Category Archives: Institutions

Foreign Investment Boosts Sophistication of Domestic Manufacturing: New Evidence from Turkey

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By Beata Javorcik (University of Oxford), Alessia Lo Turco, (Marche Polytechnic University), Daniela Maggioni (University of Catania)

Recently, there has been a renewal of interest in industrial policy across the world. Advanced economies promise to use industrial policy to revive their declining manufacturing, while emerging markets hope that industrial policies will help them upgrade their production structure and in this way stimulate economic growth. Yet, little is known about the micro determinants of product upgrading.

The existing research suggests that inflows of foreign direct investment (FDI) can foster host countries’ production upgrading, where upgrading is measured in terms of the unit values of exports (Harding and Javorcik,  2012).[1]

In our recent work, we move away from unit values – a highly imperfect proxy for product quality –  and examine the link between FDI and product upgrading, as captured by complexity of new products introduced by domestic firms.[2] We focus on manufacturing firms in Turkey, a country that has experienced a spectacular surge in FDI inflows during the 2000s and dramatically increased the sophistication of its productive structure in the last decades.[3]

Anecdotal evidence

Anecdotal evidence suggests that foreign affiliates stimulate product upgrading among their suppliers. For example, Indesit Company, an Italian white good producer – recently acquired by Whirlpool – has produced refrigerators in Turkey since the 1990s. In 2012, Indesit built a new plant to produce washing machines. To become a supplier of this new plant, a local company purchased new presses and automated its production process. This allowed it to start producing a new and more sophisticated product, a washing machine flange, and to increase efficiency and production volumes. The flange is a very complex product as it needs to be produced with no aesthetic defects by an 800-1,000 tonne metal presses. It also needs to withstand the stress of between 1,000 and 1,400 revolutions per minute while remaining within a certain range of vibration and noisiness. Indesit has shared essential tacit knowledge, information processes, instructions and control procedures with the local company, thus stimulating and supporting the supplier’s complexity upgrading.

Inspired by the anecdotal evidence, our study examines the link between the presence of foreign affiliates and production upgrading by Turkish firms located in the same region and active in the input-supplying industries.

Measuring product complexity

To capture product complexity we use a measure proposed by César Hidalgo and Ricardo Hausmann, who relate the concept of product complexity to the extent and exclusivity of capabilities needed to produce a given product.[4] It is easiest to explain this measure using a Lego analogy. Think of a country as a bucket of Lego pieces with each piece representing the capabilities available there. The set of products (i.e., Lego models) a country can produce depends on the diversity and exclusiveness of the Lego pieces in the bucket. A Lego bucket that contains pieces that can only be used to build a toy bicycle probably does not contain the pieces to create a toy car. However, a Lego bucket that contains pieces that can build a toy car may also have the necessary pieces needed to build a toy bicycle.  While two Lego buckets may be capable of building the same number of models, these may be completely different sets of models. Thus, determining the complexity of an economy by looking at the products it produces amounts to determining the diversity and exclusivity of the pieces in a Lego bucket by simply looking at the Lego models it can build.

Our findings

Our analysis suggests that the presence of foreign affiliates does not affect the propensity of Turkish firms to innovate. However, the presence of foreign affiliates is positively correlated with the complexity level of products newly introduced by Turkish firms active in the supplying industries and located in the same region.

The estimated effect is economically meaningful. A 10 percentage point increase in foreign presence implies moving about half of the way from the production of pot scourers to producing stainless sinks. An increase of about 17 percentage points in FDI in the relevant sectors would be necessary in order to move from the production of stainless sinks to the production of the washing machine flanges.

Conclusion  

Our findings matter for policy. Dani Rodrik argues that enhancing an economy’s productive capabilities over an increasing range of manufactured goods can be considered an integral part of economic development.[5] As foreign affiliates facilitate the upgrading of the host country’s productive capabilities, our results, then, imply that FDI inflows can act as an important stimulus for economic growth. Thus, there is room for investment promotion activities, a policy that is quite effective in developing countries.[6] In contrast to many other industrial policies, investment promotion is relatively inexpensive and causes few distortions. Therefore, there is little downside when the government gets it wrong.

References

Harding, T. and Javorcik, B.S. (2011). ‘Roll out the red carpet and they will come: investment promotion and FDI inflows’, Economic Journal, vol. 121(557), pp. 1445–1476.

Harding, T. and Javorcik, B.S. (2012). ‘Foreign direct investment and export upgrading’, The Review of Economics and Statistics, vol. 94(4), pp. 964–980.

Hidalgo, C.A. and Hausmann, R.(2009). ‘The building blocks of economic complexity’, Proc. Natl. Acad. Sci., vol. 106, pp. 10570–10575.

Javorcik, B.S., Lo Turco, A., Maggioni, D. ‘New and Improved: Does FDI Boost Production Complexity in Host Countries?‘ Economic Journal, forthcoming.

Rodrik, D. (2006). ‘Industrial development: stylized facts and policies’, Kennedy School of Government.

Endnotes

[1] See Harding and Javorcik (2012).

[2] Javorcik, Lo Turco and Maggioni (forthcoming).

[3] See Hidalgo (2009).

[4] See Hidalgo and Hausmann (2009)

[5] See Rodrik (2006)

[6] Harding and Javorcik (2011)

Self-Enforcing Trade Agreements and Lobbying

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By Kristy Buzard (Syracuse University)

Going back to the mid-1980s, the repeated prisoner’s dilemma has been used to model the absence of strong external enforcement mechanisms for trade agreements.[1] Cooperation is enforced by promises of future punishment for any deviation from the agreement, and the amount of cooperation that can be achieved depends on the severity of the chosen punishments. The strongest incentive-compatible punishment is often the grim trigger strategy in which all players play the static Nash equilibrium forever when any of them defects.

