Frankel critigues Bhagwati

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

The Crusade for Free Trade
by Jeffrey Frankel
Foreign Affairs March / April 2001
Foreign Affairs, April 2001

REVIEW ESSAY
The Wind of the Hundred Days: How Washington Mismanaged Globalization.
by
Jagdish Bhagwati. Cambridge: MIT Press, 2001, 383 pp. $32.95.

POP ECONOMIST
Many economists despair at the public's frequent misunderstanding of
international trade theory -- the common failure, for example, to
understand the principle of comparative advantage, or the popular notion
that imports are bad and exports are good. Many experts have thus given
up the attempt to communicate with the general public. But Jagdish
Bhagwati, one of the world's most eminent economists, is also one of the
most consistent and successful at bringing the lessons of international
trade theory -- particularly the virtues of free trade -- to the public.
In Seattle in 1999, for example, he explained why the campaign to bring
environmental and labor issues into the World Trade Organization (WTO)
was detrimental not only to the trade interests of the rich, but
especially to those of the world's poor, who need the opportunities
offered by trade to develop their economies and raise their living
standards.
The Wind of the Hundred Days, a collection of many of Bhagwati's recent
influential newspaper columns, speeches, and articles, is an impressive
sequel to his earlier collection of public policy essays, A Stream of
Windows. Highly readable and enlightening, Bhagwati's new book covers
the major policy issues in the international economy over the last few
years. Yet it is also packaged as a critique of the Clinton
administration's international economic policy -- and here its line of
argument is idiosyncratic.

TWO BIRDS, ONE STONE
A recurrent theme in The Wind of the Hundred Days is the principle of
targets and instruments: given a particular social or economic goal, one
must choose the policy instrument that is appropriate for the target.
One of Bhagwati's most important early contributions to trade theory
(made with V. K. Ramaswami)
was to show that rationales for trade barriers are often claims of
market failure that, if valid, would be more appropriately addressed by
some other specific policy. For example, a desire to protect a natural
resource would be optimally met by taxing all use of that resource, not
by limiting imports that use that resource. A government's propensity to
reach for the trade weapon is due partly to a failure to understand the
principle of targets and instruments, and partly to the hidden desire to
protect domestic producers.
In his new book Bhagwati explains the principle of targets and
instruments with the common-sense proposition that someone who tries to
hit two birds with one stone is likely to miss both of them. In one
chapter, the two birds are the twin targets of maximizing GDP and
protecting the environment. The former should be achieved by trade
policy, and the latter by appropriate environmental initiatives. In
another chapter, the two birds are free trade and a global social
agenda. The former target should be tackled by the WTO, and the latter
should be left to other multilateral institutions such as the
International
Labor Organization, the United Nations Children's Fund, and the United
Nations Environment Program -- beefed up to whatever extent that is
politically possible. Trying to use the WTO to establish both
growth-promoting trade rules and environmental or social standards, in
contrast, is unlikely to achieve
both objectives and more likely to achieve neither. Even leaving aside
the goal of economic growth, conflicting objectives have motivated the
demonstrators at Seattle and subsequent trade gatherings.
Because of newly important global environmental issues such as
greenhouse gas emissions, environmentalists need regulations enforced by
multilateral agreements and institutions (along the lines of the Kyoto
Protocol, for example), whereas labor unions oppose this kind of
infringement on national
sovereignty. Thus the two supposed allies in fact disagree about the
direction in which global governance should move. A well-designed set of
international institutions could achieve a favorable balance of goals
within the global marketplace. But an unthinking mass movement to tear
down multilateral institutions in general is the wrong instrument for
achieving the various targets of the demonstrators.

