Trade liberalization through asset markets

Journal of International Economics 64 (2004) 151 – 167 www.elsevier.com/locate/econbase

Trade liberalization through asset markets JoAnne Feeney a,*, Arye L. Hillman b a

School of Nanosciences and Nanoengineering, University at Albany, State University of New York, 255 Fuller Road Albany, NY 12203, USA b Bar-Ilan University, Ramat Gan, 52900, Israel, CEPR, CESifo, Received 3 June 1997; received in revised form 20 April 2003; accepted 17 June 2003

Abstract Political-economy expositions of trade policy have traditionally described asset or factor ownership as not subject to change. Asset markets, however, allow individuals to change the composition of income sources. We consider an economy with stochastic productivity to show how the equilibrium composition of asset portfolios influences individual attitudes toward free trade. The model links financial market completeness and trade liberalization in the second half of the 20th century and provides a contributing answer to why governments in poorer countries without welldeveloped financial markets have failed to liberalize trade. D 2003 Elsevier B.V. All rights reserved. Keywords: Trade liberalization; Asset markets; Political economy JEL classification: F13; F3; D52

1. Introduction The history of international trade policy in the second half of the 20th century is characterized by substantial liberalization. This liberalization is reflected in growth in world trade that markedly exceeds growth in world output (Yi, 2003). At the same time, financial markets across industrialized countries have become increasingly sophisticated. While the increased specialization associated with trade in the presence of industryspecific productivity shocks serves to amplify uncertainty, this development of financial markets allows diversification of these greater trade-related risks (Feeney, 1994). Against this background, this paper presents a theory that connects trade liberalization to financial * Corresponding author. Tel.: +1-518-437-8637; fax: +1-518-437-8687. E-mail address: [email protected] (J. Feeney). 0022-1996/$ - see front matter D 2003 Elsevier B.V. All rights reserved. doi:10.1016/j.jinteco.2003.06.001

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market deepening. We show that financial markets moderate private incentives to seek protectionist trade policies from government. We also account for continued use of trade barriers and indicate changes necessary for further liberalization of international trade. When interest groups can influence international trade policy (Hillman, 1982; Grossman and Helpman, 2002) or if opportunities are present to vote on trade policy (Mayer, 1984), the policies that are sought will depend on the composition of individual income. Free trade that maximizes national income also maximizes all individuals’ incomes, when individuals are identical or when the source of income for each individual matches the economy’s asset or endowment composition. It is therefore asymmetric personal income sources that underlie the incentive to seek protectionist policies from government.1 The relation between personal income sources and individuals’ preferred trade policies also forms the basis for an explanation of trade liberalization. As asset or financial markets in an economy develop to facilitate greater diversification in factor ownership, personal interests in trade policy become more closely aligned with the aggregate advantages of free trade and political support for liberalized trade policies increases. While opportunities to diversify are available through trading claims to factor income, some claims may not be tradeable due to asymmetric information or other limitations. We shall show how the prospect for asset markets to provide personal incentives to support trade liberalization depends on the relation between tradeable and nontradeable industryspecific capital. The view of trade liberalization linked to the development of asset markets complements descriptions of multilateral trade liberalization in the rounds of international trade negotiations of the GATT or WTO.2 Reciprocal liberalization has been described as occurring because, with subsidies to exporters ruled out, increasing income of export industries requires foreign market access, which obliges governments in return to allow access of foreign goods to their domestic markets (Hillman and Moser, 1996). At the same time, it is not only individuals with incomes specific to export sectors who gain from reciprocal trade liberalization; appropriately diversified individuals also gain, and the income diversification achieved through asset markets increases support for liberal trade policies.3 By describing the role of asset markets, the model that we set out departs from the traditional political-economy analyses of trade policy where individuals lack the means 1

We begin with a setting wherein free trade is efficient and maximizes national income, and thereby set aside the various descriptions of departure from free trade as efficiency-improving and increasing national income. For a survey and critical evaluation of these descriptions, see Hillman (2003b). 2 See Hillman et al. (1995), Hillman and Moser (1996), Ethier (1998, 2001), and Bagwell and Staiger (2003), and on how the GATT or WTO rules do or do not facilitate trade liberalization, see Lloyd (2001). Our focus is on the individual interest in trade policy and we shall not consider the process of trade negotiations between or among governments. Devereux and Lee (1999) model bilateral trade negotiations making allowance for asset markets and show that a tariff game between two governments can result in free trade and complete risk diversification, while, in other cases, risk diversification is less than complete and negotiations do not result in the elimination of all trade barriers. 3 Trade liberalization can also occur when import competition reduces domestic output and employment so that the political will to sustain protection of an import-competing industry, is lost (Cassing and Hillman, 1986). In that case, asset values in the import-competing sector have declined to become insignificant in influencing political policy decisions.