More recent work shows that grim trigger punishments can be improved upon in some circumstances. Jee-Hyeong Park, for instance, has demonstrated that the presence of asymmetric information and imperfect monitoring can make it more efficient to choose shorter punishments.[2] In a similar setting, Alberto Martin and Wouter Vergote show that retaliation — i.e. delayed punishment — dominates reciprocity.[3]

In a recent paper, I identify a different rationale for limiting punishments: endogenous politics.[4] This paper is the first to incorporate endogenous lobbying along the lines of the classic Grossman-Helpman “Protection for Sale” model — the standard model for endogenizing politics in trade policy — into a repeated-game setting. In place of a unitary government, this model has two branches of government who share policy-making power.[5] By endogenizing the political economy weights, one can address questions about the commitment value of trade agreements, and examine the implications of self-enforcement constraints for the design of trade agreements.

I assume that the social-welfare maximizing executives of two countries choose trade agreement tariffs that must then be implemented by politically-susceptible legislatures.[6] For simplicity, only the import-competing industry is represented by a lobby. The weight the legislature puts on the import-competing industry’s profits increases in lobbying effort, which can be thought of as including campaign contributions as well as broader measures of lobbying activity. The lobby will choose its effort level to optimally influence the legislature’s decisions about whether to abide by the trade agreement and how to set tariffs in the absence of an agreement. Assuming there is no uncertainty about the effect of lobbying effort on the outcome of the political process, the lobby either exerts the minimum effort needed to derail the agreement or exerts no effort at all. The executives maximize social welfare by choosing the lowest tariffs that make it unattractive for the lobbies to provoke the legislature to violate the trade agreement. There will thus be no trade disputes in equilibrium, but the out-of-equilibrium threat that a lobby might provoke one is crucial in determining the equilibrium trade agreement structure.

Adding a lobby to the usual repeated-game model adds a new constraint. The constraint on the legislature is loosened by an exogenous increase in the length of the punishment: defections become relatively more unattractive as the punishment becomes more severe as in the standard prisoner’s dilemma. However, the new constraint due to the presence of lobbying becomes tighter because the lobby prefers punishment periods. The higher tariffs during punishment periods give the lobby increased incentive to exert effort as the punishment lengthens. In the face of this heightened lobbying incentive, the executives must raise the trade agreement tariff to avoid a trade dispute.

The optimal Nash-reversion punishment strikes a balance between these two competing forces, so adding endogenous politics suggests an optimal length for punishments: it is  finite for most values of the political weighting function and can be derived directly from the players’ incentive constraints.[7] Shortening the punishment in models with uncertainty serves to increase welfare by minimizing time spent in punishment periods. Since there is no uncertainty in this model, the players remain in the cooperative state in all periods.[8] Here, social welfare improves because shorter punishments weaken the lobby’s incentive to exert effort and this allows the executives to reduce the trade agreement tariffs.

For a given punishment length, increases in the patience of the legislature mean the lobby must exert more effort to induce the legislature to endure the punishment. The executive can thus reduce trade agreement tariffs without fear that the agreement will be broken. Increases in the lobby’s patience and the lobby’s ability to influence the legislature (as measured by the political weighting function) work in the opposite direction: they allow the lobby to exert less effort to provoke a trade dispute, and therefore higher equilibrium trade agreement tariffs are necessary to avoid a dispute.

The optimal punishment length itself also depends on how readily special interests are able to influence the political process. If the lobby is weak, the optimal punishment converges to that of the model without a lobby: longer punishments are better because the key constraint is the legislature’s. As the lobby becomes more influential, the optimal punishment becomes shorter because the lobby’s incentive becomes more important. That the optimal length of punishments is a function of the influence of the lobbies reinforces the idea that endogenizing politics can be critically important for institutional design questions.

References

Bagwell, K., and R.W. Staiger, (2005); “Enforcement, Private Political Pressure, and the General Agreement on Tariffs and Trade/World Trade Organization Escape Clause.” Journal of Legal Studies, 34(2): 471–513.

Buzard, K., (2017a); “Self-Enforcing Trade Agreements and Lobbying.” Journal of International Economics, 108(1): 226–242.

Buzard, K., (2017b); “Trade Agreements in the Shadow of Lobbying.” Review of International Economics, 25(1): 21–43.

Dixit, A., (1987); “Strategic Aspects of Trade Policy.” in: T.F. Bewley (ed.), Advances in Economic Theory: Fifth World Congress. Cambridge University Press, pp. 329–362.

Maggi, G., and A. Rodríguez-Clare, (2007); “A Political-Economy Theory of Trade Agreements.” The American Economic Review, 97(4): 1374–1406.

Martin, A., and W. Vergote, (2008); “On the Role of Retaliation in Trade Agreements.” Journal of International Economics, 76(1): 61–77.

Milner, H.V., and B.P. Rosendorff, (1997); “Democratic Politics and International Trade Negotiations: Elections and Divided Government as Constraints on Trade Liberalization.” Journal of Conflict Resolution, 41(1): 117–146.

Park, J.-H., (2011); “Enforcing International Trade Agreements with Imperfect Private Monitoring.” Review of Economic Studies, 78(3): 1102–1134.

Endnotes

[1] See for example Dixit (1987).

[2] Park (2011).

[3] Martin and Vergote (2008).

[4] Buzard (2017a).

[5] This approach follows Milner and Rosendorff (1997).

[6] The model admits an interpretation in which the same branch of government both negotiates the trade agreement and decides on the applied tariff ex-post, and thus the one-shot game shares much in common with Maggi and Rodríguez-Clare (2007).

[7] In Park (2011), the finite punishment length is due to imperfect monitoring and/or uncertainty.

[8] In Buzard (2017b), I show how uncertainty can be incorporated into this model.

Global Tariff Negotiations as a Stumbling Bloc to Global Free Trade?

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By James Lake (Southern Methodist University) and Santanu Roy (Southern Methodist University)

The principle of non-discrimination lies at the heart of the WTO. GATT Article I mandates that, for a given product, a country cannot set different tariffs on different trading partners. Indeed, GATT Article I has provided the bedrock for the various rounds of global trade negotiations, including the 1994 Uruguay Round. However, GATT Article XXIV allows Free Trade Agreements (FTAs) whereby members eliminate tariffs on each other while maintaining tariffs on non-members. Thus, FTAs directly contradict the non-discrimination principle. In turn, an important and long standing issue in the FTA literature is whether FTAs help or hinder global trade negotiations. In the famous language of Jagdish Bhagwati, are PTAs “building blocs” or “stumbling blocs” to global trade liberalization?

