TRADE LIBERALIZATION AND ASSET MARKETS*
JoAnne Feeney University at Albany, State University of New York Arye L. Hillman Bar-Ilan University
Revised: March 2001
Abstract This paper identifies the liberalizing effect of financial market development on trade policy. We examine a small open economy which is characterized by stochastic productivity and populated by risk averse residents who use asset markets to acquire diversified portfolios. The composition of these portfolios influences individual incentives to seek trade intervention from government since the ownership structure reflected therein determines the resident’s interest in the returns generated by particular industries. Interests in protection for any one industry are diluted when individuals hold well-diversified portfolios. The model links the extensive trade liberalization in the second half of the twentieth century to development and globalization of financial markets, and also reveals that protectionist interests can persist due to nontradeability of some assets. The behavior by private agents and government in the model is consistent with trade liberalization trends in economies with developed domestic asset markets and access to global asset markets, and with observed historical trade-policy phenomena. JEL Codes: F13, F3, D52
*
We are grateful for comments from seminar participants at Bar-Ilan University, the University of Konstanz, the University of Colorado, the International Monetary Fund, the University of California at Los Angeles, Clemson University, New York University, and the University at Albany. We have also benefited from comments made by James Anderson, Ken Beauchemin, Jose Campa, Betty Daniel, Jonathan Eaton, Raquel Fernandez, Karen Lewis, and two anonymous referees on earlier drafts. Any remaining errors are our own. Feeney gratefully acknowledges financial support from the National Science Foundation and the hospitality of the Stern School of Business at New York University (visitor, 1997-98). Address for correspondence: JoAnne Feeney, Department of Economics, University at Albany, BA 110, Albany, NY 12222; phone: (518) 442-4732; fax: (518) 442-4736; email:
[email protected]
INTRODUCTION The history of international trade policy in the second half of the twentieth century is characterized by substantial liberalization beginning from initially high levels of protection (Hillman, 2001). This liberalization is reflected in growth in world trade that markedly exceeds growth in world output (Yi, 1999). At the same time, a process of globalization has also occurred in financial markets. While the increased specialization associated with trade in the presence of stochastic productivity serves to amplify output uncertainty, the development of financial markets allows diversification of these greater trade-related risks (Feeney, 1994). Against this background, this paper presents a theory that connects trade liberalization to financial market deepening. We show that financial markets moderate private incentives to seek protectionist trade policies from government. We also account for continued use of trade barriers and indicate changes necessary for further liberalization of international trade. Our explanation for liberalizing trends in trade policy is consistent with the politicaleconomy motives used to explain protectionist trade policies. The theory of the political economy of trade policy describes how private self-interest is translated through collective action and political processes into government decisions that may result in departures from efficient free trade.1 The fundamental reason for the protectionist policies is nondiversified individual income sources. Our model describes how asset markets, by allowing income diversification, shift private interests away from protection which increases returns to specialized industry-specific assets. Our proposed focus on asset markets complements other explanations for trade liberalization which focus on changes in the political strength of interest groups (Cassing and Hillman 1986), or reciprocal gains from exchange of market access (Hillman, Long, and Moser 1995). The most-favored-nation clause has also been interpreted as providing a foundation for broad trade liberalization through multilateral negotiations (Ethier, 1998a, 1998b). In bilateral negotiations, Devereux and Lee (1999) also focus on the connection between asset markets and trade policy, but rather than examining internal political economy forces, they examine the aggregate gains achieved through bilateral trade negotiations. They show that gains from international financial markets can be 1
See the surveys of the literature by Hillman (1989), Magee (1994), and Rodrik (1995).
1
enhanced by the endogenous response of trade policy to the presence of those asset markets.2 Previous political-economy analyses of trade policy generally assume individuals lack the ability to alter income sources. The differences among agents are typically drawn along lines relating to each group’s source of income, whether that be from labor or from industry-specific or intersectorally mobile capital (Mayer 1974). Income sources then remain fixed as the political-economy mechanisms are set out (Mayer 1984). Domestic and international financial markets, however, allow individuals to diversify income sources. We illustrate the liberalizing impact of financial market development in the framework of an economy populated by fully rational, risk-averse, expected-utility maximizing agents who assemble portfolios, influence trade policy through lobbying activities, and trade consumption goods with the rest of the world. Stochastic productivity reflects observed industry-specific risk, and realized productivity determines the direction of trade and the level of import competition for the country. Protection is determined in response to lobbying by private agents. Lobbying is costly, since time otherwise used for leisure is instead devoted to this activity. Private agents understand the government’s policy function and all other aspects of the model, form rational expectations about future trade policy, and use these expectations when making decisions. Individuals are initially endowed with industry-specific capital that delivers a stochastic level of income due to uncertain productivity. Opportunities to diversify are available through trade in claims to factor income in domestic and international asset markets. We show that as an indirect consequence of individuals’ desires to diversify industry-specific risk, asset markets reduce lobbying activities and liberalize trade policy. 3 When some claims to factor income are nontradeable, an interest in protection may remain even after asset trades have taken place.
2
In the tariff game between two governments, there is one equilibrium characterized by free trade and complete risk diversification. In others, diversification is less than complete and trade barriers are not eliminated. 3 In Fernandez and Rodrik (1991), by contrast, uncertainty may have the opposite effect: uncertainty over the consequences of liberalization erodes support for elimination of tariffs and protectionist policies persist.
2
Trade liberalization in our model is enhanced by technological and institutional improvements that increase the ease with which asset-market transactions can take place. These include reduced transactions costs in financial markets, decreases in informational asymmetries, and greater enforcement of property rights. Since these are attributes of developed market economies, our results accord with the greater willingness of governments in developed economies to liberalize trade than governments in countries where domestic asset markets are not developed, international capital-account transactions are restricted, and contracts are not reliably enforced. This is consistent with the observed positive correlation between tariffs and the use of capital controls across a wide range of countries (see Table 1, Campa, Feeney, and Walter, 2000). In a historical context, our model provides a perspective for looking at trade liberalization in the repeal of the English Corn Laws in 1846. The liberalization has been diversely interpreted as the triumph of liberal ideology and as the successful culmination of a campaign of influence by interest groups (see, for example, Irwin, 1989). We set out the formal basis for an explanation of the repeal of the Corn Laws that looks to the portfolio diversification opportunities provided to import-competing English agricultural interests. This supports the arguments in McKeown (1989) and Schonhardt-Bailey (1991, 1996) that asset markets permitted landowners in the protected agricultural sector to diversify income sources away from agriculture. The individual asset portfolios then reflected more closely the factor composition of the economy at large. In the ante-bellum United States, by contrast to 19th century England, diversification possibilities through asset markets were more limited (Wright, 1978). Individuals with claims to import-competing manufacturing capital (concentrated in the north) did not diversify by holding claims to factors (including slaves) specific to southern agriculture, and the diversified asset portfolios required for a broad consensus for a liberal trade regime were therefore not established. 4 Consequently, in the British case asset diversification gave rise to liberal trade, whereas in the United States, absence of asset diversification sustained divided interests. An empirical analysis by Svaleryd and Vlachos (2001) more broadly tests the implications of our model by studying the relation between the development of domestic 4
The value of a portfolio that included claims to slaves was subject to principal-agent problems when working conditions and the health of slaves were determined by distant plantation managers.
3
asset markets and changes in trade barriers during the period of trade liberalization and globalization of financial markets in the latter part of the twentieth century. Svaleryd and Vlachos first look at the correlation between the extent of financial markets and openness to goods trade and find the positive correlation implied by theory. An examination of multiple measures of trade barriers and financial market depth also reveals that not only are trade liberalization and access to financial markets positively related, but the development of financial markets has an independent positive impact on trade openness. We proceed in section 1 by presenting the economic and political environments, private agents’ decision problems, and the trade policy mechanism. Section 2 contains the main results of access to domestic financial markets in the form of four political-economic equilibria. Section 3 illustrates the impact of international financial markets on trade policy. Section 4 provides concluding remarks.
