The Crusade for Free Trade: Evaluating Clinton's International Economic Policy

POP ECONOMIST

Many economists despair at the public's frequent misunderstanding of international trade theory -- the common failure, for example, to understand the principle of comparative advantage, or the popular notion that imports are bad and exports are good. Many experts have thus given up the attempt to communicate with the general public. But Jagdish Bhagwati, one of the world's most eminent economists, is also one of the most consistent and successful at bringing the lessons of international trade theory -- particularly the virtues of free trade -- to the public. In Seattle in 1999, for example, he explained why the campaign to bring environmental and labor issues into the World Trade Organization (WTO) was detrimental not only to the trade interests of the rich, but especially to those of the world's poor, who need the opportunities offered by trade to develop their economies and raise their living standards.

The Wind of the Hundred Days, a collection of many of Bhagwati's recent influential newspaper columns, speeches, and articles, is an impressive sequel to his earlier collection of public policy essays, A Stream of Windows. Highly readable and enlightening, Bhagwati's new book covers the major policy issues in the international economy over the last few years. Yet it is also packaged as a critique of the Clinton administration's international economic policy -- and here its line of argument is idiosyncratic.

TWO BIRDS, ONE STONE

A recurrent theme in The Wind of the Hundred Days is the principle of targets and instruments: given a particular social or economic goal, one must choose the policy instrument that is appropriate for the target. One of Bhagwati's most important early contributions to trade theory (made with V. K. Ramaswami) was to show that rationales for trade barriers are often claims of market failure that, if valid, would be more appropriately addressed by some other specific policy. For example, a desire to protect a natural resource would be optimally met by taxing all use of that resource, not by limiting imports that use that resource. A government's propensity to reach for the trade weapon is due partly to a failure to understand the principle of targets and instruments, and partly to the hidden desire to protect domestic producers.

In his new book Bhagwati explains the principle of targets and instruments with the common-sense proposition that someone who tries to hit two birds with one stone is likely to miss both of them. In one chapter, the two birds are the twin targets of maximizing GDP and protecting the environment. The former should be achieved by trade policy, and the latter by appropriate environmental initiatives. In another chapter, the two birds are free trade and a global social agenda. The former target should be tackled by the WTO, and the latter should be left to other multilateral institutions such as the International Labor Organization, the United Nations Children's Fund, and the United Nations Environment Program -- beefed up to whatever extent that is politically possible. Trying to use the WTO to establish both growth-promoting trade rules and environmental or social standards, in contrast, is unlikely to achieve both objectives and more likely to achieve neither.

Even leaving aside the goal of economic growth, conflicting objectives have motivated the demonstrators at Seattle and subsequent trade gatherings. Because of newly important global environmental issues such as greenhouse gas emissions, environmentalists need regulations enforced by multilateral agreements and institutions (along the lines of the Kyoto Protocol, for example), whereas labor unions oppose this kind of infringement on national sovereignty. Thus the two supposed allies in fact disagree about the direction in which global governance should move. A well-designed set of international institutions could achieve a favorable balance of goals within the global marketplace. But an unthinking mass movement to tear down multilateral institutions in general is the wrong instrument for achieving the various targets of the demonstrators.

BHAGWATI'S WRONG INSTRUMENT

Bhagwati wastes no time making clear that the "Washington" in his book's subtitle, "How Washington Mismanaged Globalization," refers to the Clinton administration. Although attacks on the administration from the antiglobalization camp are very common, attacks from the proglobalization side (i.e., Bhagwati's) are less so.

Bhagwati accuses the Clinton White House of not doing enough to advance free trade. He seems to blame Bill Clinton for all political obstacles to trade, such as Congress' refusal to renew the fast-track negotiating authority that he sought.

At the same time, Bhagwati objects to the administration's support of regional trade agreements, such as the North American Free Trade Agreement (NAFTA) and the proposed Free Trade Area of the Americas (FTAA), because he considers this position inconsistent with the multilateral pursuit of free trade. He also believes that the administration's pursuit of open financial markets in Asia, Mexico, and other emerging economies caused the 1990s crises in these areas. In short, Bhagwati seems to take exception to Clinton's broad strategy of seeking to remove trade and financial barriers whenever possible. But this attack on the administration's international economic policy is itself a poor instrument for the target of advancing free trade ideals.

(NOT SO) FREE TRADE AREAS

Regional trade agreements are Bhagwati's bête noire. As he persistently points out, regional free trade areas (FTAS) should not be confused with free trade, although they often are. He prefers to describe such arrangements as "preferential" or even "discriminatory." These terms make clear that FTAS can distort price incentives to favor the exports of member countries over those of nonmember countries. Instead of creating new trade, FTAS may divert existing trade from nonmembers to less efficient trade with members. This distinction between trade creation and trade diversion is a staple of international-economics textbooks. Although the textbooks say the net effect on economic well-being depends on the specific situation, Bhagwati thinks the net effect is likely to be negative. In the case of NAFTA, for example, Bhagwati worries that much of the resulting 45 percent increase in U.S. exports to Mexico between 1993 and 1996 represented trade diversion -- that Mexico really should have purchased those goods from low-cost suppliers elsewhere but instead bought from American producers because of the reduced Mexican tariffs on imports from the north.

