A note on the welfare economics of regional cooperation (1988)

A note on the welfare economics of regional cooperation

Subroto Roy

April 22 1988

(Statement at a conference on regional cooperation in Asia and Latin America held at the East West Centre, Honolulu, April 1988)

How should we evaluate the success of efforts at regional cooperation? When we look at different attempts at cooperation around the world, what general principles and observations might we bring to bear from within the discipline of economics? I propose to try to answer this broad normative question, and at the same time to report on certain aspects of the interesting and informative papers given by Dr. Ffrench-Davis, Dr. Wong, and Dr. Bhuyan on Latin America, ASEAN, and South Asia respectively.

It may be helpful to remind ourselves at the outset of the textbook classification of forms of economic cooperation.  This usually traces a route from the least orderly and least integrated to the most orderly and most integrated — from the free-trade area to the customs union to the common market to the economic union.  The free-trade area has no intra-area tariffs and therefore has a free flow of goods, although each member can have what tariffs it pleases with the rest of the world.  The customs union maintains the free flow of goods of a free-trade area and in addition has a common tarriff barrier with the rest of the world.  The common market is a customs union and in addition has free flow of factors like labour and capital.  The economic union is a common market which in addition has a common currency and a uniform monetary and fiscal policy, and which probably must have a common federal government as well.

Now we learn about one thing through comparison and contrast with other things.  Thus efforts at cooperation in South Asia and Latin America and ASEAN are fittingly compared and contrasted both with one another as well as with efforts, say, in post-War Europe.  It has been generally believed too that more integration is a good thing.  So for instance, while the European Community still remains something between a customs union and a common market, the European experiment as a whole has been motivated by a desire (or perhaps by wishful thinking) to form an economic union like that of the United States.  And it is the U. S. — whose Constitution in 1789 started with the words: “We the people…, in order to form a more perfect union….” —  which surely remains the best example the world has yet seen of an effective economic and political union.  Yet even in the U. S. the process took a hundred years and a lot of bloodshed.  In many places in the south today, the Civil War between 1861 and 1865 is still referred to as the “War between the States”.  A lesson from the American experience may be that an important and yet intangible benefit of attempts at integration, regardless of how much integration it actually leads to, may be the prevention of unnecessary war.  No matter how far the European Community is from its explicit goal of an economic and political union, or how wishful such a goal might be, or how much is wasted in resources by the bureaucracy in Brussells, if European cooperation has helped to reduce to zero the probability of a third European war in the twentieth century, it may have contributed to the economic welfare of Europe.

Now the prospect of pointless war within the European Community has become ludicrous but this may not be so elsewhere.  Neither Dr. Ffrench-Davis nor Dr. Wong has found it necessary to say anything about military tensions, so it is possible that the prospect of needless wars within Latin America or within ASEAN has become as ludicrous as in Europe, and it is possible that regional institutions have helped towards that.  If so, that should be registered on the credit-side of the balance sheet when we are evaluating the success of LAFTA or ASEAN or the Andean Pact.  But certainly the same cannot be said in South Asia, where military tensions between India and Pakistan have seldom been far from the surface.

In fact the South Asian case is interestingly seen from another angle as well.  For consider the basic fact that the main economic point of regional cooperation is to improve mass welfare via increasing trade.  Yet Dr. Bhuyan reports that trade has yet to be put on the SAARC agenda in any serious way.  The leaders of the SAARC nations have been talking about meteorology and drug abuse and the rights of children and science policy and solar technology and all kinds of other worthy issues, but they have not been talking about abolishing quotas and reducing tariffs on one another’s goods.  In terms of the textbook classification, regional cooperation in South Asia in the late 1980s has not yet reached even the starting point of discussing a free-trade area.   Yet paradoxically just about forty years ago, the same nations which today find it so difficult even to talk about improving trade, were completely united and integrated from an economic point of view — not merely in a free-trade area or customs union or a common market but in a full-fledged economic union.  The departure of Britain from the subcontinent and the political partition between India and Pakistan did not logically entail that the economic union which South Asia had been for numerous centuries had to be completely destroyed.  Yet that is what happened. The welfare costs of the lack of foresight on all sides at the time have not yet been calculated.

Drawing these thoughts together then, my first general observation is quite an obvious one.  Efforts at regional cooperation can lead to more and better contacts, information, and channels of communication – between heads of governments, finance ministers, businessmen, private citizens, and so on.  There is, in short, an increase in trust.  Or to put it in economists’ language, there is a reduction in transactions costs or an increase in the stock of what may be called the “informational capital” available to traders and potential traders.   Regardless of whether tariffs do in fact come to be reduced and trade increased, the stock of trust or informational capital is valuable.  The maintenance of this stock may require expenditures on bureaucracies, conferences etc. (expenditures which Dr. Wong reports to be small in case of ASEAN).  But if these expenditures have quietly reduced or are reducing the probability of needless wars between the member-states of LAFTA or ASEAN or SAARC (and here we might recall just how many needless wars were fought in European history between countries at the same so-called “stage of development” as those now in Asia and Latin America) then the expected utility of the bureaucracies may be certainly positive and perhaps rising.