1. ECONOMIC AND POLITICAL ENVIRONMENTS 1.1 Production, Preferences, and Trade Our model begins with a country that trades with the rest of the world at exogenous terms of trade.5 We consider the importance of industry coalitions in creating political incentives for protectionist policies and attempt to determine the impact of financial markets on those coalitions and on equilibrium trade policies.6 To highlight the political role played by sectoral associations in a manner that allows for analytical solutions to portfolio allocations, we introduce a simple model that focuses exclusively on the lobbying activities of owners of sector-specific factors.7 We assume that each sector-specific factor embodies both physical and human capital in order to determine the importance of different degrees of domestic and international tradeability in claims to factor income.8
5
Here, world prices are not manipulable by the domestic government. See Stockman and Dellas (1986) for the relation between asset markets and the “optimal” tariff. We focus on policies with exclusively internal redistributive effects. 6 Empirical evidence suggests that industry associations underlie lobbying coalitions (Baldwin 1989). Other approaches reviewed in Hillman (1989, chapter 1), suggest Heckscher-Ohlin associations where broad coalitions of capital and labor hold conflicting policy positions. See Maggi and Rodriguez-Clare (1998) for an analysis with both approaches. 7 The identification of an individual’s preferred trade policies was first derived in Feeney and Hillman (1995) and is the basis for the current paper. 8 While we thus omit homogeneous and intersectorally mobile labor, we recognize that adding it here
4
Two goods are stochastically supplied to this economy. We specify the nature of production only to distinguish between inputs whose returns are tradeable in capital markets from those which are not. We will see that the relative shares of tradeable returns will be critical for trade policy determination. Hence, we proceed by assuming that competitive firms produce the consumption goods, X and Y, with stochastic, constantreturns-to-scale technologies using industry-specific inputs of human and physical capital, H j and K j , for j=X,Y, with fixed supplies given by H j = H j and K j = K j .9 Output is given by X ( s) = φX ( s ) F ( K X , HX ) = φX ( s) and Y ( s) = φY ( s ) F ( KY , HY ) = φY ( s ) in state of nature s for s = {1,2,3,... S} , where F (⋅) is the same across industries and normalized to unity to simplify the presentation and to provide tractability in solving for portfolio allocations. The productivity shocks, φ j ( s ) , are strictly positive, independently drawn from the same distribution, symmetrically distributed around the common mean, φ , and have variance, σ 2 . The difference in the shocks, φ X ( s ) − φY ( s ) , is also assumed to be symmetrically distributed around its mean of zero. 10 Relative supplies of human and physical capital will affect trade policy: to allow for differences in these supplies across sectors in a tractable way, we let supplies differ only in combinations that preserve equality in expected levels of production. The dividends paid to owners of physical and human capital depend on the productivity shocks and domestic prices, Pj ( s ) = (1 + τ j ( s )) ⋅ Pjw , which in turn depend on whether a tariff, τ j ( s ) , has been imposed through the political process. The total would only introduce a factor which is fairly insulated from relative price changes effected through tariffs (Ruffin and Jones, 1977). 9 This setup is therefore identical to a stochastic endowment economy: factors provide a plausible distinction between tradeable and nontradeable claims to industry output and add empirical insights. This framework also captures a situation where at any point in time capital in its different forms is not readily transferable between industries, and the existing supplies of specific capital form the basis of trade-policy preferences in the private sector. Although the role of factor accumulation (and shifts in these proportions across sectors), is left to future work, this paper determines the effects of endogenous policy on asset prices and thus provides insight into these dynamic effects. 10 This symmetry would follow, for example, from a uniform distribution on φ j .
5
dividends paid by each industry are denoted by δ j ( s ) , and form the basis of those paid to human and physical capital individually, δ ij ( s ) for i=H,K. These are: (1)
δ j ( s ) = Pj ( s ) φ j ( s )
and
δ ij ( s ) = θ ij δ j ( s )
where θ Hj = F2 ( K j , H j ) H j F ( K j , H j ) and θ Kj = F1 ( Kj , H j ) K j F ( K j , H j ) denote the factors’ distributive shares, and numerical subscripts denote partial derivatives. With perfect competition, therefore, all proceeds from production are paid to factor owners through these dividends. Any tariff revenues collected by the government are redistributed directly to agents in equal amounts, and agents take this to be exogenous. Initial endowments of factors distinguish the two types of agents which populate the economy: the representative type-x agent is endowed with the physical and human capital used in the X sector, while the representative type-y agent is endowed with Y-type capital stocks. Hence we will also index agent type by j=x,y (superscript) to indicate the sector from which the agent’s initial endowments of human and physical capital derive.11 We normalize the number of each type of agent to unity and assume identical preferences. In the absence of government, note that these agents would have equally valuable capital stocks, given the properties of productivity. Agents derive utility over consumption of both goods and leisure. Agent j’s consumption utility, u ( x j , y j ) , depends symmetrically on X and Y consumption, u ( x , y ) = u ( y , x ) , and the function is increasing, homothetic, strictly concave with constant relative risk aversion, and twice-continuously differentiable. Each agent also receives one unit of time to divide between leisure and lobbying. Leisure enters separably into utility so that the choice of lobbying does not alter either total or relative demand for the two consumption goods. This simplification preserves the costliness of lobbying behavior, while keeping it from altering consumption in ways that add to the distortionary effects of tariffs. With no a priori belief about the link in preferences between one good or the other and leisure, we choose the neutral position of separability. Expected utility for the representative type-j agent then is given by 11
The common use of index j will be convenient for focusing on the industry associations of individuals.
6
{ (
)} { ( ) ( )} ( s ) ) , with z '( ⋅) > 0, z′′ ( ⋅) < 0, where l ( s ) denotes
E Ψ x j ( s ) , y j ( s ) ,l j ( s ) = E u x j ( s ) , y j ( s ) + z 1 − l j ( s ) with the utility of leisure as z (1 − l j
j
the fraction of time engaged in lobbying. E is the expectations operator. The rest of the world is comprised of many countries which produce X and Y with the same stochastic technology. We assume that supply shocks are independently distributed across countries, and agents in other countries have the same preferences as those at home. This independence of shocks across countries supports a risk-free world portfolio of physical capital. With nonstochastic levels of world output of X and Y, the fixed world relative price can be normalized to one. To further simplify, we let individual world goods prices equal one: PXw = PYw = 1 . With such similarity in the nature of production and preferences at home and abroad, the realization of home supply shocks determines the country’s pattern of trade. 1.2 Endogenous Policy Mechanism We introduce a simple mechanism that links the choice of trade policy to the interests of private agents. Since tariffs can replicate other forms of trade intervention (e.g., quotas), we limit the government’s policy choice to an import tariff, and assume that the home government responds to demands for protection made by its constituents. To focus solely on protectionist trade policy, we do not allow agents to lobby for other sorts of reallocation policies, such as export subsidies or direct transfers. Finally, we assume agents lobby only for a tariff, not against. More complex models, where fewer agents are associated with the import-competing than the export sectors, would associate the greater influence of lobbying by import-competing sectors with a more severe free-rider problem among exporters and consumers.
