"Why Large American Gains from Globalisation are Plausible"

[This spends some time setting the stage by repeating past posts, if you want to skip to the new part - a defense of the gains from globalization from Gary Hufbauer and Matthew Adler of the Peterson Institute - click here.]

Awhile back, I issued a challenge:

In a recent speech, Federal Reserve Chairman Ben Bernanke said:

How important is [international trade] for the health of our economy to trade actively with other countries? As best we can measure, it is critically important. According to one recent study that used four approaches to measuring the gains from trade, the increase in trade since World War II has boosted U.S. annual incomes on the order of $10,000 per household (Bradford, Grieco, and Hufbauer, 2006). The same study found that removing all remaining barriers to trade would raise U.S. incomes anywhere from $4,000 to $12,000 per household. Other research has found similar results. ...

...You can read Dani Rodrik if you want to know "under what conditions will trade liberalization enhance economic performance?" ... Whatever the theory says, the evidence in this paper and the evidence more generally is pretty clear, globalization has large net benefits.

If you want to have this debate, fine, let's have it. But let's engage on a professional level... 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.

If you dig into a paper, you can always find its weaknesses. And it's important to do so because finding such weaknesses allows us to check to see if correcting the problems alters the conclusions. So please, have at it, take an honest look at the evidence and tell us why we should doubt this papers conclusions or the conclusion that trade is beneficial more generally, and help us to move things forward in our attempts to find the correct answers to these important problems. My own view is that the results from the papers in this area are very clear - trade is highly beneficial overall and it's the distribution of benefits and costs across individuals that's at issue - but I'm very open to well constructed arguments to the contrary....

Dani Rodrik took up the challenge:

[He] responds...:

The globalization numbers game, by Dani Rodrik: ...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... 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! ...

As Thoma says, we cannot dismiss "evidence" just because we disagree with it. ...[W]hile 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. ...

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. ... 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. ...

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?

...I can't say whether Bradford et al. intentionally made "non-standard methodological choices ... designed to generate large numbers" in order to sell their case rather than the choices they believe give us the best answer to the question. They will have to speak to that themselves. ...

I emailed the authors offering the opportunity to respond to Dani: Here's Paul Grieco's response:

Paul Grieco has has taken me up on the offer and his remarks are below. ...

Paul Grieco: ... Rodrik makes the very good point that the results that come out of any empirical research are heavily dependent on the assumptions that go in. .... We tried to document our sources and our assumptions as carefully as possible. Many of the points which Rodrik brings up are actually explicitly addressed in the text. We believe the assumptions that we made were reasonable...

I think Rodrik's critique fails to consider his own assumptions. Namely, he argues our numbers are too large, but fails to mention that his alternatives assume (rather than show) that a lot of the effects we try to capture don't exist...

Next there is the issue of CGE models. In our paper we do cite several CGE models (including one based on the GTAP model from Purdue), not just the one from the University of Michigan. Of course all of these models are built on a large number of assumptions. Having read the work, it is my belief that all of these researches take a lot of care in creating and documenting their models. The real learning comes from understanding how estimates change with changing assumptions. Rodrick seems to imply that a constant returns to scale model is a more realistic assumption, but I'm not sure why, since the world is full of examples of increasing returns to scale. For the record, Rodrick's preferred model omits services liberalization. Services are a huge part of the US economy today, so ignoring this sector must cause a downward bias. ...

And finally, the latest on the issue from Gary Clyde Hufbauer and Matthew Adler writing at Vox EU:

Why large American gains from globalisation are plausible, by Gary Clyde Hufbauer and Matthew Adler, Vox EU: The Peterson Institute calculates that the US economy was approximately $1 trillion richer in 2003 due to past globalisation – the payoff both from technological innovation and from policy liberalisation – and could gain another $500 billion annually from future policy liberalisation (Bradford, Grieco, and Hufbauer 2005). Past gains amounted to about 9% of GDP in 2003, and potential future gains constitute another 4%.

