Bringing New Research Developments to Bear
The President’s goal of doubling exports elicited a lot of discussion, and skepticism. In a previous blog post, I examined the prospects of accomplishing this goal from a macroeconomic perspective. However, a few discussions I’ve had with journalists have reminded me that the frontier of international trade theory has moved considerably over the past few years, even as the much of the economic commentary remains mired in the older models. In this respect, the most recent edition of the Economic Report of the President was extremely welcome, as it brought to bear recent innovations in the trade literature.
One observation, not yet firmly in the literature when I first started teaching international trade (link to my old course), was the role of heterogeneity across firms of productivity. Of course, in the simple one-factor Ricardian model, unit labor costs (the inverse of labor productivity) are critical in determining comparative advantage. With a few extra assumptions, the same is true in the infinite-good version of Dornbusch-Fischer-Samuelson. But these models really couldn’t deal with the observation, associated with Bernard and Jensen among others, that higher productivity firms tend to be exporters. What is the real world implication of this observation? From the Economic Report of the President, 2010 (pages 133-34):
The Administration is taking many concrete steps to encourage exports. The Trade Promotion Coordinating Committee brings government agencies together to help firms export. While the final decision of whether and how much to export is a market decision made by private businesses, the government can play a constructive role in many ways. The Export-Import Bank can help with financing; consular offices can provide contacts, information, and advocacy; Commerce Department officials can help firms negotiate hurdles; a combination of agencies can help small and mid-sized businesses explore overseas markets. Much of the academic literature in trade models a firm’s decision to export as involving a substantial one-time fixed cost (Melitz 2003). The Administration is doing all that it can to lower that initial fixed cost to help expand exports.
As an aside, I think it’s a long overdue development that the ERP 2010 contains references for the theoretical/empirical results cited; hopefully this will help return knowledge-based decision-making to policy debates.
What is the innovation that the Melitz model brings? From the abstract:
This paper builds a dynamic industry model with heterogeneous firms that explains why international trade induces reallocations of resources among firms in an industry. The paper shows how the exposure to trade will induce only the more productive firms to enter the export market (while some less productive firms continue to produce only for the domestic market) and will simultaneously force the least productive firms to exit. It then shows how further increases in the industry’s exposure to trade lead to additional inter-firm reallocations towards more productive firms. These phenomena have been empirically documented but can not be explained by current general equilibrium trade models, because they rely on a representative firm framework. The paper also shows how the aggregate industry productivity growth generated by the reallocations contributes to a welfare gain, thus highlighting a benefit from trade that has not been examined theoretically before. The paper adapts Hopenhayn’s (1992a) dynamic industry model to monopolistic competition in a general equilibrium setting. In so doing, the paper provides an extension of Krugman’s (1980) trade model that incorporates firm level productivity differences. Firms with different productivity levels coexist in an industry because each firm faces initial uncertainty concerning its productivity before making an irreversible investment to enter the industry. Entry into the export market is also costly, but the firm’s decision to export occurs after it gains knowledge of its productivity.
In many standard models taught in a typical undergraduate course, any aid to exporters are merely transfers to the exporters, and result in a dead weight loss to the nation. I have the feeling that a lot of people still run around with models of that nature in their head; yet these models are wholely incapable for explaining the patterns we observe in real world pertaining to what firms participate in international markets.
Productivity vs. Factor Proportions?
I would be the first to say that productivity is not the be all or end all. Comparative advantage derived from factor proportions also plays a role (or else I’d better stop teaching it in my trade course). My new colleague, Isao Kamata, has an interesting paper (“Comparative Advantage, Firm Heterogeneity,
and Selection of Exporters”) that addresses how both productivity and factor proportions motivations can coexist in the same model.
… This paper explains this cross-industry and cross-country variation in the exporter fraction from the perspective of comparative advantage, in particular comparative advantage in terms of factor
proportion. Although other potential country-specific or industry-specific determinants of the
selection of exporters can be considered, the empirical analysis in this paper shows that the
observed patterns of the exporter fraction can be well explained by comparative advantage, or
countries’ relative factor abundance and industries’ relative factor intensity.
