Source: Kozul-Wright and Rayment (2004)
main exports are primary commodities have exposure to terms of trade
volatility. Most developing countries
are primary commodities exporters when they first open themselves up to trade;
see Table 5 for details showing that the countries that are primary exporters
are developing countries. The income
elasticity of demand for primary commodities is lower than manufactured
goods. The Prebisch-Singer hypothesis
states that the terms of trade will hurt exporters of primary commodities over
time because exporters will not be able to purchase as many imports. An example of this problem was the price of
corn, which is a primary commodity, in
Trade liberalization must be implemented slowly so that markets that are exposed to world prices can diversify into different goods or markets (Winters et al (2004)). The best way to mitigate the terms of trade concern is to diversify away from exporting primary commodities. Exporting manufactured goods has worked well for the East-Asian countries over the past few years.
If price volatility causes prices to get too expensive, then social safety nets, such as deferred payments or subsidized inputs, may be provided so that producers can smooth production, and therefore smooth output. These should only be considered as short-term solutions because long-term safety nets will impede incentives.
Increased competition leads to lower prices. Lower prices, even though they may be volatile, are ultimately better for the consumer. In addition, if there are many suppliers of a particular good, then consumers are no longer subject to the decisions of a limited number of suppliers.
Those who are just above the poverty line are net producers of primary commodities, and therefore are hurt by the fall in primary commodity prices. This can have an adverse effect on absolute poverty because more people may be below the poverty line than before trade. However, lower prices of primary commodities will have a positive effect on the extreme poor because they are net consumers of primary commodities (Winters et al (2004)).
volatility not only requires sound institutions and policies, but it also
requires countries that already have bad policies and institutions to implement
reform carefully. Government purchasing
programs are prime examples of programs that should be
Sound policies and institutions can minimize the volatility from trade shocks. Safety nets should be provided for the poor who are unable to cope with the negative effects of volatility from trade shocks. Safety nets, coupled with sound policies and institutions, will insure that globalization has the opportunity to be pro-poor. Exporting products that have less exposure to world price fluctuations will also limit the volatility from trade.
(2.2) Tariffs and Subsidies
Trade is liberalized when tariffs and subsidies are reduced. Negotiations among countries about changing tariffs and subsidies are slow. No country wants to be at a competitive disadvantage from lowering its tariffs or subsidies before its trading partners lower theirs. Unfortunately, the use of tariffs and subsidies create a suboptimal situation whereby resources are not used efficiently. These inefficiencies hurt the poor.
Without free trade, the developing countries remain too poor. Trade can be advantageous for all participants because each country should produce the goods that it has a competitive advantage to produce. A country has a comparative advantage to produce a good when it can produce the good cheaper than its trading partner can. When country X (country Y) trades the goods that it has produced using its comparative advantage with country Y (country X), both countries gain because each countries is able to consume more total goods.
The Heckscher-Ohlin theorem predicts that trade will favor the abundant factor because a country will have a comparative advantage when it produces goods that use the abundant factor. Goods that are imported use the scarce factor, according to the Heckscher-Ohlin theorem. Therefore, when tariffs reduce the amount of goods imported in a developing country, consumers in the developing country have to purchase these goods from domestic sources. These goods will cost more for the consumers, which can be bad for the poor if the cost of purchasing these goods is larger than the increased wage from producing these goods.
In addition, according to the Stolper-Samuelson theorem, which predicts that an increase in the price of goods will lead to an increase in the price of the factor used intensively to produce those goods, the real reward to the scare factor (capital) will decrease and the real reward to the abundant factor (labor) will increase during free trade. Therefore, high import tariffs depress the wages of unskilled laborers because wages do not raise to their free trade levels.
In the short-term, not all tariffs are bad. Nissanke and Thorbecke (2005) argues that trade liberalization is the most successful when export promotion precedes import liberalization. Export promotion occurs when export tariff rates are set low, when the exchange rate is undervalued, or when the government provides subsidies to firms that export. This creates an incentive for domestic firms to produce goods for exportation. The East Asian countries that followed this approach have had some success. In addition, export promotion allows export producers to strengthen technological capabilities.
Larger gains to the people in developing countries would come from lower tariff rates than were discussed at the Doha WTO talks. Figure 2 shows that the gains from free trade are larger than the gains from the tariffs and subsidies agreed upon at the Doha WTO talks. The World Bank estimates that "if trade in industrial and farm products were fully freed, the one-off gains from reallocating resources more efficiently could boost income in developing countries by $86 billion by 2015 and pull an extra 30 million people out of extreme poverty" (Economist (2005d)). An agreement on free trade for services (from telecoms to legal work) and industrial goods would also lower poverty dramatically (Economist (2005b)). The World Bank estimates that the gains from complete tariff reduction across all countries would result in $200 billion extra income world-wide, which would pull many people out of extreme poverty (Economist (2005d)).
Tariffs should be reduced in both developing and developed countries (Economist (2005c)). Lower tariffs in developed countries will decrease poverty in developing countries because a large proportion of the poor in developing countries are farmers. However, the representatives who participate in the WTO talks have focused too much attention on lowering tariffs and cutting subsidies in developed countries. However, this is not the only problem: lower tariffs and subsidies in developing countries comprise half of the potential gains that developing countries can expect from free trade because one-third of trade for a developing country is with other developing countries (Economist (2005d)). Tariffs and subsidies should be lowered incrementally to allow markets to adjust. This has been the traditional policy of the World Trade Organization (WTO).
Agreement among countries for the appropriate tariff and subsidy amounts is difficult to attain. Over the past year, the WTO has had several rounds of discussion about how much tariffs and subsidies should be lowered. Observers of these talks agree that countries have a hard time reaching agreement (Economist (2005e)). One problem that makes reaching agreement difficult is that several factions from both developing and developed countries want protectionism. For example, during the Hong Kong WTO talks, South Korean rice farmers demonstrated against freer trade in their markets. The rice farmers are concerned because they fear that world competition will lower the price of rice. This creates problems for politicians who would like to negotiate for lower worldwide tariffs and subsidies.
Another problem that
makes reaching agreement difficult is that the expected results of the WTO
talks vary widely among countries (Economist (2005e)). The European Union does not want to cut its
farming subsidies (which, despite all of the focus on cutting subsidies, will
only increase the gains from the trade by 2%).
