Trade and development: Some reflections on the linkages

While the belief in free trade is almost a "sacred tenet" in
orthodox economics, economic theory has provided
justifications for departures from the free trade doctrine.
Yet it is the Washington Consensus views advocating more
openness and less State intervention which prevail today.
Such neo-liberal prescriptions, contends Deepak Nayyar, are
strong generalizations which fail to adequately consider
specificities of economies and are founded on an orthodoxy
beset by analytical limitations.

I. Introduction

In the post-colonial era, which began soon after the end of the
second world war, most underdeveloped countries adopted
strategies of development that provided a sharp contrast with
their past during the first half of the twentieth century. For
one, there was a conscious attempt to limit the degree of
openness and of integration with the world economy, in pursuit
of a more autonomous, if not self-reliant, development. For
another, the State was assigned a strategic role in development
because the market, by itself, was not perceived as sufficient
to meet the aspirations of latecomers to industrialization.
Both represented points of departure from the colonial era
which was characterized by open economies and unregulated
markets. But this approach also represented a consensus in
thinking about the most appropriate strategy for
industrialization. It was, in fact, the development consensus
at the time. It is almost fifty years since then. And it would
seem that, in terms of perceptions about development, we have
arrived at the polar opposite. Most countries in the developing
world, as also in the erstwhile socialist bloc, are reshaping
their domestic economic policies so as to integrate much more
with the world economy and to enlarge the role of the market
vis-a-vis the State. This is partly a consequence of internal
crisis situations in economy, polity or society. It is also
significantly influenced by the profound transformation in the
world economic and political situation. The widespread
acceptance of this approach represents a new consensus in
thinking about development. It has come to be known as the
Washington Consensus.
In spite of the shift in paradigm from the development
consensus of the 1950s to the Washington Consensus of the
1990s, the degree of openness vis-a-vis the world economy and
the degree of intervention by the State in the market have
remained the critical issues in the debate on development. The
past fifty years have, of course, witnessed a complete swing of
the pendulum in thinking about these issues. But the complexity
of the reality is not captured by either consensus: old or new.

II. Economic theory and the free trade doctrine

The belief in free trade is almost a sacred tenet in the world
of orthodox economics. Yet, from time to time, the profession
of economics has recognized that there are reasons - orthodox
and unorthodox - which may justify departures from free trade.
Economic theory has analyzed these exceptions to the rule,
mostly in response to developments in the real world which have
questioned the free trade doctrine.
In the era of classical political economy, even before the
doctrine gained widespread acceptance, it was recognized that
there are two critical assumptions underlying the strong
prescription of free trade: first, that market prices reflect
social costs and, second, that a country's trade in a good is
not large enough to influence world prices. If these
assumptions do not hold, free trade cannot ensure an efficient
outcome. Market failure provides the basis of the infant
industry argument, recognizing that free trade may prevent an
economy from realizing its comparative advantage in
manufacturing activities. Monopoly power provides the basis of
the optimum-tariff argument recognizing that restricting the
volume of trade may enable an economy to increase its real
income at the expense of the rest of the world. These arguments
were accepted as valid exceptions to the rule by Mill, thus
providing the analytical foundation for legitimate departures
from free trade. It must be rcognized that this thinking was
prompted largely by the concerns of late industrializers such
as the United States and Germany who wished to follow in the
footsteps of England and France. It was also motivated by the
pursuit of economic interests rather than economic efficiency
on the part of nation states.
More than a century later, at the beginning of the post-
colonial era, the aspirations of underdeveloped countries were
similar for they were latecomers to industrialization and
wanted to accelerate the catching-up process. In the realm of
politics, of course, the strong sentiment against free trade
stemmed from the perceived association between openness and
underdevelopment during the colonial era. In the sphere of
economics, however, the argument against free trade was based
on market failure. It had two dimensions. First, it was argued
that there were significant positive externalities in any
process of industrialization which were difficult to identify,
let alone capture. Second, it was argued that imperfections in
factor markets, both labour and capital, would pre-empt the
realization of potential comparative advantage in
manufacturing. The infant industry argument was, thus,
generalized into the infant manufacturing sector argument. The
industrial sector was protected from foreign competition and
the pursuit of industrialization in most developing countries
came to be based on the strategy of import substitution.
Recent developments in the theory of international trade
which have relaxed the assumptions of constant returns to scale
and perfect competition, to model scale economies and market
structures, have, once again, questioned the free trade
argument. This literature on strategic trade policy, which
surfaced in the industrialized countries during the 1980s,
developed a theoretical case for government intervention in
trade on the basis of assumptions which are different from
those in orthodox theory but conform more to observed reality.
In terms of positive economics, the new theories suggest that
trade flows are driven by increasing returns rather than
comparative advantage in international markets which are
characterized by imperfect competition. This has led to the
formulation of two arguments against free trade in the sphere
of normative economics. The first is the strategic trade policy
argument which states that appropriate forms of government
intervention can deter entry by foreign firms into lucrative
markets and thus manipulate the terms of oligopolistic
competition to ensure that excess returns are captured by
domestic firms. The idea is that, in a market which has a small
number of competitors, strategic support for domestic firms in
international competition can raise national welfare at the
expense of other countries. The second is an old argument in a
new incarnation which states that government should encourage
activities that yield positive externalities. In a world of
increasing returns and imperfect competition, such
externalities are easier to identify in industries where R&D
expenditures are large and firms cannot entirely appropriate
the benefits from investment in technology and learning.
Economic theory has, from time to time, thrown up serious
questions about free trade. The response of orthodoxy has been
predictable. It has endeavoured to reduce the validity of the
widely accepted arguments for protection to a set of stringent
conditions. It has attempted to dilute the arguments against
free trade, in the context of industrialization and
development, by arguing that domestic economic policies provide
the first-best corrective. It has coaxed the new trade
theorists into an acceptance of free trade as the best policy
by invoking the real world of politics. The exceptions, it
would seem, have been explored to establish the rule.
Yet, these exceptions have provided the rationale for
departures from free trade in the real world of policy choices.
The infant industry argument, sometimes generalized into the
infant manufacturing sector argument, has shaped the strategies
of most countries that were, or are, latecomers to
industrialization, at least in the earlier stages of their
development. It has, therefore, been the focus of an extensive
literature and an intensive debate on trade and
industrialization, particularly with reference to the
experience of the developing world during the second half of
the twentieth century. In recent years, the new trade theories
have revived the same issues and similar concerns by exploring
the linkages between trade, industrialization and growth in a
dynamic context. For one, these theories have emphasized, once
again, the importance of externalities, scale or learning, and
recognized, for the first time, the significance of market
structures. For another, these theories have pointed to the
inequalizing effects of trade, given the importance of initial
conditions, so that even if trade is good more trade is not
always better. Thus, unmindful of the conclusions reached by
orthodoxy, economic theory has lent new dimensions to the
discussion on trade and development or openness and

III. Openness, intervention and industrialization

The actual industrialization experience of economies in Asia,
Africa and Latin America, during the quarter century which
followed the second world war, led to questions about the
development consensus. Research on the subject which attempted
to describe, analyze and evaluate this experience suggested
that industrialization in developing countries was
characterized by success stories in a few, muddling-through in
some and near-failure in others. Such uneven development, over
time and across space, should not have come as a surprise. For
those who questioned conventional wisdom, however, the post-
mortem of failures led to a diagnosis while the analysis of
successes led to prescriptions. These lessons drawn from the
experience of particular countries were sought to be
generalized and transplanted elsewhere. Such an approach tended
to ignore not only the complexities of the growth process but
also the characteristics of economies which are specific in
time and space.
Yet, this approach came to exercise a profound influence on
thinking about development. The bottom line was clear.
Industrialization policies, which protected domestic industries
from foreign competition and led to excessive or inappropriate
State intervention in the market, were responsible for the high
cost and the low growth in these economies. Inward-looking
policies, particularly in the sphere of trade, were seen as the
prime culprit. The prescription followed from the critique.
More openness and less intervention would impart both
efficiency and dynamism to the growth process. And outward-
looking policies, particularly in the sphere of trade, were
seen as the prime saviour. Thus, trade policies were perceived
as critical in the process of industrialization and
It needs to be said that this approach to trade and
development was narrow in its focus. For it was not recognized
that there is more to trade policies than the distinction
between import substitution and export promotion or inward and
outward orientation, just as there is much more to
industrialization and development than simply trade policies.
Even more important, perhaps, this approach was selective in
its use of theory and history. For one, there was a striking
asymmetry between the unqualified enthusiasm of policy
prescriptions advocating free(r) trade, unmindful of the
distinction between statics and dynamics or irrespective of
time and place, and the formal exposition of the free trade
argument in economic theory with its careful assumptions,
proofs and exceptions. For another, the characterization of the
success stories as economies which approximated to free trade
and laissez faire was partial if not caricature history for
their export orientation was not the equivalent of free trade
just as the visible hand of the State was more in evidence than
the invisible hand of the market.
In spite of these limitations, however, the neo-classical
critique continued to gather momentum through the 1980s. The
policy prescriptions derived from it became increasingly
influential as these were adopted by the World Bank, to begin
with in its research agenda and subsequently in its policy
menu. The process was reinforced by the reality that unfolded.
The earlier success stories - Korea, Hong Kong, Taiwan and
Singapore - turned into the East Asian miracle which spread to
China, Malaysia, Thailand and even Indonesia. The debt crisis
which surfaced in Latin America moved to sub-Saharan Africa and
ultimately caught up with South Asia. The collapse of the
political system in East Europe, particularly in the former
Soviet Union, represented the failure of planned economies. The
disillusionment with the development consensus was complete.
And, by the early 1990s, the Washington Consensus acquired a
near-hegemonic status in thinking about development.
It would mean too much of a digression to enter into a
detailed discussion on the industrialization experience, its
neo-classical critique and the neo-liberal prescription. There
is an extensive literature on the subject, which is
characterized by a diversity of views that range from the
orthodox through the heterodox to the unorthodox. Elsewhere, I
provide a criticl assessment of the neo-classical analysis and
the neo-liberal prescription in terms of theory and experience.
It would serve little purpose to do the same here. Instead, I
would simply like to highlight some of the analytical
limitations of the new orthodoxy on trade and
First, it is a simple fallacy in logic to claim that if
something (State intervention or protection) does not work, its
opposite (the free market or free trade) must work. This is
true only in a dichotomous world of two alternatives. In the
world of economic policies, where there are always more than
two alternatives, such a view is obviously false. Thus, if A is
wrong, it does not mean that the opposite of A (say B) must
necessarily be right. If there are other alternatives, say C,
D, E or F, one of these rather than B may be right.
Second, the emphasis on trade liberalization, which assumes
that international competition will force domestic firms to
become more efficient, makes an elementary but commonplace
error in the design of policies. It confuses comparison (of
equilibrium positions) with change (from one equilibrium
position to another). In the real world, economic policy must
be concerned not merely with comparison but with how to direct
the process of change. Thus, even if a reduction in protection
can, in principle, lead to a more cost-efficient economy, the
transition path is by no means clear. And the process of change
should not be confused with the ultimate destination of an
economy that is competitive in the world market.
Third, the analytical construct is narrow. Success at
industrialization is not only about resource allocation and
resource utilization at a micro-level. It is as much, if not
more, about resource mobilization and resource creation at a
macro-level. The excessive concern with resource allocation, in
terms of static allocative efficiency criteria, is perhaps
misplaced, while the strong emphasis on resource utilization,
in terms of competition through deregulation and openness, is
important but disproportionate. Significant new developments in
the neo-classical tradition, whether in industrial economics or
in trade theory, are almost ignored when such analysis is
applied to problems of industrialization and development. Hence
this approach, which is static rather than dynamic in
conception, tends to ignore intertemporal considerations and
does not quite incorporate increasing returns, market
structures, externalities or learning which are inherent in any
process of industrialization.
Fourth, there is a presumption that what is necessary is
also sufficient. The management of incentives, motivated by the
object of minimizing cost and maximizing efficiency at a micro-
level, is based on a set of policies that are intended to
increase competition between firms in the marketplace. Domestic
competition is sought to be provided through deregulation in
investment decisions, in the financial sector and in labour
markets. Foreign competition is sought to be provided through
openness in trade, investment and technology flows. It must,
however, be recognized that policies may be necessary but are
not sufficient, for there is nothing automatic about
competition. Policy regimes can allow things to happen but
cannot cause things to happen. The creation of competitive
markets that enforce efficiency may, in fact, require strategic
intervention through industrial policy, trade policy and
financial policy.
Fifth, the strong emphasis on allocative efficiency is
matched by a conspicuous silence on technical efficiency. It is
forgotten that low levels of productivity in most developing
countries are attributable more to technical inefficiency than
to allocative inefficiency. And inter-country differences, as
also inter-firm differences, in technical efficiency are
explained, in large part, by differences in technological (and
managerial) capabilities at a micro-level. These capabilities
determine not just efficiency in the short run but also
competitiveness in the long run. But, given the nature of the
learning process, such capabilities are both firm-specific and
path-dependent. The new orthodoxy simply ignores this critical
dimension on the supply side. In contrast, the heterodox
literature places the acquisition and development of
technological capabilities at centrestage in the story of
success at industrialization. It also shows that the presumed
relationship between trade liberalization and technical
efficiency is dubious in terms of both theory and evidence.

