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An Ignored Relationship: Free Trade, Poverty, and Developing Countries

I. Introduction

Trade liberalization is often seen as an important, if not vital, element to eradicating poverty levels. There is evidence that trade liberalization increases growth and production levels while improving the overall economy.  This is a widely held belief that can be traced back to classical economists such as Adam Smith (1776) and David Ricardo (1815) and has been rigorously put into an international practice for over twenty years (Winters 2000). However, even in spite of the studies that ‘prove’ trade liberalization’s benefits, there is still a mounting hostility with the process itself, especially by the millions who have been thrown into poverty from market liberalizations.  Indeed, the growing enmity culminated into the Seattle protests against the World Trade Organization (WTO) in 1999, and, historically, there have been outspoken opponents against free trade that can fill volumes.

The effort to diminish poverty levels cannot be overstated in its importance, which is exactly what free trade proposes to achieve.  However, the methods employed and the ways in which free trade policies have been implemented not only cause a great deal of controversy, but also produces inequitable results that often exacerbate the economic woes of developing nations.  Although the long-run goal of globalization and free trade is to eradicate poverty levels, they have fallen woefully short in the current and historical state. 

This discussion will be primarily focused on trade liberalization and its connection to poverty, but it will also provide an overview of the key players involved in free trade, and the exhausting debate around it.  An overall understanding of this very complex issue will help provide a clear overview, as well as elucidate the link between free trade and poverty, which is so often ignored.  Indeed, a substantial bulk of the research on the so-called benefits of trade liberalization focus on the aggregate level of economic improvement and growth, yet conveniently ignore the inequalities free trade policies incur, especially on the microeconomic level.  This discussion therefore offers an alternative view on the effects of free trade, as it will provide evidence that free trade practices do not assist in closing economic gaps, but rather, they assist in making these gaps wider. Moreover, trade liberalization is generally accompanied by market liberalization, which effectively destroys the social and political fabric of the country[1]. The bottom line is that economic development implies a transformation of society, and the West has pursued free trade in a very ideological way, using it as a vehicle for globalization policies, displacing the poor, creating massive inequalities, and leaving social and political chaos behind.

II. What is Trade Liberalization?

          From a layman’s perspective, trade liberalization involves the reduction of barriers in the international trade of various goods and services. These barriers can include the removal of government interference in financial capital markets as well (Stiglitz 2002). It is thought that by eradicating barriers to trade, the economy will be stimulated, job opportunities will be created, competition will enhance, there will be an increase in investments, and, as a result of the latter, an increased flow of capital into a country. By providing a nation with a comparative advantage—that is to say, free trade will enhance a country’s income by forcing resources to move from less productive uses to more productive uses (Stiglitz 2002)—imports and exports will increase. Obviously, this is beneficial to a country’s GDP rate and overall economic viability.

However, the comparative advantage concept is more complex than it appears.  So too is free trade.  Trade liberalization is the driving force of globalization (McCulloch, Winters, & Cirera 2001, p. 5) and is often put into practice in a very ideological way, which generally conforms to the Western view of how capitalism and democracy should work (Stilgitz 2002). On these areas, however, we will return. For now, it would be useful to investigate how free trade was conceptualized and who is in charge of free trade policies.

III. Who Are Behind Free Trade Practices, Anyway?

          The idea that free trade is a one-size-fits-all policy became popular after World War II, with America at the helm. Advocates of free trade and free market theories, most notably the Noble-prize winning economist Milton Friedman, began to popularize the notion that markets are inherently democratic (Bruner 2002). If the correct institutions are in place, it is thought that full competition will ensue and thus fair practices as well (Bruner 2002)[2].

          There was a good reason for Freidman’s conceptualization, a universal band-aid for economic downturns. The near global depression of the 1930s had forced many leaders and scholars to believe that there was a need for “collective action at the global level for economic stability” (Stiglitz 2002, p. 12), and the UN Monetary Financial conference in July 1944 became the forum for new ideas that would assist in future economic depressions.

