"Globalisation and the Costs of International Trade from 1870 to the Present"

Will the rising price of oil reduce international trade as some have suggested? According to this research, which uses a gravity model of international trade to answer the question, the answer is no, "only protectionism would seriously threaten trade":

Globalisation and the costs of international trade from 1870 to the present, by David Jacks, Christopher M. Meissner, and Dennis Novy, Vox EU: 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?

Gravity redux

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.

References

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.

Comments

[hari]

..."Unless there is a backlash in the form of protectionism, world trade as the potential to keep growing strongly over the coming decades."

In principle, this a sound judgement based on historical evidence.

In 1973-74 we noticed the bunker fuel cost on shipping lines escalating and making transport cost not only expensive but unpredictable. It was a very difficult phase in which to contain trade costs simply because of the cartels monopoly on oil prices.

The situation today is not the same because we've seen how, for example, consumers have managed oil prices at almost five times the going price before the 70s inflation. Current EU unit prices are almost double what it is in US. Yet export trade is not (yet) constrained by transport cost.

Protectionism of one kind or another - in the form of NTBs - are the main culprits constraining global trade. Health issues are dominant when it comes to imports from mainland China, as volume and value of trade expands across the board.

So, from my perperspective, trade policy must focus on bringing the Doha Round to shore and give global trade developments a shot in the arm. It seems now that US and Indian disagreement on agri-subsidies...is breachable.

[hari]

spelling - *as* shld be *has*.

[Trance]

"for example, consumers have managed oil prices at almost five times the going price before the 70s inflation."

but this is done at the cost of diminishing discretionary income (which is worse in Europe than US). This discretionary income would otherwise go elsewhere in the economy. This money now goes into only one pocket, the oil industry.

[Bruce Wilder]

"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."

"the key innovations in the shipping industry were induced technological responses to the heightened trading potential of the world."

I think one would have to have a much better model of international trade, to sort this out reliably. Talking rather generically and bloodlessly about "the secular rise in incomes" seems almost a distraction.

What drives trade, international and local, are the productivity gains from specialization. These gains from specialization can rest on a variety of quite different bases. By focusing on "international" trade in particular, we are focusing on goods, where the productivity gains from specialization are extreme. In common parlance, there might be a monopoly of technical knowledge, extreme economies of scale or external economies, or a gift of nature, which can be exploited in only rare places. Not very many people will find it worthwhile to go more than a few blocks to get a haircut, even though most people will go to a professional barber or hairstylist. On the other hand, prospecting for oil in one's backyard, or refining it one's self, is rarely worthwhile. Nor do people go to a local craftsman for a television or cellphone.

The period, 1870-1913, marks the Second Industrial Revolution, a misnamed third or fourth phase of industrial revolution that began in Britain in the 18th century. Steamships were rather famously a central part of this phase -- their ability to keep to a schedule as important as their speed and capacity, and the ability to adapt them to more efficient means of carrying specialized cargoes (oil tankers, refrigerated ships, etc)

In addition, the industrial revolution was widening its geographical scope in three important respects. First, the industrial revolution was spreading out, to the Low Countries, Switzerland, France, the U.S. and Germany. After 1820, the industrial revolution was no longer occurring in one country only, and it was accelerating. Moreover, after 1870, the industrial revolution was involving more and more industries, moving from textiles and steam engines and railroads, to steel, oil, chemicals, electricity, with leadership often passing to countries other than Britain.

And, thirdly, as the industrial revolution drove economic growth, it drove demand for the fruits of the earth, sucking up everything from guano and bananas to copper and petroleum from distant places.

The ability to wrest enormous factor productivity gains from specialization was increasing markedly in both scope and depth. The number of products that could be affected, and the gains possible were rising markedly. If we recall the dictum that specialization is limited by the extent of the market, then we shouldn't be surprised to see the rise of national consumer markets in response to transportation and communication innovations: this is the period in which J. Walter Thompson invented magazine advertising (1877), and brandnames emerge, Nabisco (1901) and Coca-Cola (1886) and Lucky Strike (1871, 1907), Colgate toothpaste (1872) and Palmolive soap (1898).

Somehow, for me, "the secular rise in incomes" doesn't quite cover it.