Our assumption, made for simplicity, causes the
outcome of protection to arise more readily and thus puts the role of asset markets in liberalizing trade to a more stringent test. Government responds to lobbying by imposing a tariff on imports of good j, τ j , that increases with the effort, l j ( s ) , allocated to lobbying by the representative type-j agent in
7
state s:12 (2)
τ j ( s) = τ ( l j ( s) )
where
τ ′ ( l j ( s ) ) > 0 , τ ′′ ( l j ( s ) ) < 0 , and τ (0 ) = 0
This parsimonious political framework captures the influence of private agents on trade policy in the context of political-support maximization or political competition under representative democracy (as in Hillman 1989, Hillman and Ursprung 1988, Ursprung 1990, Grossman and Helpman 1994, or Rodrik 1995), and remains sufficiently general to admit a role for government concern over aggregate welfare. In these environments, lobbying reflects the extent of political support, in the form of real resources, offered to a representative in exchange for a tariff or to a candidate who promises a tariff. When the presence of a democratic system itself is in doubt, lobbying represents the political support given to the regime in power in exchange for a tariff.13 1.3 Consumer/Investor Decisions We proceed by examining portfolio, consumption, and lobbying decisions and the corresponding policy choice implemented under different asset market structures. Initially, we examine trade policy when agents have no access to financial markets and must retain initial endowments. Next, we permit agents unrestricted access solely to domestic asset markets, and finally, we include access to international capital markets. Agents choose to trade assets due to the uncertainty in dividends which creates undesirable risk in individual income. Since dividends are imperfectly correlated across sectors and countries, asset trades can reduce this risk exposure. We assume, however, that capital markets permit trade in claims only to a subset of each sector’s returns. The imperfection in capital markets can be thought to arise from many possible sources, although the explicit introduction of such factors is omitted here.14 We associate the subset of returns for which claims are tradeable with physical capital and the nontradeable portion with human capital. These labels have some intuitive appeal in that moral-hazard and 12
It will be the case that at most one type of agent will choose to lobby in a given state, so we simplify by incorporating only one argument in the tariff function. 13 Austen-Smith (1995) and Anderson (1996) model political support as attempts to gain access to political agents. 14 The source of this market imperfection would need to be modeled to determine socially optimal trade policies. Our objective, by contrast, involves uncovering the desired policies of private agents, which need not be socially optimal.
8
adverse-selection problems are thought to inhibit trades in claims to the returns to human capital. Of course, claims to the factor traditionally called physical capital may also be restricted in tradeability due to information imperfections and contracts that address principal-agent problems (as in Demsetz and Lehn 1985 and Cassing 1996). In broader terms, these labels, therefore, do not necessarily reflect characteristics of the production technologies across industries, but rather capture capital market imperfections. Asset trade takes place before the resolution of uncertainty, but with complete information on the distribution of the technology shocks and the nature of the political process. Once expected-utility-maximizing portfolios are established, shocks occur and determine the industry that faces import competition. Agents then choose lobbying activity, and the political process determines tariffs. Consumption choice and goods trade follow. The ex-ante portfolio choice and the value of endowed assets depend on expected future trade policy, which requires that the agent’s problem be solved recursively. In this setting, lobbying only occurs after productivity shocks identify the import-competing industry. Earlier work (Eaton and Grossman, 1985, and Dixit, 1989) examines the role for ex-ante lobbying: to seek government insurance provision via contingent trade policy. By considering solely the ex-post lobbying decision, we focus on the income-shifting motive underlying lobbying, rather than the insurance motive. We proceed with the general form of the problem and then consider its resolution for different financial market settings. Solving the problem recursively, we first determine consumption. The type-j agent maximizes (ex-post) utility subject to the constraint, (3) I j ( s) ≡ α jδ ( s ) + 12 R ( s ) = (1 + τ X ( s ) ) x j ( s ) + (1 + τ Y ( s ) ) y j ( s ) , where each agent’s ex-post income, I j ( s ) , depends on (vectors of) equity shares and dividends, denoted α j and δ ( s ) , respectively. The dividends are defined in (1), and agent j’s portfolio includes four assets ordered as follows:
(α
j HX
j j j , α KX , α HY , α KY ) , where
industry X human and physical capital shares precede those of industry Y. The tariff revenue, R ( s ) , either equals τ X ( s ) x x ( s ) + x y ( s ) − X ( s ) (X as the import good), or equals τY ( s ) y x ( s ) + y y (s ) − Y ( s ) (Y as import), and is taken to be exogenous by both
9
agents. The relative asset wealth of the agents depends on equity prices, q ( s ) , which will be shown to reflect policy expectations. At the time consumption is selected, the agent’s income is established and tariffs (if any) are in place. The consumption bundle will therefore be chosen such that: u1 ( x j ( s) , y j ( s ) )
(4)
u 2 ( x ( s ) , y ( s )) j
j
=
PX ( s ) 1 + τ X ( s ) = PY ( s ) 1 + τY ( s )
Since preferences are symmetric in x and y, a free trade equilibrium would lead to equal consumption of the two goods. With unitary terms of trade, shocks that favor the X sector, φ X ( s ) > φY ( s) , cause X to become the export good and Y the import good. This follows since the greater supply of X relative to Y causes the autarkic relative price of X to fall below one given the symmetry in preferences. To facilitate discussion, we define states m where φ X ( s ) > φY ( s) , with Y as the import-competing sector, and define states n where φ X ( s ) < φY ( s ) , with X as the import-competing sector. The
consumption
solution
gives
rise
to
the
indirect
utility
function,
V ( I j ( s ) ,τ X (s ) ,τ Y (s ) ) , which we use henceforth to simplify the lobbying and portfoliochoice problems. Since portfolio selection will depend on expected dividends, and since these are affected by trade policy, it is necessary to determine – for any arbitrary portfolio – the lobbying decision. Lobbying is selected to (5)
max V ( I j ( s ) ,τ X (s ) ,τ Y ( s) ) + z (1 − l j ( s ) ) l j ( s)
subject to
0 ≤ l j (s ) ≤ 1 .
The agent’s portfolio is established at this point, realization of the productivity shocks has occurred, and the political process is fully understood. Lobbying must satisfy the following for an interior solution: ∂ I j ( s ) ∂τ ( s ) ∂τ ( s ) j V1 ( I j ( s ) , ⋅) − x j ( s ) Xj − y j ( s ) Yj − z′ (1 − l ( s ) ) = 0 j ∂ l (s ) ∂ l (s ) ∂ l ( s ) where equilibrium X consumption, x j ( s ) = x j ( I j ( s ) ,τ X (s ) ,τ Y (s )) = − Vτ (⋅ ) V1 (⋅ ) , and x
Y consumption, given analogously, determine the magnitude of the consumption
10
distortion created by a tariff. We express this condition separately for tariffs on X imports and Y imports as follows: (6) (a) V1 ( I ( s ) , ⋅) Γ ( s )
∂τ X ( s ) − z′ (1 − l j ( s ) ) = 0 j ∂l ( s )
where Γ ( s ) ≡
∂ I j (s) − x j (s ) ∂ τ X (s )
(b) V1 ( I j ( s ) , ⋅) ΓYj ( s )
∂τ Y ( s ) − z ′(1 − l j ( s )) = 0 ∂ l j (s )
where ΓYj ( s ) ≡
∂ I j (s) − y j (s ) ∂ τY ( s )
j
j X
j X
where Γ Xj ( s ) and ΓYj ( s ) indicate agent j’s net gain from a tariff on imports of X and Y, respectively. The individual weighs any positive net gain against the utility loss associated with time away from leisure. Agents choose not to lobby when (6) is negative at l j ( s ) = 0 , and use all time to lobby when (6) remains positive at l j ( s ) = 1 . We rule out the latter case by assuming sufficiently rapid decreasing returns to, and increasing marginal costs of, lobbying activities. We see from (6) that portfolio composition, via Γ j ( s ) , will influence the lobbying decision and thus tariffs. Agents will recognize this interdependency when designing asset holdings. Asset trades are subject to a no-short-sales constraint, and asset-market x y clearing occurs when α Kjx + α Kjy = 1 and α HX = α HY = 1 with solely domestic markets. The
latter condition reflects the prohibition on trade in claims to human capital. 15 When international markets become available, agents trade claims to physical capital at prevailing world relative asset prices (Appendix). With only domestic markets, each agent chooses assets to: (7)
max
j j α KX ,α KY
{
}
E V ( I j ( s ) ,τ X (s ),τ Y ( s )) + z (1 − l j ( s ))
j j subject to q j = q X α KX + qY α KY , 0 ≤ α ijj ≤ 1 , and (3),
where q j is the relative price of a claim on K j and also indicates the market value of agent j’s tradeable initial claims to capital. The latter follows since the total number of claims to each type of capital has been normalized to one. The right hand side of the constraint indicates agent j’s purchases of tradable capital. Equation (3) describes
15
The impact of the no-short-sales constraint is assessed when each equilibrium is derived.
