Research

Co-authors: Alejandro Graziano, Kyle Handley

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Abstract:We estimate the impact of trade policy uncertainty (TPU) on CES import price indices, focusing on the implications of Britain’s exit from the European Union (Brexit). Our analysis reveals that a higher probability of Brexit increases U.K. import price indices by raising the prices of existing products and reducing product variety from the E.U. We find evidence that the risk of higher import protection from the 2016 referendum increased current import price indices by 11 log points. This amounted to a 2 log point increase in manufactured goods prices and a 0.6 log point decrease in consumers’ real income.

Co-authors: Kyle Handley, Rod Ludema and Zhi Yu

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Abstract: We examine the role of trade policy uncertainty in shaping the import decisions of firms. If the adoption of a new input requires a sunk cost investment, then the prospect of price increases in that input, e.g. due to trade barriers, reduces the adoption of that input (a substitution effect) and possibly other inputs (complementarity via lower profits). Thus trade policy uncertainty can affect a firm’s entire input mix. We provide a new model of input price uncertainty that captures both effects and derive its empirical implications. We test these using an important episode that lowered input price uncertainty: China’s accession to the WTO and the associated commitment to bind its import tariffs. We estimate large increases in imported inputs by firms from accession; the reduced uncertainty from commitment generates substitution effects larger than the reductions in applied tariffs in 2000-2006 and has significant profit effects.

Co-authors: Saad Ahmad, Sarah Oliver and Serge Shikher

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Abstract: We estimate the impact of increased policy uncertainty from Brexit on UK trade in services. We apply an uncertainty-augmented gravity equation to UK services trade with the European Union at the industry level from 2016Q1 to 2018Q4. By exploiting the variation in the probability of Brexit from prediction markets interacted with a new trade policy risk measure across service industries we identify a significant negative impact of the threat of Brexit on trade values and participation. The increased probability of Brexit in this period lowered services exports by at least 20 log points. 

Co-authors: Kyle Handley and Jeronimo Carballo

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Abstract: We examine the interaction of economic and policy uncertainty in a dynamic, heterogeneous firms model. Uncertainty about foreign income, trade protection, and their interaction dampens export investment. Trade agreements can mitigate uncertainty and the probability of policy uncertainty shocks. We use firm data from 2003–2011 to establish new facts about U.S. export dynamics. These facts include a differentially lower export growth to non-preferential markets driven by the extensive margin at the start of the Great Trade Collapse. The structural model can explain this differential as a consequence of a shock to demand uncertainty. The shock was three times larger for non-preferential markets than preferential ones and it was later reversed, which is consistent with the timing of trade war fears in the crisis.

Co-author: Kyle Handley

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Abstract: Trade policy uncertainty (TPU) has become an important source of economic uncertainty and research. We review the main sources and measures of TPU. We then provide a conceptual framework for modeling TPU and methods for estimating and quantifying its effects. We analyze its role in trade agreements and discuss open questions for future research. 

Co-authors: Alejandro Graziano and Kyle Handley

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Abstract: We estimate the uncertainty effects of preferential trade disagreements. Increases in the probability of Britain’s exit from the European Union (Brexit) reduce bilateral export values and trade participation. These effects are increasing in trade policy risk across products and asymmetric for UK and EU exporters. We estimate that a persistent doubling of the probability of Brexit at the average disagreement tariff of 4.5% lowers EU-UK bilateral export values by 15 log points on average, and more so for EU than UK exporters. Neither believed a trade war was likely. 

Co-authors: Alejandro Graziano and Kyle Handley

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Description: Brexit uncertainty has reduced trade between the United Kingdom (UK) and rest of the European Union (EU). Recent evidence finds lower UK firm export entry into the EU (Crowley et al., 2019) and lower UKEU bilateral export values and product entry (Graziano, Handley and Limão, 2018; hereafter GHL). The ongoing risk of renegotiation since the June 2015 referendum announcement, generates an option value of waiting for firms making sunk cost investments, e.g., to export. After Brexit the UK will no longer be subject to the EU common trade policy and will therefore have to renegotiate preferential trade agreements (PTAs) and multilateral ones. We test the importance of this source of Brexit uncertainty and find evidence of negative trade externalities beyond Europe. 

The trade effects of Brexit threaten to spillover beyond UK trade with the EU and Europe. Forecasts of the costs of Brexit expost focus on trade with the EU (Dhingra et al., 2017; Sampson, 2017). Similar costs apply to non-EU countries that do not renegotiate agreements with the UK, but also to others for the following reason. Any UK renegotiation with non-EU countries will be lengthy and the resulting agreement subject to trade policy uncertainty (TPU) given the UK’s propensity to abandon PTAs (e.g., EFTA in 1973).1 Less credible commitments may reduce the value of future PTAs to governments and firms (Carballo et al., 2018). 

