Environmental reforms which in a closed economy would benefit the environment and increase welfare may have the opposite effect in the presence of international trade. These unintended consequences are likely where the reforming country begins with a higher level of environmental protection. In that case, environmental reform might be counterproductive in an open economy.

In our two-country model there exists a single environmental distortion in each country. Under autarky, a reform which reduces the domestic distortion improves a country's welfare. With trade, there are two relevant distortions. The theory of the second best alerts us to the possibility that reform in one country, i.e., the reduction of its distortion, does not necessarily increase welfare in either country.

Economists usually argue against harmonization of environmental policies for local pollution problems. The basis for this position is the belief that differences in policies reflect differences in tastes, technology, or endowments. This argument against harmonization disappears if policy differences are caused by cross-country differences in market failures.

Differences in market failure, like differences in technology or factor endowments, can cause international trade. When environmental reform occurs in the country which initially has a smaller environmental distortion, the difference between the countries increases. To the extent that trade is driven by this difference, trade is also likely to increase, and the welfare effects of reform are ambiguous.

We use a general equilibrium model to compare the short and long run effects of environmental reform in open and closed economies.

In open economies, relative distortions across countries, in addition to absolute distortions, are important. In the short run harmonization can improve welfare even if it involves lowering standards in one country ("downward harmonization"). Dynamic analysis provides an important reason for preferring upward to downward harmonization. Non-negligible changes in policies can have dramatic effects in economies with multiple equilibria. Upward harmonization increases the chance of arriving at a high steady state. Downward harmonization, despite the fact that it may have identical instantaneous (aggregate) effects, can reduce the chance of arriving at a high steady state.

Increasingly open markets requires that environmentalists adopt a global perspective, even for local pollution problems. It is important to compare the benefits of investing, in different countries, resources that promote reform. Reform in the most highly distorted economies decreases both absolute distortions and differences in distortions. Therefore, lobbying for reform in these countries may have the highest environmental payoff, even if reform is more difficult to achieve there. Developing countries sometimes advise environmentalists to put their own house in order before attempting to export environmental reform. This is bad advice, especially from the standpoint of developing nations likely to have relatively serious environmental distortions.

We also study the relation between the goals of improving the environment and reducing unemployment. In the short run the two policy goals may conflict, but in the long run they are compatible when increased environmental stocks increase the demand for labor.