[Economic Report of the President (2002)]
[Administration of George W. Bush]
[Online through the Government Printing Office, www.gpo.gov]

 
CHAPTER 7

Supporting Global Economic Integration


The world economy has become increasingly integrated. Goods, services,
capital, and people flow across borders with greater frequency and in
ever-greater volumes. For some, cross-national interaction has become
even more a part of day-to-day activity than interactions within their
own country.
Americans benefit tremendously from their interactions with other
countries, just as they do from their interactions with each other in
different States. Such interactions allow Louisianans to drink
California wine, Chicagoans to eat bananas and pineapples from Hawaii,
and savers in Ohio to provide financing to business startups in Florida.
In the same way, international trade allows Americans to enjoy French
wine and Colombian coffee and to take advantage of investment
opportunities in the United Kingdom.
Despite these benefits, many geographic, institutional, and historical
factors impede the free flow of goods, capital, and people across
national borders. Realizing the full benefits of international
interactions requires building into our economic system mechanisms
that facilitate the removal of such impediments. National compacts
such as the interstate commerce clause of the Constitution help to
link the activities of different States. In the same way, international
institutions have developed to promote linkages around the world. Such
institutions seek to provide a stable framework for international
transactions, while respecting the sovereignty of each country that
chooses to participate, as well as serving a valuable coordinating
role. International financial institutions such as the International
Monetary Fund (IMF) help to promote international monetary and
financial cooperation. All of these institutions also evolve in
response to changes in the global economy, just as the transactions
themselves are likely to change in response to institutional
initiatives.  This chapter begins by describing the increasing
integration of the world economy and of the United States with the
world economy. It then sets out some of the benefits of this
globalization and addresses some of the concerns it has engendered.
Finally, it discusses the role of institutions within the
international economy, covering both recent activities and some
likely areas for change.


The United States in the
International Economy


Trends and Patterns in U.S. and World Trade

Several factors have contributed to the increased integration of the
U.S. economy with the rest of the world. For one, the costs of
communicating between a producer in one country and a buyer in another
have fallen dramatically, thus reducing the total costs of dealing
with a foreign trade or financial partner. One measure of these
falling costs is the cost of international telephone service: the
average amount billed to end users for a minute of international
telephone service fell from $2.23 in 1975 to $0.45 in 2000
(in dollars unadjusted for inflation).
In 2000, of the 10 largest international telecommunications carriers
in the world as measured by minutes of outgoing traffic, three were
U.S. companies, and they held first, second, and sixth place.
International telephone traffic worldwide continued to grow rapidly,
by more than 20 percent in that year. The flow of international
telephone traffic to and from the United States continues to exceed
that for any other country in the world. Worldwide satellite industry
revenue also grew by 17 percent in 2000. These numbers suggest the
continuing significance of international and global communications to
U.S. and foreign business firms, who sell and purchase products and
services in all parts of the world, and to U.S. and foreign consumers.
The costs of transporting goods between countries have also fallen,
and this, too, stimulates international trade. Average nominal
freight and insurance costs for U.S. imports fell by about 50
percent between 1975 and 2000, and air cargo rates on long-distance
routes declined substantially. Over the same period, the share of
U.S. imports that arrives by air increased from 9.2 percent to 25.4
percent. With this widespread use of speedier delivery times, trade in
perishable goods as well as in inputs used in just-in-time production
processes has grown. The United States now imports eggs from New
Zealand and electronic components from Malaysia. Exports from the
United States, such as the telecommunications equipment we send to
Japan, are also available more quickly to consumers and producers
in other countries.
In tandem with these falling communications and transport costs,
international efforts to reduce policy barriers to trade have helped
to further link the economies of different countries. Average tariffs
on industrial goods in developed countries have fallen from 40
percent 50 years ago to around 4 percent today. Nontariff barriers to
trade, such as quotas and some regulatory barriers, have also been
dramatically reduced.

All these changes in transactions costs have profoundly affected
international flows of goods, services, and capital. On a pure volume
basis, global merchandise trade has increased substantially in the
last two and a half decades, growing by 277 percent between 1975 and
2000 (Chart 7-1). During this same period, U.S. exports grew by around
393 percent, from $230 billion to $1.1 trillion (in 1996 dollars).
The importance of international transactions in relation to overall
U.S. economic activity has also risen. In 1975 total trade (measured
as exports plus imports) was equal to less than 16 percent of GDP,
but by 2000 that figure was over 26 percent (Chart 7-2). About 8
percent of the labor force is now engaged in producing goods and
services that will be sold in foreign markets.
The United States trades with many countries around the world.
Canada is our top-ranking trading partner, accounting for 20.3
percent of trade in 2000 (again measured as exports and imports
combined). Mexico (12.4 percent) and Japan (10.6 percent) rank
second and third, respectively. The countries of the European Union
together account for 19.3 percent of U.S. trade. This concentration
of U.S. trade in transactions with other high-income countries
follows a historical pattern. But trade with a broader





range of countries already constitutes an important share of our
international transactions, as Mexico's high ranking demonstrates.
And this trade is growing: trade with low- and middle-income
economies grew from $78.5 billion in 1975 to $750.2 billion in 2000.
The reduction in impediments to international transactions has also
been accompanied by changes in the types of goods being traded.
Manufactures have become an increasingly important element of world
trade in goods: their share of world merchandise exports rose from
69.8 percent in 1975 to 74.8 percent in 2000. About 80 percent of
both U.S. merchandise exports and imports in 2000 were manufactured
goods; as recently as 1980 only 55 percent of imports and 70 percent
of exports consisted of manufactures. Within manufacturing, certain
industries are particularly trade-oriented. Ranked on the basis of
exports as a share of shipments, nonelectrical machinery and
computer and electronic equipment were the leaders. In each of these
industries, exports accounted for 30 percent or more of U.S. firms'
total shipments
(Table 7-1).
This increasing importance of manufactures reflects in part another
important change in the nature of U.S. trade: more and more trade now
involves the exchange of intermediate inputs across borders.
For example, a






firm may purchase one input to its production from one country, and
another from another country, and assemble the final good at home or
even in a third country. One way to measure such interactions is to
look at the amount of imported inputs used in goods that are in turn
reexported. One study found that, in 1990, such vertical
specialization accounted for about 20 percent of all exports in a
sample of 14 major trading economies, including the Group of Seven
(G-7) large industrial economies (Canada, France, Germany, Italy,
Japan, the United Kingdom, and the United States). Increases in such
vertical trade have been found to account for more than 30 percent
of the growth in the ratio of world exports to world GDP. Such trade
may help to enhance the efficiency of producers, since they now have
access to a wider range of input sources than are available
domestically. (Box 7-1 discusses the importance of vertical trade
in overall U.S. trade.)

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Box 7-1. Vertical Trade and Production Sharing
A large portion of U.S. trade, both imports and exports, is trade in
partially finished products, also called intermediate inputs. Examples
include the steel used in automobile manufacture, and the cloth and
other textiles from which finished apparel is made.This type of trade
goes by many names, such as vertical trade, vertical specialization,
and production sharing, although these terms have somewhat different
meanings. Vertical trade, the broadest category, includes any
production process that is not confined to one country. Vertical
specialization is slightly narrower. It is defined as the use of
imported inputs to produce goods that are subsequently exported.
Production sharing is narrower still: imported inputs are used to
produce goods that are then exported to the country from which the
inputs came.
Some of these production processes are organized by a single
(vertically integrated) firm, but in a growing number of cases
separate companies in different countries manage different stages of
production. In the past, many companies felt that the only way to
guarantee the timely arrival, exact adherence to specifications, or
quality of an intermediate good was to own all the steps on the supply
ladder (hence the name ``vertical integration``). For similar reasons,
it may sometimes have been difficult to locate plants overseas.
However,the past decade or so has seen large improvements in the
technology available to coordinate and monitor manufacturing in
different parts of the world. This includes everything from cheaper
and better international telephone service to fax machines to
Internet-linked computer-aided design packages. These advances have
allowed companies and countries to specialize in those steps of the
production process that they are best at performing, leading to an
increase in vertical trade.
The extent of vertical trade can be gauged in a number of different
ways. One way is simply to measure the amounts of intermediate goods
that are imported or exported. However, it is sometimes difficult to
decide whether a good should be classified as intermediate, because
this depends on its intended use, which may not be known. Auto tires
are a good example of this. They can be used as an intermediate good
and put on cars to be sold as part of a final product, or they can be
sold in retail stores as a product themselves. The ideal would be to
look at how much of a traded good's value is added in each of the
countries involved in its production. One measure of this is the
imported input share, that is, the share of the value of production
that is attributable to imported inputs. Another such measure would
be the amount of production sharing, which is defined as U.S.
materials shipped abroad for processing and then sent back to the
United States. Note that production sharing is a special case of
vertical trade, since vertical trade also covers inputs shipped to
Mexico or Canada, finished there, and exported to any country, not
just the United States.

The U.S. Government has kept statistics on production sharing since
about 1963. These numbers are collected because products assembled
abroad from U.S. manufactured components qualify for different tariff
treatment: only the portion of the product's value not accounted for
by U.S. inputs is subject to duties. The tariff provision that governs
such production sharing is number 9802. Two main categories of goods
covered under this provision are goods assembled of U.S.-made
components, and metals. Of course, the data collected do not capture
the entire extent of production sharing, as certain products are
exempt from duties under various agreements such as the North
American Free Trade Agreement (NAFTA). In fact, in the first
table below, which traces U.S. imports from selected economies
in the Asia-Pacific Economic Cooperation (APEC) forum, the total
recorded in 2000 fell from the previous year, possibly because of
increased exemption of goods. In the table, ``customs value`` is
the total value of the goods imported into the United States, and
``U.S. content`` is the percentage of value that comes from U.S.
inputs. Therefore, under provision 9802, duties would only have
to be paid on the difference between the customs value and
the value of U.S. components: the value added abroad.For example, in
2000, the United States imported $1.38 billion worth of goods from
Korea for which a 9802 exemption was claimed. The U.S. content of
those goods totaled 54.6 percent, or $750 million, and therefore the
value added abroad was 45.4 percent, or about $630 million.
In addition to collecting statistics, the U.S. Government
occasionally publishes surveys of developments in production sharing.
According to a recent survey, major industries involved in vertical
trade include the automotive industry and various electronics
industries. For example, the United States imports motor vehicles
from Canada ($45.7 billion, or 35 percent of the total),
Japan ($34.5 billion, or 27 percent), and Mexico ($21 billion,
or 16 percent). Exports of motor vehicles from Japan, which is not
covered by NAFTA, contained U.S. components comprising 2.4 percent
of the value of these imports. Exports of motor vehicles from
Canada and Mexico, however, have historically contained U.S.
components equal to one-quarter and






two-fifths of their value, respectively. (The last years for which
such data are available are 1988 for Canada and 1993 for Mexico.
After that, those countries were covered by free-trade agreements
and no longer recorded values for provision 9802.) And indeed, the
United States exported $17 billion worth of automotive parts to
Canada in 2000, and $7.3 billion to Mexico.
Another sector in which production sharing is prevalent is electronic
products. U.S. content in machinery and electronic products imported
from Mexico under the production sharing provision was $4.9 billion
in 2000. As mentioned previously, however, not all production sharing
is captured by provision 9802, as there may be other programs under
which the goods in question get more favorable treatment. Luckily,
we can get a rough idea of the discrepancy through the following
calculations. Mexico also collects statistics on U.S. products
imported as inputs to planned exports under its maquiladora and PITEX
programs. The measured value of imports of machinery and electronics
intermediate goods from the United States was $37.2 billion in 2000
(a much larger number than $4.9 billion). Overall, Mexico exports 92
percent of its maquiladora products to the United States, and so
one can estimate that the U.S. content of machinery and electronic
products under all production sharing arrangements was at least
$34.2 billion in 2000. This implies that the 9802 statistics capture
only a small portion of all production sharing between the United
States and Mexico. As an illustration, the second table in this box
lists the top 20 production sharing commodities from Mexico. The
U.S. content, measured as a percentage of the final value, is
typically quite high.




