The globalization numbers game

Many many years ago when I was a recently minted assistant professor, I heard Gary Hufbauer tell an anecdote at a conference on international trade. A government economist is called in by his superior, who tells him "Look, I have to make a case for this policy in front of Congress, and I need a number real bad."  The economist responds, "well, I haven't done a proper analysis, so I can give you a real bad number." Perhaps it was a true story based on Gary's own government experience.

I am reminded of this story by Mark Thoma's post, which focuses on the magnitude of the gains from globalization. He says "there's something important that's generally missing from the attacks on globalization's supporters, actual evidence."  He refers to a Bernanke speech and at length to a paper which Bernanke cites by Bradford, Grieco, and Hufbauer (yes, the same Hufbauer). The Bradford et al. study argues that removing all remaining barriers to trade would raise U.S. incomes anywhere from $4,000 to $12,000 per household (or 3.4-10.1% of GDP). That is a whole chunk of change! Thoma writes:

Whatever the theory says, the evidence in this paper and the evidence more generally is pretty clear, globalization has large net benefits....

If you disagree that trade benefits the US overall, what are the problems with the econometric methodology used to produce these results or the results in other papers coming to similar conclusions? Saying the results must be wrong because they don't support your point is not an argument. What specifically in the data, estimation procedures, etc., do you think is problematic and leads to the wrong result? Are there other notable academic papers that come to different conclusions? If so, what is the source of the difference in the estimates? Is it the data, the estimation technique, the theoretical assumptions, or what? Help us to understand why we should be doubtful about the results Bernanke cited, or about the results of other papers reaching similar conclusions.

As Thoma says, we cannot dismiss "evidence" just because we disagree with it. In my own research, I have invested considerable amount of effort scrutinizing existing empirical work on trade and growth (see this in particular). And while I would not quarrel with the assertion that globalization increases the size of the pie for the U.S., I do have a big quarrel with the kind of numbers presented by Hufbauer and company. They seem to me to be grossly inflated. Let me take up Thoma's challenge and explain why.

First a reality check. The standard partial equilibrium formula for calculating the gains from moving to free trade is 0.5 x [t/(1+t)]^2 x m x e, where t is the tariff rate, m is the share of imports in GDP, and e is the (absolute value of the price elasticity of import demand).  In the U.S.  average tariffs stand in low single digits and imports are less than 20% of GDP. There is no way of tweaking this formula under reasonable elasticities that would get us a number anywhere near the Bradford et al. estimates. For example, using the generous numbers t = 0.10, m = 0.2 and e = 3, the gains from moving to complete free trade are a meager 0.25% of GDP (compared to Bradford et al.'s lowest estimate of 3.4% of GDP).

Now of course this is a back-of-the envelope calculation, and in particular it ignores general-equilibrium interactions--both across sectors within the U.S. and among countries.  What if we take those into account? There is a cottage industry of computable general-equilibrium models which attempt to do just that. Using these models, we can perform multi-sector, multi-country variants of the simple calculation above. The most accomplished work along these lines takes place at the World Bank and at Purdue.  A representative recent estimate comes in a paper by Anderson, Martin, and van der Mensbrugghe--hardly a bunch of rabid anti-globalizers. Their bottom line for the U.S.: full liberalization of global merchandise trade would eventually increase U.S. income by 0.1% by 2015 (see their Table 2). No, you did not read that wrong. The gain amounts to one-tenth of one percent of GDP!  (And the bulk of it comes not from the liberalization in the U.S., but from the terms-of-trade effects of other countries' liberalization.) Is this number right?  I have no clue. But at least it passes the test that it is consistent with first principles.

So how come Bradford et al. get wildly different numbers? Some of the difference is due to Bradford et al.'s attempt to take into account liberalization in services as well as in merchandise trade. But that is only a small part of the story. The real action is in the non-standard methodological choices made by Bradford et al.--choices which are designed to generate large numbers.

Bradford et al. report three different methods of arriving at their estimates. One is based on a University of Michigan computable general-equilibrium model with increasing returns. As I have already discussed (see point 5 in this post), increasing returns greatly enlarge the range of possibilities from trade opening. You can easily magnify the gains from trade, as well as produce losses, depending on how you build your model. The model Bradford et al. rely on is designed to do the former (surprise, surprise!). The results are entirely model-driven, and it is hard to see how they could count as "evidence."   

The second approach is based on estimating the gains from price convergence. The basic idea is that removing remaining restrictions on trade in goods and services should equalize prices at home with those abroad (making due allowance for transport costs). The difficulty with this is that the bulk of these price discrepancies today arise not from trade restrictions per se, but from jurisdictional discontinuities  that arise from differences in legal regimes, regulatory systems, and currency arrangements across countries. If you want to believe that globalization will yield full price convergence, you must also believe that it is practical and desirable for the U.S. to harmonize its laws and regulations with those of its trading partners and to join a currency union with them. (To imagine what this might look like, you may want to think of the contortions that the EU is going through--with its common currency, European Court of Justice, 80,000-plus pages of regulations, and huge inter-regional transfers--in order to achieve a "single market" on a much smaller scale and among an already like-minded set of countries.)

