Outward Orientation: Trade Issues

Mohsin Khan, Morris Goldstein, and Vittorio Corbo
Published Date:
September 1987
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Jagdish Bhagwati

This session addresses the question of outward-oriented growth. There are two aspects of the question that need to be distinguished: the wisdom of adopting a strategy of outward-oriented trade policy and the problems of transitting to this strategy if a country is not already embracing it. I shall focus mainly on the wisdom of adopting such policies since the companion paper by Professor Sachs addresses the transitional questions that raise, in many cases, issues of macroeconomic and exchange rate policy.

Components of an Outward-Oriented Trade Strategy

The question of the wisdom of an outward-oriented (“export-promoting” (EP))1 strategy may be considered to have been settled. The strategy has been demonstrated in numerous studies to have produced not merely rapid export growth but also rapid economic growth. It has also, over the last few years, become an accepted component of conditionality from the World Bank and from some bilateral donors since conditionally generally follows the triumph of certain trends in economic thinking instead of being capricious or ideological.2

In economics, consensus is produced by sharpening differences; in politics, by obfuscating them. Much of the debate over the merits of the outward-oriented strategy is the result of different conceptions of what that strategy is; these need to be clarified if we are to illuminate the issues and convince the few skeptics of its merits.

The outward-oriented trade (or EP) strategy, as defined by international economists, has little to do with “export-led” growth or with customary decompositions (e.g., by Professor Chenery and his associates) of output growth from identities into elements attributed to “export-growth” and “import-substitution.”3 It is rather a matter of setting price incentives in such a fashion as to ensure that the home market does not become more lucrative than the foreign market.

The commonly accepted price-incentives definition of the outward-oriented trade strategy is that the effective exchange rate for the country’s exports (EERx) is less than for its imports (EERm). These effective exchange rates measure the incentives to export and to substitute for exports, respectively.4 For, if EERx < EERm, this implies that sale in the home market produces more revenues than sale abroad, so that the price incentives are, on balance, set such that there is a “bias against exports.”

Outward orientation then implies a trade-and-payments regime that ensures that this bias against exports is reversed or absent, such that EERx is no longer below EERm. Hence, many trade economists identify the outward-oriented, EP strategy as one that broadly ensures EERxEERm, and is therefore synonymous with “neutrality” of relative incentives for home and export sales. On the other hand, a significant excess of EERx over EERm may also obtain: a phenomenon described sometimes, to avoid terminological confusion, as ultra-EP strategy.5

A few classifications are in order, to clear up the confusions over what an EP trade strategy implies.

First, the definitions relate to average incentives. Within the EP strategy, some activities may be import substituting in the sense that their EERm exceeds the average EERx. The pursuit of either the EP or ultra-EP trade strategy does not preclude import substituting in selected sectors. This is, in fact, true for most of the successful Far Eastern developers. Nor does this fact render meaningless the distinction among the different trade strategies, as is sometimes contended. As I have argued elsewhere,

We also need to remember always that the average EERx and EERm can and do conceal very substantial variations among different exports and among different imports. In view of this fact, I have long emphasized the need to distinguish between the questions of the degree of import substitution and the pattern of import substitution. Thus, within the broad aggregates of an EP country case, there may well be activities that are being import-substituted (i.e., their EERm exceeds the average EERx). Indeed there often are. But one should not jump to the erroneous conclusion that there is therefore no way to think of EP versus import substitution (IS) and that the distinction is an artificial one—any more than one would refuse to acknowledge that the Sahara is a desert, whereas Sri Lanka is not, simply because there are some oases.6

Second, one should not equate the EP strategy with the absence of government intervention, as is often done by proponents of IS strategy and sometimes by advocates of the EP strategy as well. It is true that a laissez-faire policy would satisfy the requirement that EERxEERm. On the other hand, this is not a necessary condition for this outcome. In fact, the Far Eastern economies (with the exception of Hong Kong) and others that have come close to the EP strategy have been characterized by considerable government activity in the economic system. Such intervention can be of great value, and almost certainly has been so, in making the EP strategy work successfully. This is because credibility of commitment on the part of governments is necessary to induce investors to take decisions that reflect the inducements offered by the policy framework. By publicly supporting the outward-oriented strategy, by even bending in some cases towards ultra-export promoting, and by gearing the credit institutions to support export activities overtly, governments in these countries appear to have established the necessary confidence that their commitment to the EP strategy is serious, thus inducing firms to undertake costly investments and programs to take advantage of the EP strategy. The laissez-faire model does not quite capture this aspect of the problem since its proponents implicitly assume that the policy of laissez-faire will be accepted at face value. But neither the establishment nor the continuation of laissez-faire is a realistic assumption since governments, except in the models of Friedman and Bakunin, fail to abstain or self-destruct; they will find invariably something, indeed much, to do. Therefore, explicit commitment to an activist, supportive role in pursuit of the EP strategy would appear to constitute a definite advantage in reaping its benefits.

Third, the incentives-defined EP strategy has to be distinguished from the traditional concept of “export-led” growth with which it is often confused. Export-led growth relates to a situation in which external growth, owing to income effects centered on a country’s exports, generates income expansion attributable to direct gains from trade and indirect beneficial effects. On the other hand, it is evident that the incentives-related EP definition has nothing to do with such beneficial external phenomena. Whether the success of an EP strategy, defined in terms of freedom from bias against exports, requires the presence of a beneficial external environment is an important issue discussed below in light of the current international environment.

Fourth, the concept of EP or outward orientation relates to trade incentives (as defined by either trade policies directly or by domestic policies that influence trade or by exchange rate policies that have consequences for trade) but does not imply that the EP strategy countries must be equally outward oriented in regard to their foreign investment policies. As it happens, Hong Kong and Singapore among the four Far Eastern economies have been more favorable in their treatment of foreign investors than the great majority of the IS countries, though the historic growth of Japan, presumably as an EP country, was characterized by extremely selective control on the entry of foreign investment. Logically and empirically, the two types of outward orientation, in trade and in foreign investment, are therefore distinct phenomena, though whether one can exist efficiently without the other has been raised in the literature and is surrounded by far more controversy than the question of the desirability of an EP strategy in trade.

Finally, the pattern of incentives, defining the relative attractions of the home and foreign markets, is a result of not just trade but also exchange rate policies. An overvalued exchange rate, by making foreign exchange scarce (i.e., creating an excess demand for it at the given exchange rate) and hence allocated by administrative allotments, will lead to a scarcity premium on imports and hence to EERm > EERx, that is, to bias against exports. In fact, much of the inward-oriented or import-substituting trade strategy during the bulk of the postwar period can be attributed to the effects of overvalued exchange rates rather than to the use of tariffs to protect import-competing industries. The macroeconomic management of payments accounts in a manner that permits the avoidance of overvaluation and attendant exchange or import controls is essential to the pursuit of an outward-oriented trade strategy.

