U.S. Terms of Trade: Significance, Trends, and Policy

Order Code RL32591

CRS Report for Congress

Received through the CRS Web

U.S. Terms of Trade:

Significance, Trends, and Policy

September 15, 2004

Craig K. Elwell

Specialist in Macroeconomics

Government and Finance Division

Congressional Research Service ˜ The Library of Congress

U.S. Terms of Trade: Significance, Trends, and Policy

Summary

The nation’s terms of trade — the ratio of an index of export prices to an index

of import prices — is a measure of the export cost of acquiring desired imports.

Increases and decreases in its terms of trade indicate whether a nation’s gains from

trade are rising or falling. A sustained trend of improvement of the terms of trade

expands what our income will buy on the world market and can make a significant

contribution to the long-term growth of economic welfare. Similarly, a falling terms

of trade raises the export cost of acquiring imports and reduces real income and the

domestic living standard. While trade is a process of mutual beneficial exchange,

each trading partner’s share of those benefits can change over time, and movement

of the terms of trade is an indicator of that changing share.

A force or forces that changes the average level of export or import prices will

change a nation’s terms of trade. In this regard we can first distinguish between

transitory and more enduring forces. Relatively short-term changes in national

spending patterns can lead to similarly short-term changes in the terms of trade.

These spending changes could be the result of changes in economic policy or swings

in private sector spending over the course of the business cycle. In either case, the

general scenario will be that the spending change induces either an inflow or outflow

of foreign capital and an associated appreciation or depreciation of the exchange

rate. A more enduring effect on the terms of trade is likely to emerge from more

fundamental changes in world demand and the productive prowess of the economy.

In general, anything that leads to an increased demand for the nation’s exports would

cause that nation’s terms of trade to improve. Such demand changes will often be at

the caprice of shifting tastes and preferences in the market place, for good and for

bad. It is also possible that an economy can do things that raise the probability that

its exports will be highly desirable.

A steady post-war rise in the U.S. terms of trade appears to have ended in the

late 1960s. The rate of decline of the U.S. terms of trade was fairly substantial

through the 1970s. In the 1980s, the pattern changed again with the terms of trade

strengthening through mid-decade, then resuming its deterioration. In the 1990s, the

deterioration stopped, with the terms of trade remaining relatively steady through

mid-decade, then strengthening moderately through the end of the decade. By the

year 2003, the U.S. terms of trade was more or less at the same level that it was in the

1980s, suggesting that the post — 1960s trend deterioration seems to have stopped,

with the U.S. terms of trade at a lower but generally stable level.

The terms of trade is unlikely to be a direct focus of economic policy, with

changes most often a collateral effect of policies aimed at other economic goals.

Nevertheless, it is useful to understand how various economic policies would

influence the terms of trade, so as to craft policies that have the greatest positive

effect on economic well-being. Also, it is possible to configure policies that, while

primarily focused on other goals, maximize the probability of a favorable terms of

trade effect. As such, particular configurations of macroeconomic policy, trade

policy, and technology policy each have the potential for improving the nation’s

terms of trade. This report will not be updated.

Contents

Significance of the Terms of Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

What Determines the Terms of Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

Trends in the U.S. Terms of Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Macroeconomic Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

Technology Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

Trade Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Industrial Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

List of Figures

Figure 1. U.S. Terms of Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

U.S.Terms of Trade: Significance, Trends,

and Policy

Economics tells us that a nation exports so that it may import. Exports are the

cost — goods and services the domestic economy must give up — while imports are

the benefit — foreign goods and services that we wish to acquire in trade. Clearly

the nation is better off if, for any given volume of imports, it exchanges a smaller

volume of exports rather than a larger volume. The nation’s terms of trade is a

measure of the export cost of acquiring desired imports. Increases and decreases in

its terms of trade indicate whether a nation’s gains from trade is rising or falling.

While trade is a process of mutual beneficial exchange, each trading partner’s share

of those benefits can change over time and movement of the terms of trade are an

indicator of that changing share.