The final calculation is based on an econometric estimate by Andy Rose of how much a regional trade agreement raises the volume of trade. At least that's what Bradford et al. say. When I checked out Rose's paper, I could not find the number that Bradford et al. use. (Rose says "belonging to a regional trade agreement raises bilateral trade by (exp(1.17)-1»)222%," whereas Bradford et al. use 118%, without explanation). In any case, Rose explicitly discounts his own estimate (pp. 9-10), saying that it is too large to be credible and too large by the standards of other findings in the literature.

I don't really mean to pick on Bradford et al. (although as a particularly egregious example, their paper fully deserves it). But as Thoma rightly says, we can move the discussion forward only when we present specific critiques of the work out there that disagrees with our own conclusions. So consider this an exercise in that vein.

What puzzles me is not that papers of this kind exist, but that there are so many professional economists who are willing to buy into them without the critical scrutiny we readily deploy when we confront globalization's critics. It should have taken Ben Bernanke no longer than a few minutes to see through Bradford et al. and to understand that it is a crude piece of advocacy rather than serious analysis. I bet he would not have assigned it to his students at Princeton. Why are we so ready to lower our standards when we think it is in the service of a good cause? 

Come to think of it, did I not write about this earlier?

Comments

[jon]

First you say

"...I would not quarrel with the assertion that globalization increases the size of the pie for the U.S.,..."

Then you appear to support an estimate of

"...increase U.S. income by 0.1% by 2015..."

which is nothing more than a rounding error, in my opinion.

Do you believe that globalization increases the size of the pie or do you think that international trade effectively amounts to a zero sum game?

[jon]

Oh, and an interesting note is that while

(exp(1.17)-1) ~=222%

a simple misreading could result in

exp(1.17 - 1) ~=118%

[dissent]

Wow. I'm not an economist, I just read the blogs. I had no idea the case for free trade is so flimsy. And for this we are losing our shirts? A scandal!

[gallagher]

Rodrik is indeed right regarding the estimates of the gains from trade that come from the most established CGE models. What's more, these models also estimate that the Doha Round will do very little to alleviate poverty around the world. For a user's guide to these models and the estimated impacts of the Doha Round see:
http://www.ase.tufts.edu/gdae/Pubs/rp/PB07-02WTOPovertyApr07.pdf

[Dean Baker]

very nice piece, you saved me the trouble of having to read through this tripe.

[Pancho Villa]

In your paper you said that "an increase in the tariff has the effect of allocating more of the economy's labor to the manufacturing sector; dn/dτ > 0"

This would then normally also imply "higher" inflation in the agricultural sector...

[notsneaky]

Isn't the flip side of the "trade doesn't increase GDP that much" argument that
"trade doesn't have that much of the effect on the distribution of income"?

[unlawflcombatnt]

Thanks for posting this and the posting the link to the study. As you've stated, it appears that the potential gain to U.S. income from full trade liberalization by 2015 is only 0.1%. This number is shown in at least 3 of the tables- Table 2, Table 6, and Table A5. From Table 2, the real income gain for the United States by 2015 would be only $16.2 billion. (For comparison, the annual budget for the state of California is $100 billion.) The "alternate" scenarios show an even smaller U.S. income gain, ranging from only 0.01% to 0.05%. Worldwide, the total estimated income gain from total liberalization of trade was only +0.7%.

Table A-7 shows that U.S. (non-food) merchandise exports would DECLINE by $10 billion by 2015 with full global trade liberalization. (Just what our declining manufacturing sector needs-an agreement that will cause further declines).

As best as I can tell from the charts, U.S. tariffs are lower than any other country in the world (Though I'm not completely sure I read the charts correctly on this.)

The authors' conclusion reads "In conclusion, the July Framework Agreement does not guarantee major gains from the Doha Development Agenda. On the one hand, even if an agreement is ultimately reached, it may be very modest...."

"Modest" indeed. For the United States, the benefit is essentially 0.

The microscopic alleged "benefits" to full trade liberalization certainly don't seem worth the massive increase in income inequality they'll cause. And this is assuming that there's actually any benefit at all.

[Adam]

Dani,

If you think that's bad, you should see Hufbauer's pre-NAFTA NAFTA-related employment forecasts. Talk about making up numbers: http://bookstore.petersoninstitute.org/book-store/70.html

[Dani Rodrik]

Adam --

You are indeed right. I had referred to the study you mention in earlier post. See my post on "Can the Wrong Answer in the Classroom be the Right Answer in Public Debate?"

[notsneaky]

"The microscopic alleged "benefits" to full trade liberalization certainly don't seem worth the massive increase in income inequality they'll cause."