The Americans do not expect to dramatically lower subsidies on cotton. However, most countries agree that subsidies should be cut in the European Union and that subsidies
should be cut further in
Unfortunately, talks among countries have been relatively stagnant despite ongoing efforts. Finding agreement among everyone has proven to be very difficult. Academic and political efforts should be placed on finding an alternative approach to handling these WTO talks because the gains that can be made for the poor are enormous. Furthermore, even when countries reach agreement about lower tariffs and subsidies, many of these countries do not implement them on time. Emphasis needs to be placed on mechanisms that would create the necessary incentives for countries to implement lower tariffs and subsidies on time.
Tariff and subsidy reduction depend not only on successful negotiations and implementation but they must also be paired with an anti-dumping policy so that markets are not undermined. Dumping occurs either when a foreign firm sells its goods to an international market sold for less than its production costs, or when the foreign firm sells its goods internationally for less than the firm sells the goods for in its own country. The goal of the dumping firm is to gain market share or hurt competitors. These actions hurt the natural competitiveness of markets because artificially low prices from dumping may limit (destroy) the creation (existence) of long-term competitive firms. Anti-dumping policies can lead to protectionism, which is when the tariff structure of a country is set so that consumers favor domestically produced goods over imported goods, whereas anti-dumping policies are supposed to regulate the activity of dumping, not discourage goods from being imported (Beth Yarbrough and Robert Yarbrough (2000)). Fortunately, the Uruguay Round of the WTO talks partially dealt with this problem. If countries want to keep anti-dumping measures in effect for more than five years, they have to provide evidence to show that removing the protection would cause undue damage to domestic companies.
This paper is emphasizing fair trade among all trading countries. Fair trade requires common subsidy and tariff levels. Fair trade allows countries to produce and export goods that have a comparative advantage. Fair trade can be regional or global, and Deardorff (2005) finds that countries have a desire to join PTAs (Preferential Trade Areas), which are regional, when liberalizing trade. This paper is not suggesting that trade zones are the best solution, because trade zones only benefit the countries that participate. PTAs are worse than global fair trade because producers do not produce according to their comparative advantage because trade diversion, which is when the tariff structure among countries within a PTA favors goods produced within the PTA, creates an incentive for consumers to favor goods produced within the PTA. Consumers would be able to consumer more goods if they could purchase goods produced by producers that have a comparative advantage. PTAs also favor trade creation, which allows industries to grow when they might not have otherwise had a chance to compete in these sectors. Although infant industry protection is justifiable in the short-term, in the long-term this protection creates a disincentive for industries to become globally competitive.
Until no PTA’s
exist, global fair trade is not possible.
Therefore, with our current global structure of PTA’s, if a country does
not join a
Changes in tariffs and subsidies are hard to enact. The members of the WTO talks regularly delay these talks and the talks rarely attain drastic results. Lower tariff and subsidy levels allow imported goods from developing countries the opportunity to compete with domestic goods in the developed country. Overall, if all countries lowered tariffs and subsidies simultaneously, the gains from trade would far outweigh the negative effects that would occur to industries that are currently producing goods inefficiently. Over the long-term, tariffs and subsidies hurt the poor because fair trade can lead to pro-poor growth.
(2.3) Introduction to the Labor Market
The poor can have a hard time gaining from trade liberalization because they are not equipped for exportation of the goods that they produce. The wage of the poor will not increase unless the poor can find jobs linked with the export sector. Trade can lead to higher prices for certain goods, but trade should lead to an increase in the real. Assuming labor mobility, trade should lead to increased real wages for the poor. Labor mobility allows workers to move from shrinking sectors into expanding sectors over the long-term. Unemployment may arise in the short-term; however, mixed empirical evidence is available about whether unemployment rises in the short-term after tariff changes.
New sectors can
develop, which can provide new jobs for the poor, after trade liberalized. In
In a developing country, producers will export goods produced that have a comparative advantage. These goods will use unskilled labor because unskilled labor is the abundant factor in developing countries. The prices of the goods produced with comparative advantage will increase, and therefore, according to the Stolper-Samuelson, the wages of workers in these sectors will increase. The wages of the workers in the shrinking, once-protected, industries will decrease. The consumption effect states that the higher priced goods produced by unskilled workers will lower the amount of goods that consumers can purchase, holding income constant. According to the Heckscher-Ohlin model, the price of the abundant factor increases after trade. The income effect states that, in developing countries, the nominal wage of unskilled workers increases because they are the abundant factor of production. Goldberg et. al (2004) write about Jones (1965), who shows with the Heckscher-Ohlin model that over the long-term the consumption effect is smaller than the income effect, and therefore, the higher wages and prices in the unskilled labor market is beneficial for unskilled laborers.
In the short-run, when factors are immobile, trade liberalization will have different effects depending on the preexisting tariff structure. In protected sectors that employ unskilled workers, these workers will face lower wages or higher unemployment after tariff reductions. Unskilled workers are already at the lower end of the income distribution, and are more likely to be closer to the poverty line. The reduction of tariffs in these sectors may have contributed to increased poverty in some countries over the short-term.
Although unemployment effects should only exist in the short-term, unemployment is important to study because increased unemployment drags people into poverty. Therefore, during the short-term, those who become unemployed need a safety net to protect them from extreme poverty. Goldberg et al (2004) explain that that a way to measure the effect of trade policy on unemployment is to look at the correlation between unemployment levels before and after tariff reductions.
Household surveys performed by developing countries lack information about what industry the unemployed used to work in or about what industry they are currently seeking work in. Goldberg et al (2004) explain that without transitional unemployment information, it is very difficult to gauge the impact of tariff reductions on unemployment.
In sectors that
have had tariffs reduced, they expected unemployment levels to be worse. However, in
Disagreement exists between Goldberg et al (2004) and Winters et al (2004) about the effect of trade liberalization on unemployment. Whereas Goldberg et al (2004) state that there is no correlation between tariff reduction and unemployment, Winters et al (2004) write that the duration of unemployment was the longest in sectors that had the largest tariff reductions. Winters et al (2004) explain that temporary unemployment may also exist while labor markets adjust to new prices in the goods market.
