Grumpy Economist: Irwin on Trade Reform

Doug Irwin from Dartmouth gave a very informative paper to the Hoover Economic Policy Working Group based on his paper. Wave of trade reforms 1985-1995AER May 2022 Insert (hopefully) below or go to link here.

Doug opened my eyes, hence this post. I love learning new things. I am a strong supporter of free trade. So naturally I move on to the answer: stop protecting industries. Get rid of tariffs. Don’t worry about the bargaining mercantilism of trade deals – “you can sell to us if our exporters can sell to you” deals. The point of exporting a foreign country is to get dollars, and the point of dollars is for them to buy in the US. Full stop.

Doug shows that this story is too simplistic to make sense of the closed economy of the 1950s and 1970s and the great trade liberalization that the world has experienced since the 1980s and which, unfortunately, we are likely to lose in the coming years. A small reminder of what we have acquired, and a sad peak:

The process of liberalization began with money, not tariffs: First, countries devalued their overvalued currencies, usually to floating rates. Quantitative restrictions on imports were then lifted, including import licenses. Then they lowered the rates.

In turn, how did they get there and why didn’t they reform earlier? The standard story compares domestic industry with domestic industry. consumers. The interest of the domestic industry in protection is concentrated, consumers are dispersed. This explains the status quo bias, but not why they ended up changing.

The source of the problem and the reason for the change are different. Countries (especially in the “developing” world) experienced a “terms of trade” shock – they exported goods, say, in order to import goods; the price of commodities fell so they couldn’t buy imports. Many countries financed imports with foreign aid and loans, and these transfers dried up.

What are they doing? They have to choose between deflation, currency depreciation, or import controls. Deflation at the same exchange rate makes foreign goods more expensive. Depreciation does the same without changing the domestic price level. Or stop imports by directly controlling and rationing foreign exchange, leading to a black market. In terms of the early post-war period, consistent with Bretton Woods, they chose the latter. (Why so much nostalgia for Bretton Woods? It was a rotten system.)

Naturally, it didn’t work out. Eventually they gave in and devalued or reversed the exchange rate. Now there is no need to ration foreign exchange or restrict licensed imports. (Tariffs are bad, but quantitative restrictions are worse, because you never know what the cost is, and then imports are distributed for political, not economic reasons. It’s just more efficient to pay tax!) Switched to exports to generate foreign exchange for buying imports.

So, Doug answers the main question:

Why were there no reforms in the 1970s? “Foreign exchange reserves kill the will to reform”

Oil and commodity exporting countries were full of cash to buy imports. Foreign aid recipients had the cash to buy imports.

Why reform in the 1980s?

The era of foreign exchange deficit – all three balance of payments shocks.

Purpose: to increase foreign exchange earnings by increasing exports.

Learning from experience – the cost of controlling imports, the benefits of exporting

Shift from import suppression to export promotion to overcome foreign exchange shortages

And later

Michael Bruno (World Bank): “We’ve done more for Kenya by stopping aid for one year than we’ve done for the previous three decades”

Aid allows the country to delay reforms.

I asked one question about the importance of an open capital account. This, too, used to be the gospel, now it is being discussed. Doug’s answer was interesting: in these cases, the free foreign exchange market was decisive, but the free capital markets less so.

Ideas matter.

This process is not just played out in terms of standard political economy, one interest group gains power over another. Changing ideas in universities, the IMF, central banks, and countries was critical. I find it touching as an idea maker and terrifying when I see these successful ideas crumble around me.

Doug discusses the reform process in Mexico (which first failed due to some bad ideas, and then reform when a new group of economists came in), India, South Korea, and other countries. Listen to the conversation!

Final slide: