[A-List] Global economy: trade rules need fixing

["Michael Keaney" <michael.keaney@xxxxxx>]

Liberalisation is a two-way street

Tony Thirlwall and Amelia Santos-Paulino
Monday November 18, 2002
The Guardian

Poor countries have been opening up their markets to international trade for
30 years, urged on by their richer counterparts, but the debate about the
benefits of trade has been confined to the supplyside orthodoxy of improving
resource allocation, ignoring its effect on demand.

There has been, for example, extensive research on the impact of trade
liberalisation on export performance, but hardly any on how liberalisation
has affected imports and countries' foreign exchange position.

This is a serious omission, because if imports grow faster than exports,
some of the real income gains from a more efficient allocation of resources
will be offset by the necessity for deflation to equalise the balance of
payments.

The reason for this neglect lies in the fact that in mainstream trade and
growth theory, the monetary consequences of trade policy and trade reforms
are ignored - or rather the balance of payments assumed to look after
itself, so there are never any demand constraints on output. The classical
full-employment presumption prevails. The balance of payments is assumed to
equilibrate automatically through relative price changes.

This was the way the old gold standard mechanism was supposed to work, with
prices falling in deficit countries losing gold, making goods more
competitive; and this is the contemporary assumption if exchange rates are
flexible.

In practice, however, huge payments imbalances persist in the world economy
which seem impervious to exchange rate fluctuations.

When deficits do persist, the mainstream orthodoxy treats them either as a
private matter, representing the smoothing of consumption over time, or as
evidence that foreigners want to invest in the country so that the current
deficit is simply the counterpart of the capital account surplus.

Either way, deficits are of no public concern. In the UK during the 1980s,
this was known as the Lawson doctrine, when Nigel Lawson, then chancellor of
the exchequer, embraced it.

But the Lawson doctrine ignores two points. First, deficits cannot be
financed indefinitely, there is a limit to the ratio of deficit and debt to
national income. Second, countries are not indifferent to their exchange
rate if it comes under pressure. Either way, domestic interest rates have to
rise and adjustment take place, which has damaging effects on the real
economy.

The 1997 financial crisis in East Asia was a dramatic illustration of what
can happen if payments deficits are allowed to grow too large. At the time,
the IMF gave no warning of the impending crisis because it too believed that
if the internal macroeconomic fundamentals were sound, external deficits
were of no concern.

Interestingly, however, in its latest World Economic Outlook, the IMF seems
much more circumspect in its view, and concedes that current account
deficits can matter for long run growth performance.

As far as trade liberalisation is concerned, what we have found in our
research of 22 developing countries which have undergone extensive
liberalisation over the past three decades is that export growth has
improved on average by about two percentage points, but import growth has
risen by six percentage points, and that liberalisation has led to the trade
balance deteriorating by 1%-2% of national income*.

This may seem relatively small but, in practice, financial markets
invariably start to become nervous and speculative runs on currencies can
occur, with deficits of a similar order of magnitude.

And, of course, there are individual countries where the deficit in the
first years after liberalisation deteriorated by much more, which
necessitated painful internal adjustment.

Examples are Argentina, Mexico, Chile, Uruguay, Colombia, Turkey, Zambia,
Malawi, the Philippines and Malaysia.

What the evidence points to is the need for greater care in the sequencing
of export and import liberalisation - as in the case of internal and
external financial liberalisation - to avoid the need for damaging internal
macroeconomic adjustment.

Liberalisation for liberalisation's sake will be counterproductive if it
simply leads to a flood of imports without a corresponding rise in exports
to pay for them. The balance of payments matters for the economic
performance of nations.

· Tony Thirlwall and Amelia Santos-Paulino teach at the University of Kent
at Canterbury

· The Impact of Trade Liberalisation on Export Growth, Import Growth and the
Balance of Payments in Developing Countries:
www.ukc.ac.uk/economics/staff/at4