Econ 102 --- The World Economy

Simon Fraser University

Summer 2015

Instructor: Yang Wang

Topic 2: Institutions

Outline:

• Definition of int’l institutions • The three main institutions • RTAs • The role of Int’l institutions • Criticism of int’l institutions

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International Institutions:

• Definition of institution: Rules and organizations that govern and constrain behavior

– Formal institutions: Written sets of rules that explicitly state what is and is not allowed (embodied in a club, an association, or a legal system)

– Informal institutions: Customs or traditions that define appropriate behavior, but without legal enforcement (e.g. the rules of socializing, gift exchange, table manners, e-mail etiquette)

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TABLE 2.1 A Taxonomy of International Economic Institutions, with Examples

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The Three Main Institutions:

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• IMF (International Monetary Fund): Financial Assistance

• World Bank: Development Assistance

• WTO (World Trade Organization): Trade Policy Regulation and Negotiation

IMF: • IMF is the central monetary institution in today’s international economy

• Founded by 29 countries at the Bretton Woods conference in July 1944 and began operation in 1945

• Currently (in 2012), 188 members

• Original purpose: to strengthen int’l cooperation

– Originally enforced pegged exchange rate to prevent “beggar-thy-neighbor” exchange rate policies

• Main function: provides financial assistance (loans) to its members.

• Major currencies switched to floating in 1970s

• Funding for the IMF comes from its membership fee, or quota

the size of quota depends on:

– size of the economy

– Importance of its currency in world trade

• Important decision are made by vote, the weight of vote is proportional to quota, so high-income countries have higher voting power

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IMF (cont’d) • The most visible role for the IMF is to intercede, by invitation, whenever a

nation experiences a crisis in its international payments.

– if a country imports more than it exports, then it may run out of foreign exchange reserves.

– Foreign exchange reserves are dollars, yen, pounds, euros, or another currency (or gold) that is accepted internationally.

– IMF has its own currency, called an SDR, or special drawing right. SDRs are based on a country’s quota and are a part of its international reserves.

• In the event of a financial crisis,

– Members borrow against IMF quotas

– Subject to IMF conditionality: Requirement for the borrowing member to carry out economic reforms in exchange for a loan, e.g. a cut in currency value, limits on the central bank’s creation of credits.

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World Bank:

• Original purpose – To provide financing mechanisms to rebuild Europe after World War II

• Main function today

– Assisting development in non-industrial economies

• Has same membership and similar structure to IMF

• Member’s voting rights are proportional to number of shares owned

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The GATT, the Uruguay Round, and the WTO: • Began with 23 nations in 1946 when the International Trade Organization (ITO)

was established

• The General Agreement on Trade and Tariffs (GATT) followed in 1950

• The GATT functioned through trade rounds: countries periodically negotiate a set of incremental tariff reductions

• During the Kennedy Round in the mid-1960’s, and the Tokyo Round in the 1970’s, other issues included:

- Problems with dumping

- Subsidies to industry

- Nontariff barriers to trade

• The Uruguay Round established the WTO (1995) • The Doha Round/Doha Development Agenda (2001-2006)

– Focused on trade issues of importance to developing countries

• The General Agreement on Trade and Tariffs (GATT) followed the following principles: – National treatment: Imports must be given similar treatment on the domestic market as

domestically produced goods – Nondiscrimination: Enshrined in the concept of most favored nation (MFN); a

prohibition against discrimination

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Regional Trade Agreements (RTA):

• RTA is another important institution in the world economy.

• between two (bilateral) or Several countries (plurilateral)

• Called multilateral agreement because it includes, potentially, all the countries of the world.

– The WTO is not an RTA because it is worldwide in scope

• Five types of RTAs

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Regional Trade Agreements (RTA): Five types of RTAs:

1. Partial trade agreement: Two or more countries agree to drop trade barriers in a selected group of product categories such as steel or autos (the least comprehensive RTA)

– The U.S.-Canada Auto Pact

2. Free-trade area (FTA): Nations trade goods and services across international boundaries without paying a tariff and without the limitations imposed by quotas.

– NAFTA (North America free trade area),

– EFA (European free trade area)

3. Customs union (CU): An FTA plus a common external tariff (CET) – European Union in the 1970s and 1980s – MERCOSUR in South America

4. Common market: A CU plus an agreement to allow the free mobility of inputs, such as labor and capital.

– The European Union in the 1990s

5. Economic Union: A common market with coordination of macroeconomic policies (including common currency, harmonization of standards and regulations)

– The states of the United States

– The provinces of Canada

– The 12 European Union members participating in the Euro currency zone

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Other Institutions:

• G-7, G-8, G-20: Groups of countries – G-7 = US, Canada, Japan, Britain, France, Germany, Italy

• Finance ministers meet regularly • Heads of state meet annually

– G-8 = G-7 + Russia (1998-2014) • Heads of state met annually

– G-20 = G-8 + Australia & EU, + 10 major EMEs (Emerging Market Economies)=19 countries + EU • meet regularly, but only the finance ministers

• UN (United Nations) – Founded in 1945, currently 193 members – Promote international cooperation

• OECD (Organization for Economic Cooperation and Development) – Club of mostly high-income countries – Does research, collects data, drafts policies – Does not have any direct power

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RTA and the WTO:

• When a WTO member signs an RTA, it is obligated to notify the WTO.

• Since 1948, over 500 agreements have been listed with the WTO; with majority of the notifications since 1990

• 338 of these agreements are still active (2012) • The WTO and GATT allow RTAs, assuming they create

more new trade than they destroy trade creation > trade diversion

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For and Against RTAs:

• The central economic question: • Are RTAs supportive of gradual, long run increases in world trade (building

blocks), or • Do they tend to become obstacles to further relaxation of trade barriers

(stumbling blocks)?

• Proponents view RTAs as building blocks toward freer, more open world trade. 1. Easier for a few countries to reach agreement than it is for all the countries in the WTO.

2. The domestic effects of a reduction of trade barriers are less dramatic.

3. RTA member countries can experiment with new agreements.

4. RTAs can be used as a political and economic threat to encourage agreements in the WTO.

• Opponents’ criticism: 1. RTAs undermine progress toward multilateral (worldwide) agreements. 2. Pro-trade opponents do not believe that they encourage agreements through the WTO 3. RTAs are often discriminatory against poor and less-developed countries

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The Role of International Economic Institutions:

• The primary difference between international institutions and national governments is that the former have limited enforcement power

• Two important functions of international economic institutions:

– Maintaining order in international economic relations

– Reducing uncertainty

• Order and certainty are intangibles that are different from most goods and services

• Order and certainty are public goods.

Public goods are: – Nonexcludable: The normal price mechanism does not work as a way of regulating access to

them

– Nonrival (or nondiminishable): They are not diminished or reduced by consumption

– Private markets fail to supply public goods because of free riding: People have no incentive to pay for a public good because they cannot be excluded from its consumption even if they don’t pay

Two important functions of international economic institutions reduce free riding.

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Criticism of International Institutions:

• Sovereignty and Transparency – Sovereignty refers to the rights of nations to be free from

unwanted foreign interference in their affairs. – International institutions can violate national sovereignty by

imposing unwanted domestic economic policies – Transparency concerns are based on questions about the

mechanism with which decisions are made within an international institution

• Ideology – the advise and technical assistance provided to developing

countries are often a reflection of the biases and wishes of developed country wishes.

• Implementation and adjustment costs – When agreements are reached that combine developed and

developing countries, there are often asymmetries in the ability to absorb the costs associated with them that favor developed nations.

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