The Role of International Trade and Investment

In combating the deepening worldwide recession, policymakers should heed lessons from the last great global downturn--the depression of the 1930s. The lessons are both negative and positive. That is, they tell us what policies should not be applied, as well as which ones should serve as models in this first decade of the twenty-first century.

Certainly, a key component of any strategy to jump-start national economies will be domestic stimulus packages. They need to be carefully crafted to provide short- and medium-term stimuli (tax cuts and targeted spending increases) without gravely damaging long-term fiscal health or thwarting structural adjustment. But given the advanced state of globalization, U.S. policymakers should give special attention to the role of trade and foreign direct investment (FDI) as a means of restoring noninflationary economic growth.

Here the lessons of the 1930s, particularly of what nations should not do, are striking. In 1930, after the stock market crash but before the full onset of the Depression, Congress passed the infamous Hawley-Smoot Tariff Act. Logrolling and the reconstruction of most individual tariff rates caused the average U.S. tariff rate to rise steeply to almost 60 percent, thereby reducing import volume by 12-20 percent. Today economists do not argue that Hawley-Smoot caused the Depression, but they generally agree that it was one important factor in precipitating a worldwide trade collapse. The League of Nations argued in 1933 that the U.S. tariff act “was the signal for an outburst of tariff-making activity in other countries, partly at least by way of reprisal.” Studies have documented this result in Canada, Spain, and Switzerland; in other nations, purely domestic pressures were deciding factors.

In any case, the international economic scene changed dramatically between 1929 and 1932. Worldwide, trade volume fell 26 percent, and industrial production plummeted 32 percent during these years. Protections in the form of tariffs, import quotas, and foreign exchange restrictions spread like wildfire. The collapse of trade during the 1930s meant that one key engine of economic growth was no longer available to turn around national economies. Thus, while increased protection may not have caused the Depression, it did prolong and deepen it.

Postwar Trading Program

Those who constructed our postwar multilateral trading system were very mindful of the disastrous international economic experience of the 1930s. Though protectionist sentiment still prevailed in many nations, postwar leaders from North America and Europe established the General Agreement on Trade and Tariffs (GATT) to begin the laborious process of reducing trade and investment barriers.

Over the past 50 years, as a result of negotiations in eight rounds, average national tariffs have gradually been reduced from 55 percent in 1945 to 3-4 percent today. In the Uruguay Round that ended in 1994, the GATT tackled major nontariff barriers behind the borders in such areas as services and agriculture.

The economic consequences of this steady reduction of restrictions, which resulted in more open markets and increased competition, constitute a second positive lesson from the past. Trade and FDI became true engines for economic growth, not only for developed countries like the United States but also for developing countries such as South Korea, Singapore, Chile, and, more recently, China, Mexico, and Brazil.

A review of the figures for trade, FDI, and national economic growth weaves a convincing tale of positive synergy. In almost every year from 1945 to 2000, the worldwide growth of merchandise trade exceeded the growth of national output, often by substantial margins. From 1950 to1963 annually, the average growth in trade volume was almost 8 percent, while national output growth averaged 5 percent. From 1990 to 2000, trade volume grew 7 percent and average output grew 3 percent. Thus, throughout the entire period, international trade exerted a positive, pulling effect on individual national economies, allowing them to exceed their domestic growth potential through commerce with other nations.

During the 1990s, FDI began to enhance growth throughout the world economy, particularly in the United States. The United States was far and away the largest investor in foreign economies, and it attracted the most FDI within its own economy. In 1998, for instance, U.S. FDI amounted to $980 billion, while FDI in the United States reached $812 billion. Directly connected to trade, FDI enhanced the positive “pulling effect” of trade on the U.S. national economy. Forty percent of our merchandise trade and about 60 percent of our services trade consist of commerce between domestic and foreign affiliates of U.S. and foreign companies.

The Payoff from Future Trade Negotiations

Recent trading rounds have liberalized trade and investment, but much remains to be done. Highly respected University of Michigan economists have calculated the potential future gains that would flow from additional trade liberalization. They estimate that a 33 percent reduction of post-Uruguay Round tariffs on agricultural and industrial products, combined with a 33 percent reduction in services barriers, would produce annual world welfare gains of $613 billion, with $177 billion of this total going to the United States, $169 billion to Europe, $124 billion to Japan, and $90 billion to developing countries. (In the United States, a one-third reduction in trade barriers would translate into an additional $2,500 annually for a typical American family of four--just the kind of jump start for consumerism that is needed in a potentially severe downturn.)