The influence of factor proportion-based comparative advantage on difference in firmlevel
export decision has been theoretically examined by Bernard, Redding and Schott (2007).
They incorporate the model by Melitz (2003), which has provided a theoretical benchmark
explaining the empirical regularity of self-selection of exporters (i.e., firms that are the most
productive in a domestic market become exporters), into a two-country, two-factor and twoindustry
framework. To derive a prediction describing an empirical relationship between the
exporter fraction and factor proportion, this paper extends the model by Bernard, Redding and
Schott to a multi-industry framework. That is, this paper considers an economy that comprises
two countries differing in the relative abundance of two production factors (skilled and
unskilled labor) and a large number of industries differing in the relative intensity of the two
production factors. In these two countries each industry is populated with a continuum of
firms differing in total factor productivity. Two threshold levels of firms’ productivity, one of
which divides domestic producers from “exiters” and the other divides these domestic
producers into exporters and non-exporters, are created through monopolistic competition and
costly international trade. However, the impact of international trade on the two productivity
cutoffs is asymmetric across industries, due to the difference in factor proportion. Keener
competition among firms seeking larger potential export profits raises the domestic production
productivity cutoff more in comparative-advantage industries, while the cutoff for exporting is relatively lower in these industries due to the comparative advantage over foreign
competitors. This impact of trade on the two productivity cutoffs is more pronounced with the
strength of comparative advantage; as a result, the “gap” between the two productivity cutoffs,
which is measured as the ratio of the export cutoff to the domestic-production cutoff, is the
largest in the industry with the lowest relative intensity of the factor with which the country is
relatively well-endowed, and the smallest in the industry with the highest relative intensity of
that factor. This ratio of the two productivity cutoffs determines the ex post fraction of
exporters among domestic producers (the smaller the gap, the larger the fraction). Therefore,
if all other conditions are equal between countries and among industries, in the relatively
more skilled-labor abundant country, the exporter fraction rises with an industry’s relative
skilled-labor intensity, and vice versa.
Kamata examines four diverse countries — Chile, Colombia, India, and the United States. He finds the evidence is consistent with the model. For instance, a scatterplot of proportion of exporter firms against skill intensity reveals an upward slope for the US, while this relationship is less pronounced in countries that do not possess a comparative advantage in high-skill goods.
Figure 5:Fraction of Exporters among All Active Firms vs Industry Skill Intensity: the United States. Numbers denote 2-digit SIC industries. Source: I. Kamata, “Comparative Advantage, Firm Heterogeneity,
and Selection of Exporters,” La Follette working paper No. 2010-05.)
Policy Ramifications?
Kamata’s paper does not contain any explicit policy implications. However, it seems to me (recalling I’m not a trade economist) that one of the implications of the model is that reductions in the fixed (per period) costs of entering into the export markets can have a particularly large impact on the proportion of firms that export when the country possesses a factor-proportions driven comparative advantage in that specific industry. This in turn suggests the emphasis should be placed on firms operating in industries which are high-skill intensive (assuming the US remains a high skill labor-abundant economy).
Another implication of papers in this literature more generally is that an open trading system leads to higher productivity through the reallocation of factors of production, but not only via the standard channels. From pages 278-79 of ERP.
Firm Productivity. Trade can also allow productive firms to grow
relative to less productive firms as they increase their scale. A new literature
on “heterogeneous firms” has focused less on differences in endowments
or comparative advantage across countries and more on how firms within
an economy respond to trade. A crucial insight in this literature is that
most firms do not engage in trade, but those that do are on average more
productive and pay higher wages. This literature shows that when a
country opens to trade, more productive firms grow relative to less productive
firms, thus shifting labor and other resources to the better organized
firms and increasing overall productivity. Even if workers do not switch
industries, they move from firms that are either poorly managed or that
use less advanced technology and production processes toward the more
productive firms. Thus, firm-level evidence demonstrates that trade
allows not only economy-wide advances through resource allocation, but
also allows within-industry productivity advances through reallocation of
resources across firms. This shift has clear welfare-enhancing impacts; see
Bernard et al. (2007) for a general overview of this literature.
