The financial crisis, economic slow down and international trade

The financial crisis, economic slow down and international trade... an unhappy mix of developments.

The tumultuous changes in the world’s financial markets and sharp down turn in the availability of credit and liquidity will provide economists and financial analysts with experiences that will serve as a fertile source of subjects for topical research for years to come. Policy makers, including regulators, will also spend much effort in diagnosing the financial disease in order to find a cure and design preventative measures that, once the crisis like all past crises is something of the past, will prevent a recurrence. While analyzing the present crisis two observations demand serious consideration.

The first deals with the conventional wisdom that markets can fail and that market failure justifies intervention by governments and government agencies. What the current crisis, however, clearly illustrates is that markets can fail spectacularly with devastating results for economies in general. It also illustrates that a failure in a particular market such as that of the USA has a contagious impact on other markets; what we have is a stark reminder that we live in the clichéd global village.

Market failure of the current degree and scope demands serious and innovative reactions by the authorities. A good illustration of unusual action taken is the decision of the American Federal Reserve to move beyond the central bank function of acting as last resort to commercial banks and not only to come to the assistance of investment banks but now also to act as lender to companies through the purchase of the commercial paper of companies. The seriousness with which governments is acting is fortunately so totally different from the advice which Andrew Mellon, at the time Secretary of the US Treasury, gave President Herbert Hoover on how to deal with Great Depression: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. Purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people.”

Comments in the media and the degree and nature of government intervention to address the crisis are signals that in the post-crisis phase a major re-design of regulatory structures can be expected. A reaction to overzealous deregulation in the past is appropriate but important conditions or warnings should be flagged. Governments also fail and the consequences can be as serious as those of market failure. Furthermore, efficient markets are a prerequisite for economic growth and financial stability and in redesigning regulatory structures care should be taken not to rid the baby with the bath water. The architects of the new regulations will have to avoid structures that stifle the ability of markets to allocate credit and resources efficiently.

The second observation that the current crisis elicits is the demonstration of the close link between financial markets and the so-called real economy. The dichotomy of neoclassical economics does not apply. Developments in the financial markets, especially as radical as those of the current situation, have a negative impact on real economic activity. The causal link also runs in the opposite direction from the real economy to financial markets. What the current crisis illustrates is that the credit squeeze and the illiquidity that constrain banking activity are in all likelihood bound to exacerbate the cyclical downturn in economic activity. The outcome could be a deeper and more prolonged recession than what would have been the case otherwise.

Observers who are concerned about the impact on real economic activity and the consequences this hold for international trade relations need to note three possible developments. All three, but the first two in particular, call for special vigilance if the idea of international trade as welfare-enhancing is to remain alive and reflected in policy decisions at the national and international level.

First, a sharp and prolonged downturn in economic activity is not conducive to a revival of multilateral negotiations on trade liberalization. Recessionary conditions have a negative impact on world trade through the positive link between real income and imports, the latter for one country being the exports of a trading partner. Under these conditions protectionist thinking could thrive, as they did in the aftermath of the 1929-32 depression. These conditions are not favourable for the resuscitation of the Doha Round of negotiations.

Second, in a policy environment that favors protectionist thinking a fortunate source of discipline will be the principle of non-discrimination embodied in Article 1 of the General Agreement on Tariffs and Trade (GATT) and the security and transparency provided by WTO tariff bindings. These principles guide trade relations within the framework of the WTO Agreements. However, it is not impossible and perhaps even likely that protectionism will enter through the backdoor, with firms and governments utilizing WTO acceptable exceptions to non-discrimination and tariff bindings. In a protectionist environment with little possibility of import tariff amendments because of the WTO Agreements, it is likely that we will see an increase in the number of anti-dumping cases. Experience has shown that it is not difficult to use this mechanism, provided for by Article VI of GATT 1994 and further regulated through the Anti-Dumping Agreement, as a protectionist measure.

But it is not only anti-dumping action that could provide room for protectionism posing as contingent protection. In severe recessionary conditions it would even be possible to invoke the safeguard protection provided for in Article XIX of GATT, further clarified and regulated by the Agreement on Safeguards. Safeguard action allows emergency protection on a temporary basis against ‘serious injury’ caused by a surge in the imports of a particular product. However, the surge need not manifest as an absolute increase in imports; it can also be a relative increase in the share of imports of a shrinking market. It does not take much imagination to see how this can be used as a means of industrial protection in a situation of recession plagued markets.

In the third place, it should be noted that reaction to the financial crisis has demonstrated that even an advanced regional integration arrangement such as that of the European Union (EU) does not ensure collective action. Within the EU not even a single currency and regional central bank could provide the basis for collective action. The Irish, a Euro country, led the way in doing their own thing with the introduction of a deposit guarantee scheme and since then other countries have followed, regardless of high-level meetings to coordinate and plan reactions. What this illustrates is that in the end national interests reign supreme and if collective action is to be achieved, post-crisis planning will have to bring banking regulation into the realm of the regional integration arrangement.

By Colin McCarthy - The author is an Associate at The Trade Law Centre For Southern Africa - tralac is a not-for-profit organisation, building trade law capacity in the southern Africa region; in governments, the private sector and civil society. http://www.tralac.org/cgi-bin/giga.cgi?cmd=cause_dir_cause&cause_id=1694

US EXPORT COUNCIL PROVIDES ASSISTANCE TO US COMPANIES SEEKING ACCESS TO HIGH GROWTH MARKETS OVERSEAS. http://usexportcouncil.com/