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Interestingly, the often back-and-forth nature of vertical trade
means that a significant portion of the value of U.S. imports simply
represents the value of previous U.S. exports. Many domestically
produced goods are shipped abroad for further processing or assembly
and then returned to the United States, in another illustration of how
international trade becomes part of the overall production process.
This is a particularly striking feature of U.S. trade with Mexico. In
1998, for example, the United States imported $93 billion worth of
goods from Mexico, $27.2 billion of which entered the country under a
special ``production sharing`` provision of U.S. law that gives
duty-free treatment to the reimportation of goods produced with U.S.
components. Of this $27.2 billion, $14.5 billion (53 percent)
represented the U.S.-made content of these imports. That $14.5
billion also represents at least 15 percent of all U.S. imports from
Mexico.
Lower international transactions costs have facilitated trade
in services as well as in goods. Between 1986 and 2000, total U.S.
trade in services grew by over 200 percent. One reason is that falling
communications costs have allowed many products that were not traded
in the past, such as financial services, to become more readily
available on the international market. U.S. trade in financial
services quadrupled between 1986 and 2000, from $5.1 billion to
$21.5 billion. Other categories of U.S. services trade, such as travel,
education, and royalties and license fees, have also greatly
increased.

Trends and Composition of Capital Flows
Like trade and services flows, global capital flows have increased
enormously over the past 30 years. These flows represent funds
channeled from savers in one country to borrowers in another. From
the end of World War II through the early 1970s, capital controls
in most countries heavily regulated or even prohibited the
international flow of capital. Only when these controls were
liberalized, especially in the late 1970s and early 1980s, did
cross-border financial transactions begin to surge.
Global capital movements can be analyzed in terms of both gross and
net flows. For example, suppose that early in December German
residents purchase $200 worth of U.S. securities from U.S. residents,
and that later that month they sell $50 worth to U.S. residents.
Considering only these transactions, capital flows into the United
States from Germany amount to $150 ($200 in purchases minus $50 in
sales). Suppose further that, over the same month, U.S. residents
first purchase $100 worth of German securities from German
residents and then sell them $30 worth. Considering the latter two
transactions, capital flows into Germany from the United States
amount to $70 ($100 in purchases minus $30 in sales). From the
perspective of the United States, net capital inflows amount to
$80 ($150 of inflows minus $70 of outflows). One measure of gross
capital flows, used in the tables in this chapter, would sum the
capital flows into and out of the United States to arrive at a
total of $220. A broader measure, usually not available from official
data sources, would sum all cross-border purchases and sales to
arrive at a total of $380. Regardless of which concept is used,
gross capital flows will be larger than net flows by definition.
Although it may appear that the gross basis overstates the importance
of capital flows, gross flows do measure the amount of international
funds flowing in and out of a country's financial system. Especially
for developing economies, it is important to know if these flows are
so large that they might overwhelm the capacity of the domestic
financial system to process them.
Unfortunately, data on gross capital flows come from different
sources and are often fragmentary. Since cross-border financial
transactions are  usually not subject to tariffs or quotas, national
authorities have lacked a strong incentive to document their size.
Nonetheless, the IMF estimates that, in the 30 years since 1970,
gross capital flows as a percentage of GDP have risen almost tenfold
for the advanced economies and more than fivefold for developing
economies. Table 7-2 presents more recent measures of capital flows.
From 1990 through 2000, estimated capital flows on a gross basis in
advanced economies more than quadrupled.





Capital flows can also be categorized by the nature of the investment
being undertaken. Capital used by a firm in one country to establish
a plant in another is labeled foreign direct investment, as are large
purchases of equities that imply a lasting interest in an enterprise.
Purchases of long-term bonds, money market instruments, and small
amounts of equities are labeled portfolio investment. Residual
transactions such as loans fall into the category labeled ``other`` in
Table 7-2. Gross capital flows have shifted toward direct and
portfolio investment in the past decade.
The explosion in gross capital flows obscures the fact that, on a net
basis, capital flows have grown much less rapidly (Table 7-3). This
difference in the two measures means that larger amounts of funds
are crossing borders, but that the balance of inflows and outflows is
remaining roughly constant. These net flows also reflect the balance
of domestic saving and investment in a country. If a country saves
more than it invests, the excess savings must go abroad. Similarly,
if a country invests more than what is available from domestic saving,
the extra funds must come from abroad.
These net capital flows are also just the mirror image of the
country's current account balance, which, roughly speaking,
consists of the balance in its combined goods and services trade
and the net flow of income generated from cross-border investments.
A country that sends savings abroad, on net, is enabling the rest
of the world to spend more on that country's goods and services than
that country is spending on goods and services produced by the rest
of the world; such a country has a current account surplus. A
country that is attracting savings from abroad, on net, is able to
spend more on goods and services produced by the rest of the world
than the rest of the world is spending on goods and services that
the country itself produces;that country has a current account
deficit.  Although net capital flows on a global basis have increased
relatively little in recent years, this is not the case for the
United States, as Table 7-3 also shows. The United States recorded
large current account deficits over the past decade, reflecting an
increased desire on the part of foreigners to invest in the United
States. The United States also ran large current account deficits in
the 1980s. An important source of financing for these deficits was
foreign official  purchases of U.S. government debt securities. In
the 1990s, however, the bulk of foreign investment entering the
United States consisted of purchases of private assets. In particular,
direct investments in the United States have shown a very rapid rate
of increase over the past several years. In short, rapid rates of
productivity growth and increases in economic activity over the past
decade have made private assets in the United States more attractive
for foreign investors.
Because the world's developing economies have relatively little
capital compared with the developed economies, there is a presumption
that capital





should flow from the latter to the former. Hence capital
flows to and from these developing economies receive much attention.
Table 7-3 shows that these flows have varied enormously over the past
decade. In the early 1990s some developing economies made enormous
strides in structural economic reform and removed restrictions on
capital flows, leading to a renewed interest on the part of
international investors. Net flows skyrocketed, reaching $233 billion
in 1996. However, the financial crises that began in East Asia in 1997
and then occurred in Russia and Brazil in 1998 and 1999 dampened
investors' appetites. Net flows fell to close to zero in 2000 but are
believed to have increased moderately in 2001. A swing in net banking
flows accounts for most of the decline since 1996. This was due to
both a decrease in international bank lending to developing economies
and an increase in deposit outflows from developing economies to
international banks. (The lower international bank lending reflects
in part a move from cross-border lending to more lending by
subsidiaries within the countries.) However, direct investment flows
have remained fairly stable over the past 3 years, a sign that
investors are still willing to undertake long-term investments in the
developing economies. Cumulating net capital flows for a given
country and accounting for changes in the prices of assets held
across borders yields the net international investment position for
that country with the rest of the world. For example, suppose that a
country begins international transactions with the rest of the world
and for 10 years enjoys net capital inflows of $1 billion a year
(possibly including reinvested earnings). At the end of these 10
years that country's net international investment position would
show that the rest of the world has accumulated a total of $10
billion in claims on that country, assuming that the prices of these
claims did not change over the 10-year period. These claims could be
in the form of portfolio investments (if, for example, investors in
the rest of the world bought bonds issued by the country's
corporations) or direct investments (if the rest of the world bought
controlling interests in the country's corporations).
Table 7-4 indicates that, worldwide, these cross-border claims are
quite large in the aggregate, at over $21 trillion, equal to almost 70
percent of world GDP. The claims are largely divided among bank loans,
equities, and bonds. Central bank reserves make up a fourth,
relatively small category. These holdings are now much smaller than
those of private investors, having grown at about half the rate of
gross capital flows over the last 30 years.





Table 7-4 also indicates that the United States is a party (either a
lender or a borrower) in roughly 80 percent of global cross-border
claims. As noted above, foreign investors have found the U.S. economy
very attractive and have built up their holdings of U.S. assets.
At the same time, U.S. citizens have substantial holdings of foreign
assets. Foreign-owned assets in the United States total $9.4
trillion, and U.S. claims on the rest of the world total $7.2
trillion, so that the United States is today in the position of a
net debtor. In most cases, transferring capital across borders
requires a foreign exchange transaction, in which the currency of
one country is exchanged for that of another. As capital flows have
increased, so has turnover (the total value of transactions) in the
foreign exchange market. Data for foreign exchange turnover
correspond to the broadest measure of capital flows discussed
earlier. There is no attempt to net purchases and sales against each
other, either across trading days or across transactions that
finance one country's purchases versus those that finance its sales.
Since 1989 daily nominal foreign exchange turnover has more than
doubled; it now averages $1.2 trillion. But turnover has actually
fallen since 1998, for two reasons. One is that the introduction
of the euro as the common currency of the European economic and
monetary union means that many cross-border transactions within
Europe no longer require an exchange of currencies, and the other
is that consolidation has occurred in the international banking sector.
Given the annual capital flow data summarized in Table 7-2, the
turnover data suggest that gross flows for the year as a whole are
the product of extraordinarily large flows on a daily basis within
the year. This provides yet another explanation for policymakers'
concern that in some cases the sheer size of these flows could
overwhelm the resources of a poorly supervised financial system in
the event of a sharp reversal. This issue is discussed further later
in the chapter.

The Benefits of Globalization

The various trends, described in the previous section, toward
increased interaction between people and firms in different
countries-increases in trade as well as increases in capital flows
-are often collectively referred to as globalization. Each of these
forms of globalization, and others such as international migration,
benefit the United States in a variety of ways, as this section will
show.

The Benefits of Trade
International trade, both exports and imports, benefits the economy
in a number of different ways. In a general sense, exports benefit the
economy because American workers have another market-the global
market-in which they can sell the goods and services they produce.
Over 12 million American jobs are supported by exports. Opening
foreign markets for U.S. producers allows them to expand their output
and hire more American workers. Before the North American Free Trade
Agreement (NAFTA) went into effect in 1994, for example, U.S.
shipments of assembled motor vehicles to Mexico were severely
hampered by Mexico's high tariffs and other regulations designed to
protect the local automotive industry. Under NAFTA, Mexico was
required to reduce these barriers: in 1998 Mexico eliminated its
tariffs on light trucks produced in the United States, and all
remaining Mexican tariffs on medium and heavy trucks and buses were
eliminated on January 1, 2002. Subsequently, U.S. exports of motor
vehicles to Mexico rose from $975 million in the 5 years preceding
NAFTA to $6.6 billion in the 5 years after NAFTA. And this happened
despite a major recession in Mexico following that country's
financial crisis of 1994-95.  The health of many sectors of the
American economy depends upon trade.America's farmers, for example,
rely on sales to foreign markets. Exports of U.S. agricultural
products amounted to $53 billion in 2000,and roughly 25 percent of
cash sales by farmers and ranchers come from sales to foreign
consumers. U.S. agricultural exports support 740,000 American jobs.
Trade also benefits the economy in a number of more specific ways.
First, trade may reduce the prices of some of the goods that we
consume. When a country is closed to trade, domestic consumers are
forced to buy only those goods produced in their home market. Often,
however, a producer in another country is able to produce the same
goods more efficiently, that is, at a lower cost. When trade is open,
consumers have the choice of buying the imported good at the lower
price. In addition, now that domestic producers are competing with
imports, they will have greater incentive to produce using the
lowest-cost methods possible. Thus international trade tends to reduce
the prices of some goods traded. Of course, if the United States is
already the lowest-cost producer of a good, domestic consumers will
continue to purchase it from domestic suppliers.
A second specific benefit of trade is that it gives a country's
consumers access to the many different goods and services produced
around the world. For example, without trade, we would not be able to
purchase coffee from Costa Rica, or enjoy certain fresh tropical
fruits year-round. We would not have access to some products at all,
or would be able to consume only the domestic variety. Similarly,
when a firm needs a specialized input for a production process, trade
often allows it to choose from many options available around the world,
rather than only those produced at home. This option allows the firm
to produce more efficiently, and be more competitive internationally,
than without this choice.
As a third benefit of international integration, trade helps boost
productivity in the United States. Increased competition from trade
provides incentives for domestic firms to produce using the most
efficient, lowest cost methods possible. Firms that are successful in
international competition are likely to be more productive than those
that sell only at home. In fact, recent evidence shows that exporters
tend to be relatively more efficient and to pay higher wages than
nonexporters. One study found that, in 1992, a worker at an exporting
plant earned wages that were 10 percent higher, and nonwage benefits
that were 11 percent higher, than a worker at a nonexporting plant.
Trade also allows the U.S. economy as a whole to specialize in the
products that it is comparatively best at producing. This is because
trade between nations is the international extension of the division
of labor. The United States exports some of the goods and services
that it is relatively better at producing, and receives in exchange
goods and services that other countries are relatively better at
producing. For example, the United States exports manufactured goods
that require high levels of technical skill, such as
telecommunications equipment and professional scientific instruments.
Some of these industries, such as electronics and computer equipment,
sell at least a quarter of their merchandise overseas (Table 7-1).
This reflects the relative abundance of highly skilled labor in the
United States. U.S. imports, on the other hand, tend to be in areas
such as consumer goods (Chart 7-3). This specialization of economic
activity based on comparative advantage




allows the United States as a whole to use its resources most
effectively, and it allows Americans to purchase goods from the
world's best sources of those goods. Thus both exports and imports are
beneficial and help make the United States a richer and more efficient
economy.
Trade also increases productivity because it gives exporters access
to a larger total market. Because some goods, such as automobiles, are
produced most cheaply in large quantities, a larger market may allow
exporters to reduce their production costs through economies of scale.
Finally, trade benefits the economy through the access it provides to
foreign technology and ideas. We can import innovative products from
abroad and use them to increase our own efficiency, or to create even
newer technologies, raising the rate of economic growth.

