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11.19 Trade and Economic Growth

Another important strand of the growth literature points to the importance of

increasing international economic integration (‘globalization’) as a major

fundamental determinant of economic growth. It is argued that there are

sound theoretical reasons for believing that more open economies grow faster

than more closed economies. In a recent survey of the literature, Lewer and

Van den Berg (2003) conclude that the ‘impact of trade on economic growth

appears to be very important for human welfare’. Moreover, the proponents

of this view support their case with numerous empirical studies and conclude

that, overall, ‘globalization’ has had a positive effect on economic growth

(Sachs and Warner, 1995; Krueger, 1997; Edwards, 1998; Frankel and Romer,

1999; O’Rourke and Williamsom, 1999; Baldwin, 2000; Bhagwati and

Srinivasan, 2002; Dollar and Kraay, 2003, 2004; Bordo et al., 2002b; Bhagwati,

2004; Winters, 2004; see also Snowdon, 2001c, 2003c).

While economists recognize that freer trade will have a ‘level effect’ in

raising a country’s output once and for all, the likely impact on the rate of

growth of output is much more controversial. For example, Lucas (1988)

suggests that the removal of barriers to trade may induce a series of boosts to

output which are level effects disguised as growth effects. In the standard

open economy version of the Solow growth model, trade liberalization can

have a temporary, but no permanent, effect on the long-run rate of growth. As

Rivera-Batiz and Romer (1991) note, the main problem is that economists do

not have a ‘rigorous model’ to justify their belief that increased economic

integration will tend to increase the long-run rate of growth. Rodriguez and

Rodrik (2000) have claimed that little evidence can be found ‘that open trade

policies – in the sense of lower tariff and non-tariff barriers to trade – are

significantly associated with economic growth’. In response, Bhagwati and

Srinivasan (2001) argue that an open trading regime not only allows the

beneficial level effects to be gained from comparative advantage but also has

a positive influence on growth. But rather than relying on ‘endless’ (and

‘mindless’) cross-county regression evidence, Bhagwati and Srinivasan appeal

to the numerous in-depth country case studies which support the

growth-inducing effects of greater openness (Bhagwati, 1978; Krueger, 1978;

Balassa, 1989; Edwards, 1998). Krueger (1997, 1998) is in no doubt that the

developing countries that followed more outward-oriented strategies have

grown faster on a sustained basis than those who ‘blithely abandoned’ the

principle of comparative advantage and adopted, and maintained for long

periods, import substitution (ISI) policies. Krueger links the initial hostility

to outward-oriented strategies after 1945 to the powerful influence of dirigiste

ideas which in turn were a legacy of the Great Depression and the apparent

success of state-led development in the Soviet Union. Bhagwati (1993) recalls

how India was propelled towards a ‘harmful’ ISI strategy because many

of India’s influential economists during the 1950s, including P.C. Mahalanobis,

took the idea of ‘elasticity pessimism’ with respect to exports too seriously.

In contrast to India, the experience of over four decades of outstanding

economic growth performance achieved by the East Asian ‘miracle’ economies

is also positively linked to their choice of open trade regime. The

empirical work of Sachs and Warner (1995), Ben-David (1996), Edwards

(1993, 1998), and Ben-David and Loewy (1998) adds support to the mainstream

view that there is a strong link between free trade and income

convergence among nations. Lawrence and Weinstein (2001), while providing

support to those who advocate more liberal trade policies, reject the

‘export fetishism’ of some earlier studies and emphasize instead the growthenhancing

effects of an increasing share of imports in GDP via its effect on

innovation and learning (see Rodrik, 1995). What is certain is that a more

open economy will have access to cheaper imported capital goods from the

world market (see DeLong and Summers, 1993; Jones, 1994).

An important factor influencing convergence identified by Sachs and Warner

(1995) is the degree of openness of an economy:

We suggest that the most parsimonious reading of the evidence is that convergence

can be achieved by all countries, even those with low initial level of skills,

as long as they are open and integrated in the world economy … the convergence

club is the club of economies linked together by international trade … In terms of

the conditional convergence hypothesis, we argue that the apparent differences in

long-term income levels are not differences due to fundamental tastes and technologies,

but rather to policies regarding economic integration.

