International Economics Notes

October 8, 1998

reciprocity - central to GATT - multilateral equal concessions

principal supplier: When two countries come together to make deals, they look for ways to make equal concessions. One country may be the principal supplier of something and trade is not equal unilaterally, so they may bring in another player to even things up. Non-principal suppliers tend not to be included in the GATT negotiations.

Reciprocity-related problems: 1) Large countries change worldwide prices when trade is liberalized, so these countries will push for liberalized trade multilaterally. 2)


GATT - An attempt to establish a system of rules of trade. Its aim is to reduce uncertainty and risk in international trade. If protectionism is increased in one area, GATT tries to make this be compensated for in other areas.

marginal reciprocity - Start with where the countries are protectionism-wise, then get countries to agree on reductions in certain areas.

total reciprocity - Later policy, such as used by the US; a "level playing field" is asked for.

The focus of GATT has historically been on products and goods as related to protectionism. Some areas, such as agriculture and textile, have been, up to the Uruguay Round, excluded from most of the negotiations. Textile, for example, brought about certain protectionistic policies from the 1960's and the 1980's, such as the Microfibre Arrangement; "extracted" these products from GATT, as it were.

Sidenote: The EEC is a trade community, where all the countries can independently alter their trade policies. With NAFTA, on the other hand, which is just a free-trade zone, each country can have independent trade policies.

October 15, 1998

Mercantilism: trade as a zero-sum game, where exports were good and imports were bad.

Opportunity cost: what you give up in terms of one item to get a unit of another item.

McDougall, Economic Journal, 1951 - A famous empirical study.

Bagwati's idea of Immesurizing (?) Growth: If you raise supply in an export situation, the price may fall low enough to reduce revenue. This requires special conditions to occur.

October 22, 1998

When exports are freed, the amount of exports increase, but the wages in the export sector will not go up as much. If wages in the import sector are fixed, there may be some unemployment.

Hecksher-Ohlin Trade Theory

Factor price equalization theorem:

Rybczynsky Theorum: If one of the factor endowment increases, it all depends on which factor grows and whether it is the one which is used intensively.

Reasons for Leontief Paradox

There has been:

High-skilled labor wages have risen in the US, but low-skilled labor has grew until the mid-70's, and then dropped. If this is a H-O phenomenon, we should see the opposite effect in the Newly Industrialized Countries, but we don't. Furthermore, all industries have become more skill-intensive, when H-O says that the other industry should absorb the unskilled workers. One answer for this is the technological change.

Gains of trade will also result in a larger income distribution.

October 29, 1998

The move towards freer trade results in a potential welfare increase, where the gainers could compensate the users and still come out ahead.

Specificity Rule - Policy problems should be dealt with at source.

Woods thinks that free trade has brought about an absolute loss in certain blue-collar areas in some countries. He suggests income redistribution and the like, and also helping society adjust to economic change. In other words, compensation, and facilitating the transfer to the different areas. Although free trade may shift workers from basic skills to high-skill jobs in the long run, the short run may reduce the number of basic skill jobs, leaving unemployment, so a good policy may be to facilitate the transfer.

GATT, Article 19, the "Safeguards Clause" allows (???) to be added if liberalization would be hurtful by shocking the economy, although lots of countries have resorted to countervailing duties and such. "Sunset Provision:" It allows for only four years of safeguarding, although this may be extended to eight years if the country demonstrates it is making efforts to adjust, thereby linking the Safeguard Clause to adjustment, which hopefully will cut down on Voluntary Export Restrictions (VERs) and the like. It has no means for addresses the Specificity Rule, though.

All of these problems are linked to rigidity of the economy; the economy doesn't always change in a straightforward manner.

J. S. Mill brought forth the optimum tariff argument for protectionism. If a company is a power in some areas, it can affect the international terms of trade and actually lower the international price by restricting some imports. This, of course, will lower the world economy more than it benefits the domestic economy, bringing about the possibility of retaliatory tariffs.

If growth by factor accumulation (the labor force is growing, for example), the export sector expands rapidly. Over time, the price of the products go down, and the terms of trade deteriorate. So you need some policy to alter the economy - maybe a tariff, controls on capital flows, or immigration restrictions. There isn't many examples of immeserizing growth, except maybe Brazil.

Specificity Rule and the concept of "Second Best."

There is an export industry and an import industry. The prices in the market do not match opportunity cost. For example, suppose an industry creating pollution is in the export sector. If you have a tariff of the import product, you lower exports and also lower pollution. But this is not the best way to do things. The first best way is to have pollution laws that directly affect the pollution, which really has nothing to do with trade itself. If it is impossible (administrative, political, legal, etc.) to have legislation, trade policy may be a "second best" way.

Effective Rate of Protection (ERP) - Suppose you have tariffs on product A, which raises the cost of A. A could be an input to product B. Any product on A will have an adverse effect on the price of B. ERP looks at the effect of value added: (V'-V)/V. Suppose you have a product that sells for $100. Material inputs cost $80. The value added is $20. A 20% tariff will raise the price to $120. The value added is now $140. The ERP is 100%; in other words, it doubles the value added.

An implication of ERP is sometimes to raise protection. For example, some of the inputs of coconut oil had tariffs lowered in the UK, but not on coconut oil itself, which increases the amount of coconut oil being produced in the UK. This is the same as raising the tariffs on coconut oil, since it will be imported less and created more in the UK.

Infant Industry Argument - Proposed by John Stuart Mill. He said that encouragement for certain industries which could in the future develop a comparative advantage might negate free trade arguments. This is an argument that involves time.

Corden's Hierarchy of Policies for Trade Divergences

Private cost of labor to manufacturing exceeds the social opportunity cost.

3a. Tariff plus export subsidy for manufactures (labor-intensity too low, consumption distortion). This is in effect a self-financing subsidy.

3b. Subsidy to import-competing manufacturing production (labor-intensity too low, home-market bias). Much more common.

4a. Tariff (labor-intensity too low, consumption distortion, home-market bias). Doesn't meet the employment issue. It isn't even close to the Specificity Rule.

4b. Export subsidy (labor-intensity too low, consumption distortion, pro-trade bias). An export subsidy is like a tariff, because it tends to raise the price of the exports both in the world and domestically.

