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Key parameters for Brexit forecasts

The NBER Summer Institute hosted a panel discussion of Brexit on Tuesday. Richard Baldwin, Thomas Sampson, Helene Rey, and Anil Kashyap spoke about the consequences of Brexit for the European project, trade policy, macroeconomic growth, and London as a financial hub. I won’t try to summarize the discussion. The NBER should post video of the panel soon, and you can also learn their views from Baldwin’s twitter feed, Kashyap’s 538 piece, and Sampson’s CEP chapters.

I want to highlight three parameters that are key to forecasting Brexit’s economic consequences. They are (1) the size of the non-tariff barriers eliminated by the EU as a customs union, (2) the elasticity of real income with respect to trade, and (3) the strength of agglomeration economies in finance.

Non-tariff barriers are important because rich countries’ import tariffs are quite low. The two potential UK trading regimes people are most frequently discussing are a “Norway option” and a “WTO option“. Under the Norway option, the UK would have tariff-free access to EU markets via the EEA, but face non-tariff barriers due to leaving the customs union (e.g. rules of origin requirements and anti-dumping duties). Under the WTO option, the UK would face the EU’s MFN tariff schedule (only a few percentage points, on average) and a much wider array of non-tariff barriers due to the EU being far ahead of the WTO in reducing and/or harmonizing behind-the-border barriers and regulations.

Non-tariff barriers presumably don’t look like the iceberg trade costs frequently employed in quantitative trade models. You can find some estimates of these meaures, but they don’t seem to receive academic attention proportionate to their relevance for policy concerns like Brexit.

In contrast, the second key parameter, the elasticity of real income with respect to trade, has received considerable academic attention. However, there is not yet consensus regarding its value. In their CEP chapter, Dhingra, Ottaviano, Sampson and van Reenen review different paths one might take.

Using the class of quantitative trade models that yield the ACR formula, they estimate Brexit losses on the order of 1.3% to 2.6%. Given that the United Kingdom’s total gains from trade (relative to autarky) range from 3% to 23% in Table 4.1 of Costinot and Rodriguez-Clare’s Handbook chapter, this methodology necessarily produces numbers of this magnitude.

An alternative approach is to use reduced-form estimates of how trade changes income, presumably on the premise that there are important channels (such as dynamic effects) that are omitted from the standard quantitative models. Ed Prescott, for example, holds this view. Using Jim Feyrer’s air-vs-sea paper, which estimates that the elasticity of income with respect to trade is about one half, the CEP team infers that Brexit would reduce UK income by 6.3% to 9.5%.

The effect of trade on income is obviously important, and I expect that trade economists will always be investigating this question. At the moment, plausible predictions of Brexit-induced trade losses range widely, from 1% to 10%.

The third parameter of interest is the strength of agglomeration economies in finance. Brexit is going to reduce the role of London as a financial center, as EU-specific activities migrate to the continent. The question is whether non-EU-specific activities will follow. How complementary are these different types of financial services and how large are the relevant scale economies? I think this is an open question in urban economics, in the sense that we don’t entirely understand why the US financial sector is so concentrated in New York City. Suddenly, this has become a crucial question for London in the context of Brexit. Anil Kashyap has stressed that the financial services industry generates 11% of UK tax revenue, so strong agglomeration economies that imply an unraveling of the City of London would mean a big budget problem for the UK government.

The volatility and uncertainty of the unfolding political process makes forecasting Brexit’s consequences virtually impossible, but these are three parameters that are important to thinking about the relevant economic mechanisms.

Trade JMPs (2015-2016)

It’s already November, which means it’s job-market season once again. Who’s on the market in trade? As I have for the last five years, I focus on trade papers, thereby neglecting international finance and open-economy macro papers. If I’ve missed someone, please contribute to the list in the comments.

Also, candidates should sign up at Jon Haveman’s full-featured database of trade candidates with candidate-created profiles.

The NAFTA trucking dispute in 2015

I’ve been blogging the NAFTA trucking dispute since 2008. Under NAFTA, Mexican trucks were supposed to be able to operate in Texas, California, New Mexico, and Arizona by December 1995. That never happened, and it took a dozen years for a pilot program to be started, only to be aborted in 2009. Another pilot took place 2011-2014.

Nearly twenty years late, the US government may be close to fulfilling its NAFTA obligations. In January 2015, the US DOT announced “that Mexican motor carriers will soon be able to apply for authority to conduct long-haul, cross-border trucking services in the United States.” I’m not immediately finding confirmation that this has actually started, so I won’t call this case closed quite yet. We’ll see if it hits the 20-year mark this December.

What the Heckscher-Ohlin theorem is and is not about

In a piece for Bloomberg, Noah Smith wrote:

No. 9. The Heckscher-Ohlin theorem

This is a theory about trade. It says that countries with more capital — industrialized countries such as the U.S. or Japan — will tend to make things that are more capital-intensive. And countries with more labor — such as India — will tend to make things that are more labor-intensive. That’s why the U.S. makes a lot of semiconductors (which require huge fabrication plants), and India makes a lot of clothes.