BHAGWATI'S WRONG INSTRUMENT
Bhagwati wastes no time making clear that the "Washington" in his book's
subtitle, "How Washington Mismanaged Globalization," refers to the
Clinton administration. Although attacks on the administration from the
antiglobalization camp are very common, attacks from the
proglobalization side (i.e., Bhagwati's) are less so. Bhagwati accuses
the Clinton White House of not doing enough to advance free trade. He
seems to blame Bill Clinton for all political obstacles to trade, such
as Congress' refusal to renew the fast-track negotiating authority that
he sought.
At the same time, Bhagwati objects to the administration's support of
regional trade agreements, such as the North American Free Trade
Agreement (NAFTA) and the proposed Free Trade Area of the Americas
(ftaa), because he considers this position inconsistent with the
multilateral pursuit of free trade. He also
believes that the administration's pursuit of open financial markets in
Asia, Mexico, and other emerging economies caused the 1990s crises in
these areas. In short, Bhagwati seems to take exception to Clinton's
broad strategy of seeking to remove trade and financial barriers
whenever possible. But this attack on
the administration's international economic policy is itself a poor
instrument for the target of advancing free trade ideals.

(NOT SO) FREE TRADE AREAS
Regional trade agreements are Bhagwati's bête noire. As he persistently
points out, regional free trade areas (ftas) should not be confused with
free trade, although they often are. He prefers to describe such
arrangements as "preferential" or even "discriminatory." These terms
make clear that ftas can distort price incentives to favor the exports
of member countries over those of nonmember countries. Instead of
creating new trade, ftas may divert existing trade from nonmembers to
less efficient trade with members. This distinction between trade
creation and trade diversion is a staple of international-economics
textbooks. Although the textbooks say the net effect on economic
well-being depends on the specific situation, Bhagwati thinks the net
effect is likely to be negative. In the case of NAFTA, for example,
Bhagwati worries that much of the resulting 45 percent increase in U.S.
exports to Mexico between 1993 and 1996 represented trade diversion --
that Mexico really should have purchased those goods from low-cost
suppliers elsewhere but instead bought from American producers because
of the reduced Mexican tariffs on imports from the north.
Bhagwati also worries that regional initiatives will use up political
capital and energies and thus divert momentum from multilateral efforts.
To use phrasing that he originally coined and that has since become
popular, trade blocks may be "stumbling blocks" to global liberalization
rather than "building blocks." But other economists see evidence from
recent decades that the political forces behind regional trade
arrangements tend to be consistent with those working for free trade
generally. Liberalizing trade with a neighbor, they reason, makes it
easier to do so with others. In fact, leaving aside an antiglobalization
minority in Mexico, Bhagwati is virtually alone in seeing harm in the
rapid growth of U.S. exports under NAFTA. Still, Bhagwati's distaste for
regional negotiations is an intellectually respectable position. After
all, the United States must fight some of the same political battles
(over labor rights and environmental protection, for example) on both
regional and global fronts, so it might as well debate them at the
multilateral level. But success on a global scale is not always
possible. A new multilateral round of negotiations in the WTO may not be
politically feasible -- either because of traditional clashes between
the United States and the European Union or because of newly critical
North-South disagreements. If multilateral initiatives break down, and
if regional ones such as the ftaa are possible, then the United States
should go for the latter.

DON'T GO WITH THE FLOW
Free-market purists argue that countries can improve their economies
through unfettered capital markets -- an argument analogous to the case
for free trade.
But Bhagwati contends that free capital movements can harm developing
economies -- and he is not alone in this stance. Indeed, it is striking
how many major figures in international economics, including those who
stand for globalization and free markets, have expressed strong doubts
that international financial
markets actually behave in the benign way that economic theory predicts.
In the former Soviet bloc, for example, Harvard Professor Jeffrey Sachs'
name is practically synonymous with free-market philosophy. Billionaire
George Soros has become a symbol of unrestrained financial speculation.
Former Federal
Reserve Chairman Paul Volcker and former U.S. Treasury Secretaries
Lawrence Summers and Robert Rubin are all considered prophets of
American-style capitalism, preaching the discipline of the international
free market. Yet each of these five figures has stated that financial
markets regularly experience excessive volatility and that some
government intervention may be justified.
Jagdish Bhagwati, apostle of free trade, has joined this distinguished
list.