If you start out with no trade at all and remove trade restrictions, you would get gains from trade. But one reason you might not go to completely free trade is that you get some government revenue from tariffs.

November 5, 1998

If two countries are exporting to a third country, one of the countries can subsidize the export and make an overall gain, as long as the subsidy is less than the rents. This is only because there is an imperfect market - that is, PC>MC>AC. In this manner, trade policy can be strategic.

Krugman talks about industries which are so large than there is only room for one - whichever one gets in first. Export subsidies can shift rents from foreigners, or the threat of subsidies can give advantages in entering a market. A subsidy may be favorable to an entire nation, but could cause retaliation. One of the major problems with this is the availability of information. A government would have to know what another government would do. Also, by subsidizing an industry you draw resources away from another industry; you can't just look at that industry, but must look at what happens to the other industries that would get the resources instead. The three problems, then, are retaliation, information, and general equilibrium.

November 19, 1998

Jackson, The World Trading System, is a very clear book with people with a limited background in economics.

The New Protectionism

The visions of the people who setup GATT and the other Bretton Woods system can be expressed by nondiscrimination and multilateralism.

Agriculture has never, until the Uruguay Round, included in GATT very much. Textiles also became a major breach in the system. In 1961, the Multi Fibre Agreement came into affect, having evolved as a safeguarding measure, from the Short Term Agreement, to the Long Term Agreement to the MFA. It set quotas on a bilateral basis. You then had Voluntary Export Restraints (VERs) on such industries such as vehicles and steel.

At various points in GATT it says that there may be cases for protection, such as anti-dumping, but most of the time it specifies that tariffs should be used, not quantitative restrictions such as quotas.

Anti-dumping (which thinks that some trade is unfair because of subsidies or whatever) should be distinguished from Article 19, which deals with fair trade. "Dumping" refers to selling in an export market below the price of the home market price. The definitions of dumping and subsidies are being increasingly manipulated not to combat dumping or subsidies but to reinstate protectionism.

Quotas and tariffs are not the same. For one thing, let's say that the price drops in the domestic market. With quotas, if the production quality increases, shifting the demand curve to the right, you will still be limited to the quota, raising the domestic price, instead of allowing more to be sold like tariffs. Another difference is if domestic prices drop. Also, if the market is open to the world then it doesn't matter if you only have one firm in a country, because it is exposed to the international market. A tariff would still make the domestic firm keep its prices down, while a quota will "tend to convert an incipient (potential) monopoly into an actual monopoly," because the firm will be able to raise its prices.

When you get another country to voluntarily limit its exports, it will raise its prices and the exporters collect the difference. Not only does the price rise to consumers, the government doesn't collect any tax revenue on the difference, the importing country pays more out in foreign exchange. For example, some figures have shown that a VER on Japanese cars has cost the US economy $180,000 per job saved.

In principal, these are being done away with in GATT and replaced with tariffs. "The Multi Fibre Agreement is being unwound, and the countries are being 'tariff-ied.'"

November 26, 1998

Contingent Protection

Contingent Protection in the context of anti-dumping and other "unfair" trade. This is also called administered protection.


Dumping: selling in a foreign market lower than the domestic market. DM (Dumping Margin) = Pd-Px. Another definition is selling in a foreign market at less than the cost, making DM=C-Px.

Prices usually vary at different times to different people in order to maximize profits. Predatory dumping is to charge very low prices, squeeze out competitors, hopefully establishing a monopoly. In the US there are anti-trust laws that make predatory pricing illegal. The current thinking is that it's pretty hard to establish a domestic monopoly, and even harder to create an international monopoly.

There is an entire structure of anti-trust legislation in the US and the UK, but anti-dumping doesn't fall in this structure.

In a lot of anti-dumping analysis, the focus is on the producers, and do they lose - whether or not consumers gain by "dumping" is usually ignored.

Short-term dumping may occur as part of the normal business cycle, if demand for a product is falling.

Fixed costs are independent of the level of output. Variable (avoidable, marginal, or opportunity) costs can be avoided just by stopping production. Assume marginal costs (MC) are constant for a period, and the Average Fixed Costs (AFC) takes on the shape of a "rectangular hyperbola" - it falls as you produce more units. If there is a recession and demand is always below the AFC, it might be better to charge a price over the MC but which would be under the AFC.

Now, over time, learning will make AFC shift downward because of increased accumulated output. It may therefore be wise for a company to charge very low initial prices just to accumulate output, increase learning, lower the AFC, and over the lifetime of the product to recoup all these initial losses.

The demand of a product is not just a function of the price, but it is sometimes a function of the quantity produced in a previous period. In other words, you might buy a cellular phone if your neighbor buys one. Therefore, someone might charge really low prices initially just to promote "consumer learning."

None of these practices just mentioned are illegal. However, in the current US/UK system, all these methods will be considered dumping on the international scene. The American system is first to determine if dumping has taken place, and secondly if "material injury" has taken place. Two separate entities take care of these things.

The firms involved have an interest in providing information, because if they don't the Department of Commerce will use Best Available Information (BAI) which may not be very good. If, say, Brazil doesn't provide any information, the US may look around the world for a similar country to use those prices as comparable. This can allow prices to be "jacked up" by arbitrarily choosing the third country. For example, the Poles started selling golf bags and you couldn't look at the golf bags in the home market since the Poles don't play golf. The US then looked at Spain. Obviously, if the Poles were exporting golf bags and Spain wasn't, Spain must be charging more.

Also, institutional differences in different countries cause differences in fixed costs and variable costs. Therefore, the figures which go into the DM equation are often artificial.

It also has to be shown that there was "material injury to like products." This can also be very arbitrarily chosen. The definition of "like product," if defined narrowly, will many times show "material injury." There has never really been a good definition of material injury. There's a tendency to use these criteria to actively find damage. There is plenty of scope for administrative leeway.

There has therefore been a rise in the use of anti-dumping legislation. The US, Canada, and the like are increasingly using anti-dumping legislation to get around GATT tariff bindings. There has been little improvement on this.

Trebilcock and Howse have a discussion on alternatives: place anti-dumping in anti-trust legislation, either domestically or internationally. Why are perfectly legitimate practices (discussed above) when they are carried out domestically be illegal internationally? Is the so-called "dumping" hurtful to the competitive process? The teacher, however, doesn't even see much of a likelihood that predatory pricing would occur on an international scale to establish an international monopoly by squeezing out competitors, because this monopoly would probably be very short-term.