Two central ideas held. The general consensus of both economists and government planners at the time was that protectionist policies led to tension between nations, which caused trade wars and hostile relations (Bruner 2002). The best way to fix the protectionist blanket—used notoriously by Japan, but in other Asian nations as well—that frustrated free trade efforts was to dismantle political and economic barriers.

These two key ideas brought about the birth of the International Monetary Fund (IMF), the World Bank, and the General Agreement on Tariffs and Trade (GATT), which was later reformed into the World Trade Organization (WTO). The IMF was supposed to limit itself to administering macroeconomic policies in specific countries, such as monetary policies and inflation controls. The World Bank was relegated the task of administering structural policies in a country, such as trade policies, labor markets, and overseeing the money that a specific government spent (Stiglitz 2002). An international agreement for the administration free trade issues emerged with the General Agreement on Tariffs and Trade (GATT). GATT hopelessly failed, however, and the WTO was created in its ruin. The WTO now acts as a forum for other nations to have discussions and make agreements on free trade issues and regulations (Stiglitz 2002). The three organizations that run the globalization process, often referred to by detractors as the ‘Unholy Trinity’, manage and create economic policies in the international arena.

There is an important point to be made from all of this, beyond the obvious reason of understanding how global economic policies are implemented. The first is the imperialistic nature of the WTO, IMF, and World Bank. These institutions and the policies they make are not open to the general public; agreements, discussions, and economic policies are made behind closed doors (Bruner 2002).  The reason provided for these closed-door operations was that open discussions regarding amendments in trade or economic procedures could possibly led to economic phenomena such as capital flight[3]. However, the risk of capital flight does not give credence to the autocratic process. Indeed, with the director of the WTO openly declaring his goal for the organization was nothing less than the task of "writing the constitution for a single global economy" (Bruner 2000, p. 27), the people can do nothing but question the institution’s true intentions[4]. Even today, there are no laws where a citizen can appeal to find out what these institutions are doing, which, as Stiglitz rightly contends, is an essential part of government accountability (p. 50).

Worse still is the governance of these international finance organizations. The leaders of the IMF and World Bank are always European or American, and there is no prerequisite for them to have any experience (academically or otherwise) with the developing world they are making economic policies for (Stiglitz 2002). The final blow is that those who speak for developing nations do not serve the country’s interest. At the IMF, for instance, the finance ministers and central bank governors (either Americans or the Europeans) speak for developing nations. Over at the World Trade Organization, the trade ministers (Americans or Europeans) speak for developing nations, and these ministers will naturally reflect the concerns and issues of the business and financial community[5] (Stiglitz 2002). In short, developing nations interests are not being served by those in charge. These issues, however, are just the beginning of the problem.

IV. The Debate

The debate over free trade is exhausting. Understanding the arguments for and against free trade will help to clarify this important and destructive issue. We’ve already seen the arguments from free trade advocates in brief: (1) the reduction of prices in goods, which results from the reduction of barriers (2) more efficient production, which results from the re-allocation of resources; (3) increased investments, which results in an increased flow of capital (McCulloch, Winters, & Cirera 201, p. 16-21). Finally, (4) there is the argument that free trade provides an economy with a comparative advantage (Irwin 2002). These arguments, however well intended they may be, fail to notice critically important issues that free trade agreements exclude.

          First, trade reforms are often narrowly defined and commonly ignore issues that will be incurred through the liberalization of good and services that are not economically related. For instance, there is not one provision, in either the North American Free Trade Agreement (NAFTA)[6] or the recent Australian Free Trade Agreement (AUSTFA)[7] for environmental policies or, perhaps more pressing, standards for labor and protection clauses.

