This PDF is a selection from an out-of-print volume from the National Bureau of Economic Research Volume Title: Issues in US-EC Trade Relations Volume Author/Editor: Robert E. Baldwin, Carl B. Hamilton and Andre Sapir, editors Volume Publisher: University of Chicago Press Volume ISBN: 0-226-03608-1 Volume URL: http://www.nber.org/books/bald88-1 Publication Date: 1988 Chapter Title: East-West Trade, Embargoes, and Expectations Chapter Author: Alasdair Smith Chapter URL: http://www.nber.org/chapters/c5959 Chapter pages in book: (p. 153 - 172) 6 East-West Trade, Embargoes, and Expectations Alasdair Smith 6.1 Introduction The subject of this paper is the divergence between the policies towards East-West trade of the United States on the one hand and its Western European allies on the other. The most striking differences are in their willingness to use the trade embargo as a means of exerting political pressure, and in the extent to which they believe it is possible or sensible to limit the export of high-technology goods to the East, but even a casual study of the history of East-West trade since 1945 shows that the differences go rather deep. Both the Eastern bloc and Western Europe have recognised the existence of linkages between trade and political relations but have been resistant to direct or explicit use of trade policy as a political tool; while the United States has, generally, maintained a more skeptical stance about the positive link- ages and has exhibited a greater willingness to use trade embargoes as a political weapon. In the first part of this paper I sketch the main features of East-West trade in the past 35 years and the differences in Western attitudes to it. I draw a distinction between two related views of the connection between trade and political relations, which I label the “linkage” and the “leverage” views. The relevance to East-West trade of the received wisdom on the effectiveness of trade embargoes is reviewed. The need to take explicit account of expectations of future policy is the key theme Alasdair Smith is professor of economics at the University of Sussex, and codirector of the international trade research programme at the Centre for Economic Policy Re- search, London. I am grateful for comments by Avinash Dixit, Gene Grossman, Carl Hamilton, Carl Jonietz, Kala Krishna, and Alan Winters. 153 154 Alasdair Smith of the paper, and I argue that the United States may have attained the worst of all possible worlds by acquiring a reputation for imposing ineffective embargoes. The second part of the paper is devoted to aformal model that focuses on the role of expectations in shaping the investment behavior of mul- tinational corporations and therefore on their exposure to embargo threats. 6.2 East-West Trade: Linkage, Leverage, and Expectations 6.2.1 Western Conflicts on East-West Trade It is beyond the scope of this paper to give a systematic historical account of 40 years of East-West trade. The sketch below is based on Becker (1983), Cooper (1987), Rode and Jacobsen (1985), and Stent (1981). The divergence in the views of the United States and most Western European countries on East-West trade goes back to the early 1950s when trade relations between the United States and the Soviet Union were minimal, the basis of trade policy being that trading with an enemy should be minimized. The Export Control Act of 1949 and the later Export Administration Acts regulated trade in strategically important goods; and on the principle that all trade strengthens the economy, the presumption in the early years seems to have been that all potential exports were strategically important unless demonstrated not to be. The U.S. Mutual Defense Assistance Control Act of 1951 provided the basis for harmonized actions by the NATO nations and Japan on export controls, and the Paris-based “Coordinating Committee” (COCOM) drew up the lists of restricted exports. There is a distinction in principle to be made between trade restric- tions imposed for reasons of strategic defense policy, and those imposed from broader motives of foreign policy. There has been a greater con- cordance of views between the United States and the Europeans on the former than on the latter, but in practice, as the previous paragraph indicates, the distinction between the two motives becomes fuzzy, and from the earliest years there were conflicts between the U.S. and its allies on the stringency with which COCOM restrictions should be applied. One important case was the 1962-63 pipeline embargo, described in some detail by Stent (1981), which in fact was imposed under the auspices of NATO rather than COCOM. This embargo was rendered ineffective by the refusal of Britain and Italy to participate, a refusal which may have been partly influenced by the suspicion that the em- bargo was motivated more by the desire to protect U.S. oil companies 155 East-West Trade, Embargoes, and Expectations against the alleged dumping of Soviet oil on world markets than by strategic defense considerations. West Germany initially backed the embargo but later withdrew its support. The fate of this embargo is symptomatic of a general tendency for American embargoes on stra- tegic materials to be gradually slackened in the light of the availability to the Soviet bloc of alternative sources of supply in Western Europe, as European nations have been more permissive than the United States. The differences between the NATO allies on East-West trade seemed to be eliminated in the early 1970s with the Nixon-Kissinger pursuit of detente in the United States and Willy Brandt’s Ostpolitik in West Germany. The economic effects of trade were now not seen as a dan- gerous strengthening of an adversary, but as the incentives to coexis- tence and political liberalization. Agreements between the United States and the Soviet Union granted the latter most-favored-nation status as well as trade credits. The process quickly ran into difficulties with the U.S legislature, as the Jackson-Vanik amendment tied the granting of most-favored-nation status to the liberalization of Soviet