The story of Mexico – poster boy of the free-trade camp – is particularly telling. If any developing country can succeed with free trade, it should be Mexico. It borders on the largest market in the world (the US) and has had a free trade agreement with it since 1995 (the North American Free Trade Agreement or NAFTA). It also has a large diaspora living in the US, which can provide important informal business links.[2] Unlike many other poorer developing countries, it has a decent pool of skilled workers, competent managers and relatively developed physical infrastructure (roads, ports and so on).
Free trade economists argue that free trade benefited Mexico by accelerating growth. Indeed, following NAFTA, between 1994 and 2002, Mexico’s per capita GDP grew at 1.8% per year, a big improvement over the 0.1% rate recorded between 1985 and 1995.[3] But the decade before NAFTA was also a decade of extensive trade liberalisation for Mexico, following its conversion to neo-liberalism in the mid-1980s. So trade liberalization was also responsible for the 0.1% growth rate.
Wide-ranging trade liberalization in the 1980s and the 1990s wiped out whole swathes of Mexican industry that had been painstakingly built up during the period of import substitution industrialization (ISI). The result was, predictably, a slowdown in economic growth, lost jobs and falls in wages (as better-paying manufacturing jobs disappeared). Its agricultural sector was also hard hit by subsidized US products, especially corn, the staple diet of most Mexicans. On top of that, NAFTA’s positive impact (in terms of increasing exports to the US market) has run out of steam in the last few years. During 2001–2005, Mexico’s growth performance has been miserable, with an annual growth rate of per capita income at 0.3% (or a paltry 1. 7% increase in total over five years).[4] By contrast, during the ‘bad old days’ of ISI (1955–82), Mexico’s per capita income had grown much faster than during the NAFTA period – at an average of 3.1% per year.[5]
Mexico is a particularly striking example of the failure of premature wholesale trade liberalization, but there are other examples.[6] In Ivory Coast, following tariff cuts of 40% in 1986, the chemical, textile, shoe and automobile industries virtually collapsed. Unemployment soared. In Zimbabwe, following trade liberalization in 1990, the unemployment rate jumped from 10% to 20%. It had been hoped that the capital and labour resources released from the enterprises that went bankrupt due to trade liberalization would be absorbed by new businesses. This simply did not happen on a sufficient scale. It is not surprising that growth evaporated and unemployment soared.
Trade liberalization has created other problems, too. It has increased the pressures on government budgets, as it reduced tariff revenues. This has been a particularly serious problem for the poorer countries. Because they lack tax collection capabilities and because tariffs are the easiest tax to collect, they rely heavily on tariffs (which sometimes account for over 50% of total government revenue).[7] As a result, the fiscal adjustment that has had to be made following large-scale trade liberalization has been huge in many developing countries – even a recent IMF study shows that, in low-income countries that have limited abilities to collect other taxes, less than 30% of the revenue lost due to trade liberalization over the last 25 years has been made up by other taxes.[8] Moreover, lower levels of business activity and higher unemployment resulting from trade liberalization have also reduced income tax revenue.When countries were already under considerable pressure from the IMF to reduce their budget deficits, falling revenue meant severe cuts in spending, often eating into vital areas like education, health and physical infrastructure, damaging long-term growth.
It is perfectly possible that some degree of gradual trade liberalization may have been beneficial, and even necessary, for certain developing countries in the 1980s – India and China come to mind. But what has happened during the past quarter of a century has been a rapid, unplanned and blanket trade liberalization. Just to remind the reader, during the ‘bad old days’ of protectionist import substitution industrialization (ISI), developing countries used to grow, on average, at double the rate that they are doing today under free trade. Free trade simply isn’t working for developing countries.
Free trade economists find all this quite mysterious. How can countries do badly when they are using such theoretically well-proven (‘the economics is all there’, as Professor Buiter says) policy as free trade? But they should not be surprised. For their theory has some serious limitations.
Modern free trade argument is based on the so-called Heckscher-Ohlin-Samuelson theory (or the HOS theory).* The HOS theory derives from David Ricardo’s theory, which I outlined in chapter 2, but it differs from Ricardo’s theory in one crucial respect. It assumes that comparative advantage arises from international differences in the relative endowments of ‘factors of production’ (capital and labour), rather than international differences in technology, as in Ricardian theory.[9]
According to free trade theory, be it Ricardian or the HOS version, every country has a comparative advantage in some products, as it is, by definition, relatively better at producing some things than others.† In the HOS theory, a country has comparative advantage in products that more intensively use the factor of production with which it is relatively more richly endowed. So even if Germany, a country relatively richer in capital than labour, can produce both automobiles and stuffed toys more cheaply than Guatemala, it pays for it to specialize in automobiles, as their production uses capital more intensively. Guatemala, even if it is less efficient in producing both automobiles and stuffed toys than Germany, should still specialize in stuffed toys, whose production uses more labour than capital.
The more closely a country conforms to its underlying pattern of comparative advantage, the more it can consume. This is possible due to the increase in its own production (of the goods for which it has comparative advantage), and, more importantly, due to increased trading with other countries that specialize in different products.How can the country achieve this? By leaving things as they are.When they are free to choose, firms will rationally (like Robinson Crusoe) specialize in things that they are relatively good at and trade with foreigners. From this follows the propositions that free trade is best and that trade liberalization, even when it is unilateral, is beneficial.
But the conclusion of the HOS theory critically depends on the assumption that productive resources can move freely across economic activities. This assumption means that capital and labour released from any one activity can immediately and without cost be absorbed by other activities.With this assumption – known as the assumption of ‘perfect factor mobility’ among economists – adjustments to changing trade patterns pose no problem. If a steel mill shuts down due to an increase in imports because, say, the government reduces tariffs, the resources employed in the industry (the workers, the buildings, the blast furnaces) will be employed (at the same or higher levels of productivity and thus higher returns) by another industry that has become relatively more profitable, say, the computer industry. No one loses from the process.
2
Most of the Mexican diaspora are recent immigrants but some of them are the descendants of the former Mexicans who became Americans due to the annexation of large swathes of the Mexican territory – including all or parts of modern California, New Mexico, Arizona, Nevada, Utah, Colorado and Wyoming – after the US-Mexico War (1846–48) under the Treaty of Guadalupe Hidalgo (1848).
3
The numbers are from M. Weisbrot et al. (2005), ‘The Scorecard on Development: 25 Years of Diminished Progress’, Center for Economic and Policy Research (CEPR), Washington, DC, September, 2005 (http://www.cepr.net/publications/development200509.pdf), Figure 1.
4
Mexican
5
Mexico’s
6
For further details, see H-J. Chang (2005),
7
Tariffs account for 54.7% of government revenue for Swaziland, 53.5% for Madagascar, 50.3% for Uganda and 49.8% for Sierra Leone. See Chang (2005), pp, 16–7.
8
T. Baunsgaard & M. Keen (2005), ‘Trade Revenue and (or?) Trade Liberalisation’, IMF Working Paper WP/05/112 (The International Monetary Fund, Washington, DC).
*
The HOS theory is named after the two Swedish economists, Eli Heckscher and Bertil Ohlin, who pioneered it in the early 20th century, and Paul Saumelson, the American economist who perfected it in the mid-20th century. In this version of free trade theory, for each product there is only one ‘best practice’ (i.e., most efficient) technology, which all countries will use if they are producing it. If each product has one best production technology for its production, a country’s comparative advantage can
†
So, ‘comparative’ in the term ‘comparative advantage’ is not about comparison between countries but about comparison between products. It is because people mix these two up that they sometimes believe that poor countries do not have comparative advantage in anything – which is a logical impossibility.