The case for free trade

Cecília Hornok, Miklós Koren 07 May 2016

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There is increasing public resistance to free trade in the developed world. US presidential candidates on both sides have turned towards a protectionist narrative. Donald Trump would protect US jobs with a massive tariff on imports from China and Mexico. All leading candidates oppose the completed (but not yet ratified) Trans-Pacific Partnership (TPP) trade deal. Negotiations toward the Transatlantic Trade and Investment Partnership (TTIP) agreement between the US and the EU stalled on key issues and amid fierce public opposition, particularly in the EU. The UK is going to decide on its EU membership in June, risking damaging consequences for its trade relations (Dhingra et al. 2015).

Concerns about free trade and new trade deals have some merit. There is ample evidence showing that globalisation has increased inequality in both developed and developing countries (Goldberg and Pavcnik 2007, Ebenstein et al. 2014). Moreover, the impact on labour markets after trade liberalisation may have been costlier and slower than previously thought (Dix-Carneiro 2014).

We are, however, convinced that trade protectionism is the wrong answer to these problems. Like other advocates of free trade, we also believe that a return to protectionism would only jeopardise the already slow economic growth in the world economy and may eventually lead to trade wars. In making the case for free trade, we begin with a short overview of what we have learned about the gains and losses from globalisation in the context of the FP7 COEURE project (Hornok and Koren, 2016). Then, we point out the need for better understanding and addressing the problems of globalisation’s losers.

A positive-sum game

There is wide consensus among economists that, when taking countries as a whole, international trade is beneficial for all countries involved. A country that opens up to trade will enjoy an overall net welfare gain.

Evidence on the size of this net gain is mixed. Credible reduced-form estimates find it to be large. Feyrer (2009) measures the gain from a natural experiment. He looks at the closure of the Suez Canal between 1969 and 1975 to see how it affected countries’ trade flows and income. He concludes that 10% more trade increases per-capita income by 1.6%. Gains from trade estimated from general equilibrium models are more modest. According to such studies a typical country is only about 1-2% richer due to trade than it would be in complete isolation (Arkolakis et al. 2012, Costinot and Rodríguez-Clare 2014).

The welfare gains from trade may come from several sources.

  • First, countries gain from specialising according to their comparative advantage.

As a country sells whatever it produces more cheaply and buys whatever is cheaper abroad, the purchasing power of its consumers increases.

  • Second, free trade means firms can access a larger market, where economies of scale can be better exploited (Krugman, 1980).

The resulting cost efficiencies can transform into lower prices and more product varieties, which benefit consumers.

  • Third, with globalisation more competitive producers survive and grow, while others lose market share or go out of business.

This reallocation of resources toward the more productive firms increases aggregate productivity (Melitz 2003).

Firms can also gain from trade directly. They can access cheaper and/or better quality inputs abroad. Easy trade also makes firms able and willing to locate parts of their production in low-cost countries, which raises their profitability. Moreover, imported inputs or physical capital that represent higher technology than what is available domestically may trigger technological advance.

Importing also matters

It is worth emphasising the role importing plays in reaping the full gains from trade. Better access to foreign inputs has contributed significantly to higher firm productivity, as evidence from several – mostly less-developed – countries shows (Amiti and Konings 2007, Kasahara and Rodrigue 2008, Topalova and Khandelwal 2011, Halpern et al. 2015). The importing of production inputs is hence shown to be an important source of growth in a globalised world.

Using Hungarian data, Halpern et al. (2015) find that a manufacturing firm that increased its share of imported inputs from zero to 100% could raise its productivity by 24%. On the aggregate level they find that importing is responsible for more than a quarter of the observed productivity increase in the Hungarian manufacturing sector over the period 1992-2002.

A remarkable result of this study is that domestic input suppliers may not be hurt that much, either. The reason is that only half of the productivity gain is due to firms replacing domestic inputs with cheaper and/or higher-quality foreign ones. The other half comes from combining imperfectly substitutable domestic and foreign input varieties in the production.

Watch out for the losers

Almost any change in openness to global competition creates winners and losers. In the simplest textbook case a reduction in import tariffs makes consumers better off, while import-competing producers worse-off. Models of new trade theory also produce losers, not only winners. In Melitz-type models, a fall in trade costs in an economy benefits the more productive firms who can enter the foreign market, while it hurts the non-traders who have to compete with the traders for scarce production resources.