IV. Conclusion

In my reflections on the linkages between trade and
development, I set the stage by explaining the rationale of
departures from free trade in economic theory and by outlining
the orthodox critique of the industrialization experience in
developing countries. The latter highlights the sins of import
substitution and State intervention to stress the virtues of
openness and markets. However, the policy prescriptions derived
are strong generalizations, which do not match orthodox theory
in terms of rigour and do not recognize recent theoretical
developments in terms of insights. What is more, the neo-
classical critique and the neo-liberal prescription are both
characterized by analytical limitations. Most important,
perhaps, the mainstream literature on trade and development is
narrow in its focus just as it is selective in its use of
theory and experience.
The changed international context, attributable to
globalization, has important implications for trade and
industrialization in the developing world which must be
recognized. An increase in the degree of openness of economies
is inevitable, while the degrees of freedom for nation states
are bound to be fewer. But it would be a mistake to consider
this necessity a virtue. Simplified prescriptions, which
emphasize more openness and less intervention to advocate a
rapid integration with the world economy combined with a
minimalist State that vacates space for the market, are not
validated either by theory or by history. Economic theory
recognizes and economic history reveals the complexities of the
industrialization process. The degree of openness and the
nature of intervention are strategic choices in the pursuit of
industrialization, which cannot be defined (and should not be
prescribed) once-and-for-all for they depend upon the stage of
development and must change over time. And there can be no
magic recipes in a world where economies are characterized by
specificities in time and in space. The irony is that, at the
present juncture, when the disillusionment with the State is so
widespread, given the reality of globalization, its role in the
pursuit of industrialization and development is more critical
than ever before. However, this does not mean, nor should it
suggest, more of the same. Correcting for mistakes and learning
from experience is vital. It is, therefore, essential to
redefine the economic role of the State vis-a-vis the market,
so that the two institutions complement each other and adapt to
one another as circumstances or times change. That is what
success at industrialization and development is about. (Third World
Economics No. 207/208, 16 Apr-15 May 1999)

Deepak Nayyar is Professor of Economics at Jawaharlal Nehru
University (New Delhi) and a former Chief Economic Adviser to
the Government of India. This paper was presented at the World
Trade Organization's High Level Symposium on Trade and
Development in Geneva on 17-18 March 1999.