Critics, driven by their instinctive beliefs that $1 trillion is simply too large to be realistic, have attacked the Peterson Institute estimates (Rodrik 2007, Bivens 2007a, 2007b, 2007c). However, the estimates are often and prominently cited in the public debate on globalisation (USTR 2007, Schwab 2007). So are these Peterson Institute estimates reliable? To address this question we respond to our critics and reinforce our claim that globalisation has been very good for America.

In May 2007, Dani Rodrik took us to task on his blog for exaggerating the benefits. Professor Rodrik long ago established his reputation as a globalisation sceptic. To debunk the payoff from globalisation, Rodrik resurrects arithmetic developed by Frank Taussig (1927) as a "reality check" on our calculations. Taussig was a great economist, but economic science has actually progressed since 1927. The partial equilibrium formula cited by Rodrik essentially confines the benefits of globalisation to the "welfare triangles" generated when tariffs are abolished.[1] As calculated by Rodrik, the welfare triangles total not more than 0.25%of US national income, around $35 billion of potential gains if all US tariffs were abolished (Rodrik 2007). By contrast, our conservative estimate suggests that full global liberalisation would ultimately increase US national income by about 4.1%, about $570 billion based on GDP in 2007.

To support his own calculations, Rodrik cites a World Bank study that estimates the effects of global free trade in merchandise goods. Using a computable general equilibrium (CGE) model, the World Bank study (Anderson et al. 2005, 2006) estimates that free trade in merchandise would increase US income by just 0.1%in 2015, an estimate that falls well below the calculations reported from other CGE models.[2] Though saying he has no idea whether the World Bank number is right, Rodrik seems to regard the 0.1% figure as confirmation for his own "reality check" (Rodrik 2007).

So why do our estimates differ so much from Rodrik and the World Bank? First, both Rodrik and the World Bank authors disregard services, which account for a substantial share of total US trade and therefore a large part of the globalisation story. More importantly, though, by virtue of the methodologies adopted, both Rodrik’s quick calculation and the World Bank study ignore powerful forces that enormously expand the payoff from policy liberalisation and technology innovation for a country that participates in the global economy.

What are these forces?

• "Rightsizing" inputs to the needs of industrial producers;
• lowering the true cost of household purchases below the advertised inflation rate;
• "sifting and sorting" firms so that the most efficient expand and the least efficient shrink;
• curtailing the markup margins associated with monopolistic competition
• stimulating laggard industries (remember autos and steel) to match the productivity of foreign competitors;
• reducing the enormous international differences that prevail in prices for traded goods, and
• enjoying the benefits of internal and external returns to scale.[3]

The Peterson Institute study combines the payoff from these powerful forces with traditional comparative advantage to obtain a more complete picture of the gains from globalisation.[4] If forces like monopolistic competition, economies of scale, and productivity gains are left out of the mix, the Peterson Institute calculations would approach the Rodrik and World Bank estimates, but that would be less than half of the globalisation story.

L. Josh Bivens along with Jared Bernstein, both of the Economic Policy Institute, embrace the same antiquated arithmetic as Rodrik, claiming that "reasonable estimates" of potential US gains from trade liberalisation range between $4 billion and $20 billion (Bivens and Bernstein 2007). Bivens gives a simple-minded calculation, based on assumed parameters, suggesting that a return to the Smoot-Hawley tariff would only reduce the US economy by 1%. For the same reasons we cite with respect to Rodrik’s critiques, Bivens and Bernstein’s estimates do not speak to the reality of globalisation: they leave out forces like induced productivity, shifting and sorting, and returns to scale.

Bivens repeated his arguments and criticism of the Peterson Institute calculations in three more papers (Bivens 2007a, 2007b, 2007c). He missed far more than he scored in these repetitive critiques, but foremost he ignored Solow's landmark finding (1956) that productivity gains explain above 80% of US economic growth. Some of these productivity gains come from globalisation and the powerful sources already mentioned. To be perfectly clear, we do not suggest that the bulk of US productivity gains are due to globalisation, but we do believe that engagement with the world economy makes a significant contribution.

