TCS Daily

No More of the Same Mistakes

By Desmond Lachman - December 8, 2005 12:00 AM

Editor's note: This essay is the winner of the recent TCS writing contest that asked writers and scholars to answer the question: "How Can Free Trade Boost Latin American Economies?"

Rudi Dornbusch, the renowned MIT economist, used to say of the Bank of Mexico's board of directors that he could understand their making mistakes. For after all, they were human. However, what he could not understand was how the same people could make the same mistakes time after time.

The same might perhaps be said of Latin American policymakers when it comes to trade policy issues. For time after time, these policymakers retreat from free trade policies each time they encounter the first setback to those polices. They do so despite the patent long-run benefits that their countries might reap from a properly supported liberal trade regime. They also do so in the face of overwhelming evidence from around the globe that free trade is an essential ingredient for successful economic growth.

From the time of Adam Smith and David Ricardo, economists have almost unanimously recognized the many benefits that flow from free trade. Amongst these benefits is the fact that free trade allows domestic producers to exploit economies of scale that they could not possibly enjoy in a small domestic market. Equally important are the benefits that free trade brings to domestic consumers through wider product selection and through increased competition. And then there are the benefits that open markets bring by pressuring domestic policymakers to pursue disciplined economic policies.

If the classical economists came up with the theoretical arguments favoring free trade, the contrasting experience in the industrialized countries between the 1930s and the post-war period provides compelling evidence supporting open markets. Determined not to repeat the protectionist mistakes of the 1930s, the architects of the post-war international economic order placed trade liberalization high upon their list of policy priorities. And the economic results of that new order surpassed even their most optimistic expectations. Global economic performance proved incomparably better than in the inter-war years, with an even more rapid expansion of world trade driving the rapid rise in global GDP.

From the 1960s onwards, a number of developing countries also began to recognize the enormous benefits of trade openness. East Asian economies in particular experienced economic miracles as they abandoned import substitution policies and adopted outward-oriented development strategies. Amongst these countries, Korea's remarkably high growth over a period of 40 years is perhaps the most striking. However, other countries, including China, Malaysia, Singapore, Thailand, and Taiwan, all achieved impressively rapid and sustained growth through outward-oriented trade strategies.

In contrast to the Asian tigers, most Latin American countries, with the notable exception of Chile, have not been nearly as persistent in opening up their economies to international trade. As a result, most Latin American economies today are classified as relatively closed to trade and are lacking the outward dynamism of their Asian counterparts. It is this lack of openness that goes a long way toward explaining why Latin America has not lived up to its economic potential despite its being so rich in human and natural resources.

It is true that Latin American tariff rates have moved downwards across the continent from an average 49 percent in the mid-1980s to around 11 percent by 2000. However, there are still import tariff peaks, high effective protection rates for some goods, and non-tariff barriers, which all restrict free trade. In addition, much remains to be done to liberalize Latin American trade in services such as communications, transport, and finance. In today's more service driven world, these activities are such important inputs for production and trade.

Both theory and experience suggest that the benefits to be gained from freer trade are all the greater if other countries are freeing their trade at the same time. After all, this was the industrialized countries' post-war multilateral approach that met with such great success. It is also the reason why the successful completion of the present Doha round of multilateral trade liberalization would seem to be so important for Latin America.

In the event that the Doha round remains stalled, it would be a grave mistake for Latin American countries to passively accept the status quo. The experience of many countries -- among them Chile, Hong Kong, Korea, and Singapore -- has shown that unilateral trade liberalization brings significant benefits. And it does so without prejudice to the benefits that might be gained from future multilateral trade liberalization.

While multilateral trade liberalization would be the best way for Latin American countries to go in opening up their markets, further regional trade arrangements, like NAFTA and CAFTA, would also offer important benefits to the continent. They can do so provided that they are fashioned in a way that leads to trade creation rather than to trade diversion. It is also important that these regional trade arrangements be designed so that they lead to lower rather than to higher barriers to multilateral trade liberalization.

Experience suggests that there are many ways for Latin America to reap the benefits of freer trade. However, in the Latin American context, it cannot be overemphasized that free trade is not a panacea for faster economic growth. Indeed, for free trade to produce its full potential, it must be supported by broader economic reform and by prudent financial policies. All too often in the region, the benefits that would otherwise have flowed from freer trade have been negated by fiscal profligacy, by monetary excesses, or by ill-conceived exchange rate experiments.

The Book of Ecclesiastes teaches that for everything there is a season. As in most other parts of the world, Latin America is presently experiencing more buoyant economic growth than it has seen for many years. A better moment for freeing up trade is unlikely to present itself. It would be a crying shame if Latin America turned up this opportunity to adopt a more outward looking growth strategy, which has served so many other emerging market economies so well.

Desmond Lachman is a Resident Fellow at the American Enterprise Institute where he focuses on major emerging market economies and the role of the multilateral lending institutions. Before joining the AEI, he served as a managing director and chief emerging market economic strategist at Salomon Smith Barney. He previously served as Deputy Director in the International Monetary Fund's Policy and Review Department and was active in staff formulation of IMF policies toward Latin American economies. Lachman has written on topics such as economic policy, fund arrangements, monetary reform, import restrictions, and exchange rates.

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