Bhagwati also worries that regional initiatives will use up political capital and energies and thus divert momentum from multilateral efforts. To use phrasing that he originally coined and that has since become popular, trade blocks may be "stumbling blocks" to global liberalization rather than "building blocks." But other economists see evidence from recent decades that the political forces behind regional trade arrangements tend to be consistent with those working for free trade generally. Liberalizing trade with a neighbor, they reason, makes it easier to do so with others. In fact, leaving aside an antiglobalization minority in Mexico, Bhagwati is virtually alone in seeing harm in the rapid growth of U.S. exports under NAFTA.

Still, Bhagwati's distaste for regional negotiations is an intellectually respectable position. After all, the United States must fight some of the same political battles (over labor rights and environmental protection, for example) on both regional and global fronts, so it might as well debate them at the multilateral level. But success on a global scale is not always possible. A new multilateral round of negotiations in the WTO may not be politically feasible -- either because of traditional clashes between the United States and the European Union or because of newly critical North-South disagreements. If multilateral initiatives break down, and if regional ones such as the FTAA are possible, then the United States should go for the latter.

DON'T GO WITH THE FLOW

Free-market purists argue that countries can improve their economies through unfettered capital markets -- an argument analogous to the case for free trade. But Bhagwati contends that free capital movements can harm developing economies -- and he is not alone in this stance. Indeed, it is striking how many major figures in international economics, including those who stand for globalization and free markets, have expressed strong doubts that international financial markets actually behave in the benign way that economic theory predicts. In the former Soviet bloc, for example, Harvard Professor Jeffrey Sachs' name is practically synonymous with free-market philosophy. Billionaire George Soros has become a symbol of unrestrained financial speculation. Former Federal Reserve Chairman Paul Volcker and former U.S. Treasury Secretaries Lawrence Summers and Robert Rubin are all considered prophets of American-style capitalism, preaching the discipline of the international free market. Yet each of these five figures has stated that financial markets regularly experience excessive volatility and that some government intervention may be justified. Jagdish Bhagwati, apostle of free trade, has joined this distinguished list.

The "wind of the hundred days" in Bhagwati's title refers to the turbulence of the 1997-98 Asian financial crisis, which Bhagwati claims stemmed from U.S. pressure on Asian countries to let in foreign money and financial institutions. He states that "the U.S. administration really blew it" and that Rubin and Summers "may well have presided over the largest man-made disaster in the world economy since Smoot Hawley," referring to the 1930 U.S. tariff that prompted widespread protectionism and thus exacerbated the Great Depression. The Clinton administration's mistake, according to Bhagwati, was its promotion of "imprudent financial liberalization." Attacking what he calls the "Wall Street-Treasury complex" in his widely noted May/June 1998 Foreign Affairs article, Bhagwati argues that Wall Street "naturally wished to enlarge its sphere of operations," and that "the U.S. Treasury reflected that lobbying pressure" and "succumb[ed] to the 'ideology' of the market while forgetting that the capital funds market is not as innocuous as goods markets and needs to be monitored and regulated carefully."

Some of this may be true. But financial integration affords clear advantages. Capital-poor countries can finance investment more cheaply by borrowing abroad than by depending solely on domestic savings. International financial markets provide discipline on macroeconomic policy, and international banks and securities dealers are often the only source of competitive pressure on oligopolistic and inefficient domestic banks. Another advantage, at least in theory, is that access to international financial flows allows countries to stabilize their economies in the face of fluctuations. But here is where reality does begin to diverge from theory. International financial markets in fact seem to cause or exacerbate economic fluctuations at least as often as they stabilize them. After the international debt crisis of 1982-89, the Mexican peso crisis of 1994, and the Asian crisis of 1997-98, it has become difficult to maintain that financial markets always work as smoothly as economic theory predicts.

Nonetheless, developing countries will probably enjoy higher average growth rates with access to international capital markets than without it, even if the effects of periodic crashes are taken into account. That said, well-targeted government interventions -- such as Chilean-style penalties on short-term inflows or high reserve requirements for banks borrowing in foreign currency -- can sometimes improve stability without sacrificing the benefits of international capital flows. But short of the unattainable ideal of maintaining perfect macroeconomic and structural policies, or perhaps short of harmful prohibitions against all portfolio capital flows, occasional crises may be an inevitable price of economic development.

WHY ME?

The most surprising aspect of Bhagwati's attack on the Clinton administration is its lack of historical perspective. Both the Reagan and the George H.W. Bush administrations pursued FTAS and open financial markets at least as vigorously as did the Clinton team. The new Bush administration is likely to pursue both goals as well. Why single out the Clinton White House for unique opprobrium?