Significance of the Terms of Trade

The terms of trade is most often defined as a ratio of an index of export prices

to an index of import prices. An increase in this ratio — a rising terms of trade —

means that any given volume of export sales will now exchange for a larger volume

of imports. In this circumstance, the nation’s real income and living standard

increase because an improved terms of trade allows the economy to expend fewer

resources for export production, yet command the same volume of imports. These

freed resources can be used to produce more domestic goods or buy more imports.

Either way the volume of goods available to the economy for a given level of

resource use is now larger. A sustained trend of improvement of the terms of trade

could make a significant contribution to the long-term growth of economic welfare.

Similarly, a decrease in the ratio of export prices to import prices — a falling terms

of trade — raises the export cost of acquiring imports and reduces real income and

the domestic living standard. The decrement to economic well-being occurs because

the economy must allocate more resources to the production of exports and reduce

the production of domestic output to command the same volume of imports. In this

case, the total volume of goods available for consumption for a given level of

resource expenditure must fall.

A fall of the terms of trade, however, does not mean that trade is harmful to the

nation, merely less beneficial. A lower terms of trade will mean that there was a

reduction of the magnitude of the nation’s gains from trade, but gains most often will

still exist. So the nation is likely to still be better off with trade than without trade.1

1

It is theoretically possible for an economy to be made absolutely worse off by trade due

to a large deterioration of its terms of trade. The practical significance of such an outcome

(continued...)

CRS-2

In a dynamic framework, we have to recognize that it is possible that changes in the

terms of trade are coincident with changes in the level of trade that also changes the

magnitude of the overall gains from trade. Thus, the size of the share and the size of

the “pie”to be divided-up are both changing. For the United States in the post-World

War II period, the level of trade has steadily risen and along with it the size of the

gains from trade. Therefore it is possible even with a falling terms of trade, for there

to be a net increase in economic welfare, albeit a smaller gain then would have

occurred had the U.S. terms of trade been steady or increasing.

Nevertheless, a nation need not be indifferent to a trend of deterioration in its

terms of trade because over time this can tally up to a significant decrement to

economic well-being. This report examines the recent history of the U.S. economy’s

terms of trade, the forces that could have influenced the path of the terms of trade,

and what policy options there are for favorably affecting the terms of trade.

What Determines the Terms of Trade

A force or forces that changes the average level of export or import prices will

change a nation’s terms of trade. In this regard we can first distinguish between

transitory and more enduring forces. Relatively short-term changes in national

spending patterns can lead to similarly short-term changes in the terms of trade.

These spending changes could be the result of changes in economic policy or swings

in private sector spending over the course of the business cycle. In either case, the

general scenario will be that the spending change induces either an inflow or outflow

of foreign capital and an associated appreciation or depreciation of the exchange rate.

These events affect the terms of trade in two ways. For an economy

experiencing an appreciating currency caused by a net capital inflow, there will also

be an increase in the foreign currency price of its exports and a decrease in the

domestic currency price of imports, and an improvement of that nation’s terms of

trade. In addition, the inflow of foreign capital can cause a change in the home

currency price of imports from the lending nation (e.g., the yen price of a Japanese

export). That capital inflow represents a net transfer of income from the lending

nation to the borrowing nation. If, as is likely, the lending nation has a higher

propensity to spend on its exported goods than does the borrower nation, the overall

demand for that good is reduced and the home currency price of the exported good

will tend to fall. This, of course, also improves the terms of trade of the borrower.

As we would expect, the economy that has a net outflow of capital will have the same

two forces working in the opposite way and induce a deterioration of its terms of

trade.

Such exchange rate movements and capital flows may not be long lived,

however. There will be limits imposed by borrower and lender alike on how long

such an imbalance can be sustained. Therefore, there is a strong expectation that

1

(...continued)

is, however, likely slight , and particularly unlikely for an advanced industrial economy like

the United States.

