Answering the Critics: Why Large American Gains from Globalization Are Plausible
by Gary Clyde Hufbauer, Peterson Institute for International Economics
© Peterson Institute for International Economics.
The author thanks research assistant Matt Adler for his contribution to this paper.
The Peterson Institute calculates that the US economy is approximately $1 trillion richer each year owing to past globalization—the payoff both from technological innovation and from policy liberalization—and could gain another $500 billion annually from future liberalization (Bradford, Grieco, and Hufbauer 2005 [pdf]). These estimates have attracted sharp criticism, notably from Dani Rodrik (2007) and L. Josh Bivens (2007a, 2007b, 2007c). The critics are particularly annoyed that the Peterson Institute calculations enjoy wide circulation in the public debate (USTR 2007, Schwab 2007), and Bivens has gone so far as to urge that they be "retired" (Bivens 2007a ). Apart from answering these critics, it is worth commenting on a US International Trade Commission report (USITC 2007) that gives an unbelievably low figure for the cost of import protection to the US economy.
Underlying the noisy attack from our critics is their fear that, if public officials believe in a substantial payoff from globalization, they will be too eager to negotiate new trade agreements. Many of our critics implicitly fault us for paying insufficient attention to domestic losers. The Peterson Institute, however, can point to a long and vigorous record of urging meaningful remedies for workers adversely affected by globalization (Rosen 2008). Our research and recommendations on this critical topic stretches from 1986 to the present day.1 Judging from presidential primaries in Ohio and Pennsylvania, meaningful programs for domestic losers will become a priority if a Democrat is elected in 2008. That said, a short rejoinder is in order both to defend the magnitude of our payoff calculations and to urge the next administration not to put trade liberalization in the freezer.
Dani Rodrik. In his weblog for May 7, 2007 (http://rodrik.typepad.com/), Dani Rodrik took us to task for exaggerating the benefits of globalization. Professor Rodrik long ago established his reputation as a globalization skeptic; today he is the favorite Harvard economist among the backlash crowd. In 1997, Rodrik voiced a critical note in a book published by the Institute for International Economics, Has Globalization Gone Too Far? Two years later, Francisco Rodríguez and Rodrik (1999) notched their academic guns against Jeffrey Sachs and Andrew Warner (1995), questioning the benefits of liberal trade policy for developing countries. As targets of Rodrik's latest outburst, we share good company.
To debunk the payoff from globalization, 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 globalization to the "welfare triangles" created when tariffs are abolished. As calculated by Rodrik, the welfare triangles total 0.25 percent or less 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 liberalization would ultimately increase US national income by about 4.1 percent of GDP, about $570 billion based on GDP in 2007. Even on its own terms, Rodrik's application of welfare triangle analysis is biased downward for reasons spelled out in appendix A. The more serious problem, however, is that welfare triangle analysis misses the big story.
Done properly, welfare triangles are fine for examining the cost of protecting individual products in otherwise perfectly competitive and undistorted markets. Years ago, we used this analytic framework for examining steel quotas, textile and apparel tariffs, sugar duties, and other barriers (e.g., Hufbauer and Elliott 1994). But this sort of analysis completely misses multiple forces that enormously expand the payoff from policy liberalization and technology innovation for a country that participates in a 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 (think 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 increasing returns to scale.
Even using a simplistic formula, Rodrik's analysis compares apples and oranges. His "reality check" of 0.25 percent of GDP reflects the static cost of US tariff barriers imposed only on merchandise trade. Our number of 4.1 percent (which Rodrik compares to his 0.25 percent) reflects a comprehensive analysis that includes US tariff and nontariff barriers on merchandise trade, US barriers on services trade, foreign barriers of all kinds, and multiple dynamic effects thwarted by assorted barriers here and abroad. If all of these features of our analysis are stripped away, we would be left with an estimate near 0.5 percent of US GDP. This is about what one would expect from a proper static formula that accounts for differences in protection across sectors. But why focus on a misleading comparison when more robust analysis is available?
In analysis that Rodrik criticizes (Bradford, Grieco, and Hufbauer 2005), we used alternative methods to calculate some, but not all, of the progrowth forces unleashed by globalization. The literature points to additional channels besides those we cited; for example, Keller and Yeaple (2005) showed that a growing role of foreign multinational enterprises (MNEs) in the United States boosts the productivity of domestic firms; Arnold, Javorcik, and Mattoo (2007) reported that services liberalization enhanced the productivity of downstream manufacturing firms in the Czech Republic; and Henry and Sasson (2008) provide evidence that capital account liberalization raises real wages.