Military conflicts or civil wars destroy not only physical and human capital but this kind of informational capital as well.  It is this stock of informational capital which was destroyed with the breakup of the economic union in South Asia forty years ago, and which the South Asian nations are now finding so hard to rebuild.  The same can be said perhaps of China and Taiwan, North and South Korea, and so on.

Next, I would like to return to the basic rationale of regional cooperation being to increase welfare via increasing trade via lowering tariffs, probably reciprocally but perhaps even unilaterally.  It is to encourage as much improved efficiency in production and hence in consumption as possible; or in Jacob Viner’s terms to have as much “trade creation” and as little “trade diversion” as possible.  Such a purpose would or should take as axiomatic Adam Smith’s remark: “Consumption is the sole end and purpose of all production; and the interest of the producer ought to be attended to, only so far as it may be necessary for promoting that of the consumer.” (Wealth of Nations, IV.viii.49).   Yet, at the same time, the fact of the matter is that it is national governments, and not business firms let aside ordinary households and consumers, who are involved in attempts at regional cooperation.  Stated in terms of a principal-agent problem, it is governments who are the agents while the mass of individual taxpayer/consumers are the principals.

The situation is such that the agents can probably get away quite well without attending to the interests of their principals in matters of mutual tariff-reduction.  But if they do want to attend to the interests of their principals, what Smith’s remark does is give them a simple rule of thumb to apply: does such-and-such a policy proposal have a reasonable chance of helping the ordinary consumer?  That is to say, will it enlarge the budget-set of the average household?  Or in other words, will it reduce the average household’s expenditures and/or increase the average household’s income?

Improving trade necessarily implies exploiting comparative advantages better, and hence it implies increasing specialization.  So if the basic purpose of regional cooperation is indeed to improve economic welfare via more trade, and if this purpose is indeed to be seriously served, then the process of obtaining the greater specialization will necessarily imply the decline of some industries and the rise of other industries in each participating economy.

If country A and country B are both involved in import-substitution, and country A’s industry 1 is relatively less inefficient than country B’s industry 1, then the economic integration of A and B will imply that country A’s industry 1 will rise and country B’s industry 1 will decline, while country B’s industry 2 will rise and country A’s industry 2 will decline.

Again I am saying something which is obvious from an economist’s standpoint.  I do so for the following reason.  It is clear from Dr.Wong’s paper that the leaders of ASEAN seem to be relatively serious about tariff-reduction.  They may not have succeeded as much as they would have liked but they see and understand the fundamental purpose of regional cooperation.  The spirit is willing but the body is weak.  It would seem from Dr. Ffrench-Davis’s paper too that mutual tariff-reduction has also been a central part of the discussion surrounding Latin American cooperation, and Dr. Ffrench-Davis himself has decried the slowing down of reciprocal trade in the 1980s.  However Dr. Bhuyan’s report suggests that, with trade off the SAARC agenda and all kinds of other activities on it instead, SAARC is in danger of becoming merely another vehicle for the ever-expanding role of the State in South Asia.  If I might generalize on a remark Sven Arndt made yesterday: if the domestic policies of individual countries are an unsound basis for economic development, then no amount of regional cooperation will have any significant beneficial effect.  Indeed it might even worsen things by distracting attention from fundamental problems, increasing centralization and politicization of economic decisions, and so on.

A few small points to end with.
1.  Dr. Ffrench-Davis refers, I think in a neutral way but I am not sure, to “regional investment planning” in the Andean Pact.  Dr. Bhuyan refers, I think with approval, to “balanced regional industrialization through agreed specialization… the idea is to allot particular industries to particular countries in which they have special interest” (p. 17).  I have not been able to see how the increasingly centralised allocation of resources entailed by such a policy is conducive to the basic purposes of regional cooperation.   Greater specialization is indeed a natural corollary of economic integration.  But the forces of trade, and not the SAARC headquarters in Kathmandu, surely need to be allowed to determine its direction.

2.  Both Dr. Ffrench-Davis and Dr. Bhuyan refer to stronger and weaker, or bigger and smaller, members of a regional grouping.  And Dr. Bhuyan suggests “that a straightforward liberalization of trade by dismantling all trade barriers may benefit the larger countries more than the smaller ones” (p. 12).  I am not at all sure that this is right.  For example, in the Heckscher-Ohlin model the scale of an economy is not relevant to the gains from trade — one country may have absolutely greater amounts of every single factor than another, and yet trade may benefit both because they have relatively different amounts of the factors.  (Similarly in the Ricardian model, one country may have an absolute advantage in the production of both goods, and yet trade may still be beneficial because the countries differ in the relative advantage of the production of each good.)

Thus, in conclusion, all three reports we have been given of efforts at regional cooperation in Asia and Latin America are interesting and informative.  Once again it would seem ASEAN has been leading the way in getting the basic economics as right as possible given what is politically feasible.  And here again we have to think not of ASEAN’s absolute success, but its success relative to other attempts, including I would say the European Community).   Latin America does not seem to have been very far behind in the matter of getting the basic economics right.  While South Asia, which not long ago was in fact the most closely integrated economy of all, sadly seems to lag far behind both in thinking and in achievements.