policy towards Jewish emigration, and the Stevenson amendment restricted ExIm bank credits. The Soviet Union withdrew from the agreement, complaining of improper interference in its internal affairs. The Soviet invasion of Afghanistan in 1979 brought the process of detente to an end: the Carter administration reacting by imposing an embargo on trade in grain and in fertilizer. (An interesting feature of the fertilizer embargo was that the Soviet Union maintained the deliveries of materials that they had agreed to supply in exchange for super-phosphate fertilizer even though the Occidental corporation was legally barred from delivering the fer- tilizer.) Meanwhile, the process of dCtente seemed much smoother for the Western Europeans and an agreement had been reached for the supply of pipes and compressors, mainly by West Germany, for the new Urengoi gas pipeline in exchange for natural gas. The Reagan administration removed the grain and fertilizer embargo, but the worsening political situation in Poland led the Americans to seek a tightening of trade in strategic goods, and in particular an end to the pipeline deal. (The possibility of forcing Poland into default on its huge foreign debts was evidently seriously considered and argued over within the American administration, but rejected primarily be- cause of the dangerous implications for the Western banking system.) Since direct American participation in the pipeline had been eliminated in 1979, and since the Western European countries were opposed to the abrogation of the pipeline agreement, the Americans attempted to enforce the embargo by exerting extraterritorial pressure on the foreign subsidiaries of U.S. corporations such as Dresser-France and the for- eign licensees of American technology such as John Brown Engineering 156 Alasdair Smith of the U.K. Both the British and the French had laws aimed at pre- venting the exercise of such authority by a foreign government. The resulting conflict was eventually resolved in late 1982 with an agreement by which the Western Europeans continued with the pipeline deal but agreed to tighten up COCOM restrictions on strategic goods. Subse- quent remarks by the French president, however, suggested that the agreement represented a unilateral climbdown by the United States. The persistent divergence in attitudes to East-West trade has to be seen in the light of the differing economic importance of trade to the different parties. Table 6.1 shows that quantitatively East-West trade is more significant to Western Europe than to the United States (and of more significance to the East than to the West). Thus the Europeans have more to lose from trade disruption than do the Americans. It would be futile to attempt to disentangle cause from effect in the in- teractions between the politics and economics of trade. It would cer- tainly be a gross oversimplification to say that Western European policymaking has been dominated by considerations of economic self- interest, while the Americans have, by reason of lack of direct economic involvement, been free to pursue purely political objectives, for it is clear from even the abbreviated narrative above that considerations of economic self-interest have entered into American decision making, while Western European policy has been influenced by political as well as economic considerations. Table 6.1 East-West Trade in 1980 East-West Trade in 1980 ~ ~_______ U.S. EEC FRG France Volume ($b) 5.28 56.8 23.8 10.21 Share of trade 1.14 4.14 6.2 4.2 Share of GNP 0.2 2.0 2.9 1.58 Eastern Trade with OECD USSR CMEA-6 CMEA-Europe Volume ($b) 46.4 39.1 85.5 Share of GNP 3.4 6.2 4.2 Source: Guillaume (1983). Nch-t CMEA-6 refers to the six Eastern European countries excluding the USSR; CMEA- Europe are the CMEA-6 plus the USSR; OECD is the Organization for Economic Cooperation and Development. 157 East-West Trade, Embargoes, and Expectations 6.2.2 Linkage and Leverage The concept of ‘‘linkage’’ between international economic and po- litical relations was at the heart of the American dCtente policy of the 1970s as of the West German Ostpolitik. It also seems to provide an underpinning of Soviet trade policy. Linkage can mean several different things. One general sense in which there can be linkage is that global trade liberalization can reduce the scope for conflicts over access to markets or to raw materials. Of more relevance to East-West trade is the idea that as trade is mutually beneficial, the building of trade relations gives each party a stronger incentive to avoid conflict. More specifically, some have argued that East-West trade will bring concrete political gains for the West: citizens of Eastern bloc countries are exposed to Western influences as consumers of Western goods or users of Western technology; the Eastern Clite is exposed more to Western contacts and ideas; and communist planners, faced by the incentives arising from foreign prices, are led to liberalize their methods of economic management. Further, it seems that the Soviet Union has seen trading links with the West as an important component of “peace- ful coexistence,” and as a step toward one of their major foreign policy aims-Western acceptance of the post-war status quo in Europe and of the Soviet position as a super-power equal to the United States. A still more specific form of linkage is when trade seems to be made conditional on political progress, as with the relaxation of restrictions on the emigration of Jews from the Soviet Union in the early 1970s and of Germans from East to West Germany in the same period. The Soviet Union was evidently content that such liberalization was seen as intimately linked with progress on other aspects of dCtente, but most decidedly was not willing to have the linkage made explicit and ex- plicitly conditional by the Jackson-Vanik amendment. This serves to make the point that the line between linkage and leverage is not easily drawn, especially where the latter concept is taken to refer to the use of economic pressures to achieve specific political goals, a trade embargo being the prime