The correlation between trade and income has been extensively documented in empirical research. But the ‘endogeneity issue’ of whether trade increases income or income increases trade has not received a definite answer. The first attempts to solve the endogeneity issue involved the use of geographical instruments. A natural choice of instrument is the geographical distance from one country to other countries, since distance provides considerable information about trade volumes. For example, New Zealand is far from most other countries and the amount it trades is reduced when compared to Belgium, which is close to many of the world’s richest countries. But the concern with this approach is that distance may be acting through channels other than trade. For example, countries close to the equator may be further from the world’s richest countries, but this happens to coincide with the fact that they have weak institutions, which may be the real cause for reduced trade volumes.
An alternative approach, which still relies on geography as an instrument for trade, is to observe natural experiments that generate asymmetric shocks in trade distances. One type of experiment focuses on the effects of trade disruption associated with wars or natural disasters. The Six Day War fought between Israel and Egypt, which resulted in the closure of the Suez Canal between 1967 and 1975, is an example of such a natural experiment. Because the Suez Canal provides the shortest sea route between Asia and Europe, its closure implied that in some cases the transport of goods through the alternative route around the Cape of Good Hope would take almost double the nautical miles. This variation in shipping distance allows for the analysis of the impact of pure transportation costs on trade and the effect of trade on output. Another experiment, that explores the effects of unexpected variation in trade distances in a similar manner, focuses on air transportation. It uses the two months disruption in flights caused by the eruption of a volcano in Iceland in 2010, allowing for the direct analysis of goods flows to European destinations, and an indirect analysis of non-European destinations via network effects. Not only do both of these experiments enable the evaluation of the effect of trade to be free from confounding factors, like the movement of people. They also create the opportunity for research in economic development, patterns of production specialization across countries, and the ability of supply chains to react to these shocks.
A second type of natural experiment is the change in transportation technology over time. One striking example is the reduction of the costs of air freight between 1955 and 2004, which fell by a factor of ten, leading to a substantial shift toward air freight around the globe. Similar effects have been found for the development of ‘containerization’ in shipping. Both of these innovations can be interpreted in terms of a change in the physical distance between countries over time that may be used to identify the effect of trade on income. One of the main findings of the work on air freight is that, in general, trade has a significant positive effect on income. However, a different technological shock indicates a more nuanced story. Going back to the first wave of globalization at the end of 19th century and beginning of the 20th century, the invention of the steamship removed the dependence of transport on wind. This produced an asymmetric change in shipping times across countries because some shipping routes benefited more from trade winds than others. After this change, the research found that the income per capita gap between poor and rich countries increased even more. One explanation is that a reduction in relative trade costs together with increasing returns in manufactures causes a process of industrial agglomeration that is beneficial for countries that specialize in manufacturing but might actually harm countries that specialize in agriculture which is characterized by constant returns to scale. Since this suggests that a reduction in trade costs across countries does not automatically generate large positive effects on economic development, more research is necessary to understand the mechanisms through which trade may lead to positive effects on income.
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Freyer, James (2009) “Distance, Trade, and Income: The 1967 to 1975 Closing of the Suez Canal as a Natural Experiment” NBER Working Paper 15557.
Gerritse, Michiel (2017) “Does Trade Cause Unfortunate Specialization in Developing Economies? Evidence from Countries South of the Suez Canal,” Working Paper.
Pascali, Luigi (forthcoming) “The Wind of Change: Maritime Techonology, Trade, and Economic Development,” American Economic Review. [working paper]
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