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to diversify factor or asset ownership. We incorporate the recognition that asset markets allow individuals to change income sources to accommodate income risk.4 With domestic asset or financial markets allowing individuals to diversify income sources, we consider a population of fully rational, risk-averse, expected-utility maximizing individuals who choose asset portfolios, view outcomes of stochastic productivity, and then seek to influence trade policy. Stochastic productivity in our model reflects observed industry-specific risk, and output realization determines the direction of trade and the level of import competition for the country. Trade policy is chosen in response to political support expressed by private individuals who understand how the government decides policy, form rational expectations about future trade policy, and base decisions on these expectations. We show that as an indirect consequence of individuals’ desires to diversify industry-specific risk, asset markets reduce individual opposition to free trade and, through political influence, results in a more liberal trade policy.5 In a limiting case, with a suitable configuration of portfolios established through asset diversification, there is support for free trade. Since, however, some claims to factor incomes are nontradeable, personal opposition to free trade may persist after asset trades have taken place. In historical context, the relation between asset markets and trade policies describes different outcomes in the 19th century in the United Kingdom and the United States. In studying the liberalization of trade policy in the United Kingdom, known as the repeal of the Corn Laws, Schonhardt-Bailey (1991, 1996) provided evidence showing how the increase in support for trade liberalization coincided with expanded personal asset diversification opportunities. Asset markets permitted previously undiversified landowners to diversify income sources away from agriculture. This reduced their interests in the protectionist Corn Laws and paved the way for their repeal in 1846. In the antebellum United States, by contrast, diversification possibilities through asset markets were more limited (Wright, 1978). Individuals with claims to income from importcompeting manufacturing capital (concentrated in the north) did not diversify by holding claims to factors (including slaves) specific to southern agriculture. The diversified asset portfolios required for broad consensus for a liberal trade regime were therefore not established in the US.6 In the British case, asset diversification therefore gave rise to consensual trade liberalization, whereas in the US, absence of asset diversification sustained divided interests. The relation described by our model between assets markets and political support for trade liberalization has also been present in the second half of the 20th century. Trade liberalization and growth of trade occurred in the richer countries at the same time as asset markets developed to allow greater factor-ownership diversification. Empirical evidence 4 See Feeney (1994). In Feeney and Hillman (2001), we point out how recommendations that governments implement strategic trade policies reduce individual welfare by introducing extraneous risk (that the proposals will be adopted) when individuals have spread risk through asset market diversification. 5 Fernandez and Rodrik (1991) point out that uncertainty may have the opposite effect of sustaining protectionist policies, but do not consider that individuals may be able to spread risk. 6 Ethical considerations aside, the value of a portfolio that included claims to slaves was subject to principalagent problems since working conditions and the health of slaves would be determined by distant plantation managers.

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that supports the relation between asset diversification and liberal trade policy has also been provided by Svaleryd and Vlachos (2002). Our model also suggests that trade liberalization is enhanced by technological and institutional changes that facilitate assetmarket transactions, such as reductions in transactions costs in financial markets, decreases in informational asymmetries, and improved protection of private property rights. Such changes are more characteristic of higher-income countries than the poorer developing world. Governments in the developing world have correspondingly displayed greater reluctance to liberalize trade than governments in countries with developed asset markets.7 We proceed in Section 2 to set out the economic and political framework, private individuals’ decision problems, and the trade policy mechanism. Section 3 derives the different possible relationships between trade liberalization and asset markets. Section 4 sets out concluding remarks.

2. Economic and political environments 2.1. Production, preferences, and trade We shall describe a population in a country that trades with the rest of the world at exogenous terms of trade.8 In the absence of asset markets, individuals deriving incomes in the import-competing industry confront personal incentives to oppose free-trade policies. We consider how financial markets affect these incentives.9 To highlight the political role played by sectoral special interests in a manner that allows for analytical solutions to portfolio allocations, we focus exclusively on the activities of owners of sector-specific factors of production.10 We assume that each sector-specific factor embodies both physical and human capital in order to determine the importance of different degrees of domestic tradeability in claims to factor income. Production consists of two stochastically supplied final consumption goods X and Y. We specify the nature of production only to distinguish between inputs with returns that are diversifiable in capital markets and those with returns that are not. The relative shares of factors with tradeable returns will underlie trade policy determination. Hence, we proceed by assuming that competitive firms produce the consumption goods, X and Y, with stochastic, constant returns-to-scale technologies. Production uses industry7 Campa et al. (2000) consistently find a positive correlation between tariffs and the use of capital controls across a wide range of countries. In the absence of domestic asset markets, domestic residents may have sought diversification through international asset markets. However, the capital controls preempt such diversification through international capital markets. In the absence of diversification opportunities, the outcome is protection. 8 That is, the government cannot influence world prices. See Stockman and Dellas (1986) on optimal tariffs and asset markets. 9 The identification of an individual’s preferred trade policies was first derived in Feeney and Hillman (1995) and is the basis for the current paper. 10 We omit homogeneous and intersectorally mobile labor, which has its own sources of diversification through mobility between sectors. See Ruffin and Jones (1977) for a full specification of the specific-factors model.