Perhaps sensing that his own back-of-the-envelope calculations cannot be trusted, Rodrik cites the results of computable general equilibrium (CGE) studies carried out by Kym Anderson, Will Martin, and Dominique van der Mensbrugghe (2005, 2006). These respected World Bank economists suggest that global free trade in merchandise would increase US incomes by just 0.1 percent in 2015, an estimate that falls well below the median of other CGE models. Though saying he has no idea whether the World Bank number is right, Rodrik seems to regard the 0.1 percent figure as confirmation for his own "reality check" (Rodrik 2007). So it is worth exploring the World Bank model a bit further.
The basic flaw in the World Bank CGE model is that it omits virtually all the important channels of growth opened by policy liberalization and technology innovation—the forces we have already enumerated—and it also omits services from the story. Services are the fastest growing component of global commerce and promise the biggest payoff from future liberalization. In reality, the World Bank CGE model is a glorified version of Taussig's framework, made vastly more complex thanks to computer power, but limited to merchandise trade under static conditions. The only "dynamic" feature in the model is its ability to calculate year-by-year results. For a truly dynamic CGE model that reflects forces set in motion when an economy liberalizes, and covers services as well, interested readers should instead consult the University of Michigan model, designed by Drusilla Brown, Alan Deardorff, and Robert Stern (e.g., Kiyota and Stern 2007). Similar to our calculations, the Michigan modelers estimate that global free trade in goods and services would increase US national income by 3.4 percent.
Rodrik implicitly accuses us of using increasing returns to scale to cook the books. Increasing returns may be important in the real world, but they play a minor role in our 4.1 percent figure. Rodrik further claims that our calculated price gaps are caused mostly by things other than trade barriers. He provides no evidence for this claim even though published studies make the case that trade barriers are substantial (Bradford 2003, Bradford and Lawrence 2004).
To embellish his argument, Rodrik credits us with several straw men and ridicules the whole lot. Supposedly, according to Rodrik, we believe that globalization "will yield full price convergence;" supposedly we urge the United States to harmonize its laws with those of its trading partners and join them in a global currency union; and supposedly we welcome 80,000 pages of EU-style regulations. All this is nonsense.
Finally, Rodrik takes us to account for misstating Andrew Rose's (2003) gravity model as to the increase in merchandise trade created by a regional trade agreement (RTA). As we explained (Bradford, Grieco, and Hufbauer 2005, 93, footnote 60), we used the most conservative RTA coefficient calculated by Rose (middle column, Rose's table 1), namely 0.78 (exp0.78 –1.00 = 118 percent), which we then discounted by our own estimate of trade diversion. Subsequent gravity model studies, reflecting additional free trade agreements besides those included in Rose's original data set, buttress our expectation that global free trade would substantially boost world commerce (e.g., DeRosa and Gilbert 2005, Hufbauer and Schott 2007).
Speaking of gravity models, these modern econometric workhorses demonstrate that free trade agreements (FTAs) enlarge bilateral commerce to a much greater extent than predicted by Frank Taussig's classic framework. The payoff of FTAs, in terms of boosting two-way merchandise trade flows, are many times larger than classic trade theory, based on estimated price elasticities, might suggest.
It makes an enormous policy difference whether those in power think the gains to the United States and to the world at large, from total free trade in goods and services, would be only 0.1 percent of GDP, or instead could reach 4 percent of GDP. If gains are as small as 0.1 percent, why bother? Forget about the Doha Development Round and put those pesky free trade agreements (300 and counting) on the shelf. If gains are as large as 4 percent, the payoff is handsome: That's right at the top of what governments can deliver through economic policy reform.
In this debate with Rodrik and Bivens, we are glad to be on the same page as Federal Reserve Chairman Bernanke and Treasury Secretary Paulson.2 Free trade remains our prescription.
L. Josh Bivens. L. Josh Bivens along with Jared Bernstein, both of the Economic Policy Institute, launched an attack on April 9, 2007, with a personal criticism of the director of the Peterson Institute, C. Fred Bergsten, and the Washington Post columnist, Sebastian Mallaby. In "Cheerleaders Gone Wild," Bernstein and Bivens embraced the same antiquated arithmetic as Rodrik, claiming that "reasonable estimates" of potential US gains from trade liberalization range between $4 billion and $20 billion (http://www.huffingtonpost.com/jared-bernstein-and-josh-bivens/cheerleaders-gone-wild_b_45405.html). Enjoying his Rip van Winkle moment in the yesteryear of trade analysis, Bivens repeated his arguments in three more papers (Bivens 2007a, 2007b, 2007c).
