Prof. Dr. Marcos C. Cavalcanti de Albuquerque
S. Paulo Business School - Getulio Vargas Foundation
Very few topics in the history of international relations have been as controversial as the patterns of trade between nations. Disputes have been occurring ever since transportation made long-distance exchanges possible. In the beginning, controversies arose related to problems of control and monopoly over supply sources and transportation routes. These disputes evolved into those concerning trade-related internal welfare gains and losses, on one side, and competition from foreign products on the other. In this case, however, trade questions were related to whether countries should produce domestically what they were capable of or import such goods. This question still keeps discussions alive, as evidenced by the successive rounds of negotiations of the General Agreement on Tariffs and Trade (GATT).
More recently, however, this question has reached different grounds, which include not only the issue of making or buying abroad, but also more complicated issues of technological dependency and the right, or the possibility, to learn. This is a dynamic problem that becomes particularly worrisome when trade discussions arise between countries at unequal stages of development. Previously, the issues involved domestic welfare gains and losses and redistribution of income—which could, in principle, be corrected by compensation mechanisms if overall welfare was increased. Now, however, they involve structural questions, such as relations of dependency across nations, which are not likely to be subject to the same compensation mechanisms.
As such, trade issues and policy discussions among nations with equal levels of economic development do not raise the same controversies as those between countries at different stages of technological development. This is a fundamental difference that must be considered in the analysis of patterns and policies of international trade.
The Classical Doctrine of Trade
The paradigm of the classical doctrine of trade posits that the countries of the world can benefit from trade and from an international division of labour. It is a long-run theory that penetrates the veil of money and stresses that both absolute cost advantages and comparative cost advantages give rise to trade possibilities that potentially benefit all partners. Specialization increases the standard of living by making more goods and services available for consumption.
Initially, the basic idea of comparative advantage was based on the assumption that production functions differ between countries. In its modern formulation, the Hecksher-Ohlin model stresses that if factor proportions differ between countries, that alone would be enough to make trade profitable.
No logical objection can be raised against this trade model. It requires, however, that certain premises hold true: perfect competition, no wage and price rigidities, no factor intensity reversals, constant returns to scale, and no externalities or other forms of market failure. If all of this is true, it can be safely said that a country will gain by specializing in the production of that commodity which uses more intensively the country’s more abundant factor (the Hecksher-Ohlin Theorem). Furthermore, trade can replace factor mobility, as factor prices will be equalized between countries (the factor-price equalization theorem).
Additionally, it can be shown that the direction of trade will depend on pre-trade equilibrium price ratios, which depend on production possibilities and internal demand conditions. Production possibilities also depend on technology and factor availability.
All these assumptions are usually taken to be true, and as a result, the idea of free trade is presented as an immediate objective, requiring only political will and common sense to be achieved.
The free-trade doctrine can be challenged in terms of its own basic assumptions. In static terms, which characterize the main structure of the classical trade doctrine, it can be shown that free trade and specialization are not always the best policies for a national economy, especially in the case of a large country, which by its actions can induce a favorable change in its terms of trade. Although trade may lead to an increase in the world’s availability of goods and services, there is no guarantee that the benefits from trade will accrue to all participants. Depending on the terms of trade, the gains from exchange may be entirely absorbed by one country, leaving the other in the same situation, in terms of social welfare, as before trade started. As a matter of fact, trade may even make a country worse off than it was before trade.
Thus, it is not enough to show that trade is capable of increasing world welfare; it is also necessary to show that the distribution of these gains will benefit all partners, and this the classical trade theory is not capable of doing, even on its own theoretical foundations.
In general, tariffs and other forms of protectionism reduce the volume of trade and increase domestic production in the protected industry, at the expense of exportables. In the limit, a tariff can be prohibitive, preventing trade. It also redistributes income in favor of factors used intensively in the protected industry, at the expense of the welfare of the economy as a whole (the Stolper-Samuelson theorem). These results hold if the basic postulates of neo-classical economic theory are satisfied and if the country is a price-taker in international trade.
In the case of a large country, however, tariffs may improve the terms of trade and increase its social welfare. For a small country, the optimum tariff is zero, but this is not necessarily true for a large country, which may increase its welfare at the expense of others, even if the world’s welfare decreases as a result of its protectionist policies.
Since international trade cannot yet be shown to be a cooperative game—if it ever will be—retaliation may occur, reducing world output of commodities by reversing the international division of labor and forcing a suboptimal allocation of commodities among consumers.
Arguments for protectionism become even more powerful if the postulates of neo-classical theory are questioned. Two of the most important distortions with regard to perfect competition are external economies and factor-price differentials. If these are present, then tariffs are called for.
Price rigidities and factor immobility can also justify protectionist policies to avoid domestic unemployment. Thus, in terms of static theory, laissez-faire is the best policy for a perfectly competitive economy with no monopoly-monopsony power; it is also the best policy for the world as a whole. However, for a large country, the best policy may be attained through an optimal tariff.