Sachs and Warner identify a ‘closed’ trading regime as one that has at least

one of the following characteristics: (i) non tariff barriers covering 40 per

cent or more of trade; (ii) average tariff rates of 40 per cent or more; (iii) a

black market exchange rate that is depreciated by 20 per cent or more relative

to the official exchange rate, on average, during the 1970s and 1980s; (iv) a

socialist economic system (as defined by Kornai, 1992); and (v) a state

monopoly on major exports. An open economy is one where none of the

above conditions hold. The case of China is the only real puzzle. However, as

Sachs and Warner explain, with respect to international trade, the Chinese

economy was essentially liberalized for non-state firms, especially those

operating in the Special Economic Zones in the coastal areas. And the fastestgrowing

areas in China in the period 1978–94 were all coastal provinces with

the exception of Xinjiang (Ying, 1999).

The research findings of Sachs and Warner lead them to four important

conclusions: first, ‘there is strong evidence of unconditional convergence for

open countries, and no evidence of unconditional convergence for closed

countries’; second, ‘closed countries systematically grow more slowly than

do open countries, showing that “good” policies matter’; third, ‘the role of

trade policy continues after controlling for other growth factors’; and fourth,

‘poor trade policies seem to affect growth directly, controlling for other

factors, and to affect the rate of accumulation of physical capital’. Therefore,

Sachs and Warner’s reading of the evidence suggests that trade policy should

be viewed as ‘the primary instrument of reform’ where trade policy serves as

a proxy for an entire array of market reforms.

At the theoretical level, work in the endogenous growth literature has

emphasized the importance of the flow of ideas in stimulating technological

innovation (P. Romer, 1990, 1993, 1994b). In this context the greater a

country’s exposure to the world outside the more it is likely to gain from the

research and development activities of other countries, including new ideas

relating to organizational methods. As Paul Romer argues, ‘The key role for

trade is that it lets developing countries get access to ideas that exist in the

rest of the world’. This view also receives support from Robert Solow, who

suggests that ‘The only way you can make sense of trade having an effect on

the long-run growth rate is not so much whether the country is export led, but

whether the country is in contact with the rest of the world’ (see Solow

interview at the end of this chapter). Edwards (1998) provides a simple

framework for considering the relationship between TFP growth and openness.

This framework is summarized in equations (11.44) and (11.45).

Yt = At f (Kt , Lt ) (11.44)

A˙/A = θ + ω(W − A)/A (11.45)

Here Yt is GDP, At is the stock of knowledge, or TFP, Kt is physical capital

and Lt is labour measured in efficiency units. Growth will depend on the rate

of change of At, Kt and Lt. Edwards assumes that there are two sources of TFP

growth: first, a domestic source fuelled by innovation and dependent on

domestic human capital (education); and second, an international source

‘related to the rate at which the country is able to absorb (or imitate) technological

progress originating in the leading nations’. Imitation depends on a

‘catch-up’ term. Those countries furthest from the technological frontier have

the greatest potential for imitation. In equation (11.45) A˙/A is the rate of

growth of TFP, θ is the domestic rate of innovation, ω is the speed at which a

country is able to close its knowledge gap and is influenced by trade policies,

W is the world stock of knowledge assumed to grow at a rate g (where g ≥ θ).

For the world’s technological leader (the USA since the 1890s) g = θ and W

= A. Edwards argues that, in keeping with many ideas-based models of

growth, more open economies ‘have a greater ability to absorb ideas from the

rest of the world and, thus, have a higher ω’ and ‘an important property of

this simple model is that countries that liberalise trade will experience transitional

productivity growth that exceeds that of countries that maintain their

trade distortions’. Because trade between nations is likely to act as a conduit

for the dissemination of ideas, inward-looking trade and development strategies

which erect barriers to trade will therefore inhibit the transmission of


The extent of North–South R&D spillovers has been investigated by Coe et

al. (1997). Given that almost all R&D activity is carried out in the developed

countries, there are clearly opportunities for developing countries to benefit

from knowledge spillovers, especially from the USA. The empirical evidence

presented by Coe et al. indicates that the total factor productivity of developing

countries is ‘positively and significantly related to R & D in their industrial

country trade partners and to their imports of machinery and equipment from

the industrial countries’.