Trade liberalization requires tariff and subsidy reduction. Ideally, trade should be a net positive for the society, and enough money for transfers, in the short-term only, should be available to make everyone at least no worse off than before trade liberalization. In the long-term, labor mobility will allow the unskilled laborers to move into growing sectors and receive higher real wages.
(2.4) Income Inequality
Economists generally view increased income inequality as having a negative impact on the poor. Narrowing the skill gap between unskilled and skilled workers will lower income inequality. However, even if trade liberalization increases income inequality, traditional sector enrichment will have an overall positive impact on the poor because absolute income relative to the cost of living increases for unskilled workers during traditional sector enrichment. Heshmati (2004) concludes that increased trade has a small impact on reducing income inequality.
Improved access to new technology after trade liberalization has increased the marginal productivity levels of skilled workers. This has increased their per capita income levels. Inequality will rise unless skilled-biased businesses create linkages with unskilled-biased businesses because these linkages can cause the absolute income levels of the poor to rise. One example of a linkage is when a skilled-biased company demands more goods from an unskilled-biased company. Another example of a linkage is when a skilled-biased company creates intermediate inputs that are used by an unskilled biased company.
There is dispute
about whether trade liberalization increases or decreases income
inequality. Winters et al (2004)
highlights this dispute by stating that the East Asian countries have
experienced a narrowed gap between skilled laborers and unskilled laborers
after trade liberalization whereas the Latin American countries have
experienced a wider gap between these two labor markets. It is important to try to understand the
difference between these two regions to learn why
workers gain more skills, the income gap between unskilled and skilled wages
increases initially after globalization (Nissanke and Thorbecke (2005), who
write about Agénor (2002)). Policies that focus on upgrading the skills
of unskilled workers promotes modern sector enlargement, which is pro-poor for
those the new skilled workers. The
unskilled workers in
(2.5) Unskilled laborers
In the long run, an increased demand for unskilled labor in developing countries from trade will cause poverty to decline. Trade has the ability to move some informal workers, who typically earn very low wages, into the formal wage market (Bardhan (2004a), who wrote about Hertel et al (2003)). In developing countries, trade will lead to an increased demand for unskilled laborers, which will lead to an increased wage for these laborers. In addition, a positive side effect of trade liberalization is increased compliance with minimum wage requirements (Goldberg et al (2004)).
Two opposing effects affect the real income levels of unskilled workers. The consumption effect lowers real income for these workers because they have to pay higher prices for unskilled labor goods, such as food. The income effect raises real income because these workers are receiving higher wages. According to the Heckscher-Ohlin model, the income effect is larger than the consumption effect, and therefore, the higher wages and higher prices are beneficial for unskilled laborers.
According to the Stolper-Samuelson theorem, which predicts that an increase in the price of goods will lead to an increase in the price of the factor used intensively to produce those goods, the real reward to the scare factor (capital) will decrease and the real reward to the abundant factor (labor) will increase. Therefore, the wages of unskilled laborers should increase after trade. However, many unskilled laborers work in the agriculture sector, and therefore, there are counter-effects from trade, such as the effect of trade on primary commodities, that also affect the real wage of unskilled laborers.
irrigation systems, and other solutions aimed at increasing the marginal
productivity will increase marginal productivity of unskilled workers in the
agricultural sector. The Green
Revolution is an example of a period where the marginal productivity in
agriculture increased in
Poor farmers do not typically gain from productivity improvements in agricultural productivity because these farmers lack the productive assets to increase their productivity. Multinational corporations gain from the improvements in agricultural productivity (Nissanke and Thorbecke (2005)). Institutions are necessary to prevent multinational corporations from taking all of the benefit from productivity improvements because multinational corporations may not share this extra wealth with the poor.
Safety nets must be provided to farmers so that they can produce their comparative advantage products. Farmers will need to move from traditional crops into products such as fruits, vegetables, flowers, dairy products, and processed foods. In addition to public adjustment services, farmers may also require storage (which allows farmers to avoid low prices in the post-harvest season), transportation, infrastructure, laws, and money for retooling and marketing so that they are not pushed out of business by the influx of large marketing chains. Overall evidence suggests that these institutions will be pro-poor.
Africa, the agricultural productivity did not increase. Sindzingre (2005)
states that Sub-Saharan Africa’s agriculture sector was hurt by geographical
constraints (weather), policy (resistance to reform), and institutional factors
(price stabilization schemes, monopsonies, and agricultural marketing boards),
which led to output stagnation.
Agricultural marketing boards have hurt the agriculture sectors in
Sub-Saharan countries such as
Without land rights,
farmers will not expend as much energy producing goods. Even worse, when the government takes away
land from farmers, they have to find work elsewhere. These farmers might find work on larger tenants,
but they might earn lower wages. For
example, after the
Trade opens up many avenues for unskilled workers to break away from poverty. The real wages of unskilled workers should increase after trade. Poor farmers can receive higher real wages by using better fertilizers, better irrigation systems, and other solutions that increase their marginal productivity. The poor farmers need access to credit markets to be able to make the transition away from producing commodities, to purchase fertilizers, and to gain access to irrigation systems.
(2.6) Skilled laborers:
Skilled workers are
better equipped to take advantage of trade.
Those who can find jobs in sectors that export manufacturing goods will
gain the most from trade. Due to
capital-intensive technology transfer, the marginal productivity of workers in
manufacturing sectors is higher, and therefore, they receive higher wages. Winters et al (2004) explain that finding
employment in the formal sector, which includes manufacturing industries that
export, is one of the surest ways to move out of poverty. Table 6 shows the details about
Distribution of GDP (percentages)
Agriculture Industry Services
1965 1989 1994 1965 1989 1994 1965 1989 1994
Low income LDC’s 44 32 28 28 37 34 28 31 36
Others 44 33 38 17 28 21 37 39 39
Low-middle-income LDC’s 21 14 13 30 35 36 48 51 49
Upper-middle-income LDC’s 18 -- 8 38 -- 37 42 -- 53
High-income LDC’s 8 4 -- 45 41 -- 46 54 --
Industrialized countries 5 -- »2 43 -- »30 54 -- »68
Note: In the 1965 and 1989 data, countries are grouped according to 1989 per capita GDP.
