Trade policy and economic growth: which way to go?

Development economists will quickly tell you that trade policy is central to the design of policies for economic growth. This is even more so today in a globalised economy that is governed by the rules-based World Trade Organization (WTO). The WTO's mandate is to create a world economy where there are little or no distortions to trade, so that economies can benefit from international trade and improve the wealth of their nations.

The WTO, in responding to criticisms that it operates in the interest of developed countries and that free trade does more harm than good to developing countries, generally responds by pointing out the distortions to trade (e.g. tariffs, subsidies, non-tariff barriers, etc.) that derail the true benefits from free trade.

The argument is that if countries do not erect barriers to trade to protect inefficient industries, and allow trade to flow freely and fairly, the benefits will flow freely and developing countries would be able to trade their way out of their growth problem.

The theoretical justification for free trade is quite strong. Why then do so many countries ignore this message and, instead, erect barriers to trade that distort the market and limit the true benefits to be derived from trade? In most cases, not enough technical work is being put in to determine the best trade model for a country, and sometimes the voice of lobbyists is too strong for policymakers to do what is in the best interest of the country and not in the favour of special-interest groups. Selecting the right trade policy will be important in driving economic growth, especially for small, developing economies like Jamaica.

In the early 1950s when development economists discussed trade policy, there was almost consensus that the policy prescription should be one of import-substitution. This policy suggests that the domestic economy should produce import-competing goods to satisfy local demands for those goods, under incentives provided through whatever level of protection against the imported goods or the complete prohibition of imports, if necessary.

The rationale is that economies will grow local industries, especially manufacturing, which is key to the development of the economy. The fallacy of this thinking, however, was exposed when the new industrialised countries of Asia recog-nised that producing for the domestic market under an inefficient incentive structure was not generating the development and economic growth that were needed to transform their economies into wealthy places to live. Soon, the policymakers switched gears and moved to a more proactive policy of export-led growth.

The thinking today with regard to trade policy is for a policy that is more outward-oriented in its outlook. This suggests a trade policy which produces for export across a range of goods and services under a fairly uniform incentive regime, mainly through a strong enabling business environment. Goods and services are produced not merely to satisfy domestic demand, but for the export market as well. There is also no prohibition of imports, and locally produced goods are able to compete with imported goods. In this case, the winner will be goods that are internationally competitive.

Where should Ja position itself?

It appears to me that in 2011, Jamaica is still not clear what its trade policy should be. On one hand, there is the gesture of import-substitution. We are hearing that we should substitute J$800 million of imported food with locally grown food; we are hearing about giving distorting incentives to industry sectors to help them to compete. And I could go on. In another breath, we hear policymakers say that we should export our way out of our growth problem. We cannot have it both ways. We cannot want to prohibit imports into our economy but expect to export to everybody else's economy.

What surprises me is that we have not learnt anything from our experience with import-substitution in the 1950s. We have gone the route of import-substitution before, and the experience was not palatable. We are too small to produce everything for ourselves. Further, given our liability of size, if we are to produce solely for the local market, our firms will face a huge production cost because of their inability to generate economies of scale in production. This cost will be passed on to the consumers. In essence, they will pay higher prices for goods that are produced locally.

The fixed cost of production will be the same if 10 items are produced or if 100 items are produced. If we can spread more items over the same fixed costs, firms will enjoy better margins on their outputs. Limiting production to the domestic market hinders this possibility. Producing for a huge export market provides firms with the ability to spread their fixed cost over a larger volume of products and, therefore, their prices can be lowered.

Therefore, a small, open economy like Jamaica should not be thinking about import substitution as a trade-policy option for development. Instead, the policymakers ought to be pushing for an export-led trade policy. In trade jargon, this is called outer-oriented trade policy.

The success of the export-led policy in emerging small economies in Asia tells the story very well. Singapore, an entrept in South East Asia, realised that import-substitution trade policy would not take it very far and has moved to an export-led strategy. The success of Singapore is clear to all. Jamaica should learn from the lessons of its early practice with import substitution to know that it should not go this route again.

Indeed, Anne O. Kruger of the Department of Economics at Stanford University wrote a very interesting piece for the National Bureau of Economic Research in 1997 titled 'Trade Policy and Economic Development: How We Learn'. That work essentially looked at the change in thoughts on trade policy and identified the lessons learnt. This will make interesting reading for Jamaican policymakers, especially those who are shaping trade policy.

Dr Densil A. Williams is a senior lecturer of international business and head of the Department of Management Studies, UWI, Mona.