Evolving Patterns in Global Trade and Finance

The following sections are included:

• About the Author
• Table of Contents
• Preface
• Acknowledgments

There have been far-reaching changes in international trade and finance during the past half-century. Not only has the share of trade in the GDP of most countries expanded with the reduction of tariffs, transportation costs, and assorted other barriers, but significant innovations in communications technologies have facilitated the growth of economic and financial linkages among countries. These developments have also opened the door to cross-border production sharing and global production networks. Changes of such magnitude and import inevitably raise challenges not only for policy makers, but for economic theorists and model builders. The papers assembled in this volume explore the implications of these changes and assess the quality of the policy response…

Free trade as the widely preferred policy regime has enjoyed a very long and largely successful run. In recent years, however, political support for it has cooled substantially, especially in the arena of multilateral trade negotiations. Its wide acceptance was in part nurtured by memories of the devastating protectionism of the interwar years. Interestingly, the strongest and most unequivocal intellectual support for it comes from a model whose assumptions are more than a little at odds with modern reality. The case for free trade becomes more ambiguous under circumstances involving product differentiation and intra-industry trade, economies of scale, imperfect competition, and externalities.

Nevertheless, while introduction of greater realism weakens the universality of the case for free trade; it does not add up to an argument for protectionism. When markets are free, it can readily be shown that trade should also be free. In the years since World War II, trade barriers have been reduced significantly, while many markets have become less free, with greater concentration of economic power and rising volumes of transactions that do not take place in markets at all. This is particularly true in the financial services industries. Hence, the alternatives to free trade are not just simply a return to protection, but strengthening competition in markets that are encumbered by public and private distortions.

In a recent paper published in this JOURNAL, Cooper and Massell [1] have argued that “customs union is necessarily inferior to an appropriate policy of non-preferential protection” (p. 745). This conclusion, the authors maintain, emerges naturally from the separation of the effect of customs union into two exhaustive components, the one a tariff reduction component and the other a pure trade diversion component. As the terms themselves suggest, the former incorporates the single potential gain from customs union.

These results depend crucially upon the assumption that the union is small and therefore incapable of influencing the terms of trade. Thus, the possibility that dominant terms-of-trade effects may endow the union with certain favourable outcomes which are not otherwise attainable need not be considered. It is the object of the present note to investigate the relevance of changes in the terms of trade to the conclusions reached by Cooper and Massell. It will turn out that even within the context of a model which resembles in most respects the one used by the authors, a positive terms-of-trade effect may indeed be dominant. However, and more important, it will be suggested that the relevant alternative to customs union is not unilateral, non-preferential tariff policy, but some form of international collusion. In the light of the latter, customs union may present the only effective solution to the problems of control and enforcement of “collective” policies.

The standard analytical vehicle of customs union theory consists essentially of a two-commodity, three-country model of the trading world. Within this framework, two of the three countries form the union, while the third “country” comprises the “rest of the world.” The latter is either assumed to contain a single country or, where several economies are involved, these are taken to be perfectly homogeneous, so that differentiation among them is immaterial to the analysis…

WHEN a country possesses monopoly power in the international markets in which it trades, a competitive free trade situation will be characterized by a disparity between the domestic and foreign rates of transformation. Achievement of an optimal solution requires that this disparity be eliminated in a manner which does not simultaneously destroy the equality between the domestic rate of substitution and the domestic rate of transformation. To this end, the theory of optimum tariffs provides a criterion for appropriate intervention in foreign trade by means of duties and subsidies on trade. A tax-cum-subsidy policy of intervention in domestic production, on the other hand, is not appropriate, because in removing the existing distortion it creates a new inequality between the domestic rate of substitution in consumption and the domestic rate of transformation. Consequently, a tax-cum-subsidy policy of intervention is necessarily inferior to an optimum tariff…

Fragmentation involves the decomposition of a production process into its constituent activities and the dispersion of those activities across national borders. It gives rise to cross-country production sharing and production networks. Under fragmentation, traded goods and services contain value added from more than one nation…

An important facet of “globalization” is the spread of cross-border production, which is variously known as intra-product specialization, super-specialization, or production fragmentation. This advanced stage in the international division of labor works particularly well between high-wage developed and low-wage emerging economies. But it is precisely this context in which the practice has been criticized for destroying jobs and undermining wages.