Benefits of Outward-Oriented Trade Strategy

By now, most developmental experts agree that an outward-oriented trade strategy promises economic benefits, even though this consensus emerged after considerable controversy and the eventual demonstration effect of successful countries on the outward strategy and failure of those continuously wedded to an inward course. Nonetheless, the recent return of the export pessimists, who in the 1950s provided the intellectual backbone for the IS strategy, has rekindled skepticism on the question of the desirability of outward trade orientation. This second pessimism, as I shall argue below, has an altogether different basis, in the threat of protectionist closure of access to foreign markets and will require an assessment of this threat in terms necessarily characterized by considerations of political economy. It also necessitates a brief recapitulation of what we have learnt about the sources of the EP strategy’s success in promoting economic development.

Empirical Findings

Several studies, conducted as large-scale comparative projects of diverse countries, examined the question of the relationship between trade strategy and economic performance and concluded in the 1970s that the EP strategy comes out the winner.7 In particular, the evidence on this issue is strong in the NBER project, where the EP strategy was clearly defined in terms of incentives in the way set out above and transition to it from an IS strategy via several phases was systematically discussed for ten semi-industrial countries.8

Other evidence relates largely to associations between growth rates of exports and growth rates of income, as in the work of Michaely (1977), who used data for 1950-73 for 41 countries, and the further extension of this type of work by Balassa (1978) and Feder (1983).9

Complementing this approach is the altogether different statistical formulation in Michalopoulos and Jay (1973). This study takes a different approach to the problem by using exports as an argument in estimating an economy-wide production function from aggregate output and factor-use data. Using data for 39 countries, this study argued that exports are an independent input into national income.10

While these cross-country regressions are certainly interesting, valuable, and suggestive, they cannot be considered compelling on this issue. By contrast, the detailed country studies are indeed methodologically superior and more persuasive. And, as noted already, they do indicate the superiority of the EP strategy.

Explanatory Factors

The reasons why the IS strategy has been generally dominated by the EP strategy, and why the countries that rapidly made the transition from the former to the latter have done better, have preoccupied economists since these findings came to light.

Resource Allocation Efficiency

The first set of reasons relies on the fact that the EP strategy brings incentives for domestic resource allocation closer to international opportunity costs and hence, as international economists recognize, closer to what will generally produce efficient outcomes.11

This is true, not merely in the sense that there is no bias against exports and in favor of the home market (i.e., EERxEERm) under the EP strategy, whereas often the researchers have observed a substantial excess of EERm over EERx in the IS countries. It is also valid in the sense that the IS countries seem generally to have had a chaotic dispersion of EERs among the different activities within the broader categories of export and import-competing activities as well. That is, the degree of IS goes far and the pattern of IS reflects widely divergent incentives. By contrast, the EP strategy does better on both degree and on pattern.

The interesting further question relates to why the degree becomes outsized and the pattern also goes wrong under IS. The answer seems to lie in the way in which IS is often practiced and in the constraints that surround EP. IS could, in principle, be contained to modest excess of EERm over EERx, but, as I have already argued, typically IS arises in the context of overvalued exchange rates and associated exchange controls. So, there is no way in which the excess of domestic over foreign prices is being tracked by government agencies in most cases, and the excesses of EERm over EERx simply go unnoticed. The nontransparency is fatal. By contrast, EP typically tends to constrain itself to rough equality, and ultra-EP also seems to be moderate in practice, because policy-induced excesses of EERxover EERm would generally require subsidization that is constrained by budgetary problems.

In the same way, the pattern of EERm can be terribly chaotic because exchange controls and quota restrictions on trade will typically generate differential premia and hence differential degrees of implied protection of thousands of import-competing activities, all of which are simply the side consequence of the administrative decisions on exchange allocations. By contrast, the EP strategy will rely more on unifying exchange rates that avoid these problems and, when relying on export subsidization, will be handled both with necessary transparency and with budgetary constraints that would then prevent IS-type spectacular dispersions in resulting EERs

Directly Unproductive Profit-Seeking (DUP) and Rent-Seeking Activities

Yet another important aspect of the difference between EP and IS strategies, once we recognize that IS regimes have typically arisen in the context of exchange rate overvaluation and associated controls on foreign exchange and trade, is that this kind of regime is more likely to trigger what economic theorists now call DUP (Bhagwati, 1982b) and rent-seeking activities (Krueger, 1974). These activities divert resources from productive use into unproductive but profitable activities designed to earn profits (or income) by lobbying to change policies, or by evading them, or by seeking the revenue and rents they generate.12

With IS policies typically conducted within the framework of quantitative allocation systems, the diversion of entrepreneurial energies and real resources into such DUP activities tends to add to the conventionally measured losses from the high degree and chaotic pattern of IS.

How important are such DUP-activity costs? Attempts have been made by several economists to estimate some aspects of these costs in developing countries. Krueger (1974), in her classic article, estimated the costs of license-seeking in Turkey, assuming that it cost one Turkish lira in real resources to chase one lira worth of premium on these licenses, producing staggering estimates of the resulting losses relative to Turkish national income! Recently, computable-general-equilibrium (CGE) practitioners, such as Dervis, de Melo, Whalley, and Robinson, have incorporated DUP activities into the corpus of their work, emerging again with noticeable estimates that exceed the conventional, small deadweight losses.13 Nevertheless, this area of analysis is still new, and micro studies that would provide more realistic foundations to enable these economists to make reliable parametric estimates of DUP-activity costs of different kinds to work into their CGE exercises are still lacking.

There is, however, plenty of casual evidence that evasion and rent seeking (directed at licenses), among other DUP activities, are rampant in many developing countries and absorb significant resources.

Foreign Investment

If IS regimes have tended to use domestic resources inefficiently in the ways that were just outlined, the same applies to the use of foreign resources.

This is perhaps self-evident, but substantial theoretical work by Bhagwati, Brecher and Diaz-Alejandro, Uzawa, Hamada, and others has established that foreign investment that comes in over quota restrictions and tariffs—the so-called tariff-jumping investment—is capable of placing the recipient country under conditions that seem uncannily close to the conditions in the IS countries in the postwar decades. These conditions require capital flows into capital-intensive sectors in the protected activities. It is thus plausible that, if these inflows were not actually harmful, the social returns on them were at least low compared to what they would be in the EP countries in which the inflows were not tariff jumping but rather aimed at world markets, in line with the EP strategy of the recipient countries.

In addition, one may hypothesize (Bhagwati (1978)) that, ceteris paribus, foreign investments into IS countries will be self-limiting in the long run because they are aimed at and therefore constrained by the home market. If so, and there seems to be some preliminary evidence in support of this hypothesis in econometric analysis,14 then IS countries.would have been handicapped also by the lower amount of foreign investment flows and not just by their lower social productivity compared with the EP countries.

