The title borrows from the term “immiserizing growth,” coined by Jagdish Bhagwati, but doesn’t have much to do with it.1 Instead, my point here stems from a discussion on Jamaica, free trade, and the possibility that tariff reductions can damage, rather than help grow, small economies. I think they can, but that in the not-too-long-run the initial shock is worth it.
If we start out in a world where there are n countries and none of them trade with each other, the point of full employment equilibrium will correspond to the opportunity costs of the economic goods within each country. What this means is that economic goods in each separate economy will be allocated in a way that maximizes the attainment of ends, but in a way that only reflects each economy’s resource constraints and value scales. Over time, as countries begin trading with each other, assuming that the two options are “no trade” and “free trade,” resources will be re-allocated to reflect the broader range of values, factor endowments, and comparative advantages. In other words, trade requires a structural readjustment of economies that have to adapt to changes in the data — as Hayek liked to put it.
Suppose you are a small a country located only a few hundred miles away from an economy roughly 1,000 times larger than your own. Some time ago you were a colony of a distant empire and your indigenous population was put to work in gigantic sugarcane plantations, owned by wealthy imperial immigrants. Your society was bifurcated between wealthy landowners and the poor, a large fraction of them employed on the plantations, and this compressed caste system remains to this day. As the world passes you by in wealth and know-how, your country’s government decides to borrow on international capital markets — when you can get it, otherwise you borrow conditionally from the World Bank and International Monetary Fund — to fund investment. Much of this investment never materializes due to the inadequacy of your capital stock, or because of straightforward corruption, and your government buries itself beneath a growing pile of debt. The international community, led by your neighbor a few hundred miles away, offers your government an aid package, with the condition that it open itself to free trade.
With free trade comes even greater wealth, so the theory goes. As a free market oriented economist, I agree. But, benefits always come with costs. Your economy has one major industry: sugarcane. Uh-oh, as it turns out, there are already other countries — which now have access to your markets, as you do theirs — that produce sugarcane, and they do so while having the lowest global opportunity cost in sugarcane production. In other words, they have the comparative advantage. You also have a comparative advantage in something, but it’s in a good (or a set of goods) that your economy currently isn’t geared towards producing. Your economy must go through a period of structural readjustment. This is the equivalent of a “real” shock.
The size of the short-term disturbance caused by free trade depends on the size of the economy and how diversified it is. A more competitive economy is not going to suffer as much as a smaller one, because the size of the sectors impacted by changes in the global data is comparatively smaller. But, the real world countries I have in mind — e.g. several Carribean nations — are small enough where this kind of issue may be important. I’m sure that this has occurred, or would occur, to several mid-sized nations with relatively small economies, like in Latin America and Africa. Because, not only are these economies relatively non-diversified, but they also suffer from major institutional burdens and inadequacies. In the former category are things like taxes, an extractive regime, violence, and corruption. The latter includes the all-important lack of property rights, where they are poorly defined and rarely enforced. These factors tend to exacerbate the pains of structural readjustments, by delaying them.
It’s not uncommon to come across pieces on small economies which opened themselves to trade and didn’t seem to benefit. Free trade often receives the blame. Maybe the critics aren’t wrong. Should this make us re-think free trade? I don’t think so. The benefit of an international division of labor is to maximize global efficiency, and free trade is the only way a global division of labor can come about. Small countries that have non-diversified economies, based on industries that are only profitable in closed, autarkic economies, might go through an initial shock that may be worsened by bad institutions, but after the structural readjustment their economies will be stronger, and their society will be able to consume more (in terms of value, that is subjectively) than they produce. There’s a caveat, though.
Where institutions are bad and entrenched, what comes first: free trade or institutional improvement? I’m inclined towards the second option. Institutional development and changes in wealth come hand-in-hand. As trade grows, the distribution of income will change and newly empowered people will begin acting to change the institutions in ways that allow them to participate in the political process. These marginal institutional improvements will tend to help improve economic conditions, which in turn continues to broaden the distribution of wealth. The processes of institutional improvement and market growth are reflexive. Now, imagine what happens when there major shocks to one or the other process. The dissolution of institutions of governance tend to force dramatic economic collapses. A large shock to markets can be socially devastating, especially if institutions are so bad that a readjustment becomes unbearably long. They can bring social upheaval and changes to institutions, but these aren’t guaranteed to work out in the right direction. They can worsen, achieving an outcome that is often even worse than the original, but better than the chaos of transition. Consider the real world case of Venezuela. My opinion is that we should allow countries to gradually come around to free trade, instead focusing on encouraging institutional advancements on the margin.
1. A country’s international purchasing power can be defined by the ratio of average price of exports to average price of imports, such that the smaller the ratio becomes the less well-off the country is made through trade. An increase in exports may lead to a situation — although, whether this is possible in real life is disputed (that is, whether any country fits the conditions of the model) — where the average price of exports falls, and therefore a country’s terms of trade worsen.