Monday, April 10, 2006

Measuring the Effects of Globalization

I am an unabashed advocate of globalization (as you can see in this paper on antidumping and this paper on outsourcing). The same can be said of Larry Summers, who is giving today's ec 10 lecture.

So I should welcome the op-ed in today's NY Times by Richard W. Fisher and W. Michael Cox (president and chief economist of the Federal Reserve Bank of Dallas). They write:

[G]lobalized nations tend to pursue policies that achieve faster economic growth, lower inflation, higher incomes and greater economic freedom. The least globalized countries are prone to policies that interfere with markets and lead to stagnation, inflation and diminished competitiveness....[A]s nations become more integrated into the world economy, they tend to maintain fewer barriers to trade and the movement of money. They are less likely to impose punishing corporate taxes and onerous regulations. Their technology policies are more favorable to innovation. Nations more open to the world economy score above the less globalized countries in respect for the rule of law and protection of property rights. More globalized countries also offer greater political stability.
But do these international correlations prove the benefits of globalization? No. The op-ed admits this:

So, do our statistics show that globalization is necessarily the cause of good policies? That would be overstating it — our data simply show the two trends are complementary.... The chicken-and-egg debate shouldn't detract from the fundamental fact that globalization and good policies go together.

The new edition of my intermediate textbook Macroeconomics (available in a few weeks) has a case study that tries to sort out the "chicken-and-egg debate." Here is a sneak preview:

Case Study
Is Free Trade Good for Economic Growth?

At least since Adam Smith, economists have advocated free trade as a policy that promotes national prosperity. Here is how Smith put the argument in his 1776 classic, The Wealth of Nations:

“It is a maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy. The tailor does not attempt to make his own shoes, but buys them of the shoemaker. The shoemaker does not attempt to make his own clothes but employs a tailor.…

What is prudence in the conduct of every private family can scarce be folly in that of a great kingdom. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry employed in a way in which we have some advantage.”
Today, economists make the case with greater rigor, relying on David Ricardo’s theory of comparative advantage as well as more modern theories of international trade. According to these theories, a nation open to trade can achieve greater production efficiency and a higher standard of living by specializing in those goods for which it has a comparative advantage.

A skeptic might point out that this is just theory. What about the evidence? Do nations that permit free trade in fact enjoy greater prosperity? A large literature addresses precisely this question.

One approach is to look at international data to see if countries that are open to trade typically enjoy greater prosperity. The fact is that they do. Economists Andrew Warner and Jeffrey Sachs studied the period 1970 to 1989. They report that among developed nations, the open economies grew at 2.3 percent per year, while the closed economies grew at 0.7 percent per year. Among developing nations, the open economies grew at 4.5 percent per year, while the closed economies again grew at 0.7 percent per year. These findings are consistent with Smith’s view that trade enhances prosperity, but they are not conclusive. Correlation does not prove causation. Perhaps being closed to trade is correlated with various other restrictive government policies, and it is those other policies that retard growth.

A second approach is to look at what happens when closed economies remove their trade restrictions. Once again, Smith’s hypothesis fares well. Throughout history, when nations open themselves up to the world economy, the typical result is a subsequent increase in economic growth. This occurred in Japan in the 1850s, South Korea in the 1960s, and Vietnam in the 1990s. But once again, correlation does not prove causation. Trade liberalization is often accompanied by other reforms, and it is hard to disentangle the effects of trade from the effects of the other reforms.

A third approach to measuring the impact of trade on growth, proposed by economists Jeffrey Frankel and David Romer, is to look at the impact of geography. Some countries trade less simply because they are geographically disadvantaged. For example, New Zealand is disadvantaged compared to Belgium because it is farther from other populous countries. Similarly, landlocked countries are disadvantaged compared to countries with their own seaports. Because these geographical characteristics are correlated with trade, but arguably uncorrelated with other determinants of economic prosperity, they can be used to identify the causal impact of trade on income. (The statistical technique, which you may have studied in an econometrics course, is called instrumental variables.) After analyzing the data, Frankel and Romer conclude that “a rise of one percentage point in the ratio of trade to GDP increases income per person by at least one-half percentage point. Trade appears to raise income by spurring the accumulation of human and physical capital and by increasing output for given levels of capital.”

The overwhelming weight of the evidence from this body of research is that Adam Smith was right. Openness to international trade is good for economic growth.