We provide evidence for one such source of TPU by following GHL: they estimate elasticities of export value and participation with respect to Brexit uncertainty for the UK-EU whereas we focus on UK trade with a set of non-European countries it had PTAs with by 2016. We use monthly and product level variation in exports to identify the cross elasticity of changes in the probability of Brexit (before the June 2016 referendum) and the tail-risk for different products. This model-based tail-risk measures the share of lost profits if trade barriers increased to a particular level. We focus on a scenario that seems plausible: a return to the higher most-favored-nation tariffs (MFN). Using these elasticities, we quantify the average change in Brexit probability before vs. after the referendum: it reduced UK-PTAs average trade value by around 18% and net product entry by 37%, but only in industries with high sunk costs of exports. 

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Description: The research in this volume aims to understand the impacts of international trade on policies and economic outcomes of highly interdependent countries and the role of institutions in shaping them. It comes at a critical time: the unprecedented wave of international economic integration since the 1990s was abruptly interrupted by a collapse in commerce and fears of a trade war in 2008–2009. Moreover, the recent backlash against trade agreements by two of its traditional supporters threatens a wave of disintegration. The United Kingdom (U.K.) has voted to exit the European Union, and the United States (U.S.) is renegotiating and possibly abandoning some of its trade commitments. 

Co-author: Kyle Handley

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Abstract: We examine the impact of policy uncertainty on trade, prices, and real income through firm entry investments in general equilibrium. We estimate and quantify the impact of trade policy on China’s export boom to the United States following its 2001 WTO accession. We find the accession reduced the US threat of a trade war, which can account for over one-third of that export growth in the period 2000– 2005. Reduced policy uncertainty lowered US prices and increased its consumers’ income by the equivalent of a 13-percentage-point permanent tariff decrease. These findings provide evidence of large effects of policy uncertainty on economic activity and the importance of agreements for reducing it. 

2011 Chair Jacquemin Prize: best paper in Trade Policy and Heterogeneous firms

Co-author: Kyle Handley

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Abstract: Using a dynamic, heterogeneous firms model with sunk costs of exporting we show that: (i) investment and entry into export markets is reduced when trade policy is uncertain and (ii) credible preferential trade agreements (PTAs) increase trade even if applied trade barriers are currently low. We structurally estimate the effect of policy uncertainty on firm entry following Portugal’s accession to the European Community in 1986 and find that (i) the trade policy reform accounted for a large fraction of the observed Portuguese exporting firms’ entry and sales (ii) the accession removed uncertainty about future EC trade policies and (iii) this uncertainty channel accounted for a large fraction of the predicted growth. These results have broader implications for other PTAs and our approach can be applied to analyze other sources of policy uncertainty. 

Co-author: Giovanni Maggi

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Abstract: We explore conditions under which trade agreements can provide gains by reducing trade-policy uncertainty. Given the degree of income risk aversion, this is more likely when economies are more open, export supply elasticities are lower and economies more specialized. Governments have stronger incentives to sign trade agreements when the trading environment is more uncertain. As exogenous trade costs decline, the gains from reducing tariff uncertainty become more important relative to reducing average tariff levels. We also develop a simple "sufficient statistic" approach to quantify the gains from managing trade-policy uncertainty and examine the impact of ex-ante investments on such gains. 

Co-author: Patricia Tovar Rodriguez

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Abstract: Why do governments employ inefficient policies when more efficient ones are available for the same purpose? We address this puzzle in the context of redistribution toward special interest groups (SIGs) by focusing on a set of important policies: tariffs and non-tariff barriers (NTBs). In our policy choice model a government can gain by committing to constrain tariffs through international agreements even if this leads to the use of less efficient NTBs; commitment has political value because it improves the bargaining position of a government that is weak relative to domestic SIGs. Using detailed data we find support for several of the model's predictions including: (i) tariff commitments in trade agreements increase the likelihood and restrictiveness of NTBs but not enough to offset the original tariff reductions; (ii) tariff commitments are more likely to be adopted and more stringent when the government is weaker relative to a SIG. Thus, the results can explain the use of inefficient policies for redistribution and suggest that the bargaining motive is an important source of the political value of commitment in international agreements.

Co-authors: Christian Broda and David Weinstein

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Abstract: We find that prior to World Trade Organization membership, countries set import tariffs 9 percentage points higher on inelastically supplied imports relative to those supplied elastically. The magnitude of this effect is similar to the size of average tariffs in these countries, and market power explains more of the tariff variation than a commonly used political economy variable. Moreover, US trade restrictions not covered by the WTO are significantly higher on goods where the United States has more market power. We find strong evidence that these importers have market power and use it in setting noncooperative trade policy. 

Co-author: Allan Drazen

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Abstract: When two policies are available to achieve the same goal why is the relatively inefficient one often observed? We address this question in the context of policies used to redistribute income towards special interest groups (SIGs) where in the first stage the constraints on policy instruments are chosen and in the second the government bargains with SIGs over the level of the available policies. Restrictions on the use of efficient policies and the use of inefficient ones reduce the surplus over which SIGs and governments can bargain but it also improves the government's bargaining position thus increasing its share of the surplus. The positive effect for the government dominates under plausible conditions. Inefficient policies are the equilibrium outcome under alternative policy selection mechanisms, e.g., election of policymakers and bargaining between SIGs and the government. The model also explains the coexistence of transfer policies. Moreover, we show why a weak government is more likely to choose the inefficient transfer and discuss how this result may be tested.

