- Dr. John E. Charalambakis is the Chief Economist at Blacksummit Financial Group, Inc. Lexington, Kentucky. He is also with the Adjunct Faculty at Patterson School of Diplomacy, University of Kentucky.
Coauthored by: Dr. David Coulliette of Asbury University and Dr. Kenneth Rietz of Centre College
This article will be posted in three segments due its length. This is Part II.
To that of course, we should add that it was the ability that the U.S. extended to Europeans to reconstruct themselves and buy American products, that helped not only the American producers but also the local communities in Europe for their reconstruction efforts, for employment, for income, for capital formation, and for growth. So unless there is international trade, unless there is the liberty to move things, to buy imported goods, to move capital, to move technology, to move people across nations and communities, unless there is freedom to move financial capital across oceans, there could not be a case of capital formation. The latter is the seed that is necessary for any kind of infrastructure to be produced whether that infrastructure is in the social sector (hospitals or schools), in a physical form (highways, roads, bridges and water systems), or in the financial field (banks, exchanges, brokerages). The buildup of these kind of infrastructures will create jobs and by creating jobs there will be savings and that savings will become the seed for loans and for credit extension which is necessary for business formation. Now, all the above could be represented in the following diagram.
In a framework like the one above free trade is advanced for the sake of justice. Therefore, free trade is not an end in itself, it is a means to a higher end and that higher end is to treat equals equally.
We believe the following table, taken from Bernstein’s book would demonstrate our argument, in the sense that open and free trade cultivates the means for the advancement of persons’ capabilities in a holistic way.
When we contemplate on the above arguments, we will wonder what has been happening to the distribution of income across nations, what has been happening to inequality and poverty or the concept of convergence among nations.
Just a couple of years ago, Xavier Sala-i-Martin (Sala-i-Martin, 2006) published a well- documented survey of the world distribution of income, and he concluded that we have been experiencing falling poverty. At the same time he shows that convergence is taking place around the globe, primarily in continents and nations that were characterized prior to the 1970s by extreme poverty and divergence. His chief examples are the nations of China and India along with the whole region of Southeast Asia.
It would have been great if the survey had discussed the role that free trade has played in uplifting those countries and those continents out of poverty. However, before we explore in greater detail Sala-i-Martin’s arguments regarding the reduction of poverty and convergence of global income, as well as discuss this paper’s findings regarding the role that international trade plays in the formulation of capital, the forming of infrastructures, and the establishment of the middle class, we would like us to review briefly what the classic arguments of John Stuart Mill (Mill, 1910) were in the midst of the nineteenth century when he was writing on international trade.
We would like to emphasize that in his writings, while he articulates well the advantages of free trade in terms of lower prices, higher incomes, great efficiencies, reduction of costs, allocation of resources, inviting new investments and in terms of higher productivity, he makes a very good point when he says that international trade and foreign transactions become the cornerstone of surplus capital that can be used to produce other things. Therefore, it is the savings in capital which advances efficiency, prohibits misallocation of resources, and assists nations in the production of goods or in the consumption of imports, all of which lead to higher standards of living, higher levels of disposable income, and thus greater propensity for capital accumulation. However, all these benefits from free trade are not as important according to John Stuart Mill as the intellectual and moral advantages that free trade carries with it.
Empirical studies throughout the world have documented that free trade of goods, capital, and technology not only reduce prices and enhance incomes, but also act as the conduit for transferring the technologies that enhance productivity, increase competition and therefore, stimulate industries to become more efficient. Moreover, the push for efficiency forces unproductive businesses to reform or go out of business. Competition stimulates efficiency, and over the years study-after-study has documented this phenomenon. Therefore, when we look at studies by Keller (Keller, Wolfgang, and Yerple, 2003), Hay (Hay 2001), Edwards (Edwards, 1998), Crafts, (Crafts, 2000), Harrison and Hanson (Harrison and Hanson, 1999), and Sachs and Warner (Sachs and Warner, 1995), we can see that overall economic growth as well as productivity growth can double and sometimes triple when industries become less sheltered from foreign competition.
Mexico is a classic case because it can be demonstrated that after its trade liberalization in 1985 its productivity increased dramatically. The same happened in India as well as in South Korea. These productivity gains, which we clearly understand to be economic gains, take place due to the new and more efficient allocation of resources within industries as well as across industries. Empirical studies have also shown that trade liberalization over the past few decades in Spain, Chile and New Zealand have contributed to rapid growth in productivity as well as greater growth in their economy. While there might be a dispute as to whether trade is directly responsible for greater growth – studies actually diverge in their conclusions, see Franklen and Romer, 1999 or Rodriguez and Rodrik, 2001 – we do have however, a consensus which says that trade may not be directly correlated with growth, however it stimulates growth indirectly through investments, i.e. we have sufficient evidence of indirect relationship where growth increases in countries via the mechanism of international investments, which in our paradigm is the cornerstone of capital formation.