11
income’s dependence on these shares. The portfolio choices must satisfy the following first-order conditions for an interior solution: (8)
(a)
E { VI ( s ) δ KX ( s)} − γ j qX = 0
(b)
E { VI ( s ) δ KY ( s)} − γ j qY = 0
where γ j is the marginal utility of asset wealth for agent j. With dividends defined in (1) and equilibrium consumption given by (4), we combine (8a) and (8b) to determine each agent’s (shadow) relative price of a claim to K Y in terms of K X :
{{ {{
} }
{ {
}} }}
(9)
j j j qY θ KY E VI ( I (s )) E {δ Y ( s )} + Cov VI ( I ( s ) ) ,δ Y ( s ) = q X θ KX E VI ( I j ( s ) ) E {δ X ( s )} + Cov VI ( I j ( s )) ,δ X ( s )
where
δ j ( s ) = (1 + τ j ( s )) φ j ( s ) . We will illustrate the interdependence between
equilibrium portfolios, prices and trade policy for each asset market setting. In the event that the no-short-sales constraint binds on one of the agents, prices from (8) reflect the demand of the unconstrained agent. The portfolio, lobbying, and consumption decisions of the two types of agents give rise to a political-economic equilibrium, which we define as follows: Definition 1. A political-economic equilibrium consists of portfolio allocations, α x and α y ; lobbying effort, l j ( s) ; trade policy, τ (l j ( s )) ; consumption, x j ( s ) and y j ( s ) ; equity and goods prices, q ( s ) and p ( s ) , that satisfy: (i) consumer first-order conditions, (4,6,8); (ii) budget, time, and the no-short-sales constraints, in (3,5,7); (iii) the government policy mechanism, (2); (iv) asset-market clearing conditions.
2. POLITICAL-ECONOMIC EQUILIBRIA 2.1 No Risk-Sharing Markets We first consider the implementation of trade policy when neither domestic nor international asset markets permit the agents to alter initial factor ownership. This case most closely resembles the traditional framework used to examine the political economy
12
of protection, where agents’ associations with particular factors or industries remain fixed throughout. The political-economic equilibrium here establishes a benchmark from which the impact of asset markets may be assessed: Equilibrium 1 (No Risk-Sharing Markets). The political-economic equilibrium in the absence of domestic or international asset markets consists of a positive tariff in every state of nature, provided the marginal value of agents’ time is not too high. Absent financial markets, portfolios are restricted to initial endowments and income from (3) becomes: I x ( s) = δ HX ( s ) + δ KX ( s ) + 12 R ( s ) and I y ( s ) = δ HY ( s ) + δ KY ( s ) + 12 R ( s )
(10)
The lobbying decision for each agent depends on whether X or Y becomes the importcompeting industry. For all states n (where X is the import-competing sector), the net effect of a tariff on agent x is Γ xX ( s ) = 12 φX ( s )
(11) since
∂ I x ( s) ∂ (δ HX ( s ) + δ KX ( s )) = = φX ( s ) > 0 , ∂ τX ( s ) ∂ τX ( s )
and
− x x ( I x ( s ) ,τ X (s ) ,τ Y ( s ) )
l =τ =0
= − 12 φ X ( s ) < 0
in
the neighborhood of free trade. The symmetry in preferences guarantees that agents spend half of total income on each good. The net effect of a tariff is positive in every state, and provided that the marginal utility of time is less than this net benefit, l x ( s ) > 0 from (6) for all states n. The y agent gains nothing from lobbying for a tariff in states n since all income accrues from the Y sector, so l y ( s ) = 0 . The political process leads to τ X ( s ) > 0 in all states n. Inserting (11) into (6) reveals that for a marginal tariff lobbying will be selected such that16 (12)
τ ′ ( lx ( s ) ) =
2 z ′(1 − l x ( s ))
=
2 z ′ (1 − l x ( s ) )
VI ( Ix ( s ))φ X ( s ) VI ( Ix ( s) ) I x ( s)
. l =τ =0
16
Of course, for a finite tariff, the consumption distortion term becomes a function of the tariff and then depends on the functional form for consumption utility. With log preferences, for example, x x (s ) = 12 I x ( s) (1 + τ X ( s ) ) , and since I x ( s) = δ X ( s) = (1+ τ X ( s) ) φ X ( s) , the tariff term disappears and (12) continues to describe the lobbying equilibrium.
13
Note that with τ ( l ) strictly concave, higher realizations of φ X may either increase or decrease lobbying effort. When X is the import competing sector, the greater is φ X , the smaller are the economy’s comparative advantage and extent of trade. Yet the larger X sector magnifies the impact of a tariff-induced price increase on X-sector dividends. This would tend to increase lobbying activity and the equilibrium tariff. Countering this is the decline in marginal utility of income associated with the higher φ X . In the absence of asset markets, this agent’s income derives entirely from the X sector and rises in direct proportion to the supply shock. The neutral case, in which these two effects just cancel, occurs with log utility. An elasticity greater than one would cause lobbying and the tariff to be increasing in φ X , while an inverse relationship would appear with an elasticity less than one.17 The smaller is the volume of trade in the former case, the higher is the tariff. This unusual result derives in part from the simplicity in the political mechanism: if lobbying were weighted by the extent of import penetration, for example, tariffs would come to fall eventually as the volume of trade shrinks. Regardless of this tradeoff, a more rapidly decreasing marginal value of leisure limits the amount of lobbying, while a less responsive political process reduces the tariff for any given level of lobbying activity. The lobbying activities of agent y in states m correspond exactly to those by agent x in states n. Due to the symmetry of φ X − φ Y around zero, for each state n there is an equally probable state m in which φ X − φ Y < 0 by the same magnitude. Evaluation of (12) expressed for the y agent in states m indicates that for each such pair of states in n and m, the tariff rates on X and Y imports, respectively, will be identical. This implies that the dividends on input i in sector j, which from (1) equal θij (1 + τ j ( s )) φ j ( s ) , have the same expected value and variance across sectors, and consequently, agents have the same ex-ante wealth. Tariffs will cause the domestic relative price of goods to deviate from the world price of unity. This implies that in states of nature m the tariff on Y causes consumption of Y to fall below one-half of income, while consumption of X exceeds one-half. In states n, 17
Once we evaluate (6) and (13) for a finite tariff, a higher tariff level adds to the consumption distortion and thus lowers the net benefit of further lobbying.
