Does the removal of trade barriers increase trade? Does trade increase income? These questions are crucial for thinking about the impact of trade liberalisation and yet they are extremely difficult to answer. Ever since Smith and Ricardo, economists have firmly believed that trade increases income. The correlation between trade and income at the country level has been extensively documented (Sachs and Warner 1995, Dollar 1992 and Edwards 1998), but it is hard to know whether trade increases income or income increases trade. Perhaps wealthy countries trade more because high incomes simply lead to a taste for foreign goods.
Frankel and Romer (1999) attempt to establish causality from trade to income by exploiting geography. Country pairs that are physically near each other tend to trade more than country pairs that are far apart. The difficulty with this approach is that the relationship between distance and trade may reflect many factors other than trade costs. Countries that are near each other may share common tastes or historical relationships that lead to more trade even if trade costs were eliminated. Blum and Goldfarb (2006) find that distance effects are substantial even for goods consumed over the internet such as music and games. This suggests that there is more to the distance-trade correlation than simple trade costs. Since distance between countries is constant over time, historic patterns of economic activity play a large role even as trade costs have declined.
New findings based on a natural experiment
I exploit a temporary shock to distance – the closing of the Suez Canal between 1967 and 1975 – in order to eliminate these historic effects and isolate the impact of modern changes in trade costs.
On 5 June 1967, at the beginning of the Six Day War, Egypt closed the Suez Canal. The closure was sudden and unexpected – fifteen cargo ships known as "The Yellow Fleet"' were trapped inside during the closure. At the end of the war, the Egyptian and Israeli armies were stationed on either side of the canal and the prospects for reopening were very uncertain. The canal remained closed until the end of a second conflict – the Yom Kippur War – and subsequent peace negotiations, eight years later.
The Suez Canal provides the shortest sea route between Asia and Europe and currently handles about 7.5% of world trade. The closure of the canal was a substantial unexpected shock to world trade that appeared at the time to be permanent. For some pairs of countries the increase in distance was substantial. Figure 1 illustrates the distance increase caused by the closing of Suez. The distance between Mumbai and London is roughly 6,200 nautical miles using the Suez Canal and 10,800 nautical miles taking the longer route around the Cape of Good Hope.
Figure 1. Mumbai to London – the Suez Canal versus the Cape of Good Hope
Figure 2 shows the path of bilateral trade from 1959 to 1984 for the 79 county pairs with distance increases of over 50%. For these pairs, the closure caused an average fall in trade of over 20% with a three to four year adjustment period. Trade between these pairs recovered completely after the canal reopened eight years later with a similar adjustment period. A 10% decrease in ocean distance results in a 5% increase in trade. The responsiveness of trade to changes in trade costs suggests that lowering trade barriers leads to increases in trade volumes.
Figure 2. The fall in trade caused by closing Suez
Note: Average bilateral trade residuals for country pairs with distance increases of over 50%. Residuals from a regression with country pair and year dummies. Source: IMF direction of trade database, author's calculations.
The aggregate effect on trade was substantial for countries that relied on the Suez Canal for a large portion of their trade. Particularly hard hit were countries in South Asia and East Africa. Pakistan and India had a trade-weighted average increase in sea distance of roughly 30% during the closure. Table 1 lists some of the countries experiencing average distance increases of 5% or more.
Table 1. Trade weighted increase in sea distance from Suez closure
Do changes in trade volumes have an impact on income?
The movements in trade caused by the closure of the canal provide a natural experiment for answering this question. The results suggest that every dollar of increased trade raises income by about twenty-five cents. These income increases occur relatively quickly, reaching a new level four to five years after the shock.
Moreover, the closure of the canal caused movements in trade that are unconnected to income for most countries and thus the causality clearly runs from trade to income and not the other way around.
Increases in trade volumes appear to lead to higher income. Because the variation in trade is coming through changes in sea distance, these results are specifically about trade that goes by ship. The shocks isolate the impact of trade in goods and rule out many country interactions that are affected by distance, such as movements of people between countries or trade in services. The changes in trade costs that were generated by the closure of Suez therefore are more directly analogous to changes in policies such as tariffs that affect the costs of trade between countries. These results provide clear evidence that lowering trade barriers leads to higher trade volumes and higher incomes.
Blum, Bernardo S. and Avi Goldfarb (2006), “Does the internet defy the law of gravity?” Journal of International Economics, 70 (2): 384-405.
Dollar, David (1992), “Outward-Oriented Developing Economies Really Do Grow More Rapidly: Evidence from 95 LDCs, 1976-1985,” Economic Development and Cultural Change, 40 (3): 523.
Edwards, Sebastian (1998), “Openness, Productivity and Growth: What Do We Really Know?” The Economic Journal, 108(447): 383-398.
Feyrer, James (2009), “Distance, Trade, and Income – The 1967 to 1975 Closing of the Suez Canal as a Natural Experiment,” NBER Working Papers 15557
Frankel, Jeffrey and David Romer (1999), “Does Trade Cause Growth?,” American Economic Review, 89(3): 379-99.
Sachs, Jeffrey D and Andrew Warner (1995), “Economic Reform and the Process of Global Integration,” Brookings Papers on Economic Activity, 1, 1–118. 4