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specific inputs of human and physical capital, Hj and Kj, for j = X and Y, which are fixed ¯ j and Kj = K¯j.11 Output is given by at Hj and H X ðsÞ ¼ /X ðsÞFðKX ; HX Þ ¼ /X ðsÞ and Y ðsÞ ¼ /Y ðsÞFðKY ; HY Þ ¼ /Y ðsÞ in state of nature s for s={1,2,3,. . .S}, where F() is the same across industries. The form ¯ j, K¯j) = 1. The ¯ j and K¯j are chosen so that F(H of this function and the magnitudes of H productivity shocks, /j(s), are strictly positive, independently and identically drawn from the same distribution, and have variance, r2. Relative supplies of human and physical capital affect trade policy: to allow for differences in these supplies across sectors in a tractable way, we let supplies differ only in combinations that preserve equality in expected levels of production. The dividends paid to owners of physical and human capital depend on the productivity shocks and domestic prices, Pj(s)=(1 + sj(s))Pjw, which in turn depend on whether a tariff, sj (s), has been imposed through the political process. The total dividends paid by each industry are denoted by dj(s) and form the basis of those paid to human and physical capital individually, dij(s) for i = H and K. These are: dj ðsÞ ¼ Pj ðsÞ/j ðsÞ and dij ðsÞ ¼ hij dj ðsÞ

ð1Þ

where hHj = F2(Kj,Hj)Hj/F(Kj,Hj) and hKj = F1(Kj,Hj)Kj/F(Kj,Hj) denote the factors’ distributive shares and numerical subscripts denote partial derivatives. With perfect competition, therefore, all proceeds from production are paid to factor owners through these dividends. Any tariff revenues collected by the government are redistributed directly to individuals in equal amounts, and individuals take this to be exogenous. Initial endowments of factors distinguish the two types of individuals who populate the economy: the representative type-x individual is endowed with the physical and human capital used in the X sector, while the representative type-y individual is endowed with Ytype capital stocks. Hence, we also index individual type by j = x,y (superscript) to indicate the sector from which the individual’s initial endowments of human and physical capital derive.12 We normalize the number of each type of individual to unity and assume identical preferences. In the absence of government, these individuals would have equally valuable capital stocks, given the properties of productivity. Individuals derive utility over consumption of both goods and leisure. Individual j’s consumption utility, u(x j,y j), depends symmetrically on X and Y consumption, u(x,y) = u( y,x), and the function is increasing, homothetic, strictly concave with constant relative risk aversion, and twice-continuously differentiable. Each individual also receives one unit of time to divide between leisure and lobbying. Leisure enters separably into utility so that 11 This is therefore identical to a stochastic endowment economy: factors provide a plausible distinction between tradeable and nontradeable claims to industry output and add empirical insights. This framework also captures a situation where at any point in time, capital in its different forms is not readily transferable between industries, and the existing supplies of specific capital form the basis of trade-policy preferences in the private sector. Factor accumulation and shifts in these proportions across sectors would affect outcomes. We determine the effects of endogenous policy on asset prices and thus provide insight into these dynamic effects. 12 The common use of index j will be convenient for focusing on the industry associations of individuals.

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the choice of lobbying does not alter either total or relative demand for the two consumption goods. This simplification preserves the costliness of lobbying behavior, while keeping it from altering consumption in ways that add to the distortionary effects of tariffs. With no a priori belief about the link in preferences between one good or the other and leisure, we choose the neutral position of separability. Expected utility for the representative type-j individual then is given by Efuðx j ðsÞ; y j ðsÞÞ þ zð1  S j ðsÞÞg with the utility of leisure as z(1  S j(s)), zV()>0, zW() < 0, and where S j(s) denotes the fraction of time engaged in lobbying. E is the expectations operator. The rest of the world is comprised of many countries which produce X and Y with the same stochastic technology. We assume that supply shocks are independently distributed across countries, and individuals in other countries have the same preferences as those at home. This independence of shocks across countries supports a risk-free world portfolio of physical capital. With nonstochastic levels of world output of X and Y, the fixed world relative price can be normalized to one. To further simplify, we let individual world goods prices equal one: PXw = PYw = 1. With such similarity in the nature of production and preferences at home and abroad, the realization of home supply shocks determines the country’s pattern of trade. 2.2. Policy determination A mechanism for policy determination links the choice of trade policy by government to the policy preferences of private individuals. We use an import tariff as the means of trade policy variable. The government is responsive to individuals seeking protection. Individuals lobby only for protection, not against.13 The policy response is a tariff on imports of good j, sj, that increases with the effort, S j(s), allocated to lobbying by the representative type-j individual in state s:14 sj ðsÞ ¼ sðS j ðsÞÞ

where sVðS j ðsÞÞ > 0; sWðS j ðsÞÞ < 0; and sð0Þ ¼ 0:

ð2Þ

This parsimonious political framework is sufficient for our purposes.15 2.3. Consumer/investor decisions We proceed by examining portfolio, consumption, and lobbying decisions and the corresponding policy choice implemented under different asset market structures. Initially, we examine trade policy when individuals do not have access to financial markets and 13 To focus solely on protectionist trade policy, individuals do not seek other income redistribution policies from government. More complex models include descriptions of collective action and free-rider problems of organization. For an overview of political redistribution, see Hillman (2003a, Chapter 6). 14 At most one type of individual will lobby in a given state since import tariffs are the only form of intervention. Hence, we simplify by incorporating only one argument in the tariff function. 15 For expanded treatments of the process of political determination of trade policies, see Hillman (1989/ 2001) and Grossman and Helpman (2002).

