The Political Economy of Trade Integration

The Political Economy of Trade Integration

Contributions to Economics Peter R. Haiss Cultural Inf1uences on Strategic Planning 1990. ISBN 3-790S-0481 9 Manfred KremerlMarion Weber (&!s.) Transforming Economic Systems: The Case of Poland 1992. ISBN 3 790S"()S85-8 Marcel F. van Marion Uberal Trade and Japan 1993. ISBN 3 7908-0699-4 Hans SchneeweiBi Klaus F. Zimmermann (Eds.) Studits in Applied Econometric; 1993. ISBN 3 790S'{)716-8 Gerhard Gehrig! W1adyslaw Welfe (Eds.) Economies in Transition 1993. ISBN 3-7908-0721-4 Christoph M. Schneider Researcll and Development Management: From the Soviet Union to Russia 1994. ISBN 3 790S'()7S7 S Bernhard Btihml LioneUo F. Punza (Eds.) Economic Performance 1994. ISBN 3-7908-0811-3 Michael Reiter The Dynamics of Business Cycles 1995. ISBN 3-7908-0823 ' Michael Carlberg Sustainability and Optimality of Public Debt 1995. ISBN 3-7908-0834-2 Lars Olof PerssonlUlf Wiberg Microregional Fragmentation 1995. ISBN 3-7908-0855-5 Andreas Foerster Institutional Analysis of Development Administration 1995. ISBN 3-7908-0853 9 Emesto FeUiJFurio C. RosatiJ Giovanni Tria (Ed$.) The Service Sector: Productivity and Growth 1995. ISBN 3-7908-0875-X Giuseppe MWlda Multicriteria Evaluation in Fu.zzy Environment 1995. ISBN 3-7903-0892-X Boris Maurer R&D, Innovation and Industrial Structure 1996. ISBN 3-7908..Q900...4 Giovanni GalizzilLuciano Venturini 03<".) Economics of Innovation: The Case of Food Industry 1996. ISBN 3-7908-0911-X David T. Johnson Poverty, InequaJjty and Social Welfare in Australia 1996. ISBN 3-7908-0942-X Rongxing Guo Border-Regional Economics 1996. ISBN 3-7908-0943-8

Oliver Fratzscher The Political Economy of Trade Integration With 10 Figures Physica-Verlag A Springer-Verlag Company

Series Editors Werner A. Muller Peter Schuster Author Dr. Oliver Fratzscher International Monetary Fund 700 19th Street, N.W. Washington, DC 20431 USA The views expressed are those of the author and should not be attributed to the International Monetary Fund. Die Deutsche Bibliothek - CIP-Einheitsaufnahme Fratzscher, Oliver: The political economy of trade integration/oliver Fratzscher. - Heidelberg: Physica-VerI., 1996 (Contribution to economics) ISBN-13: 978-3-7908-0945-9 e-isbn-13: 978-3-642-61490-3 DO I: 10.1 07/978-3-642-61490 3 This work is subject to copyright. All rights are reserved, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microftlm or in any other way, and storage in data banks. Duplication of this publication or parts thereof is permitted only under the provisions of the German Copyright Law of September 9, 1965, in its current version, and permission for use must always be obtained from Physica-Verlag. Violations are liable for prosecution under the German Copyrig~t Law. Physica-Verlag Heidelberg 1996 Softcover reprint of the hardcover 1st edition 1996 The use of general descriptive names, registered names, trademarks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. SPIN 10538445 88/2202-5 4 3 2 1 0 - Printed on acid-free paper

FOR My PARENTS WITH GRATITUDE

PREFACE This dissenmion looks at increasing trade iluegrorionjrom three angles: FirSl, what are welfare implications of trade integrmion and trading blocks? Second, what mechanism can improve the sustoinabiliry oj trade integration? Third, who! relationship evolved between trade and foreign direct investment? Chapter I starts by questioning Krugman's (1993) trading block modej, which suggested that world trade is increasingly conducted between three trading blocks, which produces a minimum in world welfare. His symmetrical trading block model is extended into a two-sector model, where trade is not only beneficial through increased varieties in a Dixit-Stiglitz framework, but also through comparative advantage. Results show that: (i) regionalism and multilateral ism can be compatible and welfare enhancing; (ii) sequential integration can monotonously increase world welfare; (iii) more dissimilar countries have higher potential benefits from integration; (iv) about one third of potential gains from free-trade under average tariffs are already realized in a system of three trading blocks. Chapter II studies the political sustainability of trade integration. The previous trading-block-model is combined with a political pressure group model, where domestic interest groups lobby their government to proceed with sequential trade integration. Theory shows that trade integration is politically not sustainable

viii Pre/(lct when consumers' and producers' interests are opposed, unless a mechanism is designed which links sequential trade integration with factor reallocation and which worsens the best alternative to integration. An application to the case of Central European integration shows that such a mechanism has been implemented, but that special interests in the European Union oppose new memberships. Chapter III asks whether foreign direct investment (FDI) is a substitute or complement fo r international trade, since both possibilities are modelled in the thoory of multinational firms. A gravity model estimates the cumulative effect fo r a sample of 63 countries and suggests that FDJ inflows reduce overall trade and in some cases deteriorate the trade balance. Three channels are identified in case studies of Spain, Mexico, and Thailand but need to be quantified in further research. Predictions should not be based on the gravity model because it appears structurally unstable. As a result, some policy implications are also reflected from three angles:. First, regional integration (for example NAFTA, APEC, ASEAN, CEFTA. EU) as a parallel process to muililateral integration (within the WTO) is usually welfare enhancing, and most squabbles are about redistribution.. Second, redistribution appears as a key obstacle to integrating Central Europe into the European Union, which requires a mechanism to improve the political

