Most countries trade more on international markets today than ever before – both in absolute terms and as a proportion of their national output. How can we explain this phenomenal increase in international trade over the past few decades? Will the recent rise in oil prices reverse this trend of globalisation?
History provides us with a natural comparison. Beginning in the nineteenth century, the world saw a remarkable rise in international trade that came to a grinding halt during World War I and later on in the wake of the Great Depression. This “first wave of globalisation” from about 1870 until 1913 led to a degree of international integration – measured by trade-to-output ratios – that many countries only achieved again in the mid-1990s.
Taking a comparative perspective, we juxtapose the first wave of globalisation from 1870 to 1913 and the second wave after World War II. We also study the retreat of world trade during the interwar period from 1921 to 1939. We are interested in the driving forces behind these trade booms and trade busts. Was it changes in global output or changes in trade costs that explain the evolution of international trade?
To answer that question we set up a gravity model of international trade. This model borrows Isaac Newton’s insight that the gravitational force between two planets in space is inversely related to their physical distance. Instead of planets, we consider countries whose “gravitational force” is the amount of their bilateral exports and imports. Instead of physical distance, bilateral trade is impeded by trade costs such as transportation costs, tariffs and language barriers.
The innovation of our approach is to model these trade costs in a micro-founded way and to obtain an analytical general equilibrium solution for these trade costs based on the well-known gravity model of James Anderson and Eric van Wincoop (2003). (Also see Novy, 2008.) We then take the model to the data, inferring international trade costs from observed output and trade data for the United States, the United Kingdom, France and 18 of their trading partners for the period 1870-2000.
Trade booms and trade busts
Our results show that international trade costs dropped much faster during the first wave of globalisation up to World War I than during the second wave after World War II. The average level of trade costs for the countries in our sample fell by 23% in the 40 years before World War I. But from 1950 to 2000 average trade costs only fell by 16%. For the same countries, we find that the average level of trade costs increased by 10% in the 20 years from the end of World War I to the beginning of World War II.
Figure 1a: Trade cost indices, 1870-1913 (1870=100)
Figure 1b: Trade cost indices, 1921-1939 (1921=100)
Figure 1c: Trade cost indices, 1950-2000 (1950=100)
What are the factors underlying these trade costs? Our evidence suggests that the determinants that matter most for explaining trade costs are standard factors like geographic distance (which is a rough proxy for information and transportation costs), trade policy and tariffs, adherence to fixed exchange rate regimes, and membership in the British Empire or Commonwealth. In particular, the technological breakthrough and spread of the steamship in the course of the nineteenth century is associated with increased international trade, as is the spread of container shipping from the 1960s.
Comparing two waves of globalisation
On the surface, the percentage growth in trade volumes is roughly comparable in the two waves of globalisation (at 400% and 471%, respectively). But since trade costs dropped faster during the first wave, they are also more important in explaining the growth of trade in that period. From 1870 to 1913, falling trade costs account for over half of the growth in international trade, while the rest is explained by secular increases in output. But from 1950 to 2000, falling trade costs account for only a third of trade growth.
In explaining the trade bust of the 1930s, the role of trade costs is dominant. Based on output growth alone, we would have expected world trade volumes to increase by nearly 90%. The fact that they declined by 13% highlights the critical role of the general tariff hike during the Great Depression and the collapse of the Gold Standard.
How much will rising oil prices dampen trade?
In their survey of trade costs, Anderson and van Wincoop (2004) find that the tariff equivalent of international trade costs is about 74%. Transport costs only make up a third of these trade costs. The rest consists of border-related costs such as informational barriers, tariffs and red tape. Even if oil prices directly feed through to transport costs, the impact on overall trade costs is limited.
But we should expect a change in the composition of trade. As David Hummels, Jun Ishii and Kei-Mu Yi (2001) and Yi (2003) have shown, the increase in the length of international production chains has contributed a sizeable amount to the growth of international trade flows. Many companies use imported inputs in producing goods that are exported. We might see a slowdown in such “back-and-forth trade” for heavy and bulky goods that are costly to transport such as steel. For example, earlier this year IKEA opened its first furniture factory in the United States. But overall, history gives us little reason to expect a sharp and fundamental reaction of international trade in response to changes in transportation costs.
Shipping costs before World War I
Historical evidence also suggests that shipping costs are endogenous. David Jacks and Krishna Pendakur (2008) use data on over 5000 maritime shipping transactions between 21 countries in the period from 1870 to 1913. Over that period maritime freight rates fell on average by 50% due to the spread of the steamship and general productivity growth in the shipping industry, and global trade increased by roughly 400%. But freight rates might be driven by bilateral trade, as they are partially determined by import demand. In the short run, increases in import demand could interact with capacity constraints in the shipping industry to create higher freight rates. To address this simultaneity, Jacks and Pendakur (2008) use shipping input prices and weather conditions on major shipping routes as an instrumental variable. Overall, they find that there is little systematic evidence to suggest that the maritime transport revolution was a primary driver of the late nineteenth century global trade boom. Rather, the most powerful force driving the boom was the secular rise in incomes across countries.
In this view, the key innovations in the shipping industry were induced technological responses to the heightened trading potential of the world. Strong income growth in the late nineteenth century caused high demand for foreign goods. As a consequence the shipping industry had a strong incentive to increase its productivity and exploit new technologies such as steamships, iron hulls and the screw propeller, ultimately leading to lower shipping costs. In a similar vein, Marc Levinson (2006) shows that the movement towards containerisation of the world mercantile fleet was strongly conditioned upon agents’ expectations of commercial policy in light of attempts to re-establish the pre-World War I international economic order.
Protectionism and trade costs
Instead of transportation costs, the biggest reversal of international trade in recent history is linked to large increases in protectionist measures. The Great Depression marked the most dramatic increase in trade costs over the last 130 years. Trade costs jumped on average by 18 percentage points in the space of the three years between 1929 and 1932. This corresponds exactly to the well-documented rise of protectionist trade policy during that period.
What does our research say about the future of world trade? Compared with historical patterns, the level of bilateral trade costs is still high for many country pairs, especially for those that are far away from each other. This means that there is scope for trade costs to fall further. Unless there is a backlash in the form of rising protectionism, world trade has the potential to keep growing strongly over the coming decades.
Anderson, James; van Wincoop, Eric. “Gravity with Gravitas: A Solution to the Border Puzzle.” American Economic Review 93(1), March 2003, pp. 170-192.
Anderson, James; van Wincoop, Eric. “Trade Costs.” Journal of Economic Literature XLII, September 2004, pp. 691-751.
Hummels, David; Ishii, Jun; Yi, Kei-Mu. “The Nature and Growth of Vertical Specialization in World Trade.” Journal of International Economics 54, 2001, pp. 75-96.
Jacks, David; Meissner, Christopher; Novy, Dennis. “Trade Costs, 1870-2000.” American Economic Review 98(2), Papers & Proceedings, May 2008, pp. 529-534.
Jacks, David; Pendakur, Krishna. “Global Trade and the Maritime Transport Revolution.” National Bureau of Economic Research Working Paper No. 14139, June 2008.
Levinson, Marc. The Box: How the Shipping Container Made the World Smaller and the World Economy Bigger. Princeton University Press, 2006.
Novy, Dennis. “Gravity Redux: Measuring International Trade Costs with Panel Data.” Working Paper, Warwick University, 2008.
Yi, Kei-Mu. “Can Vertical Specialization Explain the Growth of World Trade?” Journal of Political Economy 111(1), 2003, pp. 52-102.