Sources: Bencivenga (2005) from World Development Reports, World Bank (1991), Table 3 and 1996, Table 12.
causes productivity levels to increase (Goldberg et al (2004)). If the increased productivity results in more
profit for the firms, then the industry wages can be
increased, provided these increased profits are shared with the
employees. However, the empirical
evidence is mixed about whether or not industrial
workers see this money. Skill-intensive
intermediate goods may be transferred from less
developed countries to countries that are even less developed to be
manufactured. Kozul-Wright and Rayment (2004)
explains that some Latin American and Sub-Sahara African countries are
experiencing premature deindustrialization, despite the backward and forward
linkages afforded by some industrial sectors, such as metalworking. Premature deindustrialization is when a
country stops producing manufactured goods, even though it may have a competitive
advantage in producing those manufactured goods. Latin American is an example of an
environment that lacked foreign direct investment after the debt crisis in the
late 1990’s. This led to premature
deindustrialization. Table 7 shows details
about the manufacturing output as a share of GDP by region, and emphasizes the
fact that manufacturing in
Source: Kozul-Wright and Rayment (2004)
Foreign direct investment can produce skill transfer and technology transfer to domestic producers (Kozul-Wright and Rayment (2004)). Skill-based technical change leads to both a higher relative wage for skilled workers, and an increased share of skilled workers within most industries (Goldberg et al (2004)). Most technological change is skilled-based because most research and development activities occur in developed countries (Nissanke and Thorbecke (2005)). Technological change in developed countries focuses on decreasing the amount of labor required to perform a specific task because labor is scarce in developed countries. Labor is abundant in developing countries, and therefore technological change that decreases the need for laborers may not have a significantly positive impact in a developing country.
Firms and sectors
that are able to make the necessary technological advances to become
competitive in the world market will survive the globalization process. Goldberg et al (2004) write about a study performed
by Harrison and Hanson (1999) that shows a positive correlation between the
number of skilled workers in
"The elasticity of poverty reduction with respect to non-farm output growth varies depending on initial conditions, like literacy or land distribution" (Bardhan (2004b), who writes about Ravallion and Datt (2002)). Non-farm growth is more pro-poor in countries that have lower initial landlessness and higher literacy rates (Ravallion and Datt (2002)). Higher literacy correlates positively with higher levels of education because education leads to higher marginal productivity levels. Landlessness may decrease the pro-poor impact of non-farm growth because governments where landlessness is prevalent may not have sound institutions and policies in place for the poor to take advantage of non-farm growth. The poor need institutions, such as education and insurance, to prepare for non-farm labor.
Exportation from the manufacturing and services sectors helped the East Asian countries grow in a pro-poor fashion. This method of production focus should be replicated in newly globalizing countries. Globalization requires a “long-term vision for upgrading a country’s comparative advantages towards high value added activities by climbing the technology ladder step by step through learning and adaptation” (Nissanke and Thorbecke (2005)).
(2.7) Decreased government revenue:
After trade liberalization, government revenue might go down. Increased government revenue is important, because government spending can reduce poverty if it the money spent on productivity enhancing investments, such as research and development, infrastructure, such as roads and electricity, and development targeted directed on the poor (Fan et al. (1998)). However, there appears to be no empirical evidence to support the claim that decreased government revenue increases poverty (Goldberg et al (2004)). One way to reconcile these seemingly contradictory positions is to provide short-term redistributions from some of the net gains from trade (however, not through import, export, or trade taxes) to the poor. In the long run, decreased government spending must be replaced with sound institutions and policies that create a catalyst for moving the poor out of poverty.
However, despite all the concern about lower government revenue, Winters et al (2004) write about Ebrill, Stotsky, and Gropp (1999), who found in an empirical study that after countries reduced their tariffs, they did not have significantly lower government revenues than countries that did not reduce tariffs. If government revenues do decrease, and the situation is such that lower revenues will lead to increased poverty, then alternative non-tariff sources of revenue must compensate for the fall in government receipts. Replacement taxes should not be complex so that people will cooperate and so that the administrative overhead is low; this will create a profit maximization situation. These taxes should be progressive so that the taxes do not burden the poor.
Government spending is complicated because it can have a pro-poor impact if the government spends the money on the right programs. However, because the poor are the least likely to vote, they do not have enough of a voice to receive ample government expenditures. Winters et al (2004) explains that there is substantial evidence to support the fact most of the poor do not receive the benefits of government spending. Therefore, the impact of globalization on government spending, even though it is statistically not significant, is not important because the poor are not receiving the benefits of governments spending anyways.
(3) Institutions and Policies
After trade liberalization, institutions and policies that keep people in poverty will only make matters worse for the poor. Sound institutions and policies must be created before trade liberalization and financial liberalization because the impact of globalization “will depend on the initial conditions at the time of exposure and the effective design and implementation of policy to manage the integration process” (Kozul-Wright and Rayment (2004)). Institutions and policies create a threshold effect for globalization, which means that institutions and policies have a larger impact than before globalization. If institutions and policies are pro-poor (not pro-poor), then these institutions and policies will affect the poor even more positively (negatively) than before globalization.
Defining institutions is important because many economists use this term loosely. The definition used herein is consistent with the definition used by Sindzingre (2005), who uses Douglass North’s (1990, 1991) definition. Institutions are constraints that structure political, economic, and social interactions. Institutions consist of formal regulations (such as constitutions, laws and property rights), and informal regulations (such as traditions, conventions, and norms of behavior). Institutions reduce transaction costs, stabilize volatility, strengthen incentives, properly channel resources, and deliver flexible responses to uncertainty. In addition, the causal link between globalization and institutions and the casual link between globalization and policies is unclear because the distinction between the isolated effects of institutions and policies is unclear.
(3.1) Impact of institutions and policies
Institutions and policies create a threshold effect on the causal link between globalization and poverty (Nissanke and Thorbecke (2005)). Based on the structure of policies and institutions, the effect of globalization on the poor can lead to several different outcomes. Globalization can increase or decrease inequality. Globalization can pull people out of poverty or it can push people into poverty. The outcome for the poor depends on whether these institutions can successfully favor collective action of the poor, prevent collective action or the wealthy, regulate redistribution gains to ensure that the poor receive redistribution in the short-term and medium-term when necessary, and regulate insurance mechanisms to ensure that the poor have access to insurance and credit markets.