A long literature has tackled Bhagwati’s question.[1] However, the interdependence between FTAs and global trade negotiations need not only run from FTAs to global negotiations. The process of global negotiations may also impact the process of FTA formation and, in turn, the degree of global trade liberalization. That is, the tariff concessions embedded in the Uruguay Round may have shaped the subsequent process of FTA formation and, in turn, the ultimate degree of global trade liberalization. Yet, as noted by Caroline Freund and Emanuel Ornelas in their review of the literature, the impact of global negotiations on FTAs has received surprisingly little attention in the literature.[2]

In a recent paper, we investigate how an initial round of global negotiations over tariff bindings (i.e. the upper bound on tariffs) impact the subsequent process of FTA formation in a three-country world where governments favor the interests of their import competing sector due to political economy motivations.[3] To do so, we compare the outcomes of two extensive form games that differ only because of the presence or absence of an initial round of global tariff negotiations. In the first game, global negotiations precede FTA negotiations and forward looking governments anticipate the possibility of FTA formation during global negotiations. In the second game, there are no global negotiations preceding FTA negotiations. In either game, FTA negotiations take place sequentially through a randomly chosen order. This framework generates interesting insights.

Our main result is that, when political economy motivations are not too strong, global tariff negotiations actually prevent global free trade. When global tariff negotiations precede FTA negotiations, a tariff ridden world emerges with globally negotiated tariff bindings above zero and no more than one pair of countries linked by an FTA. However, in the absence of global tariff negotiations, FTA formation continues until global free trade is attained via all pairs of countries linked through FTAs. Thus, global tariff negotiations are the cause of a world stuck short of global free trade. In other words, global tariff negotiations are a stumbling bloc to global free trade!

The driving force behind our main result is the different level of tariff concessions given by the eventual FTA non-member in the presence and absence of global tariff negotiations. In the absence of global tariff negotiations, the FTA non-member has no pre-existing tariff bindings. To gain tariff concessions from the outsider, FTA members have strong incentives to form subsequent FTAs with the non-member. Indeed, as long as government political economy motivations are not too strong, sequential FTA formation leads to global free trade. However, global negotiations produce significant tariff binding concessions by all countries before FTA negotiations. These tariff concessions obtained through forward looking global negotiations are deep enough that, upon FTA formation, FTA members no longer have any incentive for FTA formation with the non-member and global free trade does not emerge. In this sense, the success of global tariff negotiations in lowering tariffs drives our result that global tariff negotiations prevent global free trade.

From a practical standpoint, our analysis explains how globally negotiated tariffs depend on anticipations regarding future FTA formation and how binding overhang and tariff complementarity depend on political economy motivations.[4] Indeed, our analysis can shed light on the different empirical results of Antoni Estevadeordal, Caroline Freund and Emanuel Ornelas versus Nuno Limao and Baybars Karacaovali.[5] The former find empirical evidence for tariff complementarity among South American FTA members (i.e. FTA members choose to lower their tariffs on non-members after FTA formation). However, the latter find no evidence that preferential tariff liberalization begets multilateral tariff liberalization for the US and the EU. Our theoretical results suggest the former (latter) should emerge among governments with relatively strong (weak) political economy motivations. Indeed, these predictions based on political economy motivations square well with the recent cross-country empirical estimates of political economy motivations by Kishore Gawande, Pravin Krishna and Marcelo Olarreaga.[6]

References

Estevadeordal, A., C. Freund, and E. Ornelas (2008); “Does Regionalism Affect Trade Liberalization Toward Nonmembers?” Quarterly Journal of Economics 123(4): 1531-1575.

Freund, C. (2000); “Multilateralism and the Endogenous Formation of Preferential Trade Agreements.” Journal of International Economics 52 (2): 359-376.

Freund, C. and E. Ornelas (2010); “Regional Trade Agreements.” Annual Review of Economics 2(1): 139-166.

Gawande, K., P. Krishna, and M. Olarreaga (2012): “Lobbying Competition over Trade Policy.” International Economic Review 53 (1), 115-132.

Karacaovali, B. and N. Limão (2008); “The Clash of Liberalizations: Preferential vs. Multilateral Trade Liberalization in the European Union.” Journal of International Economics 74(2): 299-327.

Krishna, P. (1998); “Regionalism and Multilateralism: A Political Economy Approach.” Quarterly Journal of Economics 113(1): 227-251.

Lake, J. and S. Roy (2017); “Are Global Trade Negotiations Behind a Fragmented World of Gated Globalization?” Journal of International Economics 108, 117-136.

Limão, N. (2006); “Preferential Trade Agreements as Stumbling Blocks for Multilateral Trade Liberalization: Evidence for the United States.” American Economic Review 96(3): 896-914.

Ornelas, E. (2005a). “Endogenous Free Trade Agreements and the Multilateral Trading System.” Journal of International Economics 67(2): 471-497.

Ornelas, E. (2005b); “Trade Creating Free Trade Areas and the Undermining of Multilateralism.” European Economic Review 49 (7): 1717-1735.

Endnotes

[1] Some influential contributions include Krishna (1998), Riezman (1999), Ornelas (2005a,b) and Saggi and Yildiz (2010).

[2] See Freund and Ornelas (2008) for two exceptions, and see Freund and Ornelas (2010) for their review of the literature.

[3] In our paper Lake and Roy (2017), we model global tariff negotiations over tariff bindings because countries negotiate over tariff bindings rather than the actual tariffs (i.e. applied tariffs) in practice.

[4] Binding overhang is the difference between the tariff binding and the actual tariff set by a country. Tariff complementarity is the phenomenon where, upon FTA formation, the FTA members choose to lower their tariffs on non-members.

[5] Estevadeordal et. al. (2008), Limao (2006) and Karacaovali and Limao (2008).

[6] Gawande, Krishna and Olarreaga (2012).