CRS-3

economic forces will cause an eventual reversal of the domestic spending pattern or

of economic policy that initiated this process, and a reversal of the effect on the terms

of trade.

More enduring effects on the terms of trade are likely to emerge from more

fundamental changes in world demand and the productive prowess of each economy.

In general, anything that leads to an increased demand for a nation’s exports would

cause that nation’s terms of trade to improve. Such demand changes will often be at

the caprice of shifting tastes and preferences in the market place, for good and for

bad. It is also possible that an economy can systematically assure that its exports are

highly desirable. If, for example, an economy can generate a brisk pace of

technological advance that is the perpetual wellspring for the creation of new and

highly desirable products or higher quality products, then it is likely that the rest of

the world’s demand for this economy’s products will be steadily strong, boosting

export prices, and improving the nation’s terms of trade. While imitation by foreign

producers may eventually erode the large economic gains associated with any one

innovation and new product, the ongoing process of innovation will keep the

country’s exports rich in new, strongly demanded products. Such an economy can

be said to have a comparative advantage in the production of new products; and the

gains from trade in these products will likely manifest as an enduring positive effect

on the economy’s terms of trade. There is a consensus among economists that the

U.S. economy for more than a century has been such an innovating economy as

evidenced by the very high incidence of sizable research efforts among industries that

export.

However, if technological change manifests largely as an improvement in the

efficiency of the productive process for existing goods, it is an event that increases

the supply of goods that are exported, tending to deteriorate that economy’s terms of

trade, while improving that of nations it exports to. Two forces work to cause this

deterioration. One, greater output raises real income and, in turn, the demand for

imports, pulling up their price. Two, a larger supply of exports made possible by the

technological change will be absorbed in the world market only at a lower price.

A similar effect on the terms of trade would occur if foreign producers increase

the supply of the goods that an economy exports. This could occur through

efficiency improvement by current foreign producers or simply an increase in the

number of foreign sources of supply. On the other hand, forces that increase the

foreign supply of the goods an economy imports will tend to improve its terms of

trade.

Over time it is likely that economic growth, at home and abroad, will tend to

show either a bias towards the production of goods a country exports or a bias

towards production of the goods a country imports. If export biased, then the terms

of trade tends to deteriorate over time, to the benefit of our trading partners. In

contrast, an economy that experiences import-biased growth in the rest of the world

tends to improve its terms of trade to the detriment of its trading partners. It is

suspected that over the post-World War II era, economic growth in the rest of the

world was export biased, generating more than proportionate increases in the supply

of goods the U.S. exports, tending to deteriorate the U.S. terms of trade.

CRS-4

Trends in the U.S. Terms of Trade

It is telling of the economy’s international trade performance to consider

whether there has been any long-term trend in the nation’s terms of trade. A rising

trend would indicate that a country’s trade performance has improved relative to

other trading countries, reaping an increasing share of the gains from trade, and real

income benefits for the economy. A falling trend would be indicative of deteriorating

trade performance, decreasing share of the gains from trade, and decrements to real

income. It is quite possible for a nation with persistent trade surpluses to have a

declining trend in the terms of trade and a nation with recurring trade deficits to have

a rising long-term trend. It is also likely that any observed trend will not necessarily

reflect any one cause, but rather be the net effect of multiple and often opposing

forces, whose relative strength may wax and wane over time.

Figure 1. U.S. Terms of Trade

Source: U.S. Department of Commerce, Bureau of Economic Analysis

Note: A ratio of an index of export prices to an index of import prices, 1996=100.