That being said, I think a commitment to an open trading system requires more than “just say no” to protectionist measures. It also requires establishing the policy bases for mitigating protectionist pressures. This in turn (in my opinion) requires ensuring that the benefits of higher productivity and lower prices are also shared by those that experience the effects of competition from foreign producers. (See also [1].)
I wonder about the opportunity for exports of professional services, e.g., consulting, insurance, credit card processing, etc. Services are a major part of our economy, and we probably have comparative advantages and high productivity is most services. I wonder if the folks behind the Economic Report to the President have some ideas about how to reduce the “export entry” cost for mid-sized professional services. If so, doubling could be feasible, and it would generate needed jobs.
Menzie: Two questions.
1) Do you view the Brander-Spencer model of profit-shifting to be an old model or a new one?
2) Should Industrial Policy favour skill-intensive industries? Or favour sectors hurt by foreign competition? Or both?
GNP: If I learned it in graduate school, I count it as an old model (or, the original “New International Economics”).
This issue – the shifting of productivity among various domestic firms is small potatoes. What difference does that make to U.S. Gross Domestic Product?
The big issue no one with a Ph.D. in economics wants to discuss is the impact of an excess of imports over exports on the Gross Domestic Product of the country.
The answer is quite simple. Imports subtract from GDP. Exports add to GDP. A trade deficit reduces the GDP below what would exist with equal trade.
Increased productivity among certain firms in the U.S. will not add enough to GDP to be worth discussing. Tell us how to change the size of the trade deficit so that the promise of trade – to benefit all nations that participate – can be realized.
There seems to be some key aspects that are being over looked here.
(1) Who plays the “strong currency” against the US dollar in order for a USD to take place? Once it was the Sterling, and then the Dollar played that role. Now is it going to be China? I don’t think so; and I think a better argument can be made that they should actually devalue (a lot has changed in 12 months, just an example, Chinese banks have lent out about $202 billion in January alone–I’m thinking that has to be a one month world record). Eventually, they may have to devalue against gold, which what in effect they had to do in the Great Depression as all other nations rushed to devalue. To say that the “gold standard” prolonged or exasperated the Great Depression because it was too ridged is utterly absurd. Once FDR made the dollar nonredeemable, the government could valuate at what ever it wanted to with the stroke of a pen, short of causing domestic turmoil; but that’s true of fiat currencies as well redeemable
(2) Although US production as a percentage of GDP is fairly low, in terms of absolute numbers, though, it is huge, as well as the current export numbers, that is, in dollar terms. Pray tell, who is going to absorb all of these exports? Is China going to reduce their exports? Is Germany going to reduce theirs? Is Japan going to reduce theirs? It is simply an absurdity if every major economy attempts to adopt an export led model. Further, many of these export led nation’s corporations have very little profit from their domestic sales, especially China, where their corporate profits from domestic sales are basically flat.
(3) Even for such an export policy to work, it would eventually lead to a great inefficiency that will shortly be killed by higher energy costs. So, we make things and export it too China, and the things that we don’t produce, China produces and exports to us? And then we do this with Germany and Japan as well? And now that the Saudi’s are gearing their economy around plastics and other petroleum based products, so we can add them into the mix.
This ends once oil breeches $100 a barrel on an annual mean basis. This is the critical failing of ALL international trade models: they do not take into effect energy costs. The models assume that the energy costs are “priced-in” in the cost of doing business; but that only works if energy is properly priced–and it’s not. Due to US subsidies and military intervention, the price of oil has been depressed, and these subsidies and trends are quickly becoming unsustainable.