 

Dictatorship, Democratization, and Trade Policy

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By Ben Zissimos (University of Exeter Business School)

In a landmark paper, Daron Acemoglu and James Robinson argue that a key purpose of democratization is to resolve a commitment problem faced by a ruling elite under the threat of revolution.[1]  Their motivation focuses on 19th and early 20th Century Europe, during which time a number of countries in the region democratized, thus originating a number of today’s mature democracies.  The commitment problem that Acemoglu and Robinson characterize arises if the elite cannot make sufficiently large transfers within a single period, to compensate the rest of society for the gains that they would enjoy from a revolution.  If transfers must be made over multiple periods, and if the threat of revolution may dissipate prior to the transfers being completed, then the elite will not be able to credibly commit to transfers large enough to defuse the threat of revolution. By extending the franchise, the elite transfer power to set taxes to the rest of society.  Thus, democratization enables the elite to make a credible commitment to transfers over multiple periods sufficiently large to defuse the threat of a revolution.

In Acemoglu and Robinson’s model, domestic lump-sum redistributive taxation is the policy instrument used by the elite to make transfers from the elite to the rest of society.  This policy instrument simplifies the framework nicely in order to focus on the commitment role of democratization.  Yet subsequent research has shown that domestic fiscal capacity did not exist for redistributive taxation prior to extension of the franchise.  The power to tax is taken for granted in a great deal of mainstream public finance.  But, as Tim Besley and Torsten Persson note, a ruling elite may have an incentive not to install domestic fiscal capacity if they think it will facilitate redistribution from them to the rest of society.[2]  Supportive of this view, Toke Aidt and Peter Jensen show for the time period that Acemoglu and Robinson discuss, that countries in Europe and elsewhere typically did not have domestic redistributive taxation prior to extension of the franchise.  These observations open the door to a discussion of whether domestic redistributive income taxation could in fact have been used as part of a strategy to resolve the commitment problem through democratization.

In a recent paper, I identify the circumstances under which trade taxes, the capacity for which did exist in 19th-20th century Europe both prior to and after extension of the franchise, can be used to make such redistributions and hence resolve the commitment problem identified by Acemoglu and Robinson.[3]  I do this by combining Acemoglu and Robinson’s model with a classic Heckscher-Ohlin model with trade policy due to Wolfgang Meyer.[4]  The resulting new model yields insights that would not be available from either of the original models on their own.  For example, contrary to the recommendation of classical scholars, I show that when the group in power chooses its optimal trade policy, democratization may in fact go hand in hand with increased protectionism and a decline in economic efficiency.  This suggests that although democratization would broadly be regarded as desirable, it may have some adverse consequences.  In Acemoglu and Robinson’s original model, because taxation was lump-sum, policy changes associated with democratization could have no adverse efficiency implications.

My paper also identifies a new role for trade policy: that of maintaining political stability for a ruling elite regime.  Since the elite would always prefer to retain power (including the power to set trade taxes) rather than extend the franchise, the paper provides a way to think about when the elite can use trade policy to forestall democratization.[5] As an alternative to extending the franchise, the elite may be able to neutralize the threat of revolution and forestall democratization by making temporary concessions to the rest of society over trade policy, thus using trade policy to maintain their grip on power.  The framework that I develop makes it possible to delineate precisely where the elite face a commitment problem and hence must extend the franchise, and where they do not face a commitment problem and hence can use trade policy to forestall democratization.  I use the framework to motivate British and Prussian trade policy in the 19th Century, arguing that both of their ruling elites used trade policy to forestall democratization.

References

Daron Acemoglu and James A. Robinson (2000); “Why Did the West Extend the Franchise? Democracy, Inequality, and Growth in Historical Perspective.” Quarterly Journal of Economics, 115(4): 1167-1199. [Working paper version]

Daron Acemoglu and James A. Robinson (2006); Economic Origins of Dictatorship and Democracy.  Cambridge University Press, Cambridge.

Toke S. Aidt and Peter S. Jensen, (2009); “Tax Structure, Size of Government and the Extension of the Voting Franchise in Western Europe, 1860–1938.” International Tax and Public Finance, 16: 160-175. [Working paper version]

Timothy Besley and Torsten Persson, (2009); “The Origins of State Capacity: Property Rights, Taxation, and Politics.” American Economic Review, 1218–1244. [Working paper version]

Timothy Besley and Torsten Persson, (2014); “Why Do Developing Countries Tax So Little?” Journal of Economic Perspectives 28(4): 99–120. [Working paper version]

Sebastian Galiani and Gustavo Torrens (2014); “Autocracy, Democracy and Trade Policy.” Journal of International Economics,  93(1): 173-193. [Working paper version]

Wolfgang Mayer, (1984); “Endogenous Tariff Formation.” American Economic Review, 74(5): 970-985.

Ben Zissimos (2017); “A Theory of Trade Policy under Dictatorship and Democratization.” Journal of International Economics, 109: 85-101. [Working paper version]

Endnotes

[1] Acemoglu and Robinson (2000). See also Acemoglu and Robinson (2006) for a broader discussion.

[2] Besley and Persson (2009); see also Besley and Persson (2014)

[3] Zissimos (2017)

[4] Mayer (1984)

[5] Galianni and Torrens (2014) also have an element of this, in that an elite can choose between autarky and free trade to help maintain political stability.  In my paper, the full spectrum of trade policy between autarky and free trade can also be considered, including the trade policy revenue implications, making it possible to analyze incremental changes to trade policy.  This makes it possible to show how trade policy can be used to defuse the threat of revolution in the absence of all domestic fiscal capacity.  In turn this opens the door to a consideration of elite trade policy reactions to world price shocks.