A steady post-war rise in the U.S. terms of trade appears to have ended in the

late 1960s (see Figure 1 above). The rate of decline of the U.S. terms of trade was

fairly substantial through the 1970s. In the 1980s, the pattern changed again with the

terms of trade strengthening through mid-decade, then resuming its deterioration. In

the 1990s the deterioration stopped, with the terms of trade remaining relatively

steady through mid-decade, then strengthening moderately through the end of the

decade. By 2003, the U.S. terms of trade was more or less at the same level that it

CRS-5

was in the mid to late 1980s, suggesting that the post — 1960s trend deterioration

seems to have stopped, with the terms of trade at a lower but generally stable level.2

The trend of decline in the U.S. terms of trade since the 1960s is evidence that

from the United States’ perspective economic growth in the rest of the world,

particularly in the early portion of this time period, was “export biased.” That is,

economic growth in the rest of the world has been composed of a more than

proportionate expansion of production of goods that the United States produced and

exported.

This would seem a plausible outcome given the nature of economic growth for

the world economy at this time. Clearly, in the early post-war period the U.S. found

itself in a unique and, very likely, unsustainable position. It was the largest and most

productive economy on the globe, and its output probably represented more than 50%

of worldwide output. A war ravaged world economy offered a paucity of alternative

sources of supply for the goods the United States was exporting. This meant that

U.S. goods (exports) enjoyed strong demand and faced little effective competition on

world markets. In this situation, the relative price of U.S. exports could be expected

to be strong.

Yet, as economic growth steadily rekindled in the rest of the world, foreign

economies became more like the United States in what they produced and in the

efficiency with which they produced it, leading to an ever greater supply of foreign

goods to compete with U.S. exports on world markets. With these developments, one

could expect the strength of demand for U.S. exports to ebb, their relative price to

weaken, and the U.S. terms of trade to decline.

This was not the consequence of United States lagging behind; rather, other

nations were “catching up.” Such a resurgence was the predictable outcome of the

healthy recovery and growth of the post-war global economy, and an outcome the

United States would not want to reverse.

The magnitude of the trend decline over the last three decades, however, has

been small. The average annual decline amounts to a fall of about one half a

percentage point annual decrease of export prices relative to import prices. Moreover,

the effect of that decline of the terms of trade on American living standards is smaller

still, because only 10% to 12% of U.S. income was spent on imports over this period.

That roughly translates into a decrement to U.S. real income of about 0.05 percentage

points (or one-twentieth of a percent) annually. This is not a huge cost, considering

the U.S. economy averaged a 3.0% annual growth rate of real GDP over this same

period, but over time it cumulates to a loss equal to 1.0% of GDP every 15 years.

2

The pattern of change in the U.S. terms of trade was probably also affected by the change

in the world exchange rate regime in the early 1970s. The move from a fixed to floating rate

system induced a sharp fall in what was then an overvalued dollar. That exchange rate effect

is also reflected in the falling terms of trade at that time.

CRS-6

Again, this is a reduction in the United States’ share of the possible gains from trade.

Trade still makes the United States better off than not trading.3

Economic Policy and the Terms of Trade

The terms of trade is unlikely to be a prime focus of economic policy, with

changes most often a collateral effect of policies aimed at other economic goals.

Nevertheless, it is useful to understand how various economic policies would

influence the terms of trade, so as to craft policies that have the greatest positive

effect on economic well-being. Will the behavior of the terms of trade be working

with or against the desired policy outcome? Also, it is possible to configure policies

that, while primarily focused on other goals, maximize the probability of a favorable

terms of trade effect. And, of course, it is possible that there could be an interest in

making the terms of trade a policy goal. This section will consider how various types

of economic policies will likely influence the economy’s terms of trade. The likely

practical viability of each policy will also be considered.