The Benefits of Capital Flows
Just as trade flows result from individuals and countries seeking
to maximize their well-being by exploiting their own comparative
advantage, so, too, are capital flows the result of individuals and
countries seeking to make themselves better off, in this case by
moving accumulated assets to wherever they are likely to be most
productive. Increased capital flows benefit both the lender and the
borrower. From the lender's perspective, cross-border capital flows
provide an opportunity to diversify an investment portfolio. To the
extent that returns on international assets do not move in lockstep
with returns on domestic assets, diversification through cross-border
investments both increases expected returns and lowers risk. These
benefits lie behind the large increases in capital flows documented
earlier in the chapter. The ``home bias`` to investment portfolios is
falling: whereas in the late 1980s only 6 percent of U.S. residents'
equity holdings were in foreign assets, more recent estimates put
that share at more than 10 percent. Even that, however, is below the
percentage that most models of optimal portfolio selection would
predict.
For the borrower, cross-border capital flows allow for an expansion
of production possibilities. Lending from abroad allows more capital
to be combined with other inputs to increase the production of valuable
goods and services. Some of the increase in output will be used to pay
back the lender, but a substantial fraction should contribute to a
rise in domestic standards of living. This is particularly important
for developing economies, where overseas capital effectively
substitutes for or augments often-scarce domestic sources of
investment. Capital inflows can help keep domestic interest rates low,
making sure that government borrowing to finance programs for
education and health care does not crowd out private domestic
investment.
Capital flows also boost efficiency in the borrowing country. New
ideas and techniques accompany capital flows across borders, allowing
for a more efficient allocation of resources within the country. Such
knowledge transfers boost productivity in the receiving country,
allowing for more rapid technological economic progress there. This
is most evident in the case of foreign direct investment, where new
plants and new management methods can lead to sharp increases in
output.
Capital inflows also help expand and diversify the financial system
inthe recipient country, and this, too, leads to a more efficient
allocation of capital and faster growth.
The increases in economic well-being associated with increased
capital flows require a supportive domestic environment. Without this
support, capital flows can reverse themselves sharply, imposing large
adjustment costs on the borrowing economy. The risks of a reversal are
heightened if the borrowing economy is pursuing unsound macroeconomic
policies, or if supervision of the financial system is inadequate.
Quantifying the positive relationship between increased capital flows
and faster growth is difficult, for several reasons. First, poor
macroeconomic or regulatory policies may render some countries unable
to harness investment capital in ways that promote sustainable growth.
Second, causation between capital flows and economic growth is likely
to run both ways. An increase in capital available to an economy will
boost growth, but as an economy grows, it is more likely to attract
foreign capital. This confronts economists with a chicken-and-egg
question: which came first, the capital flows or the growth? Recent
empirical research has struggled with these problems but, on balance,
concludes that the increased capital flows brought about by capital
liberalization spur economic growth. All else being equal, a country
that opens up to capital flows can expect to enjoy an increase in its
growth rate per capita of half a percentage point or more per year.
For example, if an economy is growing at an annual rate of 2 percent,
opening up to capital flows would allow its economy to double in size
7 years sooner than otherwise.
There is every reason to expect that in the long run international
capital flows will continue to increase in importance, as economies
around the world become more interlinked. Continued increases in
trade volumes, discussed earlier in the chapter, will require capital
flows to finance them. Investors will continue to obtain the benefits
of diversification from increasing their international exposures. And,
as we have seen, the average investor is still a long way from holding
an optimally diversified international portfolio. Finally, although
world living standards are improving on average, both the relative
and the absolute gap in incomes per capita between rich and poor
countries continue to increase. This gap indicates that the rate of
return on capital in the world's poor economies is likely to be
several times that in the rich economies, providing an enormous
incentive for continued-and indeed, augmented-flows. Of course, this
will only be true to the extent that productivity gains achieved in
the developed economies can be transferred across borders. And most
important, it requires that the least developed economies have sound
policies and educated work forces in place, to make effective use of
the capital coming in.

The Role of Migration
Migration is another important aspect of the internationalization of
the economy. Just as trade in goods, services, and capital allows
resources to be used most efficiently, so, too, the movement of people
from country to country around the world can enable them to make the
best use of their skills and abilities. Thus removal of barriers to
immigration allows for more efficient worldwide distribution of
workers.
The United States has a long history of accepting people from other
countries, as witnessed by the numbers collected by the Bureau of
the Census on the foreign-born population. In 2000 foreign-born
residents made up 10.4 percent of the U.S. population (although in
1900 they represented an even greater 13.6 percent). Immigrants have
been a key building block for the U.S. economy. Our openness to
immigration has allowed us to reap the benefits of the presence of
newcomers from many countries.
Immigrants benefit the economy in several ways. First, people are a
resource, similar to the other resources of our economy such as land
or minerals. Immigrants who come to the United States to work allow
the country to produce more. It has been estimated that if immigrants
make up 10 percent of the population, the net overall gain from their
presence is somewhere between 0.01 and 0.14 percent of GDP per year.
Given that, in 2000, U.S. GDP was $9.9 trillion, the overall gain is
between $1 billion and $14 billion.
The increase in the labor force from immigration also affects prices.
The goods and services that immigrants produce tend to become cheaper
as more immigrants enter, and all consumers benefit from this
reduction in prices. This price drop is an average price drop across
all goods and services. Some goods and services�in particular, those
that use a lot of unskilled labor�will see sharper drops in prices
than others. Household services and services to dwellings are
examples. On the other hand, the prices of goods and services that
use less unskilled labor are likely to fall by less or stay the same,
and may even increase.
Legal immigrants who work may also contribute to government finances
by paying taxes on the wages they earn. Because they tend to be
younger workers, immigration also improves the current balance sheet
of Social Security. Of course, legal immigrants may receive welfare
benefits, which impose a cost on the government and taxpayers. Recent
research provides some estimates on the balance between taxes that
immigrants pay and the benefits they receive. These calculations
indicate the ultimate effect on taxpayers of a given legal immigrant
now and into the future, taking account of the effects of that
specific immigrant on taxes and benefits, as well as the effects of
his or her children into the future. Overall, according to this
research, the average immigrant makes a net positive fiscal
contribution of about $80,000.

Some Myths About Trade and Globalization
Although globalization, by increasing the movement of goods and
services, capital, and people across the Nation's borders, has
provided a variety of benefits to the United States, many have
expressed concerns about globalization's effects, both in the United
States and abroad. This section reviews some of those concerns and
explains why globalization is, in fact, unlikely to have the adverse
effects often feared.
Trade and the Environment
A variety of concerns have been raised about the impact of
globalization on the environment. One is that government action to
implement domestic environmental regulations may be interpreted in
other countries as protectionism and, consequently, in violation of
trade agreements that the United States has entered into. Domestic
environmental regulations may then be challenged, and the case
adjudicated by international dispute settlement mechanisms. The
concern is that the United States might be forced to change or
eliminate its own environmental standards.
In fact, environmental regulations do not normally raise issues of
consistency with international trade agreements, which are aimed at
preventing discrimination against foreign products, not at lowering
environmental standards. There is generally no reason for
environmental regulations to lead to discrimination against or among
foreign products. If a product is judged to inflict environmental
harm, its production and use are normally regulated, or prohibited,
without regard to its origin; if this is the case, such regulations
are unlikely to breach international trade obligations. Even if they
did,international trade agreements contain exceptions that allow a
country to take environmental measures against imported products
that might otherwise violate obligations under the agreement.
For example, Article XX of the 1994 General Agreement on Tariffs and
Trade-one of the agreements among members of the World Trade
Organization (WTO)-lists a number of general exceptions to members '
obligations. One of these confirms that a WTO member may adopt and
enforce measures ``necessary to protect human, animal or plant life
or health`` or ``relating to the conservation of exhaustible natural
resources.`` These exceptions are subject to a number of conditions,
among them that the measures not arbitrarily or unjustifiably
discriminate among countries and that they not constitute a disguised
restriction on international trade. (NAFTA incorporates similar
exceptions and conditions.) Thus, nothing in these international
agreements prevents the United States from establishing and
maintaining legitimate environmental measures, so long as it does
so in a way that does not unjustifiably discriminate against its
trading partners or create unnecessary barriers to trade. In fact,
the General Accounting Office concluded in 2000 that, ``The WTO
rulings to date against U.S. environmental measures have not weakened
U.S. environmental protections.``
Other concerns about globalization may stem from the fear that growth
in developing countries resulting from increased trade may lead to
environmental degradation. But in fact, there is no clear relationship
between development and pollution levels. Indeed, some evidence shows
that organic water pollution intensity falls substantially as a
country's income per capita rises from $500 to $20,000, with the
decline beginning before the country reaches high-income status (about
$10,000 in annual income per capita). Trade may also give countries
access to cleaner technologies, allowing them to build their
industries in a more environmentally sound fashion.

Trade and Employment
Some argue that globalization leads to the loss of jobs for American
workers. It is true that some domestic firms will not be able to
compete effectively with imports, and these firms may be forced to
reduce their work force or even cease operations. At the same time,
however, the opportunity for increased trade will lead other firms
to expand their operations and increase hiring, in order to serve
the international market as exporters. These firms tend to be the more
productive ones in the economy. Exporters also tend to pay higher
wages than firms that do not export-in 1992, up to 18 percent higher
on a simple average basis, according to one study.
It is also true that the firms forced by import competition to
eliminate jobs may be in different sectors from the exporters who are
increasing hiring. This can make it difficult for those who lose their
jobs to import competition to find new jobs with exporting firms that
use the skills they have acquired. But such shifts in employment also
reflect one of the benefits of trade for the aggregate economy, namely,
that it allows the economy to produce the goods and services that it
is comparatively best at producing, and to buy from other countries
those goods and services that it is relatively ill equipped to
produce. The expansion of trade that may precipitate such a shift
of workers may, as a result, lead to an increase in the average
income of the American worker, because wages in import-competing
industries tend to be below the average, whereas wages in exporting
industries tend to be above the average. Workers in export-competing
industries such as aircraft and pharmaceuticals earned about 22 to
60 percent more than the average wage in 2000. The reverse is true
for import-competing industries: wages in the apparel industry, for
example, were 36 percent lower than the average in manufacturing,
those in the leather industry were 29 percent lower, and those in the
textile industry 35 percent lower. The shifting of jobs across sectors
may take time, and some workers may face dislocation. However, the
displacement of some workers by imports should not be an excuse for
discouraging trade, any more than the costs to some workers of
technological change should stop the development of innovations. It
would have made little sense to discourage the diffusion of personal
computers just because it jeopardized the workers of typewriter
manufacturers. Imposing trade restrictions in an effort to save those
jobs will only destroy, or prevent the creation of, jobs in other
sectors. If, for example, government-imposed trade barriers were
to hinder access to imported capital goods, the domestic firms that
purchase those inputs would be forced to operate at higher costs of
production. This would adversely affect their competitive position
relative to foreign rivals who have free access to such capital
goods. Domestic producers might lose sales, and this might force
them to downsize their work forces, or even to shift production
to locations abroad where the inputs are freely available.
Of course, finding a new job in another firm or another industry,
after losing one's job to import competition, may be difficult. The
Federal Government recognizes this possibility and has put programs
in place to assist those who lose their jobs because of trade in
finding new ones, and to provide them with financial assistance while
they make the transition. For example, the Trade Adjustment Assistance
(TAA) program provides training, job search aid, and relocation
allowances; these benefits are on top of unemployment insurance and
other programs. In 1999 close to 130,000 workers were estimated to be
in groups certified as eligible for TAA. This Administration is
committed to reauthorizing and improving existing TAA programs that
are due to expire. The Administration worked during 2001 to strengthen
the performance of these programs, so that they are more effective at
easing the transition into new employment. In addition, for certain
sensitive sectors such as textiles and agriculture, trade
liberalization is designed to proceed in gradual stages so that
workers have more time to adjust.