More directly related to economics, trade reforms themselves only include tariffs and non-tariff barriers, yet somehow ignore economic policies on price controls, exchange rate adjustments, or foreign exchange restrictions (Das 2001). A reduction in barriers cannot create equitable growth on its own. As Das reports, “The effectiveness of trade liberalization is enhanced considerably when it is “accompanied or preceded by” reforms in all these policy areas (Mussa, 1998). Experience shows that most successful liberalization and trade reforms were those that were a part of comprehensive economic adjustment packages. The ones that were narrow in design either had limited impact or could not be sustained” (Das 2001, p. 18). However, unfortunately, these policies and provisions that would help stimulate the economy are usually never included in free trade agreements (Stiglitz 2002).

Moreover, the argument that free trade allows a nation to have a comparative advantage is simply incorrect[8].  It was noted above that free trade is supposed to provide this incentive to nations by forcing countries to move from less productive uses to uses that are more productive. However, more often that not, free trade brings low productivity to zero productivity. How? The destruction of jobs, which is a frequent and immediate impact of free trade, results from inefficient industries collapsing under the pressure of international competition. Foreign markets, for instance, can overrun a nation’s domestic banking industry, which will decrease the capital extended to small and medium-sized firms (Stiglitz 2002), but the more disastrous consequence is that it can led to serious macroeconomic instability. In fact, this exact occurrence precipitated Argentina’s market collapse of 2001(Stiglitz 2002).

On the last note, advocates of trade liberalization also think that jobs will emerge once the old, unproductive jobs are eliminated.  Although free trade economists theoretically espouse job creation due to specialization, there is no such thing as immediate job creation.  It takes time, capital, and entrepreneurship to create jobs, which is something that developing countries do not have.  A country cannot remove its barriers, open itself to powerful Western industries, and only focus on tariffs alone; trickle down economics will not suffice[9].  And in the interim, it is the people that suffer at the hands of free trade macroeconomic theories.  The truth is in the evidence, which overrides economic principles and show that the developing nations suffer from the West’s mantra and economic principles of free trade.

V. The Evidence against Free Trade

Even Canada, which is clearly an advanced industrialized country, has experienced both social and economic hardships due to free trade and the flow of capital. There has been, for instance, a considerable decrease of foreign capital and contraction of the country’s corporate tax base since 1989, which has in turn placed stress on the Canadian government to cut social benefits such as welfare unemployment insurance benefits (Elmslie & Milberg 1996)[10].

In the early 1990s, the global investors were impressed by the consistent rate of growth in the Asian region, and it was considered the “East Asian Miracle” that was widely compared to the failure of development in the similar economic circumstances in Latin America.  However, their growth had nothing to do with IMF or World Bank policies; the Asian governments had implemented development and financing policies that spurred successful economic growth and healthy trade with the advanced, industrialized countries (Stiglitz, 2000).  Singapore is a great example of how a government’s investment in education, high savings rates, and state-directed industrial policy dramatically increase the standard of life for all its citizens (Stiglitz, 2000).  The great rate of growth in East Asia, combined with the lower interest rates of the United States and Europe, made the Asian countries look very attractive to foreign investors.  With the liberalization of the international capital markets, new financial tools, and encouragement of the IMF and World Bank who believed full capital account liberalization would help the region grow even faster, a tremendous amount of foreign capital poured into East Asia.  Foreign banks loaned Indonesia, Malaysia, Philippines, Thailand and Korea $210 billion in 1995, and then another $261 billion in 1996, which amounts to an annual increased rate of lending of 24% (Radelet & Sachs, 1998).  Although the increased rate of lending lessened in early 1997 to only 10%, the amount of foreign capital loaned still amounted to $274 billion; this is approximately 2.8% of the pre-crises GDP in early 1997 (Radelet & Sachs, 1998).  However, with an increase in foreign capital flows, the domestic macro-economy becomes more difficult to control.  The foreign capital inflow creates an appreciation of the real exchange rate, thus attracting investments to non-tradable goods instead of the productive, export industries that are supposed to benefit from free trade.  Additionally, the major amount of foreign capital created pressures on underdeveloped financial systems not equipped with the capability of managing the inflow properly.  By mid-1997, according to the Institute of International Finance, these countries experienced dramatic reversals in net private capital inflows; during 1997, the capital dropped from $93 billion to negative $12.1 billion, which is approximately 11% of pre-crises GPD of the countries.