Sindzingre (2005) states that the effectiveness of an institution to positively affect the poor depends on the structure of human capital, the structure of the political economy, the level of social cohesion, and the relationship of the institution with other institutions. The structure of the political economy is important because social polarization, oligarchic structures, or predatory regimes will mitigate the effectiveness of an institution. The structure of human capital is important because institutions intended to lead to growth might not lead to growth if the population is poorly educated or does not have much technical ability. The level of social cohesion is important because the poor must trust the institutions aimed at helping them. The relationship among institutions is important because their ability to work together will contribute to their effectiveness.
State institutions define policies (i.e. trade and taxation policies). However, policies also determine the creation, destruction, or reformation of institutions. The connection between policies and institutions is further illustrated when noting that the effectiveness of polices focused on the poor is contingent on the combination among institutions. Policies use different combinations of institutions, and the effectiveness of the policy will depend on the strength of the relationship among institutions. The strength of the relationship is a function of the historical depth and credibility of institutions, the way in which different institutions work together, the flexibility of institutions to be able to be transformed by globalization, and the level of access to the positive effects of globalization that is provided to the poor. The power of the institutions also will determine the effectiveness of the policy. For example, the combinations of state institutions (i.e. education and welfare reform) to create social service programs can positively affect the poor. Another example to illustrate the importance of the connection among institutions is that business regulations would be ineffective without functioning judicial institutions.
Informal regulations contribute to the effectiveness of an institution because social norms may modify the goals of an institution. For example, social norms may dictate that institutions provide bribery payments to government officials, whereas the money should be spent performing the function of the institutions. The government should not own financial institutions because conflicts of interest may arise, and these conflicts might lead to corrupt payments, poor investments, excessive hiring, and inappropriate plant locations. This is already a problem in many countries because corruption has become so bad in some developing countries that the poor in these countries believe that institutions are the cause of their poverty.
Social norms that exist during globalization will create several poverty traps (Sindzingre (2005)). These traps include: 1) the lack of information and ability to take collective action to demand better institutions and policies; 2) discrimination based on race or gender; and 3) redistributive gains for the wealthy and redistributive losses for the poor. Non-corrupt institutions that protect and advance the rights of the poor can alleviate these poverty traps. Corruption can limit benefits of globalization for the by blocking access to certain institutions (such as education, legal, or health services) (Sindzingre (2005)).
economy structures and institutions, such as social polarization, oligarchic
structures, and predatory regimes, may reduce to potential gains from
globalization for the poor (Nissanke and Thorbecke (2005), who write about
Sindzingre (2004)). The goals of those
who have political power will dictate the creation and destruction of
institutions and policies (Acemoglu et al. (2004)). For example, before the seventeenth century
policies that protect property rights create incentives for people to invest in
physical or human capital. For example,
during the seventeenth century in
Some degree of
equal opportunity in society, such as equal access and protection by the law,
is necessary so that the gains from trade can spread more equally. Acemoglu et al. (2004) explains that property
rights and equal opportunity in society creates incentives to create efficient
This shows that
even though geography is a factor for economic success, it is not the main
Globalization increases the wages of educated workers and reduces the wages of workers who have no education (Nissanke and Thorbecke (2005)). Public expenditures on primary and secondary education decrease inequality, but tertiary does not generally help the poor because primarily middle- and high-income classes seek tertiary education (Dagdeviren et al (2001). Higher education levels may lead to higher wage jobs (Goldberg et al (2004)). Therefore, basic education is necessary for everyone so that globalization can have an equalization effect on incomes.
The government can
provide safety nets in the short- and medium-term to the poor that are hurt by
globalization. Some safety nets, such as health care and welfare systems, are
institutions. Sindzingre (2005) states
that the difference between the success of the safety nets program in South
Korea, which has a successful safety nets program, compared to the safety nets
program in Sub-Saharan Africa, which have failing safety nets programs, is
explained by successful combinations among institutions, among policies, and
among institutions and policies. The
institutions and policies in Sub-Saharan Africa are representative of the predatory
political regimes in this region. In
contrast, the institutions and policies in
If the country has good policies and institutions, trade liberalization should be a net positive for an economy. Macroeconomic stability, high investment/GDP ratios, human capital development, infrastructure development, and institutions development are all important economic factors that will ensure that globalization will lead to growth (Heshmati (2004)). The right combination of public policies, laws, institutions, and political environment (such as democracy) will lead to an economy that benefits the poor (Singzingre (2005)).
(4) Financial Liberalization
Financial liberation is another major component to globalization. Financial liberalization starts with financial markets opening up to private banks. Increased competition in the banking sector creates a better banking sector when sound regulations and policies are present. These regulations and policies are necessary for a strong banking sector. Countries should create regulations to avoid moral hazard, over-lending, lending to risky loan applicants, and disclosure that is anything short of full disclosure. Before opening up financial markets to external capital flows, a country needs to liberalize its domestic financial market, regulate interest rates so that they do not become excessively high, and implement a strong banking system, which requires a powerful legal framework and effective bank examiners.
financial policies and frameworks is as important as implementing good
financial policies and frameworks. The
set of requirements in the Maastricht Treaty is a good baseline of financial
goals that developing countries should pursue.
These requirements are: (1) a public sector deficit/
Import substitution can negatively affect the poor. Exchange rate overvaluation, a standard policy for import substitution regimes, can cause speculators to attack the currency and cause devaluation. Unexpected devaluation lowers the value of the currency, and this unexpectedly lowers the purchasing power of consumers, which will always negatively affect the poor. Unexpected devaluation can also lower confidence about a country’s macroeconomic stability, which can lead to capital flight. Capital flight, as already mentioned, has a negative impact on the poor.
Strong banking systems are necessary
to avoid financial crises, which hurt the poor.