A key point worth emphasising is that, in the Peterson Institute estimates, policy liberalisation was not the only or even primary driver of the estimated gains. Rapidly falling transportation and communication costs are perhaps more important features of the globalisation story. Work is underway at the Institute to sort out what share of the past gains from globalisation is attributable to policy liberalisation and what share is attributable to technological change. We do not yet have preliminary calculations for the trade barrier side of the story. However, preliminary estimates suggest that, in 2006, approximately 23% of the expansion in US inward and outward foreign direct investment (FDI) stocks, relative to the growth of GDP, resulted from FDI-related policy liberalisation in the period since 1982. By implication, most of the dramatic expansion of FDI in recent decades probably can be traced to enabling technologies that permit best-in-class firms to operate on a world scale.

Our critics also take exception to the fact that "not a single one" of the studies we cited gives a calculation of the payoff of globalisation resembling our estimates (Bivens 2007c). This is absolutely right. The cited studies made no estimates whatsoever of the payoff in GDP terms. If the Peterson Institute $1 trillion estimate made an original contribution, it was to tease out, from the academic studies, numbers that can be easily understood in the public debate.

In one of his critiques, Bivens invokes the Stolper-Samuelson theorem to support his claim that with globalisation "losers may well outnumber winners, even if winnings are greater than losses" (Bivens 2007c). Certainly these are possible outcomes. However, empirical research on the American economy does not support the contention that income distribution has been strongly affected by international trade and investment. The forces of technology, education, and immigration are much stronger (Lawrence 2008). But we sympathise with Bivens’s larger contention that many workers and communities get a raw deal from globalisation. In the same Peterson Institute study where we produce the $1 trillion estimate, we also calculate the lifetime losses of workers displaced by globalisation. Our estimate of the lifetime private cost for labour displacement, generated each year by globalisation, is roughly $55 billion. While this is a large number, and speaks to acute distress for many workers and their communities, it is a far smaller number than our estimate of annual gains from globalisation.

From a policy standpoint, however, another comparison is more relevant: federal outlays to help Americans cope with the transition costs of globalisation are less than $2 billion annually (Bradford et al 2005, OMB 2007). The US safety net is far too parsimonious, a fact that goes far to explain the popular backlash against free trade agreements and investment abroad. In our view, federal programs must be seriously updated so that displaced workers can better meet the realities of the global economy.[5]