14
the opposite pattern occurs. Equation (3) indicates that the magnitude of the deviation from one-half is uniquely determined by the size of the tariff. Since a tariff of given magnitude on X in states n occurs with the same probability as an identical tariff on Y in states m, the distributions for consumption of X and Y are symmetric and are identical for agents x and y. This guarantees equality in expected marginal utilities of future consumption (in (9))—across goods, X and Y, and agents. Relative shadow values of assets differ across agents at these exogenous portfolio allocations, however, since the covariance terms differ. While for agent of type x
{ (
)
}
{ (
)
}
Cov VI I x ( s ) ,δ KX ( s ) < 0 and Cov VI I x ( s ) ,δ KY ( s ) = 0 , the reverse holds for agent y.18 This leads the x agent to place a higher relative value on claims to Y-sector physical capital as compared to the y agent. Relaxation of the symmetry conditions – in preferences or productivity shocks – would lead to differences in the implementation of tariffs across states of type m and n. While this would introduce disparities in the relative ex-ante wealth of the two agents and change ex-post income and consumption accordingly, it would preserve the basic result that protectionist policies would be used extensively. 2.2 The Impact of Domestic Asset Markets on Trade Policy We now assess whether the development of risk sharing markets creates a political environment more conducive to liberal trade policie s. In this section we examine the extent of trade liberalization generated by the appearance of domestic financial markets alone. Section 3 provides the conditions under which access to international financial markets leads to further trade liberalization. To assess the overall impact of financial markets at the conclusion of Section 3, we compare the implications for policy when both domestic and international markets are available to the initial no-asset market situation. If domestic asset markets were to permit complete risk sharing, each agent would receive a constant share of aggregate output by (indirectly) owning equal shares of each 18
Given income in (10), income and X-sector dividends are positively correlated for the x agent.
Thus, the first covariance must be negative since V ( ⋅) is strictly concave in income. Since the Y sector does not affect this agent’s income, the second covariance is zero. The opposite situation holds for the y agent.
15
sector’s total dividends. With the same ex-ante wealth, ownership of one-half of total dividends in each sector is feasible with full tradeability of both types of capital. Since only shares in physical capital are tradeable, however, this perfectly pooled equilibrium would x require holdings for agent x of α KX
(θ
HX
x + α KX θ KX ) =
1
2
x and α KY , where these are defined so
and (αKYx θKY ) = 1 2 , and given analogously for agent y. These deliver
income of I j ( s ) = 12 δ X ( s ) + 12 δ Y ( s ) + 12 R ( s ) . Solving for these shares, we find for agents x and y, respectively, (13)
1 θ − θ HX 1 1 x x x α KX = KX , αKY = , given αHX =1 , and 2 θ KX 2 θ KY 1 1 1 θ KY − θ HY y y y α KX = , α KY = , given α HY = 1 . 2 θ KX 2 θ KY
These expressions reveal the importance of nontradeability of some portion of the economy’s productive resources: the distributive shares of physical and human capital in production determine whether agents are able to obtain these portfolios.
If this
nontradeability is sufficiently severe, perfect pooling cannot occur and agents will be left with a closer association to one industry than the other. We thus introduce the following definition: Definition 2. Physical (human) capital is said to be the dominant form of wealth in the economy if the distributive share of physical (human) capital is at least as great as (greater than) that of human (physical) capital in both sectors: θ Kj ≥ 1 2 ( θ Hj > 1 2 ) for j = X,Y. 2.2.1 Political Economy with Physical Capital as the Dominant Form of Wealth The strongest effect of domestic asset markets on trade liberalization arises when physical capital is the dominant form of wealth in the economy. Equilibrium 2 (Complete Risk Sharing). When agents have access to domestic asset markets and θ Kj ≥ 1 2 , the political-economic equilibrium consists of complete trade liberalization, complete risk sharing, and a relative value of tradeable capital across sectors that depends only on the ratio of physical capital shares.
16
Anticipating τ X ( s ) = τ Y ( s ) = 0 for all s, agents solve the portfolio problem (7) and select shares given in (13). Since agents then have identical ex-post income, and since shocks have the same properties across sectors (so covariance terms in (9) are identical), the relative asset price is equated across agents at qY q X = θ KY θ K X . Asset markets clear since (13) implies α Kjx + α Kjy = 1 for j=X,Y. When tariffs are zero in every state, (4) indicates that income is divided equally across consumption of X and Y. We have only to confirm that neither agent engages in lobbying and that tariffs are zero for all states. In any state n, the net effect from a tariff for either agent at l j ( s ) = τ j (s ) = 0 ,
Γ Xj ( s ) = 12 φX ( s ) − 12 12 (φX ( s ) + φY ( s )) = 14 φX ( s ) − 12 φY ( s ) , will be negative since portfolios effectively deliver ownership of half the X-sector dividends. In any state n, φ X ( s ) < φY ( s ) , so the consumption distortion outweighs the income gain from the tariff. In addition, lobbying reduces utility through the loss of leisure. This implies (6) is negative at l j ( s ) = 0 , and neither agent wishes to lobby for an import tariff. A similar argument shows that no lobbying occurs in any state m. In the absence of any demand from the constituency for intervention, the government adopts a free trade position irrespective of the state of productivity and the level of import competition. Inherent risk aversion drives agents to use domestic capital markets to obtain a broadly diversified portfolio. Such a portfolio has the added effect of removing any agent’s desire to lobby for protection of the domestic import-competing industry. The trade policy stance selected by a politically motivated government will match the constituents’ desire for free trade. This extreme departure from the protectionist result in traditional analyses will be moderated to some degree when agents’ incomes are dominated by human capital. 2.2.2 Trade Policy when Human Capital is the Dominant Form of Wealth The conclusion that free trade emerges in the presence of developed domestic capital markets relies on the majority of capital being tradeable. When human capital dominates income, domestic capital markets alone do not lead to free trade. Also in such cases, the
17
relative importance of human capital across sectors affects the political equilibrium. We first consider the symmetric case where θ HX = θ HY = θ H >
1
2
, and then consider the
consequences of asymmetries. In the former case, domestic capital markets will lead to Equilibrium 3 (Symmetric Capital Tradeability). When agents have access to domestic asset markets and θ HX = θ HY = θ H >
1
2
, the political-economic equilibrium features
incomplete risk sharing and a symmetric application of import tariffs. With symmetric tariffs, for each state in n there is an equally probable state in m with a tariff of the same magnitude, τ X ( n ) = τ Y ( m ) ≥ 0 . Asset markets, as in Equilibrium 2, are used by agent x to exchange endowed claims in X-sector physical capital for claims to Y-sector physical capital, and conversely by agent y. A corner solution appears since selling all claims to own-sector physical capital continues to leave industry risk incompletely diversified. Short selling would solve this problem, but doing so would in effect constitute selling claims to one’s human capital income. Since this would eliminate the market imperfection that we think important to consider, we have ruled this out. Income for each agent, given these portfolios, is I x ( s) = θ H δ X (s ) + θ K δY ( s ) + 12 R ( s ) and I y ( s ) = θ H δ Y ( s ) + θ K δ X ( s ) + 12 R ( s ) , where dividends incorporate the output shock and a tariff’s impact on prices from (1). The tariff structure maintains equal ex-ante wealth across agents, although agent x expects income to be dominated by the X sector, and conversely for agent y. When tariffs are applied symmetrically across states n and m, expected values and variances of income are the same for both agents. Evaluation of (6) establishes these symmetric trade policy outcomes. In states n, where X is the import good, the net effects of a tariff (in the neighborhood of free trade) for agent x is (14)
Γ xX ( s ) =
1 2
(θ
H
φ X ( s ) − θ K φY ( s )) > 0
iff