The GATT/WTO’s Special and Differential Treatment of Developing Countries

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By Ben Zissimos (University of Exeter Business School)

Special and differential treatment (SDT) is effectively a set of exemptions from MFN extended to developing country members of the General Agreement on Tariffs and Trade (GATT)/World Trade Organization (WTO).[1]  (MFN (most favored nation) treatment is the principle that any terms agreed between two parties to a trade agreement will automatically be extended to all others, and is a central pillar of the GATT/WTO).  SDT has two components: an access component, whereby developing countries are granted access to developed country markets, and a ‘right to protect’ component, whereby they do not have to reciprocate market access concessions that the developed countries make.  The intellectual underpinnings of SDT were: (i) that under the Gold Standard poor countries would tend to suffer from balance of payments problems that could be remedied through protection; (ii) the Prebisch-Singer thesis that developing countries would face secular decline in their terms of trade, which could be remedied by preferential access to developed country markets; and (iii) by the logic of infant industry protection, whereby fledgling industries need an initial period of protection to grow in a secure domestic market, before eventually competing abroad.  Ironically, there was no SDT during the 1950s-60s when the research community was broadly sympathetic to the idea that development can benefit from protectionism.  SDT measures were formally adopted mainly in the Tokyo Round that took place in the 1970s, right around the time that the research community was beginning to argue that development should be supported by outward-looking trade regimes to enhance economic efficiency.[2]

As a result of this history, there is an awkward mismatch between what mainstream economics would prescribe, an outward oriented development strategy, and the protectionism that is allowed for under SDT.  According to one mainstream view, a trade agreement enables countries to escape from a terms-of-trade driven prisoner’s dilemma, whereby they have a collective incentive to liberalize trade to maximize efficiency globally but an individual incentive to adopt protection in order to improve their terms of trade.  Accordingly, the benefits to a trade agreement are based on the exchange of balanced concessions.  So developing countries are currently hurt by high protection of agriculture in developed countries because, under SDT, developing countries have not come to the table offering balanced concessions of their own.  Under this view, developing countries should eschew SDT.  A second view holds that the purpose of a trade agreement is to enable governments to tie their hands against protectionist interests in their own countries.  In line with this view, many developing countries have cited commitment to openness against protectionist interests at home as the main reason why they wanted to become members of the WTO.  Here again, the aim would seem to be to eschew the kinds of protectionist measures allowed by SDT.  So a basic recommendation from mainstream economic research would be that while trade agreements under the WTO have a role to play in economic development, SDT may in fact be inimical to the development process.[3]

Several recent papers have called into question key elements of the arguments on which the above basic recommendation rests.  For example, a key implication of the terms-of-trade motivation for a trade agreement is that, if developing countries do not make any concessions of their own while developed countries do, the terms of trade will adjust to ensure that trade flows will not change at all for developing countries.  Consequently they cannot gain from any market access concessions that developed countries make.  Yet careful econometric research has found evidence (though not yet fully conclusive) that developing country exports have increased significantly for trade agreements involving SDT.  However, it is not yet clear what the basis is for this increase.  Has the surge in exports facilitated scale gains that could underpin an export-led growth strategy?  Or has it only allowed exporters to collect rents as the terms of trade adjust?[4]  A different line of research suggests that under the commitment-based motivation for a trade agreement, liberalization by a developing country must be delayed relative to a developed country if it is to be incentive compatible.  This would provide motivation for the use of SDT measures as support for phased liberalization by developing countries, akin to how they were used in the Uruguay Round, rather than using them as the basis for an outright exemption from liberalization.[5]  There appears to be a significant opportunity both to further our understanding of the effects of SDT in past trade agreements and to assess the role that it should play (if any) in future development strategies.

References

Bagwell, K., C.P. Bown, and R.W. Staiger, (2016); “Is the WTO passé?” Journal of Economic Literature 54 (4): 1125-1231. [Working paper version]

Bagwell, K., and R.W. Staiger, (2014) “Can the Doha Round be a Development Round? Setting a Place at the Table.” Published in R.C. Feenstra and A.M. Taylor (eds.), Globalization in an Age of Crisis: Multilateral Economic Cooperation in the Twenty-First Century, NBER, University of Chicago Press, 2014, 91-124. [Working paper version]

Conconi, P., and C. Perroni, (2012); “Conditional versus Unconditional Trade Concessions for Developing Countries.” Canadian Journal of Economics 45, 613-631. [Working paper version]

Conconi, P., and C. Perroni, (2015); “Special and Differential Treatment of Developing Countries in the WTO.” World Trade Review 14, 67-86. [Working paper version]

Gil-Pareja, S., R. Llorca-Vivero, and J.A. Martínez-Serrano (2014); “Do Nonreciprocal Preferential Trade Agreements Increase Beneficiaries’ Exports?” Journal of Development Economics 107, 291-304.

Little, I.M.D., T. Scitovsky, and M. Scott, (1970); Industry and Trade in some Developing Countries: A Comparative Study, London: Oxford University Press, for the Organization of Economic Cooperation and Development.

Ornelas, E., (2016); “Special and Differential Treatment for Developing Countries.” Chapter 7 in K. Bagwell & R. W. Staiger (eds.), Handbook of Commercial Policy, Elsevier/North Holland, Volume 1B:  369-432. [Working paper version]

Whalley, J., (1999); “Special and Differential Treatment in the Millennium Round.” World Economy, 22(8): 1065-1093. [Working paper version]

[1] This piece summarizes background research for a book that I am editing, titled The WTO and Economic Development.

[2] Whalley (1999) provides an excellent historical discussion of the origins of SDT, together with details of each of the relevant GATT Articles in which it is codified and when each was introduced.  He also provides a detailed discussion of the intellectual underpinnings. Little, Scitovsky and Scott (1970) were particularly influential in turning the tide toward outward oriented development strategies.

[3] See Bagwell, Bown and Staiger (2016) for a comprehensive review of the literature on the purpose of trade agreements under the GATT/WTO.  Bagwell and Staiger (2014) argue that, by the terms-of-trade motive, developing countries cannot benefit (nor loose) from multilateral trade agreements if they fail to make concessions under SDT because the volume of their trade does not change.

[4] See Gil-Pareja, Llorca-Vivero and Martinez-Serrano (2014) and the references therein for details.  See Ornelas (2016) for an excellent overview of the theoretical and econometric literature on SDT.

[5] See Conconi and Perroni (2012, 2015) for specific details, as well as the discussion by Ornelas (2016).

