During the 1980s the import-substitution consensus of policy- makers in developing countries of previous decades all but evaporated, and even Mexico and Turkey have now made a decisive push towards trade liberalization. It is paradoxical that this liberalization took place in the 1980s, since this has also been a decade of macroeconomic instability, characterized by the debt crisis, high and variable inflation and fiscal and balance-of- payments crises, which should reduce or even offset the conventional benefits of liberalization.

Two main reasons explain this paradox of liberalization during a period of instability. First a time of crisis may enable the implementation of radical reforms that would be unthinkable in calmer times. In Bolivia (in 1985), Mexico (since 1987), and Poland (in 1990), macroeconomic crises of unprecedented proportions have led to wide-ranging reforms, of which trade liberalization form only part. Second, the recommendations of foreign creditors in particular the IMF and World Bank were often adopted by cash-starved governments who were far from convinced of their ultimate benefits.

In Discussion Paper No. 447, Research Fellow Dani Rodrik considers new issues raised by this pattern of reform. First, trade reform is often met with scepticism on the part of the private sector: governments in external crisis have little alternative but to accept IMF and World Bank recommendations, but a subsequent alleviation of their financial situation may give them couse to halt or reverse the reform. The resulting lack of credibility causes incentives for adjustment to be reduced; so the gains from liberalization in terms of productive efficiency are delayed, and scepticism regarding the sustainability of reform may prove self-fulfilling.

Second, Rodrik argues that the causal link often drawn between the prevailing trade policies of the 1970s and the debt crisis is poorly grounded in theory, since even the most protectionist commercial regimes are perfectly compatible with external balance and prompt service and the critical conditions for macroeconomic stability are realistic exchange rates and small fiscal deficits. Further, the more successful stabilization programmes to date have emphasized radical trade reform at the outset, which can help to break down established practices and increase governments' credibility in fighting inflation.

Finally, in the imperfectly-competitive markets that characterize developing countries, arguments based on the potential of foreign trade to spur entrepreneurial instincts and productivity, exploit returns to scale, and force domestic monopolists to behave competitively are difficult to sustain either empirically or theoretically. Theoretical models generally yield ambiguous predictions concerning the impact of liberalization on an imperfectly competitive economy; and the empirical record is weak and inconclusive.

Rodrik concludes that if free trade is adopted as the sole answer to the economic crisis of the 1980s just as developing countries embraced protectionist policies in the 1950s and 1960s as a holistic solution to the problems of development then this will lead to unrealistic expectations of what may be accomplished through the use of trade policy alone.

Trade Policies and Development: Some New Issues
Dani Rodrik

Discussion Paper No. 447, August 1990 (IT)