3 – Trade as an Engine of Growth

Introduction:

One of the oldest policy implications supplied by international economic theory is the advocacy of free trade. While there have historically been significant disconnects between trade policy politics and economics, the rapid economic growth that export-oriented Asian countries experienced during the 1960s and 1970s amid a largely stagnant and trade-restrictive developing world, provided a precedent for effective development policy, particularly among the world’s less developed countries (LDCs). Since then, a majority of global institutions, including the International Monetary Fund (IMF), the International Bank for Reconstruction and Development (IBRD) or World Bank, the Organization for Economic Co-operation and Development (OECD), and the World Trade Organization, have championed free trade arguments (WTO hereafter). According to the reasoning, lowering trade barriers will increase economic efficiency within LDCs by giving lower world prices to home consumers (raising consumer welfare) while fostering competitive circumstances for domestic firms (forcing domestic production to shift towards the most efficient sectors based upon the availability of domestic factors).

3.1 A Brief Historical Overview

Smith is credited with identifying the positive effects of international trade (IT) on economic growth (EG) (1776). This notion persisted until World War II (WWII), albeit relatively dormant throughout the ‘marginalist revolution.’ The introverted and protectionist EG experiments had some impact after WWII, particularly in Latin America. Because of the failure of those experiments, as well as the association of quick EG with the opening of IT and the subsequent international specialisation in several countries, as well as the results of many studies based on neoclassical theories of EG and IT, IT was given a new decisive role as EG’s driving force beginning in the 1960s.

Even though the dominant theoretical stance tended to show a favourable relationship between IT and EG from the beginning (with the Classics), several studies associated IT gains exclusively with static effects. In a survey of empirical investigations, however, Baldwin (1984) concluded that the static effects were insignificant. The discussion has grown in recent decades, namely in the direction of emphasising the dynamic implications of IT. Endogenous EG models enabled theoretical development [particularly in the wake of Romer (1986) and Lucas (1988) works], which pushed for the creation of empirical research and pushed for an integrated study of EG and IT theories. As a result, the classical tradition, which appeared to have been broken by the neoclassical separation of the two domains of theory, seems to have been reinstated, allocating a key role to IT in the countries’ rate of EG.

Recognizing its significance has resulted in a never-ending stream of suggestions from international organisations such as the World Bank (WB) and the United Nations (UN). As a result, many countries began to lower commercial barriers and other economic activity constraints, resulting in a large (and long-lasting) increase in the rate of EG. This implies that extroversion has a dynamic effect on the economy, aiding in the acceleration of the rate of EG. Furthermore, economic integration procedures accelerated.

The Work’s Goals and Structure

The EG theory examines the evolution of the real product and its distribution on a broad scale (intra and inter-countries). Generally, the models consider the product to result from a restricted and aggregated number of components. Models initially designed to explain the EG of Developed Countries (DCs) are generally ‘ supply side’ models because it is acknowledged that, in the long run, the equilibrium product is located near the potential product. The latter depends on the factors’ availability and the technological level. The fundamental goals of these models are to explain the differences in the components and the production function itself (i.e., how the product depends on the factors) and to account for the effects of these variations on the evolution and distribution of output.

We aim to investigate IT’s commercial and technological effects (excluding the financial component) on the physical accumulation of productive elements and their improvement (efficiency gains). In other words, during the evolution of economic growth theory, at the pace of EG. Instead of simple ‘level effects,’ we emphasise studies that portray the ‘impact of EG’ (changes that modify, in a long-term way, the rates of EG and its tendency) (changes that influence the EG only in the short-term).

The framework of this research follows temporal evolution and the position that we believe economic and technological components have in terms of EG models. It looks like EG and IT theories were linked during the “classical period” (section 2), then they were separated during the “neoclassical period” (section 3), and finally, with the new endogenous EG approaches, they were treated together again (section 4). Finally, in Section 5, we describe the key findings.

3.2 Classical Period: Foreign Trade and Growth

Because the classics do not distinguish between EG and IT concerns, examining this difficulty brings us to the classics’ main models of IT. However, given the purpose of our work, we seek to progress on those models that essentially address the ‘static advantages of IT.’

At Smith, we discovered two primary aspects of the interplay between IT and EG (1776). On the one hand, IT enabled the internal market to overcome its reduced dimension; on the other hand, by increasing the market’s extension, the labour division improved, and productivity grew. As a result, IT would be a dynamic force capable of enhancing employees’ abilities and skills, supporting technological advances and capital accumulation, overcoming technical indivisibilities, and, in general, providing participating countries with the opportunity to experience EG.

