Overstating the Gains from Trade

Dani Rodrik has a marvelous flair for putting things into context:

Many many years ago when I was a recently minted assistant professor, I heard Gary Hufbauer tell an anecdote at a conference on international trade. A government economist is called in by his superior, who tells him “Look, I have to make a case for this policy in front of Congress, and I need a number real bad.” The economist responds, “well, I haven’t done a proper analysis, so I can give you a real bad number.” Perhaps it was a true story based on Gary’s own government experience.

I’ll have to pin this to the wall of my office and think about it every time a read some alleged evidence that seems to be inflated. Dani was thinking about a recent post from Mark Thoma on the benefits from trade, which noted a paper written by Gary Hufbauer and two other authors that was cited by Ben Bernanke. Mark also pointed us to an oped written by Gary Hufbauer and one of his co-authors:

Since World War II the United States has led the international quest to liberalize world trade and investment. With leadership from the White House, Congress has slashed the simple average tariff rate from 40 percent in 1946 to 4 percent today, and other industrial nations have done much the same. After a half-century of steady liberalization it is fair to ask, what do Americans have to show? As it turns out, quite a lot. Using four different methods, we estimate that the combination of shrinking distances – thanks to container ships, telecommunications and other new technologies – and lower political barriers to international trade and investment have generated an increase in U.S. income of roughly $1 trillion a year (measured in 2003 dollars), or about 10 percent of gross domestic product. This translates to a gain in annual income of about $10,000 per household.

Efficiency gains on the order of $10,000 per household or 10% of GDP sound almost too good to be true. Dani thinks they are and explains what may have lead to such incredibly high estimates. He also walks us through an alternative methodology for estimating the gains from trade:

The standard partial equilibrium formula for calculating the gains from moving to free trade is 0.5 x [t/(1+t)]^2 x m x e, where t is the tariff rate, m is the share of imports in GDP, and e is the (absolute value of the price elasticity of import demand). In the U.S. average tariffs stand in low single digits and imports are less than 20% of GDP. There is no way of tweaking this formula under reasonable elasticities that would get us a number anywhere near the Bradford et al. estimates. For example, using the generous numbers t = 0.10, m = 0.2 and e = 3, the gains from moving to complete free trade are a meager 0.25% of GDP (compared to Bradford et al.’s lowest estimate of 3.4% of GDP).

Dani notes the shortcomings of the simple approach as well as some research that tries to address these shortcomings. In general, when alternative procedures exist for estimating anything give such wildly different results, one should closely scrutinize each methodology before touting the results of any procedure that does appear to reach an extreme conclusion.

Update: Max Sawicky also picks up on Dani’s post as well as the sensible argument that not everyone gains from free trade. None of this stops Max from calling Lou Dobbs a nitwit:

I caught the Lou Dobbs segment on 60 Minutes last night, which I hardly ever watch. His hysteria level about immigrants undermines whatever usefulness he has about trade. As for industrial policy, one logical arena for dealing with globalization, does he have any? I don’t think so. He’s a lot like Pat Buchanan, albeit without the racism/sexism/homophobia/anti-semitism. It doesn’t help that Lesley Stahl lent him credbility by throwing hostile, stupid questions at him.

I often do watch 60 Minutes but for some reason I felt compelled to watch Tim Russert interview George Tenet. Guess my choice was the lesser of two evils.