Macroeconomic Policy

The traditional tools of monetary and fiscal policy are unlikely to be directly

aimed at achieving a particular goal for the terms of trade. The target of these

powerful policy instruments is economic stabilization: securing stable and rapid

economic growth, low inflation, and low unemployment. Such macroeconomic

policies can, however, have an significant indirect effect on the terms of trade. The

pursuit of stabilization goals will often cause the dollar’s exchange rate to increase

or decrease, and exchange rate movements will directly affect the relative price of

exports and imports and change the terms of trade. We saw in the 1980s that the

combination of a tight monetary policy (aimed at reducing inflation) with an

expansive fiscal policy (caused by tax cuts aimed at reducing the federal tax burden

and by spending increases aimed at strengthening national defense) increased the

level of domestic interest rates, inducing a large net inflow of foreign capital seeking

the higher relative return on U.S. assets, that in turn, generated a sizable appreciation

of the dollar. The United States’ terms of trade rose with the dollar. The

improvement in the terms of trade was substantial, but not long lived. With a change

in the configuration of macroeconomic policy and an ebbing of foreign capital

inflows, the improvement in the terms of trade was reversed before the end of the

decade.

3

For evidence that the U.S. gains from trade have been positive, see Jeffery Frankel and

David Romer, Does Trade Cause Growth? NBER Working Paper No. 5476, June 1999;

Edward E. Leamer and James Levinsohm, “International Trade Theory: The Evidence,” in

The Handbook of International Economics, vol. 3 (Amsterdam: North Holland, 1995);

Catherine L. Mann, Globalization of IT Services and White Collar Jobs: the Next Wave of

Growth, International Economics Policy Briefs, no. pb03-11 (Washington, IIE, Dec. 2003);

and Douglas A. Irwin, Free Trade Under Fire (Princeton NJ: Princeton University Press,

2003) pp.29-54.

CRS-7

Macroeconomic policy could have another indirect, but more enduring effect

on the terms of trade. It seems probable that a consistently well-run economy, where

macroeconomic policy has steadily secured rapid growth, low and stable inflation,

and low unemployment, is more likely to be an economy that provides a strong

incentive for technological advance and innovation, an economy that has an

abundance of healthy and forward looking industries, and an economy that is prolific

creator of a broad array of goods for which there is persistent strong demand by the

rest of the world. Such a demand response could have a positive effect on the terms

of trade. Of course, to the extent that sound macroeconomic policy only enhances our

ability to supply goods to the world market, there may be a negative effect on the

terms of trade. (This is certainly not an argument against sound macroeconomic

policy, merely that we gain somewhat more under the first scenario.)

Technology Policy

In economics, technology is the way scarce resources are combined to produce

a desired good or service. Whether the growing of wheat, the manufacture of

automobiles, or the development of a new drug, the steady improvement of

technology over time is the “engine that drives” sustained improvement in the

nation’s economic well-being, allowing the production of more and better output

from any given endowment of economic resources. One manifestation of such

improvement will be a steady improvement of productivity. Another manifestation

could be as an improvement in the nation’s terms of trade, as strong international

demand for new and improved products increases their export price and raises the

quantity of imports that a given volume of exports exchange for.

What is the public policy issue here? Improving technology is largely a process

of generating new ideas. But the production of new ideas is likely an activity toward

which the private market system will allocate less than the socially desirable level of

resources. To the extent that new ideas lead to profitable outcomes and those profits

can be secured by a private firm, the market economy will generate new ideas and

foster technological change. An inherent attribute of ideas, however, is that they are

non-rival, as my using the idea does not preclude someone else from using it.

Further, ideas will often have the attribute of limited excludability, meaning the

owner of the idea will find it difficult or impossible to charge a fee for its use. These

attributes will likely cause a divergence of private benefit and social benefit. (What

the creator of the idea can expect to gain will be less than what the overall economy

can expect to gain.) In this situation less than the socially desirable level of idea

generation will occur. Therefore, this is an activity which may warrant some level

of government involvement and support if it is to be done on a socially optimal scale.

This so-called market failure in idea production can be corrected by an

appropriate amount of public support for the idea creation process. Such support

could include public funding of research and development (R&D), particularly in the

area of basic scientific research where the prospect of market failure is the greatest;

public funding for investment in human capital, particularly education in the sciences

and engineering where benefits of cumulative knowledge often extend beyond the

individual; and public support for mechanisms to establish and enforce property

rights, such as patent and copyright administration. Of course, these are activities that

CRS-8

the U.S. government does now.4 But the open question is whether such support is

accurately targeted and undertaken on an adequate scale. This is not an easy question

to give a precise answer to because the lack of a market price for the full benefits of

the activity makes it difficult to judge relative scarcity.