example of leverage. Bayard, Pelzman, and Perez-Lopez (1983) provide a good survey of the general questions which arise in the analysis of trade embargoes. The attractiveness of an embargo depends on the relative costs which it imposes on the parties involved. The costs will be greater, the greater the share of a country’s income derives from the embargoed trade. Table 6.1 above therefore can be taken as providing an explanation for the apparent attractiveness to the United States of trade restrictions as a political lever. Perhaps more important than trade shares, however, is the question of whether it is easy to find substitutes for the embargoed 158 Alasdair Smith trade, for the gains from trade are greater the smaller is the price- elasticity of trade. In this sense the Soviet Union may well seem vul- nerable to embargo threats, for it cannot easily find an alternative market for natural gas to Western Europe, nor alternative suppliers for pipeline equipment or other technologically advanced goods. The question of substitutability is central to the evaluation of COCOM restrictions. If the Soviet Union can easily shift resources from non- military to military uses, then only a general embargo aimed at damaging the entire economy would provide an effective restraint on Soviet mil- itary capacity, and such a policy now has few supporters. The greater are the restrictions on the ability of the economy to shift resources from one sector to another the more one can justify an embargo limited to particular strategic goods. Thus, although the use in Afghanistan of trucks from the Kama River plant, built with American assistance, was polit- ically embarrassing to the United States, it is arguable that the real mil- itary situation would have been no different if there had been no Western involvement in Kama River. By contrast, export restrictions on “su- permini” computers, imperfect though the restrictions are in practice, probably do have significant effects on the Soviet Union. The importance of substitution elasticities to the cost of an embargo implies that an embargo is less likely to be successful the longer the time period under consideration, for in the long run, substitution pos- sibilities are enhanced and elasticities increased. Bayard et al. identify cartel problems as a critical factor in the success of embargoes. The more countries join in an embargo the greater will be the share of the embargoed country’s trade affected and the harder it will be to find substitute markets and suppliers. However, the more successful an embargo, the greater will be the profits to breaking the embargo. The policing of an embargo may therefore be critical to its success, and embargoes of trade in widely traded “anonymous” goods such as grain and oil are less likely to be successful than, say, an embargo on the export of supercomputers. On this basis one can justify the Reagan administration’s removal of the grain embargo and at- tempted imposition of a pipeline embargo; though from the point of view of gathering political support in Western Europe, the policy com- bination may have been less than ideal. These arguments are based on a view of markets as being sufficiently competitive for prices to be close to marginal cost. In imperfectly competitive markets, price may often be significantly above marginal cost. This raises the possibility that an embargo will have the extra cost for the embargoing nation of eliminating trade on which abnormal profits were being made, and in the case of high-technology trade this may be a significant consideration. Such considerations certainly in- 159 East-West Trade, Embargoes, and Expectations fluence the behavior of individual firms, including their lobbying behavior. All of the analysis above confirms the view expressed in the 1983 report made by the U.S. Congress’s Office of Technology Assessment, which observes that there are severe constraints on the power of U.S. licensing to deny the Soviet Union access to the Western technology it most wants. These constraints include the extent to which the Soviets use illegal means to acquire Western technology, lack of allied agreement on a more strenuous multilateral export control policy, the difficulties inherent in identifying in advance which technologies will have im- portant military payoffs, and the increasing worldwide diffusion of technology. While existing export criteria could certainly be tight- ened, it is most improbable that even drastic changes in U.S. export control policy could alter the fact thut the USSR benejits militarily from Western technology. Moreover, it is rare to find examples of technologies obtained from the West which the USSR could not have produced itself, albeit with delays. (Pp. 11- 12, emphasis in original.) Finally, the difficulties of making an empirical assessment of the effectiveness of embargoes should be noted. There was clearly no prospect whatsoever that the 1979 grain embargo would induce the Soviet Union to withdraw its military forces from Afghanistan, but that leaves open the possibility that its future behavior in Afghanistan or elsewhere could be affected. Also, an embargo may be the most ef- fective means available of making a strong moral statement (though an embargo that was known to be both wholly costless and wholly inef- fective presumably could have no value as a moral statement). 