Beim and Calomiris (2001) write about information gathered from World Bank (1998) and Calomiris and Powell (2002) that explain the steps taken by Argentina to reform its banking system: “[t]he Central Bank [of Argentina] continued the process of reform, including the following items: 1) To provide liquidity in future crises, bank reserve requirements were raised to 20 percent of deposits, which is an unusually high level. However, this was not a tax because this money held by central bank pay interest, which is also unusual. 2) The government instituted a “contingent repo facility” where international banks provided potential liquidity protection lending to the government to cover another 10 percent of deposits. 3) Capital requirements for banks start at 11.5 percent, and are higher for higher capital to loan risk (measured by loan interest rates) and market risk. In addition, banks were obliged to issue subordinated debt equal to at least 2 percent of their deposits, to provide additional capital market risk assessment and risk monitoring. 4) The bankruptcy laws were reformed. 5) The banking supervisory process was strengthened to conform with the “Core Principles for Effective Supervision,” which was issued by the Basel Committee. 6) The Central Bank sponsored the collection and dissemination of the name of every corporate and individual borrower in the country together with its aggregate debt and credit rating on a scale of 1-6, and some information about the financial condition of borrowing firms. The government sells a monthly CD-ROM that gives data on all persons and firms that have defaulted on debt. 7) A modest private deposit insurance fund (SEDESA) was instituted to cover up to $10,000 per person, supported by each bank paying in 0.03-0.06 percent of deposits” (Beim and Calomiris (2001)).
Prasad et al. (2003) states that there is no evidence to support that financial integration has a positive effect on growth. Although Prasad et al. (2003) find that financial integration alone does not cause growth, financial integration is a filter for the effects caused by the fundamentals in a country. If the fundamentals are sound, then financial integration can lead to pro-poor growth (Griffith-Jones and Gottschalk (2006)).
However, this casts too simple a picture on the relationship between financial integration and the poor, because Prasad et al. (2003) show that consumption volatility increases at low to moderate stages of financial integration. Higher consumption volatility is bad for the poor because negative swings in consumption power can push some people into poverty or absolute poverty. This short-term problem is resolved when strong fundamentals exist and after the domestic financial sector fully integrates with the global financial sector.
Some fundamentals that lead to better results from financial integration are robust legal and supervisory frameworks, low levels of corruption, high degree of transparency, and good corporate government (Prasad et al. (2003)). Strong legal frameworks encourage higher total factor productivity growth. Greater degrees of transparency, which is a form of governance, minimizes herding behavior, can lead to instability in financial markets. Corruption has strong negative effects on foreign direct investment. Foreign direct investment has a strongly positive impact on growth. In the long-run, being financially integrated has a positive impact on the country because it can better compete in the global marketplace. If a country has both policies and institutions that encourage sectors that positively affect the poor, then financial integration can have a positive impact on the poor in the long-run.
(4.1) Monetary Policy, Inflation, and Credit
When the government has a deficit, it needs to cover this deficit by selling international reserves, borrowing money, or by monetizing its deficit. A government monetizes its deficit when it prints new bonds and sells them to the central bank in exchange for newly printed money. Government deficits can create financial instability through several methods utilized to lower a budget deficit. Monetization of a budget deficit, which is when the government prints more money, leads to inflation because the government is essentially creating a larger monetary base. Inflation devalues the purchasing power of the money that people currently hold because inflation requires more money than before the inflation to purchase the same good. Therefore, inflation immediately devalued any citizen’s savings. Agenor (1998) states that the poor are negatively impacted when a government monetizes its budget deficit. The poor keep most of their money in currency, which now has less purchasing power, whereas the wealthy keep more of their money in assets and the value of these assets rise in value when inflation rises.
that are higher than world inflation will cause problems. Money supply increases need to be at par with
world inflation levels. Moderate
(extreme) inflation rates can cause modern (extreme) exchange rate volatility. (Beim and Calomiris
(2001)). The central bank
controls inflation by selecting a targeted inflation
rage (inflation targeting) and reaching this target by adjusting interest rates
or by changing the monetary base. The central
bank targets low inflation rates to keep the consumer price index annual
inflation growth rate down. This system
has worked remarkably well in keeping inflationary pressure down in
Inflation volatility depresses the financial sector because loans are not provided when expected inflation can not be gauged. Investors require high risk premiums to offset the risk of negative real interest rates if future inflation is greater than expected future inflation. The risk premium creates loans that are too expensive for borrowers. For this reason, inflation volatility creates inefficiency in the loan market. Money is not used efficiently unless an efficient loan market exists. The poor will be affected by this because they are not going to get loans that they could use to start or grow their businesses.
Credit constraints on the poor will result in risk adverse activities because a poor farmer who does not have access to extra capital will not be able to spend the additional money required to invest in a risky activity that may otherwise lead to an increase in the farmer’s marginal productivity (Winters et al. (2004)). This will decrease the likelihood that the poor will be able to move into profitable, but risky, activities to break out of poverty. To limit strategic default, which is when a borrower takes the loan without repayment, some banks require borrowers to have collateral. Collateral is something that the poor typically do not have.
Credit markets that only provide capital to a limited number
of people result in goods markets with oligopolies (Sindzingre (2005)). Credit markets need to be available to
everyone to avoid a market of oligopolies.
Governments create directed credit programs that focus lending in
specific sectors. Page (1994) explains
that the directed credit programs in Hong Kong, the
(4.2) Capital Controls and Capital Flows
Financial sector liberalization exposes developing countries to short-term capital flows, which can increase the financial sector's vulnerability to external shocks (Nissanke and Thorbecke (2005)). Capital should seek out higher returns from capital-scarce countries because capital should exhibit higher marginal productivity in developing countries. In reality, capital does not flow in this manner because of the Lucas paradox, which finds that the marginal productivity of capital is higher in rich countries than in poor countries because Lucas found that the return to scale of human capital is increasing with respect to the human capital stock of the country. The majority of capital flows into areas based on their ability to work as asset diversification as opposed to searching out higher marginal productivities to capital. Therefore, capital also flows to rich countries for this reason.
Capital controls are a set of determinants that define how capital will flow in and out of a country. Capital controls should not be removed until banking fundamentals, inflation, and interest rates are under control. If inflation is not under control, then the fixed exchange rate can become overvalued. After the exchange rate becomes overvalued, any unhedged short-term capital inflows will flow out of the country (capital flight). If interest rates are too high, unhedged short-term capital inflows will take advantage of the arbitrage. After the arbitrage is gone, the unhedged short-term capital inflows will flow out of the country. Capital flight occurs when a country is pegging an overvalued exchange rate. Concern may arise that there will be capital flight if everyone knows that the exchange rate is overvalued, the international reserves are low, and there are no capital controls. The best way to avoid capital flight is to enforce a strong financial sector, with good governance, and a floating exchange rate. Capital flight can move the financial sector into a banking crisis, which hurts the poor.