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must retain initial endowments. Subsequently, we introduce domestic markets for trading claims to (physical) capital. Individuals choose to trade assets because uncertainty in dividends creates undesirable risk in individual income. Since dividends are imperfectly correlated across sectors, asset trades can reduce this risk exposure. However, capital markets permit trade in claims only to a subset of each sector’s returns. The imperfection in capital markets can arise from many possible sources, including in particular moral hazard, although the precise reason does not matter here.16 We identify the subset of returns for which claims are tradeable with physical capital and the nontradeable portion with human capital. These labels reflect moral-hazard and adverse-selection problems that inhibit trades in claims to the returns to human capital. Claims to the factor called physical capital may also be restricted in tradeability due to information imperfections and imperfect solutions to principal-individual problems (see Demsetz and Lehn, 1985 and Cassing, 1996). In broader terms, these labels therefore do not necessarily reflect characteristics of the production technologies across industries, but rather reflect market imperfections. Asset trade takes place before the resolution of uncertainty, but with complete information on the distribution of the technology shocks and the nature of the political process. After expected-utility-maximizing portfolios are established, shocks occur and determine the industry that faces import competition. Individuals then choose political activity to influence policy choice, and the political process determines deviation from free trade. Consumption choice and goods trade follow. The ex-ante portfolio choice and the value of endowed assets depend on expected future trade policy, and hence the individual solves his or her optimization problem recursively.17 We proceed with the general form of the individual’s optimization problem and then consider the solution for different degrees of asset tradeability. Solving the problem recursively, we first determine consumption. The type-j individual maximizes (ex-post) utility subject to the constraint, 1 I j ðsÞua j dðsÞ þ RðsÞ ¼ ð1 þ sX ðsÞÞx j ðsÞ þ ð1 þ sY ðsÞÞy j ðsÞ; 2

ð3Þ

where each individual’s ex-post income, I j (s), depends on (vectors of) equity shares and dividends, denoted a j and d(s), respectively. The dividends are defined in Eq. (1), and j j j j individual j’s portfolio includes four assets ordered as follows: (aHX , aKX , aHY , aKY ), where industry X human and physical capital shares precede those of industry Y. The tariff revenue, R(s), either equals sX(s)[x x(s) + x y(s)  X(s)] (X as the import good) or equals sY (s)[ y x(s) + y y(s)  Y(s)] ( Y as import) and is taken to be exogenous by both 16 While the source of this market imperfection would need to be specified to determine socially optimal trade policies, our objective involves uncovering only the desired policies of private individuals, which need not be socially optimal. Hence, we do not specify the market imperfection. 17 Lobbying to influence trade policy occurs after productivity shocks identify the import-competing industry. On the insurance motive for trade policy, before the identity of the import-competing industry is known, see Eaton and Grossman (1985). Dixit (1992) has commented on the problem of government resolving insurancerelated market failures. Since lobbying only occurs in our model after the beneficiaries of protection are known, there is no insurance motive for departure from free trade.

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individuals. The relative asset wealth of the individuals depends on equity prices, q(s), which will be shown to reflect policy expectations. At the time consumption is chosen, the individual’s income is established and tariffs (if any) are in place. Consumption will therefore be chosen such that: u1 ðx j ðsÞ; y j ðsÞÞ PX ðsÞ 1 þ sX ðsÞ ¼ ¼ u2 ðx j ðsÞ; y j ðsÞÞ PY ðsÞ 1 þ sY ðsÞ

ð4Þ

Since preferences are symmetric in x and y and world goods prices are equal, a free-trade equilibrium includes equal consumption of the two goods. Also, note that shocks that favor the X sector, /X(s)>/Y(s), cause X to become the export good and Y the import good.18 To facilitate discussion, we define states m where /X(s)>/Y(s), with Y as the import-competing sector, and define states n where /X(s) < /Y(s), with X as the importcompeting sector. The consumption solution gives rise to the indirect utility function, V(I j(s), sX(s), sY(s)), which we use henceforth to simplify the lobbying and portfolio-choice problems. Since portfolio selection depends on expected dividends, and since these are affected by trade policy, it is necessary to determine—for any arbitrary portfolio—the individual’s lobbying decision. Lobbying is chosen to max V ðI j ðsÞ; sX ðsÞ; sY ðsÞÞ þ zð1  S j ðsÞÞ j S ðsÞ

ð5Þ

subject to 0 V S j(s) V 1. The individual’s portfolio is established at this point, realization of the productivity shocks has occurred, and the political process is fully understood. Lobbying must satisfy the following for an interior solution:  j   BI ðsÞ BsX ðsÞ BsY ðsÞ j j j V1 ðI ðsÞ; Þ  x ðsÞ j  y ðsÞ j  zVð1  S j ðsÞÞ ¼ 0 BS j ðsÞ BS ðsÞ BS ðsÞ where equilibrium X consumption, x j(s) = x j(I j(s), sX(s), sY(s)) =  Vsx()/V1(), and Y consumption, given analogously, determine the magnitude of the consumption distortion created by a tariff. We express this condition separately for tariffs on X imports and Y imports as follows: V1 ðI j ðsÞ; ÞCjX ðsÞ

BsX ðsÞ BI j ðsÞ  x j ðsÞ  zVð1  S j ðsÞÞ ¼ 0 where CjX ðsÞu j BsX ðsÞ BS ðsÞ

ð6aÞ

V1 ðI j ðsÞ; ÞCjY ðsÞ

BsY ðsÞ BI j ðsÞ j j  y j ðsÞ ðsÞÞ ¼ 0 where C ðsÞu  zV ð1  S Y BsY ðsÞ BS j ðsÞ

ð6bÞ

where CXj (s) and CYj (s) indicate individual j’s net gain from a tariff on imports of X and Y, respectively. The individual weighs any positive net gain against the utility loss associated 18 This follows since the greater supply of X relative to Y causes the autarkic relative price of X to fall below the world relative price of one, given the symmetry in preferences.

