Developing the Principles of a Managed Trade System

By Prasch, Robert E. | Journal of Economic Issues, June 1999 | Go to article overview

Developing the Principles of a Managed Trade System

Prasch, Robert E., Journal of Economic Issues

Laissez-faire fails, either as an empirical description of what is or as a normative ideal for what should be, on several grounds. Contrary to classical economics, economies are not self-regulating. History shows that purely private economic forces, left to their own devices, wreak social havoc, distributive injustice, and economic instability, which in turn produce political consequences that are far worse than a preventive dose of economic management.

- Robert Kuttner 1996, 23.

These days, most American economists instinctively recoil from the idea of a managed trade system. Instead, they cling loyally to the Theory of Comparative Advantage despite its narrow range of applicability [Prasch 1996a]. Often their "free trade" rhetoric omits the fact that the world's trade is, in reality, closely managed by an extensive system of agreements and organizations such as the North American Free Trade Agreement, the General Agreement on Tariffs and Trade, the International Monetary Fund, and the World Trade Organization that rule over a host of highly complex issues such as patent protection, the management of capital flows, and the handling of balance of payments problems. The belief that government plays a modest role in a world of free trade is a myth that cannot be abandoned too quickly.

Moreover, economic theory and history do not provide anything like the overwhelming argument for free trade that economists typically presume [Blecker 1996b; Lovett, Eckes, and Brinkman forthcoming, chaps. 3-4; Prasch 1996a]. While this is not the place to review the evidence, it is well known that over the past 150 years, protectionist policies have coexisted with superb economic performance in the United States, Germany, and Japan. This experience was successfully replicated by a number of developing countries, at least until their recent, and disastrous, decision to deregulate their financial markets [Amsden 1989; Dietz 1992; Smith 1996].

Managing Capital Flows

Given the recent experiences of Russia, Brazil, South Korea, Malaysia, and several other countries, it is time to rethink the role of short term portfolio investment in the international economy. The basic lesson is simple: money that can rush into a country can just as easily rush out again. New institutions are required to modify the structure and to reduce the quantity of the world's capital flows. Specifically, there needs to be a greater attachment between international capital flows and the projects and nations to which they are attracted. In other words, less liquidity is a desirable policy objective [Keynes 1964, chap. 12; Davidson 1997]. If such an outcome were to be realized, speculative capital movements would be less disruptive to the world's economies. Sudden capital outflows would be less likely to destabilize a country's economic prospects - including its balance of payments and exchange rate.

Several proposals for the management of capital flows exist. They vary according to the degree of international cooperation required to operate them. Given the potential existence of "free-rider" problems, any serious attempt to directly manage global capital flows should involve the smallest number of countries.

Restricting the free movement of portfolio capital is perhaps the easiest to accomplish since this does not involve a lot of coordination - a single country can simply pass a law. Chile has long had such restrictions in place. A percentage of the capital flowing into Chile must be placed in an interest-free account for a set period of time before it is released. The policy supposes that those who are interested in long-term "real" investments will be more willing to sacrifice some liquidity and pay these additional costs, as opposed to speculators who pursue short-term capital gains. If "hot money" cannot suddenly flow in, it is less likely to flow out and disrupt the real economy. So far, the evidence supports this policy; Chile has been spared the destabilizing capital outflows that have disrupted several Latin American economies over the past several years [Agosin and Ffrench-Davis 1996]. …

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