The extraction of such a large amount of capital did make serious macroeconomic and microeconomic repercussions.  First, the exchange rates drastically depreciated, despite the strongest attempts of the government to maintain currency value.  Additionally, the decrease the supply of the foreign capital caused the interest rates in these countries to increase dramatically.  The major withdrawal of credits resulted in a large reduction of the absorption originally financed by foreign capital inflows, and therefore, both the nominal and real exchange rates depreciated greatly.  Both the depreciation of real exchange rates and sharply higher interest rates led to another result: a large increase in the number of non-performing loans (Radelet & Sachs, 1998).  The IMF stepped in to “help” alleviate the situation and took away the countries’ economic sovereignty, but actually made things worse for these countries economically (Stiglitz, 2000).  Banks were forced to substantially decrease loans, as they did not have the capital to continue funding under the capital-adequacy ratios demanded by the International Monetary Fund (IMF); if the banks did not immediately meet the capital ratios, the IMF threatened to close these banks in Indonesia, Korea, and Thailand (Radelet & Sachs, 1998).  The IMF made several severe requests on the Asian banks that created more dramatic consequences for the domestic economies: bank closures, capital-adequacy ratios, tight credit limitations, high interest rates on central bank discount facilities, fiscal conservatism, and structural changes in the non-financial industries (Radelet & Sachs, 1998).  These demands exacerbated the already existing financial panic.  When these policies did not work in alleviating the crisis, the IMF blamed each country and stated that the governments did not take the necessary reforms seriously, when in fact it was the IMF that had taken away the economic sovereignty of these governments to make reforms that would actually help the situation (Stiglitz, 2000).  As a result, the crisis became worse and the unemployment rates in Korea, Thailand and Indonesia skyrocketed, while the GDP plummeted and banks closed due to the IMF restrictions and capital policies.  The East Asian financial crisis is the perfect example of how the Washington Consensus policies of free trade were the downfall of economic stability in the region.  The evidence indicates that the IMF’s perception of free trade and capital liberalization was not only ineffective, but propelled the Asian economies from healthy growth into a downward spiral of economic crises that otherwise could have been curbed by the domestic governments.     

VI. The Ambiguous Economic-Related Effects Causing Poverty

          With the exception of a handful of Eastern European countries, China, and Vietnam, the prevalence of globalization and free trade has increased the prevalence of poverty, while lowering the standard of living for those in developing countries.  Static economic models estimate that global free trade will lift 540 million people out of poverty over a 15 year time frame (Cline, 2004).  However, it is the same phenomenon that, at least in the interim, has made the lives of millions worse off, as their jobs have been destroyed and lives made more insecure (Stiglitz, 2000).  Even looking at the facts in the United States itself, the world’s greatest espouser of free trade, the evidence is overwhelming that poverty rates have increased in the world’s most advanced industrialized society (Nader, Philips, Choate, 1993).  From 1973, US free trade with other countries has doubled, but the average paycheck of the American worker has decreased by 18%.  Additionally, between the 1980s and 1990s, the number of young men who work full time at poverty wages has increased 100% (Nader, Philips, Choate, 1993), even while the national per capital income grew 28% due to those with the highest incomes getting richer.