In the model developed by Ben-David and Loewy (1998) openness creates

greater competitive pressure on domestic firms which, in response, seek to

acquire foreign knowledge relating to production processes and techniques

(see also Parente and Prescott, 2000; Baumol, 2002). Hence trade flows

facilitate the transfer of ideas and stimulate the growth of the economy.

Because many poor countries have adopted protectionist strategies, their

trade barriers act as a ‘buffer that limits knowledge spillovers’. Ben-David

and Loewy argue that so long as such barriers persist, the income gap between

countries will continue to exist.

Remarkably, Adam Smith (1776) anticipated the argument that free trade

facilitated the flow of ideas and knowledge:

Nothing seems more likely to establish this equality of force than the mutual

communication of knowledge and of all sorts of improvements which an extensive

commerce from all countries to all countries naturally, or rather necessarily,

carries with it.

In Irwin’s (1996) view, these insights of Smith, relating to technology transfer

and the dynamic benefits of openness, ‘were outstanding for the period in

which he was writing’.

While the majority view of economists leans towards the Bhagwati position

on trade and growth, Rodrik (1995, 1999a) remains critical of those who

place too much emphasis on ‘globalization’ and exports as the easy road to

economic development. He continues to emphasize that policy makers in

developing countries need to formulate a growth strategy that recognizes the

importance of domestic institutions (including democracy) and domestic investors

rather than one that is built solely around a ‘hazardous obsession with

global integration’. Unlike Bhagwati and Krueger, who have provided a

sustained critique of ISI policies, Rodrik (1999a, 1999b) argues that the

wrong lessons have been learned about the growth experiences of countries

that adopted ISI policies. According to Rodrik, ISI policies worked very well

for about twenty years before the late 1970s, and the subsequent growth

collapses and disappointing economic performance of many ISI-adopting

countries ‘had little to do with ISI policies’. The developing countries that

successfully weathered the economic shocks of the 1970s and 1980s were

those that quickly and decisively made the appropriate macroeconomic adjustments

and also had effective domestic institutions of conflict management.

So the reason that the East Asian economies have been better equipped to

cope with economic turbulence compared to Latin America and sub-Saharan

Africa is not that they were outward-oriented and the others remained closed;

rather it was because Latin America and sub-Saharan Africa ‘did a much

worse job’ in managing and absorbing the shocks. Rodrik does not deny the

potential benefits of openness, but he warns policy makers and fellow economists

that for openness to be a successful component of any development

strategy, it must not be regarded as a substitute for a domestic strategy. The

‘knee-jerk’ globalizers among policy makers mistakenly seem to imply that

globalization, by itself, can work miracles for a developing country’s economy.

Therefore Rodrik remains a strong advocate of the importance of domestic

investment, human and physical capital formation, as the fundamental determinant

of economic growth. While empirically the relationship between

investment and growth ‘tends to be erratic in the short run … cross-national

studies have shown that investment is one of the few robust correlates of

economic growth over horizons spanning decades’ (see Rodrik, 1995, 1999a;

see also Vamvakidis, 2002).

A reasonable conclusion from the above discussion is that it appears to be

openness rather than exports per se which seems to matter for enhanced

economic performance, but also that to fully benefit from the potential benefits

of openness developing counties need a complementary domestic strategy

that includes building ‘institutions for high-quality growth’ (Rodrik, 2000,

2003, 2005) . Openness is a means to an end, not an end in itself. Interestingly,

as the research of Alesina and Spolare (2003) shows, as the world

economy becomes more open, the size of a country’s domestic market becomes

less important as a positive influence on the level and growth of

productivity. As globalization spreads, the benefits of size diminish. Predictably

the number of countries in the world has increased from 74 in 1945 to

192 in 2004.