As regards spending on R&D, there is a considerable amount of economic

evidence that the social rate of return to R&D for a variety of research projects often

greatly exceeds the private rate of return, suggesting that too little research is being

undertaken. (At optimal scale, research projects would be undertaken to the point

where the social rate of return has been pushed down to the level of private return.)

By some estimates, the level of investment undertaken by firms could be as little as

25% of the level that would be economically optimal.5

This said, we also observe that total R&D spending by industry and government

as a percentage of GDP has hovered around 2.5% of GDP for nearly 30 years. The

overall steadiness of this share, however, masks divergent paths for industry and

government R&D spending. While the dollar spending levels by industry and

government have both increased, since the 1980s as a percentage of GDP, industry’s

share has risen and that of government has fallen. It is government spending on R&D

that largely provides support to basic research and this is an area where the incidence

of market failure in idea production is probably the greatest. Argument for public

support of the idea-creation process certainly transcends its possible impact on the

nation’s terms of trade, but it is one potentially significant aspect of the economic

gains from steadily advancing technology.

Trade Policy

Trade policy comprises actions by government that attempt to directly influence

trade performance. The most basic manifestations of such policies are tariffs to

protect domestic industries from competition from imports and subsidies to promote

exporting industries. These actions may also affect the terms of trade.

Economic theory indicates that there can be a circumstance when imposing a

tariff can improve the nation’s terms of trade. By reducing the demand for imported

goods, a tariff has a tendency to decrease the price of imports. In the standard

analysis this positive effect on the terms of trade ( as well as the positive effect on the

protected industries) is most often outweighed by the costs of the tariff to the wider

economy brought about by the tariff’s distortion of consumption and production

incentives. But, if a tariff causes a sufficiently large reduction of the price of

imported foreign goods, the economic gain from the terms of trade improvement

4

For a discussion of current federal programs, see CRS Issue Brief IB10088, Federal

Research and Development: Budgeting and Priority Setting Issues, 108th Congress, by

Genevieve Knezo.

5

See Zvi Griliches, “The Search for R&D Spillovers,” Scandinavian Journal of Economics,

(1991), pp. 29-47; Bruce Smith and Claude Barfield. Technology, R&D , and the Economy

(Washington: Brookings Institution, 1996); and Charles I. Jones and John C. Williams,

“Measuring the Social Return to R&D,” The Quarterly Journal of Economics, vol. 63, no.4,

(Nov. 1998), pp. 1119-1136.

CRS-9

could outweigh the distortion costs of the tariff and improve the imposing country’s

economic well-being. The economic concept of the “optimal tariff” relates to finding

the tariff rate that would maximize this favorable effect.

The export sector can also, in theory, be an avenue by which trade policy could

induce a positive terms of trade effect. Export subsidies, because they tend to lower

export prices, will cause the terms of trade to decrease. Therefore a positive effect

on the terms of trade would require a negative subsidy — or an export tax — that

raises the price of exports. If this positive effect on the terms of trade is large

enough, then it may outweigh the negative effects that arise from the distortion costs

of the export tax. The “optimal” export tax is the tax rate that would maximize the

positive effect of this instrument on overall economic well-being.

In practice, however, trade policies that attempt to increase the economy’s terms

of trade using tariffs or export taxes are of doubtful practical value. First, these are

policies that could have potential relevance only for very large trading economies

such as the United States, whose exports and imports represent a large proportion of

world wide sales and are, therefore, able to influence the exports or imports price in

the world market. Second, there is no reason be believe that such price effects are

particularly large. And third, if the potential gain is large or small, there is every

reason to believe that using these policy devices to generate terms of trade gains is

not very likely to be sustainable due to retaliation by other nations. If these trade

policy devices are used by the United States (or any nation) it would be a use of

monopoly power to extract extra gains from other trading nations. We can expect

that this would not be a matter of indifference to affected nations, quickly prompting

retaliatory actions that would tend to not only erase any initial economic gains to the

United States, but reduce the economic well-being of all trading nations if a cycle of

retaliation and counter-retaliation induces a large contraction of world trade.