Thus, there are frictions and distortions in market functioning, caused by monopolistic and oligopolistic traits, external economies and diseconomies, price and wage rigidities, lack of information, etc. Each of these may justify deviations from free-trade policies, from a purely economic standpoint. Identifying the possible consequences of such economic distortions is one thing, but identifying these cases in concrete instances, measuring their frequency of occurrence and consequences, and prescribing the correct economic policy to cope with these deviations is quite another matter.
The question becomes even more complicated when trade theory is approached from a dynamic standpoint. As Prof. Edgeworth once wrote, referring to foreign trade curves, "a movement along a supply-and-demand curve of international trade should be considered as attended with rearrangements of internal trade; as the movement of the hand of a clock corresponds to considerable unseen movements of the machinery." Although referring to internal resource allocation changes caused by international trade, these remarks can be extended to include the theory of the infant industry—an example of dynamic externality. The essence of this argument lies in the fact that a movement along the transformation curve caused by trade possibilities will lead to an outward shift of the curve itself. It can be considered an international trade application of Arrow's "learning-by-doing," coupled with other dynamic effects such as factor endowment growth and technological progress.
If the link between goods production and technological progress is proven to exist—whether through increased factor efficiency or an outward shift of the production function induced by a new input mix—then the present costs of protection must be compared to the discounted flow of future benefits. If there is a net gain, protectionism is the correct policy. Thus, the chief criticism is that comparative advantage is mainly a static theory that ignores a variety of dynamic elements.
Trade and Growth
Growth theory focuses on the interactions over time between consumers, producers, and investors. The emphasis shifts from general equilibrium considerations to a sequence of expansion paths of production and consumption. As stated by Prof. Chenery, in analyzing resource allocation, growth theory either ignores comparative advantage and the possibilities of trade entirely or focuses mainly on dynamic aspects, such as the stimulus that export growth provides to the development of related sectors or the role of imports as carriers of new products and advanced technology. From this perspective, growth theorists often suggest investment criteria that can contradict those derived from comparative advantage.
The conflict between trade theory and growth theory arises from differences in assumptions or the inclusion of factors in one approach that are excluded from the other. Growth theory assumes, or at least explicitly considers, several basic characteristics of underdeveloped economies: factor prices do not adequately reflect their social value, factors of production may change substantially over time in terms of both quantity and quality—often as a result of the production process itself—and economies of scale and externalities frequently arise in both production and consumption. These findings have undermined the simplicity of classical trade doctrine and have led to strong arguments for "balanced growth," in contrast to the international division of labor and specialization. In terms of economic policy and resource allocation, it becomes necessary to compare alternative patterns of growth, rather than focusing on isolated sectors. Simple rules, such as those suggested by the Heckscher-Ohlin model, no longer apply.
A large body of literature has developed on the dynamic effects of trade patterns on economic growth and development. This approach, usually historical in nature, attempts to explain the process of underdevelopment in terms of economic dependence resulting from international trade, production specialization, and unequal terms of exchange between countries. Adam Smith, in his own way, warned about the dangers of international trade between the "metropolis" and peripheral countries (though not using this specific terminology). He pointed out that the Europeans' unfair exploitation turned what could have been mutually beneficial (trade) into something destructive for some less fortunate countries.
Economists of the structuralist school argue that free trade served the interests of the British industrial sector. It is not a scientific truth, as they have proven, but rather a specific opportunity for profitable trade. After centuries of strong state intervention in world trade patterns, the British created conditions where their interests were best served by removing protectionist policies globally. The British manufacturing sector was prepared to enter all markets, profiting from virtual monopoly powers. According to this viewpoint, free trade was never a smooth result of laissez-faire but required substantial political and military strength to enforce. Nations unable to resist the free trade doctrine fell victim to underdevelopment induced by specialization in primary products, as seen in Africa, Asia, Latin America, and parts of Europe. Nations that could resist it, such as the US and Germany, developed into mature industrial economies. President Grant of the US sarcastically remarked that after two centuries, the British found it convenient to adopt free trade because protectionism had nothing more to offer. He predicted that the US would follow suit two centuries later, after exhausting protectionist policies.
Research in most underdeveloped countries shows that trade patterns imposed by colonial powers had lasting effects on their internal economies. As suggested by Prof. Edgeworth's analogy of a clock's hands and the unseen inner machinery, specialization in production profoundly influenced internal production relations—consider the plantation systems or enclave economies in Latin America. Unequal exchange, which governed trade, ensured that the benefits of trade were unequally distributed, favoring the exporters of manufactured goods. The degree of dependence of underdeveloped countries on international trade was pushed even further. In analyzing the Brazilian case through the 'staple hypothesis' framework, I have suggested that development patterns depend not only on structural production relations but also on the linkages generated by specific staples or products.
In summary, the relationship between trade and growth tends to be biased in favor of developed countries, and the benefits of trade and specialization are not scientifically proven truths.
Free Trade Today
If free trade cannot be shown to improve social welfare on either theoretical or empirical grounds, why does it remain one of the core dogmas of the so-called free world?
