Chapter 14

Case Studies in International Trade

Germany: From Economic "Miracle" to Stagnation

• Growth rates in most of the industrialized world decreased sharply after 1973, but while some countries recovered, Germany did not.

• Labor costs were too high, both because of high wage rates and fringe benefits and an overvalued currency

• Generous welfare state and Eurosclerosis• German companies invested outside their country• Unification handled very poorly because of the political

decision to set Ostmark at the same value as the Deutschemark

United Kingdom: Rebirth After Thatcher

• From the end of World War II through the late 1970s, growth in the U.K. sharply lagged growth in other major industrialized countries.

• Thatcher was widely praised – or castigated – for severe cutbacks in government spending, but in fact government spending as a % of GDP declined only from 43% to 42% during her tenure in office. The growth spurt occurred after she stepped down for the following reasons

End of overvalued poundEnd of union stranglehold on wages and productivity gainsLower marginal tax rates and end of brain drainResurgence of venture capitalLess regulation and more deregulation

. Many of these changes were started by Thatcher, but because of the severe and prolonged deterioration of the economy, it took much longer than usual for these changes to benefit the economy.

France: the Case of Failed Socialism

• French politicians were determined to show the world that the so-called “Third Way” – democratic socialism – could produce better economic conditions than either “pure” capitalism or totalitarianism.

• It didn’t. Growth was much lower, and inflation much higher, than in most of Western Europe

• Only when France jettisoned that approach and adopted more of the trappings of capitalism did the growth rate pick up and surpass that of Germany

The Economic Impact of the European Community

• On balance, a system that eliminates tariffs and currency differentials and encourages free trade among countries is almost certain to boost real growth and productivity.

• However, these gains will be limited if other forces are interfering to reduce the overall growth rate of the region.

• In recent years, the dead hand of Eurosclerosis has outweighed the benefits of the Common Market and the Eurocurrency.

How the Huge Japanese Trade Surplus Backfired

• The demise of the Japanese economy has been even more stunning than in Germany. And they did not have the excuse of unification to explain their slump

• Like the Germans, the Japanese economy eventually suffered from an overvalued currency. But that is not the only reason.

• Oddly enough, the trouble started in 1986, when oil prices decreased. On the surface, that would appear to be a plus for an economy that imports virtually all of its energy.

Japan, Slide 2

• That decline created a huge trade surplus. The sensible thing would have been to liberalize import restrictions, but Japan declined to take that move. As a result, the trade surplus boosted the yen to unsustainable levels. It was also accompanied by a huge bubble in stock prices and land values.

• The Japanese financial system suffered from lack of transparency, cronyism, and corruption. Many companies were losing money and were kept afloat only by inappropriate bank loans.

Japan, Slide 3

• Finally, the stock market and land price bubbles burst, reducing consumption and investment. Also, exports declined in volume terms because of the overvalued yen. But because of a series of J-curves, the current-value net export balance kept rising, driving the yen even higher.

• As a result, Japanese companies decided to invest overseas, and the economy never recovered. Real growth has averaged less than 1% per year since 1991.

The Collapse of the Growth Tigers

• The massive decline in many Southeast Asian economies in 1997 and 1998 shocked many investors. But in retrospect, 10% annual growth was clearly unsustainable.

• Most of these countries were torpedoed by an additional factor, which was the dependence on foreign loans – which was not the case for Japan. The debt on these loans could only be serviced by ever-increasing exports.

• Exports fell in 1996 for two reasons. First, in many of these countries, labor costs had risen sharply. Second, prices of high-tech components declined sharply, which meant net exports in current prices fell even though the volume kept rising. Many firms could not repay their loans.

Growth Tigers, Slide 2

• When the current account balance fell, the currencies started to decline. As a result, even more firms could not repay their debts because they were denominated in dollars.

• The value of many Southeast Asian currencies dropped by at least half, and production ground to a halt until the IMF created a payback mechanism. Once that happened, real growth picked up again, but the halcyon days never returned.

• Some decline in the growth rate was inevitable, but the sharp recession could have been avoided if these countries had moved earlier to flexible exchange rates.

Growth in China: Miracle or Mirage?

• Any comment about the recent economic performance of China must be prefaced by the comment that the economic data released by the government is extremely untrustworthy. Thus while official statistics continue to proclaim growth rates of 7% to 8%, many private economists think the actual growth rate is only about 3%.

• There is no question that Chinese exports to the U.S. have been growing dramatically in recent years, with the U.S. trade deficit which China now exceeding $100 billion per year, far larger than any other country. The question is whether any other sector of the Chinese economy is growing, or whether millions of unreported Chinese are still starving to death

China, Slide 2

• For the foreseeable future, the Chinese economy can grow rapidly only if foreign investment remains at high levels. Unlike Japan, there is not nearly enough domestic saving to generate above average growth rates.

• The orderly transition of power in China, combined with the confession of some of its past sins, have been designed to convince foreign investors that Chinese investments will now generate satisfactory returns. The response has been positive, but the results remain unclear.

NAFTA and its Effect on the Mexican Economy

• Both the U.S. and Mexican politicians were eager for NAFTA to pass. The U.S. wanted the opportunity to sell Mexicans more goods, and also to open more plants in Mexico without facing tariff barriers. The Mexicans wanted to stop the outflow of skilled and motivated workers by providing better jobs.

Mexico, Slide 2

• However, since the U.S. had low tariffs but Mexico had high tariffs, their removal would boost Mexican imports more than exports, reducing real growth and causing the currency to decline. That is indeed what happened, aided by the revolution in Chiapas that worried many foreign investors.

• Thus the Mexican economy suffered a serious setback before it began to recover. While the benefits of free trade in the long run are substantial, it is sometimes the case that the transition should be more gradual.

The Brazilian and Argentinean Devaluations

• Brazil experimented with a “floating peg” that was designed to offset the differential rate of inflation with the U.S.

• Argentina apparently did everything right by pegging its currency to the dollar and backed it by gold.

• These moves should have generated stable currencies, but neither worked. Both countries were forced to devalue, leading to severe recessions.

Brazil and Argentina, Slide 2

• Brazil originally set the value of the real too high. Also, it refused to bring its enormous government deficit under control.

• Argentina’s main trading partner and competitor is Brazil. When that country devalued, Argentine goods were no longer competitive, so it too went into recession. The decline in net exports eventually forced the peso to fall to lower levels.

Pros and Cons of Free Trade in an Imperfect World

• Retaliate Against Dumping

• Countervailing Duties to Offset Subsidies

• Worldwide Monopolies

• Infant Industry Argument

• Terms of Trade for Commodities

• Peril-Point Tariffs

Free Trade, Slide 2

• National Defense

• Diversification

• Lower Real Wages

• Tariffs for Revenues

• Optimal Tariff

• Political Unrest

Factors Boosting Growth

• Currency correctly valued in terms of PPP• Minimal import restrictions on trade• Few restrictions on international flows of

labor and capital• Government that functions by rule of law• Political freedom and encouragement of

entrepreneurship and innovation• Tolerable level of bureaucracy and

minimal corruption

Growth Criteria, Slide 2

• Independent, credible monetary policy committed to low, stable inflation

• Full-employment balanced budget• Relatively low marginal tax rates, especially on

capital• Less regulation and more deregulation • High domestic saving and investment ratio• Ability to attract foreign capital, including

repatriation of foreign earnings