Linking trade to growth

Winter McCulloch and McKay (2004) have shown that the alleviation of poverty is attained through long-term economic growth. They argue that faster economic growth raises income levels, which in turn allows governments more tax revenue to take redistributive measures. To understand the effects it is important to separate the links between the openness of an economy and growth and between growth and inequality.

The theory that trade is positively correlated with economic growth goes back to Adam Smith, who argued that trade allows for increased specialization. Specializa-tion permits increased attainment of economies of scale, especially from countries with relatively small domestic markets. A country’s abundant means of production also is fully exploited through trade. Domestic businesses are forced to improve their technologies because of competition from imports. Further, increased economic integration with the outside world encourages technological innovation through the diffusion of new technologies from more advanced countries. Increased imports curb domestic monopolies that hold production below and prices above socially optimal levels.

Trade affects economic growth via two mechanisms: efficiency gains from specializa-tion and economies of scale. For example, because of efficiency gains through

spe-cialization, most developing countries will obtain aircraft more cheaply by import-ing them from Boeimport-ing or Airbus usimport-ing earnimport-ings from exports than by attemptimport-ing to build them domestically. Most developing countries, moreover, depend even more on the world market for economies of scale than do large industrial countries. Costa Rica, for example, has economies of scale from exporting computer chips from its Intel plant. This would not be the case if it did not have access to the external market. Similarly, the anti-monopoly mechanism for a beneficial impact of open trade is likely to be even more important for developing countries than for industrial countries, again because the domestic market will tend to be smaller and hence more susceptible to monopolization.

The link between trade and growth may occur through increased productivity.

Contacts with the world market enhance total factor productivity in an agricul-tural product. Agriculture is a sector in which technical change has been extremely important. This was demonstrated by the Green Revolution in Asia in its improved practices and new seed varieties and, in Brazil, by the spread of genetically modified crops. These advances might not have occurred if these countries had had no con-tact with global markets. According to Krugman (2003), history demonstrates that poor countries that worked to improve their standard of living achieved it through globalization as they produced for the world market rather than choosing to be self-sufficient. Grossman and Helpman (1994) show that integration with the world economy can boost a country’s productivity. First, residents of a country that is integrated into world markets are likely to enjoy access to a larger technical knowl-edge base than those living in relative isolation, because trade helps disseminate technology. Second, exposure to international competition may mitigate redundant industrial research. While a firm that develops a product for a domestic market need only use technologies new to the local economy, one that hopes to compete in the international marketplace will be forced to generate ideas that are truly innovative on a global scale. Third, by expanding the size of the potential customer base, inter-national integration may bolster incentives for industrial research.

Transmission mechanisms from more open trade to the dynamic gain of factor pro-ductivity growth should not apply any less to developing countries than to industrial countries. Certainly, for the two countries with the largest poverty-stricken popula-tions in the world, China and India, the experience of the past two decades has been resoundingly consistent with the diagnosis that opening trade to the world economy fosters productivity and economic growth.

To illustrate this connection some economists use neoclassical models, which are essentially general equilibrium models, with constant or decreasing returns of scale, rational individuals acting solely through markets and no transaction costs. In this case, the trade patterns among countries are determined by comparative advantage.

Others use Ricardian models in which the comparative advantage takes the form of

technological differences. In Heckscher-Ohlin models, the comparative advantage takes the form of differences in resource endowment. The result obtained from the neoclassical models is that a country will have static gains from trade liberalization, the most important being an increase in allocative efficiency. By lowering trade bar-riers, a country faces the international relative prices that induce the efficient alloca-tion of domestic resources to sectors with comparative advantage, increasing aggre-gate welfare. However, Rodrik (1988), Devarajan and Rodrik (1989) and Krugman (1994) have challenged these results, arguing that the neoclassical models only cap-ture increases in the level of income and that therefore trade liberalization may not lead to a persistent increase in the growth rate. They argue that, under conditions of economies of scale and imperfect competition, the welfare impact of trade liberaliza-tion can be negative.

In response to the weaknesses of neoclassical growth models, some economists, while preserving most of the model, have introduced new features, which consider growth to be endogenous. The theory is that there is an “accumulable” factor, technology, which is produced by intermediate inputs. An increase in the productivity of the intermediate inputs leads to an increase in the rate of accumulation and growth of output in subsequent periods. Hence there is an appreciable difference between the neoclassical growth model and endogenous models.

Whereas the impact of neoclassical models could be negative, according to the new growth models, trade policy affects both an economy’s level and long-term rate of growth—not only its level of income. Using the endogenous model, Duncan and Quang (2003) explain that developing countries embracing protectionist policies that deny access to imported capital goods embodying improved technology inhibit long-term growth. They argue that there are “spillover effects” to be gained from trade including the dissemination of new knowledge, which could improve effi-ciency and sustainable growth.

A strand of the literature emphasizes the importance of institutions, suggesting that trade liberalization will have a positive impact on growth if the appropriate institutions are in place. Otherwise, trade reforms and other structural reforms will be ineffective. According to this strand of literature, trade liberalization thus has a much wider effect than changing relative prices. It also implies multiple institutional changes.

Empirical assessment of the connection between trade and growth is not conclusive.

Some studies find a positive correlation between the two, while others conclude that the impact of reducing trade barriers has a negative effect. Little, Scitovski and Scott (1970) and Balassa (1971) were first to address this subject. Since then many economists have attempted to relate trade policy variables to economic performance and growth. The research can be divided into two groups: multi-country studies that

investigate in detail the experience of some countries that have been subject to trade reforms and cross-country econometric studies that analyze the relationship between openness and trade.

Initial studies carried out by Dollar (1992), Sachs and Warner (1995), Ben-David (1993) and others undertook cross-country regression analyses and found positive correlations between a country’s openness and faster economic growth. However, Rodriguez and Rodrik (1999) and again Rodrik (2001) have questioned these results, arguing that openness is likely to be an outcome rather than a prerequisite of growth.

To address the problem of causality, Frankel and Romer (1999) analyse only the effect of the component of trade that cannot be influenced by growth in the short term, mainly caused by populations, land areas and distances. They observe that this component accounts for a significant proportion of the differences between coun-tries in income and growth and suggest a general relationship connecting increased trade to increased growth.

Dollar and Kraay (2002) also have shown a link between trade liberalization and the reductions in the level of poverty through growth. Salinas and Aksoy (2006) use within-country estimation to circumvent the need to measure trade openness and find that on average the growth of GDP per capita increases between 1.2 and 2.6 per cent after trade liberalization. From these studies one can conclude that trade reforms contribute to sustained economic development in developing countries.

Furthermore, trade liberalization has a positive influence on efficiency and long-term stability.

According to Winters et al. (2004), there are three potential difficulties in trying to establish an empirical link between trade and economic growth. First, for countries that engage in little or no trade with the outside world it is very difficult to measure their trade stance. Second, trade liberalization in itself does not guarantee a long-term effect on growth. It has to be combined with other structural policies. Third, causality is very difficult to establish.