The "wind of the hundred days" in Bhagwati's title refers to the
turbulence of the 1997-98 Asian financial crisis, which Bhagwati claims
stemmed from U.S. pressure on Asian countries to let in foreign money
and financial institutions. He states that "the U.S. administration
really blew it" and that Rubin and Summers "may well have presided over
the largest man-made disaster in the world economy since Smoot Hawley,"
referring to the 1930 U.S. tariff that prompted widespread protectionism
and thus exacerbated the Great Depression. The Clinton administration's
mistake, according to Bhagwati, was its promotion of "imprudent
financial liberalization." Attacking what he calls the "Wall
Street-Treasury complex" in his widely noted May-June 1998 Foreign
Affairs article, Bhagwati argues that Wall Street "naturally wished to
enlarge its sphere of operations," and that "the U.S. Treasury reflected
that lobbying pressure" and "succumb[ed] to the 'ideology' of the market
while forgetting that the capital funds market is not as innocuous as
goods markets and needs to be monitored and regulated carefully."

Some of this may be true. But financial integration affords clear
advantages.
Capital-poor countries can finance investment more cheaply by borrowing
abroad than by depending solely on domestic savings. International
financial markets provide discipline on macroeconomic policy, and
international banks and securities dealers are often the only source of
competitive pressure on
oligopolistic and inefficient domestic banks. Another advantage, at
least in theory, is that access to international financial flows allows
countries to stabilize their economies in the face of fluctuations. But
here is where reality does begin to diverge from theory. International
financial markets in fact seem to cause or exacerbate economic
fluctuations at least as often as they stabilize them. After the
international debt crisis of 1982-89, the Mexican peso crisis of 1994,
and the Asian crisis of 1997-98, it has become
difficult to maintain that financial markets always work as smoothly as
economic theory predicts.

Nonetheless, developing countries will probably enjoy higher average
growth rates with access to international capital markets than without
it, even if the effects of periodic crashes are taken into account. That
said, well-targeted government interventions -- such as Chilean-style
penalties on short-term inflows or high reserve requirements for banks
borrowing in foreign currency -- can sometimes improve stability without
sacrificing the benefits of international capital flows. But short of
the unattainable ideal of
maintaining perfect macroeconomic and structural policies, or perhaps
short of harmful prohibitions against all portfolio capital flows,
occasional crises may be an inevitable price of economic development.

WHY ME?
The most surprising aspect of Bhagwati's attack on the Clinton
administration is its lack of historical perspective. Both the Reagan
and the George H.W. Bush administrations pursued ftas and open financial
markets at least as vigorously as did the Clinton team. The new Bush
administration is likely to pursue both goals as well. Why single out
the Clinton White House for unique opprobrium?
In 1982, the Reagan administration, frustrated with European resistance
to its proposal to launch a new round of multilateral liberalization,
reversed the traditional U.S. position against regional trade
arrangements and offered to discuss bilateral or regional trade
agreements with any willing partners. The
outcome was the establishment of the Israel-U.S. fta, the Canada-U.S.
fta, the negotiation of NAFTA, and preliminary plans for an fta spanning
the entire western hemisphere. The Clinton administration continued this
approach, persuading Congress to approve NAFTA in 1993, supporting the
Asia-Pacific
Economic Cooperation forum, and beginning negotiations for the ftaa. The
new Bush administration seems inclined to pick up precisely where
Clinton left off.

While pursuing regional liberalization, each of these administrations
also pursued multilateral liberalization. The Uruguay Round of
negotiations, which eventually established the WTO, was started by the
Reagan administration, continued by the first Bush administration, and
concluded successfully by the Clinton administration. Although Clinton
was denied fast-track authority to negotiate trade treaties, he
succeeded in negotiating multilateral single-sector agreements in such
areas as information-technology products and
telecommunications services. The strategy all along has been to pursue
liberalization at both regional and global levels simultaneously,
seeking progress on the regional front when the multilateral path is
politically
infeasible.