To invoke GATT Article XIX, the Safeguards Clause, the WTO will say that the activities should be done multilaterally and that compensation should be given. The problem with Article XIX is that is hasn't been used much, because of its stringent requirements, so anti-dumping and such have been used instead. The Uruguay Round of GATT has tried to make Article XIX more attractive, but anti-dumping is still currently more attractive.

Changes in currency exchange rates in the time when contracts are made and when goods are actually produced and exchanged can cause significant problems in the analysis of dumping. Between starting production and actual selling, economic environmental changes may make lower prices inevitable - some agricultural products, for example, can't be stored, so sometimes you have to sell them for whatever you can get, regardless of what you paid to produce them.

Anti-dumping legislation increases uncertainty in the international market, because companies never know when someone might bring about anti-dumping duties. A price undertaking sometimes happens when anti-dumping charges are brought and a company may say that they'll just pay the difference of their price and how much the other country says the price should be. This results in price collusion between two countries.

The WTO is modeled on the US in many cases its definitions are just those of the US.


Countervailing duties concerns a government subsidizing exports. Therefore, a countervailing duty is against a government's action, while anti-dumping laws are against a firm's action. A countervailing duty is installed to counteract the subsidy of another country.

Subsidies can be considered inefficient. A country that, in the absence of externalities and such, has subsidies will be hurting itself. If the importing country puts in place a countervailing duty, it returns the subsidizing country to where it was before the subsidy, making resources properly allocated again. Resources are allocated properly, but revenue is simply transferred to the importing country.

Subsidies can be considered a legitimate government policy - thinking of the specificity rule, one can think of many cases where a subsidy would be the first choice to fix a market distortion. There are a lot of legitimate government payments (education, building roads, etc.), and many of them influence trade. This is a complicated problem. Attempts are being made in GATT/WTO to try to pick out "good" and "bad" subsidies and penalize the bad ones. Agriculture has been, until the latest GATT agreements, excluded.

The Tokyo Round attempted to differentiate between different types of subsidies. It wasn't compulsory on members - only about 27 or 28 out of about 120 actually did sign. The WTO agreement is now compulsory on all members.

Export subsidies that discriminate directly in international trade are banned. Non-actionable (allowed) subsidies are economy or sector-wide subsidies like research or infrastructure, training, or adaptation to environmental legislation. These don't directly affect international trade, although economists recognize that they ultimately do affect trade somewhat. There are anti-subsidy provisions that allow countervailing duties if a country sees that another country is subsidizing and if the importing country can prove injury, much like the anti-dumping provisions. There is a "gray area" of "permitted but actionable" subsidies.

The teacher thinks that subsidies should be placed in a framework like tariffs, where there is negotiation for mutual reducing of subsidies. This would help clarify which ones were allowable and economically justifiable, and which ones distort the pattern of world trade. (This is what Trebilcock and Howse promotes, apparently.)

You can't just ban subsidies altogether, because almost everything a government does subsidizes something.

December 3, 1998

Before 1980, most developing countries were rather passive in their GATT participation. After that year, they participated more. Now there are around 122 or 123 member of GATT. There was a move towards full participation by developing countries, because they saw this as a way to solve a number of problems that were balanced against developing countries, such as the Multi-Fiber Agreements and some anti-dumping policies.

Engle's Law - the income elasticity of demand for food products is low compared to that of manufacturing. In other words, once you have a certain amount of food, a doubling of income probably won't double the amount of food one would eat. There is therefore a limited market for agriculture. Agriculture is also price inelastic - people won't buy much more of them, even if prices were to fall sharply.

Later it was pointed out that developed countries has high tariff rates. There was a focus on Import Substitution policies, usually in the form of quantitative restrictions. Capital goods were usually not subject to tariffs, being allowed to enter the country duty-free. This resulted in economies that were biased, unfocused, producing distortions in the economy, focusing on capital goods and a bias against exporting, whether it be agricultural goods or whatever. If you're protecting the capital sector, you're raising the price of inputs into other sectors, such as the export sector. The more successful you are at prohibiting imports, the more you appreciate (???) the exchange rate, making a bias against exports.

Special Differential Treatment

A view developed that less-developed countries needed special treatment under GATT. There is a mass of exceptions in GATT/WTO towards developing countries, which is obviously not going along with the most-favored nations principle. Quantitative restrictions were allowed, and in 1964 (when part four of the GATT was agreed on) it was decided that less-developed countries did not have to show reciprocity. Export subsidies were allowed on manufacturing for less-developed countries. They were excepted from Article XXIV. So-called "general systems of preferences" were allowed.

Read about the Common Agricultural Policy. This started out in the 1950's by providing protection for agricultural products, putting protection on items that were basically imported, like wheat and certain dairy products, which Britain imported from places like Canada. This was to set a so-called "target price" which was above the market price. This was to encourage domestic production, working like a tariff but worked as a variable levy (tariff), which taxed up the difference between the world price and the domestic price. You insulate the domestic market from the world market. This reduced the demand for imports of these products, but in many cases the UK market eventually produced a surplus, which you had to keep off the market, so you export them. When you export these products, you further lower the world price of these products. Furthermore, this entire system produced instabilities in the world market. World price was then more unstable.

Developing countries argued for special treatments in textiles. GATT permitted a non-reciprocal exemption for less-developed countries. In the end, each of the countries produced its own arrangements of special preferences (lower tariffs than the MFN tariff). The US provides ceilings by industry, the UK by country (or vice-versa, whichever it is), each has special rules and complicated frameworks, etc.

The Generalized System of Preference (GSP) arrangements are non-binding - they could be removed at any time. There is not unlimited access - there are quotas. All of this add uncertainty, which is not good in a set of economic rules. Agricultural products are excluded, and the US and Japan exclude textiles. GSP coverage is really small, not only because agriculture is excluded, but because of rules of origin. A certain percentage of value-added has to be present to be classified as originating from a certain country, and these rules are pretty specific and regulated - this reduces the application of GSP. Furthermore, the lowering of the MFN tariff rates have eroded the application of GSP, because there is now less of a difference between the MFN rates and the GSP rates. Therefore, since GSP application has been falling, this is probably a reason why developing countries have recently started joining and being more active in GATT, working towards fixing problems (to them) in trade policy towards agriculture, textiles, and dumping.