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 percent. Such calculations may sing to Patrick Buchanan or Lou Dobbs, but not to anyone who has seriously studied the Great Depression or international economics.
Bivens missed a lot of things in his multiple and repetitive critiques, but foremost he ignored Solow's landmark finding (1956) that productivity gains explain more than 80 percent of US economic growth. Where does all this productivity come from? Innocent scientists laboring away in isolated labs, content to live on small stipends from penurious universities? That doesn't describe Charles Edison, Henry Ford, or Bill Gates. Nor does it explain why Britain has so lagged America, despite brilliant scientific achievements, nor why India and Egypt remain so far behind Korea. Competitive pressure, economies of scope and scale, and product diversity explain a great deal of productivity gains, and that's where globalization enters the picture.
My coauthors and I are not claiming that expansion of international trade and investment is the leading cause of productivity growth. But we do claim that these forces make a significant contribution through channels identified in the empirical literature and summarized in our chapter, all of them dismissed by Bivens.
Before offering further rejoinders, let me clarify a couple of points. Our analysis emphasized that globalization creates losers as well as winners and provided numerical estimates of lifetime compensation losses for dislocated workers. While national gains far exceed individual losses, we agree that the US safety net is far too parsimonious.
We did not debate the merits of the Stolper-Samuelson theorem, which underpins the assertion by Bivens that "losers may well outnumber winners, even if winnings are greater than losses" (Bivens 2007c). As a theoretical proposition, it is possible that losers may outnumber winners. But 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 far more salient (Lawrence 2008).
Another point worth clarifying is that we did not claim that policy liberalization was the only driver of the gains estimated in our chapter. Rapidly falling transportation and communication costs are equally and perhaps more important aspects of the globalization story. Bivens implies that we have attributed past gains from falling transport and communications costs to policy liberalization. Au contraire. We were careful to state that the $1 trillion retrospective figure conflates policy liberalization with technological advance. The $500 billion prospective figure, however, reflects only prospective gains from policy liberalization.
Appendix B offers rejoinders to some of the complaints that Bivens voices about our use of the work of other scholars in constructing estimates of the payoff from globalization. But one point requires emphasis here. Bivens makes a big thing of the fact that "not a single one" of the studies we cited gives a calculation of the payoff of globalization resembling our estimates. He is absolutely right. The cited studies made no estimates whatsoever of the payoff in GDP terms. If our work had an original dimension, it was to tease out, from the academic studies, numbers that can be easily understood in the public debate.
The ITC Report. The International Trade Commission Report, titled The Economic Effects of Significant U.S. Import Restraints—Fifth Update 2007, applies a CGE model to conclude that the welfare cost to the United States of all the "significant restraints" now in place is only $3.7 billion annually. By implication, removing "significant" barriers would enlarge the US economy by only $3.7 billion annually. Even taking into account its recognized limitations—for example virtual exclusion of the service industries and ignoring multiple regulatory barriers—this estimate does not pass the laugh test. It is completely at odds with estimates based on CGE models carried out by the World Bank, the Carnegie Endowment, and the University of Michigan. To summarize the alternative CGE estimates:
Leaving aside alternative estimates based on competing CGE models, a couple of rhetorical questions illustrate why the ITC figure of $3.7 billion is implausibly small.
To Conclude. Our calculations of the gains from past globalization—and the gains yet to be realized from future policy liberalization—are certainly not the last word. Better estimates will surely be made by future scholars. But the criticisms offered by Rodrik and Bivens, and the estimates published by the ITC, all represent giant steps to the past. Until we see solid contrary evidence, we stick with our calculations: To date, postwar globalization has made the US economy $1 trillion richer each year; total policy liberalization by the United States and all its commercial partners would add another $500 billion annually to the US economy.
Appendix A: Technical Flaws in Rodrik's Formula
Rodrik's formula depends on three crucial assumptions that bias the result downward. First, the formula assumes that governments use only tariffs. The protection package usually contains nontariff barriers (NTBs) such as agricultural subsidies and procurement restrictions. The more these NTBs are used, the more the formula's key number is biased downward. Second, the formula assumes that protection is the same for all goods and services. When properly accounting for the actual peaks and valleys in the protection profile across sectors, the estimated cost of barriers becomes much higher, typically two or three times as high. Third, the elasticity of import demand tends to increase as protection levels rise and import quantities fall. Taking account of this feature can also yield higher estimates of protection costs. In short, using a crude formula as a "reality check" on careful calculations is like using a yardstick to check the tolerance of a wristwatch.