Trade and Relative Wages
Over the last three decades, the returns to education, in the form of
higher wages, have increased dramatically, although the rise has
flattened out in more recent years. In 1979 a male with a college
degree could command a 30 percent wage premium over a male with only
a high school diploma. This premium had risen to 60 percent by 1995
but has remained relatively constant since then. Because workers
with less education often work in industries that compete most
closely with imports, particularly those from developing countries,
some have blamed increased trade for these changes in wages. However,
although the United States did increase its imports from developing
countries over this period, it also experienced a great deal of
echnological change, which increased demand for workers with higher
skill levels. This tends to increase the relative wages of those with
higher skill levels. In fact, it appears that this increased demand
for more educated workers, and not increased trade with developing
countries, has led to the recent change in relative wages.


The Effects of Trade on Developing Nations
Some have suggested that international trade may harm workers in
developing countries, because countries like the United States import
goods produced under poor working conditions or at very low wages.
Those who hold this position argue that the United States should use
trade measures, such as withholding access to our markets, as a weapon
to force developing countries to improve working standards or to
increase wages. The use of trade policy to force such changes,
however, would have perverse effects, actually hurting those it aims
to help. For example, if the United States and other countries
refused to import from countries where wages are below a certain
standard, workers in those countries would be denied the opportunity
to work in an export-producing industry. Unfortunately, jobs in other
industries may not be readily
available in that country, or if they are, may pay even lower wages
and impose even worse working conditions.
In addition, to cut off imports from such countries may be to deny
them one of their best opportunities for economic growth. A number
of recent studies show that participation in an open trading system
has a positive effect on a country's income per capita. One study
finds that increasing the ratio of trade to GDP by 1 percentage point
raises income per capita by 1.5 to 2 percent, and an increase in
average incomes is generally associated with higher incomes for the
poor. Several studies by the World Bank also point to a linkage
between trade liberalization and faster economic growth, as
liberalization encourages higher rates of investment and more rapid
technological innovation. Thus, limiting trade with developing
countries may only serve to keep the poor in their poverty. Perhaps
because of the negative effects of linking trade and labor outcomes,
many developing countries are strongly opposed to including
discussions on labor standards in international trade negotiations.
Many countries, including the United States, do adhere to certain
core labor standards, such as the prohibition of exploitative child
labor. Trade in and of itself does not cause poor working conditions.
Rather, they are more likely to be the result of domestic policies
and economic circumstances. In fact, trade may help to improve working
conditions, just as it may facilitate an increase in incomes.
Benjamin Franklin summarized it well: ``No nation was ever ruined by
trade.``
International Policy Issues and the
Role of International Institutions

An important factor in the continued worldwide growth in trade and
capital flows has been the creation and development of international
institutions dedicated to promoting that growth. The United States
is a participant in these institutions and has benefited from their
important work. The United States has also participated in recent
efforts to reform some of these institutions. The present section
discusses some of the most important of these organizations and recent
proposals for their reform.

International Trade Institutions and the Benefits
of Trade

International trade institutions and agreements are designed to
ensure that all parties are able to enjoy the benefits of free and
open trade. These institutions allow many countries to negotiate
together to reduce barriers to trade in ways that are acceptable to
all. They also create a stable framework for international
transactions. If progress is to continue toward the goal of increased
trade, it is crucial that the United States encourage its trading
partners to maintain the focus of trade negotiations on this main
purpose, rather than stray into areas, often very controversial, that
could stall greater progress toward free trade.
The international trade agreements in which the United States has
participated can be classified into several broad types. Those of the
first type are called multilateral agreements, in which a large number
of countries around the world agree to reduce barriers to trade among
themselves. As a rule, agreements of this type, such as the General
Agreement on Tariffs and Trade (GATT), are structured such that each
participating country agrees to reduce trade impediments to all other
participants. One of the foundations of the GATT/WTO system is the
most-favored-nation (MFN) principle, which mandates that if a WTO
member extends any benefit (such as a reduction in tariffs) to a
product of another WTO member, it must extend the same benefit to
like products of all other members.
A second type of trade agreement is the regional trade agreement,
examples of which include NAFTA and the trade agreements of the
European Union. In such agreements, each participant agrees to reduce
trade barriers only with respect to the other participating countries
in the region. So, for example, in NAFTA, the United States reduced
its barriers to Mexican and Canadian exports but made no such changes
for  exports of European or Asian countries. (Such favorable treatment
of regional trade might seem to violate the MFN principle for
countries that are WTO members; however, Article XXIV of the 1994 GATT
explicitly allows for such regional agreements under certain
conditions.) Although regional agreements generally make good
progress toward free trade among the participants, they may introduce
some distortions in trade patterns. A country may end up importing
goods from a country in the region that has high costs of production
but is subject to a low tariff, rather than from one outside the
region (or a nonparticipant within the region) that has a low cost of
production but faces a high tariff. Such trade patterns (called trade
diversion) may hinder the most efficient use of global resources.
However, an advantage of regional trade agreements over multilateral
agreements is that a smaller group of countries may find it easier
to come to a consensus on trade liberalization. Also, if the agreement
is among countries that would naturally engage in a great deal of
trade with each other in the absence of artificial barriers to trade
(for example, countries in close geographical proximity to each
other), the amount of trade diversion may be very small.
The WTO has reported a massive proliferation of regional trade
agreements in recent years, with an average of one per month being
notified to the organization. A recent study by the WTO Secretariat
identified a total of 172 regional trade agreements currently in force
(including some that have not, or not yet, been notified to the WTO),
and this number could well grow to about 250 by 2005. On the basis of
the 113 regional trade agreements notified to the WTO and deemed to
be in force as of July 2000, it is estimated that some 43 percent of
world trade occurs within such agreements. This share would rise to
51 percent if all 68 or so of the regional trade agreements currently
under discussion and scheduled to be in force by 2005 were already
in place.
Economists are divided as to whether regional agreements help or
hinder progress toward broader, multilateral agreements. On the one
hand, negotiation over regional proposals may divert negotiating
resources from multilateral talks, or a proliferation of different
regulations under various regional agreements may raise transactions
costs for trade. On the other hand, if all countries engage in
regional agreements, there will be competition to get the best trade
deals, and this competition can lead to bidding down barriers to
free trade. It may also be easier for a small country to get larger
countries to recognize and understand its needs in a regional than
in a multilateral setting.Finally, a third type of trade agreement is
the bilateral trade agreement, such as the recent agreement between
the United States and Jordan. Others include the agreement between
the United States and Israel and that between Canada and Chile. Such
agreements have pros and cons similar to those of regional agreements.
The United States benefits significantly from its participation in
international trade institutions, for a number of reasons. For one,
because U.S. tariffs on imports are already among the lowest in the
world, any agreements to further liberalize trade will likely lower
other countries' tariffs more than they lower U.S tariffs. U.S.
tariffs average about 2.5 percent on comparable, trade-weighted terms
(Chart 7-4), but U.S. producers face extremely high tariffs in many
developing countries. For example, average tariffs on U.S.-produced
goods are 13.7 percent in Brazil, roughly 17 percent in Thailand,
and up to 35 percent in India. (The numbers for Brazil and Thailand
are average applied rates; that is, they are averaged over all
imports from the United States. The rate for India is a ceiling rate,
which means that no tariff is supposed to be higher than 35 percent.
However, because of exceptions put in by the Indian government, the
applied rate could be higher.) Many of the United States' trading
partners, including the European Union and Japan, maintain high
barriers on a range of agricultural goods.