Indeed, there are consistently fewer differences on trade policy between
Republican and Democratic administrations than there are between the
legislative and executive branches of government. Congress, not the
White House, has been the primary obstacle to the sort of
internationalism that is necessary for effective U.S. leadership of the
global economic system. Given the political opposition on both the right
and the left, Clinton was remarkably effective at steering through the
shoals to find a path of market-opening agreements. Things may be easier
for Republican George W. Bush: Congress is less likely to deny him
fast-track authority or to block his use of the Treasury's Exchange
Stabilization Fund in managing financial crises. But the strategy of
liberalization, to be pursued simultaneously at the regional
and multilateral levels, will likely be the same under Bush as under his
three predecessors. Indeed, one of the few good things about the 2000
election campaign was that the two major candidates shared an
internationalist philosophy, whereas the two fringe candidates, Ralph
Nader and Pat Buchanan,
garnered little support for their isolationist positions.

A similar story applies to international financial policy. The Reagan
and Bush Treasuries badgered countries in Asia and elsewhere to remove
capital controls and to let in foreign financial institutions.
Throughout the 1980s and 1990s, the White House pursued the interests of
banks and securities dealers in bilateral discussions. In 1984, the
Reagan Treasury bullied Japan into financial liberalization with the
Yen-Dollar Agreement, which helped open Japanese financial markets. The
Reagan and Bush administrations then applied the same strategy to South
Korea and other Asian countries. To be sure, the
Clinton Treasury continued along this path. Even after the ravages of
the 1997-98 Asian crisis, insufficient progress on opening up to foreign
financial institutions was the reason that the Clinton administration
gave Premier Zhu Rongji for denying China an agreement on its accession
to the WTO in April 1999.
Even the White House's eventual turnaround on this issue does not count
as a success, according to Bhagwati, because the economic terms were too
tough on China. ("The terms were so totally biased in favor of the
United States that it was a no-brainer," he writes in the preface.) It
is true that the United
States denied China certain accommodations that have been granted to
other developing countries, of which China is surely one. More
generally, after years of seeking to persuade other countries of the
virtues of an open-market system, the United States has been reluctant
to "take yes for an answer" and has turned to a strategy of playing
"hard to get" in international dealings of all kinds. But Bhagwati's
position -- that U.S. trade negotiators have been too tough on Mexico
and China and have thus achieved unfairly rapid openings of those
markets -- puts him in a negligible political constituency.

EXCEPTIONS TO THE RULE
Admittedly, the Clinton administration made some mistakes in
international economic policy. It is true, as Bhagwati says, that some
of its members initially held naive expectations about how much progress
could be made by a "get tough" trade policy with China and Japan. As in
other administrations, the Clinton White House found it difficult to
ignore completely the steel industry's pleas for protection against
waves of cheap imports from troubled economies. The U.S. trade
representative was unable to prepare adequately for the 1999 WTO
ministerial meeting in Seattle. Finally, President Clinton's famous
comment at that time to an interviewer -- that he would like to see an
eventual international agreement to back up social standards with trade
sanctions -- departed from the carefully thought-out U.S. position.
Delegates
from poor countries understandably interpreted his statement as a
message with adverse protectionist implications, which thus helped
torpedo the meetings.

That most of these actions may have been the product of political
pressures does not change the fact that they were mistakes in economic
policy.
But these moves are exceptions to the general pattern, far outweighed by
the overall record of progress achieved by the Clinton administration's
international economic policy. The most notable gains were the
successful completion of the Uruguay Round and NAFTA during Clinton's
first term, the capable management of the Mexican peso crisis in 1995
and the Asian crisis in 1997-98, the successful negotiation of permanent
normal trade relations with China in 2000, and the light management of
the dollar throughout both terms.
More generally, the administration was remarkably successful at pursuing
an economic agenda that brought material gains to virtually all segments
of American society. It is more remarkable still that Clinton was able
to accomplish so much of his globalization agenda despite a
congressional opposition that would have crippled most politicians.

Bhagwati's writings play an important role in helping shape a better
trade policy. His points regarding ftas and financial flows make
provocative and instructive reading. But they will probably find little
resonance with readers as a verdict on the Clinton administration.¶

Jeffrey Frankel is Harpel Professor of Capital Formation and Growth at
Harvard University's John F. Kennedy School of Government. He served on
President Clinton's Council of Economic Advisers from 1996 to 1999.