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with time away from leisure. Individuals choose not to lobby when Eqs. (6a) and (6b) are negative at S j(s) = 0 and use all time to lobby when Eqs. (6a) and (6b) remain positive at S j(s) = 1. We rule out the latter case by assuming sufficiently rapid decreasing returns to, and increasing marginal costs of, lobbying activities. We see from Cj(s) in Eqs. (6a) and (6b) that portfolio composition influences the lobbying decision and thus the government’s policy response. Individuals recognize this interdependency when designing asset holdings. Asset trades are subject to a no-shortx y x y sales constraint, and asset-market clearing occurs when aKj + aKj = 1 and aHX = aHY = 1 with domestic markets. The latter condition reflects the prohibition on trade in claims to human capital. Each individual solves: max EfV ðI j ðsÞ; sX ðsÞ; sY ðsÞÞ þ zð1  S j ðsÞÞg

j j aKX ;aKY

ð7Þ

j j subject to qj = qXaKX + qYaKY , 0 V aijj V 1, and Eq. (3), where qj is the relative price of a 19 claim on Kj. Also, qj indicates the market value of individual j’s tradeable initial claims to capital since the total number of claims to each type of capital has been normalized to one. The right-hand side of the constraint indicates individual j’s purchases of tradeable capital. Eq. (3) describes income’s dependence on these shares. The portfolio choices must satisfy the following first-order conditions for an interior solution:

EfVI ðsÞdKX ðsÞg  c j qX ¼ 0

ð8aÞ

EfVI ðsÞdKY ðsÞg  c j qY ¼ 0

ð8bÞ

where c j is the marginal utility of asset wealth for individual j. With dividends defined in Eq. (1) and equilibrium consumption given by Eq. (4), we combine Eqs. (8a) and (8b) to determine each individual’s (shadow) relative price of a claim to KY in terms of KX:  j qY hKY fEfVI ðI j ðsÞÞgEfdY ðsÞg þ CovfVI ðI j ðsÞÞ; dY ðsÞgg ð9Þ ¼ hKX fEfVI ðI j ðsÞÞgEfdX ðsÞg þ CovfVI ðI j ðsÞÞ; dX ðsÞgg qX where dj(s)=(1 + sj(s))/j(s). We will illustrate the interdependence between equilibrium portfolios, prices, and trade policy for each environment. In the event that the no-shortsales constraint binds on one of the individuals, prices from Eqs. (8a) and (8b) reflect the demand of the unconstrained individual. The portfolio, lobbying, and consumption decisions of the two types of individuals give rise to a political-economic equilibrium, which we define as follows: Definition 1. A political-economic equilibrium consists of portfolio allocations, ax and ay; lobbying effort, S j(s); trade policy, s(S j(s)); consumption, x j(s) and y j(s); equity and goods prices, q(s) and p(s) that satisfy: (i) consumer first-order conditions, in Eqs. (4), (6a), (6b), (8a), and (8b); (ii) budget, time, and the no-short-sales constraints, in Eqs. (3), (5), and (7); (iii) the government policy mechanism, in Eq. (2); (iv) asset-market clearing conditions. 19

The consequence of the no-short-sales constraint is assessed when each equilibrium is derived.

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3. Political-economic equilibria 3.1. No risk-sharing markets We first consider the implementation of trade policy when individuals cannot alter initial factor ownership. This case most closely resembles the traditional framework used to examine the political economy of protection, where individuals’ associations with particular factors or industries remain fixed throughout. The political-economic equilibrium here establishes a benchmark from which the consequence of asset markets may be assessed: Equilibrium 1 (No risk-sharing markets). The political-economic equilibrium in the absence of asset markets consists of a positive tariff in every state of nature, provided the marginal value of individuals’ time is not too high. Absent financial markets, portfolios are restricted to initial endowments and income from Eq. (3) becomes: 1 1 I x ðsÞ ¼ dHX ðsÞ þ dKX ðsÞ þ RðsÞ and I y ðsÞ ¼ dHY ðsÞ þ dKY ðsÞ þ RðsÞ 2 2

ð10Þ

The lobbying decision for each individual depends on whether X or Y becomes the importcompeting industry. For all states n (where X is the import-competing sector), the net effect of a tariff on individual x is CxX ðsÞ ¼

1 / ðsÞ 2 X

ð11Þ

since BI x ðsÞ=BsX ðsÞ ¼ BðdHX ðsÞ þ dKX ðsÞÞ=BsX ðsÞ ¼ /X ðsÞ > 0 , and x x ðI x ðsÞ; sX ðsÞ; sY ðsÞÞ jS ¼s¼0 ¼ ð1=2Þ/X ðsÞ < 0 in the neighborhood of free trade. The symmetry in preferences guarantees that individuals spend half of total income on each good. The net effect of a tariff is positive in every state, and provided that the marginal utility of time is less than this net benefit, S x(s)>0 from Eqs. (6a) and (6b) for all states n. The y individual gains nothing from lobbying for a tariff in states n since all income accrues from the Y sector, so S y(s) = 0. The political process leads to sX(s)>0 in all states n. Inserting Eq. (11) into Eqs. (6a) and (6b) reveals that for a marginal tariff, lobbying will be selected such that20 x x 2zV ð1  S ðsÞÞ 2zV ð1  S ðsÞÞ ¼ sVðS x ðsÞÞ ¼ : ð12Þ VI ðI x ðsÞÞ/X ðsÞ VI ðI x ðsÞÞI x ðsÞ S ¼s¼0