State Capacity and The Unintended Consequences of Military Intervention

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State capacity determines the power of a state to raise revenues, to enforce contracts, to support markets through regulation, and to establish a ‘monopoly of violence’.  In fact, the extent of state capacity is perhaps the fundamental difference between developed and developing countries: developed countries have significantly more of it than developing countries do.  But, because state capacity is multidimensional, the challenge for developing countries is to determine which attributes of state capacity building to prioritize.  Samuel Huntington in his influential book, “Political Order in Changing Societies”, offers a guiding principle based on Max Weber’s notion that the most important attribute of a state is the monopoly of violence (also known as the monopoly of the legitimate use of force).  Huntington suggests that establishing a monopoly of violence is a necessary precondition for being able to build the other kinds of state capacity listed above, and to do this the state must build military capacity first.  A natural conclusion of this view is that the right approach for helping a developing country to build its state capacity encompasses a top-down approach, prioritizing military capacity ahead of other attributes of the state.  In recent years, this view has been embraced by a number of international institutions such as the World Bank.  In addition, this view formed the guiding principle that underpinned the US interventions in Afghanistan and Iraq.

However, experience has shown that building military capacity first and leaving aside other attributes of the state can have unintended consequences.  For example, in Colombia, the reliance on a top-down approach to military capacity building in order to suppress guerrillas and paramilitaries is correlated with a deterioration in security and a weakening of the local state.  The reason is that the attributes of the state that would make powerful agents accountable were not put in place and a major consequence was a surge of the murder of civilians falsely portrayed by the army to be guerrilla combatants.   Mexico also adopted a top-down approach to military capacity building in order to combat the drug trade but this backfired and generated significant increases in violence. In Vietnam air-strikes were used in an attempt to prevent the spread of communism and to strengthen the ability of the state to monopolize violence but, as in Mexico, this backfired because it lead more Vietnamese to participate in Viet Cong (insurgent) military and political activities.

On the other hand, bottom-up approaches that help with the provision of public goods combined with military intervention have been found to deliver more positive results.   During the Vietnam War, in areas where American soldiers were embedded in communities and helped to implement development programs, local populations were reported to have more positive attitudes towards the US and all levels of the South Vietnamese government.  In Iraq the Commanders’ Emergency Reconstruction Program was found to have reduced the level of violence against US and Iraqi troops, conditional on community characteristics.  In Afghanistan, although the National Solidarity Program has not been found to have had an effect on the local security situation, it has had a positive effect on people’s perceptions of their economic well-being and their attitudes towards the Afghani government.

Even though control over the monopoly of violence is a legitimate and sometimes necessary goal, for example in the cases of  the collapse of the communist Najibullah regime in 1992 in Afghanistan, or the fall of Siad Barre in Somalia in 1991, the over-riding conclusion of recent research appears to be that it is advisable to build state capacity on a multidimensional basis from the outset.  However, research is ongoing to establish a more nuanced perspective on exactly which aspects of state capacity building are most effective at supporting economic development and how they can be encouraged to co-evolve most effectively.

 

Acemolgu, Daron, Leopold Fergusson, James Robinson, Dario Romero and Juan F. Vargas (2016) “The Perils of Top-down State Building: Evidence from Colombia’s False Positives“. Working Paper.

Beath, Andrew, Fotini Christia, and Ruben Enikolopov  (2012) “Winning Hearts and Minds through Development: Evidence from a Field Experiment in Afghanistan,” Working Paper

Berman, Eli, Jacob N. Shapiro and Joseph Felter (2011) “Can Hearts and Minds Be Bought? The Economics of Counterinsurgency in Iraq.” Journal of Political Economy, 119(4): 766-819. [working paper]

Dell, Melissa (2015) “Trafficking Networks and the Mexican Drug War.” The American Economic Review, 105 (6): 1738–1779. [working paper]

Dell, Melissa and Pablo Querubin (2016) “Nation Building Through Foreign Intervention: Evidence from Discontinuities in Military Strategies.” Working Paper.

Huntington, Samuel P. (1968) Political Order in Changing Societies, Yale University Press.

Economics of Populism

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Social scientists regard globalization and technological progress as major contributors to the ongoing increase in job and income polarization in the United States and Europe. This increased inequality is thought to have reduced standards of living for the median voter in both regions.  Against this backdrop, the 2007-2008 financial crisis seems to have created a political and economic climate of populism on both the right and the left of the political spectrum.  Although populist politicians have emerged in the United States and Europe before, it is in developing countries and especially in Latin America that their influence on politics and economic policy has been the greatest throughout the 20th and 21st centuries.  It may now be that our understanding of the rising populist tide in developed countries can be informed by what we have learned about so-called traditional populism and neopopulism in the developing world.

Traditional populist leaders, whose greatest influence was in Latin America, claimed to hold a political position that supported ordinary citizens and tended to be against the private sector, foreign companies and multilateral international institutions.  They had strong and charismatic personalities and tended to operate outside the realm of traditional political parties and democratic institutions. Perhaps the best known of these was Juan Domingo Perón of Argentina.  Key features of a traditional populist economic program were protectionism and the promotion of economic growth and a reduction in inequality through expansionary fiscal and monetary policies, complemented by market controls and regulations.  Once a program was implemented, even though there was a short period of economic growth, bottlenecks developed causing unsustainable macroeconomic pressures: a rise in prices and a loss of competitiveness leading to balance of payments difficulties.  The typical outcome was a major macroeconomic crisis that hurt the poorer segments of society, which were the very groups that populist politicians had said they wanted to help.

The literature on populism attempts to explain the apparent paradox whereby voters choose a politician whose policies ultimately hurt their economic interests.  One line of research emphasizes the role of natural resources in providing revenues for politicians to buy popular support. In another line of research, signalling plays an important role.  For example, one model shows that a politician has an incentive to signal that he is left wing in spite of his political bliss point being to the right of the median voter’s.  Voters choose him based of his signal but he adopts right wing economic policies after he takes office.  A different model shows that a political candidate selects strategically a narrow set of issues to display to voters during his campaign in order to establish his credibility, e.g. focusing on domestic economic crisis instead of foreign policy.  There is empirical research that supports this last finding and moreover shows that candidates tend to spend more time on divisive issues during campaigning.

Although neopopulists in Latin America hold similar political positions to those of traditional populists (i.e. they tend to be against the private sector, foreign companies and multilateral institutions), the focus of their rhetorical attacks is on globalization.  A key innovation is that neopopulists appear to appreciate the importance of macroeconomic stability.  Instead of fiscal and monetary expansion they adopt targeted interventions aimed directly at redistribution, rather than macroeconomic expansion.  Examples of modern populist policy tools are: price controls on utilities, expropriation of foreign companies, import tariffs, export taxes, and exchange rate manipulation.