International trade as a model, and a profession is a dead end; and a good warning is that it’s been the new “hip thing” to study, teach, and engage in for about 30 years now; and like many things, once it becomes the popular things to do it’s usually on its way out. The next trend in economic studies will be localized and domestic markets as the world has to adjust and come to terms with expensive energy and finite resources.
What I suspect is going to happen is that President Obama will attempt to intervene and manipulate the economy in order to ramp up exports, but it won’t work (of course minus commodity exports like agriculture, natural gas, and coal). Certainly the situation can be made to look plausible, that is, governments can marshal resources in order to ramp up production, but eventually you need someone on the other side of the production to purchase it. And not to mention that the route President Obama will attempt to take is ramp up export production through an over expansion of credit, as opposed to organic growth, and eventually, if it even works, will send false demands to the market and it will all come crashing down once that demand reaches an unsustainable point.
If governments could help the economy on the advice of economists, then it stands to reason that we should always have full employment.
We can double exports easily.
Just let Zimbabwe Ben murder the dollar, and soon enough we’ll be setting up sweatshops to sell cheap junk to China.
Glad Menzi isn’t adhering to “old models”.
Me being one who started his career in US manufacturing and made a career change to the “Information Age” in the early 90s because that sounded a little more “sustainable”, I can say coming to grips with any model describing what we have had as a result of global “free market” dynamics is a mind boggling task.
A couple quickies.
Manufacturng equipment is an industry, so no one can get a comparative advantage with manufacturing technology, you can just buy it. What matters is cost and availability of unskilled, semi skilled and skilled labor. Plus overhead factors, like is there the required infrastructure (a plus) and are there cost factors on biz(negative perhaps?) like social programs, taxes etc…and are there incentives, like tax breaks, export subsidies, etc..?
We must also take into account that we have multi-national corporations, from many countries, that provide capital and global marketing and are shaping the global landscape.
In services and IT, the same international dynamic is going on. We sell the technology development tools. Global Crossing put in the trans-Pacific cable then went bankrupt and sold it to a Hong Kong investor for peanuts. The data highway to India now costs a penny a minute. IBM and the rest of the IT consulting firms are shifting programming work there. Whole “cloud computing” systems will be run in Bangalore.
I haven’t been able to figure what to do about this, but please, at least make accurate models for us!
Many assumptions are being made. We are heading into a more regionalized global trade model. Asia, S. America are forming new alliances that don’t include the US. The lack of dialogue among the EU ldrs. and the US outside of G-7,8 or 20 meetings is obvious. The US can no longer lead by example, only by force, which is waning. We are fortunate to be alive to see trend changes that occur very rarely.
Menzie: Brander-Spence profit shifting model was indeed part of the New International Economics–old model it is.
Now, I may be a tad out of date. But do the “new models” lend themselves to “new” Industrial/Trade Policy prescriptions? What are they beyond a vague prescription of protecting losers?
For example, do we have “new models” that explain the US auto company bail-outs?
For years, the US armed forces and taxpayers subsidized successful hi-tech weapon and aerospace sectors. I would guess that this situation of state-supported exports worked well for the USA as long as the USA kept its own forces out of wars. Alas, once again, the potential benefits have all been eaten up fighting low-tech insurgents on their tribal turf.
GNP,
Security is a “product” that needs to be paid for, but we tend to take it for granted when we have it.
We did have a long Cold War, which I think started in either Lenin’s or Stalin’s time, and Reagan decided to end it by using the “strength” of a capitalist economy against the flawed model of the Soviets’. So we got a military-economic war, which we “won”.
But as all government programs, they develop an inertia of their own and live on at a scale and effectiveness that do not necessarily reflect the current socio-economic need.
Now there is always a need to police beyond our borders, and if we didn’t have our Navy, we would still have the Pirates of the Caribean in addition to just the Pirates of Somalia. No Pirates of Corsair, thank someone’s God, due to our policing of the Middle East. The jury is still out on Nuclear Proliferation there, and also whether Israel is too-big-to-fail.