Note that with s(S ) strictly concave, higher realizations of /X may either increase or decrease lobbying effort. When X is the import competing sector, the greater is /X, the 20 Of course, for a finite tariff, the consumption distortion term becomes a function of the tariff and then depends on the functional form for consumption utility. With logrithmic preferences, for example, xx(s)=(1/ 2)I x(s)/(1 + sX(s)) and since I x(s) = dX(s)=(1 + sX(s))/X(s), the tariff term disappears and Eq. (12) continues to describe the lobbying equilibrium.

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smaller are the economy’s comparative advantage and extent of trade. Yet the larger X sector magnifies the impact of a tariff-induced price increase on X-sector dividends. This would tend to increase lobbying activity and the equilibrium tariff. Countering this is the decline in marginal utility of income associated with the higher /X. In the absence of asset markets, this individual’s income derives entirely from the X sector and rises in direct proportion to the supply shock. The neutral case, in which these two effects just cancel, occurs with log utility. An elasticity greater than one would cause lobbying and the tariff to be increasing in /X, while an inverse relationship would appear with an elasticity less than one.21 The smaller is the volume of trade in the former case, the higher is the tariff. This unusual result derives in part from the simplicity in the political mechanism: if lobbying were weighted by the extent of import penetration, for example, tariffs would come to fall eventually as the volume of trade shrinks. Regardless of this tradeoff, a more rapidly decreasing marginal value of leisure limits the amount of lobbying, while a less responsive political process reduces the tariff for any given level of lobbying activity. The lobbying activities of individual y in states m correspond exactly to those by individual x in states n. Due to the symmetry of /X  /Y around zero, for each state n, there is an equally probable state m in which /X  /Y < 0 by the same magnitude. Evaluation of Eq. (12) expressed for the y individual in states m indicates that for each such pair of states in n and m, the tariff rates on X and Y imports, respectively, will be identical. This implies that the dividends on input i in sector j, which from Eq. (1) equal hij(1 + sj(s))/j(s), have the same expected value and variance across sectors, and consequently, individuals have the same ex-ante wealth. Tariffs will cause the domestic relative price of goods to deviate from the world price of unity. This implies that in states of nature m, the tariff on Y causes consumption of Y to fall below one-half of income, while consumption of X exceeds one-half. In states n, the opposite pattern occurs. Eq. (3) indicates that the magnitude of the deviation from one-half is uniquely determined by the size of the tariff. Since a tariff of given magnitude on X in states n occurs with the same probability as an identical tariff on Y in states m, the distributions for consumption of X and Y are symmetric and are identical for individuals x and y. This guarantees equality in expected marginal utilities of future consumption [in Eq. (9)]—across goods, X and Y, and individuals. Relative shadow values of assets differ across individuals at these exogenous portfolio allocations, however, since the covariance terms differ. While for individual of type x Cov{VI(I x(s)), dKX(s)} < 0 and Cov{VI(I x(s)), dKY(s)} = 0, the reverse holds for individual y.22 This leads the x individual to place a higher relative value on claims to Y-sector physical capital as compared to the y individual. Relaxation of the symmetry conditions—in preferences or productivity shocks—would lead to differences in the implementation of tariffs across states of type m and n. While this would introduce disparities in the relative ex-ante wealth of the two individuals and 21 Once we evaluate (Eqs. (6a), (6b), and (13) for a finite tariff, a higher tariff level adds to the consumption distortion and thus lowers the net benefit of further lobbying. 22 Given income in Eq. (10), income and X-sector dividends are positively correlated for the x individual. Thus, the first covariance must be negative since V() is strictly concave in income. Since the Y sector does not affect this individual’s income, the second covariance is zero. The opposite situation holds for the y individual.

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change ex-post income and consumption accordingly, it would preserve the basic result that protectionist policies would be used extensively. 3.2. The effect of asset markets on trade policy We now assess whether the development of risk-sharing markets creates a political environment more conducive to liberal trade policies. If asset markets were to permit complete risk sharing, each individual would receive a constant share of aggregate output by (indirectly) owning equal shares of each sector’s total dividends. With the same exante wealth, ownership of one-half of total dividends in each sector is feasible with full tradeability of both types of capital. Since only shares in physical capital are tradeable, x however, this perfectly pooled equilibrium would require holdings for individual x of a¯ KX x x x and a¯KY , where these are defined so (hHX + a¯KX hKX) = 1/2 and (a¯KYhKY) = 1/2 and given analogously for individual y. These deliver income of I j(s)=(1/2)dX(s)+(1/2)dY(s)+ (1/2)R(s). Solving for these shares, we find for individuals x and y, respectively, x a¯ KX

