Commodity exports and the adding up problem in developing countries : trade, investment, and lending policy

Multilateral development banks, including the World Bank, have advocated free trade policies for developing countries, including free trade in commodities. But although free trade in commodities maximizes world welfare, it does not maximize income or welfare for countries with power on the world market (such as Brazil for coffee and Cote d'Ivoire for cocoa). If the reference group selected is developing countries as a whole, or the coffee or cocoa producing countries, free trade is not optimal for those commodities. Multilateral development banks that have supported the coffee and cocoa agreements in the past recognize this. The World Bank has imposed lending restrictions on coffee, cocoa, tea, and sugar for feat that added investments would result in lower terms of trade and lost income. Given that free trade is not optimal and that some restrictions on output and investment might be desirable, the author addresses the following issues: What policy should commodity-producing countries pursue? What advice should multilateral banks offer about trade and investment policy? And what lending policy should multilateral banks pursue? The following principles guide the authors analysis: (a) The fact that a country has power on the world market for a specific commodity does not mean that it should not proceed with general reform. The theory of the second-best says that distortions should be attacked at the source. So countries should proceed with stabilization and trade and domestic liberalization policies and should apply optimal export taxes to those commodities in which they have market power; and (b) In their advice on trade and investment policies, and in their lending policies, multilateral development banks should not use a country-by-country approach but should take spillover effects and strategic interactions into account.