The teachers says it's possible to argue that the GSP has been bad for developing countries because it gave them an incentive to pursue certain economic policies in the 50's and the 60's.

In 1976, Britain had to go to the IMF and the IMF prescribed certain policy changes, and the politicians were able to do what may have been what they knew they should have done anyway (according to some, such as Friedeman), while blaming the IMF. Maybe if the developing countries had been more integrated into the GATT, they could have done the same thing - had better policies, while the politicians could blame the GATT.

December 10, 1998

Regional Trading Arrangements

Regional Trading Arrangements (RTAs) are by definition discriminatory, because they give preferential treatment to those in the group. This in general is against the GATT Most Favored Nation idea.

When GATT was signed in 1947, there were a few preferential arrangements setup. The Americans didn't like preferential arrangements, preferring multilateral MFN arrangements. (Around the 1980's the American opinion changed.) When GATT was signed, many people would have favored preferential arrangements, saying that they permit free trade. That is, two countries might make a customs union by eliminating trade barriers between the two, while establishing a Common External Tariff for the entire area. Free trade areas form a group of countries, each of them keeping their own tariffs yet giving preferential treatment to those within the group.

Jacob Viner, an American economist, analyzed the result of customs unions and free trade areas. He found that trade increased within a customs union. However, if the partner has higher costs than the world, the real costs of products will rise - it costs more for the partner to produce the product than to get the product from the world, although price to the consumer will be lower. This is called trade diversion. Of course, the partner may gain through a rise in exports, and you could make an arrangement where the exporting partner compensates the importing partner.

This simple picture assumes that trade of the countries involved do not affect the world prices. (i.e. the Solomon Islands joining up with Japan probably won't affect the prices of Japanese machinery.) In general, trade diversion produces adverse affects on the world when this assumption is taken away.

Article XXIV says that these areas must cover "substantially" all trade, although this is ambiguous. It also says that on average the level of tariff should not be higher than before the RTA. It says the movement to full (no?) preference should be made in a reasonable amount of time.

There are not really any provisions in Article XXIV that specifically protect the rest of the world. The Kemp-Wan Theorem says that it is possible to protect the world by setting an appropriate CET.

Cooper-Marcel (??) Argument says that countries may have setup such agreements originally to bring about protectionism. Countries may have advantages within the group and want to develop economies of scale.

The arrangements being developed in the 1980's are somewhat different. All sorts of new trading agreements (NAFTA, European Free Trade Area (EFTA), the EU, etc.) have taken away from the GATT MFN specification.

Bhagwati believes that RTA's are inferior to multilateral trading agreements.

A Preferential Trading Arrangement may decrease protectionism in within the arrangement, making trade from other countries more "harmful" to domestic production, making such protectionistic measures as Anti-Dumping Duties (ADD) rise against non-partner countries.

The lecturer used to advocate Free Trade Areas (FTAs), but they do have major economic problems which may make them more prone to protectionistic actions. The Rules Of Origin are not very strict and can be manipulated for protectionistic purposes.

January 21, 1999

Environmental Economics

Environmentalist take the stance that all pollution is bad. Economists take more of a pragmatic approach, saying that pollution stems from a market failure. Therefore, you shouldn't have trade policy based on pollution, because the market failure should be addressed instead. This is our old friend, the Specificity Rule.

As an example, imagine that a chemical factory sits by a river upstream from a brewery. The chemical factory treats the river and the atmosphere as a free commodity, dumping wastes into the stream and into the air. It doesn't treat labor as a free commodity, because it takes account of the scarcity and alternative uses of labor by how much labor is payed. It takes no account of the effects on the brewery, giving what is called an externality or a market failure.

An environmentalist named Coase used the Coase Theorum, which goes something like this: The chemical factory will put out as much pollution until the marginal benefits of dumping in the river are zero. After a certain amount of pollution, the brewery will start bearing costs that go up as the marginal utility of the dumping to the chemical factory goes down. The optimum level of pollution would be where the two lines meet.

One solution would be to tax the pollution. You could also define property rights, saying that the brewery has a certain right to clean water and fine any polluters. The Coase Theorem says that each will have the same benefit. In one instance, the chemical factory would bribe the brewery. Thirdly (not as applicable to international trade issues), the two industries could merge, internalizing the externalities.

This all works fine when there is a limited number of sufferers. In the international sphere, however, you might just have a small number of sufferers. If a chemical factory is in one country and the brewery in another, the countries can work out a Coase solution. Poland, for example, outputted a lot of nasty pollution, and the winds would blow it to Sweden. In this case, the Swedes paid for the Poles to reduce their pollution. This could be looked at as though the Poles had the property rights, and the Swedes bribed the Poles.

Certain things can also be considered pollution. For example, the fact that bulls are being killed in Spain could be considered a psychological pollution if it makes people in other countries feel bad about it because they think it is unethical. In the Tuna/Dolphin case between the US and Mexico, the US passed legislation which outlawed certain dolphin fishing techniques that inadvertently caught dolphins. The Mexicans used these techniques, and so the US put restrictions on imports of tuna from Mexico to the US. This was ruled GATT-illegal because a country can't outlaw a certain production method of an exporter if it doesn't harm the importing country.

However, under Article XX a country can enforce all sorts of environmental-related restrictions, but this must be directed at a product, not a process. For example, a country can ban certain flammable toys, as long as it holds its domestic producers to the same criteria. So then when you have two countries that diverge on policies but there are no externalities (child labor, for instance), some would argue that their policies should be harmonized anyway.

There is a view that international trade and the environment are in conflict, because economic growth promotes pollution, so the more international trade, the more pollution. However, the evidence says that pollution plotted against per capita income forms an upside-down "U"; that is, when per capita income increases, pollution goes up but then as per capita income increases further, pollution tends to level off and go down to some extent.

It is argued that some pollution doesn't just effect one or two countries, but are inherently global so should therefore be tackled by all countries. When deciding which countries should pay for the costs of abatement, it should be taken into consideration the uneven allocation of resources and the uneven distribution of burden.

