of the ‘benefits of
the free trade doctrine’ (old variant). For their home economies, however, the
prevalence of unemployment and low growth are taken seriously, and a
remedy is sought through strategic trade of the NTT variant. Such arguments
permeate the policy moves of the advanced countries, not only at the level of
inter-governmental trade deals, but through multilateral trading institutions
such as the WTO where these nations often reign supreme.
There are many instances of anomalous and discriminatory practices in
the current WTO regime. One major example is of the unilateralist
International Trade Theory and Policy 1023
approach implicit in the emerging regional trade blocs, including NAFTA
and the EU. Article XXIV of the GATT — and its updated version in the
WTO — allowed exemptions from most-favoured nation (MFN) status for
customs unions and free trade areas. This was based on the condition that
the common external tariff of the union members should not be raised
further. While attempts have been made to justify the burgeoning of preferential
trade arrangements (PTAs) as a form of ‘open regionalism’ to
prepare the way for complete trade liberalization (see Council of
Economic Advisers, 1995), it is not hard to see the regional trade arrangements
like NAFTA and APEC ‘as a process by which a hegemonic power
[often manages] to satisfy its multiple trade-oriented demands on other
weaker nations more easily than through multilaterlism’ (Bhagwati and
Krueger, 2001: vii–ix; see also Srinivasan, 1998). At the same time, various
pressures — including threats of denying market access to the large industrialized
countries — have been countering moves by the weaker nations to
manage alternative trade forums like the SAPTA in South Asia or the
Mercosur in Latin America.
Notwithstanding the goals initially set up in the Uruguay round of trade
talks, to achieve efficiency gains by eliminating trade barriers across
nations, the rich industrialized countries have managed to retain various
non-tariff barriers. These include subsidies on agriculture, industrial and
innovative activities in the home countries. Anti-dumping provisions are
being used to weed out potential threats from developing country imports to
manufactures of local origin. There are also attempts to push through the
new WTO agenda, including the Competition Policy and level playing field
for FDI in host countries, whilst guarding against ‘outsourcing’ by FDI
subsidiaries abroad. Many of these moves have the intellectual backing of
strategic trade and industrial policy arguments.
Ministerial talks following the Uruguay rounds have opened up areas of
discord between the members, with developing countries trying to resist
pressures to adopt trade practices which have an in-built bias in favour of
the developed countries. Expansion of the negotiating agenda, rather than
the consolidation of prevailing negotiations, was the central issue in early
rounds, with the broadening of the discourse at the Singapore Ministerial
Conference in 1996. This sought to cover investment, competition policy,
government procurement, trade facilitation, labour and environmental standards.
The developed countries were not willing to incorporate these
demands, mostly from the developed countries, within the existing WTO
framework. The Doha Ministerial Round in 2001 failed to resolve issues of
market access for agriculture, especially in the advanced countries.
The last meeting of the Ministerial group at Cancun in 2003 similarly, and
spectacularly, failed to arrive at a consensus on major issues relating to the
Doha and Singapore concerns. Some felt that the plans for agriculture were
too ambitious, others that they were not ambitious enough. The member
nations even differed on whether to launch negotiations on the Singapore
1024 Sunanda Sen
issues. They also had comments on the non-agricultural market access text,
including the description of the tariff-cutting formula, and on the proposal
to introduce sectoral deals (zero tariffs for all products within specified
sectors) on a compulsory basis for all members. Several of the Ministers
felt that the text on the cotton initiative did not reflect the proposal to phase
out subsidies in the long run and to compensate African producers in the
interim. A number of African and Caribbean countries, in particular,
pointed out that the draft does too little on special and differential treatment
for developing countries. The scepticism was even reflected in the
official WTO website: ‘It is ironical that a few countries, both developed
and developing, expressed concern that the negative sentiments would wipe
out what they described as possible significant results in areas such as
agriculture, which are particularly important for developing countries.
Two large members warned that each delegation would be responsible for
what happened that night’.5
Such signs of discord between member countries in the face of ‘aggressive
unilateralism’ on the part of the more powerful nations have continued to
surface in the course of the long drawn-out WTO negotiations. Examples
include the near-collapse of the multifibre arrangement (MFA) relating to
textiles,6
the shrinking coverage of products (with the ‘graduation’ provision
of the EU) in terms of the generalized system of preferences (GSP), dilution
of the special and differential treatment for all developing countries down to
‘best endeavor clauses’, and so forth.