Although the IMF and World Bank had the purpose of lifting the financial levels of developing countries through free trade, mounting evidence indicates that these NGOs have done exactly the opposite by creating more income inequality, poverty, and political instability.  Part of the reason is due to these institutions’ unwavering and narrow ideological perspective towards economic ramifications; in order to get funding for economic development, countries had to abide by strict regulations of privatization.  Essentially, those countries that privatized the fastest were rewarded economically with good “scorecards” in making the transition from closed, communist societies to open liberalized economies practicing free trade (Stigliz, 2002).  However, the rapidity of privatization did not allow these formerly closed communist economies to develop the proper market mechanisms that would allow them to profit from free trade.  The IMF and World Bank had blindly assumed that the free market would automatically generate mechanisms that would meet the needs of these societies, but in reality, even in the United States, it has been the government creating programs and intervening especially because free markets have failed in providing essential services for society (Stiglitz, 2000).  The IMF and World Bank argued that the priority of privatization comes before the establishment of proper regulation and competition institutions, however in developing countries, this created private monopolies from original state owned enterprises (SOE) that simply garnered macroeconomic revenues at the expense of workers and consumers (Stiglitz, 2000).  Thus, the money fueled in for developing free trade decreased the quality of life and economic standing of the masses of consumers and workers, who felt strain instead of reward from the sudden market economies implemented by the IMF and World Bank.  As a result, in Russia for example, the rapid privatization of companies and free trade market shifts resulted in 30 to 40 million individuals living below the poverty line of $30/month (Freeland, 2000).

          Inherently, free trade and capital market liberalization that the IMF passionately espouse comes with immense volatility, as witnessed in East Asia.  It is this volatility that increases poverty, as foreign investors demand higher returns that put strains on the economy, and thus increases the potential of recessions, a burden the poor bear the heaviest  (Lechner, Boli, 2004).  Additionally, the economic restraints and “structural adjustment programs” that come with IMF funding makes alleviating poverty more difficult; these policies make job creation nearly impossible from the high interest rates (Lechner, Boli, 2004).  In the United States, investors and businesses are greatly concerned for economic well-being when the Fed announces a quarter-point rate hike.  How can developing countries, which do not have economic opportunities and a much less hospitable environment for investing, sustain severely high interest rates?  The result of free trade in these countries then is increased poverty, as people are shifted from low-productivity state owned enterprises to unemployment (Stiglitz, 2000).  The welfare and standard of living are greatly reduced for the citizens of developing nations faced with free trade and major structural restrictions by the IMF.

VII. Towards an Alternative, Ethical Paradigm

          Globalization can provide benefits to developing countries in the long run, but certainly not in the current state espoused by the IMF, World Bank, and WTO.  The regulations put on developing countries by these international NGOs have been to the benefit of the advanced industrialized countries, but to the detriment of the countries and citizens that need economic development the most.  The narrow viewpoints and economic theories held by these organizations have been dictated by the Washington Consensus; the implementation of the theories have resulted in the economic failures and increased levels of poverty in developing countries.  As shown by the success of the Asian governments before the IMF’s involvement, local policies need to be in place to create the right environment, institutions, and regulations to deal with free trade and the impacts of globalization.  Simply injecting a country with capital and forcing it to lift market regulations has proved to be a great disaster on economic and humanitarian levels.  Additionally, the lack of transparency in the IMF and World Bank need to be altered; how can international organizations that promote free trade and democracy close their doors to public knowledge (Stiglitz, 2000).

Additional models of free trade development need to be explored and tailored to the individual needs of each developing country; there is no universal model, as clearly seen by the varieties of liberal democracies in the advanced, industrialized countries.  These models should also include plans that recognize and alleviate the short-term negative consequences of free markets on the working people and poverty levels.  Globalization can only reach its positive effects of increasing the quality of living worldwide if it takes care of the needy in the interim.   

VIII. Conclusion

          The theoretical debate on free trade and capital market liberalization has been clarified by real-world results in the developing countries.  Poverty levels have increased, “free market” economies have collapsed into chaos, and GDPs and exchange rates have spiraled downward in the face of free trade.  The crisis after IMF intervention in East Asia and the increased levels of stark poverty in Russia show that the Washington Consensus has failed in globally lifting the standards of living in developing countries.  The forced, rapid privatization induced by the IMF have caused negative ramifications that only decades of effective domestic government policies and new economic development can alleviate.  Major alterations need to take place if globalization is meant to achieve its goals of lifting poverty from developing countries in the long-run, while still protecting the potentially displaced in the interim.     

References

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