Thus, multilateral agreements on tariff reduction often
disproportionately benefit U.S. exporters.
However, tariffs are not the only artificial barriers to trade. Other
barriers include quotas (quantitative limits on import volumes),
technical regulations and standards (such as for telecommunications
equipment), rules for the valuation of goods subject to tariffs (which
affect how the tariffs are calculated), and rules regarding investment
(for example, limiting the percentage of foreign ownership of a
domestic company). Unfortunately, whatever their stated purpose, such
rules are often in fact designed to protect domestic industries from
foreign competition. The United States faces discriminatory
regulations in many countries. Discriminatory foreign health and
safety regulations cost the United States over $5 billion in
agricultural exports in 1996,according to the Department of
Agriculture.
To circumvent this problem, most trade agreements establish the
principle of nondiscrimination, or national treatment. This means
that all countries that are parties to the agreement must treat the
exports of other parties as if they were domestically produced. Since
many international agreements now include provisions on regulatory
barriers and government procurement policy, this requirement allows
U.S. exporters to avoid such impediments in other countries. As
tariffs fall, these kinds of negotiations become increasingly
important to the opening of markets.
The United States has participated in a number of different trade
institutions and agreements over the years. For example, the United
States was a member of the GATT from its inception in 1948 until 1995,
when the WTO was formed. Until the WTO came into being, the GATT was
both the agreement (which is still in effect) and the international
organization formed on an ad hoc basis to support it. The United
States benefited significantly from the outcome of the Uruguay Round,
a recent major round of multilateral negotiations under the auspices
of the GATT. The reduction in U.S. tariffs that emerged from that
agreement had an effect on an average American household of four
similar to a tax cut of $310 a year, or the equivalent of a per-year
income gain of more than $600.
The WTO is an international institution in which the United States
negotiates agreements with 143 other members to reduce barriers to
trade. In addition, the WTO maintains a forum for dispute settlement
that enables its members to resolve trade disputes arising under the
WTO agreements. At the fourth WTO Ministerial Conference in Doha,
Qatar, in 2001, the members of the WTO agreed to launch a work program
that includes further negotiations on trade liberalization.
Negotiations will commence in a number of areas, including agriculture,
services, industrial market access, a limited set of environmental
issues, antidumping and subsidies, and WTO dispute settlement rules;
it will also include important work on trade-related capacity building
for developing countries. Members also committed themselves to
maintain their current practice of not imposing customs duties on
electronic transmissions at least until the Fifth Session of the
Ministerial Conference, which is likely to occur in 2003. Negotiations
on certain issues, such as investment and competition policy, are
delayed until that conference.
Some of the issues slated for negotiation have proved particularly
difficult to deal with in the past, suggesting that gains from the new
WTO agenda could be large. The new work program will address market
access barriers to trade in agricultural products as well as
government subsidies in this sector. Some countries, such as those
of the European Union, rely heavily on export subsidies. The
potential gains to the United States from these discussions are
indeed sizable, in part because the multilateral negotiations
promise to reduce barriers to U.S. trade around the entire world. One
study finds that if a new trade round reduced world barriers on
agricultural and industrial products and on trade in services by
one-third, the gains to the United States could amount to $177
billion, or about $2,500 for the average American family of four.
The United States is also a founding member of the Participants to the
Arrangement on Guidelines for Officially Supported Export Credits, an
independent body within the Organization for Economic Cooperation and
Development (OECD). The arrangement was established in 1978 to limit
the terms and conditions under which governments can finance their
exports, with the goal of opening export markets by eliminating
official financing subsidies. Financing subsidies close markets by
eliminating competition on the basis of price, quality, and service
and directing business to those countries willing to spend budget
resources to provide below-market export financing. The arrangement
is currently operated by 24 OECD member governments and governs
official export credits totaling $45 billion in 2000, as well as aid
financing of about $9 billion to $10 billion a year. The WTO leaves
much of the discipline for such indirect subsidization to the OECD
Arrangement, and therefore the U.S. antisubsidy efforts in the OECD
are complementary to its broader WTO work to eliminate subsidies. The
Treasury Department estimates that OECD disciplines over aid financing
subsidies alone have opened export markets worth $5 billion to $6
billion annually, leading to increased U.S. exports of about $1 billion
each year. The overall U.S. budget savings from all OECD disciplines
on financing subsidies amount to around $300 million a year.
NAFTA has been another important example of U.S. participation in
international trade institutions. From 1994, when NAFTA went into
effect, until 2000, total trade among the United States, Mexico, and
Canada increased from $297 billion to $676 billion, or 128 percent.
The share of worldwide U.S. goods exports that has gone to NAFTA
partners more than doubled over the same period, from 14 percent
to 37 percent. Trade restrictions imposed on U.S. exports by our
NAFTA partners have fallen significantly. For example, in 1993
Mexico's average tariffs on U.S. goods were more than twice as high
as U.S. tariffs on Mexican goods. Under NAFTA, Mexico's average tariff
on U.S. exports has fallen below 2 percent, and two-thirds of U.S.
exports now enter Mexico duty-free. Nearly all of the $406 billion in
goods traded between the United States and Canada enters duty-free.
The United States has benefited from this agreement, which when fully
implemented will, according to some estimates, yield an increase in U.S.
GDP of between 0.1 percent and 0.5 percent, or between $10 billion
and $50 billion relative to the size of the economy in 2000. For an
average household of four, this translates into a per-year income gain
of $140 to $720. The NAFTA liberalization is also roughly equivalent
to a tax cut of $210 for the same family. U.S. producers of various
commodities also benefit from NAFTA. Exports of beef and processed
tomatoes to Canada, as well as of cattle, dairy products, apples, and
pears to Mexico, are 15 percent higher than they would have been had
the Canada-U.S. Free Trade Agreement, and later NAFTA, not reduced
barriers to U.S. goods in those markets, according to the Department
of Agriculture.
The United States is currently involved in efforts to liberalize
trade with a larger number of our hemispheric neighbors. Discussions
toward a Free Trade Area of the Americas (FTAA) began at the Summit
of the Americas in Miami in December 1994. Thirty-four countries
agreed to construct a free-trade area in which barriers to trade and
investment would be progressively eliminated, and to complete
negotiations toward the agreement by 2005. The FTAA thus aims to
establish free trade across the Western Hemisphere, from Hudson Bay
to Tierra del Fuego. The nine FTAA negotiating groups cover a range
of areas, including market access, agriculture, services, investment,
intellectual property, government procurement, competition policy,
dispute settlement, and antidumping, countervailing duties, and
subsidies.
The potential market that an FTAA would create is enormous: the
combined GDPs of Central and South America amount to $1.57 trillion.
(This figure leaves out Mexico, as it is already covered under NAFTA.)
And the obstacles currently faced by American exporters in Latin
America are formidable, particularly since other countries in the
region already have negotiated reductions in barriers with each other.
For example, when Chile and Canada recently concluded their bilateral
free-trade agreement, Chile's across-the-board 8 percent tariff was
eliminated on Canada's exports, but it remains in effect on U.S.
exports. Under the MERCOSUR trade arrangement�a customs area
agreement signed in 1991 among Argentina, Brazil, Paraguay, and
Uruguay-imports and exports among these four countries and Chile are
largely duty-free; U.S. exporters to those countries face average
tariffs of almost 15 percent. The FTAA promises to eliminate the
discrimination against U.S. products in these markets.
The importance of breaking down barriers throughout the hemisphere is
epitomized by the experience of Caterpillar Inc. Caterpillar's motor
graders made in the United States for export to Chile face nearly
$15,000 in tariffs. Yet when Caterpillar manufactures motor graders
in Brazil for export to Chile, the tariff is just $3,700. And if
Caterpillar's competitors were to produce a similar product in
Canada, it could be exported to Chile duty-free under the Canada-Chile
free-trade agreement. One result of these high trade barriers against
the United States may be to create incentives for U.S. firms to locate
factories abroad.
If an FTAA were to eliminate barriers to trade in agricultural and
industrial goods and in services among the countries in the hemisphere,
the United States could reap a gain of $53 billion, according to one
study. An FTAA would also promote greater economic integration and
regional cooperation, bringing greater economic opportunity and
political stability to the region. Negotiations toward this agreement
continue.
As this review has shown, past U.S. participation in international
trade institutions and agreements has benefited the United States
significantly. Our continued ability to exercise effective leadership
in trade negotiations, however, depends on restoration of the
President's Trade Promotion Authority (TPA). TPA allows the President
to submit a negotiated trade agreement to Congress subject to an
up-or-down vote, without amendments. Congress retains the final
decision on whether or not the United States signs any trade agreement,
but TPA provides the President with more negotiating leverage and
gives the United States enhanced credibility in negotiations with
its trading partners.
TPA has a long history. In the 1934 Reciprocal Trade Agreements Act,
Congress for the first time agreed to give its prior approval to any
trade agreement reached by the executive, although it did require that
the negotiating authority be renewed every 3 years. Although the Trade
Act of 1974 required that Congress approve trade agreements after
their negotiation, it also provided a ``fast-track`` procedure in which
Congress would vote in a timely fashion and without amending the
agreement. This fast-track procedure has been used to pass legislation
implementing the United States' most recent important international
trade agreements, including NAFTA in 1993 and the Uruguay Round of
the GATT in 1994. These procedures, however, lapsed in 1994 and have
not been renewed.
Role and Reform of International
Financial Institutions

International financial institutions (IFIs) exist to help countries
cope with short-term balance of payments problems and address longer
term development challenges. Capital flows have played an
increasingly important role in both these areas, calling for
policy responses from countries and from the IFIs themselves.
As already noted, capital flows represent a transfer of resources
across time, as savers lend to borrowers today in exchange for
repayment plus interest or dividends tomorrow. Increased uncertainty
about those repayments can render unattractive an investment that was
once attractive. In particular, changes in economic policies or
political developments can cause investors to sharply reevaluate the
prospects for future payments. Thus their very forward-looking nature
can make capital flows subject to abrupt reversals.
Sharp reversals of international capital flows have occurred many
times in history. The United States in the 1800s was a developing
economy that benefited from European capital inflows. Financial
disruptions in the 1850s, 1870s, and 1890s were associated with sharp
reversals in these flows. The same situation played out in Latin
America in the 1930s. As capital markets collapsed with the onset of
the worldwide depression, governments in the region were hit
particularly hard. By 1935 almost 70 percent of Latin American
national government bonds were in default.
More recently, the emerging market debt crisis in the 1980s was
another example of a sharp reversal in capital flows. Rising real
interest rates associated with the effort to contain global
inflationary pressures made investment projects in developing
economies look less attractive. This reversal of capital flows led
to a ``lost decade`` for the Latin American economies until
expectations improved when new policies involving structural reform
were put in place. Most recently, the crises of the 1990s-in Mexico
in 1994-95, East Asia in 1997-98, and Russia and Brazil in
1998-99-again demonstrated how investments based on forward-looking
calculations of risk and expected return can quickly reverse,
especially when weaknesses in the recipient country's policy framework
are exposed.
These abrupt reversals in capital flows are extremely costly. The
withdrawal of foreign investment drives up interest rates in the
borrowing country, retards domestic investment, and often leads to a
sharp contraction in economic activity and a shrinking of future
production possibilities. The balance sheets of domestic firms that
depended on these flows are considerably weakened, and there is often
a wrenching reallocation of domestic resources away from the
nontradable goods sector to the tradable sector, to accomplish the
current account adjustment necessitated by the drop in capital flows.
Finally, many of the world's poorest economies, plagued by years of
economic mismanagement, have had little access to private capital
flows of any kind. Investors are unwilling to extend loans without
some prospect of repayment. But the possibility of repayment is bleak
given an unstable system of governance that cannot guarantee property
rights, or establish the necessary legal, financial, and physical
infrastructure that would foster the productivity of their citizens.
Often, the result is a cruel paradox: the countries most in need of
capital-and that might offer the highest potential rates of return on
that capital, were the proper policies in place-are precisely the
ones with the least access to international capital flows.

The Evolution of Today's International Financial Institutions
Two of today's principal IFIs were created as part of the post-World
War II international financial arrangements that came to be known as
the Bretton Woods system. Chief among the IFIs is the International
Monetary Fund, established in 1945. One of the original goals of the
IMF was to provide short-term loans to countries to help with balance
of payments adjustment. Under the system of pegged (but adjustable)
exchange rates in place from the late 1940s until 1971, it was
expected that countries on occasion would require help to manage a
set of macroeconomic policies that was inconsistent with the country's
fixed exchange rate. The usual manifestation of this inconsistency
was a current account deficit that could not be offset by private
capital flows at the prevailing exchange rate. One alternative in
such a situation would be to devalue the domestic currency in an
effort to close the current account deficit. However, following a
series of such devaluations in the 1930s in which countries essentially
competed for trade advantage, the IMF was created to provide short-term
funding to countries in such distress. This funding was meant to
provide countries with the breathing room necessary to implement a
more rational set of macroeconomic policies that would allow them to
avoid the devaluation option.
With the abandonment of the Bretton Woods system of fixed exchange
rates in the early 1970s, the IMF essentially lost its original role.
Over the past 25 years, the IMF's mandate has broadened to include
promoting international monetary cooperation and orderly exchange
arrangements with the aim of fostering economic growth. To carry out
this mandate, the IMF undertakes surveillance of the macroeconomic
policies of its 183 member economies and provides them financial and
technical assistance. In this sense, the IMF no longer functions merely
as a crisis lender to economies facing balance of payments adjustments.
The IMF has also become involved in supporting development programs,
aiding the world's most impoverished countries through loans, help in
devising a macroeconomic policy framework, and technical assistance.
The IFIs also include what are known as the multilateral development
banks (MDBs), of which the World Bank Group is the largest. The World
Bank was established in 1945 and had its initial focus on the
reconstruction efforts following World War II. As Europe and Japan
rebuilt, that focus shifted toward development, targeting the poorest
countries, which were unable to obtain access to private international
capital flows. The late 1950s saw the creation of the Inter-American
Development Bank, the first of four regional MDBs. Together the MDBs
worked toward the goal of financing the development of the world's
poorest economies. However, during the crises of the 1980s and 1990s
the scope of the MDBs' mission was broadened, and, often encouraged by
governments in the developed economies, they participated in the
financial crisis lending packages organized primarily by the IMF. Thus
the missions of the IMF and the MDBs have sometimes overlapped, with
the IMF providing some nonemergency financing for developing economies
and the MDBs contributing to crisis financing packages.