But terrorism is a difficult thing to fight, and no one has been able to really come up with an effective way.
We are well past the cost-benefit of this spending, and are rapidly running out of the means altogether. But again we seem to think that we can have major economic crisis, but somehow the status quo doesn’t have to change.
Thanks Menzie-
Figure 5 shows that increased skills (technology) correlates with greater international trade… That dovetails nicely with Obama’s budget increases for education and basic research.
What will be interesting, will be whether government expenditures will continue to increase in productive investment (education, infrastructure, research), or whether the political weight of the baby boomers apportions expenditures towards geriatric social services instead.
Cedric,
Relative to military decisions taken in this century, President Reagan’s ramp-up in defence expenditures, bellicose rhetoric and weapons flow to Afghanistan seem all rather inspired. The Soviet Union was a formidable, well-armed foe–a legitimate enemy. Even the Vietnam war must be viewed in the context of the broader Cold War.
But where is your faith in likelihood of the Soviet domestic economy buckling under the weight of such a rapidly growing military? The Soviet Union central-planned nightmare would have collapsed all the same. It might have taken slightly longer; US taxpayers might have saved a few dollars.
Frankly, I believe the USA made a mistake by helping to drive out the Soviet occupiers of Afghanistan. A Soviet-occupied Afghanistan would have eventually drained the occupier, demoralizing the armed forces and civilian society. The situation called for a lower intensity campaign of sustained harassment.
I disagree with your comments about terrorism. I believe both North America and western Europe were doing a good job of preventing and dealing with terrorism prior to Sept. 11, and that the Sept. 11 attack was a unique, unlikely event. The rhetoric and practice of the US War on terrorism has hurt the reputation of the USA and international goodwill for the USA. In that respect the box-cutter gang won a major victory against the USA. The hyper-vigilant hysterical reaction has put policy makers in a no-win situation of having to satisfy impossible to meet expectations.
Israel ain’t too big to fail. It is too strong and tough to fail. The question is what kind of price will both the USA and Israel pay for additional colonized land in Jerusalem and the West Bank now that Gaza settlements have been long abandoned.
It is interesting to observe how the Israeli economy appears to be adapting to a state of perpetual low-frequency conflict. Companies are increasingly dual-listed and multi-national. The export sector is hi-tech and arms-intensive. I suspect that many Israeli hi-tech companies are highly mobile; if the security situation were to ever seriously degrade, shop can be quickly moved to North America or other more secure jurisdictions.
If a functional peace were ever negotiated between what’s left of the Palestinian mandate and Israel, I would expect the overall Israeli economy to grow by leaps and bounds. Especially the export sector. In the beginning it could be embarrassing. The Israeli economy in absolute terms would likely rocket forward compared to the Palestinian economy that might grow proportionately faster but still grow slowly in absolute terms. Israel has more human capital and better infrastructure in place.
Could we expand the the scope of subject to the current account ?
That is Rf – Pf ~ 0 as exports may not be rewarding on a timely schedule but imports may be monitored more swiftly in accordance with trivial considerations.They include the consumer ability to repay his debts in accordance with his means, the pricing mechanism of commodities and other assets.
An additional area of constraints lies in the growing share of government expenditures in many countries GDP, as opposed to the countries wishes to see their private sectors flourishing and take a growing share of the world export. Will these constraints plead for a better allocation of resources transferred from the private sector to the public sector?
Isn’t it interesting that Presidents sometimes are criticized for not giving the citizens a “call to arms”. People will say “This generation has no cause or focus to fight for, or rally around”. Yet here is a good “call to arms”–Doubling of exports. Maybe no better cause President Obama could choose(other than increased productivity) for this country to rally around. And yet what happens?? President Obama is scoffed at and derided for having the hutzpah to even suggest the goal of doubling exports. I guess IF you didn’t have banks (and bank management) that think shifting paper around instead of creating REAL economic assets (with human capital and EQUITY funds) which have a longer life than an expiration date on a junk bond or swap, it might be something “unscoffworthy”???