It is important to realise that these redistribution effects are not secondary to the aggregate gain from trade. Often it is precisely the redistribution that brings about the overall gain. As resources flow from less productive to more productive activities, the gains outweigh the losses. Countries open to trade, however, have both the means and the obligation to ease the burden on the losers of globalisation.

Recent research has shown that, contrary to the earlier assumption, the reallocation of workers from shrinking sectors to expanding ones is not frictionless. In fact, the switching costs are estimated to be huge, amounting to several years of wage income. (Artuç et al. 2010, 2015, Dix-Carneiro 2014). These costs fall disproportionately on unskilled, old, and female workers. The adjustment process after a trade liberalisation can also take a long time, in some cases more than a decade, as Brazilian evidence shows (Dix-Carneiro and Kovak 2015).

To reduce these negative labour market effects, we need to identify the losers and work out effective policy responses. Clearly, more work is to be done on this front. Recent research shows that targeted labour market policies are more effective than general ones (Davidson and Matusz 2006). A well-designed policy response is likely to involve elements of active labour market policies such as retraining programs and moving subsidies, which compensate for the switching costs and facilitate the migration of workers away from depressed regions (Coşar 2013).

The underlying work on which this column draws was produced as part of the COEURE project "COoperation for EUropean Research in Economics” funded by the European Union’s Seventh Framework Programme (FP7/2007-2013) under grant agreement n° 320300 (COEURE).

References

Arkolakis, C, A Costinot and A Rodríguez-Clare (2012), “New Trade Models, Same Old Gains?”, American Economic Review, 102(1): 94-103.

Artuç, E, S Chaudhuri and J McLaren (2010), “Trade Shocks and Labor Adjustment: A Structural Empirical Approach”, American Economic Review, 100(3): 1008-45.

Artuç, E, D Lederman and G Porto (2015), “A Mapping of Labor Mobility Costs in the Developing World”, Journal of International Economics, 95: 28-41.

Coşar, K (2013), “Adjusting to Trade Liberalisation: Reallocation and Labor Market Policies”, working paper.

Costinot, A, and A Rodríguez-Clare (2014), “Trade theory with numbers: Quantifying the consequences of globalisation”, pp. 197-261 of E Helpman, K Rogoff and G Gopinath (eds), Handbook of International Economics, vol. 4, Elsevier.

Dhingra, S, G Ottaviano and T Sampson (2015), “Should We Stay or Should We Go? The economic consequences of leaving the EU”, CEP Election Analysis Papers No. 022.

Davidson, C, and S J Matusz (2006), “Trade liberalisation and compensation”, International Economic Review, 47(3): 723–747.

Dix-Carneiro, R (2014), “Trade liberalisation and labour market dynamics”, Econometrica, 82(3): 825–885.

Dix-Carneiro, R, and B Kovak (2015), “Trade Reform and Regional Dynamics: Evidence from 25 Years of Brazilian Matched Employer-Employee Data”, NBER Working Paper 20908.

The Economist (2016), “Free Trade in America” Open Argument, Leader from the print edition.

Ebenstein, A, A Harrison, M McMillan and S Phillips (2014), “Estimating the Impact of Trade and Offshoring on American Workers using the Current Population Surveys”, Review of Economics and Statistics, 96(3): 581-595.

Feyrer, J (2009), “The 1967-75 Suez Canal closure: Lessons for trade and the trade-income link,” VoXEU.org

Goldberg, P K, and N Pavcnik (2007), “Distributional Effects of Globalisation in Developing Countries”, Journal of Economic Literature, 45(1): 39-82.

Halpern, L, M Koren and Á Szeidl (2015), “Imported Inputs and Productivity”, American Economic Review, 105(12): 3660-3703.

Hornok, C, and M Koren (2016), “Winners and Losers of Globalisation: Sixteen Challenges for Measurement and Theory,” Chapter 6 in Blundell et al. eds, Economics without Borders, Economic Research for European Policy Challenges.

Krugman, P (1980), “Scale Economies, Product Differentiation, and the Pattern of Trade”, American Economic Review, 70(5): 950-959.

Melitz, M J (2003), “The Impact of Trade on Intra-Industry Reallocations and Aggregate Industry Productivity”, Econometrica, 71(6): 1695-1725.

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Topics:  International trade

Tags:  globalisation, protectionism, free trade, economic growth

Postdoc Researcher, Kiel Institute for the World Economy

Associate Professor, Department of Economics, Central European University and CEPR Research Affiliate

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