Performance of the International Financial Institutions in the 1990s
The turmoil in the international financial system in the second half
of the 1990s indicated a shift in the nature of financial crises. The
increase in the size of capital flows during the 1990s, documented
earlier in this chapter, led to larger, more sudden crises when those
flows reversed. These crises also appeared harder to contain, and the
result often was large-scale IMF lending. The nature of these new
crises focused attention on the role of the IFIs and raised key
questions for policymakers. First and foremost, were the resources of
the IFIs adequate to deal with these crises? Second, was the provision
of assistance itself encouraging further crises? And finally, were
countries becoming overly dependent on crisis financing provided by
the IFIs?
From the mid-1980s through the mid-1990s, the IMF's resources
available for crisis lending (also called its available liquidity)
were adequate. However, over the 6-year period beginning in 1995,
the average size of IMF stand-by arrangements (traditional lending
programs), relative to the recipient country's IMF quota, more than
tripled compared with the 6 years beginning in 1989. This is not
surprising given the increase in gross capital flows over the 1990s.
The new type of crisis was met with a larger official sector response.
As a result, it became clear that, in the second half of the 1990s, IMF
resources were shrinking relative to private financial flows. This was
especially apparent during the Asian financial crisis, when IMF
available liquidity fell to $56 billion in December 1997 from $83
billion the year before. By December 1998, available liquidity had
dwindled to $54 billion. Over the mid- to late 1990s, as crises
developed and the size of IMF assistance programs increased,
policymakers began to revisit the concern that the provision of
official assistance was contributing to the development of new
crises. The logic in support of such a proposition emphasizes
the expectations of private investors. If investors come to expect
that countries will automatically receive assistance in the
event of a financial crisis, they are likely to exercise less prudence
when making loans. Countries that are pursuing unsound policies may
still get loans from private investors, since the investors believe
that any future problems are likely to be resolved by the provision of
funds by the IFIs. This is an example of moral hazard: an increase in
risky behavior (in this case on the part of the borrowing countries
and their lenders) when insurance or a guarantee is provided (in this
case by the IMF). Thus the concern is that IFI support can encourage
risky activity on the part of private lenders and borrowing countries,
which often ends badly in further rounds of crises.
The resolution of the crises of the late 1990s was also complicated
by a shift in the composition of capital flows away from syndicated
bank loans toward bond issuance. Such a shift protected the banking
and payments systems of the industrial countries from the worst
consequences of international financial crises. However, it also
complicated the task of crisis resolution, because restructuring a
country's debt now required dealing with a large number of bondholders
spread around the world, rather than a small group of bank creditors.
When a country's creditors are few in number, it may prove possible to
coordinate an orderly restructuring that does little to interrupt
economic activity (although this proved surprisingly difficult with
bank loans to Latin American governments in the 1980s). But when the
lenders are a large, diffuse group of bondholders, an orderly
restructuring may be next to impossible. In fact, the switch from
bank finance in the 1980s to bond finance in the 1990s in part may
have reflected efforts by creditors to safeguard their positions by
making such a restructuring more difficult for borrowers. In addition,
the shift from bank to bond finance is part of a larger trend, seen
not just internationally but in domestic capital markets as well, away
from financial intermediaries to direct finance.
Efforts to Reform the International Financial System

As early as 1995, following the Mexican crisis, it became clear to
international policymakers that the set of policies and institutions
collectively known as the international financial system might be in
need of overhaul, especially the IFIs themselves. Various official
bodies commissioned reports that examined ways in which the system
could be improved. These reports tended to focus on four key areas:
transparency and accountability, strengthening national financial
systems, management of crises, and debt relief. The following sections
deal with each in turn.
Transparency and Accountability. Market-based transactions work best
when parties are fully informed. Absence of important information on
the part of the lender or the borrower in a transaction can lead to
less than efficient outcomes (a finding recognized in the work of the
most recent Nobel laureates in economics). Thus reform proposals have
called for additional transparency and accountability both on the part
of countries receiving capital flows and on the part of the IFIs
themselves. In response, the IMF has established the Special Data
Dissemination Standard to facilitate the flow of information from
countries. In addition, the IMF has encouraged the publication of
documents related to its surveillance (the annual Article IV
consultations on each member's economic policies) and of the
supporting documents submitted by the country and the IMF when a
financial assistance program is put in place and reviewed. Over the
last year, 45 percent of the full Article IV consultation reports
were made publicly available.
Strengthening National Financial Systems. Several of the crises of
the 1990s involved lax practices in the financial and corporate sectors
of borrowing economies (see the 1999 Economic Report of the President).
As a result, calls for the reform of the international financial system
have included measures to strengthen national financial systems through
the implementation of best practices in financial regulation. To meet
these needs, the G-7 authorized the creation of the Financial Stability
Forum (FSF) as a way to coordinate the activities of finance ministries,
central banks, financial regulators from key economies, the IFIs, and
international standard-setting bodies such as the Basel Committee on
Banking Supervision and the International Organization of Securities
Commissions. The FSF identified key standards and codes for countries'
financial systems and has worked toward fostering their implementation.
Beginning in May 1999, the IMF and the World Bank introduced the
Financial Sector Assessment Program (FSAP) and a key byproduct, the
Reports on the Observance of Standards and Codes (ROSCs), in order
to assess countries' implementation of these standards. As of
September 30, 2001, 57 countries had undergone review of their
standards and codes, and reports for 36 had been published. As of
the same date, 22 FSAPs had been completed, with 4 assessments
published. The IMF has identified 11 main standards and codes that
will be addressed in the ROSCs, including the Basel Committee's Core
Principles for Effective Banking Supervision.
Management of Crises. As noted earlier, resolving the capital
account crises of the second half of the 1990s required much larger
IMF programs and caused a dwindling in available liquidity. One
aspect of reform efforts was therefore the decision to increase IMF
resources in 1998. The IMF resolution required that new commitments
by member countries to the IMF be $89 billion. In February 1999 the
United States increased its share by $15 billion. For crises affecting
the global financial system as a whole rather than that of an
individualcountry, additional funds are available to the IMF through
borrowing agreements with a number of IMF members and other
institutions. Provisions for a New Arrangement to Borrow (NAB) were
agreed to in 1998, to supplement the existing General Arrangement to
Borrow (GAB). At the end of 2001, total resources available to the
IMF stood at $125 billion, of which $43 billion was available under
the GAB and NAB facilities.
Steps were also taken to shorten the response time of IMF programs
and to restructure programs to ensure that countries do not become
overly dependent on IFI resources. In 1997 the Supplemental Reserve
Facility (SRF) was created, providing another type of loan arrangement
for IMF programs. Explicitly short-term in nature (loans are expected
to be paid back in 12 to 18 months and required to be paid back in 24
to 30 months) and carrying a higher interest rate than the more
traditional stand-by arrangement, the SRF was designed to create
incentives that would favor its use only by truly illiquid borrowers.
Essentially solvent countries that have temporarily lost liquidity
could afford the higher interest rates and would be able to repay any
loan in a shorter period. Countries that have more fundamental
problems would have recourse to programs with loans that would be paid
back over a longer period.
To shorten response times, the IMF in 1999 created the Contingent
Credit Line (CCL), a facility that allows countries with sound policies
to prequalify for a line of credit that would protect against contagion
in a systemic crisis. (Contagion refers to a sudden cutoff of private
capital inflows to one country in response to a crisis in another.)
Despite subsequent modifications to the terms of the facility, to date
no countries have chosen to participate. This lack of interest appears
to relate to the stigma that might be associated with seeking a CCL.
Countries may worry that their pursuit of a CCL might be taken by
market participants as a signal of problems in the country.
The extent to which the private sector should be involved in any
solution to financial crises has been the most contentious issue in
discussions of international financial system reform. Private sector
involvement is generally taken to mean some sort of burden sharing or
participation on the part of private creditors in the provision of
financing to a country in crisis. Such burden sharing could be a
formal part of the official program to aid the country. For example,
IFI financing for the second program for the Republic of Korea in 1997
included an agreement by commercial bank creditors to extend the
maturity of their loans to Korea. Burden sharing could also come about
through a reduction in the value of private sector claims against the
distressed country; a reduction in principal was part of Ecuador's
restructuring of its debt, for example (Box 7-2). Absent such
commitments by private creditors, policymakers worry that crisis
financing provided to a country by the official sector may only serve
to reduce the losses that private sector creditors would otherwise
bear. This might encourage lenders to behave less prudently in the
future, raising the moral hazard concerns discussed above.
In September 2000 the IMF released a framework for advancing the
discussion on private sector involvement. The framework encourages
countries and private lenders to make every effort to forestall crises
through a variety of measures. Borrowers and lenders are to use
information provided under the transparency and accountability
initiatives discussed above, as well

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Box 7-2. Crisis and Restructuring in Ecuador
Ecuador's experience in 1999 and 2000 presents an interesting case, in
that during this time it became the first country to default on Brady
bond obligations. (Brady bonds were issued by 18 governments between
1990 and 1997, under a plan proposed by the then-Secretary of the
Treasury. The Brady Plan offered a means for sovereign countries to
restructure past-due loans extended to them by commercial banks, by
converting the loans to bonds.) Ecuador's decision to default was not
taken lightly and was explained by dire economic circumstances. Output
had stagnated in 1997 and had fallen sharply in 1998 because of
declining oil revenue and agricultural and coastal infrastructure
damage due to the El Ni�o effect. Many firms came under financial
pressure, compounding difficulties in the banking sector. Over the
first half of 1999, real GDP fell at an annual rate of 15.4 percent.
The decline in economic activity made it difficult for Ecuador to
service its external debt. Ecuador's poor prospects, and financial
markets that were destabilized by the Russian default in 1998,
precluded new private lending. In late August 1999 Ecuador announced
it would defer a coupon payment on PDI (past-due interest) Brady bonds,
but in September Ecuador made payment on its discount Brady bonds.
Creditors disliked the idea that Ecuador had tried to limit default to
one type of Brady bond, and shortly thereafter bondholders accelerated
their claim for full payment of outstanding interest and principal on
all Brady bonds. As a result, Ecuador defaulted on its other Brady
bonds and its Eurobonds as well.
At the same time, the IMF announced it would approve a stand-by
arrangement if Ecuador would make certain recommended changes to its
economic policies and pursue good-faith efforts to reach a
collaborative agreement with its creditors. However, no agreement
was reached. To facilitate restructuring of the debt, Ecuador
established a consultative group consisting of representative
institutional bondholders. The group was given economic and financial
information, which was simultaneously made public. No confidential
economicinformation was shared with the group, nor was any information
about the terms of the planned restructuring. Although there were many
one-on-one meetings between the Ecuadorian authorities and major
bondholders, in general there were no large-scale negotiations with the
bondholders. Unfortunately, this process failed to provide a meaningful
forum. With the rapid turnover of finance ministers and a lack of
political consensus, it was hard for Ecuador to sustain a dialogue
until political stability was restored.
Consultations continued over the next several months with no progress.
Private investors expressed concern that Ecuador had shown little
willingness to engage in open dialogue or negotiations, and about the
slow pace of progress. In January 2000 President Jamil Mahuad
announced that Ecuador would convert its monetary base from the local
currency, the sucre, to the U.S. dollar and adopt the dollar as the
country's official currency (the sucre had depreciated more than 65
percent in 1999). Shortly thereafter, Vice President Gustavo Noboa
assumed the presidency after President Mahuad was deposed in a popular
uprising. President Noboa continued with dollarization, with the
support of the IMF. The new political regime made progress in
restructuring negotiations, and in March a $2 billion aid package was
announced, which was funded by the IMF, the World Bank, the Inter-
American Development Bank, and Corporaci�n Andina de Fomento. The
loans were designed to assist the implementation of dollarization,
to resolve the banking crisis, and to strengthen the public finances.
In mid-May 2000 the Ecuadorian authorities held an open meeting with
bondholders to discuss the country's economic prospects. IMF staff
also attended and presented key features of the new economic program.
Bondholders received the details with interest, and in August, 98
percent of them accepted a debt exchange offer. A combination of exit
consents and cash incentives provided the motivation to accept the
package. (Exit consents allow the majority of bondholders to exercise
their power to amend old debt just before these creditors leave the
old debt and accept the new debt. This provides an incentive for all
other holders to come along with them.) With the exchange, Ecuador
reduced the face value of its debt by roughly 40 percent, realizing a
projected cash flow savings of $1.5 billion over the succeeding 5
years.
Since the restructuring of its debt and the implementation of the IMF
program, Ecuador's economy has recovered strongly. Real GDP growth
for the year ending in the third quarter of 2001 was 5.0 percent.
Dollarization pushed inflation down from 91 percent in 2000 to 22
percent at the end of 2001. Interest rates on 10-year bonds were
roughly 12 percentage points above those on U.S. Treasuries at the
end of 2001, down from 46 percentage points at the height of the
crisis in September 1999. Although the banking system has improved,
there is room for further reform, such as implementation of key Basel
principles.
Analysts point to restructuring nonperforming loans and additional
structural economic reforms as keys to further boosting economic
activity in Ecuador.
------------------------------------------------------------------------------


