Applying New Growth Theory To International Trade

This paper argues that the baseline assumptions in conventional trade theory may mislead many governments into belittling the role of trade in human development. The theory of comparative advantage that still shapes the mindset of most trade economists implicitly assumes that the world consists of a fixed amount of ideas, goods and services that are produced wherever there is a comparative advantage with respect to the availability of the scarce factor inputs land, labor and capital. However, economic development is essentially an endogenous process driven by individuals who succeed or fail in trying new ways of doing things. Once they succeed, their ideas on how to do things better may be simultaneously adopted in the rest of the world and thus lead to catch-up growth. Since this kind of new knowledge represents a non-rival and non-scarce resource, the market lacks incentives to invest in it to a degree that would be optimal for society. Policy makers therefore need to create such incentives and assume an active role in facilitating economic and technological change primarily by investing in people and their ability to build up new businesses. Only then can a country and its people truly benefit from international trade and only then will globalization lead to convergence rather than divergence. In this paper we show that the scattered attempts to describe this endogenous process of development are based on the ideas of Schumpeter whose theory of economic development could not be integrated into the formal language of economics until Paul Romer proved able to do so in the 1990s. Romer’s interdisciplinary approach to economics has been gradually refined over the years and many governments, especially in developing countries, decided to embrace it in their economic policies. It has also become crucial for policy makers whose aim is to make international trade work for sustainable development.