However, due to land constraints, both in quantity and quality, the additional alimentary resources were obtained under conditions of decreasing returns, in which production is absorbed by wages in an increasing proportion, reducing the stimulation of new investments and, sooner or later, reaching the ‘stationary state.’ It has the potential to postpone the decline in profit margins. Apart from underestimating the value of technology, he also underestimated the good benefits of IT for technology.

Finally, among the Classics, Mill (1848) expressly stated the Classic viewpoint that production was the outcome of labour, capital, land, and productivity. Like Ricardo, he knew behind the ‘progressive state’ was the ‘stationary state’ and that technological advancement was the only force capable of delaying this state. As a result, Smith’s emphasis on market extension diminished, even though he also backed free trade among countries. This predicament arose due to the Industrial Revolution’s (IR) expectation of technological growth.

3.3 International Trade and Growth in the Post-Classical Period

This section’s structure considers the separation between IT and EG theories and some reactions to classical and neoclassical ideas. We begin with neoclassical IT theory, then post-classical EG theory, before moving on to the reactions. The present neoclassical theory of EG follows, and we conclude with the revelation of extensions or works of synthesis, applications, and studies of commercial policies that examine the issue under consideration.

International Trade in Neoclassical Style

Ricardo’s disciples overlooked the subject of the foundations of comparative advantages. They failed to identify elements emerging from IT that may raise, in a long-term form, the rate of EG and its direction. In summary, the improvements introduced in the Ricarddian theory indicated the rise in welfare produced by IT while ignoring future gains in the rate of EG. The Heckscher (1919) and Ohlin (1933) models appeared in the setting of neoclassical general equilibrium, and Samuelson (1948 and 1949) finished their contributions in the late 1940s. A thorough analysis of the model reveals that it enables us to advocate for the openness of countries to IT, demonstrating that it is efficient, mutually beneficial, and positive for the entire world. However, it restricts the analysis to static welfare improvements.

Before Solow, there was post-classical growth.

Classical economics generally depicts a race between population growth and EG, with an unclear winner. This variant progressively faded with the IR as the product expanded in increasingly broader areas from decade to decade. That could be why EG was no longer regarded as a concern and was not thoroughly investigated in the studies and writings of the succeeding economists.

Nonetheless, Marshall (1890) stated, “The forces that determine the economic evolution of nations belong to the study of international trade.” In effect, the market growth that it represented increased worldwide output and initiated an increase in internal and external economies, resulting in increased income for the economy. But, while recognising the significance of those externalities, he also recognised the challenges of his analytic method. Only Young (1928) was worried about EG when he, like Smith, believed that the size of the market constrained the labour division (and, therefore, productivity). He also investigated the interdependence of industries in the EG process, the emergence of new sectors due to specialisation caused by market expansion, the significance of specialisation and standardisation in a large market, and the impact of this market on technological advancement.

Schumpeter (1912, 1942, and 1954) was another notable exception of this period, who repeated previous points of view concerning the tendency of profit to reach a minimum and the dependence of the rate of EG on capital accumulation. He went on to distinguish ‘invention’ (the application of usable knowledge to production) from ‘innovation’ (the economic activity of exploring that knowledge). Considering the latter to be the key component of EG, he outlined the requirements for a successful innovation, which included the need for markets to be opened to the outside.

We finish this chapter by identifying several authors who made it simpler to restart studies of dynamic themes—and, as a result, of the EG theory—creating a good platform for future research. Ramsey (1928) pioneered the description of EG and the notion of optimum EG study. Cobb and Douglas (1928) proposed production functions that became known as Cobb-Douglas production functions and were a fundamental component of several EG models. Harrod (1938 and 1948) and Domar (1937 and 1946) independently devised a Keynes-inspired model, which provided EG research with a significant boost and a clear path. Finally, when the LDCs issues drew economists’ attention, Rosenstein-Rodan (1943) retrieved some of Young’s concepts.

Classical and Neoclassical Theories’ Reactions

Immediately following the conclusion of WWII, the dominant position was called into doubt, particularly in the case of the LDCs. In examining theories that were unfamiliar to them, these reactions abandoned the classical and neoclassical orientations. Latin America’s introverted and protectionist EG experiments (industrialization for import substitution) also stood out, with rationalisation and justification owing, first and foremost, to some structuralist economists [Prebisch (1949)—executive secretary of the UN—and Singer (1950)] and the UN Economic Commission for Latin America (ECLA). Essentially, they argued that IT had long-term adverse effects for LDCs since their specialisation happened in products with low demand income elasticity and, as a result, a dismal outlook for export development, and they saw a propensity for ongoing deterioration of trade conditions. Furthermore, this specialisation came at a tremendous economic and social cost in adapting to the IT chain’s evolution.