Grey Area Dynamic Effects

While the arguments so far provide ample satisfaction to those who seek to understand why the EP strategy does so well, dissatisfaction has continued to be expressed that these are arguments of static efficiency and that “dynamic” factors, such as savings and innovations, may well be favorable under IS.

Of course, if what we are seeking to explain is the relative success of the EP countries with growth, this counter-argumentation makes little sense since, even if it were true, the favorable effects from these “grey area” sources of dynamic efficiency would have been outweighed in practice by the static-efficiency aspects. The fact remains, however, that while in the NBER project which was the only one of the major projects on trade strategy to address these questions in some fashion, the results were generally not clearcut on the issue,15 recent studies have generally strengthened the case for EP strategy on some issues here as well.

It is impossible to claim that IS regimes enable a country to save more or less than EP regimes. The evidence in the NBER project, for instance, went both ways.16 Little has changed since then by way of new evidence. Nor does it seem possible to maintain in theory that EP or IS regimes are necessarily more innovative. It is possible to argue that EP regimes may lead to more competition and less sheltered markets and hence more innovation. But equally, Schumpeterian arguments suggest that the opposite might also be true.

Recent studies, however, suggest that the EP strategy encourages greater innovation. Thus, Krueger and Tuncer (1980) have examined the 18 Turkish manufacturing industries during the 1963-76 period. They found that periods of low productivity growth roughly occurred during periods when foreign exchange controls were particularly restrictive and hence the IS strategy was being accentuated. The overall rate of productivity growth was also low throughout the period during which Turkey pursued an IS strategy.

Again, in an analysis of productivity change in Korea, Turkey, Yugoslavia, and Japan, Nishimizu and Robinson (1984) argue that if growth is decomposed into that attributable to domestic demand expansion, export expansion, and import substitution, the interindustrial variation in factor productivity growth reflects (except for Japan) the relative roles of export expansion and import substitution, the former causing a positive impact and the latter a negative one. This careful and important research is certainly suggestive, but, as the authors recognize, export expansion may have been caused by productivity change rather than the other way around, the regressions begging the issue of causality.

What about economies of scale? Theoretically, the EP success should be increased because world markets are certainly larger than just home markets, but systematic evidence is not yet available on this question. For instance, evidence is lacking to date indicating whether firms that turn to export markets are characterized by greater scale of output than those firms that do not.

On the other hand, if one assumes that economies of scale will indeed be exploited when trade expands, the cost of protection will evidently rise significantly. Harris (1986) has recently calculated for Canada that a 3.6 percent increase in GNP could follow from the unilateral elimination of Canadian tariffs, the unusually large gain accruing thanks to economies of scale.

Finally, in the matter of X-efficiency, it is again plausible that firms under IS regimes should find themselves more frequently in sheltered and monopolistic environments than under EP regimes; in fact, a great deal of such evidence is available from the country studies in the several research projects discussed. X-efficiency therefore ought to be greater under the EP regime, although this is a notoriously grey area in which measurement has often turned out to be elusive.

Other Objectives than Growth

A final word is necessary on the superior economic performance of the EP strategy. What about other objectives?

When it became evident that the EP strategy yielded higher growth and that the static versus dynamic efficiency arguments were not persuasive and probably went in favor of the EP strategy, the IS diehards shifted ground. They took to arguing that the objective of development was not growth but the eliminating of poverty or increasing employment, and that EP might be better for growth but was worse for these other objectives. This was part of a larger argument that became fashionable during the 1970s in certain development circles: that growth had been the objective of development to date, that the objective was wrong, and that the true objective of poverty amelioration was ill-served by development efforts directed at growth. In fact, growth even harmed (in certain formulations of such critics) the poor.

Of course, in theory, economists can prove anything if they are smart enough. Conflicts among different objectives can be readily demonstrated in well-defined, suitably chosen models. What was novel, however, was the assertion that the empirical experience of the 1950s and 1960s had shown that growth did not affect poverty and that it had even harmed it. These views, however, have not stood the test of detailed scrutiny.

The evidence does not support the views that the early planners in developing countries desired growth per se, that poverty elimination was not the stated objective which was pursued by means which included as a key element the acceleration of growth rates to pull up the poor into gainful employment, and that growth on a sustained basis has not helped the poor. These orthodoxies are no longer regarded as plausible.17

In regard to the narrower question whether the EP strategy procures efficiency and growth but adversely affects poverty and employment, evidence has now been gathered extensively in a sequel NBER project, directed by Krueger (1982). Essentially, she and her associates document how the investment allocations under EP require the expansion of labor-intensive activities since developing country exports are typically labor intensive. Therefore, ceteris paribus, they encourage the use of labor and hence employment and hence, in countries which typically have underemployed labor, also the alleviation of poverty.

Moreover, after more than two decades of successful growth in the EP countries, especially in the four Far Eastern economies, it has become easier for economists to contemplate and comprehend the effects of compound rates and the advantages of being on rapid escalators. Even if it had been true that the EP strategy yielded currently lower employment or lower real wages, the rapid growth rates would overwhelm these disadvantages in the long run, which can be simply one generation.

Both the employment-intensive nature of EP growth in developing countries and the higher growth rates in the EP countries have provided a massive antidote to the poverty and underemployment that afflicted these countries at the start of their development process.

Second Export Pessimism: Assessing the Protectionist Threat

It is fair then to conclude that the outward-oriented strategy emerges from both theory and empirical experience as a desirable policy option for developing countries. But this option is not independent of conditions external to the developing countries. The EP strategy, in principle, makes sense only insofar as markets can be found elsewhere to absorb exports at prices that generally do not fall as exports rise. For, according to the oldest argument for tariffs (i.e., for a well-defined IS strategy), individual nations would otherwise find it worthwhile to impose an optimal tariff that enables the country to exercise its monopoly power in world markets.

In fact, this provided a key rationale for the adoption of the IS strategy in the 1950s, as in the writings of Nurkse and others. They thought that the markets for the exports of developing countries were getting tighter and hence these countries had to shift to inward-looking, balanced growth that largely matched domestic production to domestic consumption instead of exploiting international specialization in production. This “first export pessimism” was thus based on an (as it turned out, unwarranted) assessment that export markets were simply not available.

By contrast, while the revival of IS sentiment today in several quarters is equally based on export pessimism, the source of it is altogether different. This, second export pessimism is based on fears of protectionism. That is, that while markets do exist and could justify an outward-oriented strategy, the markets would not be allowed by protectionist forces to be exploited effectively.