GNP: Your view of what “should have” been done by the U.S. in ’79-’89 Soviet-occupied Afghanistan is what actually happened. This was a big factor in the failure of the USSR. The Soviet’s weren’t “driven out of” Afghanistan any more than the U.S. was driven out of Vietnam. They left due to the drain on their economy and morale.
Menzie: Great post!
Michael Porter, in “The Competitive Advantage of Nations” (circa 1990?), pointed out the stylized fact that successful exporters emerge as a result of vigorous domestic competition, whereas as efforts to promote “National Champion” firms that could compete internationally haven’t worked so well. So perhaps the policy focus should be at least partially directed at domestic competition, particular pro-incumbent and anti-consumer regulations.
I think it would be preferable to have a combined target incorporating a reduction in imports and an increase in exports. Policies need to be structured so that the net international investment position balances and also trade deficits need to balance on average.
Higher domestic investment and consumption results in more jobs, tax revenue and a less housing/financial services focused economy.
More OT…..
benamery21: I agree with your comments on how the USA merely supplied the catalyst and the Soviets did the rest in Afghanistan.
I should have typed that the USA helped drive the Soviet Union out too quickly. Prolonging the misery would have had an even greater effect on weakening the Soviet Union.
As it turns out, weaker oil prices helped to bankrupt the USSR. The inflation-adjusted price of US benchmark oil declined by 63% from the time the Soviets invaded in 1979 and started to withdraw in 1988. Volker is the real “hero”, not tough-talking President Reagan. Cash-heavy, older Americans were the real winners.
I doubt anybody saw that one coming: monetary-policy engineered global recession as a tool in the battle between democratic free market capitalism and centrally-planned totalitarian socialism.
Reformer Ray said: “This issue – the shifting of productivity among various domestic firms is small potatoes. What difference does that make to U.S. Gross Domestic Product?”
This is classic economist myopoia. Favoring high productivity firms over low productivity firms (note that in both cases, the firms are at least breaking even) is actually huge in terms of real life impacts.
It is the difference between the hundreds of craft beers produced in the low productivity beer industry in Germany, and insipid national market beers you see in the United States. It is the difference between main street shops and Wal-Mart. It is the difference between family restaurants and McDonald’s.
A shift towards favoring high productivity firms has intense cultural impact on the consumer side and in the cultural dimensions of work. It is a antiseptic way of saying that you favor big business over small business. It opens up intense political fault lines.
Productivity as used in the international trade literature measures something considerably narrower than what most economists and economics educated non-economists realize. They are very slow to wake up to the idea that there are legitimate values in the economy beyond per capita GNP, that productivity measures simply do not capture, and are routinely stunned at the opposition and political barriers they face as a result of the productivity centric blinders they are wearing.
I think Reformer Ray has the main point, though in somewhat rough fashion. There is a real global battle going on for AD right now, and the U.S. has unilaterally disarmed itself. There is simply no excuse for currency interventions. Even Krugman has decried China’s policies, using the phrase “currency mercantilism.” It is the ultimate, most effective form of “protectionism.”
The current situation is unsustainable, just not as badly unsustainable as it was two years ago. To pretend that the debate should focus on gains from comparative advantage and efficiency is just a policy of deny and delay, presumably until imbalances reach crisis propoertions.
A doubling of exports is simply a foolish goal. When I heard that, I knew there is no known reasonable basis for expecting sustainable “recovery.” What should we do, pick the winners? The only practical, and doable goal is to try to get international cooperation to put trade back on the tracks of comparative advantage (however reached), not the highly distorted patterns we see now. (A sufficiently devalued currency can give a country an absolute advantage in everything.) Anti-protectionist propaganda that pretends the efficiency gains is the big story tody is tiring and counterproductive. We have to face up to huge adjustments that are needed, rather than wait for crisis.