Institutionalism and new trade theory: rethinking comparative advantage and trade policy.

Author:Palley, Thomas I.

Institutionalism and New Trade Theory

International trade theory has long been dominated by the theory of comparative advantage. That theory claims, subject to a few pathological exceptions, countries are made better off by international trade. (1) That said, the theory also acknowledges (Stolper and Samuelson 1941) that capital and labor share differentially in the gains from trade, and individual factors can actually lose. However, factors that lose can still in principle be fully compensated for their losses out of the gains from trade, though this seldom happens in practice for reasons of political economy.

The theory of comparative advantage has played a central role in promoting the policy case for free trade and globalization. Though accepted by most professional economists, some economists question its theoretical assumptions regarding the existence of full employment and the ability of markets to bring about a global allocation of production on the basis of country relative efficiency (Palley 2003). Institutional economists also question its lack of attention to institutional forms, particularly multi-national corporations and their impact on patterns of trade.

These theoretical critiques of comparative advantage trade theory are also being increasingly joined at the political level. Thus, more politicians and members of the public are questioning the scale of benefits from trade and globalization. In particular, there are growing concerns about the welfare impacts of possible future developments regarding offshore outsourcing of production.

The current paper explores recent work by Gomory and Baumol (2000) and Samuelson (2004)--henceforth GBS--examining these issues. In particular, the paper focuses on excavating and clarifying the economic argument of Gomory and Baumol, which is difficult to access in their book.

GBS work in the tradition of comparative advantage equilibrium theory (especially Samuelson) and explore how changing patterns of global production can affect the distribution of gains from trade. Their findings paint a much more mixed picture of the benefits from globalization than implied by conventional trade theory.

GBS's findings also reveal the potential for some convergence between neoclassical trade theory and institutionalist trade theory. This convergence operates at many levels, from the analysis of how trade works, to policy. First, expansions of trade may not be the win-win outcome conventionally claimed, and trade expansion may systematically create "country" winners and losers. Second, GBS's arguments emphasize transfers of technology and production methods between countries, and behind these transfers implicitly stand multi-national corporations that engage heavily in foreign direct investment. This links to the product-cycle theory of

trade developed by Vernon (1966; 1979). Third, increasing returns to scale (IRTS) play a central role in the Gomory--Baumol account of trade conflict, and this links with Post Keynesian economics that has long emphasized IRTS effects (Kaldor 1981). However, Gomory and Baumol work with static IRTS that links the level of productivity to market size: Post Keynesians have tended to emphasize dynamic IRTS operating through Verdoorn's law, which rests on a link between productivity growth and market size. Fourth, GBS see a place for strategic trade policy to capture greater gains from trade, and this links with the spirit of institutionalist policy thinking.

It is also important to understand the character of GBS's re-thinking of trade, which has nothing to do with "protectionism." They are strongly in favor of trade, believing there are gains to be had by all. What is open to question is how the size of those gains and their distribution across countries may change over time. That raises important new policy issues regarding what can be done to maximize the U.S. share of gains from trade and hold on to them, and it is this issue that is their ultimate concern.

Finally, GBS's analysis is conducted in terms of microeconomic theory, which is the basis of conventional trade theory. That means their rethinking tackles conventional trade theory on its own terms, which strengthens their critique. To this can then be added macroeconomic critiques (Blecker 2005a; 2005b) and empirical critiques about the effect of trade deficits on jobs and investment (Bivens 2004; Blecker 2006).

The GBS Contribution to the Trade Debate

Before engaging with the substance of GBS's analysis it is worth distinguishing their argument from some existing theoretical critiques of trade. First, their argument is not about the adverse income distribution impacts of trade. These effects are widely understood, and Samuelson made the pioneering contribution to this area of trade theory in his work with Wolfgang Stolper (1941). According to the Stolper-Samuelson theorem, the factor that is relatively scarce in the pre-trade equilibrium loses out when a country opens to trade. In the case of the United States, that means American workers lose as they implicitly become part of a global labor market. This income redistribution effect remains operative, but it is distinct from the new concerns raised by GBS.

Second, GBS's argument is not about wage losses and employment dislocation costs caused by rearranging country production patterns in accordance with the principle of comparative advantage. Kletzer and Rosen (2005) have emphasized wage losses and they propose wage insurance to compensate those losing from trade. These costs of trade-induced job dislocations and the case for wage insurance also remain real and present, but they too are distinct from and supplementary to the new concerns of GBS.

The new issue raised by GBS is the dynamic evolution of comparative advantage and the resulting impact on the distribution of gains from trade. The theory of comparative advantage says that there are gains from trade for the global economy as a whole. However, the distribution of those gains between countries depends on demand and supply conditions that determine the terms of trade (i.e. the relative price of imports and exports), and these conditions can change.

One critical factor is the global pattern of demand, and a country will benefit more from trade if international demand for its products is relatively stronger as this will drive up the price of its exports. A second factor is the evolution of supply, and it is possible that rapid supply growth can harm a country by increasing global supply and driving down the price of its exports.

This latter possibility was first identified by Harry Johnson (1954; 1955) and subsequently expanded by Jagdish Bhagwati (1958), while the empirical work of Hans Singer (1950) and Raul Prebisch (1968) on declining prices of commodities relative to manufactured goods gave it operational policy significance. The Johnson--Bhagwati work then spawned a policy literature that showed how countries whose production has an impact on global prices can use export tariffs to tilt the terms of trade in their favor, thereby capturing additional gains from trade.

In the post-World War II period the United States did relatively well from trade as capital was globally scarce, demand for capital goods was strong, and there were also relatively few capital goods suppliers. That meant the United States enjoyed favorable terms of trade, which meant it captured a large share of the gains from trade. The question is will this continue over the next fifty years?

The earlier work of Johnson (1954; 1955) and Bhagwati (1958) focused on the effects of trade opening and domestic technological advance on the terms of trade and distribution of gains from trade. Samuelson (2004) changes the focus and examines the implications of economic catch-up by trading rivals. It is commonly assumed that all countries benefit from technological progress in other countries because this expands the global production possibilities frontier (PPF). (2) However, it turns out that while it is true that the global PPF is expanded, it is not necessarily true that all countries benefit from the expansion. This is an important theoretical finding.

Samuelson's (2004) concern, developed in the context of the debate over international outsourcing and trade with China, is that increases in productivity of foreign trading partners may diminish the United States' share of the gains from trade. The economic logic is as...

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