If one is not going to be serious about analyzing what drives trade, I don't see how empty statements projecting that trends can continue really mean anything.

The right thing is to think seriously about distinguishing between the factors driving trade in commodities and fruits of the earth, and what drives trade in manufactured goods, and, finally, what drives trade in services. Underlying all of this is what drives specialization.

Peak oil implies no further gross increases in trade in raw petroleum. Similar considerations apply to many raw mineral products, like copper and zinc, and other commodities. Industrial development and rising population in the Persian Gulf will also result in more trade in petroleum products, as the expense of raw petroleum.

Peak oil also implies rising relative cost of jet fuel -- air travel is going to get more expensive, and with vacation travel to exotic places. (Recreational and business travel is a significant part of international trade.)

The kind of intense specialization, which yields enormous factor productivity enhancement, typically involves a coordination and control, which entails communication. Communication advances were important complements to the increasing speed and falling cost of transporation in 1870-1913, as well as now.

A useful analytical exercise might focus on whether falling communication costs, increasing capability imply more or less physical trade in goods. McDonald's, Toyota, IKEA, Lenovo -- are the limits to economies of scale of physical product in one place such that, say, all the corkscrews in the world should be made in one place?

Or, does falling costs of communication and control imply more widely distributed physical production of manufactured goods and less physical transport?

If we could leverage computers to design a washing machine plant, to flexibly build several different models or designs of washing machines, would we care to import washing machines from Sweden or Italy or China, and would they want to import washing machines from Benton Harbor, Michigan?

How does the financial interact with trade? If a country fails to invest in the production capacity to make and export goods and services in sectors where the gains in total factor productivity are greatest, how does that affect the terms of trade? Median incomes? If not "protectionism", what is an organizing principle for a national strategy? (Is there nothing more convincing that pieties about education, and taxcuts for plutocrats?)

[robertdfeinman]

Perhaps the analysis is backwards. The rise of highly efficient production produced an excess of manufactured goods (or at least the capacity to make them). This then led firms to seek markets elsewhere. Because of the efficiency trade costs were not enough to deter this trend.

As trade increased the efficiency of trade also improved and its costs dropped as well. The depression caused a loss of markets and trade dropped. The "protectionism" was a political attempt to fix something which was misguided effort, just like offshore drilling is the wrong fix now. The lack of markets caused a drop off in innovation so trade costs stopped dropping, then the wars intervened and destroyed productive capacity and markets.

In the latest round, the cycle has repeated, this time there has been a new set of innovations in IT and supply chain management and a corresponding rise in efficiency with containerization and high speed ships. Both these improvements have now stalled so other factors have started to become more important.

The response to this has been yet another set of political nostrums designed for their ear appeal to the public, rather than for their efficacy.

Just a conjecture...

[roger]

Huh, is this economics of numerology:

"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."

Wow, and this is considered serious economics! Why not borrow their model from, say, Revelations, where the antichrist - protectionists - put a bar code on their followers heads, with the bar code being legislation designed to discourage trade. It would make the same amount of sense.

This doesn't even achieve a low level of chicanery.

[dissent]

"overall, history gives us little reason to expect a sharp and fundamental reaction of international trade in response to changes in transportation costs."

The problem with this argument is that all prior history took place prior to peak oil. Transportation costs will be impacted by peak oil in a historically anomalous fashion.

says...

"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."

Of course ! Surely these guys aren't suggesting that the US hasn't had a favorable disposition to trade these last 20 years. What is interesting is how they blithely ignore the horrendous costs associated with our "new economic" model.

About the only thing I can agree with is that bad trade policy has horrendous costs and usually end up in great depressions or hot world wars.

[Tim]

A very funny cartoon on Newton on vadlo website!

[Bruce Wilder]

A friend points out to me that the peak oil hypothesis suggests that the price of the highest-quality -- light, sweet -- crude will rise relative to low-grade crude, and the highest energy content fuels will rise relative to less refined fuel stocks. Jet fuel is likely to be much more expensive, but the kind of asphalt + coal dust that fuels ocean-going cargo ships will not rise as much in cost.

Also, he points out that in the 1870-1913 period, although costs and rates were declining, the really revolutionary factors in shipping, driving innovation, were the remarkable reduction in transit times, the ability to schedule traffic (sailing vessels did not have reliable schedules), and things like refrigeration. Refrigeration and rapid, certain transit times, for example, enabled the banana trade. Distance and cost indices probably do not capture this dynamic.

