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IMF Institute seminar: Countries need to assess domestic objectives in deciding extent of global economic integration

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International Monetary Fund. External Relations Dept.
Published Date:
January 2000
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Based on a simple but powerful promise—that international economic integration will improve economic performance—globalization has tremendous appeal to policymakers and world leaders as a development strategy, according to Dani Rodrik of Harvard University. Speaking at a seminar organized by the IMF Institute in Washington on May 15, Rodrik explained that as countries reduce tariff and nontariff barriers to trade and open up to international capital flows, the expectation is that growth increases. This, in turn, will reduce poverty and improve the quality of life for most of the population of developing countries.

But, he asked, does this glowing description paint a true and complete picture? Is opening up to capital markets alone sufficient as a development strategy? Is, as some world leaders and policymakers have declared, “integration into the world economy the best way for countries to grow”? Or does globalization—with all its admittedly potential benefits—need to be seen as only part of the picture? These questions need to be asked, Rodrik said, because strategy and priorities matter when administrative capacity, human resources, and political capital are limited, as is inevitably the case in small developing countries.

Does trade promote growth in small economies?

The answer, Rodrik said, is “it depends.” Proponents of globalization claim that countries with lower policy-induced barriers to international trade grow faster. But, Rodrik asserted, the empirical evidence does not back this claim of a direct link between trade policies and growth. In fact, he said, even in theory, the effects of lowering trade barriers are ambiguous. Notably, while models of endogenous growth indicate that lower trade restrictions boost output growth in the world economy as a whole, a subset of countries may experience diminished growth. In particular, trade liberalization may push resources into sectors in which a country has a comparative advantage but which are technologically less dynamic than the sectors benefiting from protection.

The widespread belief that openness is linked to growth appears to derive from much of the recent empirical literature, Rodrik said. But, in his opinion, there are problems with the methodology used in these studies. Their results are questionable because they do not control for other relevant country characteristics; in particular, he said, the results “conflate trade policy with other policies and variables, such as level of macroeconomic stability, quality of institutions, and geographic location.”

Despite this tendency in academic and policy discussions to greatly overstate the systematic evidence in favor of trade openness, Rodrik stressed that he was not suggesting the opposite—that trade protection is good for economic growth. Indeed, there is no credible evidence, he said, that suggests that trade restrictions are systematically associated with higher growth rates. What he emphasized, though, is that caution and humility are called for in interpreting cross-national evidence on the relationship between trade policy and economic growth. Countries that do a poor job handling volatility in the international environment are not necessarily insufficiently open but, rather, have had trouble managing their openness. Some countries that have remained relatively closed have weathered serious crises and have prospered.

Many observers point to the experience of developing economies—especially the East Asian economies—during the 1970s and early in the 1980s as an example of open economies outperforming closed ones. But, Rodrik observed, the 1970s were turbulent years—rocked by major crises—and are thus not a good control period. For example, in the years before the oil shock of 1973, East Asia was doing well, but so also were other newly industrializing countries in Latin America, the Middle East, and North Africa. After the oil shock, Latin America and the Middle East suffered serious reversals, while Asia remained afloat, and some countries, like India, weathered the storm relatively well. Why did some countries sink and some stay afloat? It is misleading, Rodrik said, to focus solely on the trade strategies of these countries. Countries that did not succumb were able to adjust their macroeconomic policies in the aftermath of the oil crisis, even though some, like India, had highly restrictive trade policies. Others, especially in Latin America and the Middle East, went on a “borrowing rampage” that culminated in a disastrous debt crisis. In addition, Rodrik noted, the countries that fell apart had deep social and economic cleavages and weak institutions for conflict management, such as the rule of law, governance, and democracy.

Korea’s experience provides another example, Rodrik said. Korean trade and industrial policy in the 1980s was characterized by marked subsidization, administrative guidance, and implicit guarantees for investors in favored sectors. Yet the economy performed well. Now we have decided that free trade and most capital flows are good, so we are building a new set of rules, Rodrik said. But it is disingenuous to use the experience of the “Asian tigers” as an example, because before the latest crisis, they, like Korea, had been following models that did not adhere to the rules we are trying to develop today.

Capital flows

Proponents of international integration of capital markets claim that free flows of capital augment domestic saving and encourage higher domestic investment rates. But, Rodrik noted, domestic saving will rise, as happened in East Asia, if domestic investment possibilities already exist or are created, without the catalytic benefit of external flows. Moreover, the statistical evidence shows that although growth spurts promote higher rates of saving, saving booms do not necessarily increase growth.

Adherents of capital market integration also claim it permits portfolio diversification; facilitates the undertaking of higher return, higher risk activities; allows consumption smoothing; exerts discipline on fiscal and monetary policies; and generates positive technological externalities in the case of foreign direct investment. However, Rodrik noted, in the presence of asymmetric or incomplete information, inadequate enforcement of property rights, incomplete contracting, and weak regulatory structures, such integration can result in credit rationing, capital flows that move in the “wrong” direction (that is, from poor countries to rich countries), boom-and-bust cycles, and periodic financial crises with severe real consequences.

International economic arrangements

Adherents of international economic integration counter arguments about the potentially damaging effects of open capital markets by pointing to the benefits provided by international economic arrangements, Rodrik said. By adopting internationally accepted codes and standards and regulatory and legal frameworks, countries enhance their credibility and instill confidence in potential investors; these standards and regulatory frameworks also help shield their own economies from attacks, reversals, and setbacks. However, these arrangements may not be particularly development friendly, Rodrik argued, for several reasons. The budgetary and administrative costs, for example, of implementing World Trade Organization agreements or other international financial codes and standards may be prohibitive. Standardization of law may not be the most effective way of building legal institutions in developing countries. Also, priorities may differ from country to country, depending on the development strategy: for example, trade and finance versus public health, human resources, and labor mobility. And finally, the general adoption of international standards and regulations raises questions about domestic ownership and popular voice in rule making.

Thus, despite what passes for the prevailing conventional wisdom, integration into the world economy may not, by itself, be the best or only way for countries to grow, Rodrik concluded. Strategic use of international trade and capital flows is certainly part of a development strategy but does not substitute for it. The issue, Rodrik stressed, is not “more trade versus less trade,” or “more openness versus less openness.” It is, rather, whether globalization is a viable development strategy in and of itself. What policymakers should focus on, he said, is the degree to which policies and institutional reform should be targeted on trade and capital flows, as opposed to domestic investment, technological capabilities, and institutions that serve purposes far beyond that of facilitating globalization. Policymakers may certainly want to incorporate some features of external models into their development strategies—especially those that will enhance a country’s attractiveness to foreign investors. But the choice of priorities and institutions should be homegrown; tailored to domestic needs, aims, and objectives; and based on a consensus drawn from all segments of the domestic population.

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