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Bülent Ulaşan

Bülent Ulaşan is an Economist at the CBRT.

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Whether a free trade policy has a favorable impact on economic growth has been a controversial subject since the time of Adam Smith, the founder of modern economics. According to the classical international trade theory, free international trade boosts economic efficiency by allowing sovereign economies to specialize in fields in which they are doing relatively better, and thus makes all countries more prosperous. On the other hand, free trade policies that had been widespread globally since the early 1980s are now losing their popularity.

In the US case, employment in the manufacturing industry declined sharply and the current account deficit widened after the North American Free Trade Agreement (NAFTA) came into effect in 1994 and China became a member of the World Trade Organization in 2001. The sentiment that free trade policies negatively affect employment and income distribution has become more pervasive following the global financial crisis between 2007 and 2009, leading to a change in advanced countries’ view of these policies in particular. Accordingly, the number of barriers to international trade has increased and inward-oriented protectionist economy policies have come up in many countries recently, particularly in the US. In addition, the referendum held last year in the UK, the pioneering country of free trade in the global economy after the industrial revolution, resulted in a decision to exit the European Union, the world’s largest free trade block. All these developments have rekindled the longstanding controversy about the relationship between free trade and economic growth in the economics literature.

This blog post aims to review how the theoretical and empirical economics literature answers the question of how free international trade affects economic growth.

Free Trade and Economic Growth: What Does the Economic Theory Tell Us?

In the economic theory, until the 1980s, the effect of free international trade on economic growth was assessed in the framework of the Ricardian-Heckscher-Ohlin theory. This theory points out that free international trade brings only a one-time increase in output since the country allocates its resources more efficiently after its involvement in international trade, conditional on comparative advantage. However, the Ricardian-Heckscher-Ohlin theory does not suggest any certain implications for long-run growth. The neoclassical growth model developed by Solow (1956) concludes that the long-run economic growth is determined by the rate of technological progress. Therefore, free trade may promote the long-run economic growth if there is a technology-stimulating effect of international trade. However, neither the Ricardian-Heckscher-Ohlin theory nor the neoclassical growth theory provides a theoretical framework for the claim that free trade stimulates technological progress. Only the endogenous growth models developed in the mid-1980s have been able to suggest analytical models on the relationship between free international trade and long-term economic growth.

International Trade Policy and Endogenous Growth Models[1]

In contrast to the neoclassical growth model, endogenous growth theories define the capital input in the production process more broadly and include other factors such as human capital, innovations, learning by doing, etc. in addition to physical capital. The crucial aspect of these models is that capital accumulation is not subject to the law of diminishing returns and is the driving force of economic growth in the long run. In particular, innovations developed from research and development (R&D) activities lead to increasing returns to scale in production and affect growth favorably in the long run.

In this regard, Rivera-Batiz and Romer (1991) and Grossman and Helpman (1991) developed models linking the international trade policy to long-run economic growth. According to these models, free international trade affects long-run economic growth via four different channels.

  • Communication Effect: Free international trade enhances the communication among countries and facilitates the transmission of technology.
  • Duplication Effect: In a world where international trade is restricted, some innovations and technologies are duplicated in many countries whereas free trade encourages countries to invent new and distinct technologies.
  • Allocation Effect: Countries’ involvement in free trade through specialization based on their comparative advantages will cause a change in the relative prices of production factors (Stolper-Samuelson theorem). Under the assumption that the labor stock of an economy consists of partly skilled labor and partly unskilled or simple labor, specialization of a country in a skilled labor-intensive sector will increase the demand for skilled labor after free trade and change the domestic relative wage structure in favor of skilled labor. This leads to a fall in employment and/or a rise in costs in the R&D sector, which employs skilled labor and is the driving force of long-term economic growth, and accordingly a slowdown in economic growth rate in the long run. Conversely, if a country specializes in an unskilled labor-intensive sector, free trade would boost growth in the long run.
  • Integration Effect: International trade provides an opportunity for the expansion of the production scale. As innovations are also traded across countries, free trade may lead to a scale expansion in the R&D sector as well. This triggers an increase in R&D activities and accordingly the economic growth rate in the long run since the R&D sector is subject to economies of scale. Yet, the scale of domestic production in the R&D sector may also contract because of foreign competition after the involvement in free trade. In that case, economic growth slows down in the long run.

As can be seen, among these four different channels that emerge as a result of free international trade, only the communication and duplication effects necessarily increase economic growth in the long run. However, the allocation and integration channels are not unambiguously positive. More precisely, the impact of free international trade on growth may be positive, negative or neutral depending on the dominance and magnitude of these two effects.

In summary, endogenous growth models do not necessarily conclude that free international trade boosts economic growth in all circumstances and for all countries. In other words, whether openness causes economic growth, especially in the long run, depends on country-specific conditions. The fact that the economic theory does not offer a decisive result makes the free trade-growth relationship an empirical question. In this respect, the following section presents an overview of the related empirical literature.

Free Trade and Economic Growth: What Does the Evidence Tell Us?

The relationship between free international trade and economic growth has been the subject of a large number of empirical studies. The majority of empirical studies consist of cross-country growth analyses. In this framework, early studies such as Balassa (1978), Feder (1982), and Ram (1987) investigate the relationship between free trade and economic growth in the framework of neoclassical growth accounting. These studies generally consider exports as an indicator of free international trade and conclude that export- or outward-oriented trade policies favorably affect growth.