In 1982, the Reagan administration, frustrated with European resistance to its proposal to launch a new round of multilateral liberalization, reversed the traditional U.S. position against regional trade arrangements and offered to discuss bilateral or regional trade agreements with any willing partners. The outcome was the establishment of the Israel-U.S. FTA, the Canada-U.S. FTA, the negotiation of NAFTA, and preliminary plans for an FTA spanning the entire western hemisphere. The Clinton administration continued this approach, persuading Congress to approve NAFTA in 1993, supporting the Asia-Pacific Economic Cooperation forum, and beginning negotiations for the FTAA. The new Bush administration seems inclined to pick up precisely where Clinton left off.

While pursuing regional liberalization, each of these administrations also pursued multilateral liberalization. The Uruguay Round of negotiations, which eventually established the WTO, was started by the Reagan administration, continued by the first Bush administration, and concluded successfully by the Clinton administration. Although Clinton was denied fast-track authority to negotiate trade treaties, he succeeded in negotiating multilateral single-sector agreements in such areas as information-technology products and telecommunications services. The strategy all along has been to pursue liberalization at both regional and global levels simultaneously, seeking progress on the regional front when the multilateral path is politically infeasible.

Indeed, there are consistently fewer differences on trade policy between Republican and Democratic administrations than there are between the legislative and executive branches of government. Congress, not the White House, has been the primary obstacle to the sort of internationalism that is necessary for effective U.S. leadership of the global economic system.

Given the political opposition on both the right and the left, Clinton was remarkably effective at steering through the shoals to find a path of market-opening agreements. Things may be easier for Republican George W. Bush: Congress is less likely to deny him fast-track authority or to block his use of the Treasury's Exchange Stabilization Fund in managing financial crises. But the strategy of liberalization, to be pursued simultaneously at the regional and multilateral levels, will likely be the same under Bush as under his three predecessors. Indeed, one of the few good things about the 2000 election campaign was that the two major candidates shared an internationalist philosophy, whereas the two fringe candidates, Ralph Nader and Pat Buchanan, garnered little support for their isolationist positions.

A similar story applies to international financial policy. The Reagan and Bush Treasuries badgered countries in Asia and elsewhere to remove capital controls and to let in foreign financial institutions. Throughout the 1980s and 1990s, the White House pursued the interests of banks and securities dealers in bilateral discussions. In 1984, the Reagan Treasury bullied Japan into financial liberalization with the Yen/Dollar Agreement, which helped open Japanese financial markets. The Reagan and Bush administrations then applied the same strategy to South Korea and other Asian countries. To be sure, the Clinton Treasury continued along this path. Even after the ravages of the 1997-98 Asian crisis, insufficient progress on opening up to foreign financial institutions was the reason that the Clinton administration gave Premier Zhu Rongji for denying China an agreement on its accession to the WTO in April 1999.

Even the White House's eventual turnaround on this issue does not count as a success, according to Bhagwati, because the economic terms were too tough on China. ("The terms were so totally biased in favor of the United States that it was a no-brainer," he writes in the preface.) It is true that the United States denied China certain accommodations that have been granted to other developing countries, of which China is surely one. More generally, after years of seeking to persuade other countries of the virtues of an open-market system, the United States has been reluctant to "take yes for an answer" and has turned to a strategy of playing "hard to get" in international dealings of all kinds. But Bhagwati's position -- that U.S. trade negotiators have been too tough on Mexico and China and have thus achieved unfairly rapid openings of those markets -- puts him in a negligible political constituency.

EXCEPTIONS TO THE RULE

Admittedly, the Clinton administration made some mistakes in international economic policy. It is true, as Bhagwati says, that some of its members initially held naive expectations about how much progress could be made by a "get tough" trade policy with China and Japan. As in other administrations, the Clinton White House found it difficult to ignore completely the steel industry's pleas for protection against waves of cheap imports from troubled economies. The U.S. trade representative was unable to prepare adequately for the 1999 WTO ministerial meeting in Seattle. Finally, President Clinton's famous comment at that time to an interviewer -- that he would like to see an eventual international agreement to back up social standards with trade sanctions -- departed from the carefully thought-out U.S. position. Delegates from poor countries understandably interpreted his statement as a message with adverse protectionist implications, which thus helped torpedo the meetings. That most of these actions may have been the product of political pressures does not change the fact that they were mistakes in economic policy.

But these moves are exceptions to the general pattern, far outweighed by the overall record of progress achieved by the Clinton administration's international economic policy. The most notable gains were the successful completion of the Uruguay Round and NAFTA during Clinton's first term, the capable management of the Mexican peso crisis in 1995 and the Asian crisis in 1997-98, the successful negotiation of permanent normal trade relations with China in 2000, and the light management of the dollar throughout both terms. More generally, the administration was remarkably successful at pursuing an economic agenda that brought material gains to virtually all segments of American society. It is more remarkable still that Clinton was able to accomplish so much of his globalization agenda despite a congressional opposition that would have crippled most politicians.

Bhagwati's writings play an important role in helping shape a better trade policy. His points regarding FTAS and financial flows make provocative and instructive reading. But they will probably find little resonance with readers as a verdict on the Clinton administration.