The second pessimism is founded on man-made restrictions, not on natural limits as the first pessimism was. As such, it is paradoxically less worrisome. For, what is made by man can be undone by man. If protectionism is indulged in by governments, it can in principle be contained by governments. An appropriate response by developing countries to protectionism may then be not simply to accept it as given and then to retreat into IS policies, but to engage with the developed countries in exercises such as the MTN (multilateral trade negotiations) to keep market access available. This requires developing-country governments to be interventionists and energetically active, not in the exercise of extensive national protection of the IS variety, but rather in sustaining and expanding the open-trading international system. The first pessimism led to balanced national growth and IS; the second pessimism leads to international engagement and diplomacy to sustain EP—unless the assessment is that the protectionist threat is unmanageable and its translation into actual protection is either already large and irreversible or imminent despite national and international efforts to maintain an open trading system.

That proviso is evidently important. Therefore, it is necessary now to assess the protectionist actuality and threat.

State of Protection

Has protection increased significantly in the last decade for instance? Here, one distinguishes between actual protection and the threat thereof.18

It is well known that successive tariff-cutting exercises under GATT auspices have reduced the average tariffs for the United States, the European Community, and Japan down to extremely low levels, the Tokyo Round having reduced them to levels around 4-4.5 percent for manufactures. Weighted by total imports, the eventual tariffs on semi-manufactures and manufactures average only 4.9 percent, 6.0 percent and 5.4 percent for the United States, the Economic Community, and Japan, respectively (Table 1).

While therefore the tariffs have in fact gone down, including in the last decade, to negligible levels, two qualifying observations can be made about tariff protection as it applies to developing countries.

While the developed-country nominal tariffs are low on all countries, they are higher for products of interest to the developing countries (Table 1). This, as Finger has noted, is in turn attributable partly to the fact that developing countries have traditionally not engaged in reciprocal tariff-cut bargaining that GATT works with, preferring to rely on nonreciprocal MFN-route extensions of tariff cuts to them. Altruism, in contrast to mutual exchange, in GATT’s bargaining framework, has led to smaller tariff cuts than if developing countries had engaged in mutual tariff cuts.

Tariff escalation also exists on tariffs on developing country exports.19 Value-added protection is therefore yet higher than what the nominal tariffs imply.

Table 1.Tariff Averages Before and After the Tokyo Round Agreement
Tariffs on Imports from
Tariffs on Total ImportsDeveloping Countries
Semi- and finishedSemi- and finished
Raw materialsSemi-manufacturesfinished manufacturesmanufacturesmanufactures
United States
European Community
Source: The Tokyo Round Multilateral Trade Negotiations, Supplementary Report by the Director General of the CATT (Geneva: GATT Secretariat, 1980), pp. 33-37.
Source: The Tokyo Round Multilateral Trade Negotiations, Supplementary Report by the Director General of the CATT (Geneva: GATT Secretariat, 1980), pp. 33-37.

Of greater importance, however, is the fact that the reduction in tariff levels has been accompanied, since the mid-1970s, by an offsetting rise in the incidence of NTBs (nontariff barriers). Whether, however, these barriers have increased is a complex issue since the answer basically requires, if it is to be meaningful, an examination of how restrictive they are. A tightening of a quota when import supplies have become more elastic may mean nonetheless that its restrictiveness has diminished rather than increased; and two weak restrictions may be less protective than one strong restriction. The existing attempts at estimating the worldwide growth of NTBs are unable to cope with these difficulties, much as their authors are aware of them. With the corresponding caveats in mind, therefore, the following statistics may be noted.

Finger and Olechowski (1986) have estimated that, accounting for several NTBs including quota restrictions, voluntary export restraints (VERs), variable import levies, and monitoring measures, the unweighted percent of value of imports covered by NTBs in individual countries seems to range around 17 percent in 1981 and 18 percent in 1984 for all products from all sources, and 18 percent and 19 percent respectively for products imported only from developing countries. This indicates a certain stability, though at nearly a fifth these figures are not negligible.

The UNCTAD has also estimated trade coverage ratios for NTBs, using trade weights of a fixed base year (1981). A frequency index is also calculated, with the number of trade flows subject to selected nontariff barriers expressed as the percentage share of the total number of trade flows.20

With regard to all NTBs covered, the UNCTAD indices (which do not of course estimate the restrictiveness of the NTBs in question) 21show an increase during 1981 to 1986. For all nonfuel imports, both the trade coverage ratio and the frequency index increased, reflecting largely added restrictions on steel and animal and vegetable oils, while interventions in fuels (mainly in the United States) and footwear (also in Canada and Japan) diminished.22 Bad years were 1981–82 and 1983–84; 1986 seems stable.

Not merely, however, does the increase in the UNCTAD measures conceal important elements of liberalization (as on fuels and footwear). The increase is also, when examined closely, from 19.6 percent to 22.7 percent between 1981 and 1986 for nonfuel imports. This is a far cry from the notion that massive protection broke out during the 1980s. Indeed, a detailed eye-scan of the components of UNCTAD’s measures, which are an invaluable contribution to our knowledge, suggests that many, indeed an overwhelmingly large number of, import markets for industrial products are still free from NTB restraint: in absolute terms, nearly 580,000 trade flows out of almost 700,000 are free from NTBs that include a comprehensive list including (controversially) anti-dumping (AD) and countervailing (CVD) duty actions.

Trade Growth and Porous Protection

As I have already stated, the question still remains: how restrictive has the growth in NTBs been? I propose to argue that, even on this dimension, the growth of protectionism has permitted trade to grow and that one of the early virtues of NTBs may well have been their nontransparency in this regard.

Trade expansion certainly slowed down during the 1970s. But even then, world trade continued to grow faster than world increase during 1970-1984. In fact, the developing countries’ exports of manufactures to the developed countries grew almost twice as fast as the exports of these countries to one another, registering during the relatively depressed 1970s an annual growth of over 8 percent. This happened in the teeth of newly proliferating NTBs and substantial macroeconomic difficulties in the OECD countries.

That exports from the developing countries continued to grow in this fashion was first highlighted by Hughes and Krueger (1984) who thought that it was a puzzle since protectionist threats had been felt to be translated into a large amount of actual protection already. This puzzle has stimulated Baldwin (1968 and 1985) into developing the interesting thesis that protection is far less effective than one thinks simply because there are many ways in which exporting countries can get around it in continuing to increase their export earnings. Baldwin states (1985):

Consider the response of exporting firms to the imposition of tighter foreign restrictions on imports of a particular product. One immediate response will be to try to ship the product in a form which is not covered by the restriction. . . . One case involves coats with removable sleeves. By importing sleeves unattached, the rest of the coat comes in as a vest, thereby qualifying for more favorable tariff treatment. (p. 110)

The use of substitute components is another common way of getting around import restrictions. The quotas on imports of sugar into the United States only apply to pure sugar, defined as 100 percent sucrose. Foreign exporters are avoiding the quotas by shipping sugar products consisting mainly of sucrose, but also containing a sugar substitute, for example dextrose. . . . At one time, exporters of running shoes to the United States avoided the high tariff on rubber footwear by using leather for most of the upper portion of the shoes, thereby qualifying for duty treatment as leather shoes. (p. 110)

Yoffie (1983) has also recently examined the VERs on footwear and textiles from a political scientist’s perspective and found that the dynamic exporting economies such as the Republic of Korea and the Taiwan Province of China have embraced them with considerable ingenuity, much as Baldwin has documented and argued, to continue expanding their exports significantly.

