Ebook International Institutions and Terms of Trade Volatility
Economic interdependence brings rewards but also new risks. Chief among these are economic shocks generated by price instability. From June 2007 to June 2008, for example, global food and fuel commodity prices shot up by 45 and 91 percent, respectively (IMF 2008). While the magnitude of this rise in prices is unusual, Figure 1 shows that all commodity prices have displayed a striking amount of volatility over the past fifteen years. Changes in the relative prices affecting a country’s overall international payments – one part of which is commodity prices – are summarized in the economy’s “terms of trade,” defined as the unit price of exports relative to the unit price of imports. There is widespread consensus that when an economy is open with respect to trade, volatility in the terms of trade can have various adverse consequences. Specifically, such volatility can retard economic growth, deter trade and investment, raise the cost of external borrowing, aggravate budget deficits, decrease personal income security, and reduce public support for integration in the global economy.
How do states address the risks associated with an open trade regime? Existing studies point to a number of strategies. Chief among these is the expansion of social insurance. This strategy, referred to as the “compensation hypothesis” or “embedded liberalism,” emphasizes that the welfare state insures citizens against the risks introduced by ties to the global economy, reducing opposition to open market policies. Another option is for a developmental state to absorb globalization’s risks itself by playing a heavy hand in national resource allocation. Beyond that, states may embrace globalization and suppress opposition from those bearing its distributional costs through dictatorial means.
This is a fairly limited and costly menu of alternatives. As studies have begun to emphasize, many states simply cannot afford the level of funding for social programs needed to fully insure citizens against the vicissitudes of global markets. Indeed, some research suggests that global competition, which increases domestic demand for welfare expenditures, simultaneously makes it harder for government to raise the revenue necessary to fund such programs (e.g., Rodrik 2002). Regardless, what these strategies all have in common is that they are purely inward looking: they ignore the role states can play in managing their own external environments directly. By assuming that terms of trade volatility is exogenous, the literature fails to appreciate how states might be able to dampen price instability itself, rather than merely limiting exposure to such fluctuations or compensating for risk after the fact.
In this paper, we identify a different mechanism by which states can directly address terms of trade volatility. Namely, we argue that the same international institutions that help to open foreign markets are also explicitly designed to make changes in relative prices more predictable. These institutions include bilateral and regional preferential trade arrangements (PTAs) as well as the multilateral General Agreement on Tariffs and Trade (GATT) and its successor, the World Trade Organization (WTO).
We hypothesize that both types of international trade agreements (PTAs as well as the GATT/WTO) reduce the volatility of a member country’s terms of trade. They do so by (a) constraining other member-states from introducing new trade barriers, but also giving members a degree of flexibility to relax certain market-opening concessions in sanctioned circumstances; and (b) fostering policy transparency and convergence in expectations, standards, and policy instruments, thereby making policies more predictable and limiting overreactions to market changes. These consequences, in other words, flow from the way trade institutions promote the rule of law, which is quite distinct from the standard function attributed to trade agreements, i.e., serving as vehicles to achieve market openness above and beyond the status quo. As a separate channel of effect, however, any liberalization actually accomplished due to a trade agreement may help diversify the products in a country’s export portfolio. Such diversification can be expected to further reduce the volatility of the country’s terms of trade.
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