[Lafayette]

Article: How can we explain this phenomenal increase in international trade over the past few decades?

Containerization. Period.

Look no further.

[Lafayette]

BW: Jet fuel is likely to be much more expensive, but the kind of asphalt + coal dust that fuels ocean-going cargo ships will not rise as much in cost.

Carbon taxes are intended to hit with an impact in proportion to the level of pollution emitted.

They could well change the trade-offs in play.

BTW: Diesel fuel is employed in the ocean-going ships, which are mostly cargo type.

[Lafayette]

anon: About the only thing I can agree with is that bad trade policy has horrendous costs and usually end up in great depressions or hot world wars.

Yes, well the last time that happened, Hitler was the result. Is that really a menacing alternative today? I think not.

The only real menace today is Chinese hegemony, particularly in the basic resources market. It has a ginormous appetite for raw materials and its going after them with a fury.

Beyond the self-glorifying Olympics, China has itself a huge imponderable .. what to do with its masses that long for a decent living just a tiny bit like those living in comparative luxury around the large manufacturing centers. China's Gini Index is ridiculously high, and they have to attend to that challenge ... or self-implode. And, Export Growth is not the solution for that problem.

This has lead to shortages and could even lead to confrontations. Still, the means to increase overall supplies has always been a technological factor, which is not Mission Impossible. (Except for petroleum, where the solution is a technological swap of the internal combustion engine for electric cars and/or fuel cells.)

The arguments and justifications for another "Trade War" are simply no where to be seen and even less likely to be taken in serious consideration.

[Real Person from the Real World]

I doubt there will be a trade war. Only a few certain items in any economy create a demand for protectionism, and as someone pointed out, to day, if you need certain resources, say ZINC or OIL for example, you have to get them from where they exist geographically, whatever the cost, unless you find a substitute. If you need a vital resource such as oil, discretionary spending will suffer, but you don't really need an item or can use substitutes you look for these alternatives from somewhere else. However, I do think that some corporations will re-consider the problem of resources being remote vs. resources closer at hand for other reasons. The rise in oil prices may make it less profitable to exploit cheap labor overseas, hence something once made "over there" in twenty different places may start getting made in twenty different other places, including locally.

[Bruce Wilder]

L: Diesel fuel is employed in the ocean-going ships, which are mostly cargo type.

Most ocean-going ships, today, use diesel engines, but, technically, consume what are termed, residual fuels. Hence, my reference to asphalt and coal dust, which is only a slight exaggeration. Residual fuels are what is left after most of the good stuff has been refined out of crude. It is typically a highly viscous sludge, that may have to be heated, enriched or diluted, to be used, but it is cheap. And, dirty.

Even the ships using medium-speed marine diesels typically consume fuels that wouldn't be

Carbon taxes and other measures to reduce pollution might well increase the cost of ocean transport.

My comment, though, was about the effect of "peak oil" -- reaching the ceiling on total output imposed by the marginal energy cost of additional petroleum extraction and refining.

Carbon taxes and pollution regulation will be a policy choice. The rising relative cost of high-grade fuels, implied by peak oil, is more nearly a fact of nature.

[Lafayette]

BW: Carbon taxes and pollution regulation will be a policy choice. The rising relative cost of high-grade fuels, implied by peak oil, is more nearly a fact of nature.

Indeed.

That policy choice has already taken place in Europe, which is, compared to the US, more fuel efficient. Carbon taxes are helping to reduce pollution since they make companies more concious of expedient usage of petroleum sources (whether as an energy source or a factor input to production, as in the plastics industry). (The taxes on petroleum products, throughout Europe, was already very high, which is why the average fleet mileage of European cars was better historically than that in the US.)

Another action, taken just three months ago, is also having its effect. It is the Pollution Tax on high cylindric capacity cars, introduced by France. The production of such "SUVs" has diminished considerably -- though, admittedly, the same is happening stateside.

The meaning of all this, I suggest, is the message that America's wanton use of oil as an energy source must stop is finally hitting home. And that the "policy choice" is likely to be a great deal more urgent than Americans, today, willingly realize.