References

Anderson, Kym, Will Martin, and Dominique van der Mensbrugghe. 2005. Market and welfare implications of Doha reform scenarios. In Trade Reform and the Doha Agenda, ed. K. Anderson and W. Martin. Washington: World Bank.
Anderson, Kym, Will Martin, and Dominique van der Mensbrugghe. 2006. Doha Merchandise Trade Reform: What's at Stake for Developing Countries? World Bank Policy Research Working Paper 3848 (February). Washington: World Bank.
Arnold, Jens Matthias, Beata Smarzynska Javorcik, and Aaditya Mattoo. 2007. Does Services Liberalisation Benefit Manufacturing Firms? Evidence from the Czech Republic. World Bank Policy Research Working Paper 4109 (January). Washington: World Bank.
Bernstein, Jared, and L. Josh Bivens. 2007. Cheerleaders Gone Wild.
Bivens, L. Josh. 2007a. Marketing the Gains from Trade. Economic Policy Institute. Issue Brief #233 (June 19).
Bivens, L. Josh. 2007b. The Marketing of Economic History: Inflating the Importance of Trade Liberalisation. Economic Policy Institute Issue Brief #238 (December 17).
Bivens, L. Josh. 2007c. The Gains from Trade: How Big and Who Gets Them? Economic Policy Institute. Working Paper (December 17).
Bradford, Scott C., Paul L. E. Grieco, and Gary Clyde Hufbauer. 2005. The Payoff to America from Global Integration. In The United States and the World Economy: Foreign Economic Policy for the Next Decade, in C. Fred Bergsten and the Institute for International Economics. Washington: Institute for International Economics.
Brown, K. Drusilla, Alan V. Deardorff, and Robert M. Stern. 2002. Multilateral, Regional and Bilateral Trade Policy—Options for the United States and Japan. University of Michigan, Research Seminar in International Economics. Discussion Paper No. 490.
Henry, Peter Blair, and Diego L. Sasson. 2008. Capital Account Liberalisation, Real Wages, and Productivity. NBER Working Paper No. W13880. Cambridge, MA: National Bureau of Economic Research.
Hufbauer, Gary Clyde, and Kimberly Ann Elliott. 1994. Measuring the Costs of Protection in the United States. Washington: Institute for International Economics.
Hufbauer, Gary Clyde, and Howard F. Rosen. 1986. Trade Policy for Troubled Industries. Washington: Institute for International Economics.
Keller, Wolfgang, and Stephen R. Yeaple. 2005. Multinational Enterprises International Trade, and Productivity Growth: Firm-Level Evidence from the United States. Discussion Paper Series 1: Economic Studies no. 07/2005.
Lawrence, Robert Z. 2008. Blue-Collar Blues: Is Trade to Blame for Rising US Income Inequality? Policy Analysis 85. Washington: Peterson Institute for International Economics.
OMB (Office of Management and Budget). 2007 Budget of the United States Government, Fiscal Year 2008 – Appendix. Washington: US Government Printing Office (accessed July 14, 2008).
Rodrik, Dani. 2007. The Globalization Numbers Game (May 7). Dani Rodrik's weblog.
Rosen, Howard F. 2008. Strengthening Trade Adjustment Assistance. Policy Briefs in International Economics 08-2. Washington: Peterson Institute for International Economics.
Schwab, Susan C. 2007. US Trade Update and Agenda. Presentation of United States Trade Representative, Ambassador Susan C. Schwab to the Senate Finance Committee. February 15, Washington.
Solow, Robert M. 1956. A Contribution to the Theory of Economic Growth. Quarterly Journal of Economics 70, no.1 (February): 65–94.
Taussig, Frank W. 1927. International Trade. Reprinted by Augustus M. Kelley Publishers: New York (1966).
USTR (United States Trade Representative). 2007. Trade and Services: Services Trade Fuels Growth of US Economy. Benefits of Trade (January). Available at www.ustr.gov. (accessed April 29, 2008).

Footnotes

1 Partial equilibrium analysis is a useful tool when examining restrictions for specific goods in perfect or nearly perfect competitive markets. Years ago, Peterson Institute authors used this analytic framework for examining steel quotas, textile and apparel tariffs, sugar duties, and other barriers (e.g., Hufbauer and Elliott 1994). However this sort of analysis cannot capture the gains to the whole economy from across-the-board policy liberalisation.
2 See, most prominently, Brown, Deardorff, and Stern (2002).
3 L Josh Bivens, questions how many of these forces can occur simultaneously. For example, he questions how consumers can have more choice in the market place (i.e., product variety) while inefficient firms are being pushed out (i.e., sifting and sorting) (Bivens 2007c). A simple example illustrates how this is possible: IBM was a pioneer in the PC market. But when Dell entered the field, and enormously expanded the range of PC models, IBM eventually exited the market and sold its PC division to Lenovo.
4 The literature points to additional channels besides those we cited; for example, Keller and Yeaple (2005) showed that an expanding role of foreign multinational enterprises (MNEs) in the United States boosts the productivity of competing domestic firms; Arnold, Javorcik, and Mattoo (2007) reported that services liberalisation enhanced the productivity of downstream manufacturing firms in the Czech Republic; and Henry and Sasson (2008) provide evidence that capital account liberalisation raises real wages.
5 The Peterson Institute can point to a long and vigorous record of urging meaningful remedies for dealing with the cost of globalissation (see, for example, Hufbauer and Rosen 1986, and Rosen 2008).