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Trade & Investment

International trade economists have long established that a liberal and outward-oriented trade regime is the best strategy for a small open economy that takes international prices as given. An open trade regime increases welfare and income by leading to an optimum allocation of resources in production (reorienting resources to areas of comparative advantage) and consumption and by minimizing the incentive for engaging in income-generating but unproductive activities associated with protection, such as smuggling, lobbying, tariff evasion, and the like. As well established as these results are, they have also been troubling to economists for two reasons. First, numerical estimates of the welfare impact of allocative efficiency have traditionally been very small, a fraction of one percent of GDP. Secondly, the welfare effect of efficient resource allocation is a one time event that leads to a higher level of income but does not affect long-term growth, although growth in the short-run, whilst the economy moves to the higher income level, increases.

Extensive empirical research in the past decade (see the sample bibliography below) has shown the existence of a positive and strong association between trade openness and economic growth over very long periods of time. However, this research has been criticized on several grounds (see for example the latest article by Rodrik, 1999), including (i) lack of conclusive evidence on the direction of causality between  openness and growth;  (ii) the  fact that the openness measures used in the literature do not reflect purely trade phenomena but include other policy variables that are more macroeconomic in nature (this is particularly true with regard to the Sachs Warner openness measure); (iii) the sensitivity of results to the choice of time period and/or sampled countries; (iv) other econometric shortcomings. 

Be that as it may, the fundamental question concerns the channels through which an outward trade policy affects growth. The literature points to the following broad types of channels:

The first channel is the channel of investment.  Openness can affect both the level and efficiency of investment and growth in several ways. First, an open trade regime can increase market size and hence lead to investment in industries with increasing returns that would not have been viable in a small market. Openness can also lead to increased investment by allowing domestic agents access to capital goods that were unavailable previously or were available at too high a cost, thus removing structural constraints to investment and export. Moreover, openness can also be assumed to increase the efficiency of investment or lead to higher foreign direct investment (see GEP 97).   Empirical research (see Wacziarg 1998) shows that if the effect of trade openness on growth is decomposed and attributed to the various channels of transmission, increased investment would by far be the most important channel of transmission.

The second channel is the productivity channel. To the extent that open trade regimes lead to greater exposure to a worldwide stock of productivity enhancing knowledge, then openness leads to increased growth. Ben David and Loewy (1995), for example, state that the growth impact of freer trade derives from the premise that "..(1) knowledge may be characterized as a non-rivalrous public good which in many cases is non-excludable, and (2) trade flows facilitate the diffusion of knowledge among countries. ...Heightened trade will, in general, lead to greater diffusion and faster knowledge growth and hence, faster per capita income growth." 

A third channel for the impact of trade on growth is the government policy. If and to the extent that trade openness creates incentive to or obliges (through commitment at multilateral institutions) policy makers to pursue virtuous macroeconomic and regulatory policies, then it can lead to higher growth.

Whatever the channel,  empirical estimates of the impact of trade on growth and welfare are quite substantial. Sachs and Warner (1995) for example, maintain that the open economies have grown about 2.5 percent faster than closed economies, with even greater differences among developing countries. Wacziarg (1998) estimates that an improvement of 10 percentage point in an especially-constructed trade policy measure is associated with a 0.71 point increase in annual growth rate once all channels of influence are brought into the picture. Tarr and Rutherford (1998) use a CGE model to estimate that a 10 percent reduction in average tariff (from 20 to 10 percent) brings about a welfare gain of between 10 to 37 percent of the present value of consumption, depending on the assumption about what kind of taxes are used to replace lost tariff revenues and whether or not a country has access to international capital. This welfare gain is in line with Wacziarg's estimates since a welfare gain of 10 to 37 percent corresponds to a permanent increase in the growth rate of between 0.4 and one percent.

Further Readings and links:

  • Edwards, Sebastian (1992), Trade Orientation, Distortions and Growth in Developing Countries, Journal of Development Economics, vol. 39, pp. 31-57.
  • Edwards, Sebastian (1998), "Openness, Productivity and Growth: What do We Really Know?" Economic Journal, 1998
  • Frankel, Jeffrey A. and David Romer (1995) "Trade and Growth: An Empirical Investigation" mimeo, UC Berkeley, November.
  • Kim, Se-Jik (1999) Growth Gains from Trade and Education,  International Monetary Fund, Research Department, IMF Working Paper WP/99/23
  • Krishna, K., Ataman Ozyildirim, Norman R. Swanson (1999): Trade, Investment, and Growth: Nexus, Analysis, and Prognosis; NBER Working Paper No. W6861
  • Krueger, Anne O. (1998) "Why trade liberlisation is good for growth", Economic Journal, September issue
  • Lawrence, Robert Z., David E. Weinstein (1999): Trade and Growth: Import-Led or Export-Led? Evidence From Japan and Korea, NBER Working Paper No. W7264
  • Francisco Rodriguez, Dani Rodrik (1999) Trade Policy and Economic Growth: A Skeptic's Guide to Cross-National Evidence; NBER Working Paper No. W7081
  • Oxford Economic Papers, January 1999  Symposium on trade, technology, and growth.
  • Sachs, J. D. and A. Warner (1995): Economic Reform and Process of Global Integration," Brooking Papers on Economic Activity pp. 1-117.
  • Thomas, Vinod and Nash, John D (1991):" Best practices in trade policy reform" Published for the World Bank [by] Oxford University Press.
  • World Bank (1997) Global Economic Prospects and the Developing Countries (GEP 1997), chapter 3. 

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