There is also a more subtle factor at play here which relates to why VERs, which represent the method by which an attempt has been made to cut imports in many recent NTB actions, may have provided the mechanism by which the executives interested in maintaining freer trade despite mounting protectionism may have succeeded in keeping trade expanding. VERs are, in that view, a porous form of protection that is deliberately preferred because of this nontransparent porousness. I have argued recently (Bhagwati, 1986b) that in industries, such as footwear, two characteristics seem to hold that lend support to this porous-protection model as an explanation for why protection is ineffective. First, undifferentiated products (i.e., cheaper varieties of garments and footwear) make it easy to transship, that is, to cheat on rules of origin, passing off products of a country restricted by VERs as products of countries not covered by VERs. Second, low start-up costs and therefore small recoupment horizons apply in shifting investment and products to adjacent third countries that are not covered by VERs, so that an exporting country can get around (admittedly at some cost) the VERs by investment shunting to sources unaffected by VERs. This type of strategy allows the exporter to recover his investment costs since it is usually some time before the VERs get around to covering these alternative sources or VERs are eliminated as the political pressure subsides (as was the case with United States footwear).23

In both ways VERs in these types of industries can yield a closer-to-free-trade solution for the exporting countries that are afflicted by the VERs. These countries can continue to profit from their comparative advantage by effectively exploiting, legally (through investment shunting) and illegally (through transshipments), the fact that VERs leave third countries out whereas importing-country tariffs and quotas do not.24

Why would the protecting importing countries prefer this porous protection? Does it not imply that the market-disrupted industry fails to be protected as it would under a corresponding import trade restraint? Indeed it does. But that is precisely its attractiveness.

If executives want free trade in the national interest whereas legislatures respond to the sectoral interests—definitely the stylized description of the two-headed democracies such as exist in the United States and Britain—then it can be argued that executives will prefer to use a porous form of protection that, while assuring free market access, will nonetheless manage to appear as a concession to the political demands for protection from the legislature or from its constituencies.25 Whether this game plan works over time as the porosity is increasingly perceived is an important question. In the multi-fiber agreement, the VERs have proliferated, successively closing loopholes and increasing coverage until they come to approximate comparatively non-leaky import restrictions instead. In other cases, as in footwear, they were terminated and evidently gained the freer trade-oriented executives and exporters the access that import restrictions would have denied them.

Shifting International Political Economy

While the preceding analysis suggests that protection has left significant access open for developing countries in the markets of the developed countries, and that the protection has been relatively porous often permitting trade to grow despite it, what about the future prospects? Is the threat of new protection extremely serious?

It would be foolish to disregard this threat altogether. Indeed, it is an important reality in the United States and the Economic Community today. Some of it is due to the substantial unemployment rates in the Economic Community; some of it is attributed to Eurosclerosis which, in turn, cannot be treated as exogenous to unemployment since it is evident that a growing and prosperous economy makes it easier for sectoral adjustments by, first, providing jobs for those who must exit from declining industries and, second, often making adjustment to imports possible by reducing growth of jobs rather than their absolute number in the industries losing comparative advantage. It is trivially true therefore that if macroeconomic policies can be worked out to ensure a growing world economy, protectionism will tend to ease. Bad macroeconomics and protectionism are happy bedfellows.

Moving beyond this truism, I believe that the international political economy has changed dramatically in the last two decades to generate new and influential actors supportive of freer world trade.

A fairly common complaint on the part of analysts of the political economy has been the asymmetry of pressure groups in the tariff-making process. The beneficiaries of protection are often concentrated, whereas its victims tend to be either diffused (as is the case with final consumers) or are unable to recognize the losses they incur as when protection indirectly affects exports and hence hurts those engaged in producing exportables.26

Direct foreign investment (DFI) and the growing maze of globalized production have changed this equation perceptibly. When DFI is undertaken, not for tariff jumping in locally sheltered markets, but for exports to the home country or to third markets, as is increasingly the case, protectionism threatens clearly the investments so made and tends to galvanize these influential multinationals into lobbying to keep markets open.

For example, it was noticeable that when the United States semiconductor suppliers recently gathered to discuss anti-dumping legal action against Japanese producers of memory microchips known as EPROMS (or erasable programmable read-only memories), noticeably absent were Motorola, Inc. and Texas Instruments, Inc., which produce semiconductors in Japan and expect to be shipping some back to the United States.27

Almost certainly a main reason why United States protectionism did not translate into a disastrous Smoot-Hawley scenario, despite high unemployment levels and the seriously overvalued dollar (in the Dutch-Disease sense) until recently, is that far fewer congressmen today have constituencies in which DFI has not created such protrade, anti-protectionist presence, muddying waters where protectionists would have otherwise sailed with great ease. The spider’s web or spaghetti-bowl phenomenon resulting from DFI that crisscrosses the world economy has thus been a stabilizing force in favor of holding the protectionists at bay.

It is not just the DFI in place that provides these trade-reinforcing political pressures.28 As I have often argued (1982a and 1986a), the response to import competition has been diluted by the possibility of using international factor mobility as a policy response. Thus, the possibility of undertaking DFI when faced with import competition also provides an alternative to a protectionist response. Since this is the capitalist response, rather than that of labor which would lose jobs abroad, the defusion of protectionist threat implied here works by breaking and hence weakening the customary alliance between both pressure groups within an industry in their protectionist lobbying, a relationship with which Magee has made us long familiar.

Interestingly, labor today seems also to have caught onto this game and is not averse to using threats of protection to induce DFI from foreign competitors instead. The United Auto Workers labor union in the United States appears to have in this way helped induce Japanese investments in the car industry. This is, in fact, quite a generic phenomenon where DFI is undertaken by the Japanese exporting firms to buy off the local pressure groups of firms or unions which can, and often do, threaten legislative pressures for tariffs to close the import markets. This type of induced DFI has been christened as quid pro quo DFI (Bhagwati, 1985c) and appears to be a growing phenomenon29 (certainly on the part of Japanese firms), representing a new and alternative form of response to import competition than provided by old fashioned tariff-making.30

In short, both actual DFI (through the spider’s web effect) and potential DFI (outward by domestic capital and quid pro quo, inward by foreign capital) are powerful forces influencing the political economy of tariff-making in favor of an open economy. They surely provide some counterweight to the gloom that the protectionist noises generate today.

Can All Export? The First Export Pessimism

Old worries do not always die out, they often smoulder. The fear that markets simply cannot exist for developing country exports keeps coming up; it is particularly alive and well in some diehard IS countries.