Appendix B: Further Rejoinders to Bivens' Critique
In his working paper (2007c), Bivens offers a critique of several of the studies we relied upon, and the way we used them, to construct our estimates of the payoff to the US economy from past globalization and future liberalization. Here we give short rejoinders to some of his criticisms.
Bivens points to a supposed contradiction between the product variety account of Broda and Weinstein (2004) and the price convergence analysis of Bradford and Lawrence (2004). However, the US tariff schedule at the 8-digit level enumerates some 9,000 lines, and most of these 8-digit lines cover multiple products. In other words, the absolute number of products sold in the American economy is very large and, according to Broda and Weinstein, the variety has grown substantially over the past 30 years. Increased product variety is a microphenomenon. By contrast, the Bradford and Lawrence analysis covered a fairly small number of aggregated product categories, fewer than 100. The convergence of average prices between broad categories can go hand-in-hand with greater variety within each category.
Bivens also suggests that there is a contradiction between the sifting and sorting literature (Bernard, Jensen, and Schott 2003) and the concept of product variety (Broda and Weinstein 2004). He asks "if imports are largely adding to variety and often do not directly compete with domestically-produced output, then one must ask why they are killing domestic plants…" (Bivens 2007c). Here, Bivens misses the key idea of the substitution effect between similar goods—i.e., consumers can and will switch their purchases between similar but still different products—which in turn can foster the sifting and sorting of firms. An example illustrates how increasing product variety and sifting and sorting can occur simultaneously. Coca-Cola enjoyed market dominance for decades after its introduction, but when Pepsi Cola—a similar but different product—came on the scene, it cut into Coca-Cola's market share, presumably forcing the soft drink maker to ditch its less efficient distributors and plants.
Bivens dismisses OECD (2003), stating, the method used in the study "is an inadequate and potentially misleading way to measure the impact of trade on growth" (Bivens 2007c). We disagree. So does Cline (2004). Bivens first takes issues with the causality between trade and growth, but earlier works have already addressed this question. The instrumental variables approach applied by Frankel and Romer (1999) to disentangle cause and effect strengthens the argument that greater trade intensity promotes higher growth.
Second, Bivens disregards the openness ratio—two-way trade divided by GDP—as an appropriate way to gauge a nation's trade policy stance. He cites the example of a larger openness ratio for Vietnam than the United States as evidence that the ratio says nothing about the nation's trade policy stance. However, even Bivens (2007c) concedes, in an endnote, that the OECD (2003) study controls for other factors, like country size, that explain much of the variance across countries in their openness ratios. When the statistical method controls for other factors, as was done in the OECD (2003) study, the openness ratio serves as a good proxy for the nation's trade policy stance.
The sifting and sorting literature criticized by Bivens is still in an early stage. However, evidence is accumulating that competitive pressure enlarges the relative size of more productive firms within an industry, thereby increasing the productivity of the average surviving firm. Here's what the abstract from the paper by Bernard and Jensen (2004) says: "Exporting is associated with the reallocation of resources from less efficient to more efficient plants. In the aggregate, these reallocation effects are quite large, making up more than 40 percent of total factor productivity growth in the manufacturing sector."4
Bivens doesn't like the CGE model used by Bradford and Lawrence to reconstruct the Smoot-Hawley world. Bivens is correct that any CGE model embodies a large number of assumptions, and scholars obviously differ as to the correct assumptions.5 However, the Bradford-Lawrence CGE calculations are buttressed by the gravity model exercise reported elsewhere in Bradford, Grieco, and Hufbauer (2005).
To conclude this response, Richardson (2004) emphasizes, in writing up the growth accounting model, that rightsizing and precision fitting of imported inputs makes the difference. Purchasing industries can get just the component they need by tapping global sources of supply. Perhaps Bivens missed this point,6 because our exposition of Richardson's analysis did not give sufficient emphasis to the rightsizing aspect of Richardson's account.
See also Answering the Critics: Summary.
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1. The first Institute publication on this subject was Hufbauer and Rosen (1986).
2. See for example Bernanke (2007) and Paulson (2006).
3. See Hoekman and Olarreaga (2007) and, importantly, a correct version of their table 2.2, which is available from the authors.
4. Bivens (2007c) also distrusts our extension of Bernard, Redding, and Schott (2004) from the 65 industries and OECD countries used in the model to all industries and countries. Further research may show that this extension cannot be made, but until then, the work of Bernard Redding, and Schott (2004) provides the best available estimate.
5. For example, Bivens (2007c) questions the use of increasing returns to scale in the model, preferring constant returns to scale.
6. Bivens (2007c) calls the use of Richardson (2004) in the context of growth accounting an "odd mistake."