In the empirical economics literature, the free trade-growth nexus received renewed interest in the 1990s. Dollar (1992), Sachs and Warner (1995), Edwards (1998), and Frankel and Romer (1999) stand out as important studies in the recent period. Like the early studies, these studies have also concluded that free international trade has a positive impact on growth. The salient feature of these studies is that they employ new indicators directly addressing trade policy stance.

However, these empirical studies have been subject to substantial criticism. In particular, Rodrik and Rodríguez (2000), employing the original data sets of important studies on the topic, show that the findings of these studies are highly fragile. According to these authors:

i) Free trade indicators used in the studies are weakly related to international trade policy, and in most cases, they are correlated to other macroeconomic policies and the institutional structure,

ii) Most studies include simple economic growth models, ignoring other influencing factors on growth such as institutions and geography.

Following the criticism of Rodrik and Rodríguez (2000), the empirical literature has moved along two main lines. Studies in the first line have analyzed the free trade-growth relationship taking into account the institutional structure and geography, and have concluded that institutions are predominantly influential on economic growth whereas trade does not have a direct impact (For example, Easterly and Levine (2003), Alcalá and Ciccone (2004), Dollar and Kraay (2003), Rodrik et al. (2004)).

The second-line studies attempt to answer the question of under which conditions free international trade may positively affect long-term growth. They have found that the growth-promoting effect of free trade appears only at certain critical threshold levels. For instance, Chang et al. (2009) reveal that the effect of free trade on growth may be either positive or negative depending on whether some structural reforms, particularly those based on institutional structure, have been accomplished or not.

Overview and Conclusion

In this blog post, we have analyzed the impact of free trade on growth, one of the oldest questions of economics, within the framework of theoretical and empirical economics literature. In light of this brief analysis, it is possible to accentuate two important conclusions regarding the free trade-growth nexus:

  • The current economic theory fails to offer a decisive result concerning the impact of free international trade on economic growth in the long run. Theoretically, this impact may be positive, negative or neutral depending on country-specific conditions.
  • Although empirical studies on the topic find that free international trade generally has a favorable impact on growth in the long run, these studies have important deficiencies in terms of methodology. To be more precise, the empirical economics literature cannot provide any robust and convincing evidence on the free trade-growth nexus. On the other hand, it should be underlined that current empirical studies cannot present any robust evidence that protectionism has a positive effect on growth, either.

In this respect, we believe the most significant policy inference on the free trade-growth relationship is that without a high-quality institutional structure, free trade does not by itself assure economic growth. Therefore, a country’s, particularly emerging countries’, performance in improving its institutional structure will be decisive in the economy’s potential to grow and benefit from international trade, regardless of an increase or weakening in the trend of protectionism in the world economy.

[1] Endogenous growth theories analyze technological progress, which is the driving force of growth increasing the efficiency of production factors, as an endogenous variable determined by the decisions of economic units in the model, rather than taking it as an exogenous variable. These theories are called endogenous growth models because technological progress is determined in the model.

 

Bibliography:

Alcala, F., and Ciccone, A. (2004), Trade and productivity. Quarterly Journal of Economics, 119(2):613-646.

Balassa, B. (1978), Exports and economic growth: Further evidence. Journal of Development Economics, 5(2):181-189.

Chang, R., Kaltani, L., and Loayza, N.V. (2009), Openness can be good for growth: The role of policy complementarities. Journal of Development Economics, 90: 33–49

Dollar, D. (1992), Outward-oriented developing economies really do grow more rapidly: Evidence from 95 LDCs, 1976-1985. Economic Development and Cultural Change, 40(3):523-544.

Dollar, D., and Kraay, A. (2003), Institutions, trade, and growth. Journal of Monetary Economics, 50(1): 133–162.

Easterly, W., and Levine, R. (2003), Tropics, germs, and crops: How endowments influence economic development. Journal of Monetary Economics, 50(1):3-39.

Edwards, S. (1998), Openness, productivity and growth: What do we really know? Economic Journal, 108(447):383-398.

Feder, G. (1982) On exports and economic growth. Journal of Development Economics, 12(1-2):59-73.

Frankel, J. A., and Romer, D. (1999), Does trade cause growth? American Economic Review, 89(3):379-399.

Grossman, G. M., and Helpman, E. (1991), Innovation and Growth in the Global Economy. MIT press, Cambridge, USA and London, UK.

Ram, R. (1987), Exports and economic growth in developing countries: Evidence from time-series and cross-section data. Economic Development and Cultural Change, 36(1):51-72.

Rivera-Batiz, L. A., and Romer, P. M. (1991), International trade with endogenous technological change. European Economic Review, 35(4):971-1001.

Rodrik, D., and Rodríguez, F. 2000, Trade policy and economic growth: a skeptic's guide to the cross-national evidence. In: Bernanke, Ben, Rogoff, Kenneth (Eds.), NBER Macroeconomics Annual, volume 15. MIT Press, Cambridge, USA, pp. 261–325.

Rodrik, D., Subramanian, A., and Trebbi. F. (2004), Institutions rule: The primacy of institutions over geography and integration in economic development. Journal of Economic Growth, 9:131-165.

Sachs J. D., and Warner, A. M. (1995), Economic reform and the process of global integration. Brookings Papers on Economic Activity, 1995(1):1-118, (25th Anniversary Issue).

Solow, R. M. (1956), A contribution to the theory of economic growth. Quarterly Journal of Economics, 70(1):65-94.

 

Bülent Ulaşan

Bülent Ulaşan is an Economist at the CBRT.

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For views, suggestions
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* The views expressed here are those of the authors. They do not necessarily reflect the official views of the Central Bank of the Republic of Turkey.