While erecting trade barriers may not be a viable means to improve the terms

of trade, reducing barriers could be.6 For the United States, such a lowering of trade

barriers could improve the U.S. terms of trade for two reasons. First, because the

level of U.S. trade barriers is already very low relative to the level of many U.S.

trading partners; therefore, a multilateral reduction or removal of those barriers will

likely have a stronger positive effect on the demand for U. S. exports than it will on

U.S. demand for imports, tending to increase export prices relative to import prices

and improve the U.S. terms of trade. Second, services trade is likely to be high on

the agenda of the new round of negotiations. The prospect of lower barriers to

services trade may bode well for the U.S. terms of trade. Services account for a much

smaller share of U.S. trade than they do of GDP. The United States is the world’s

largest producer of services and it seems very likely that it could export an array of

6

The last large multilateral trade policy initiative was the Uruguay Round in 1994.

However, preliminary negotiations for a new round of reductions have occurred and a

further multilateral lowering of trade barriers may be in the offing in the years just ahead.

For more on the current state of these negotiations and their likely agenda, see CRS Report

RL32060, World Trade Organization Negotiations: The Doha Development Agenda, by

Lenore Sek.

CRS-10

strongly demanded products to the rest of the world. This can also lead to an

improvement in the terms of trade as that demand pulls up U.S. export prices.

Industrial Policy

In theory there can be “special” industries, which, if given government

nurturing, will grow to generate large economic returns in the future. Without this

public support, however, these special industries will not emerge or will emerge at

too small a scale. While there are many variants of the argument for government

promoting particular industries, two have some plausible economic merit. One is

support for industries that generate what economist call “positive externalities.” This

means that the firm’s or industry’s actions have the potential to generate substantial

economic benefits that spill over to other firms or sectors, but none or only a fraction

of those benefits can be appropriated by the initiating firm. The generation of new

ideas is often the activity of central economic importance for economic well-being.

Yet, because an idea can have limited excludability, it can be difficult for the firm

to fully appropriate the economic benefits of the idea it has created. The new idea

may easily spill over to benefit other enterprises without compensation accruing to

its creators. In this environment, without government support the firm will not have

the incentive to invest in the knowledge-creating process at a level that the whole

society would find most economically beneficial.

The likely existence of significant positive externalities is a theoretically valid

argument for government support for an industry. In practice, however, it is a

problematic endeavor.7 To be economically effective, such support needs to be

targeted at the knowledge that would not otherwise be produced. This is likely a

difficult task. Even if the right target is identified, it will be virtually impossible to

know what amount of support is called for because these types of activities to not

carry a market price from which to judge relative scarcity. A policy of support runs

the risk of being too blunt an instrument to just raise economic efficiency, as it is

possible that it creates other costly distortions. At the international level, knowledge

nurtured at considerable expense by one nation may be easily appropriable by

industries in other nations, tending to reduce any national advantage to accrue from

supporting a special firm or industry.

The other theoretically valid argument for government promotion of a particular

industry is based on the possible existence of “strategic industries.” These are

industries in which only a very few firms would be able to operate profitably and

each firm’s action will have strong repercussions on the profit potential of other

competitors. In this oligopolistic market structure, firms will likely have a

significant degree of monopoly power and the potential to earn above normal profits.

Capturing a large share of those profits would increase the home nation’s economic

well-being. In this environment, nations may be tempted to compete for those

profits. Without government support those profits will most likely be appropriated

by the first few firms to establish themselves in the industry. Subsequent entry by

7

For a discussion of the problematic success of industrial policy in practice in several

industrial countries, see Paul Krugman and Maurice Obstfeld, International Economics:

Theory and Policy (New York, Harper-Collins, 1994), pp. 287-296.