Now, if we return for a moment to our previous intellectual benefits, the non-economic benefits from trade, we can still remember the perpetual peace advocated by Immanuel Kant who suggested that a durable peace could be built upon a tripod of representative democracy, international organizations and economic interdependence. Of course, we cannot neglect the expanding political science literature which illustrates that indeed economic interdependence among nations reduces the risk of conflict, mitigates the risk of war and finds that there is a positive link between trade and peace. Even if we are tempted to question the plausibility of the relationship, we should not neglect the fact that study-after-study points to the apparent link between political reforms as an outcome of liberalization. So while trade may fail to generate movement towards democracy, there is ample evidence to point that domestic institutions perform better, and are less corrupt when there is open trade and competition and when nations are open to each other in an accountable manner (Irwin, 2002).
Is it Convergence or Divergence?
Of course, there is plenty of literature that reviews the distributional effects of globalization. We could point out reviews by Harrison and Gordon (1999), Adrian Wood (1999), Goldberg and Pavcnik (2007.) The latter, points out to the fact that countries that have experienced great forms of globalization either through more imports and exports or through the magnitude of capital flows, (FDIs, foreign exchange fluctuations, etc.) have experienced higher levels of inequality. Particularly on pp.48-49 of that review, the authors point out that countries from different continents have experienced either significant or slight increases in inequality, with the latter being measured either as skill premium between skilled and unskilled workers, or by the Gini coefficient, and sometimes by consumption or income patterns.
We need to point out that, as we mentioned earlier, the Xavier Sala-i-Martin (2006) article is very emphatic in demonstrating that worldwide poverty has been reduced and convergence has been achieved through globalization.
Sala-i-Martin points out that China has a lot to do with this kind of convergence, and he shows that if we use the $2 per day income line, then we could clearly see that poverty estimates have experienced a significant decrease in China between 1980 and the beginning of the twenty-first century, from about 48% to less than 15%. For China, Sala-i-Martin reports that more than 250 million people escaped poverty because of globalization. He further reports the same thing for countries such as Indonesia and Thailand with the only exception is Southeast Asia being Papua New Guinea. Overall, and excluding China, more than 200 million people escaped poverty because of globalization in the last quarter of a century.
He does point out that the big Asian success is dramatically different from the African experience. In Africa, the total number of those living in poverty has jumped by more than 200 million persons. In all African countries poverty and inequality has increased, with the exception of Botswana and maybe some small countries like Mauritius. Sala-i-Martin composes what he calls the WDI (World Distribution of Income) and presents an impressive time-series table of the WDI from the 1970s to the beginning of this century. In that table, we could clearly see that all measures of inequality have been declining, whether we measure inequality using the Gini coefficient or the variance in the logs of income. Moreover, he shows that that ratio of income of the top twenty percentile to the bottom twenty percentile, as well as the ratio of income of the top ten percentile to the bottom ten percentile has been experiencing significant decreases by as much as 30%. Therefore, the graph below summarizes the WDI from the 70s to the beginning of the twenty-first century.
Source: Xavier Sala-I- Martin, 2006
The argument of the paper is that the significant reduction in inequality which has been empirically demonstrated by Sala-i-Martin is the effect and the outcome of capital formation using the means of international trade. Now, this is a strong argument that needs further investigation and a lot more work, however from a theoretical standpoint as well as from a historical standpoint we can say that nations, empires and economic powers have built themselves up through savings and capital formation using the means of international trade.
As Bernstein clearly explains in his book, A Splendid Exchange, whether we talk about the Sumerians, Chinese, Portuguese, Spanish, British or the Americans, they all have built their capital by opening or financing (in the case of the U.S.) international exchanges. So, in our theoretical framework there is always a need for a rule of law and the right to property, what we call the legal infrastructure.
However, this must always be accompanied by capital formation.
If historical experience is teaching us anything, it is that capital formation is best done through international trade, trade liberalization and international exchanges. Eventually, trade liberalization becomes the venue or vessel of empowering people to experience upward economic mobility. It is like having many people at a port on the coast and some of them board a vessel, the vessel empowers them to get better acquainted with technologies, to have better access to capital and other resources, exposes them to ideas, to better education, because it takes them away from the port, to new places. The distance between those who are left behind at the port and those who are now sailing away from the port may be rising initially, but the ones who are on the vessel are the ones who are experiencing the phenomenon of being part of the middle class. In another analogy, we can think of a moving escalator, the international trade becomes the escalator of moving people up, being part of better educational opportunities (social infrastructure), better health care provisions (again, social infrastructure), being able to move around and experience upward mobility, get better jobs, save and invest i.e. take advantage of physical and financial infrastructures. The country as a whole in that case, is able to export and import, to experience growth through investments and FDIs, capital importation, better technologies and production techniques.
The country through export-led growth experiences physical and social infrastructure investments, which eventually empowers the people and the middle class to enjoy savings. Those savings will become the seed for a financial infrastructure, both local and foreign-owned. The emergence of the this kind of infrastructure will finance the formation of new vessels, which in turn will bring the people from the port/coast to the ocean, thus sustaining the creation of the middle class.
So while we may be taking a leap forward without enough evidence at this point, I think it would be normal to expect that globalization, as it is evolving may be showing some measures of higher inequality. However, if properly realized that is simply a means to create and sustain a middle class via capital formation, then over time liberalization and higher international trade will lead to the creation of the middle class, leading eventually to lower rates of inequality and poverty.
If convergence is indeed achieved, then justice has been implemented, because justice relates to others and becomes reality when equals are treated equally.