1 ¼ 2

y a¯ KX

1 ¼ 2





 hKX  hHX ; hKX 1 hKX

 ;

y a¯ KY

x a¯ KY

1 ¼ 2



1 ¼ 2



 1 ; hKY

 hKY  hHY ; hKY

x ¼ 1; and given aHX

y ¼ 1: given aHY

ð13Þ

These expressions reveal the consequence of nontradeability of some portion of the economy’s productive resources: the distributive shares of physical and human capital in production determine whether individuals are able to obtain these portfolios. If this nontradeability is sufficiently severe, perfect pooling cannot occur and individuals will be left with a closer association to one industry than the other. We thus introduce the following definition: Definition 2. Physical (human) capital is said to be the dominant form of wealth in the economy if the distributive share of physical (human) capital is at least as great as (greater than) that of human (physical) capital in both sectors: hKj z 1/2 (hHj>1/2) for j = X, Y. 3.2.1. Physical capital as the dominant form of wealth Domestic asset markets have a greater influence on trade liberalization when physical capital is the dominant form of wealth in the economy: Equilibrium 2 (Complete Risk Sharing). When individuals have access to domestic asset markets and hKj z 1/2, the political-economic equilibrium consists of complete trade liberalization, complete risk sharing, and a relative value of tradeable capital across sectors that depends only on the ratio of physical capital shares. Anticipating sX(s) = sY(s) = 0 for all s, individuals solve the portfolio problem Eq. (7) and select shares given in Eq. (13). Since individuals then have identical ex-post income

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and shocks have the same properties across sectors [so covariance terms in Eq. (9) are identical], the relative asset price is equated across individuals at qY/qX = hKY/hKX. Asset x y markets clear since Eq. (13) implies aKj + aKj = 1 for j = X and Y. When tariffs are zero in every state, Eq. (4) indicates that income is divided equally between consumption of X and Y. We have only to confirm that neither individual engages in lobbying and that tariffs are zero for all states. In any state n, the net effect from a tariff for either individual at S j(s) = sj(s) = 0 is given by CXj ðsÞ ¼

  1 1 1 1 1 /X ðsÞ  ð/X ðsÞ þ /Y ðsÞÞ ¼ /X ðsÞ  /Y ðsÞ; 2 2 2 4 2

and will be negative since portfolios effectively deliver ownership of half the X-sector dividends. In any state n, /X(s) < /Y(s), so the consumption distortion outweighs the income gain from the tariff. In addition, lobbying reduces utility through the loss of leisure. This implies Eqs. (6a) and (6b) are negative at S j(s) = 0, and neither individual wishes to lobby for an import tariff. A similar argument shows that no lobbying occurs in any state m. In the absence of any demand from the constituency for intervention, the government adopts a free trade position irrespective of the state of productivity and the level of import competition. Inherent risk aversion drives individuals to use domestic capital markets to obtain a broadly diversified portfolio. Such a portfolio has the added effect of removing any individual’s desire to lobby for protection of the domestic import-competing industry. The trade policy stance selected by a politically motivated government will match the constituents’ desire for free trade. This extreme departure from the protectionist result in traditional analyses will be moderated to some degree when individuals’ incomes are dominated by human capital. 3.2.2. Human capital as the dominant form of wealth The conclusion that free trade emerges in the presence of developed domestic capital markets relies on the greater part of capital being tradeable. When human capital dominates income, domestic capital markets do not always lead to free trade. For simplicity, we continue to assume that sectors are symmetric in the extent of human and physical capital inputs. Now, we find that: Equilibrium 3 (Incomplete Risk Sharing). When individuals have access to domestic asset markets and hHX = hHY = hH>1/2, the political-economic equilibrium features incomplete risk sharing and both free trade and protectionist outcomes. With symmetric tariffs, for each state in n, there is an equally probable state in m with a tariff of the same magnitude, sX(n) = sY(m) z 0. Asset markets, as in Equilibrium 2, are used by individual x to exchange endowed claims in X-sector physical capital for claims to Y-sector physical capital, and conversely by individual y. A corner solution appears since selling all claims to own-sector physical capital continues to leave industry risk incompletely diversified. Short selling would solve this problem, but doing so would, in effect, constitute selling claims to one’s human capital income. Since this would eliminate

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the market imperfection that we believe are important to consider, we have ruled this out. Income for each individual, given these portfolios, is 1 1 I x ðsÞ ¼ hH dX ðsÞ þ hK dY ðsÞ þ RðsÞ and I y ðsÞ ¼ hH dY ðsÞ þ hK dX ðsÞ þ RðsÞ; 2 2 where dividends incorporate the output shock and a tariff’s effect on prices from Eq. (1). The tariff structure maintains equal ex-ante wealth across individuals, although individual x expects income to be dominated by the X sector, and conversely for individual y. When tariffs are applied symmetrically across states n and m, expected values and variances of income are the same for both individuals. Evaluation of Eqs. (6a) and (6b) establishes these symmetric trade policy outcomes. In states n, where X is the import good, the net effects of a tariff (in the neighborhood of free trade) for individual x is CxX ðsÞ ¼