This paper examines the welfare implications of this type of specialization on the part of labor-intensive, import-competing industries in advanced countries. The results will surprise the skeptics, for when import-competing industries abandon production of labor-intensive components, wages rise and industry employment and output expand. National welfare increases. For a large country, the terms of trade improve, raising national welfare still further.

The following sections are included:

• INTRODUCTION
• TRADE LIBERALIZATION VERSUS ECONOMIC COOPERATION
• TRADE CREATION AND DIVERSION UNDER PRODUCTION SHARING
• THE EXCHANGE RATE AND THE TRADE BALANCE
• PRODUCTION SHARING AND FOREIGN DIRECT INVESTMENT
• FIXED VERSUS FLOATING RATES
• CONCLUDING REMARKS
• NOTES
• REFERENCES

This article discusses an approach to “open regionalism” based on regional production networks and component specialization. Component specialization, or intra-product trade, has been shown to be welfare-enhancing. It creates jobs and raises output by improving competitiveness. It is one of the innovative features of the current phase of globalization. It offers groups of small countries opportunities to make regionalism work in ways which the traditional European model does not. It is less discriminatory and less inward-looking than the European model. It stresses regulatory reform and the creation of a single market early in the process of regional economic integration. The welfare gains flow from elimination of market distortions and minimization of trade diversion.

This paper examines the repercussions of cross-border production sharing for the welfare effects of preferential trade liberalization. In a general-equilibrium context, a free trade agreement (FTA), which incorporates production sharing, raises the likelihood of welfare improvement. Thus, two members of a free trade area, who each have comparative disadvantage in the production of a final product relative to a non-member, may nevertheless enjoy net trade creation if they jointly possess comparative advantage in key components of that product. At a minimum, cross border production sharing reduces the trade-diverting elements of an FTA. It follows, that rules of origin, viewed as constraints on cross-border fragmentation, augment the negative, trade-diverting elements of free trade areas.

As cross-border production sharing and multi-country production networks expand to cover more countries and more goods and services, questions arise about their implications for stability and adjustment in the open macro-economy. Participation in a production network ties a country more closely to other members of that network, thereby reducing cross-border asymmetries and promoting cyclical convergence. This strengthens the case for monetary cooperation and currency integration. On the other hand, if network activities are confined to a narrow, but non-trivial part, of the economy, then cross-border convergence may come at the expense of rising asymmetries within the economy. Rising asymmetries may compromise the effectiveness of monetary and fiscal policies. When the standard open-economy macro model is amended to take account of production sharing, the consequences for policy efficacy are similar to those arising from greater capital mobility. Further, production sharing may enhance or diminish the case for cross-border policy coordination, depending on whether it is broadly based or narrowly confined to specific sectors and industries.

This paper examines the effect of cross-border production sharing on trade and exchange-rate behavior. When a country's exports contain imported components, changes in exchange rates tend to have offsetting effects on imports and exports. Imports may fall, remain unchanged or even rise with depreciation, depending on the share of domestic value-added in exports. The effect of domestic and foreign GDP on imports and exports is also altered by production sharing. These behavior patterns are identified in trade in motor vehicles between the United States and Mexico with the aid of OLS and VEC techniques.

This paper explores the implications of cross-border production networks and vertical intra-industry trade for macroeconomic adjustment and for the effectiveness of monetary and fiscal stabilization policies. Vertical intra-industry trade introduces direct links between countries’ imports and exports and thereby affects the manner in which trade balances respond to variations in exchange rates and to global shocks more generally.

The precise effects depend on whether the direct link runs from exports to imports or vice versa. In the U.S., for example, exports of auto parts and components rise with an increase of imports of passenger vehicles from Mexico. This produces a change in balance-of-payments adjustment similar to high capital mobility and raises the likelihood that a fiscal expansion will lead to appreciation rather than depreciation of the currency. In China and Mexico, on the other hand, a rise in exports of assembled end products raises imports of parts and components.

The differences in outcome are more pronounced under floating rates, because of the role of the exchange rate in the adjustment process. Direct export-import links undermine the impact of the exchange rate on the trade balance, hence necessitating larger changes in rates in order to achieve a given degree of adjustment and raising exchange-rate volatility as a result. In the case of both types of exchange-rate regime, vertical intra-industry trade weakens the response of the trade balance to price and income shocks.