as to maintain continuing
dialogues, perhaps through the establishment by borrowing countries of
investor relations offices. The IMF itself, in July 2000, formed the
Capital Markets Consultative Group to enhance communication with the
private sector. Lenders are also encouraged to promote the inclusion of
collective action clauses in future bond issues (discussed further
below), to allow for easier coordination of creditors in the event of a
crisis.
The framework stresses that, should a crisis develop, voluntary
solutions between debtors and creditors are to be preferred over
involuntary solutions that involve unilateral actions. In most cases,
it is hoped that policy adjustments and temporary official financing
will suffice to restore an economy to sustainability. In a minority
of cases, however, the official sector is envisioned as encouraging
creditors to reach voluntary agreements to help overcome their
coordination problems.
In some such cases, the country may have no choice but to suspend
payments on its debt. The IMF has reaffirmed its policy of ``lending
into arrears`` in such cases, that is, providing lending to countries
that are experiencing debt-service difficulties before those
difficulties are fully resolved. Lending into arrears is to be
decided on a case-by-case basis and is to occur only where prompt IMF
support is considered essential for a successful adjustment program,
and the country is pursuing appropriate policies and is making a
good-faith effort to reach a collaborative agreement with its
creditors. This policy came into play in the case of Ecuador's 1999
default, mentioned above.
Debt Relief. Finally, reform efforts have also included addressing
the debt burdens of the poorest countries. After some gradual efforts
in the late 1980s and early 1990s, the IMF and World Bank executive
boards, at the request of the G-7, agreed in 1996 to launch the Heavily
Indebted Poor Countries (HIPC) initiative. This initiative marked the
first time that multilateral, Paris Club, and other official bilateral
and commercial creditors joined in an effort to reduce the external
debt of the world's poorest and most debt-burdened countries.
(The Paris Club is the voluntary gathering of governments of creditor
countries willing to treat in a coordinated way the bilateral debt due
them by developing-country borrowers.) The HIPC initiative is funded
by both bilateral and multilateral creditors. Originally, 41 countries
were identified as candidates for the program, and so far 24 of these
have debt relief agreements in place. To qualify for assistance under
the HIPC initiative, a country must meet three conditions: it must have
a low enough income per capita to qualify for concessional lending
from the IMF and the World Bank; it must have an unsustainable debt
burden even after the exhaustion of available debt-relief mechanisms;
and it must have demonstrated a commitment to economic reform and
poverty reduction with a track record of good performance and drawn
up a Poverty Reduction Strategy Paper (PRSP) showing how the country
intends to use debt relief to improve living standards for its poor.
The first 3 years of the initiative did not prove as productive as
had been hoped: only seven countries qualified during that time. In
September 1999 the program was enhanced to provide deeper and faster
debt reduction. The HIPC initiative will allow 24 countries to reduce
the net present value of their debt by a total of $22 billion-roughly
half of what they owe�and when combined with traditional debt relief
and additional bilateral debt forgiveness, it will reduce their debt
by almost two-thirds. The IMF and the World Bank expect average social
spending in the HIPCs to increase by 45 percent in 2001-02 from 1999
levels, with savings from HIPC debt relief accounting for a sizable
proportion of this increase. In 2001-02 these countries are expected
to spend three times more on social services than debt service.
Critiques of Reform Efforts

As the above discussion makes clear, many changes have been made
to the international financial system over the past 7 years in an
effort to improve its stability and performance. However, fundamental
problems remain, and new proposals have been put forward by both
private sector and public sector entities. Critiques of the efforts
to date can be broken down into the same four key areas discussed
above: transparency and accountability, strengthening national
financial systems, management of crises, and debt relief.
Reform efforts appear to have made the most progress in enhancing
transparency and accountability and strengthening national financial
systems. Nevertheless, several complaints have been raised. With
regard to accountability, critics often raise objections to ``mission
creep`` on the part of the IFIs, which can lead to an overlap of
efforts that hinders accountability. Without a precise understanding
of each IFI's responsibilities, it is difficult to judge the degree to
which each IFI is accomplishing its objectives. The IMF draws on its
expertise to consult and provide helpful advice on such matters as
the appropriate stance of monetary and fiscal policy as well as the
related choice and operation of an exchange-rate regime. At the same
time, the MDBs have considerable expertise in development issues,
both at the individual project level and in providing fundamental
public goods such as health and education. Most recently, the MDBs
have contributed substantial sums to programs for such
middle-income economies in crisis as Argentina and Turkey, which,
until their crises broke, had benefited greatly from private capital
inflows. The MDBs should not be used as a source of immediate
emergency financing. Rather, their role in crisis countries is to
provide support to address longer term policies and institutional
capacity building, to help cushion the impact of crises on the poor.
Thus almost all observers have argued for a clearer delineation of
the IFIs' responsibilities, allowing each institution to focus on its
core mission and expertise. Mission creep into other areas only
serves to divert scarce expertise away from its best use. The IFIs
have responded to this criticism and have taken steps to better
coordinate their assistance, most noticeably through joint
participation in the preparation of ROSCs and FSAP reports.
Progress on transparency has also been uneven, both on the part of
borrowing countries and on the part of the IFIs. As mentioned earlier,
public; nonetheless, market participants remain critical of what they
regard as the scant and untimely release of information from the
official sector during crisis resolution and negotiations. These
criticisms have been directed toward the IFIs and even more pointedly
toward the Paris Club. Without sufficient information and coordination,
private creditors worry that their claims on a borrowing country
will be treated less favorably than the claims of government and
other official creditors. The Paris Club has begun taking steps to
improve information flow, with the launch of a website disclosing the
terms of debt restructurings and other information. The Paris Club
has also initiated a dialogue with private sector creditor
organizations in an effort to improve communication.
Efforts to strengthen national financial systems have focused on
using agreed standards and codes aimed at implementing best practice
in financial regulation. This effort has been judged quite promising,
although implementation remains an area of concern. In particular, it
may be expensive for developing economies to find and develop the
expertise necessary to observe the standards and codes. For example,
recruiting, training, and retaining skilled bank examiners may be
difficult. The standards also require certain supporting institutions.
In a country where the rule of law is weak, it may be difficult for
financial examiners to make a real difference in financial
institutions' practices. Finally, there has been some concern over
the appropriate body to judge an economy's compliance with a standard.
Local authorities may be too prone to find their own country's
institutions in compliance, and the same might be true for IFIs that
happen to be lenders to the country. There is no reason why private
markets could not provide the necessary evaluation of compliance;
indeed, this option has been advocated by many but has not yet been
fully realized. Efforts to reform the management of financial crises
have generated
the most criticism and the most additional proposals. The criticisms
have focused on essentially two areas: the structure of IFI programs,
and mechanisms for facilitating private sector involvement. Much
attention has been paid to the conditions imposed on borrowing
countries as part of IFI lending programs, called ``conditionality.``
Some observers have argued that such conditions have too often
involved overly restrictive austerity policies, which have deepened
economic slumps and postponed recovery. IMF programs during the East
Asian crisis, which required fiscal austerity of economies, are often
cited in this context. Critics have also argued that IMF programs
should have allowed for more accommodative monetary policies, on
grounds that high interest rates made it harder for debtors to service
their debt, heightening investors' concerns and worsening the
economic downturn. However, the IMF still argues that high interest
rates, in relation to both expected inflation and interest rates on
U.S. dollar-denominated assets, were necessary to stabilize currencies,
whose depreciations also made it difficult for debtors to service
their foreign currency-denominated debt.
According to another view, IFI programs too often went beyond
macroeconomic (fiscal and monetary) conditions to impose unnecessary
structural economic reforms. This view claims that the problems of
debtor countries largely require macroeconomic solutions, and that
therefore it is reasonable for the IFIs to insist on macroeconomic
performance criteria to be met as a condition for loan disbursements.
But in the late 1990s, some observers feel, the IMF often overstepped
these bounds-and its own expertise-by placing too much emphasis on
micromanagement of the recipient economies. An often-cited example
is the Indonesian program, which required the elimination of the
Clove Marketing Board and changes in the structure of the sugar, flour,
and cement markets. Defenders of the existing approach have responded
that, without a change in structural conditions, changes in
macroeconomic policies are likely to have little effect. They also note
that involvement of the MDBs in crisis lending provides whatever
microeconomic and structural expertise is required. In any case, in
response to these criticisms, the IMF has recently sought to streamline
the conditionality attached to its lending programs, and to focus
that conditionality on core macroeconomic and financial concerns.
Frustration with a lack of progress in some countries, as evidenced
by repeated IMF programs over a prolonged period, raises another issue
concerning the structure of these programs. For example, since 1980
the Philippines has been under six IMF programs, with disbursements
made in 17 of the past 21 years. This example raises the concern that
more attention should be paid to the nature of the crisis facing an
economy. It may be necessary to tailor program lending differently
for liquidity crises than for insolvency crises. In a liquidity crisis,
where an otherwise healthy borrower is incapacitated by a cutoff in
private financing, programs would appropriately involve short-term
lending at penalty interest rates, to encourage and facilitate the
borrower's quick return to private capital markets. In the case of an
insolvent borrower, in contrast, where private funds are cut off
because of poor economic prospects, the IFIs should not provide
financing to avoid a debt restructuring. However, in such cases the
IMF may still have a role in helping to support the country and
facilitate the rebuilding of reserves, as happened in Ecuador
(see Box 7-2). Although the IFIs have different types of lending
facilities for each of these two purposes, the repeated occurrence
of ``crises`` in some economies suggests that sufficient attention was
not paid to the possibility that recipients were insolvent rather
than illiquid.
The issue of private sector involvement in the resolution of crises
remains the most contentious, as evidenced by a recent flurry of
proposals and analysis. Proposals to enhance private sector involvement
range from the very modest (limiting involvement to the voluntary
modification of sovereign bond contracts), to somewhat structured
proposals involving standstills (temporary suspension of debt service),
to formal proposals calling for an international recognition of
standstills in a manner similar to an international bankruptcy
proceeding.
Many observers, including the IMF, continue to urge that new
sovereign bond issues include collective action clauses. One type of
clause allows for a majority or supermajority of creditors to make
changes in the financial terms of a bond's contract; bonds issued
under United Kingdom law typically contain such provisions. These
clauses attempt to foster an orderly negotiation process that would
allow the debtor country to reach agreement with its creditors on a
restructuring that permits a return to a sustainable situation.
However, many sovereign bonds are issued under jurisdictions,
including that of New York, where collective action clauses are not
customary. These bonds often require the unanimous approval of
creditors to modify the payment terms. In this situation, a single
holdout creditor, in hopes of obtaining more favorable treatment than
the other creditors, can block a restructuring that is in the best
interest of both the creditors and the debtor. It remains a bit of
an economic mystery why more recently issued bonds do not include less
restrictive collective action clauses; empirical work finds that
borrowers do not face a higher interest rate on instruments that have
this flexibility. One explanation may be simple inertia.
The modification of sovereign bond contracts in a sense represents an
attempt to facilitate restructuring of private debt by creating an
appropriate legal framework. Two other ideas have been advanced along
the same lines. One proposal calls for more widespread use of rollover
clauses in lending contracts, representing a precommitment by lenders
that could be invoked during a crisis. This proposal would make
automatic the rollover of bank loans like that negotiated in the case
of Korea in 1997. Another recent proposal would generate private
sector involvement before a crisis, by taxing the stock of cross-border
claims to create a fund that could then be used for lending in the
event of a crisis. All cross-border investors would thus contribute
to the resolution of a country's crisis.
A recent joint proposal from the Bank of Canada and the Bank of
England advocates the use of standstills by insolvent debtor economies.
The proposal calls for tight limits on IMF lending for all but
exceptional cases, in an attempt to force a distinction between
insolvent and illiquid borrowers. A borrower that could not meet its
obligations through this limited IFI support would declare a payment
standstill and begin negotiations with its creditors on a debt
restructuring. This would put the borrower in violation of the payment
terms of its loan agreement, opening the door to legal action by
creditors that might disrupt the negotiations. However, the proposal
argues that fears of such disruption are overstated. Private creditors
find it difficult to execute judgments against a sovereign borrower,
especially when the borrower does not have readily identifiable assets,
such as those of state-owned enterprises, outside its borders.
Critics of the proposal counter that the cloud of legal action could
nevertheless weigh on negotiations during the standstill, especially if
cooperative creditors fear that any new payment arrangements agreed to
could be subject to attachment by holdout creditors. The recent
experience with the holdout creditor Elliott Associates in the case
of Peru is cited in this regard (Box 7-3).
At roughly the same time that the Bank of England/Bank of Canada
proposal was announced, the First Deputy Managing Director of the IMF
called for a framework that would create the analogue of bankruptcy
at the sovereign level, providing legal protection for a necessary
restructuring. The proposal cites specifically the troubling
implications of the Peruvian case. Legal protection from holdout
creditors would be offered under two conditions: the country must be
negotiating in good faith with its creditors to restructure its debt
burden, and it must agree to follow sound policies to avoid similar
problems in the future. The proposal also envisions that participating
borrowing countries would likely impose temporary exchange controls,
to ensure that capital did not flee the country while negotiations
with creditors were under way. The protection from litigious
creditors, in effect a formal standstill, would be sanctioned by the
IMF and would have legal standing in national courts.
Implementation of the IMF proposal might take many years, because the
IMF's Articles of Agreement would have to be amended, as might
national legal codes around the globe. Some criticism of the proposal
has focused on the impracticality of implementing these changes.
Other critics argue that because the IMF might well be one of the
creditors in the case, an IMF-sanctioned standstill would create a
potential conflict of interest. (In domestic bankruptcy cases, the
judge who presides over the resolution may not be one of the
creditors of the troubled firm.) Other observers, however, note that
any internationally sanctioned proceeding would not be able to remove
the ``management`` of the debtor economy (that is, its government),
also unlike in domestic bankruptcy proceedings. In that case
involvement of an official creditor, such as the IMF, that can impose
conditions on new lending programs may make sense. In any event, the
IMF proposal has generated a great deal of interest and calls for
further study.