There are striking similarities between anti-globalization and nationalistic discourses of neopopulists from developing countries and the populists who are ascending in developed countries.  However, the populists of developed countries go beyond their developing country counterparts with their emphasis on the association between international trade and job losses at home, and on their support of anti-immigration policies.  The current debate is over whether populists in developed countries misrepresent the facts and their corresponding policy proposals in a way that gains political support and, if so, whether or not voters are able to see through this.  A key question is whether this works in the same way as in traditional populism or whether it represents a new approach.

 

 

Acemoglu, Daron, Georgy Egorov, Konstantin Sonin (2013) “A Political Theory of Populism,” Quarterly Journal of Economics, 128 (2): 771-805.

Autor, David, David Dorn and Gordon Hanson (2016) “The China Shock: Learning from Labor Market Adjustment to Large Changes in Trade,” Annual Review of Economcs, 8 (1): 205-240. [working paper version]

Ash, Elliott,  Massimo Morelli and Richard Van Weelden (2016) “Elections and Divisiveness: Theory and Evidence,” Working Paper.

Banks, Jeffrey (1990) ‘‘A Model of Electoral Competition with Incomplete Information,’’ Journal of Economic Theory, 50: 309–325.

Dornibusch, Rudiger and Sebastian Edwards (1990) “Macroeconomic Populism,” Journal of Development Economics 32: 247-277.

Edwards, Sebastian (2010) Left Behind: Latin America and the False Promise of Populism, University of Chicago Press.

Egorov, Georgy (2015) “Single-Issue Campaigns and Multidimensional Politics,” Working Paper.

Harrington, Joseph (1993) ‘‘The Impact of Re-election Pressures on the Fulfilment of Campaign Promises,’’ Games and Economic Behavior, 5: 71–97.

Masten, Egil, Gisle Natvik, Ragnar Torvik (2016) “Petro Populism,” Journal of Development Economics, 118: 1-12. [working paper version]

Ottaviano, Gianmarco and Giovanni Peri (2012) “Rethinking the Effect of Immigration on Wages,” Journal of the European Economic Association, 10 (1): 152-197.

Storesletten, Kjetil (2000) “Sustaining Fiscal Policy through Immigration,” Journal of Political Economy, 108 (2): 300-323. [working paper version]

The trade-off between tax revenues and trade liberalization

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Standard theory predicts that, in the long term, trade liberalization leads to an increase in allocative efficiency and hence an increase of fiscal revenues.  This prediction is based on the idea that overall economic surplus determines the size of the tax base and an improvement in allocative efficiency increases surplus.  Given this attractive feature of trade liberalization, especially from a fiscal standpoint, it is puzzling that developing countries remain relatively protectionist.  A new branch of the literature has begun to shed light on this issue.

The empirical evidence shows that trade taxes in low-to-middle income countries, and particularly low-income countries (LICs), account for a significant share of their fiscal revenue.  For example, in Sub-Saharan Africa trade taxes account for an average of about one quarter of all government revenues and in the developing countries of Asia and the Pacific they account for around 15 percent.  In contrast, high-income countries depend more on domestic income taxes and for many of them the share of revenues from trade taxes is very small.  It is argued that developing countries’ dependence on revenues from trade taxes might itself account for their failure to liberalize further.  The problem appears to be that many developing countries do not have the domestic fiscal capacity to increase domestic taxation.  That is, the machinery of domestic tax collection does not exist within the country.  If within a country different social groups with conflicting interests cannot agree on investing in fiscal capacity, then domestic taxation fails to develop and the country remains reliant on trade taxation.

Consistent with this perspective, the empirical evidence shows that after trade liberalization episodes, developing countries typically take a long time to replace trade tax revenue losses with domestic tax revenue gains.  A significant number of LICs never manage to replace the revenues that were lost to trade liberalization. A political economy approach has been developed to understand this paradox. Research shows that the governments of powerful countries sometimes succeed in influencing the trade policies of their less powerful developing country trade partners. This could lead them to decrease taxes on trade ‘too early’ from a fiscal perspective, i.e. before they are in a position to increase revenues from domestic sources of taxation.

One line of research suggests that structural changes associated with the process of development of the domestic economy could in turn facilitate trade liberalization, rather than the reverse prediction of standard theory.  Through structural change the cost of monitoring and enforcing income taxes decreases, the domestic tax base expands and allows the government to rely less on (inefficient) trade taxes, which could in principle lead to more liberalization in the future.

Antràs, Pol  and Gerard Padró i Miquel (2011) “Foreign Influence and Welfare,” Journal of International Economics, 84: 135–148.

Besley, Timothy and Torsten Persson (2011) Pillars of Prosperity: The Political Economics of Development Clusters. Princeton University Press.

Besley, Timothy and Torsten Persson (2014) “Why do developing countries tax so little?” Journal of Economic Perspectives, 28(4): 99-120.

Baunsgaard, Thomas and Michael Keen (2010) “Tax Revenue and (or?) Trade Liberalization,” Journal of Public Economics, 94(9-10): 563 – 577 [working paper]

Cagé, Julia and Lucie Gadenne (2014) “Tax Revenues, Development, and the Fiscal Cost of Trade Liberalization, 1792-2006“, Working Paper

Dixit, Avinash (1985) “Tax policy in open economies,” in Handbook of Public Economics, ed. by A. J. Auerbach, and M. Feldstein, vol. 1 of Handbook of Public Economics, chap. 6, pp. 313–374. Elsevier.

Riezman, Raymond, and Joel B. Slemrod (1987): “Tariffs and Collection Costs,” Review of World Economics, 23(2): 209–287.

Technological Change, Inequality and Skills

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The rise of inequality in recent decades has led to the polarization of politics and social instability across developed and developing nations.  Explaining the origins of the increase in inequality has become a subject of intense debate among scholars.  A commonly accepted hypothesis is that new technologies are complementary to high skilled labor and at the same time tend to displace the lower skilled.  This increases relative demand for the highly skilled and exacerbates inequality in labor incomes.  This basic idea gives rise to a strand of the literature that examines more complex interactions between the technological environment and the allocation of workers to jobs according to their skills.

