Explaining the Mysteries of International Trade

Summary of working paper 7777
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Once one allows for trade costs in goods markets, a host of puzzling market behaviors seem less mysterious.

Goods shipped from one country to another incur an array of costs. These include but are not limited to transport charges, currency conversion costs, tariffs, and an assortment of "nontariff" expenses, such as those associated with meeting country-specific product standards. The conventional wisdom has been that these costs of transactions in goods markets, while having some effect on trade flows, have little to do with the apparent failure of international capital markets to reach nearly the same degree of integration as domestic ones, even across OECD countries. But NBER Research Associates Maurice Obstfeld and Kenneth Rogoff contend that, in fact, trade costs have profound and surprising indirect effects on inhibiting capital market integration.

In The Six Major Puzzles in International Macroeconomics: Is There a Common Cause? (NBER Working Paper No. 7777), they show that international trade costs are the central actor in a range of economic dramas whose plot twists have confounded experts for quite some time. These include, according to the authors, the fact that, free trade notwithstanding, consumers in the industrialized world consistently display a "strong preference" for domestically produced goods. Similarly, while globally integrated financial markets would seem to inspire a bit of wanderlust in investment capital, the bulk of a country's savings don't stray across borders but, over the long term, are invested at home, and in homegrown equities. "Remarkably, we find that once one allows for trade costs in goods markets," a host of puzzling market behaviors seem less mysterious, they write.

For example, Obstfeld and Rogoff find that the "cost of international trade can dramatically skew domestic consumption in favor of home-produced goods." This insight clarifies previously unexplained findings, like the fact that U.S. investors hold only about 11 percent of their equity wealth in foreign stock markets despite the conventional wisdom that international diversification is prudent. Trade costs also play a role in showing how exchange rate swings can induce such large and persistent discrepancies in countries' relative price levels and in the relative prices of similar internationally tradable goods--as the euro's sharp depreciation against the dollar is doing right now.

In addition, though it may seem highly esoteric to the layman, Obstfeld and Rogoff's study is getting considerable attention because it holds out trade costs as the solution to what some economists consider the "mother of all economic puzzles:" the fact that in developed countries, national savings don't usually flow to other parts of the world where they might get a better rate of return but, for the most part, stay at home as investment. In other words, while there may be periods of large cross-border capital flows -- such as the United States is now experiencing, where the amount of goods and investment flowing into this country versus what's going out has produced a "current account deficit"-- these are temporary phenomena. Despite the current hand wringing about the size of the U.S. current account deficit, what surprises economists is that such deficits are actually relatively small when compared to total national savings and investment. Furthermore, over the long term, the deficits rarely get very big before a correction takes place.

Obstfeld and Rogoff argue that there is a good reason why, ultimately, foreigners finance so little domestic investment and that, as a result, account balances stay in a relatively narrow range. They contend that the "friction" generated by trade costs doesn't just show up in the price of imported products. They find that as a country increases consumption of foreign goods, trade costs aggravate the current account balance in a way that threatens to escalate the real domestic interest rate.

Obstfeld and Rogoff conclude that the mere prospect of high interest rates is enough to prompt "trade reversals." In this situation, imports are increasingly replaced by domestically produced "substitutes," which in turn leads to a reduction in foreign investment and a reduction in the account deficit. The authors find similarly complex forces at work in equities markets, with problems introduced by trade costs--and their effect on such things as the ability of foreign investors to "repatriate" their dividends--explaining why stock investors maintain a preference for home assets.

Finally, they believe that trade costs should be considered by economists who are having a hard time understanding why growth in consumption is still highly variable from one developed country to another, despite the fact that integrated financial markets should produce a more consistent rate. (Obstfeld and Rogoff note that trade costs likely are an important ingredient in resolving issues surrounding the impact of exchange rates. But they admit they lack the kind of compelling evidence of their influence found for the other "puzzles.")

The analysis suggests that the problems created by trade costs might explain why markets have not become more fully integrated than would otherwise be expected, given the progressive drop in barriers to trade and investment. From this prospective, anything that can be done to reduce trade costs should have significant implications for trade and investment flows and, in turn, global economic growth.

-- Matthew Davis