Bad policy induces macroeconomic instability. In this way, poor governance entails
negative externalities for private transactions, and consequently raises transaction costs.
We can neatly extend the argument to international trade. Besides the effects of
exchange rate variability (see Frankel and Rose, 2002), the effects of governance on the
general business and investment climate are an extra concern for the political economy of
international trade. Still, little research has been independently targeted at the assessment of
the impact of institutions on international trade flows3. In a recent paper, Wei (2000)
suggests that the effect of good governance on transaction costs may be higher for
international trade than for domestic exchange. On the one hand, trade often requires
investing in long term business relations, while on the other hand trading partners in
international markets have more outside options. Because of the greater extent of
competition and higher uncertainty, explained by the incidence of multiple governance
systems in international markets, the impact of institutions on cross-border trade is more
pronounced. Moreover, the incentive to invest in good governance may then be higher in
countries that naturally seek to participate relatively intensively in international markets.
We may then expect a substantial positive relation between institutional quality and
international trade flows.
If institutions affect trade, this provides support for an additional link between
governance and economic performance4. Many studies have identified openness to
international trade as an important determinant of economic growth (e.g., see Frankel and
Romer, 1999). Trade relates positively to economic growth, since openness to international
trade enlarges the potential scale of the sales market and increases competitive pressures.
Both provide incentives for increased research and development. The intensity of
innovation is a key ultimate cause of economic growth, as argued in many new growth
theories5. Also, trade may increase the absorption of knowledge, through spillovers of
technology that are embodied in imports (Lejour and Nahuis, 2000). A positive relation
between trade and the quality of institutions is then particularly interesting.
If good governance is the underlying determinant for international competitiveness, it
may help us explain the missing trade mystery. Deardorff (2001) argues that international
competitiveness to a large extent depends on largely unobservable trading cost, instead of
Bilateral Trade Flows and Institutions