θ H θ K > φY ( s ) φ X ( s )
and for agent y is analogously, Γ yX ( s ) = 12 (θ K φ X ( s ) − θ H φY ( s ) ) < 0 . The net effect from a tariff on X imports in states n is unambiguously negative for agent y since θ K < θ H , but
18
for the x agent depends on the comparison of relative productivity shocks to the relative importance of human to physical capital in production. By assumption, the ratio of distributive shares exceeds one, but it is also the case that in states n the ratio of shocks always exceeds one. Only for those states in which the X sector is sufficiently large (but still import-competing), will the X agent find it worthwhile to lobby, provided the marginal value of leisure time is not too high. When φ X ( s ) is very low, the income gain, based only on the increase in payments to human capital, fails to compensate the agent for the consumption distortion. In these states, the tariff is zero. A similar argument reveals that with Y as the import-competing sector, the x agent never has incentive to lobby for a tariff, while the y agent only lobbies when the Y sector is sufficiently large (using a condition analogous to (14)). Given the symmetry in the shocks across states n and m, tariffs on X and Y are symmetrically applied. The corner solution in portfolio allocations implies that the market relative price of claims to X-sector capital is determined by the demand for this asset by agent y
{
}
( q Xy = E VI ( I y ( s ) ) δ K X ( s ) γ y ), while the price of a claim to Y-sector capital depends on
{
}
agent x’s demand ( q Yx = E VI ( I x ( s ) ) δ KY ( s ) γ x ). Agents have the same asset wealth, so γ x = γ y , with the market relative price given by:
{ {
} { } {
} }
{ {
} }
E VI ( I x (s )) E (1 + τY ( s ) )φY ( s ) + Cov V I ( I x (s )) , (1 + τY ( s ) )φY ( s ) qY = =1 q X E VI ( I y ( s ) ) E (1 + τ X ( s ) )φ X ( s ) + Cov VI ( I y ( s ) ), (1 + τ X ( s )) φ X ( s ) Given incomes above expected marginal utilities are the same. Also the income expressions reveal that the dividend to K Y affects x’s income in precisely the same way that the return to K X affects the y agent, and therefore covariances in numerator and denominator are equal. By the symmetry in tariffs and productivity shocks, an equilibrium relative asset price of unity follows.19 Compared to an economy without asset trade, access to limited domestic capital markets lowers the expected level of protectionist policies since in all states the net benefit is reduced by diversification of income across sectors. In some states, the net 19
Each agent’s autarkic relative price of claims to capital displays the same ranking across agents as in Equilibrium 1; this can be demonstrated by precisely the same argument as given there.
19
benefit is zero or negative, while in others it will remain below the value of leisure time. Free trade prevails in these environments. Relative to the extreme concentration of individual income in a single sector that leads to Equilibrium 1, this broader income base reduces the lobbying effort of private agents. The decline in political pressure for trade restrictions leads the government to adopt a more free-trade stance. Since limitations in domestic asset markets leave individual income more closely associated with one sector than the other, however, a potential for protectionist policy remains. When the dominance of human capital differs across sectors, one of the agents will retain some own-sector physical capital at the conclusion of domestic asset trades, and international financial markets will allow this group diversification opportunities that reduce its interests in protection. An asymmetry in which both agents’ incomes remain dominated by human capital, but the x agent more so, arises if θ HX > θ HY = θ H >
1
2
. The x
agent now has less tradeable wealth with which to diversify income risk, while the y agent, with the same tradeable wealth, finds that the smaller dividends paid on claims to K X provide a lesser degree of diversification against own human capital earnings. With
access to domestic asset markets alone, we establish the following political-economic equilibrium for such a country: Equilibrium 4 (Asymmetric Capital Tradeability). When agents have access to domestic asset markets and θ HX > θ HY = θ H >
1
2
, the political-economic equilibrium consists of
equal risk sharing through the asymmetric portfolios, α x = (1, 0 , 0 , ε ) , α y = ( 0,1,1,1 − ε ) for 0 < ε < 1 , and symmetric import tariffs across states. Symmetric tariffs preserve equality in ex-ante wealth across agents, and, accordingly, equilibrium portfolios deliver the same expected income and support equal risk-sharing across agents. Due to the smaller dividends paid by X sector physical capital, however, the y agent retains a share, 1 − ε , of the Y-sector physical capital. Hence, ε must satisfy θ HY + (1 − ε )θ KY = θ HX and, equivalently, θ KX = εθ KY . Income becomes: I x ( s) = θ HX δ X ( s) +εθ KYδ Y ( s ) + 12 R ( s ) I y ( s ) = θ HY δ Y ( s ) + (1 − ε )θ KY δ Y ( s) + θ KX δ X ( s ) + 12 R ( s )
20
Since θ KX < θ KY , we know ε must be less than unity, and the equilibrium relative price (from (9)) of claims to Y capital must exceed one. Asset markets clear at these allocations and prices. Note that the retained ownership of own-sector assets is greater for both agents, compared to Equilibrium 3, due to the increase in the nontradeable share of assets in one of the sectors. Lobbying activities remain symmetric across agents. From the income expressions above we find that agent x’s net gain from a tariff on X will be Γ xX ( s ) =
1 2
(θ
HX
φ X ( s ) − εθ KY φY ( s )) > 0
iff
θ HX εθ KY > φY ( s ) φ X ( s ) .
The right-hand side is identical to that in (11′′), while the left-hand side is greater since the x agent’s income is even more dominated by X sector dividends ( θ HX > θ H , θ KY = θ K , and ε < 1 ). For a given utility cost of lobbying, we find that tariffs are more likely to be invoked in these circumstances: an industry relying more heavily on human capital inputs will generate more lobbying and protectionist policies. The y agent also becomes more likely to lobby for a tariff on Y imports in states m since ΓYy ( s ) =
1 2
( (θ
HY
+ (1 − ε )θKY ) φY ( s ) − θKX φX ( s ) ) > 0 iff
θ HY + (1 − ε )θ KY φX ( s ) > . θ KX φY ( s )
The left-hand side is strictly larger than in Equilibrium 3, since θ HY = θ H , θ KY = θ K , θ KX < θ K , and ε < 1 . Consequently, the expected net benefit of a tariff rises, so higher
levels of protection would be forthcoming in both sectors. Although the Y sector embodies greater tradeable capital, the lack of diversification opportunities through the X sector leaves the y agent with more Y sector-specific income. These limitations in one sector lead to higher expected protection, regardless of which sector faces import competition. 3. INTERNATIONAL FINANCIAL MARKETS AND TRADE POLICY The addition of access to international capital markets when domestic markets are complete (given the constraints on human capital trade), in some cases will enhance trade liberalization, but in others will, perhaps surprisingly, may lead to increased protectionist policies. To the extent that international financial markets lead individuals away from the
21
concentrated holdings of a specific industry’s equity, goods trade will become more liberalized. When the connection to a domestic industry stays the same, while the remainder of residents’ portfolios become more internationally diversified, an interest in protectionist trade policies may reemerge. The circumstances in which these alternatives arise are related to the importance of nontradeability of claims to firms’ dividends across domestic industries. Hence, we consider in turn the three cases developed in the prior section: physical capital as the dominant form of wealth, and human capital as the dominant source of wealth, both symmetrically, and asymmetrically. When international financial markets become available, protectionist trade policies may, perhaps surprisingly, reappear as individuals exchange risky tradeable home assets for shares in the risk-free world portfolio. Such an exchange reduces the agent’s interest in the broader home economy: the only connection lies with the industry that employs the agent’s human capital. The appendix provides the problem’s setup and solution. For the x agent, the shadow value of world capital relative to home K X exceeds its market price: w x qKW δ KW qKW δ KW = = > w x q X θ KX E {δ X ( s)} q X θ KX E {δ X ( s )} + Cov{VI ( s ) ,δ X ( s )} E {VI ( s )}
{
}
where δ KW is the sure dividend paid by one share in the world diversified capital j j portfolio and α KW indicates the agent’s ownership claims of the world capital ( α KW ≥ 0 ).