6.2.3 Reputations and Expectations The Office of Technology Assessment report goes on to observe (in the context of extraterritorial and retroactive sanctions) that “sanctions may well have a long-term adverse effect on the U.S. reputation as a dependable business partner in countries other than the USSR” (59), but there is another sense in which the reputation of the United States matters. In the long run, as we saw above, a country has better op- portunities to avoid the effects of an embargo. It can do even better if it can anticipate the imposition of an embargo. Perfect anticipation is an unattainable objective, but any trading nation must make assess- ments of the likelihood of future trade disruption by an embargo. Thus when Hanson (1983) reports that the Soviet trade statistics in the 1970s seem to show a deliberate attempt to reduce reliance on Western technology but no attempt to restrain grain imports, one inter- pretation that can be offered (in addition to the reasons offered by 160 Alasdair Smith Hanson) is that Soviet policymakers may have been concerned about future attempts by the United States to use trade as a political lever and felt that their exposure to leverage was greater in the case of technology imports than in the case of grain. At first sight there is a contradiction in what one can oversimplify as the Western European position of being enthusiastic about linkage and unenthusiastic about leverage, for apparently these are two sides of the same coin. The gains from trade will be greater when trade shares are greater, when elasticities are larger, and when there are no alternative trading partners, so the circumstances in which economic relations create a strong interest in the maintenance of good political relations between the trading parties seem to be precisely the circum- stances in which a trade embargo will be effective. But this is to miss an essential difference between the two cases: linkage will be more successful, the greater the extent to which the trading partners’ ex- pectations are fulfilled; leverage will be more successful the greater the extent to which expectations are disappointed. On this interpretation, the difference between the United States on the one hand and the Europeans, both Western and Eastern, on the other, is not that one gives priority to political over economic consid- erations, but that the political and economic priorities of the Europeans call for settled and growing economic relations between East and West, while the Americans see dangers in this policy and attractions to the use of economic pressure for the attainment of specific political ends. The obvious conflict between linkage and leverage makes for diffi- culties for both positions. The American concern that West Germany may be making itself too dependent on Soviet energy would be taken more seriously if it had been more consistently expressed, but there is scope for genuine concern that West Germany would be vulnerable to a shift in Soviet policy in which the Soviet Union embraced a policy of leverage towards the Western nations, it having shown no reluctance to use leverage towards its allies and former allies (see Daoudi and Dajani 1983, chap. 4). American concern that investment by U.S. mul- tinationals in the Soviet Union would give a hostage to future Soviet pressure is less credible: it is hard to envisage circumstances in which an American administration would make serious political concessions to the Soviet Union because of a threat to expropriate American assets in the Soviet Union. The Soviet reaction to the Jackson-Vanik amendment and to the superphosphate embargo can be interpreted as a clear statement of the Soviet Union’s desire (and interest) that trade relations should involve linkage and not leverage, and in the superphosphate case, an indicator of its belief that the embargo would be ineffective and short-lived. But one must also be aware that increasing confidence in the stability of 161 East-West Trade, Embargoes, and Expectations trade relations strengthens the Soviet Union’s position should it reverse its policy. It is, however, for the American position that the conflicting needs of linkage and leverage pose the severest difficulties. For the embargo weapon to be most effective, it should be a weapon deployed by a country with a reputation for not deploying it. For linkage to be effec- tive, a country might want to bind itself to a policy of eschewing the embargo weapon even when it was tempted to use it-a “time- inconsistent” policy, in the current jargon. It is hard to escape the conclusion that the United States has contrived to attain the worst of all possible worlds by its apparent willingness to try to use economic leverage frequently, in circumstances when it did not have the support of its allies, and when for other reasons the leverage seemed unlikely to be effective. 6.2.4 The Role of Multinational Corporations The issue of the extraterritorial reach of American law over the foreign subsidiaries of American multinationals was at the center of the 1981-82 pipeline dispute with Western Europe. There is also the more general issue of how the activities of multinational corporations may be influenced by expectations of government behavior. Vernon (1971, chap. 7) reports that the desire to avoid government control over foreign activities is an important incentive for the multinationalization of economic activity. The prevalent theory of the multinational corporation (see Dunning 1979, or Ethier 1983, for example) is based on the ownership-location- internalization paradigm, and sees multinationality as the outcome of a decision by a firm to establish a foreign subsidiary rather than to supply a foreign market from exported home-country production or to license the firm’s technological knowledge to independent foreign pro- ducers. The decision not to export implies the balance of advantage lies in overseas location of production; the fact that overseas firms have not already taken over the market implies that the foreign firm has some ownership advantages such as superior technological knowledge; and the decision not to exploit the ownership advantage by licensing implies an advantage to internal as opposed to market transactions. Multinationality may therefore provide a most important channel through which expectations of future policy and reputations of gov- ernments change the effectiveness of economic leverage. The estab- lishment of a foreign subsidiary, or even the licensing of technology to an independent foreign firm, may not wholly remove a firm’s foreign transactions from the extraterritorial reach of its home government, but it certainly greatly reduces the power of the home government over the firm’s activities. A potential multinational, faced by choices of how