The strong-arm tactics of the advanced nations within and outside the
WTO continue alongide the never-fulfilled promise to developing countries
of greater market access (in agriculture, textiles and clothing), and movement
of natural persons under services. In addition, the international financial
insitutions including the International Monetary Fund, the World Bank
and even the G10-controlled Bank for International Settlements, exercise
control over finance, imposing regulations which have a major impact in
shaping world trade. It has proved important to the advanced nations not to
give up their ‘export platforms’ in countries with cheap labour, and accordingly
to protect FDI as well as other forms of finance in these regions.
Problems in developing areas, which remain the major suppliers of raw
materials to the rest of world, are sometimes addressed by ‘debt cancellations’.
These protect not only the cheap source of raw materials, but also the
lending institutions. Such debt cancellations (including the debt negotiations
of the G8 at Edinburgh in July 2005) carry a price tag in terms of further
trade opening by the debt-ridden countries, which will make it easy for the
5. See http://www.wto.org/english/thewto_e/minist_e/min03_e/min03_14sept_e.htm. See also
RIS (2003).
6. Even after the phasing out of the MFA on 1 January 2005 under WTO, developed
countries have sought to restrict imports from countries like China.
International Trade Theory and Policy 1025
lending nations to make good the cancelled debt, in the form of export
earnings. Theory seems to have been turned on its head, with tradeliberalizing
forces operating in developing countries, while protectionist
subsidies continued unabated in the developed world.
CONCLUDING OBSERVATIONS
From the discussion above, we observe that the evolution of trade theory,
from old free trade doctrines to the NTT, has impacted on policy at three
levels. The first relates to the advocacy of the free trade doctrine to determine
policy for developing areas. Thus traditional trade theory, in the form
of comparative cost or the HOS doctrine, continues to be used to justify
trade liberalization in developing countries, notwithstanding the serious
theoretical and empirical limitations embedded in these theories.
Unsurprisingly, the use of such (old variant) free trade policies is defended
by the advanced nations, both at inter-governmental levels and in multilateral
institutions like the IMF and the WTO.
The second impact relates to policies pursued by the advanced nations
themselves, which rely heavily on the NTT doctrine of strategic trade. Thus
NTT is used to justify the strategic trade objectives of advanced countries
with interventionist policies in the sphere of trade negotiations and domestic
industrial policy. The uneven power relations between the rich and poor
nations of the world permit the continuation of this asymmetrical combination
of policies, to which the microeconomic approaches to efficiency gains
under free trade have contributed much. Neglect of the macroeconomic
issues relating to the national as well as the world economy has led these
theories and the related policies to ignore the implications of demand-led
recession in the global economy. Instead of launching a global expansionary
policy along with trade opening, which is potentially capable of working the
links between trade, growth and development (Sen, 1998), policies in
advanced nations have reinforced the ‘beggar-thy-neighbour’ approach,
garbed in strategic trade principles.
The third impact is the preoccupation of some academics and policymakers,
even from developing areas, with trade liberalization for developing
countries. This precludes an understanding of the role which mutually
gainful trade can play in economic growth and development, even though
this was one of the professed goals of multilateral trading organizations like
the WTO, which promised wider market access to the member countries
through trade liberalization. Very little of this promise has been fulfilled,
despite adherence to efficiency gains under liberalization as prescribed by
the WTO and its rich member nations for the developing world. With
tendencies for global recession, especially in advanced countries, the need
to protect jobs has led to protection of domestic markets, using new forms
of trade barriers which tally with WTO obligations. The recent outcry
1026 Sunanda Sen
amongst advanced countries about ‘outsourcing’ by FDI subsidiaries, the
continuation of agricultural subsidies in their domestic economies, and
pressures on so-called ‘cheap labour’ economies like China to revalue their
currency, are just some of these devices. There seems to be little recognition
of the mutual gains which could potentially accrue to both advanced and
less developed countries, as additional demand is generated through tradeled
expansion of these economies.
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Sunanda Sen is a Visiting Professor at the Academy of Third World Studies,
Jamia Millia Islamia, New Delhi, and former Professor of Economics at
Jawaharlal Nehru University, New Delhi. Books recently published by her
include Global Finance at Risk: On Stagnation and Instability in the Real
Economy (Palgrave-Macmillan, 2003) and Trade and Dependence: The
Indian Experience (Sage India, 2002). Her current research interests include:
Basel Regulations for banks; labour in Indian manufacturing industry;
gender and development; and the China model of finance and trade.
International Trade Theory and Policy 1029