Myrdal (1956 and 1957) maintained that IT did not equal factor compensation (contrary to the neoclassical model’s proposal) and that, unlike the DCs’ traditional industries, the LDCs’ traditional sectors remained weak. In short, IT had some positive diffusion effects on LDCs. Still, the negative consequences persisted in the long run since it supported the production of primary goods (plantations and mining enclaves) subject to erratic pricing and demand. Lewis (1954 and 1969) and the Marxist author Emmanuel (1969) determined the degradation of the LDCs’ trade terms and the existence of uneven trade skewed against the LDCs, respectively. Nurkse (1959) questioned the importance of commercial trade between DCs and LDCs for the latter. Perroux (1978) believed that the LDCs were under control. As a result, the DCs caused the EG and structural alteration, resulting in the loss of potential positive effects to the external world in the long run.

Another group of (radical) authors examined economic relations as a whole (chain of products, services, and capitals): radical Marxist views [among them, Destanne de Bernis (1977) and Andreff (1981)] and dependence theory [among them, Santos (1970), Frank (1970), and Amin (1970 and 1973)]. They argued that underdevelopment resulted from alterations and deformations in economic and social systems generated by the economic and social relationship with DCs.

Growth Theory in the Modern Neoclassical Era

The revival of the classical approach, according to which production was a function of labour, capital, land, and their productivities, reawakened interest in the EG in the late 1950s and early 1960s. The issue of ‘accounting of EG’ was also discussed.

Solow [and Swan (1956)] can be credited with the origin of the “current neoclassical theory of EG” in 1956. The proposed model illustrates the relationship between savings, capital accumulation, and EG as a function of aggregate production (critical supply), with a point of sustainable equilibrium (steady-state) that would be attained regardless of initial conditions. Exogenous technical advancements favoured the accumulation process and made the model compatible with a balanced growth path by boosting the productivity of the factors. In economic terms, this means it is considered the convergence of economies. Furthermore, if technological development spreads, the rate of EG per capita would converge toward a typical steady state. As a result, IT is crucial for LDCs since it facilitates the transmission of technological advancement.

In terms of ‘accounting of EG,’ Solow (1957) used aggregate production as a starting point to measure the sources of EG in the United States. The rate of EG is determined by the rates of labour and capital growth (which we refer to as conventional sources), the relative participation in production and technical development, or the overall productivity of factors (TPF). The TPF arose from the discrepancy between the observed rate of EG and the portion of that rate explained by traditional causes (thus the term “residual of Solow”). He clearly distinguished between EG and level effects (the three sources indicated above). As a result, IT would eventually have a ‘level impact,’ causing good results in a short time.

Many economists, beginning with Solow, saw the advancement of knowledge as a source of the ‘residual.’ But the “accountants of EG” (after Solow) looked at a lot of different factors, such as the growth of “human capital,” economies of scale, better resource allocation, and new generations of machines that are more productive [see, for example, Kendrick (1961), Denison (1962, 1974, and 1985), and Griliches and Jorgenson (1967)]. They did not, however, quantify the progress in knowledge, leaving a residual factor unaccounted for. Furthermore, they did not expressly list IT as a source of EG. We believe that this circumstance is the result of two previously mentioned variables. On the one hand, the separation of IT and EG theories, and on the other, the effects of IT on the level rather than the long-term rate of EG.

Empirical Applications, Theoretical Synthesis, and Commercial Policies

As previously stated, the work of ‘accounting of EG’ broadened the area of source studies and began analysing new structural conditions, renouncing several neoclassical assumptions in the process. Thus, research conducted since the late 1960s has incorporated other explanatory variables and traditional elements while adhering to Solow’s functional scheme. In this environment, there was an upsurge in trade and growth research due to the necessity to discover the totality of growth sources, the failure of introverted growth experiments, and EG’s relationship with the opening of IT.

We discuss various theoretical research and empirical applications that resulted, as well as studies/suggestions on external commercial policy, the defining feature of which is that IT (particularly the exporting component) is seen as an explanatory variable of EG. They generally associate this situation with better resource allocation (based on comparative advantages), greater utilisation of productive capacity (allowing for economies of scale), a greater propensity to implement technological improvement (in response to increased competition), and a higher level of employment created when compared to introverted strategies.