Further, about 80 percent of the gains stem from liberalization in the services sectors--areas where the United States enjoys a strong competitive advantage and where increased liberalization would result in often doubling or tripling U.S. services exports over the short term, further stimulating U.S. job growth.

A Plan of Action

Given the potential payoffs, the Bush administration should give high priority to liberalizing trade and investment as an essential element of its drive to return the U.S. economy to a path of sustained, noninflationary economic growth.

First, do no harm. Harking back to the experience of the 1930s, the initial guideline should be “First, do no harm.” This means actively opposing interest groups that want increased protection in such areas as steel and textiles. The Bush administration, unfortunately, has already made some concessions to the steel industry.

But in fashioning a “safeguards” measure to grant temporary relief for steel, the administration should demand that current protectionist antidumping actions be dropped for the duration of government relief. It should publicly pledge that after a short (two- to three-year) period we would open our steel market to all comers.

Such a program makes overwhelming economic sense for it builds upon the reality that steel users contribute tenfold more to U.S. economic and job growth than does the shrinking and uncompetitive U.S. steel industry.

In the same category of “do no harm,” the administration should oppose the farm bill that Congress is considering, which increases agricultural subsidies and price supports. Passage of a bill that increases subsidies would inevitably result in greater distortions in the international market for agricultural products and greatly complicate future trade negotiations.

Multilateral liberalization. A new trade round is the most important positive element of a growth-enhancing international trade and investment strategy. Among the areas that could bring the highest economic gains, the following are the most essential:

  • Services. Some 80 percent of welfare gains accruing to the United States stem from liberalization of key service sectors such as telecommunication, financial services, energy services, and professional services.
  • Agriculture. To achieve substantial world welfare gains in a new round, liberalization in the trade of agricultural products is absolutely essential. Progress here is a prerequisite for obtaining support from developing countries for liberalization in all other sectors.
  • Industrial Tariffs. While average industrial tariffs in developed countries are now relatively low (3-4 percent), there are important exceptions. In addition, many developing countries have special exemptions that should be gradually removed in the new round.
  • Textiles. As with agriculture, this sector (which is protected in some developed countries by tariffs up to 20-25 percent) is of major importance to the economies of many developing countries. Indeed, the United States should unilaterally reduce textile tariffs starting in 2005 and after.
  • Investment. Though the rights of investors to sue governments are controversial, a set of simple, transparent rules for foreign investors should be formulated. Of particular importance would be regulations further restricting performance (export) requirements for foreign investors.
  • Environment and labor policies. In return for advances in agriculture and textiles, developing countries should allow the WTO to establish study groups in these areas--without any implication that such activities will result in new rules and sanctions in these areas.

Regional and bilateral agreements. Economically, the two most important agreements for the United States are the Free Trade of the Americas Agreement (FTAA) and the Asia Pacific Economic Community agreement. In both cases, negotiations should be pursued as backups if WTO talks bog down. But all parties to these two agreements should keep in mind that their economic payoffs are much less than with worldwide trade liberalization.

The FTAA, for instance, is estimated to increase world welfare by only $78 billion-$53 billion for the United States and about $25 billion for the rest of North and South America. Bilateral agreements are correspondingly smaller in payoff and introduce additional problems of trade diversion (i.e., increased trade between two countries because of differential tariff rates and not because either is necessarily the lowest-cost producer).


For most of its history, the U.S. economy has operated as an independent, relatively self-contained unit. During the 1930s, even though the global Depression had a negative impact on the U.S. economy, trade (exports plus imports) as a percentage of the total U.S. economy never even reached 10 percent.

Today, matters are dramatically different. The United States is much more affected by international trade and investment disruptions. Exports and imports now represent about one-quarter of the total U.S. economy, and the new importance of foreign direct investment (about 20 percent of the U.S. economy) links the U.S. economy even more directly to the world economy.

Thus, getting it right on international trade and investment policy is an indispensable component of any U.S. strategy to combat the growing menace of recession.

Claude E. Barfield is a resident scholar at AEI.

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