Effective capital controls that regulate and control destabilizing capital flows, such as preventing a large stock of foreign financial capital from building, is necessary to maintain strong financial health (Kozul-Wright and Rayment (2004)). The suggested techniques to control capital “range from market-based measures -- intervention in the foreign exchange market, more flexible exchange rate bands, non-interest bearing reserve requirements on foreign liabilities, or taxes [that narrow] the international arbitrage margin – to direct controls on, say, banks’ net external positions, borrowing abroad by non-banks, or on foreign equity participation in domestic firms” (Kozul-Wright and Rayment (2004)). Attention needs to be paid to the confidence of investors to make sure that these measures do not deter foreign direct investment.
Foreign direct investment is one of the best forms of capital inflows that a country can receive from investors. The capital flight problem is avoided with foreign direct investment because foreign direct investment is a long-term capital inflow. Furthermore, foreign direct investment leads to growth. The availability of foreign direct investment has varied throughout time and by region. Because of this elusive nature of foreign direct investment, many people have studied why countries will receive countries when they do. My discussion that follows about foreign direct investment includes examples about why countries have stopped receiving foreign direct investment, states policies that must be followed to receive foreign direct investment, and details some of the effects of foreign direct investment.
Following the debt
crisis of the 1990’s, foreign direct investment in Latin America and
Economic uncertainty, such as inflation, will drive foreign direct investment inflows away. Investors will put their foreign direct investments money in developing countries that have low cost labor that has high skills and high productivity levels. Furthermore, Regional Trade Agreements between countries will increase foreign direct investment inflows. Policies within the developing country will determine foreign direct investment inflows dramatically. Host countries must have good policies regarding repatriation of profits and capital, liberal technology policies, and easy entry and operation.
An analysis of opportunity, risk and market reform factors in relation to foreign direct investment inflows with respect to seven Latin American countries, Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela, was conducted by Trevino, Daniels, and Arbeláez (2002). They found that privatization had a positive correlation with foreign direct investment inflows because firms saw this as a country’s positive attitude towards private enterprise.
They also found that there was a positive
correlation between the host country’s capital account liberalization and
inward foreign direct investment. They
found that the size of
Foreign direct investment is that it appears to be limited in its ability to create backwards linkage to the rest of the economy (Kozul-Wright and Rayment (2004)). Although backward linkages may not occur, the multi-national corporations brought into the developing country by foreign direct investment should bring skill-biased technology, which may lead to modern sector enlargement growth. Modern sector enlargement growth is pro-poor.
Developing differentiated and
efficient clusters of skilled labor for particular market increases the foreign
direct investment inflows. Multinational
corporations put foreign direct investment in countries that can create this skilled
market. An example of this is in
(4.3) Exchange Rates
The correct exchange rate system that should be used by a country depends on the quality of its fundamentals. Beim and Calomiris (2001) explain that if a country has sound policies and institutions, and has little to no deficit, that it should choose a crawling peg, fixed exchange rate. Fixed exchange rates allow a country to gain creditability in the global economy if it can maintain a fixed exchange rate that does not become overvalued, and that does not lead to economic crisis. Most developing countries do not have the discipline to deal with the periodic stress of high interest rates and contraction that can result from fixed exchange rates. Kozul-Wright and Rayment (2004) writes about Helleiner (2003), who states that successful management of the exchange rate means choosing a rate that will remain competitive over the long-run and making adjustments when faced with external shocks. When the wrong exchange rate is chosen, unhedged short-term private financial flows that are interested in taking advantage of arbitrage and speculative gains will enter the developing country. These types of financial flows can create financial crises, which hurt the poor.
Floating exchange rates do not offer a developing country the opportunity to increase its credibility and therefore is not the right way to control exchange rates. Financial policies that keep inflation and debt low help to stop the overvaluation of fixed exchange rates. If a country has an overvalued exchange rate, switching away from a fixed exchange rate to a floating exchange rate can perpetuate a bank run that will lead to a financial crisis. Financial crises disproportionately lower the consumption power of the poor, so making letting an exchange rate become overvalued can lead to a dangerously impact the poor.
Fixed exchange rates have the advantage of building trust in the world economic community if the peg can be sustained without becoming overvalued. This requires low fiscal deficits, inflation rates not exceeding world inflation rates, and a large level of financial reserves to defend small speculative attacks. Volatility in the exchange rate from a floating exchange rate can be problematic for trade (Beim and Calomiris (2001)).
A fixed exchange rate that becomes overvalued will be the target of a speculative attack because speculators believe they can make money when the currency is devalued. The speculators sell domestic currency and purchase foreign currency, anticipating that the central bank will not be able to continue supplying the speculators with foreign currency. Once the central bank runs out of foreign currency, it must devalue the exchange rate. When speculators attack the fixed exchange rate, the economy will experience periods of high interest rates and economic contraction (Beim and Calomiris (2001)).
To defend a fixed exchange rate from depreciation, some central banks sterilize the capital outflows by purchasing local currency bonds held by banks in exchange for domestic money. The central bank replaces the outgoing foreign reserves with government bonds and, therefore, maintains the same amount of total assets. This policy prevents a monetary contraction from financial outflows even though the central bank now has less foreign assets. This will eventually lead to a financial crisis because it worsens the ratio of domestic money to international reserves, which creates incentive for speculators to attack the weaker international reserves further. Devaluation will follow a successful speculative attack, and devaluation can lead to capital flight and financial crisis. Overvalued fixed exchange rates can lead to financial crises. These crises disproportionately lower the consumption power of the poor because poor hold most of their assets in money.