Theoretical integration

We start with Kuznets’ (1972) structuralist EG synthesis and move on to Chenery and Syrquin (1975 and 1989), then Chenery et al. (1986). In summary, we discovered that the observation of the country’s EG process is dependent not only on changes in factorial provision but also, mainly, on changes in demand, resulting in the expansion of the internal market, the replacement of imports, and the variation of exports. In this regard, they argue that the TPF took into account, among other things, IT’s weight and demeanour.

In turn, we include Young (1928), Florence (1948), Stigler (1951), Meade (1953), Svennilson (1954), and Scitovsky (1954) in a brief reference to the analyses that highlight economic integration (more or less institutional) (1958). This set of authors considered dynamic impacts, such as those caused by increased competition, gains in economies of scale, changes in the volume and form of investments, increases in research expenses, technological advancement, and the reduction of risk and uncertainty in trade.

Findlay’s (1980 and 1984) concept for commercial interactions between the (developed) North and the (underdeveloped) South is another example. While integrating the neoclassical theories of IT and EG and recognising the specificities of the LDCs, he assumes that the North’s economy is dynamically described by Solow’s (1956) model of EG, except that it consumes an importable good in addition to its product. In contrast, the South’s economy works according to Lewis’ (1954) model of unlimited labour supply—the terms of trade in the two economies [according to Johnson (1967)] related to EG. As a result, the South’s primary driving factor of EG was IT. On the other hand, the (exogenous) EG rate of the North determined the rhythm of EG.

We finish with Feder’s (1982) work, in which EG progressed from the influence of conventional sources to the performance of the exporting sector. In summary, he believes that economies have two separate productive sectors (exporter and non-exporter), which differ in terms of the eventual destination of goods and the superiority of the productivity of traditional elements in the exporter sector. He concluded that the rates of investment, labour growth, and export growth could describe the rate of EG. He also offers a method for analysing the relative benefits of allocating resources to both areas.

Statistical applications

In terms of empirical applications, we immediately note the structuralist leanings of Hagen and Hawrylyshyn (1969), Chenery et al. (1970), Chenery et al. (1986), and Chenery and Syrquin (1989). (1989). These authors investigated the significance of structuralist variables and concluded they were relevant in explaining EG, particularly in samples of LDCs and the years following the 1960s. They demonstrate, through empirical findings, that exports increase EG. Furthermore, they claim that the existence of import restrictions may reduce EG.

Feder (1982) then applied the created framework empirically in semi-industrialized and slightly semi-industrialized nations between 1964 and 1973.

He concludes that its formulation was statistically superior to the usual neoclassical version. He also concluded on the superiority of the exporter sector’s marginal production and the externality of this sector over the others. Finally, he reasoned that allocating one unit of capital to the exporter sector would provide a marginal value for the economy greater than what would be obtained if a non-exporter sector influenced the economy. Ram (1987) extended Feder’s research to estimating time series for each nation in a sample of 88 LDCs from 1960 to 1985. The derived regressions (statistically significant internationally) confirm the favourable effect of the export sector in roughly 70% of the countries.

We continue by stating that even more sceptical empirical applications, such as those of Michaely (1977), Tyler (1981), and Dodaro (1991), do not question the positive influence of IT on EG, provided the countries have reached a certain level of development.

The issue of international trade policies

In light of the failure of introverted EG experiments, the success of extroverted EG experiences (as seen in Southeast Asian countries), and the prevalent theoretical idea, the UN began to promote openness to IT. They began the process with UN Resolution 1707 in 1961 and continued it, for example, with the UN Conference on Trade and Development in 1964. (UNCTAD I). Both the General Agreement on Tariffs and Trade (GATT / WTO), through successive rounds of negotiations, and the Organization for Economic Cooperation and Development (OECD) recommendations worked in favour of trade liberalisation [see, for example, Arndt (1987, pp. 72–77)].

Little et al. (1970) attributed the import substitution strategy to the growth of businesses with high costs and, consequently, high prices for their goods, which were only affordable by consumers with high incomes. As a result of this circumstance, businesses would become dependent on government actions. As a result, they defended export promotion.

Balassa (1978) contrasted export promotion strategies with import substitution strategies. Michalopoullos and Jay (1973) influenced his work. He examines a sample of ten LDCs with varying degrees of application of those tactics (in 1960–1966 and 1966–1973). Using a neoclassical production function, he employs several functional forms, resulting in varying export performances. On the one hand, he emphasised the significance of export growth from the data and that countries with higher export growth rates than the average also had the best performances. More recently, Balassa (1986 and 1987) examined the EG of a set of LDCs separated into those directed toward the exterior and those turned toward the interior between 1963 and 1984, concluding that the former outperformed the latter, particularly from the middle of the 1970s onward.