The Montreal Protocol, for example, has side payments being paid from the richer countries to poorer countries. This is basically the same as giving countries such as Brazil the right to pollute, but bribe them not to. Another new idea is giving out permits that allow countries to pollute, thereby making a cap on the total amount of pollution. Now you have to decide the burden allocation, that is, which countries get the permits. You could give, on the day this system starts, all the permits to the poor countries. Then the richer countries would want to buy the permits from the other countries, and the poorer countries would have to consider whether or not to sell; they would sell permits if the cost of abatement is less than what they are getting for the permits. If abatement has a very high cost, then they wouldn't sell the permits and the rich countries would have to abate. One variation of this is to have all permits be purchased from the outset from some sort of third party.

An alternative to taxing the pollution is subsidizing the abatement. Environmental subsidies are permitted under GATT and the WTO.

Trade affects the allocation of resources. If you assume that the export industries are polluters, free trade may cause pollution to go up, but it also will give good things to the economy in other areas, and the overall effects (good or bad) can go either way under various scenarios. Free trade is therefore not necessarily optimal pollution-wise. On the other hand, import-substituting industry may be pollution intensive.

January 28, 1999

Direct Foreign Investment and the TRIMS Agreement

There is a difference between portfolio investment and Direct Foreign Investment (DFI). In most economies in the world, international trade has been growing faster than output, but since the 1980's foreign investment has been growing even faster than trade. In the 19th century, portfolio capital was the most prevalent. A British citizen could buy an American bond, as an example of portfolio investment. There's no control over what is done with the money. With DFI, however, the investor controls an enterprise in another country.

You might want to look at portfolio investment rate of return as rus>rUK, with capital moving from high risk to low risk locations, and DFI doesn't even bring about much in the way of capital flows between countries. It is very possible for near 100% (or even 100%) of the money to be raised in the country in which a company is being created to be raised in that country, so no capital is flowing international (although there's always the possibility that the banks in the foreign country are in turn borrowing from the first country). Some countries may invest a lot of money in other countries (such as UK mergers with US companies), but there is a lot of investment in the other direction, so the simple equation of which country has the highest rate of return is too simplified.

In looking for a more complete answer, think of why a company want to setup an entity in another company in the first place. One reason is that the foreign company has protected against imports, protecting the local industries. This way the company gets around the protectionistic policies of the foreign companies. Another reason is that the foreign company might be rich in a product or even a process. But this isn't a sufficient reason to explain a US company going to Argentina, however; if the market is protected, why don't Argentinian companies setup the same companies instead? Sometimes there are intangible items (such as patents) owned by the company, but a foreign company could still license these processes. In these cases, the domestic company owns something that is essential to the development process, but it can be gotten around through licensing. None of these are good explanations for the multinational company, though.

The theory is that multinational companies then only exist because of market imperfections. Knowledge is a public good, in the case that, once it is known, it has no value. One wants to know the knowledge to validate it before purchasing it, but knowing the knowledge destroys its value - who wants to buy what one already knows? Hence the best way to exploit this knowledge is to use it yourself - internalize it.

Therefore, you have Dunning's OLI Hypothesis: Ownership, Location, and Internalization. In fact, you find very few multinational corporations (MNCs) in textiles, shipbuilding, etc., because these things use public knowledge, things that aren't secrets. You'll find a lot of MNCs in pharmaceuticals, electronics, and other technological companies that require special knowledge. Other MNCs are ones that have certain brand names that others cannot get.

Trade-Related Intellectual Property (TRIP) issues then become important because sometimes intellectual property isn't protected in other countries. This is yet another mark against licensing, because your license may mean less in another country.

A Japanese professor named Kojima made the Kojima Hypothesis: US foreign investment was bad, and Japanese investment was good, because US foreign investment looked to be counter to comparative advantage, developing activities in less-developed countries that were contrary to comparative advantage. He saw Japanese investment, on the other hand, as being along with comparative advantage. However, the fact that the Japanese over this period developed labor-intensive enterprises is because the Japanese had a comparative advantage in this area, and the US had a comparative advantage in other areas, such as air conditioners.

There are two views about the role and effects of MNCs. Both sides basically agree they are the result of market imperfections. One view is that the firm exists to cut down on transaction costs. Therefore, MNCs are more efficient because they internalize transaction costs, etc. - they are market perfecting, which means that they make the international economy more efficient. The other view says that, while they are more efficient for themselves, they are more efficient at the expense of countries themselves and the international economy as a whole.

One thing not covered in TRIPS/TRIMS is general competition policy, a body to oversee competition. There is also no attempt to address transfer pricing. If you have a country such as, for example, Argentina, that might imports some products, make some changes, and re-export, what prices are to be placed on the inputs and the outputs? You can show losses in Argentina by putting high prices on the inputs and low prices on the outputs (for example, you could say that part of the output price is production cost). This way you could get out of paying a lot of corporate taxes in Argentina. If there's an open market, everything is open and transparent, so transfer pricing isn't much of a problem. The more trade that is intra-firm (and therefore not through the market and less transparent), the more companies can get away with transfer pricing, transferring the profits to countries that have less corporate taxes.


Trade-Related Investment Measures (TRIMs) attempts to address policies which affect trade. It confirms Article III and Article XI. The TRIMS agreement banned certain TRIMS, such as local-content requirement.

February 4, 1999


Trade-Related Intellectual Property (TRIPs) attempts to protect intellectual property - important knowledge, such as copyrights and patents. Most countries have some sort of intellectual property protection. As far as economy goes, harmonization of labor standards would not be desirable, although countries are expected to evolve toward similar labor standards as they become more similar. TRIPS is "strange" in that it raises protection and reduces competition.

Patents protects inventors for a certain period of time. It gives the person getting the patent a monopoly. They are necessary for innovation - since knowledge is a public property, if there were no patents no one would have an incentive to invent.

Dr. Ayre recommends an article by Plant in the February 1934 issue of Economics.

There are several problems with patents because they are a "second-best" solution (the first-best would to be to have free competition, but that can't be done because it would remove incentives to innovate). One problem is that patents might give too much incentives to innovation, taking resources away from other things (such as inventing new products instead of innovating from already-invented products).