Perhaps the best exposition of this view is, however, in the work of Cline (1982), who has tried to answer the question: if the EP model is exported to all other developing countries, can the markets absorb the resulting trade volumes? Yet another question has been one revised by Arthur Lewis’s (1980) contention that trade of the developing countries is in a tight embrace with growth in the developed countries, hence external growth determines what developing countries can export, hence slow OECD growth condemns them to an IS strategy.

On the latter version of the first pessimism, several analyses by Kravis (1970) and most recently and thoroughly by Goldstein and Khan (1982) and Riedel (1984), have laid this relationship to rest.31Indeed, the comparative and absolute export performance of the developing countries is better explained by reference to domestic incentives (or supply) than to external (or demand) conditions. Stable relationships based on foreign demand simply will not fly.

The Cline exercise, on the other hand, suffers from two different afflictions: the fallacy of composition and an unwarranted conceptual leap.

First, Cline puts all countries on a curve, duly adjusted, for the successful Asian exporters with very high ratios of trade to national income. The pursuit of an EP strategy, however, simply amounts to the adoption of a structure of incentives which does not discriminate against exports in favor of the home market. This does not imply that the resulting increases in trade-to-income ratios will be necessarily as dramatic as in the Far Eastern cases! To infer otherwise is a non sequitur.

Second, the share of developing countries in the markets for manufactures in most developed countries has been, and continues to be, relatively small. While there are obviously variations in individual industries, in the aggregate the share of manufactured exports from developing countries in the consumption of manufactures in the developed countries runs even today at a little over 2 percent. Absorptive capacity purely in the market sense, therefore, is not prima facie a plausible source of worry.

Third, a chief lesson of the postwar experience is that policymakers who seek to forecast exports typically tend to understate export potential by understating the absorptive capacity of import markets. This comes largely from having to focus on known exports and partly from downward estimation biases when price elasticities for such exports are econometrically measured. Experience underlines the enormous capacity of wholly unforeseen markets to develop when incentives exist to make profits. Miscellaneous exports often represent the source of spectacular gains when the bias against exports, typical of IS regimes, is removed on a sustained basis.

Fourth, trade economists have increasingly appreciated the potential for intra-industry specialization as trade opportunities are provided and seized. The experience of the Economic Community, where the progressive dismantling of internal trade barriers led to increased mutual trade in similar products rather than to massive reductions in scale of output in industry groups within industrial member states, has only underlined this lesson.32 There is no reason therefore to doubt that such intra-industry trade in manufactures among developing countries and between them and the developed countries can also develop significantly, difficult as it is to forecast with plausible numbers.

Finally, if we reckon also with the potential for intra-developing country trade (where again policies can change to permit its increase), and the possibility of opening (again by policy) new sectors, such as agriculture and services, to freer trade, then the export possibilities are even more abundant than the preceding arguments indicate.33

Export pessimism, if traced to market forces as in the postwar period, is then unwarranted.34 If, however, it is traced to policies, that is, to protectionism as with the Second Export Pessimism today, then I believe that the earlier analysis in this section suggests again caution in leaping into the IS strategy based on unexplored and exaggerated fears.

Concluding Observations

My main conclusion therefore is that the appropriate policy for the developing countries is indeed to seek the advantage of outward orientation, without being overwhelmed by the renewed export pessimism. SAL and donor conditionality, where extended to such a shift in strategy for countries that are strongly inward looking, is not a matter of uninformed economic ideology, unmindful of existing economic conditions, but rather a matter of a considered evaluation of the prospects of keeping a functioning trading order with access to foreign markets. The occasional charges that such conditionality is a matter of ideology are therefore not based on a valid assessment of the donors’ views and predilections.

On the other hand, it is equally imperative that the developing countries, and these very international agencies seeking to spread outward-oriented strategy today, energetically engage in diplomatic efforts to sustain the open trading order. This requires that the developing countries actively participate in the multilateral trade negotiations at Geneva, seeking the kinds of bargains and trade-offs that characterize these negotiations and have led to the immense reduction in tariff levels that were noted earlier. It also requires that the international agencies that encourage or require outward orientation also strengthen their own expertise in the analysis of protectionism, its incidence, causes, and consequences, and offer the benefits of this expertise also to member countries who must confront these questions at the multilateral trade negotiations and in other areas of trade diplomacy.35


The discussion of this paper and Professor Sachs’s companion contribution prompts a few observations.

The EP strategy can be pursued in alternative formats. Broadly speaking, the anti-export bias of overvalued exchange rates can be eliminated either by adjusting them to offset the overvaluation or by providing export subsidies that bring EERx into line with EERm on the average. In the Bhagwati-Krueger NBER project, the latter regime was described as Phase II and the former as Phase IV in a sequencing scenario.

Are the two methods equivalent or is one superior to the other? Michael Bruno and I reminded Professor Sachs that, even if the export-subsidization route is superior as he seemed to believe, it is simply unavailable in the world of the 1980s in which countervailing (CVD) duties and anti-dumping (AD) actions are the norm. Professor Sachs properly responded that he was more interested in what was theoretically good for developing countries than in what was practically feasible.

Even at the theoretical level, however, I am afraid that there are problems with the export-subsidization route that may have been insufficiently appreciated by its proponents. First, if you replace a 50 percent devaluation by a 50 percent import duty and a 50 percent export subsidy, the two measures are equivalent in the classroom and graduate texts on trade theory. In reality, however, think of what happens in the latter alternative by imagining the incentives for evasion via faked invoicing (Bhagwati (1974, 1981)) and bribery that this will give rise to. The equivalence disappears fast in favor of devaluation in the reality of the developing countries, for sure. Second, similar considerations of political economy suggest that the export subsidization alternative is likely to be captured in many developing countries by pressure groups that will use the theme of offsetting the anti-export bias in the overvalued exchange rate regime to seek wasteful but self-serving export subsidies. This was evident in some developing countries of the set of ten studied in depth in the Bhagwati-Krueger NBER project, especially India and Israel in their Phase II trade-and-payments regimes. In fact, it was an encounter with these realities that prompted the now-burgeoning theoretical literature on rent seeking (Krueger (1974)) and directly unproductive profit seeking (DUP) (Bhagwati (1982)) activities.36

None of this is to deny that an export subsidy program may well be important and welfare improving. Thus, in conventional trade theory, many have argued such a case on theoretical grounds, implying that EERx > EERm, that is, an ultra-EP strategy, can be sensible under appropriate circumstances.37 For example, there may be externalities to a firm in export markets that are not matched by similar externalities in the domestic market, as when the export markets require investment promoting a product among foreign buyers who are unacquainted with a country’s capacity to export this type of good and the returns to this investment then accrue equally to other free-riding potential exporters from that country.