The earlier chapters utilize traditional trade theory models of perfect competition, constant costs, homogeneous goods, services and factors of production and an emphasis on trade at the sectoral or industry level. It is, of course, well-known that much of international trade takes place under conditions of imperfect competition, distorted markets and variable returns to scale, as well as heterogeneity of goods, services and factors of production. When these conditions prevail, the so-called new trade theory with its focus on imperfect competition, economies of scale, and product diversification provides a more appropriate analytical approach…

Decision rules for stabilization policy in an open economy arc examined under alternative specifications of the balance of payments. In particular, distinction between interest-sensitive debt capital and equity capital which responds to an activity variable alters the comparative static properties of instrument assignment. Various aspects of dynamic adjustment are further investigated in a context in which time is endogenous and in which the decision process minimizes a criterion function. It is shown that traditional one-to-one pairing of targets and controls may be inferior to assignment of clusters of instruments to some targets for specified time intervals.

When two countries enter into a monetary union, the consequent extension of their mutual dependence impinges upon the nature and ordering of their economic goals and alters both qualitatively and quantitatively the policy instruments in their individual and joint possessions. The adoption of a uniform currency effectively removes the monetary instrument from the individual country's arsenal, and the freedom to employ fiscal controls is restricted because the transfer of monetary powers to the community constrains the available means of financing government outlays. The latter constraints operate even where each member country retains the right to issue the common money, for monetary conditions within any country are inseparably tied to conditions in the area at large…

The role of speculative short term capital movements in balance of payments adjustment and in exchange market stability is examined. A theory of speculative behavior with a distributed lag model of expectation formation at its core is developed and empirically tested using the Canadian data for the period 1952-1960. Tests of an alternative but generically similar specification of the model are also presented and discussed.

The following sections are included:

• Introduction
• Key Issues in the Debate
• New Perspectives on an Old Problem
• Evolving Economic Structure
• Concluding Remarks
• Acknowledgments
• Endnotes
• References
• Appendix

This paper examines adjustment in a model with three economies, two exchange-rate regimes, and varying capital mobility. In the benchmark scenario, the U.S. dollar fluctuates against the euro and the Chinese yuan, but capital mobility is high in the former and low in the latter case. This generates offsetting exchange-rate adjustments, which affect the efficacy of U.S. fiscal policy. In the next two scenarios, the yuan is fixed against the dollar. Rate pegging by a large country like China “interferes” with U.S. macro adjustment and undermines U.S. policy autonomy.

This paper uses a flex-price open economy macro model to examine the effectiveness of U.S. monetary and fiscal policies when the dollar floats freely against the euro, but is fixed against the Chinese yuan. It is assumed that capital mobility is high between the U.S. and the Eurozone, but low between the U.S. and China. The model allows for short-run price flexibility and imperfect substitutability between domestic and foreign financial assets.

The focus is on the implications for the efficacy of U.S. macro stabilization policies of China's fixed-rate strategy. While many countries have pegged their currencies to the dollar, China is large enough to have an impact. It is shown that its large size enables China to impede the effectiveness of U.S. macroeconomic policies. Indeed, while the U.S. is officially tagged as an independent floater, Chinese intervention is capable of interfering with dollar-euro flexibility and thereby creates outcomes that are more consistent with policy under fixed rates.

It is known that the effectiveness of macro policies depends on the exchange-rate regime. Pertinent models have typically considered either fixed or floating rates rather than mixed regimes. In recent years, however, the dollar has floated against most currencies, while being fixed against the yuan. This paper argues that a flex-price, dual-rate model consisting of the U.S., China and the Eurozone, combined with distinct adjustment patterns in tradables and non-tradables sectors and a tendency for policy makers to treat inflation in housing as pure asset inflation, provides a plausible explanation of the great moderation and its aftermath.

In the early nineties, the U.S. economy was emerging from a brief slump, monetary policy was easy, and economic activity recovered quickly during the decade, with GDP eventually reaching and then passing the consensus full employment level. Yet aggregate inflation remained surprisingly subdued. This moderation in prices at the aggregate level persuaded policy makers to allow the easy-money stance to continue in spite of the presence of inflation in non-tradables and in housing and construction in particular. This paper uses a flex-price, mixed-exchange rate model to examine some of the major contributing factors to economic developments in the two-decade period that ended in the financial meltdown and the great recession. It argues that Chinese exchange rate manipulation and China's preference for holding dollar reserves were important contributing factors. On the U.S. side, failure to understand the importance of differencial inflation patterns in tradables and non-tradables sectors, and especially failure to see inflation in housing and construction as goods rather than asset inflation, allowed monetary expansion to last much longer than it should have.

The following sections is included:

• Index