Another problem is with the time of the patent. Why should there be a standard time limit (20 years in the US, for example) for patents across all sectors, applying to technology, medicine, industry, etc. A shorter time period might not cut down too much on innovation, but bring benefits to the economy because of competition. A long time period would not only keep prices above the cost of production, but also keep cost of production higher, because it is usually cheaper to copy the product. As for the last point about the lower cost of production, though, it's always possible that the licensing system will still allow the producer to use other producers (in Singapore, for example) to produce the product at a lower price.

Sometimes a country may have compulsory licensing laws. Argentina, for example, may say that other countries cannot export a certain product to Argentina, but they must license a company in Argentina to produce it for them. This is an important area in which intellectual property relates to trade, because compulsory licensing is against free trade.

Let's say that someone in the EU holds a certain patent, and then exports the product to country A. Country A then copies the product, the modified version being exported to countries B and C. Country A may even attempt to export them back to the EU, while the EU is also exporting to B and C. Therefore, country A is therefore cutting the EU out of its share, and the EU can legally prevent imports from country A back to into the EU.

International standardization through the TRIPs agreement will strengthen those countries that have comparative advantage in innovation (mostly developed countries). In the short term, the incentive is then for developed countries to innovate, and critics note this inequality without an increase in efficiency. Others say that in the long term this protection will increase innovation in the developed countries and maybe even eventually in the developing countries.

February 11, 1999

Dr. Ayre recommends the journal "The World Economy."

Uruguay Round Agreement on Services

General Agreement on Trade and Services (GATS). Services covers things from hotels, banking services, shipping services, etc. Services were not included in the original GATT because, the traditional line went, you can't trade services because, after all, you have to go to a hairdresser to get a haircut. Of course, someone could go to another country to get a haircut or the hairdresser could go to another country. Technology has also increased trade of services, as has privatization. There has been a trend of "splintering" of big companies; Ford, for example, now contracts advertising, instead of having its own advertising section as it used to. Advertising would then be a service, versus a part of manufacturing previously.

There has been a shift in developed countries from manufacturing to service. Service has a high elasticity: as incomes rise, high-cost specialized services arise, which means richer countries will have different sort of services. About 1/3 of world trade is in services.

GATS refers to the four modes of supply

The story goes that the freer services are, the more exports of services countries like the US would make, meaning more income for services into the US, meaning more money being paid to developing countries for products, which can be cheaper through buying cheaper services. Developing countries would specialize in more labor-intensive less human-capital-oriented services. A lot of services, for competition in services to go into affect, require migration. Migration was excluded from the GATS agreement.

GATS has two major principles: the most-favored nation principle, and the transparency principle. Exemptions are possible, but on a negative list principle. A general rule applies unless it is listed as an exception. That is, countries can be exempt from certain obligations if they make this explicit. In other instances, however, there is a positive list principle: obligations only apply if they are specifically listed. Therefore, with different conditions on different modes of supply, there may be biases before or against certain modes of supply.

One advantage of GATT is that negotiations take place across the board, which means an administration to present both exporting and important benefits and detractions. However, the positive list principle is on a by sector basis, which means that an administration can't say, "this hurts our textile industry, but helps another industry," for example.

The TRIMS agreement only refers to goods, and GATS refers to services, a distinction which at times is not too logical.

February 18, 1999

The International Monetary System

The foreign exchange is the exchange of one currency for another. All foreigners who buy domestic products are essentially supplying foreign currency in exchange for the domestic currency. Using British pounds as an example, when foreigners buy British products they are essentially supplying foreign currency (US dollars, for example) into the British economy, exchanging dollars for pounds. When Britains go on holiday in the States they instead exchange pounds out for foreign products.

Summary of Balance-of-Payments Concepts

(from handout)

Trade Balance

+ Exports of goods
- Import of goods
= Trade balance

Current Account

Trade balance
+ Exports of Services
+ Interest, dividends and profits received
+ Unilateral receipts
- Imports and Services
- Interest, dividends and profits paid
- Unilateral payments abroad
= Current account balance

Basic Balance

Current account balance
+ Balance on long-term capital account
= Basic balance

Settlements Balance

Basic balance
+ Balance on short-term capital account
+ Statistical discrepancy
= Settlements balance

The "statistical discrepancy" is a certain amount that, in essence, money that no one knows where went.

If, for instance, you add up everything and have a -$100, you have to balance things so the central bank adds $100 and takes out the equivalent amount in pounds, meaning the central bank gains domestic currency. These have potential domestic monetary implications. If the central bank didn't intervene, the exchange rate would change.

Assume you have a bundle of goods in the US that cost $100. If the price stays at $100 and the price of dollars in pounds drops (the lower the price of dollar), Britains will want more books and therefore want more dollars, so the demand for dollars go up. At any point in time, there is an exchange rate which captures the supply and demand of a currency, but if you are exactly at the exchange rate there will be no movement of currency.

Therefore, if the central bank were to not intervene in foreign exchange, you would have a completely flexible exchange rate, but this situation is very rare. So, going back to the example, if the central bank were not to invest the foreign currency, the domestic currency would depreciate. If there are too much of the domestic currency (a net inflow of the domestic currency), the demand for domestic currency will go down - the domestic currency will depreciate - if the central bank does nothing.

There are other policies the central bank can follow to manipulate the exchange rate. They can raise interest rates. This will happen to some extent anyway, though: with a depreciated domestic currency, people invest less and save more.

With a manipulation of interest rates and such, though, there's a conflict between policies: raising interest rates will cause a recession (or, in extreme circumstances, a depression), which causes unemployment to rise and output to fall. Prices may begin to drop. In short, reserve losses -> interest rates rising -> domestic credit falling -> investment falling -> employment falling -> output falling.

It is argued that a fall in the price level will raise demand (how much it is raised is another issue). If prices are flexible enough, you can solve the problem of the foreign exchange balance by a fall in prices. That is, instead of the domestic currency devaluing, the "bundle of goods" can decrease in prices, both of which will have identical outcomes. Flexible prices is therefore a substitute for a flexible exchange rate.

The Bretton Woods used an adjustable peg system which essentially said that the central bank would fix up the exchange discrepancy, but if the difference became too big they would change the exchange rate.

Eichengreen explains that in the 19th century prices were much more flexible. There was a credibility that the participating countries were going to uphold the gold standard. Rising interest rates would attract foreign capital. In the modern world, though, an increase in interest rates may not attract capital because there is the fear of changing exchange rates, and the fear that something might be wrong. If there were no confidence in the fixity of the exchange rate, there might be no capital inflow (and indeed a capital outflow) under this scenario.

