This paper examines the extent to which the emerging world trading regime leaves nations the "policy space" to deploy effective policy for long-run diversification and development and the extent to which there is a convergence of such policy space under global and regional trade regimes. We examine the economic theory of trade and long-run growth and underscore the fact that traditional theories lose luster in the presence of the need for long-run dynamic comparative advantages and when market failures are rife. We then review a "toolbox" of policies that have been deployed by developed and developing countries past and present to kick-start diversity and development with the hope of achieving long-run growth. Next, we examine the extent to which rules under the World Trade Organization (WTO), trade agreements between the European Union (EU) and developing countries, trade agreements between the United States (US) and developing countries, and those among developing countries (South-South, or S-S, agreements) allow for the use of such policies. We demonstrate that there is' a great divergence among trade regimes over this question. While S-S agreements provide ample policy space for industrial development, the WTO and EU agreements largely represent the middle of the spectrum in terms of constraining policy space choices. On the far end, opposite S-S agreements, US agreements place considerably more constraints by binding parties both broadly and deeply in their trade commitments.
Development is a long-run process of transforming an economy from concentrated assets based on primary products, to a diverse set of assets based on knowledge. This process involves investing in human, physical and natural capital in manufacturing and services and divesting in rent seeking, commerce, and unsustainable agriculture. (1) Imbs and Waczairg (2) have confirmed that nations that develop follow this trajectory. They find that as nations get richer, sectoral production and employment move from a relatively high concentration to diversity. (3) They find such a process is a long one and that nations do not stabilize their diversity until they reach a mean income of over $15,000. (4) For many years it has also been known that as countries diversify they also undergo a process of deepening whereby the endogenous productive capacities of domestic firms are enhanced through forward and backward linkages. (5)
This paper examines the extent to which the emerging world trading regime leaves nations the "policy space" to deploy effective policy for long-run diversification and development, and the extent to which there is a convergence of such policy space under global and regional trade regimes. Part I of the paper examines the economic theory of trade and long-run growth and underscores the fact that traditional theories lose luster in the presence of the need for long-run dynamic comparative advantages and when market failures are rife. We then exhibit a "toolbox" of policies that have been deployed by developed and developing countries past and present to kick start diversity and development with the hope of achieving long-run growth but also stress that tools alone are not the recipe for development, that "getting the political economy right" is also of vital importance. In Part II, we examine the extent to which rules under the World Trade Organization (WTO), trade agreements between the European Union (EU) and developing countries, trade agreements between the United States (US) and developing countries, and developing country-developing country trade agreements (or South-South, S-S) allow for the use of such policies. Part III of the paper summarizes our findings and offers conclusions for policy and future research. This paper is intended to assist policy-makers as they choose trade partners that affect their ability to design long-run development strategies.
Trade Theory and the Long Run
The traditional trade theory that provides the backdrop and justification for the majority of trade treaties is limited in terms of long-run growth for developing countries. Such theories assume a static approach to technological change and assume that there are no market failures among trading partners, (6) two assumptions that do not hold in the developing country context. This section of the paper provides an overview of trade theory and its limitations and shows how some countries have used various tools to correct for the theoretical limitations identified.
Neo-classical trade theory demonstrates that liberalizing trade can make all parties better off. The economist David Ricardo showed that because countries face different costs to produce the same product, if each country produces and then exports the goods for which it has comparatively lower costs, then all parties benefit. (7) The effects of comparative advantage (as Ricardo's notion became called) on factors of production were developed in the "Heckscher-Ohlin" model. (8) This model assumes that in all countries there is perfect competition, technology is constant and readily available, there is the same mix of goods and services, that factors of production (such as capital and labor) can freely move between industries, and there are no externalities. (9) In other words, this model is "static" and not "dynamic" and there are no market failures.
Within this rubric, the Stolper-Samuelson theorem adds that international trade can fetch a higher price for the products (and hence lead to higher overall welfare) in which a country has a comparative advantage. (10) In terms of foreign direct investment (FDI), multinational corporations (MNCs) moving to another country) can contribute to development by increasing employment and by human capital and technological "spillovers" where foreign presence accelerates the introduction of new technology and investment. (11) In theory, the gains from trade accruing to "winning" sectors freed to exploit their comparative advantages have the (Pareto) possibility to compensate the "losers" of trade liberalization. Moreover, if the net gains from trade are positive there are more funds available to stimulate growth and protect the environment. In a perfect world then, free trade and increasing exports could indeed be unequivocally beneficial to all parties.
To some, static comparative advantage poses problems for countries who want to sustain long-run growth. Some countries may only have a static comparative advantage in a single commodity where prices are very volatile and where longer-run prices are on the decline relative to industrial goods. What's more, small initial comparative static advantages among countries in the short-run may expand into a growing technology gap between rich and poor nations in the longer-run. (12) If the developed world has a static comparative advantage in innovation, it can continually stay ahead by introducing new products, even if the developing world eventually catches up and gains a comparative advantage in low-cost production of each old product over time. (13)
In the longer-run then, what matters most is not static comparative advantage at any one moment in time, but the ongoing pattern of dynamic comparative advantage: the ability to follow one success with another, to build on one industry by launching another, again and again. Since the process of technology development is characterized by increasing returns, many models will have multiple equilibria. It is easy to specify a model in which the choice between multiple equilibria is not uniquely determined by history; rather, it becomes possible for public policy to determine which equilibrium will occur. (14) If, in such a model, the multiple equilibria include high-tech, high-growth paths as well as traditional, low-growth futures, then public policy may make all the difference in development.
Neo-classical trade theory also assumes that there are no market failures among trading partners. (15) However, four key market failures plague nations seeking to catch up to the developed world: coordination and information externalities, dynamism and technological change, and human capital formation. (16) "Diversification by definition can mean the creation of whole new industries in an economy and sometimes may require linking new industry to necessary intermediate goods markets, labor markets, roads and ports, and final product markets. For fifty years economic theorists have demonstrated how markets fail at 'coordinating' these efforts." (17) "Coordination failures and the asymmetric distribution of world income has led economists to argue that the nation state should provide 'big push' investments to build scale economies and enhance the complimentary demand and supply functions of various industries" over the long run. (18)
While historically such efforts took the form of large industrial planning efforts and infant industry protection, more recently industrial clustering has taken place where nations focus on the development of specific technologies or sectors in specific geographical regions--especially when facing scale economies. (19) Clustering and export processing zones have been created to attract foreign firms, link them to domestic input providers, and serve as exporting platforms. (20) To support these efforts, nations (most successfully in Asia) provide tax breaks and drawbacks to foreign firms but required them to source from domestic firms and transfer technology. (21) In tandem, the state provides an educated labor force, public R&D, tariff protection, and subsidized credit to support the domestic firms, and provided export subsidies to the domestic firms until they could produce products at the global technological frontier. (22)
Markets also fail at providing the socially optimal amount of "information" to producers and consumers as well--such phenomena are termed information externalities. (23) Technological...