1 ðhH /X ðsÞ  hK /Y ðsÞÞ > 0 iff hH =hK > /Y ðsÞ=/X ðsÞ 2

ð14Þ

and for individual y is, analogously, CXy(s)=(1/2)(hK/X(s)  hH/Y (s)) < 0. The net effect from a tariff on X imports in states n is unambiguously negative for individual y since hK < hH, but for the x individual depends on the comparison of relative productivity shocks to the relative importance of human to physical capital in production. By assumption, the ratio of distributive shares exceeds one, but it is also the case that in states n, the ratio of shocks always exceeds one. Only for those states in which the X sector is sufficiently large (but still import-competing) will the X individual find it worthwhile to lobby, provided the marginal value of leisure time is not too high. When /X(s) is very low, the income gain, based only on the increase in payments to human capital, fails to compensate the individual for the consumption distortion. In these states, the tariff is zero. A similar argument reveals that with Y as the import-competing sector, the x individual never has incentive to lobby for a tariff, while the y individual only lobbies when the Y sector is sufficiently large [using a condition analogous to Eq. (14)]. Given the symmetry in the shocks across states n and m, tariffs on X and Y are symmetrically applied. The corner solution in portfolio allocations implies that the market relative price of claims to X-sector capital is determined by the demand for this asset by individual y [ qXy = E{VI(I y(s))dKX(s)}/c y], while the price of a claim to Y-sector capital depends on individual x’s demand [ qYx = E{VI(I x(s))dKY(s)}/cx]. Individuals have the same asset wealth, so cx = c y, with the market relative price given by: qY EfVI ðI x ðsÞÞgEfð1 þ sY ðsÞÞ/Y ðsÞg þ CovfVI ðI x ðsÞÞ; ð1 þ sY ðsÞÞ/Y ðsÞg ¼1 ¼ EfVI ðI y ðsÞÞgEfð1 þ sX ðsÞÞ/X ðsÞg þ CovfVI ðI y ðsÞÞ; ð1 þ sX ðsÞÞ/X ðsÞg qX Given incomes above, expected marginal utilities are the same. Also, the income expressions reveal that the dividend to KY affects x’s income in precisely the same way that the return to KX affects the y individual, and therefore covariances in numerator and

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denominator are equal. By the symmetry in tariffs and productivity shocks, an equilibrium relative asset price of unity follows.23 Compared to an economy without asset trade, access to limited domestic capital markets lowers the expected level of protectionist policies since in all states, the net benefit is reduced by diversification of income across sectors. In some states, the net benefit is zero or negative, while in others, it will remain below the value of leisure time. Free trade prevails in these cases. Relative to the extreme concentration of individual income in a single sector that leads to Equilibrium 1, this broader income base reduces the lobbying effort of private individuals. The decline in political pressure for trade restrictions leads the government to take a more liberal policy position. Since limitations in domestic asset markets leave individual income more closely associated with one sector than the other, however, a potential for protectionist policy remains.

4. Concluding remarks We began with a benchmark economy where individuals derive income exclusively from one sector of the economy and sources of income cannot be changed. We have shown that the government chooses protection in every state of nature, provided the value of leisure (or the value of resources used to influence government policy) is not too high, and that the degree of protection is state-dependent. When physical capital is the dominant form of wealth in the economy, domestic asset markets allow individuals to acquire equal shares in the industries’ total returns and no individual finds it worthwhile ever to seek a protectionist policy. A free trade regime therefore emerges as the political response to private interests. If, however, tradeable (physical) capital is not the dominant form of a country’s wealth, individuals remain closely associated with the industry where specific nontradeable human capital is employed. Individuals diversify to the extent possible, but ultimately retain a greater income association with one industry. A protectionist policy then arises when the import-competing sector is large enough to make a small price increase cover the utility loss of lobbying. We have abstracted from accumulation of physical and human capital. Our results indicate, however, that capital values diverge across sectors and individuals due to the presence of nontradeability of claims and intersectoral immobility in the uses of capital. This implies that accumulation decisions and future trade policies will reflect diversification opportunities. If risk cannot be diversified, adding human and physical capital accumulation may endogenously generate a broader production base as risk-averse individuals take steps to self-insure.24 Endogenizing accumulation decisions will not by itself generate free trade, however, when imperfect information continues to prevent the perfect diversification of human capital income. Greater sophistication of asset 23

Each individual’s autarkic relative price of claims to capital displays the same ranking across individuals as in Equilibrium 1; this can be demonstrated by precisely the same argument as given there. 24 Self-insurance activities—and the role of asset-market completeness—that lead to a broader production base are discussed in a static, two-sector model in Feeney (1994), and the endogenous growth implications are considered in Feeney (1999).

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markets that resolves information asymmetries is needed to remove protectionist trade policies. The addition of international asset markets will do little to alter the trade policy equilibrium relative to the incomplete risk-sharing outcome described in Equilibrium 3. There, individuals are as diversified as endowments of tradeable capital will allow. Access to international capital markets would not improve the individuals’ diversification opportunities. Each person would still retain the human capital that drives protectionist interests. This result obtains due to the assumed symmetry across sectors in the extent of asset nontradeability. When asymmetries exist, the individual with more physical (tradeable) capital may be able to increase the diversification of his portfolio by acquiring international assets. For this case, and the role of international asset market completeness, see Feeney and Hillman (1995, 2003). Acknowledgements We are grateful for comments from seminar participants at Bar-Ilan University, the University of Konstanz, the University of Colorado, the International Monetary Fund, the University of California at Los Angeles, Clemson University, New York University, and the University at Albany. James Anderson, Ken Beauchemin, Jose Campa, Betty Daniel, Jonathan Eaton, Raquel Fernandez, Karen Lewis, Cheryl Schonhardt-Bailey, and two anonymous referees provided comments on earlier drafts. Feeney gratefully acknowledges financial support from the National Science Foundation and the hospitality of the Stern School of Business at New York University (visitor, 1997– 1998).

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