There is also a third way of responding to the current account difference: besides flexible interest rates and flexible prices, there can be flexible exports.

March 4, 1999

(X-M)=(S-I)+(T-G) or (exports-imports)=(savings-investment)+(taxes - government spending)

So the reason the US has a trade deficit with Japan, there is a high level of investment with a low level of savings. A country with a trade deficit (imports are higher than exports) must have higher investment than savings and/or higher government spending than taxes.

Countries may decide to live with a trade deficit by borrowing if they perceive the change to be permanent - during the oil crises in the 1970's, for example, countries decided that the oil price raises would be temporary and borrowed instead of cutting back.

The textbook picture of account balances is that a country has an account surplus or deficit, and ultimately it "passes around the hat" to finance a deficit if there is one (that is, is borrows from the IMF or whatever). Nowadays, this may happen in the reverse order; a large inflow of foreign currency may influence the account balance.

Let's say that Argentina sees a large inflow of dollars. (This is with a currency board.) Before, the ratio of pesos to dollars was 10:1, but with all these dollars the local currency appreciates against the dollar, maybe to 8:1 (8:$). To keep the exchange rate at 10:$, Argentina will buy up the extra dollars. These dollars may go into banking, lowering interest rates, increasing investment (I) and reducing savings (S). These dollars may go into the government, increasing government spending (G).

If there were no currency board (that is, there is a more or less flexible exchange rate), the local currency would appreciate without checks. This makes imports cheaper, because one dollar only costs eight pesos instead of 10. This, through the exchange rate change, increases imports (M). This lower price of goods stimulates investment (I).

Real wages are the money wages divided by some general price level: (W/P*). P*=PT PNT, that is traded and non-traded goods. In the short term, since wages don't change instantaneously (they are "sticky"), real wages will rise because appreciation of the local currency will cause PT (the price of traded goods) to fall, increasing spending and investment (I) and decreasing savings (S). This all occurs because people are getting paid in the local currency, so a fluctuation of PT will cause the real wage to go up or down.

The real exchange rate is the nominal exchange rate adjusted for nominal prices. That is, RER=E P$/P* (the exchange rate multiplied by the world price of a commodity, divided by the nominal price). Therefore, if people buy most of their goods from abroad (a large PT), the RER won't be significantly affected by fluctuations in the exchange rate.

The difference between a central bank and a currency board is that a central bank can buy and sell currencies and affect the exchange rate. It can also finance the government; if the government is not getting enough in taxes, it can borrow from the central bank. The currency board cannot finance government deficits. It is analogous to the gold standard, but it should be remembered that under the gold standard the respective countries had central banks.

A currency board is thought to give confidence and credibility to a country's exchange rate. It gives a nominal anchor to control inflation. The only way you can issue domestic money is through foreign exchange, while a central bank can issue government securities. This means that a currency board is thought to have conservative policies, while a central bank may decide not to devaluate.

Currency boards (in their pure forms) can't supply emergency funds, so they make crises more likely. Currency boards tend to produce pro-cyclical conditions.

Historically, currency boards were found in colonies (of the British, French, and others). They operated quite smoothly. These acted like "mini central banks," acting counter-cyclical, providing some stability.

Today, currencies are not just automatically just pegged to one currency (like currencies used to do with the dollar), they sometimes peg to a "basket" of currencies.

March 11, 1999

Eichengreen has stated that there is a credibility problem with fixed exchange rates because they are not likely to remain fixed over long periods of time. There tends to be pro-cyclical behavior from external shocks, but anti-cyclical behavior from internal shocks (that is, from domestic policy).

The real exchange rate measure the amount the relation between domestic goods and foreign goods change, or alternately, the amount the relation of tradable goods vs. non-tradable goods changes. RER=(EPF)/PD. Domestic prices could rise through inflation, but if the exchange rate increases as well the real exchange rate would remain the same. This is an argument for flexible exchange rates advanced by advocates.

Some countries may want to have independent rates of inflation for two reasons. The long term reason is that inflation serves as a method of taxation. Other countries may want to keep a low rate of inflation - after initial Bretton Woods agreement, some countries didn't like the high inflation of the US. The Germans, for example, saw a depreciation of their exchange rate because German exports were encouraged by the depreciation of the dollar domestically. In the short term, inflation encourages employment.

Milton Friedman's famous The Case for Flexible Exchange Rates argued that flexible exchange rates allow countries to have independent policies. He also said that the real exchange rate may need to change from time to time, and the exchange rate is a more flexible way to do this than relying on changing price levels.

Nurkse in 1944 argued to the League of Nations that flexible exchange rates, from the experiences in the past, are disastrous because they are volatile and countries can manipulate them to achieve artificial advantages. Friedman said that they are instead stable. He said that free capital movements would stabilize exchange rates because exchange rates changes arise from a temporary change in fundamentals - a bad harvest, for example. Long-run permanent changes in the fundamentals would be gradual, and short-term permanent changes would be stabilized by speculation.

Friedman further argued that there would be no need for countries to hold international reserves. Flexible exchange rates would reduce protectionism, because a fixed exchange rate would at times force a country to reduce output and raise unemployment, which would increase protectionism because people would not want external competition to exacerbate the situation. Flexible exchange rates would dampen foreign shocks.

Those were the expectations. Most large countries switched to flexible exchange rates in the early 1970's. There was a time when the US dollar did not follow purchasing power parity. Changes have tended to be more erratic than expected.

From the Journal of Political Economy of 1976 we get the idea of Interest Rate Parity (IRP). iE=iUS+expected depreciation of the euro. That is, the difference between interest rates in two countries will reflect the expected appreciation or depreciation of their respective currencies. There's an insight here that requires more explanation: the long-term adherence to the purchasing power parity (PPP) is reconciled with the interest rate parity by understanding that the exchange rates tend to overshoot.

Friedman comes back after flexible exchange rates give erratic changes and says that the changes are due not to the flexible exchange rate system but to diverging government monetary policies. The case for flexible exchange rates rests on the need to change the real exchange rates by changing the exchange rate, which will smooth shocks. A fixed exchange rate requires the price levels to be changed.