CRS-11

other firms would be deterred as they can only expect to incur losses. Who enters

and who is deterred can be influenced by the government of one country making a

strategic intervention that gives support with a subsidy sufficient to assure that

whether firms from other nations enter or not, its firm will earn a profit. Because any

unsubsidized firm would now earn losses, they will likely be deterred from entry.

The government intervention has thereby shifted potential profits from the foreign

to the domestic firm and raised economic well-being in the home economy.

Again, while it is conceptually possible for a strategic trade policy to raise

national economic well-being, its practical significance has been widely questioned

by economists. Perhaps the greatest doubt as to the efficacy of strategic trade policy

is that the information required for the government to successfully execute the policy

most likely exceeds what would be readily available. Economic theory indicates that

the conditions needed for the execution of a successful strategic trade policy are

many and a favorable outcome will be extremely sensitive to small deviations from

any of those necessary conditions. This means that pursuing such a policy with

substantially incomplete information could easily result in subsidies supporting more

inefficiency than efficiency, and leading to more loss than profit.

Further, if large subsidies are to be handed out without all necessary information

available, policy makers can anticipate some politicization of the process and the

rising probability that more subsidies will be given than can be analytically justified.

Success is likely to be even less tractable if trading partners can be expected to

retaliate against a policy that will clearly make them worse off.

Finally, economic studies have suggested that even if the policy is well

implemented, the realized gains could be very small. For all these reasons, it is

unlikely in practice that federal government support of strategic industries would be

a viable means for raising the terms of trade and overall economic welfare.8

Conclusion

The terms of trade can be a telling indicator of changes in the economy’s gains

from international trade. Changes in the terms of trade point to either an increment

or decrement in real income. While short-term changes are often offsetting and carry

little significance, long-term trends can point to significant enhancement or erosion

of economic well-being. Nevertheless, the terms of trade is unlikely to be at the

center of most discussions of trade policy or macroeconomic policy because it is not

a variable that is easy to influence directly.

8

For an appreciation of the evolution of thinking about strategic industries and economic

policy by a trade economist prominent in the development of the idea, see Paul Krugman,

“Is Free Trade Passe?,” Journal of Economic Perspectives (fall 1987), pp. 131-141; and

“Does the New Trade Theory Require a New Trade Policy,” The World Economy (July

1992), pp. 423-441. For a general survey of the issue, see Douglas A. Irwin, Against the

Tide: an Intellectual History of Free Trade (Princeton University Press, 1996), pp. 207-216.

CRS-12

While there may be opportunities for a nation to use economic policy to directly

influence its terms of trade, these are unlikely to be exploitable tools. Because your

gain is going to be at their expense, other nations are likely to try to counter such

policies. This is a situation that could all too easily devolve into a vicious cycle of

retaliation and counter-retaliation, shrinking the volume of world trade and leaving

all parties worse off.

Nevertheless, economic policy may be able to influence the economy’s terms

of trade in a favorable manner. It is most likely to do so indirectly, with positive

effects on the terms of trade emerging as a beneficial by-product of policies that

support an “infrastructure” that generally furthers the goal of vigorous economic

growth. A number of economic policies are likely to raise the probability (but

certainly not assure) a favorable terms of trade effect. Macroeconomic policies that

minimize economic instability and nurture forward looking activities such as

investment and innovation, policies for focused public support of knowledge

producing activities that are very likely undervalued by the private market, and

continued initiatives toward the lowering of trade barriers at home and abroad are all

likely to be important to developing such an infrastructure. In this way terms of

trade gains would likely be seen as emerging from a process that has probably

increased the gains to each trading partner (although not necessarily equally), and

thereby not seen by other nations as a “zero sum game” where our gain is their loss.