(5) Crises and Shocks
are one of the fastest ways to affect negatively the poor in a developing
nation. The East Asian Financial Crisis
hurt the poor in
Kozul-Wright and Rayment (2004) explain a typical exchange rate crisis as follows. After a country deregulates its financial market and capital account, the developing country attracts short-term capital with stable exchange rates and tight monetary policies. The banking sector over-lends to businesses that want to take advantage of the low interest rates offered abroad. New capital inflows create interest rates that are relatively low for domestic firms compared to before financial deregulation. Eventually, these policies create upward pressure is on the exchange rate, and sterilization (the sale of domestic bonds to offset reserve inflows so that the monetary base can remain unaffected) of capital inflows puts upward pressure on interest rates because the monetary base is smaller than it otherwise should be. When investors realize that the overvalued exchange rate might fall, investors might quickly remove their short-term capital (commonly referred to as capital flight).
Early models of currency crisis (first generation models) view currency crises as arising from the monetization of fiscal deficits together with fixed exchange rates. The first generation models show how long the country can depend on its reserves after monetary or fiscal policies that are expansionary. The key element of this modeling includes the maintenance of a fixed exchange rate. Broner (2003) explains that Krugman (1979) found that speculators attack the central bank’s stock of foreign reserves. Speculators attack the currency when foreign reserves are low and the current account deficit is high. This would occur in the absence of any random shocks. The advantage of this model is that a probability function predicts the timing of a crisis. This model predicts that speculators will attack the currency when the shadow exchange rate, which is the predicted exchange rate that would occur if the reserves were exhausted and the exchange rate were allowed to float, has depreciated as much as the current fixed exchange rate.
Second generation models are less about the government’s ability to defend its fixed exchange rate, but rather their willingness to defend it. The government in this model would abandon a fixed exchange rate, or devalue its currency, if necessary. The cost associated with abandoning a fixed exchange rate could include raising interest rates, and therefore depressing the local economy. If the central bank can bear these costs, then the government would abandon (in theory) the fixed exchange rate. The costs associated with defending a fixed exchange rate include unemployment, an increase in short-term debt, and the depletion of reserves. Investor confidence is difficult to predict, but the rate of reduction in reserve levels does influence their confidence levels.
Some second generation models identify ranges of likelihood that a crisis will occur. If the probability is certain of a crisis, then a speculative attack would cause the exchange rate to collapse. If the probability is not certain of a crisis, then external factors, such as investor confidence, information dissemination, and coordination among speculators are extremely important in the potentiality of a crisis.
The major difference between the first generation and the second generation model is whether or not the government will defend a currency attack and also maintain a fixed exchange rate. Fixed exchange rates are poor methods of defense and a floating exchange rate is better. Countries will still defend their currency in the second generation model, but this defense will happen through interest rate hikes and monetary base expansion. These methods of defense are much less detrimental in the long term.
(5.1) East Asian Financial Crisis
The sudden decrease
in the real incomes of the poor during the East Asian Financial crisis hurt the
poor. The weak banking sector led to banking
crises, which led to increased unemployment and decreased output. Winters et al. (2004) state that during the
Asian Financial Crisis real wages fell in
Enoch, Frécaut and Kovanen (2003) explain that some banks were owned by local conglomerates, and that these banks would lend money to the conglomerates at levels above legal requirements (commonly refereed to as directed lending). Poor governance existed because there was an information gap between what the bank managers knew about their loan portfolio and what the supervisory organization knew. Chua (2005) states that the banks owned by conglomerates ignored legal lending requirements, and provided their conglomerates with levels of capital above what they should have received.
Private debt levels
increased dramatically during the 1990’s, and an increasing amount of the debt
was denominated in
High levels of unhedged short-term financial liabilities created exposure to capital flight. Overvalued fixed exchange rates will depreciate when a government decides to float its exchange rate. This led to capital outflows that caused the exchange rate to depreciate even further. The banks were not able to handle this scale of capital flight because capitalization was too low.
The poor are hurt disproportionately during contractionary periods (Nissanke and Thorbecke (2005), who write about Birdsall (2002)). Dagdeviren (2001) adds that inequality rises during recessions, which is consistent with the fact that unemployment levels increase during times of recession. In early stages of financial integration and diversification, developing countries have significant exposure to contagion.
Contagion is categorized one of two different ways: fundamentals based contagion and pure contagion. Fundamentals-based contagion occurs when a crisis in one country increases an investor’s risk assessment of other countries. If the developing country has weak fundamentals, the new risk assessment may cause the investor to pull money out of the developing country. Prasad et al. (2004) write about Van Rijckeghem and Weder (2000) and Kaminsky and Reinhart (2001), who documented the fact that most banking lending to developing countries is in the form of unhedged short-term financial liabilities. This form of financial liability has much more exposure to capital flight. Pure contagion is when fundamentals do not stop capital flight because herd or momentum trading causes the capital flight.
Prasad et al. write that “in addition to ‘pure contagion,’ financial integration exposes developing economies to the risks associated with destabilizing investor behavior that is not related to fundamentals” (Prasad et al (2004)). Countries need to focus on gaining foreign direct investment instead of bank borrowing and portfolio flows because foreign direct investment has the least amount of exposure to problems related to financial crises. Foreign direct investment is inherently a long-term investment, and can therefore be a way of insulating a country from pure contagion or herd behavior.
is a perfect example of contagion at work.
devaluation of the real, and the subsequent decision to allow the currency to
float, lowered investor confidence because investors felt that
consequences of devaluation were that there was a switch from a trade deficit
to a trade surplus, which had a major impact on
Brazil was Argentina’s largest trading
partner, and therefore, Brazil’s depreciation caused Argentina to fall into a
recession for four years because the goods exported from Argentina to Brazil were
sold much less than before Brazil’s depreciation. The Argentine Currency Board did not stop
exchange rate overvaluation and fiscal indiscipline after the fall of
Globalization can be pro-poor if the developing country implements the correct policies and institutions. Globalization magnifies the effects of policies and institutions, so policies and institutions that are bad for the poor or that create macroeconomic instability will hurt the poor even more after globalization. Countries need to make a committed effort to implementing policies and institutions that strengthen the trade and financial sectors. These institutions and policies must also fend off problems, such as trade shocks, speculative attacks, volatility, and corruption. Problems are larger after a country globalizes because it is open to massive shocks, but countries must join the globalization trend because those who do not globalize become worse-off, such as the Sub-Saharan African countries, after other countries globalize. Countries that want to help their poor must globalize, and they must do so carefully, implementing the proper institutions and policies.
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