Prtface ix sustainability by real locating factors away from agriculture, by strengthening multi-nationals as key proponents, by allocating structural funds to disadvantaged regions, and by worsening any alternative to integration.. Third, trade integration often coincides with increasing flows of FDI, which can have various macro-economic effects: a direct effect of FDI inflows usually substitutes for trade, an indirect effect usually increases investment and thereby complements trade, and an exchange rate effect can deteriorate the trade balance. Completing this dissertation has been a great intellectual and personal challenge, and I am deeply grateful for the support I received from my advisors, colleagues, friends, and sponsors. I could not have succeeded without the great enthusiasm of my parents and my teachers in Germany and in Canada, especially of Professor Ulrich Blum and Professor Leonard Dudley. I was then extremely fortunate to be guided by Professor Dale Jorgenson as my mentor at Harvard, and by the invaluable support of my advisors, Professor Robert Lawrence and Professor Shang-Jin Wei. Many ideas were generated during my work for the Polish Council of Ministers in 1992-93, with special thanks to then deputy prime minister Jan-Krzysztof Bielecki and to Professor Jeffrey Sachs, whereas most theoretical work was completed while I was visiting the Brookings Institution during 1993-94 where I was most grateful for the support of Dr. Barry Bosworth.

1I Preface Moreover, I could not have completed this dissertation in such a focused and timely fashion without the various financial support, especially the generous grants from Harvard University and the Gottlieb-Daimler and Karl-Benz Foundation through the National Science Foundation, and the scholarships from the Colonia-Foundation, the German Academic Exchange Service (DAAD), and the Konrad-Adenauer Foundation. Finally, one very special appreciation should go to my wife l ianping for her endless support, love and encouragement. Oliver Frarzscher Washingron D. C. in March J 996

CONTENTS Preface................ VII Chapter I: Regionalism and Multilateralism: How Are They Compatible? - A Symmetrical Two-sector Trading Block Model Abstract 1. Introduction...... 2 2. A Look al Trade Data: More Regionalism and More Welfare... 5 3. Krugman's Trading Block Model... 14 4. Two-sector Trading Block Model with Comparative Advantage.. 23 5. A Brief Critique, Conclusions, and Outlook... 43 6. References.............. 47 7. Appendix-I: Two-Sector Closed Economy Model...... 53 8. Appendix-II: Two-Sector Open Economy Model........... 57 9. Figures.... Chapter II: Political Economy of Trade Integration - A Mechanism of Central European Integration Abstract.................. 67 1. Introduction...................... 68 2. A Pressure Group Model of Trade Policy......... 69 3. Simulations with a Modified Trading Block Model....... 81 4. The Central European Demand for Integration...... lo3

xii COli/ems 5. The European Union's Supply of Integration........... III 6. Conclusions.............. 117 7. References............. 119 8. Appendix-I: Objective Functions for Consumers and Producers... 126 Chapter III: FDI: The Neglected Twin of Trade - A Substitute or a Complement? Abstract........... 129 1. Introduction.................. 130 2. FDI and Trade as Vehicles of Global Integration.......... 132 3. FDI and the Theory of Multinational Firms......... 137 4. Data Material..... 146 5. A Gravity Model of International Trade and FOI......... 149 6. Pitfalls of the Gravity Model.............. 157 7. Macroeconomic Considerations................. 162 8. Conclusions 9. References.............. I~.......... 1& 10. Appendix 1: FDI Effects on Trade in a Three-Country-World... 174 II. Appendix 2a/b/c: Gravity Model of International Trade - Basic Model 175 12. Appendix 3a/b/c: Gravity Model ofintemational Trade - Ext. Model. 178 13. Appendix 3d: Gravity Model of International Trade - Notes... 181

hujex xiii INDEX OF TABLES AND FIGURES Table Il l: Annual Percentage Growth in World GoP and World Merchandise Exports......... 9 Table 112: Ad Valorem Average Rates of Protection by Region (1986)... 10 Table 113: Indices of Intra- / Extra-regional World Merchandise Trade... 13 Table I14: Comparing Gains from Free-trade under Specialization... 41 Table IIIl: Profit and Welfare Changes of Trade Integration....... 99 Table 1112: Output and Employment in Four Sensitive Sectors in E-Europe 106 Table III3: Size of Gains and Losses for the EU in Four Sensitive Sectors 114 Table III/I: Flows of Foreign Investment...... 135 Table IIII2: Robustness of the Gravity Model........ 161 Table IlI /3: Capital Inflows and Their Impact: Mexico/Spain/Thailand... 164 Figure Il l: Three World Trading Blocks... 60 Figure I12: Symmetrical Two-Seelor-Model of International Trade 60 Figure 113: Krugman 's (1992) Basic Trading Block Model... 61 Figure 114: Two-Se<:tor Trading Block Model with Comparative Advantage 62 Figure 115: Two-Sector Trading Block Model with Comparative Advantage 62 Figure U6: Two-Sector Trading Block Model with Transport Costs..... 63 Figure 117: Two-Sector Trading Block Model with PTAs... 63 Figure 118: Parameter-Fields for Krugman (A) / Fratzscher (B) Models.. 64 Figure 119: Minimum-Utility-Values as a General Function of s and t... 65 Figure II/ I : Partial Derivatives of Social Welfare U and Profits 'r:a... 91