We henceforth normalize δ KW to unity for ease of presentation. The risk premium term that appears in the denominator places the home agent’s relative value of world capital above the world price.20 Rather than using endowed physical capital wealth to buy home K Y , the x agent buys claims to the risk-free world capital. Income for the x agent will x now be I x ( s ) = θ HX δ X ( s) + α KW + 12 R ( s ) , and analogously for y.
Imposing the asset-market constraint in (A1) at world asset prices (A3), we solve for x each agent’s holdings of world capital to see that α KW = θ KX E {δ X ( s )} and
α KW = θ KY E {δ Y ( s )} : each agent buys an amount of world capital equal to the expected y
value of his physical capital endowment. The alternative perspective – that of an agent 20
{
}
Cov{VI ( s ), δ X (s )} < 0 , since Cov I x ( s ), δ X ( s ) > 0 for shares given by (13), and V ( s )
strictly concave.
22
with an established domestically diversified portfolio – reveals that the addition of international markets causes both agents to exchange the two types of home risky capital, K X and K Y , for the risk-free world capital.
The income gain from lobbying remains the same, but now the costs have changed. 21 For the x-type agent, the net effect of a tariff on X is given by: (15)
Γ xX ( s ) =
1 2
(θ
HX
x φ X ( s ) − α KW )=
1 2
(θ
HX
φX ( s ) − θKX E {δ X ( s )}
)
This will be positive in some states of nature. In particular, when human capital returns comprise a dominant portion of the agent’s ex-post income, relative to the predetermined, nonstochastic portfolio income, the benefit of a tariff will outweigh the consumption distortion. When the agent’s portfolio was balanced by home Y-sector capital, the X sector could never be so large and still be the import-competing sector. To be import competing it had necessarily to comprise less than half the agent’s income. Now, the portfolio component of the x agent’s income is constant, so that when output in both sectors is sufficiently high (with Y larger to set it as the export sector) the gains from a tariff on X exceed the consumption distortion. The y agent continues to have no interest in lobbying for a tariff on X imports, but would lobby for protection of Y under analogous conditions. Lobbying occurs when the net benefit exceeds the agent’s marginal value of time, and tariffs follow. The model predicts, therefore, that when the home country’s aggregate output is high, tariffs may become politically popular. The state-dependent tariff structure then influences the relative value of home capital in world financial markets. Using (A3) we find the relative price of the tradeable portion of the home Y firm to be:
{ {
} }
w θ KY E (1 + τ Y ( s ) ) φY ( s ) qY = q X θ KX E (1 + τ X ( s ))φ X ( s )
Since θ Kj has not been constrained to be equal across sectors, incentives to lobby for a tariff on X (in (14)) generally differ from those for Y. Consequently, the anticipated tariff structure will alter the relative stock market value of firms compared to that in the free trade situation associated with domestic markets.
21
Note that the value of agent’s world assets is taken as given at this point, although the agent’s equilibrium ex post lobbying and resulting tariff structure will have influenced those holdings.
23
When human capital is the dominant form of wealth, the addition of international capital markets will have a similar effect as that described above. Once again, each agent exchanges risky domestic physical capital for claims to the risk-free world capital according to precisely the same argument. Condition (15) determines when the sector employing the x agent’s human capital becomes large enough to make the net effect of a tariff positive. A similar expression indicates the states in which the y agent sees a positive net effect from a tariff on Y. Now, however, θ HX is higher and θ K X lower, so the x agent will find that this condition is more likely to be satisfied. In evaluation of these two cases, we should note that relative to an economy without asset markets, the combined presence of domestic and international markets reduces the incidence of protectionist policies. This follows from a comparison of (11) and (15): in the latter, the net benefit of a tariff is unambiguously lower in all states of nature. Moreover, in some states – those where the import-competing sector is sufficiently small – the net benefit of a tariff falls to zero or below. In these states, no lobbying will take place and free trade will prevail. The reappearance of protectionist policie s when a country expands into international capital markets from domestic ones alone follows from the assumptions about the relative risk of home and foreign assets. Here, it is assumed that the world portfolio is less risky than the home tradeable assets and that those home assets provide no better insurance for the agent’s human capital than does world capital – as it would if home shocks were negatively correlated across sectors, for example. If, by contrast, international returns were even slightly more risky than domestic returns (rather than risk free, as here), the agents would retain domestically diversified portfolios and the predicted return to protectionist policies would not materialize. Also, our assumption of a small home economy underlies the elimination of home physical capital from the home agent’s portfolio. Residents of a large country, by contrast, would retain some of the opposite sector’s physical capital, and we now know this would mitigate interests in protectionist policies. Nevertheless, we would expect to see a return of support for protectionist policies, and would find that individuals associated with industries having greater shares of human (nontradeable) capital would lobby for and be awarded the higher levels of protection.
24
The liberalizing effect of international asset markets appears in economies where the dominance of human capital differs in magnitude across sectors. Access to international markets will generally create an asymmetry in the application of trade protection as the sector with the greater tradeable assets comes to have a more diversified ownership base. This stands in contrast to the outcome with only domestic asset markets, where tariffs were symmetrically applied in equilibrium. Recall that we assume the X sector is more dominated by nontradable human capital than is the Y sector. From the domestically diversified portfolio position, the y agent will use international markets to eliminate remaining holdings of the Y sector physical capital: the 1 − ε share of K Y . This asset perfectly covaries with own human capital and its elimination from the agent’s portfolio reduces the lobbying efforts of y agents for protection of the Y sector. The former exchange reflects the ranking of relative shadow (with superscript y) and world prices (superscript w) of world capital: y qKW 1 = y qY θ KY E {δ Y ( s )} + Cov {VI ( s ) ,δ Y ( s )} E {VI ( s )}
{
}
>
w qKW 1 w = qY θ KY E {δY ( s )}
This type of agent also sells claims to all the risky K X in favor of claims to the risk free world capital. After both trades at world prices, the y agent’s portfolio holdings will be y y y α KW = θ KY E {δ Y ( s )} and income will be I ( s ) = θ HY δ Y ( s ) + α KW + 12 R ( s ) . The x agent, by
contrast, cannot further reduce ownership of the domestic X industry’s assets: this agent already owns claims only to the human capital therein. Access to international markets allows the X agent only to replace independently risky domestic physical capital ( K Y ) x with riskless world capital in the amount, α KW = θ KX E {δ X ( s )} . This will give the x agent x income, I x ( s ) = θ HX δ X ( s) + α KW + 12 R ( s ) .