The fundamental assumption of models in this literature is the complementarity of factors. Complementarity can occur between technology and specific skills, capital and skills, or between team members. The basic outcome of complementarity is that the most efficient teams are formed only by workers with the same level of skill, that is, the segregation or stratification of skills.  The intuition is that if skill levels were mixed in a given team, lower skilled workers would drag down the productivity of the highly skilled.  The variation of technology in the model maintains the feature that skills are segregated but tends to amplify income inequality.  The reason is technological change tends to favor highly skilled workers because for them the cost of learning the new technology is lower than the cost for low skilled workers.

These models bring about important insights for developing countries. For example, they can explain whether or not a technology developed in a developed country can actually improve the overall productivity of a developing country.  It is argued that developed countries tend to create technologies that are complementary to high skilled workers. But if developing countries do not have the necessary skill base to operate the new technology, its introduction may actually lead to a relative decline in productivity.  Moreover if developing countries have a smaller proportion of workers who can operate a new technology, the effect on income inequality is likely to be worse than in developed countries.

Acemoglu, Daron and Fabrizio Zilibotti (2001) “Productivity Differences,” Quarterly Journal of Economics, 116(2): 563–606.

Acemoglu, Daron (2002) “Technical Change, Inequality, and the Labor Market“, Journal of Economic Literature, 40(1): 7-72.

Basu, Susanto and David N. Weil (1998) “Appropriate Technology and Growth“. Quarterly Journal of Economics, 113(4): 1025-1054.

Caselli, Francesco (1999) “Technological revolutions”, American Economic Review, 89(1): 78–102.

Garicano, Luis and Esteban Rossi-Hansberg (2006) “Organization and Inequality in a Knowledge Economy” Quarterly Journal of Economics, 121(4): 1383–1435.

Kremer, Michael  (1993) “The O-Ring Theory of Economic Development“, Quarterly Journal of Economics, 108(3): 551-575.

La Porta, Rafael and Andrei Shleifer (2014) “Informality and Development“, Journal of Economic Perspectives, 28(3): 109-26.

Lucas, Robert E. Jr (1978) “On the Size Distribution of Business Firms”, Bell Journal of Economics, 9(2): 508–523.

Porzio, Tommaso (2016) “Distance to the Technology Frontier and the Allocation of Talent“, Working Paper.

Break-up of Nations

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The Brexit vote on June 23rd 2016 highlights the basic fact that the costs and benefits of economic and political integration are unequally distributed across different social groups within a region.  Because integration has winners and losers, when decisions on sovereignty are taken through majority voting it is possible that a majority against integration emerges even if it is efficient to integrate.

To understand how the democratic process affects a region’s incentive to separate from a political jurisdiction, the starting point is the analysis of the trade-off between the benefits of large jurisdictions and the costs of heterogeneity in large populations.  On one hand, in large jurisdictions there are scale gains in the provision of public goods, gains from internal trade (when international trade is not free), and reductions in the costs of localized exogenous shocks.  On the other hand, the larger the population the more difficult it is for the government to satisfy their diverse demands for public goods since individuals are likely to have heterogeneous tastes and needs.  If the differences between individuals are significant, they may prefer to break away from the union in order to get public goods closer to their preferences.  The loss of efficiency arises because voters at the margins do not internalize the negative externalities imposed on others.  This leads to an equilibrium where there are too many small regions relative to a benchmark where the optimal number of regions is determined by a social planner who maximizes average world utility.

Because income redistribution is a fundamental decision-making variable for voters, research on secession also focuses on the role of conflicts that arise from differences in preferences over fiscal policy.  The logic is that poor agents favor high income tax rates and rich agents favor low rates, while the equilibrium tax rate is the one most preferred by the median voter. When the level of income varies across regions, the equilibrium tax rate in the union does not coincide with the preferred tax rate in each region.  Restrictions on regions’ freedom to set their own tax policies makes separation more tempting because the institutional constraint imposed by the union is relaxed.  Interestingly, when capital and labor are perfectly mobile, fiscal policies equalize across regions, which should defeat the purpose of seeking independence.  But in practice mobility is often sufficiently limited that fiscal policies across regions remain diverse.

Although existing research provides a deeper understanding of secessions, many research questions remain open.  For example, when is economic integration alone sufficient to ensure that a union will endure, and when is political integration helpful? What is the role of supranational institutions such as a supreme court?  Do the size of firms influence the likelihood of separation?

 

Alesina, Alberto and Enrico Spolaore (1997) “On the Number and Size of Nations“, Quarterly Journal of Economics, 112(4): 1027-1056.

Bolton, Patrick and Gérard Roland (1997) “The Breakup of Nations: A Political Economy Analysis” Quarterly Journal of Economics, 112 (4): 1057-1090.

Bolton, Patrick, Gérard Roland and Enrico Spolaore (1996) “Economic Theories of the Break-up and Integration of Nations“, European Economic Review, 40: 697-705.

Buchanan, James and Roger Faith (1987) “Secession and the Limits of Taxation: Toward a Theory of Internal Exit“, American Economic Review, 77 (5): 1023-1031.

Casella, Alessandra and Jonathan Feinstein (2002) “Public Goods in Trade: On the Formation of Markets and Jurisdictions“, International Economic Review, 43 (2): 437-462.

Ellis, Christopher and Silke Friedrich (2014) “Public Goods and the Dissolution of States” Working Paper.

Friedman, David (1977) “A Theory of the Size and Shape of Nations“, Journal of Political Economy 85 (1): 59-77.

Spolaore, Enrico (2013) “What is European Integration Really About? A Political Guide For Economists“, Journal of Economic Perspectives, 27 (3): 125-144.

Ruta, Michele (2005) “Economic Theories of Political (Dis)Integration“, Journal of Economic Surveys 19 (1): 1-21.

Wei, Shang Jin (1991) “To Divide or to Unite: A Theory of Secessions”, Mimeo, University of California at Berkeley.  [online version not available]