March 18, 1999

(Arrived in class late...)

In practice, the IMF rarely fulfilled its role of authorizing change rate changes because the big players would usually change their exchange rates and then tell the IMF.

To maintain a fixed exchange rate, you need reserves. The Bretton Woods system established that there should be a supplement to a country's reserves. The International Monetary Fund can be thought of as a "pool" of currencies, with each country given a quota based on their trade at the time. Countries had to contribute 25% of their quotas in gold or dollars, and the rest in their own currencies.

The Bretton Woods system didn't work out quite as well as was thought. The exchange rate system turned out to be less flexible - the British pound and the French franc were changed very few times. It was closer to a fixed exchange rate system than a flexible exchange rate system. Eichengreen notes that capital movements became prevalent. Because of the workings of the Bretton Woods system, it became obvious what would happen to a currency if it changed, which made currency speculation "one-way." No one in 1966/67, therefore, thought that the British pound would appreciate. This brought about massive movements of capital that put pressure on the system.

There is a view that the US saw the Bretton Woods system as enforcing the view of the dollar. McKinnon says that this wasn't really the case; the dollar was already strong. The way things were set up was to cause surplus countries to ease the problems of the deficit countries - it was set up symmetrically.

A major asymmetry arose between the US and the rest of the world. Gold was set at $35/ounce. At the end of WWII, most countries felt that they had inadequate reserves. In the 1940s and 1950s, the capital account was not that significant. With the current account, the only way to get reserves is to have current account surpluses - and they wanted to have surpluses with the US. There were three sources of reserves: gold, the IMF, and other people's currencies. Gold was set at the same prices as it used to be, but world prices were up, so gold was unattractive. Countries could earn interest from holding other countries' currencies. The IMF's resources were extremely limited.

So the additional liquidity came from US dollars. The US pursued a passive policy, allowing other countries to have a surplus with it. The US therefore had a current account deficit. Everyone liked this for a while; people were building up their reserves, with more liquidity, etc.

There was the so-called Triffin problem in the 1960s called Gold and Dollar Crisis. He said there was a fundamental problem with the Bretton Woods system: there was a conflict between liquidity and confidence. Confidence in the dollar rests on people's belief that they can exchange dollars for gold (i.e. something backs it). The US had about 60% of the world's stock in gold at the end of World War II. That meant that short-term dollar liabilities (deposits in the US, etc.) by central banks were more than covered by US gold holdings.

But by the time Triffin wrote, US gold holdings were tending to fall and the outstanding dollar liabilities were rising. Triffin said that you need an expanding source of liquidity, but you need an expanding source of dollars to provide liquidity to the system.

In the latter part of the 1960s, budget deficits in association with the Vietnam War and Johnson's social policies made inflation go up. This made the dollar less attractive. Other countries kept lower inflation, but inflation in the US continued to rise. If you have less inflation than the US, this means you'll have a current account surplus, bringing in more foreign currency.

March 25, 1999

European Monetary Union (EMU)

The EMU is the ultimate of a fixed exchange rate system: it involves replacing all national currencies with a regional currency.

For countries to benefit from this, they must have similar inflation objectives.

The purpose of modifying the exchange rate as a policy tool is to change the real exchange rate (RER), the relative prices of domestic and imported goods. In the UK, RER=(EPE)/PUK. The more diversified an economy is, the less asymmetric shocks are going to have effects. Diversification helps factors displaced from one section of an economy to be absorbed into other areas of the economy. There are other ways than the exchange weight to help such adjustment. The more labor is mobile between two countries, the more likely they are candidates for monetary union. Many comparisons have shown that in Europe labor is not as mobile as it in the United States.

However, real wage (W/P) flexibility can substitute for labor mobility, but Europe's real wages are relatively inflexible as well. Then again, inflexible real wages make a flexible exchange rate less effective as a policy tool, as well.

On these basis of these and other arguments, some have said that the European Union is not an optimum area for currency combining. But a lot of these statistics were gathered in other areas under different conditions, and may not apply to the current situation.

Seigniorage is the profit for issuing money instead of gold or other commodities. Central banks collect seigniorage because they issue money, but under monetary integration each country would no longer collect seigniorage.

The benefits of monetary integration are several. Monetary integration is more credible than simply locking currencies, and provides a currency anchor. Monetary union lowers transaction costs. It facilitates the development of a single market and thereby competition. It removes uncertainty (no more need to hedge) and helps trade integration. With monetary integration, the banks of the countries involved can pool their reserves, lowering the quantity of reserves. Lastly, there is the possibility of the euro becoming a major monetary player.

The dollar is currently used as an intermediate currency between many foreign exchanges. The more a currency is used, the more acceptable it becomes, just like the more a telephone is subscribed to the more it is worth to its current users and the more attractive it is to new users. Over time, a certain currency is likely to become more used and more important than others. This happened with the dollar. The more of a certain currency that exists, the easier you can acquire it or get rid of it without affecting its price.

In a currency, you want liquidity and stable inflation. The dollar has shown recent inflation and instability in its real exchange rate.

The US is a debtor, and sooner or later it may have to start paying back its debts. It will then have to have a current account surplus, which will involve a dollar depreciation. This will in turn mean an appreciation of the euro. A large portfolio shift could cause the euro to appreciate further and the dollar depreciate.

During the interwar period, the pound sterling was the major currency, along with the French franc, with the dollar reluctantly become a major rival. This situation was unstable, because domestic policies of any of these players could cause instability in foreign exchange rates. Pessimistically, in a decade or so the euro could rival the dollar and cause instability. Optimistically, central bankers could, with their knowledge of history, cooperate more to prevent instability. McKinnon has advocated the G-3 (Japan, Europe, and the US) cooperating to create an international monetary stability by stabilizing an index of a basket of internationally traded goods and fixing exchange rates at purchasing power parity levels. They could ensure that any shifts of currencies between the major currencies are neutralized.

If you go as far as McKinnon to link the three great currencies, why not just have a single worldwide currency? They euro could gradually gain on the dollar, encouraging greater central bank cooperation, something like the McKinnon proposal could temporarily go into effect, with eventual integration of the three currencies, or even worldwide monetary integration. The pessimistic view, though, is that the rise of the euro could cause a repeat of the instabilities of the 1920s.