Tyler Cowen says Noah Smith oversimplified/misrepresented the theorem. He raises four objections, concluding with:

I continue to believe most economists don’t have such a clear sense of the Hechscker-Ohlin theorem. There are so many tricks to HOT I wouldn’t be surprised if I slipped up somewhere myself in this post.

Indeed, I do think Tyler slipped up a bit. He’s right that identifying “effective units” of capital and labor is the relevant exercise and also very difficult (objection #2), and of course the Heckscher-Ohlin theorem is all about ratios, not absolute quantities (objection #3).1

But I want to defend Noah a bit from Tyler’s first complaint, which was:

The HOT proposition is about exports being relatively capital- or labor-intensive, not about production per se. Even for a popular audience, I think that substitution should have been easy enough.

Is that so? Here’s how Ron Jones and Peter Neary stated the theorem in question in their 1984 Handbook chapter, which surely was not aimed at a popular audience:

Heckscher-Ohlin theorem. A country has a production bias towards, and hence tends to export, the commodity which uses intensively the factor with which it is relatively well endowed.

Why does production composition determine net export composition in this model? Well, the factor-abundance theory is a story about economies’ endowments determining the pattern of trade. To talk only about endowments (and thus only about supply-side elements), we have to neuter demand by assuming identical, homothetic preferences.2 Given commodity-price equalization and homothetic preferences, each country has a consumption vector that is proportionate to its share of world income. With no differences in the composition of consumption, differences in the composition of production translate into differences in the composition of net exports, which are simply production minus consumption.

Thus, the prediction about the pattern of trade simply falls out of the prediction about the pattern of production. Here’s how Jones and Neary explained it:

The final core proposition is the Heckscher-Ohlin theorem itself, but this in fact is closely related to the Rybczynski theorem. Consider two countries with different relative factor endowments and the same technology for producing both goods. If both countries face the same commodity prices then, by the Rybczynski theorem, the country with the greater relative endowment of capital will produce relatively more of the capital-intensive good… Provided this production bias is not offset by a demand bias, the relatively capital-abundant country will export the relatively capital-intensive good. When it is expressed in terms of a physical definition of factor abundance, the Heckscher-Ohlin theorem is thus a simple corollary of the Rybczynski theorem…

In terms of the canonical theorem, I think that Noah got that part right. And in a meta sense, Tyler was right as well.

1. When he cites the Leontief paradox, he’s getting into more complicated territory, see Leamer (JPE 1980).
2. In reality, of course, I think that the composition of demand matters!

When international shipping is cheaper than domestic

The Washington Post headlined this “The Postal Service is losing millions a year to help you buy cheap stuff from China“:

This strange consequence of postal law was less significant when the mail was mostly personal correspondence. But as Chinese companies began logging on to Web marketplaces like eBay, Amazon, and Alibaba, they started taking advantage of the shipping deal to sell directly to American consumers. And so it’s never been easier to get something cheap and Chinese delivered to your door for a startlingly low price: $4.64 for a digital alarm clock; $2.50 for a folding knife; $1.88 for an iPhone cable — all with shipping included…

Countries used to provide this forwarding service to each other for free, but in 1969 an update to this postal treaty called for small fees (called terminal dues) on each mail piece. Since then the dues have grown, and the payment system has become labyrinthine. In most cases, however, postal services still charge each other less than they would charge their own citizens for moving a package across the country.

According to the terms set out in Universal Postal Union treaty, the USPS in 2014 gets paid no more than about $1.50 for delivering a one-pound package from a foreign carrier, which makes it hard to cover costs. [1] The USPS inspector general’s office estimated that the USPS lost $79 million in fiscal year 2013 delivering this foreign treaty mail. (The Postal Service itself declined to provide specific figures.) …

At the latest round of negotiations in 2012, countries did agree to raise fees slightly. The United States will get to charge about 13 percent more every year from 2014 to 2017. Under the new terms, the inspector general’s office believes that the USPS will start to lose less money on inbound mail. [3]

All this should be a reminder that any trade deal has winners and losers and unintended consequences. Internet commerce suddenly made the terms of a long-standing mail treaty a competitive advantage for Chinese merchants, and U.S. importers like the McGraths have been feeling the squeeze. But this same system also means that average Americans can get a really sweet deal on an iPhone case shaped like an Absolut bottle.

Hat tip to Corinne Low.

Trade JMPs (2014-2015)

It’s already that time of year again, and I’m a little late. Who’s on the job market this year with a paper on international trade?

As in prior years, I focus on trade papers, thereby neglecting international finance and open-economy macro papers. If I’ve missed someone, please contribute to the list in the comments.

Here are folks listing international trade as a field with a JMP in economic geography:

Also, Jon Haveman is making my annual compilation obsolete by offering a full-featured database of trade candidates with candidate-created profiles: Job Candidate Database.