Krueger reported in 1985 that, particularly in the early 1960s, certain LDCs lowered commercial barriers and other economic activity regulations and received a large (and long-lasting) increase in the rate of EG. Specifically, technological factors, financial behaviour, and political and economic considerations that involved dynamic impacts (in addition to static effects) aided in explaining disparities in economic performance. Rajapatirana (1987), co-author of the World Development Report 1987, reiterated Krueger’s arguments, claiming that information technology allowed for dynamic gains when subjecting internal production to international competition and also allowed countries to specialise in different branches of industry and production stages. Furthermore, allowing access to DC technology and expanding exports spurred internal technological growth.

Finally, the World Bank’s World Development Report 1987 is a must-read when it comes to dissemination on an academic, institutional, and political level. Using data from 41 LDCs over two time periods (1963–1973 and 1973–1985), it classified the nations into four groups based on the commercial approach used (strongly extroverted, moderately extroverted, moderately introverted and strongly introverted). That is why it concluded that the outgoing strategy was better. This commercial focus led to the fastest, most stable, and even fair personal income distribution.

3.4 Endogenous Growth and International Trade Models

The “paradox of Leontief” caused a lot of discussion and disagreement in IT theory. As a result, new ideas came up that tried to explain the benefits not from the point of view of a natural situation that does not change but from the point of view of an evolutionary process connected to the EG, where the structural characteristic from which they proceed is constantly evolving. The models of endogenous EG also had a considerable impact on the EG theory. These models identify the driving force of growth, its dynamics, and the factors that influence its accumulation (case of IT). As a result, the accumulation of human capital and the production and dissemination of technological discoveries were prioritised. The connection between these factors and the growth of IT theory is not coincidental. In reality, endogenous EG models moved toward an integrated study of EG and IT, resuming the classical tradition that the neoclassical division had halted.

The endogenous EG models did not appear by chance. They result from the overall evolution of economic theory, as they are concerned with the precise microeconomic underpinnings. We should mention the developments and dissatisfaction with Solow’s work, earlier studies of themes such as learning by doing [Arrow (1962)], the role of human capital [Uzawa (1965)], increasing returns to scale [Kaldor (1961)], and even the idea of per capita growth sustained by increasing income from capital goods investment, which includes human capital, dating back to Knight (1944); as well as the inspiration provided by countless authors who have already influenced us.

In light of these recent developments, we begin this section with a brief and special mention of Lucas’ second model (1988) and the models of endogenous research and development (R&D) devised by Romer (1990 and 1993), Grossman and Helpman (1990, 1991a and 1991b), and Aghion and Howitt (1990, 1991a and 1991b) (1992). We finish by mentioning a few applications.

The Lucas Model and Endogenous R&D Models

Lucas’s 1988 concept of learning by doing and comparative advantage addresses the relationship between IT and EG. Essentially, he viewed the aggregate production function with two consumption products and just one production function, human capital, the accumulation rate of which was determined by the quantity of labour associated with production (thus expressing the learning effects). He concluded that with IT, each country would specialise in the goods for which the autarky gift of human capital provided a comparative advantage. And because the learning took place in the specialised domain, this specialisation tended to be reinforced. As a result, if the learning rate varied from sector to sector, the rates of EG would differ from country to country.

The economy’s production function arose from the aggregation of companies in the endogenous EG models established by Romer (1986) and Lucas (1988). As a result, they proved to be very aggregate and incapable of accurately explaining the microeconomic foundations capable of supporting the operation of externalities and the agents’ investment decisions. A second generation of models [Romer (1990 and 1993), Grossman and Helpman (1990, 1991a and 1991b), and Aghion and Howitt (1992)] saw innovations as the EG process’s foundation. The innovations resulted from an explicit R&D effort in the firms, with the outcome of R&D being the primary predictor of the EG rate.

Technological knowledge is, by definition, a good with no competitor of use (public good). The market system cannot properly guarantee its production without some public intervention in implementing a patent system. This concept gives technology the economic nature of a private good, allowing for the exclusion of use and thus allowing it to be sold. Immediately, an economic dilemma occurs. The patent, by definition, places the holder in a monopoly position, and by exploiting that position, he earns a monopoly rent. On the other hand, the patent has a set cost for the user because its price is often independent of use. In these models, an economic policy dilemma exists regarding the diffusion of innovations.