Co-author: Baybars Karacaovali

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Abstract: Preferential trade agreements (PTAs) are characterized by liberalization with respect to only a few partners and thus they can potentially clash with, and retard multilateral trade liberalization (MTL). Yet there is almost no systematic evidence on whether the numerous existing PTAs actually affect MTL. We provide a model showing that PTAs hinder MTL unless they entail accession to a customs union with internal transfers. Using product-level tariffs negotiated by the European Union (EU) in the last two multilateral trade rounds we find that several of its PTAs have clashed with its MTL. However, this effect is absent for EU accessions. Moreover, we provide new evidence on the political economy determinants of trade policy in the EU.

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Abstract: In many preferential trade agreements (PTAs) countries exchange not only reductions in trade barriers but also cooperation in non-trade issues such as labor and environmental standards, intellectual property, etc. We provide a model of PTAs motivated by cooperation in non-trade issues and analyze its implications for global free trade and welfare. We find that such PTAs increase the cost of multilateral tariff reductions and thus cause a stumbling block to global free trade. This occurs because multilateral tariff reductions decrease the threat that can be used in PTAs and thus the surplus that can be extracted from them. By explicitly modeling the interaction between preferential and multilateral negotiations we derive a testable prediction and provide novel econometric evidence that supports the model’s key prediction. The welfare analysis shows that the current WTO rules allowing this type of PTAs may be optimal for economically large countries, thus the model can predict the rules we observe. We also analyze alternative rules that constitute a Pareto improvement.

Reprinted in “Economics of International Trade Law” by Edward Elgar, ed. Alan Sykes

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Abstract: Most countries are members of preferential trade agreements (PTAs). The effect of these agreements has attracted much interest and raised the question of whether PTAs promote or slow multilateral trade liberalization, i.e., whether they are a "building block" or "stumbling block" to multilateral liberalization. Despite this long-standing concern with PTAs and the lack of theoretical consensus, there is no systematic evidence on whether they are actually a stumbling block to multilateral liberalization. We use detailed data on U.S. multilateral tariffs to provide the first systematic evidence that the direct effect of PTAs was to generate a stumbling block to its MTL. We also provide evidence of reciprocity in multilateral tariff reductions.

Reprinted in “The WTO and Reciprocal Preferential Trading Agreements” by Edward Elgar, ed. Caroline Freund

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Abstract: We analyze whether linking international cooperation in trade policy to environmental policy (or other issues with nonpecuniary externalities) promotes more cooperation in both policies, or whether cooperation in one is strengthened at the expense of the other. In the context of self-enforcing agreements, we show that if the policies are independent in the government's objective function, then linkage promotes cooperation in one policy at the expense of the policy that is easier to enforce under no-linkage. However, if the linked policies are not independent and if these policies are strategic complements, then linkage can sustain more cooperation in both issues than no-linkage. The policies are strategic complements only if (i) the production externality has cross-border effects; (ii) the weight on the externality cost is high; (iii) import competing lobbies are not “powerful”.

Reprinted in “The WTO and Labour and Employment” by Edward Elgar, ed. Drusilla Brown and Robert Stern

Reprinted in “Recent Papers in Trade and the Environment” by Edward Elgar, ed. Brian Copeland

Co-author: Anthony Venables 

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Abstract: We analyse the trade and production patterns of countries located at varying distances from an economic centre. Exports and imports of final and intermediate goods bear transport costs which increase with distance. We show how production and trade depend on factor endowments and factor intensities, and also on countries’ locations and the transport intensities of different goods. Countries divide into zones with different trade patterns, some export oriented and others import substituting. We study the implications of distance for factor prices and real incomes, the effects of changes in transport costs, and the locational choice of new activities.

Reprinted in “Economic Integration and Spatial Location of Firms and Industries” by Edward Elgar, ed. M. Jovanovic

Co-author: Anthony Venables

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Abstract: The authors use different data sets to investigate the dependence of transport costs on geography and infrastructure. Infrastructure is an important determinant of transport costs, especially for landlocked countries. Analysis of bilateral trade data confirms the importance of infrastructure and gives an estimate of the elasticity of trade flows with respect to the trade cost factor of around –3. A deterioration of infrastructure from the median to the 75th percentile raises transport costs by 12 percentage points and reduces trade volumes by 28 percent. Analysis of African trade flows indicates that their relatively low level is largely due to poor infrastructure.

Reprinted in a special volume on trade and transport costs by ICE, Revista de Economia, January-February 2007, 834, 23-43

Co-author: Alejandro Graziano and Kyle Handley

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Abstract: We estimate the impact of trade policy uncertainty (TPU) on CES import price indices, focusing on the implications of Britain’s exit from the European Union (Brexit). Our analysis reveals that a higher probability of Brexit increases U.K. import price indices by raising the prices of existing products and reducing product variety from the E.U. We find evidence that the risk of higher import protection from the 2016 referendum increased current import price indices by 11 log points. This amounted to a 2 log point increase in manufactured goods prices and a 0.6 log point decrease in consumers’ real income.