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Box 7-3. Elliott Associates versus Peru
In October 1995 Peru announced an arrangement under the Brady Plan
(see Box 7-2) to restructure loans extended to two Peruvian banks that
had been guaranteed by the government in 1983. The plan culminated in
November 1996 with 180 creditors agreeing to exchange the old debt for
a combination of Brady bonds and cash. Under the agreement, coupon
payments on the new Brady bond were to begin in March 2000, with the
second coupon to be paid in September 2000.
From January through March 1996, as details of the plan were being
negotiated, Elliott Associates, an investment fund specializing in
the purchase of securities of distressed debtors, bought Peruvian bank
loans with a face value of $20.7 million for $11.4 million. After
sending a formal notice of default on the bank loans, and shortly
before the Brady exchange, Elliott Associates filed suit in New York
State's Supreme Court seeking payment. Elliott did not participate in
the Brady exchange, thus becoming a ``holdout creditor.`` Elliott's
suit was removed to Federal district court where, after a trial, the
claim was dismissed in August 1998.
In dismissing Elliott's claim, the district court ruled that Elliott
had purchased the Peruvian bank debt with the intent and purpose of
bringing suit. This was found to be a violation of Section 489 of the
New York Judicial Law, which is based on the long-standing legal
concept of champerty. (Champerty is defined as maintaining a suit
primarily in return for a financial interest in the outcome.) Howeve,r
in October 1999 the U.S. Second Circuit Court of Appeals overturned
the district court's ruling. The case was remanded to the Federal
district court, which in June 2000 awarded Elliott a judgment of $55.7
million, representing principal and past-due interest on the bank
claims. To enforce this judgment, Elliott sought to attach the September 7,
2000, coupon payment that was to be made to the creditors that had
participated in the Brady exchange. Elliott obtained a restraining
order to prevent the New York fiscal agent for the Brady bond from
making the coupon payment, and the firm tried to obtain a similar order
against the European fiscal agent. After arguing in the Belgian courts
without Peru's attorneys present, Elliott was granted the restraining
order on appeal on October 5, 2000. By this time Peru was close to
defaulting on the Brady bond, as the 30-day grace period for the coupon
due on September 7 had almost expired. Rather than default, Peru settled
with Elliott by paying the firm $56.3 million (the judgment amount of
$55.7 million plus interest). Thus the case was not litigated to a
conclusion, leaving market participants uncertain about any precedents
that the case might have set.
In issuing the restraining order, the Belgian court accepted the
argument that, by paying the Brady bondholders but not paying Elliott,
Peru would violate the pari passu clause in the bank loans held by
Elliott. (The Latin phrase pari passu means ``with equal step`` or
``side by side.``) The court interpreted the pari passu clause as
meaning that if a debtor does not have enough money to pay its creditors
in full, they all should be paid on a pro rata basis. This
interpretation has proved controversial, however, with some legal
scholars arguing that the clause relates only to the act of
subordinating one class of creditors to another and should not be
interpreted so as to force pro rata payments. These scholars base
their arguments on the interpretation of pari passu clauses in
domestic corporate bankruptcies.
This case is economically important for the effects it might have
both on other developing economies' attempts to restructure their
debt and on future capital flows to these economies. The incomplete
resolution of the case leaves open the possibility that other
creditors might follow the example of Elliott Associates in
holding out on future debt restructurings by developing economies-and
that they might succeed. In particular, some argue that the Belgian
court's acceptance of Elliott's pari passu argument could complicate
Argentina's current effort to restructure its debt. Creditors may
hesitate to participate in any restructuring offers if they believe
that holdout creditors might be able to attach payments or even get
paid in full. Most observers argue that the relative balance of
power between creditors and distressed sovereign borrowers would have
been unchanged had the pari passu argument failed.
With regard to future capital flows, the concern is that if Peru had
prevailed in the case on its champerty defense, it could have made it
easier for sovereign countries to default on their debt. In that
event, creditors might have contemplated curtailing lending to
developing economies, or charging a higher interest rate. The Second
Circuit Court of Appeals decision cited these concerns in overturning
the district court's champerty finding. In any event, both market
participants and legal scholars agree that a final legal resolution
of the issues raised in this case would eliminate a source of
uncertainty now complicating transactions in the market for
developing-country debt.
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Finally, with regard to debt relief, although the HIPC initiative
has already provided significant relief, it will not ensure a lasting
exit from debt problems unless the countries receiving relief sustain
growth far in excess of their historical averages. Real GDP growth in
22 eligible HIPCs averaged only 3.1 percent from 1990 through 1999,
yet the IMF projects that they will grow at an annual rate of 5.6
percent from 2000 through 2010. Skeptics find little reason to be
so optimistic, as many of these countries were already on IMF programs
and receiving disbursements to begin with. If growth falls well short
of the IMF's projections, it could be difficult for these countries
to reduce their debt burden, even with HIPC debt relief. Most of the
HIPCs depend heavily on exports of a narrow base of primary
commodities, such as coffee or cotton, to service their external
debt. Commodity prices can be quite volatile, leaving these countries
vulnerable to price shocks. What might help this situation is if the
industrial economies, which now spend $360 billion a year on subsidies
to protect their own agricultural sectors, lowered these barriers to
trade, thereby allowing the HIPCs and other developing countries to
diversify their export base.

Advancing International Financial System Reform
The need for continued reform of the international financial system
has generated a rich debate. Clearly, the benefits of global economic
integration must be made available to all the world's citizens, and
the support of the official sector is key to ensuring the smooth
operation of the global trading and financial systems that underpin
continued integration. At the same time, it must be recognized that
official sector resources are finite and do not come out of thin air.
Resources may be provided in the form of loans to developing economies,
but these resources still come from public funds. As such, they are
obtained from taxpayers across the globe and have an opportunity cost
in terms of other governmental priorities. Both of these considerations
argue for a careful assessment of costs and benefits when designing
and using the international financial system.
With these ideas in mind, a set of principles for the IFIs can be
identified. First, all of the above arguments and examples point to
the need to differentiate between those countries that are temporarily
illiquid and those that are insolvent. Although this distinction can be
difficult in practice, it is crucial for good stewardship of official
sector resources. Shortening the maturity of official loans may help
make this distinction. Some observers have claimed that short
maturities for official loans are too constraining, arguing that it
is hard to help an economy by extending a loan that must be repaid in
12 to 18 months. However, if it is clear that such a loan is unlikely
to be repaid, then it is more likely that the economy is insolvent
rather than just illiquid. An illiquid economy should be able to
regain access to capital markets in this period of time; an insolvent
economy will not be able to. Insolvent economies require more drastic
treatment, such as a restructuring of debt obligations coupled with
limited and longer term official sector lending once the
restructuring is well under way.
Official funding can also be leveraged with private sector involvement.
Future design changes to the international financial system must
continue to focus on incentive mechanisms that encourage involvement
of the private sector. Financing that is dedicated to encouraging a
voluntary restructuring is one example of such a mechanism. Such
financing can serve as a catalyst in returning a troubled economy
to a sustainable footing.
In the first half of the 1990s, a set of International Development
Goals were developed from agreements and resolutions adopted at world
conferences hosted by the United Nations. The goals found a new
expression in the Millennium Declaration of the United Nations in
September 2000. Most of the world's poorest countries, particularly
those in Sub-Saharan Africa, are falling well behind in achieving
these International Development Goals in basic education, health, and
poverty reduction. The President has called for a bolder move away
from loans toward grants for the poorest countries. This approach,
coupled with the progress under the HIPC initiative, holds the promise
of higher living standards for the least fortunate, as it would
facilitate productivity-enhancing investments without adding to their
debt burden. In addition, grants to the poorest economies should be
targeted toward those basic needs, such as education and health, that
are vital to a growing and vibrant economy. In particular, grants can
lead toward a redirection of resources to combating scourges such as
HIV/AIDS that tear at the very fabric of society.
Consistent with the Administration's efforts to shift the MDBs'
emphasis toward grants for low-income countries is its continued
efforts to make these institutions more efficient and more focused
on productivity growth in developing countries as a core objective.
Careful selection of programs and a greater attention to results are
the two key principles underpinning the U.S. MDB reform exercise. This
means that the MDBs must do a much better job in sharpening the focus
of their activities, concentrating on basic development work and
working collaboratively among themselves and with other donors to
ensure a development framework that is consistent and efficient.
The United States has also accorded particular importance to a
comprehensive review of the pricing of MDB loans, to explore the
possibility of greater differentiation of lending terms. Price
differentiation is crucial to achieve greater lending selectivity
based on differences in the development impact of individual operations
and in borrowers' income per capita and creditworthiness, with
preferential treatment for priority core social investments.
Finally, tying official support to efforts at creating trade can
dramatically leverage any financial assistance provided to illiquid
economies. As this chapter has made clear, trade is a powerful engine
for economic growth and improvements in living standards. If
assistance packages allow an economy both to regain access to
capital flows and to invigorate trade flows, all of the developing
world will share in the improvement of world living standards.

Conclusion

International flows of resources, goods, and services have played an
increasingly important role in the world economy. The citizens of
the United States, living in one of the most open economies in the
world, have seen their well-being improve dramatically with this
increased economic integration. So have the citizens of many other
countries that were willing to open their borders to flows of goods,
services, and capital. The gains from trade are the result of an
improved allocation of resources. A more efficient global allocation
of productive inputs such as capital and labor translates into an
increase in global output and consumption.
To ensure that economic integration continues, constant attention
must be devoted to the institutional infrastructure that supports
market-based exchanges of goods, services, and capital. The past year
has witnessed signs of a slowing global economy, as well as violent
threats to the freedom that is essential to a well-functioning economic
system. These dangers make it more important than ever to ensure
continued progress toward the free flow of resources and output across
national borders.
It is therefore critical that the United States remain an active
leader in the continued liberalization of trade in goods and services,
both on a bilateral and on a multilateral basis. At the same time,
the United States must continue to encourage efforts to strengthen
the international financial system that supports production-enhancing
cross-border flows of capital. Strong U.S. leadership on both these
fronts will help safeguard and enhance both our own economic prospects
and those of the rest of the world.