Partly due to inertia; it is easy to keep discussing something that everyone is presumed to understand. Free trade serves as a convenient code word to invoke when a country's commercial interests are threatened by another. Another reason for the persistence of free trade ideals is that they can be used when convenient without requiring consistent behavior. Modern Western nations are steadily moving away from state interventionism domestically, selling off state-owned companies to the private sector, and restoring respectability to private enterprise ideals. Deregulation and market-based solutions are recommended for domestic markets, but the state's role as a negotiator, mediator, and retaliator grows stronger in international relations.
By the end of last year, there were approximately 400 legislative projects in the US Congress aimed at imposing protectionist policies to reduce the US trade deficit. Countries have been pressured to voluntarily limit exports of textiles, automobiles, and electronics. Both Europe and Japan have raised barriers against imports to protect domestic industries, and it is estimated that over $44 billion will be spent this year on agricultural subsidies in the US and the European Common Market. Recently, the US sold 140,000 metric tons of sugar to China at a price of 4.75 cents per pound, though the sugar had been deposited at the Commodity Credit Corporation and financed at 17 cents per pound. In the international market, the September price was 6.30 cents per pound. Deals like this, frequently executed by developed countries, have devastating consequences for primary product exporters in the Third World.
State interventionism has also grown in a punitive way, with strong pressure placed on Third World countries that continue to protect their tertiary sectors from foreign competition. This was evident during recent meetings in Uruguay, where developed countries pushed to include services like banking, software, insurance, shipping, auditing, business consulting, construction, and others—which together represent 25% of the $2 trillion in global trade—under the rules of the General Agreement on Tariffs and Trade (GATT). These are sectors unlikely to withstand direct competition from developed nations, and the removal of barriers would likely result in the end of domestic production and the entry of foreign firms into home markets.
A typical case is Brazil, where the high-technology market for micro and personal computers is closed to foreign firms, capital, and technology. The argument extends beyond the infant industry argument: protection during a period when the national industry learns a specific process is not applicable to high-technology products like computers. The reason is that research and development in these industries reach billions of dollars annually. Ten years ago, the US computer industry spent $2 billion on research and development, with IBM alone accounting for $1.1 billion. This figure matches the total sales of the Brazilian computer market today. In this context, opening the market to foreign competition would inevitably kill domestic firms.
The decision to close the market to foreign capital, in addition to foreign products, is based on the belief that the international transfer of a capital-technology combination could induce permanent managerial and technological dependency. In such a dynamic industry, native technology and control over production processes may never be achieved. However, it is highly unlikely that domestic production will ever catch up with the main foreign producers, at least while the industry continues to incorporate high technology. In the meantime, domestic producers of traditional products may even risk losing competitiveness in foreign markets due to their inability to incorporate high-technology components or access modern capital goods available abroad.
This is a case of a strong, highly dynamic externality that classical comparative advantage theory does not capture. As the world evolves toward more sophisticated production processes, the problem will intensify. The basic tenets of free trade doctrine will lose validity, and international trade trends will increasingly become a matter of negotiation. Game theory may soon become more useful in understanding and shaping trade patterns than economic theory.
Internal versus External Markets as Sources of Growth in Brazil
International trade is often cited as an "engine of growth" for developing economies, and the removal of trade barriers globally is seen as a mechanism for distributing demand across nations.
In the case of Brazil, I have shown that international trade created the initial momentum for developing an internal market. This chain of events became significant during the coffee cycle of primary exports in the second half of the 19th century, but development linkages were not observed during earlier cycles. For large countries like Brazil, the impact of exports on internal market growth weakens over time, reaching a point where engagement in international trade loses importance as a source of production and employment growth. Historically, in Brazil, the export drive was replaced by import substitution industrialization from 1930 to 1960 and, ultimately, by internal demand growth.
Today, exports and imports account for only 17% of Brazil's GNP. Currently, over 75% of the growth in Brazilian manufacturing is driven by the internal market, with the remainder split almost equally between export growth and import substitution. A similar pattern can be seen in employment in the industrial sector. Brazil's economy relies heavily on its internal market to sustain growth.
However, the strategic importance of external trade for internal growth cannot be ignored. Oil, capital goods, raw materials, and wheat make up nearly 95% of total imports, and just a few years ago, a balance of payments crisis triggered a recession that took almost four years to overcome. The economy's capacity to adjust is demonstrated by the fact that the trade deficit of nearly $3 billion in 1980 was turned into a surplus of $6.5 billion in 1983, and approximately $12.5 billion in 1984, 1985, and probably in 1986.
Currently, the balance of payments is in equilibrium, but the Brazilian economy is exporting capital at a rate of almost 5% of its GNP annually: $9.5 billion in debt service and $1.5 billion in profit remittances. As a result, national savings have fallen dramatically, from nearly 27% of GNP in 1980 to 16% in 1984 and 1985. Clearly, continued debt service at this level is unsustainable and will need to be reduced.
To achieve growth rates consistent with population growth, it is essential to stimulate investment, primarily to increase savings and reduce foreign debt and, ultimately, inflation. Stimulating the internal market, which has vast untapped potential, will require the creation of an effective internal market. In this context, internal demand must also be supported by external markets and international trade. Nonetheless, I believe that internal markets can and should serve as the primary source of growth for a country as large and diversified as Brazil. The internal market should become the main engine of growth.