Will they? This is pretty much wrong. If the benefits of full trade liberalization are microscopic then the inequality effects are microscopic as well.

If .5[t/(1+t)]^2*m*e are the benefits of trade then the change in producer surplus (roughly the loss to the loosers of trade liberalization) is going to be pretty similar, except that it depends on the elasticity of supply rather demand. Essentially, in order to argue that trade has profound distributional effects for an economy like US, you have to argue that the supply elasticity is very very large, much larger than the e=3 elasticity of demand Dani uses above.

There's very little of a way out in escaping the conflict here. Either free trade has large aggregate benefits and significant impact on distribution/inequality, or it doesn't much affect either. For a large, diverse, mature, developed economy like US I'd argue the latter is the case.

If we're going to present the case for free trade honestly - noting all the caveats and being up front about the magnitude of the gains - then the same thing should be done for its impact on distribution.

[Ben]

Thanks for an interesting post. I think I can see where the 118 percent cited by Bradford et al came from.

Rose estimated three benchmark models, with three associated regional FTA coefficients: 1.17, 0.78, and 0.91 (Table 1).

Bradford et al used the smallest of these - 0.78. Their calculation is 100*(exp(0.78)-1) = 118 percent (in footnote 60)

Bradford et al actually reduce the 118 percent by 25% to to 89 percent to account for trade diversion (page .

[DRR]

One of the authors have of course, already responded to your critique, but my larger point is towards the autarkists in in the thread poo-pooing the supposed minimal benefits of America fully liberalizing trade.

Doing this of course while failing to understand that, even given such low estimates for argument's sake, the reason why the proposed gains from further liberalization are so small is because America is already a very open economy with extremely low trade barriers that, as Prof. Rodrik has previously demonstrated, has already reaped most of the benefits to be realized from trade liberalization.

Put more succinctly, the more & more you liberalize your markets, the less & less benefit you reap from further liberalization as you have less far to go. The benefits the U.S. would derive from reducing an average tariff rate of 5% (already the lowest in the world) to 0%, is not going to be that large.

Comparatively, the benefits reaped from past liberalizations over the last 60+ years, In which the average tariff rate was unilaterally reduced from nearly 35% to under 5%, the same time period in which all GATT countries collectively reduced their tariffs an average of 17% per negotiating round (8 different rounds) experienced the same affect. The largest gains from liberalization occured roighly between Eisenhowers 2nd term & Carter's first.

Of course, this is obvious to any economist but worth reiterating for the benefit of autarkists arguing in bad-faith.

[Dani Rodrik]

notsneaky says:

"'The microscopic alleged "benefits" to full trade liberalization certainly don't seem worth the massive increase in income inequality they'll cause.'

Will they? This is pretty much wrong. If the benefits of full trade liberalization are microscopic then the inequality effects are microscopic as well.

If .5[t/(1+t)]^2*m*e are the benefits of trade then the change in producer surplus (roughly the loss to the loosers of trade liberalization) is going to be pretty similar, except that it depends on the elasticity of supply rather demand. Essentially, in order to argue that trade has profound distributional effects for an economy like US, you have to argue that the supply elasticity is very very large, much larger than the e=3 elasticity of demand Dani uses above.

There's very little of a way out in escaping the conflict here. Either free trade has large aggregate benefits and significant impact on distribution/inequality, or it doesn't much affect either. For a large, diverse, mature, developed economy like US I'd argue the latter is the case."

Not so fast notsneaky! Actually, the distributional effects can be quite large even though net gains are small. Lets consider a small change in the tariff, t. Then change in producer surplus is Q(dp/dt), while net gain is t(dM/dt) = t(dM/dp)(dp/dt). You can easily check that the first can be arbitrarily large relative to the second by making initial level of t sufficiently small.

[rifek]

Perhaps I'm just thick. No, I AM just thick. Nevertheless, I think notsneaky's post is an example of why reality is reality, models are models, and one should not be confused for the other, because with reality you get what you get, while with models you get what you select for.

The SPE formula selects for certain trade elements but ignores other, very real factors that any policy maker should pay attention to, such as workforce dislocation, exporting of jobs, costs of resulting losses in social infrastructure, etc. Consequently, even if the $12,000 figure were correct, it tells us nothing about the actual distribution of the increase; the distribution could be so uneven as to create a socially and politically disastrous concentration of wealth.

Basing comprehensive policy on such an incomplete model is akin to the man who drowns wading across the river because its average depth is four feet.

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Dani,
The estimates of gains from trade based on CGE models have several drawbacks. To begin with, they do not consider the possibility of X inefficiency. There is plenty of evidence that upon liberalization there are significant gains in productivity. Then there are all the Parente-Prescott stories about monopoly power. We do not have to believe with a straight face on everything Prescott claims, yet there is something on their story about the effects of monopolies.

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