NBER Reporter: Winter 2000/2001

International Trade and Investment

The NBER's Program on International Trade and Investment met on December 1-2 at the NBER's offices in Palo Alto, California. Program Director Robert C. Feenstra, University of California, Davis, organized the meeting. The following papers were discussed:

James E. Anderson, NBER and Boston College, and Eric van Wincoop, Federal Reserve Bank of New York, "Gravity with Gravitas: A Resolution of the Border Puzzle"

Peter Debaere, University of Texas, "Testing 'New' Trade Theory without Testing for Gravity: Reinterpreting the Evidence"

Donald R. Davis and David E. Weinstein, NBER and Columbia University, "A New Approach to Bilateral Trade Patterns and Balances"

Eckhard Janeba, NBER and University of Colorado, Boulder, "Global Corporations and Local Politics: A Theory of Voter Backlash"

Theo Eicher, University of Washington, Seattle, and Thomas Osang, Southern Methodist University, "Politics and Trade Policy: An Empirical Investigation"

James A. Levinsohn, NBER and University of Michigan, and Wendy Petropoulos, University of Michigan, "Creative Destruction or Just Plain Destruction? The U.S. Textile and Apparel Industries since 1972"

Robert C. Feenstra and Gordon H. Hanson, NBER and University of Michigan, "Intermediaries in Enterpôt Trade: Hong Kong Reexports of Chinese Goods"

Bruce A. Blonigen, NBER and University of Oregon, and Ronald B. Davies, University of Oregon, "The Effect of Bilateral Tax Treaties on U.S. FDI Activity" (NBER Working Paper No. 7929)

The gravity model has been widely used to infer that such institutions as customs unions and exchange rate mechanisms have substantial effects on trade flows. However, Anderson and van Wincoop show that the gravity model as usually estimated does not correspond to the theory behind it. They solve the "border puzzle" by applying that theory differently and find that national borders reduce trade between the United States and Canada by about 40 percent, while reducing trade among other industrialized countries by about 30 percent. Debaere revisits the ongoing debate about empirical support for monopolistic competition models in international trade. He refutes the claim that monopolistic competition models, which should explain trade primarily among developed countries, find empirical support among just any group of non-OECD countries. After reexamining Helpman's 1987 analysis of trade-to-GDP ratios and country similarity, Debaere re-introduces trade-to-GDP ratios in the test equations for these models; this has the advantage of providing a zero-gravity test of New Trade Theory. The results therefore will not depend on the strong correlation between countries' size and their volume of trade.

The standard approach to bilateral trade patterns is the so-called "gravity model," which holds that bilateral trade volumes are proportional to the product of country GDPs and inversely proportional to bilateral distance. Though this model generates good fits with data, it has an important shortcoming: it posits that all traded goods are differentiated by source, predicting that trade volumes move smoothly with distance and size. If instead there are also homogeneous goods for which price is the principal determinant of bilateral trade patterns, then the standard gravity model needs to be supplemented with a model of bilateral trade in homogeneous goods. Davis and Weinstein implement such a dual approach to bilateral trade patterns for a sample of 61 countries and 30 industries. The countries and industries that appear to focus largely on homogenous goods trade are so identified in this empirical exercise. Moreover, the authors identify substantial improvements in predictions of bilateral trade patterns and balances.

Host governments often display two types of behavior toward outside investors. Initially, they compete eagerly by offering subsidy packages, but often they reverse these policies later. In contrast to the literature that explains this behavior as a result of a hold-up problem, Janeba argues that these policy reversals are the result of a change in the policy choice or the identity of the policymaker. Voters disagree over the net benefits of attracting corporations because of a redistributional conflict. Economic shocks change the identity of the policymaker over time by affecting the number of people who support the corporation, the incentive of an opponent to become a candidate, and the opponent's probability of winning the election against a proponent. Janeba also shows that societies with more income inequality are less likely to attract outside investment.

Eicher and Osang examine the empirical relevance of three prominent endogenous protection models. Is protection for sale, or do altruistic policymakers worry about political support? They find that protection is indeed "for sale." However, the existence of lobbies matter, as does the relative size of the sectoral pro- and anti-protection contributions. The authors extend the previous tests of the Influence Driven approach (Grossman and Helpman, 1994), comparing its performance to well-specified alternatives. Using J-tests to directly compare the power of the models, they find significant misspecification in the Political Support Function approach. They cannot reject the null hypothesis of correct specification of the Influence Driven model, and they find evidence of some misspecification in the Tariff Function model (Findlay and Wellisz, 1982).

Levinsohn and Petropoulos use plant-level data to examine changes in the U.S. textile and apparel industries. They find that although industry-level evidence suggests that these industries are declining, some plants have experienced significant job creation, investment, and productivity gains. The authors make the case that these two industries are good examples of Schumpeterian Creative Destruction, but that this conclusion requires plant-level data, because the industry-level data paint a very pessimistic picture.

Feenstra and Hanson examine Hong Kong's role in intermediating trade between China and the rest of the world. Hong Kong distributes a large fraction of China's exports. Net of customs, insurance, and freight charges, reexports of Chinese goods are much more expensive when they leave Hong Kong than when they enter. Hong Kong markups on reexports of Chinese goods are higher for differentiated products, products with higher variance in export prices, products sent to China for further processing, and products shipped to countries that have less trade with China. These results are consistent with quality-sorting models of intermediation and with the outsourcing of production tasks from Hong Kong to China. Additional results suggest that Hong Kong traders price discriminate across destination markets and use transfer pricing to shift income from high-tax counties to Hong Kong.

The effects of bilateral tax treaties on foreign direct investment (FDI) activity have been unexplored, despite significant ongoing activities by countries to negotiate and ratify these treaties. Blonigen and Davies estimate the impact of bilateral tax treaties using both U.S. inbound and outbound FDI from 1966-92. Their estimates suggest a statistically significant average annual increase ranging from 2 to 8 percent of FDI activity for each additional year of a treaty, depending on the measure of FDI activity and the empirical framework the authors use. While treaties have an immediate impact on FDI flows, there is a substantial lag before treaty adoption positively affects FDI stocks and affiliate sales. Finally, the results suggest that bilateral tax treaties have an effect on investment beyond the withholding tax rates that they alter; this may include the commitment and risk reduction effects of these treaties.

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