But a case for net export subsidization may be made also along the lines I have indicated already in the main text. It can provide convincing credibility of commitment on the part of the government to the maintenance of a policy framework that protects the EP strategy from random or systematic inroads in the foreseeable future, thus facilitating the investment of resources and entrepreneurial energies in exploiting foreign markets. This may well be an important, distinguishing rationale for permitting a net export subsidy by developing countries in which the role of the government is almost always more manifest, as the great historian Alexander Gerschenkron observed, and hence the assurance is correspondingly greater that a strategy will be protected from disruption in search of myriad other policy pressures and goals. In this precise sense, I do have some sympathy for the proposition that a more benign view of limited export subsidization in developing countries, even in the presence of properly functioning exchange rates, would be appropriate if only the developed countries could be so persuaded today.

This brings me to the question of the role of the government. Professor Sachs is indeed right in underlining the fact, noted in my main text as well, that the Far Eastern success stories are not proof of the merits of a laissez-faire government. Indeed, this has been long known in the extensive literature on trade-and-payments regimes. For instance, in the synthesis volume for the NBER project (Bhagwati (1978), Chapter 8), this was explicitly noted. This is not to deny that some have astonishingly believed otherwise. Thus, in the segment on Tyranny of Controls in his “Free to Choose” television series, Professor Milton Friedman characterized Japan as an example of the success of the market over government. As a member of the panel that debated him, I remarked that the visible hand in Japan may be invisible to him, but was certainly not so to the Japanese! But Professor Friedman can be forgiven perhaps for this self-indulgence toward his economic beliefs; we are all prey to this in varying degrees. After all, how can an economic miracle have occurred if the policymakers had not followed our preferred policies? Recalling that public goods have the property that I can enjoy them without depriving you of that pleasure too, I have formulated the following law: economic miracles are a public good; each economist sees in them a vindication of his pet theories.

The key question then is not whether there is governmental action in the Far Eastern economies, but rather how have these successful economies managed their intervention and strategic decisionmaking in ways that dominate those of the unsuccessful ones? This is a complex question but one to which some stylized answers can nonetheless be attempted.

An important aspect of the difference in governments in their behavior vis-à-vis the private sector seems to be that the Far Eastern economies are by and large governments that practice do’s rather than don’ts (Bhagwati (1978), Chapter 8). The reverse is true of governments that have generally shown an inferior performance. The key examples are highly regulated economies, such as India, with detailed controls over what entrepreneurs can do. Is there any reason why the proscriptive governments of don’ts should tend to do worse than the prescriptive governments of do’s?

There are two reasons why this might be so. First, a prescriptive government may prescribe as badly as a proscriptive government proscribes, each leading to a suboptimal outcome if you believe that such interventions tend to subtract from efficiency. But a proscriptive government will tend to stifle initiatives, whereas a prescriptive government will tend to leave open areas (outside of the presciptions) where initiatives can be still exercised. Thus, even though each government might distort allocation of existing resources equally, the proscriptive government will tend to stifle technical change and entrepreneurial activity and hence hurt growth.

Second, proscriptive governments tend to generate DUP activities by entrepreneurs seeking to avoid and evade the don’ts, thus diverting productive resources into unproductive ways of making an income. By contrast, the prescriptive governments tend to generate less such DUP activities since large areas are left open for initiatives that the do’s do not touch.

Finally, governments that are proscriptive are more likely to be adversarial to private entrepreneurship, with the bureaucrats and politicians exclusively in the driving seat. Prescriptive governments, by contrast, appear to work in a symbiotic relationship with private entrepreneurs. To take two well-known illustrations of this contrast, the relationship between The Ministry of International Trade and Industry (MITI) and the Japanese firms, for instance, is intimate, whereas that in India between the planners and the private entrepreneurs has not been. The former pattern of governmental relationship with private entrepreneurs can have two favorable effects. First, the government thereby can take decisions informed by the microeconomic know-how that is embodied in the entrepreneurs familiar with the industry being planned for, know-how that cannot otherwise be obtained by bureaucrats. Second, the symbiosis can reinforce the credibility of commitment to a strategy that I have already mentioned as important. With MITI agreeing to a projected or planned scenario of future growth, the government can be expected to adhere to a supportive policy mode which would otherwise not be available. Where these two favorable effects obtain, they can reinforce the advantages of a prescriptive government that I set out earlier.


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Throughout this paper, outward-oriented and EP strategies will be referred to interchangeably.

Aid conditionally reflected in the 1950s the dominance of the Harrod-Domar type of thinking. Since that model basically related growth to investment, with the productivity of investment (in the shape of the capital-output ratio) taken as technologically given by the composition of output, the performance of the aid recipient was measured simply by how much was done to raise the contribution of domestic savings to domestic investment. Hence, savings performance, and therefore tax effort, became the key elements of conditionality. By now, it is well known that investment is a necessary, but not a sufficient, condition for developmental success. Conditionality has thus moved on to include questions of efficiency in use of resources, which brings into the picture the question of outward orientation, in turn. Cf. Jadish Bhagwati, Wealth and Poverty, Vol. 1 of Essays in Development Economics, ed. by Gene Grossman (Oxford: Basil Blackwell, 1985), Chapter 1.

These decompositions are essentially just descriptions, and the attribution of causality and explanation based thereon (e.g., export growth “led to” so much of the output expansion), while common, is to be avoided.

The EERx, as international trade economists have long used the concept, is simply the domestic currency acquired per unit of foreign exchange earned, taking into account not just the parity but also adding subsidies and subtracting duties, and the like. Identically, EERm is the domestic currency that must be paid, taking all pertinent duties, subsidies, and other charges into account, to acquire a unit of foreign exchange. As such, the macroeconomists’ use of the phrase “effective exchange rate” is different, insofar as their usage simply deflates the parity by the domestic price level. This latter usage is basically inadequate since, in many developing countries, duties, subsidies, and other subventions and charges are important, and concentrating on the parity is not enough. For this purpose, the Bhagwati-Krueger National Bureau of Economic Research (NBER) Project defined the added concept PEDEER, that is, price-level-deflated EER, to get at the appropriate concept that macroeconomists should use. Cf. J. Bhagwati, The Anatomy and Consequences of Exchange Control Regimes (Cambridge, Massachusetts: Ballinger, I978), and A. Krueger, Lberalization Attempts and Consequences (Cambridge, Massachusetts: Ballinger, 1978).

Cf. J. Bhagwati, “Export Promoting Trade Strategy: Issues and Evidence,” VPERS Report No. 7, World Bank, October 1986.

J. Bhagwati, “Rethinking Trade Strategy,” in Development Strategies Reconsidered, ed. by John Lewis and Valeriana Kallab (Washington: Overseas Development Council, 1986).

The chief studies were directed by Little, Scitovsky, and Scott (1970) at the Organization for Economic Cooperation and Development (OECD), Balassa (1971) at the World Bank, Bhagwati (1978) and Krueger (1978) at the National Bureau of Economic Research (NBER) in the United States, and Donges (1976) at the Kiel Institute in Germany. Complementing and overlapping each other, these studies represent a massive analysis of the central question that has preoccupied development economists from the very beginning of the discipline.