The y agent’s gain from a tariff on Y now drops to θ HY φY ( s ) , which is less than under domestic asset markets alone. Once combined with the consumption distortion, we y see that the net benefit of a tariff on Y is positive only if θ HY φY ( s ) > αKW . The model
therefore implies that the introduction of international financial markets reduces the expected net gain from protection of the more physical-capital intensive industry, and expected tariffs in this sector fall relative to the more human-capital intensive sector. If
25
world capital is slightly more risky than a diversified domestic portfolio, the y agent will eliminate only the holdings of the Y sector physical capital. This will lead to an even stronger liberalizing effect, as the agent retains a substantial interest in the efficiency of the broader domestic economy. 4. CONCLUDING REMARKS We begin with a benchmark economy where individuals derive income exclusively from one sector of the economy and sources of income cannot be changed. We show that the government chooses protection in every state of nature, provided the value of leisure is not too high, and that the degree of protection is state-dependent. When physical capital is the dominant form of wealth in the economy, domestic asset markets allow agents to acquire equal shares in the industries’ total returns and no individual finds it worthwhile ever to lobby for protection, since the associated consumption distortion outweighs the shared income gain. A free trade regime therefore emerges as the political response to private interests. If tradeable (physical) capital is not the dominant form of a country’s wealth, individuals remain closely associated with the specific industry where nontradeable human capital is employed. Asymmetries in tradeability across sectors are reflected in policy, with the more human-capital intensive sector receiving higher levels of trade protection. The presence of such asymmetries introduces the possibility that international asset markets may further liberalize trade policy. By contrast, when complete risk sharing is supported by domestic asset markets alone, the availability of a world risk-free alternative investment encourages residents to place a majority of wealth in world assets. This reduces their interest in the domestic economy to own human capital returns, in place of concern for the efficiency of the entire domestic economy. Hence protectionist policy reemerges in some states of nature, though to a lesser extent than in the complete absence of capital markets. This reversion to protectionist policies disappears if world capital is even slightly more risky than a diversified domestic portfolio. When human capital is asymmetrically used in the domestic industries, access to global capital markets allows individuals in the less human-capital intensive sector to further diversify. This
26
reduces their personal connections to the domestic industry to which human capital is specific and reduces trade barriers. Global financial markets consequently can have an important liberalizing effect on policies toward trade in goods. While this paper focuses solely on a single country’s trade liberalization, our findings also have implications for multilateral reductions in trade barriers. When international asset markets cause individuals to shift from domestic asset holdings to worldwide asset holdings, the globally diversified individuals lose interest in the efficiency of the domestic economy as a whole and care only about the one industry with which they are associated. This presumes that the rest of the world into which the agent has bought, is not similarly subject to welfare reducing barriers to trade. The model suggests that with globalization of international asset markets, people in different countries will acquire an interest in the efficiency of the world economy. Global financial markets therefore increase political support for multilateral tariff reductions. The formalization of these implications is left to future work. We have abstracted from accumulation of physical and human capital. Our results indicate, however, that capital values diverge across sectors and agents due to the presence of nontradeability of claims and intersectoral immobility in the uses of capital. This implies that accumulation decisions and future trade policies will reflect diversification opportunities. If risk cannot be diversified, adding human and physical capital accumulation may endogenously generate a broader production base as riskaverse agents take steps to self insure.22 For example, Feeney (2001) shows that occupational risk influences educational investments made by young agents: individuals accumulate less industry-specific human capital when sectoral uncertainty is greater. Endogenizing accumulation decisions will not by itself generate free trade, however, when imperfect information continues to prevent the perfect diversification of human capital income. Greater sophistication of asset markets, which resolve information asymmetries, will be required to remove protectionist trade policies completely. Finally, our analysis also has implications for developing economies in the process of adopting market-oriented policies, both internally and externally. In the shift away from 22
Self-insurance activities—and the role of asset-market completeness—that lead to a broader production based are discussed in a static, two-sector model in Feeney (1994), and the endogenous growth implications are considered in Feeney (1999).
27
state-owned enterprises characteristic of emerging market economies, our results emphasize the importance of adopting a privatization strategy that allows for future tradeability in firm shares.23 If the new owners face restricted transfer rights, they will retain a strong interest in protection. Consequently, prospects for liberal trade policies are improved when privatization distributes ownership broadly across the economy through the issue of tradeable vouchers to the population at large. Correspondingly, our analysis has implications for the preferred order of current and capital account liberalization (see, for example, Edwards and van Wijnbergen 1986). Since access to global financial markets can shift private interests to favor free trade policies, liberalization of the capital account can endogenously increase the prospects for current-account liberalization.
23
The impact of privatization on the use of strategic trade subsidies in an imperfectly competitive setting is considered in Feeney and Hillman (2001).
28
Appendix The objective function in (7) is combined with a new budget constraint. The constraint includes the opportunity to purchase claims, α KW , to a portion of the world riskfree w portfolio of capital at world asset prices, q Xw , qYw , qKW . We define one share in such a
portfolio as an amount which delivers the sure dividend of δ KW = 1 . Agent j’s endowed tradeable assets are also valued at world prices. The asset market constraint with open capital markets is then: (A1)
j w j q wj = q Xw α KXj + q Yw αKY + q KW α KW
Given these constraints, first-order necessary conditions for an interior solution for agent j are: (A2)
(a)
E {VI ( s )δ KX ( s)} − γ j q Xw = 0
(b)
E {VI ( s )δ KY ( s)} − γ j qYw = 0
(c)
w E {VI ( s )δ KW } − γ j qKW =0
We solve for the equilibrium world asset pric es by applying the conditions in (A2) to a world representative agent, indexed by w (for either the agent endowed with X or Y human capital, since it makes no difference here). Since shocks to home and foreign supply are independent, the world relative asset prices will be:
(A3)
{ (
)
}
)
}
{ (
)}
w E VI I w ( s ) δ KW E VI Iw ( s ) δ KW qKW δ KW = = = w w q wX E VI I ( s ) δ KX ( s ) E VI I ( s ) E {δ KX ( s )} θ KX E φ X ( s ) (1 + τ X ( s ) )
{ (
)
}
{ (
)}
{
}
and, similarly,
{ (
w E VI Iw ( s) δ KW qKW δ KW = = w qYw θ E φ E VI I ( s ) δ KY ( s ) KY Y ( s) (1 + τ Y ( s ) )
{ (
)
}
{
}
Note that when the political-economic equilibrium gives rise to free trade in every state of nature, market prices will reflect this, and no tariffs would appear in home dividends. In
29
w w that case, q KW q j = δ KW θ Kjφ .
Taking these prices as given, the home agents select portfolios that satisfy (A1) and (A2). The direction of asset trades can be identified by evaluating (A3) in the absence of international capital markets, and solving for the home type-j agent’s relative shadow value of world capital in terms of home capital. Relative to X capital, (A4a)
{
}
j E VI ( I j ( s ) ,τ X (s ) ,τ Y ( s )) δ KW δ KW ⋅ E {VI ( s )} qKW = = . j qX E VI ( I j ( s ) ,τ X (s ) ,τ Y ( s )) δ K X ( s ) θ KX E VI ( s)φ X ( s ) (1 + τ X ( s ) )
{
}
{
}
The analogous condition in terms of home Y capital is: (A4b)
{
}
j E VI ( I j ( s ) ,τ X (s ) ,τ Y ( s ) ) δ KW δ KW ⋅ E {VI ( s)} qKW = = . j qY E VI ( I j ( s ) ,τ X (s ) ,τ Y ( s ) ) δ KY ( s ) θKY E V I ( s ) φY ( s ) (1 + τY ( s ) )
{
}
{
}
For the x-agent considering selling off Kj , this can be expressed as: x w qKW δ KW qKW = > q xj θ Kj E {δ j ( s )} + Cov {VI ( s ) ,δ j ( s )} E {VI ( s )} q wj
{
}
and the x agent sells the risky home capital to buy the world risk-free capital. The riskpremium term appearing in the denominator will be negative provided the x agent owns some of Kj and that the dividend and the productivity shock remain positively correlated: the endogenous tariff response must not reverse the direction of this relationship. Since income and this dividend are positively correlated, and V( ) is strictly concave, the covariance is negative. We know that under log utility, small differences in the productivity shock leave the choice of tariff unaltered, but for more general preferences, a restriction on the policy process would also ensure that this condition holds. We therefore assume that the choice of tariff will never reverse the direction of the impact of a productivity shock on total dividends.
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