See the synthesis volumes by Bhagwati (1978) and Krueger (1978).

Krueger’s synthesis also contains similar cross-country regressions for the ten semiindustrial countries in the NBER project. See the extensive review in Lal and Rajapatirana (1986).

Balassa’s (1978) re-estimation of Michaely-type regressions also incorporates the Michalopoulos-Jay approach, thus combining the two methodologies under one rubric.

Factors that lead to improved efficiency and hence to income improvement need not necessarily lead to sustained higher growth rates. Thus, in the Harrod-Domar model, where labor supply is slack, a once-for-all improvement in efficiency will indeed translate into a permanent higher growth rate of income, but not so in the steady state in the Solow model where the growth rate is determined by the growth rate of labor and the rate of technical change. Over the medium-run periods, however, for which the discussion in the text is couched, and for which we are explaining growth rates of over two or three decades, these subtleties are not particularly relevant. Moreover, it is important to note that, for any given growth rate, a more efficient economic regime will require less savings (and hence less blood, sweat, and tears) to sustain it than a less efficient economic regime.

See Bhagwati and Srinivasan (1983, Chapter 30) for a taxonomy of such activities.

See the discussion in Balasubramanian (1984) and in Bhagwati (1986a). In private communication, Mr. Balasubramanian has provided further results on this hypothesis.

See, in particular, the extensive analysis of this question in the NBER synthesis volume by Bhagwati (1978) where some chapters are specifically addressed to summarizing and evaluating these kinds of arguments with the aid of the findings in the ten country studies as also extraneous evidence and argumentation on these subjects.

See Bhagwati (1978), Chapter 8.

I have discussed these propositions elsewhere (Bhagwati, 1985c) at some length, drawing on a vast literature that includes important writings by Ahluwalia, Little, Srinivasan, Streeten, Bhalla, Griffin, Isenman, Bardhan, and others.

There is a gray area here, however. If the Japanese auto exports are restricted, not because the United States negotiates voluntary export restraints but because even though they have lapsed (as in 1985) the Japanese voluntarily restrict them for prudential reasons lest the protectionist Congress react adversely if exports are greater, is this the exercise of actual protection or simply a result of a protectionist threat? I would opt for the latter.

See Alexander Yeats’s (1981) demonstration of such tariff escalation for 11 processing chains involving products such as fish, coffee, silk yarn, natural rubber, cocoa beans, raw jutes and skins, fruits, wood and oil seeds, and flour.

“The number of trade flows for each importing country is the number of national tariff lines times the number of trading partners in which imports originated at each tariff line in the base year. A trade flow subject to NTMs is counted, at the national tariff line level, every time that imports from a specific source are affected by one or more NTMs.” Cf. UNCTAD, Protectionism and Structural Adjustment, 23 March 1987, Geneva, Part 1 (p. 14).

Thus, even import surveillance (including automatic licensing) are routinely included in the ratio and index. UNCTAD does estimate the ratio and index for smaller groups of NTBs, however.

Again, auto VERs were eliminated by the United States in 1985, but it is not clear whether this substantial liberalization has been interpreted as such or ignored because Japan continued prudential, voluntary restraint herself.

The investment shunting need occur only insofar as it is necessary to meet value-added rules of origin, of course, making the cost of profiting from this porousness even less than otherwise.

Of course, the VERs in this instance represent only a partial and suboptimal approximation to the free trade solution which remains the desirable but infeasible alternative. Moreover, not all exporting countries are capable of the flexible and shrewd response that underlies the model of porous protection sketched above.

This two-headed version of governments underlies the Feenstra-Bhagwati (1982) model of the efficient tariff. The argument above is also compatible with Pastor’s (1983) “cry-and-sigh” syndrome thesis of U.S. tariff making and with Destler’s (1986) work, which suggests that the Congress relies on the Executive to ensure open markets and to protect U.S. trade policy from the consequences of protectionist cries that the Congress must make to satisfy constituents.

See, for example, Olson (1971), Finger (1982), and Mayer (1985).

See the report by Miller (1985) in the Wall Street journal.

Of relevance here is the work of Helleiner (1977) and others. These authors, and most recently Lavergne and Helleiner (1985), have argued that multinationals have become active agents exercising political pressure in favor of free trade. These authors have also investigated, for the United States, correlations on a cross-industry basis between multinationals and tariff changers, but without much success. Their work, however, does not extend to the potential DFI effects in favor of freer trade (through DFI becoming an alternative response to import competition) that is discussed in Bhagwati (1982b and 1986a) and in the text.

In fact, MITI (Ministry of International Trade and Industry) of Japan has recently completed a survey of Japanese DFI abroad and found that a large fraction of the respondents cited reasons of the quid pro variety to explain their investment decisions. I am indebted to Professor Shishido of the International University of Japan for this reference.

See the theoretical modeling of such quid pro quo DFI in Bhagwati, Brecher, Dinopoulos, and Srinivasan (1987) and in Bhagwati and Dinopoulos (1986), the former using perfectly competitive structure and the latter using monopoly and duopoly structures instead.

See the detailed arguments in the latter two papers which explicitly address the Lewis proposition.

There is a substantial empirical literature on this subject, with important contributions by Balassa, Grubel, and Lloyd. In addition, recent theoretical work by Dixit, Lancaster, Krugman, Helpman, and others has provided the analytical explanation for such intra-industry trade.

All these arguments are effectively a rebuttal also of Dornbusch’s (1986) restatement of the limited-absorptive-capacity thesis for developing country exports, which asserts that substantial terms of trade losses would follow from the simultaneous resort to EP strategy by many developing countries.

See also the excellent critique of Cline’s analysis offered by Ranis (1985).

For example, it is extremely important to assess the growing trend toward fair trade in the United States and in the EC, and its implications for protectionism. Increasingly, it is feared by many that countervailing and anti-dumping (CVD and AD) duties and processes are captured by industries seeking protection, and that foreign competitors are harassed by this soft-core protection. Assessing this threat is a very important task, which also bears on what the developing countries ought to seek at the multilateral trade negotiations. Splendid studies of this problem have been undertaken, as it happens, in the World Bank of this issue, in research papers by Finger and Nogues, Nam, and Messerlin. See also Bhagwati and Irwin (1987), where these issues are discussed in a wider context.

DUP activities include rent-seeking activities designated to secure rents on quote restrictions but embrace a wider set of activities that use resources to make a profit (or income) but produce no output, directly or indirectly. For a relationship between the two concepts, see Bhagwati and Srinivasan (1983), Chapter 30, and Bhagwati (1984)

Thus, see Bhagwati (1968) and a fine, recent formalization of an argument for export subsidy advanced therein by Mayer (1985).

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