Prospects of tariff increases and manufacturing employment

US manufacturing is on the decline, and the obvious reason is pressure from globalization. This is not necessarily bad as it means a better use of resources, except for some potentially large transition costs. Globalization has been encouraged by decreases in tariffs, thus one should find a strong correlation between tariff reductions and declines in US manufacturing. That does not seem to be the case, though, and a sharper decline in manufacturing since 2001 cannot be traced to any major change in tariffs.

Justin Pierce and Peter Schott find that it is not the actual tariffs that matter, but the potential for tariff increases. Indeed, there was a change in 2001 that removed potential increases especially for sectors in competition with China, and once these sectors lost this potential tool for protection, they withered. There was no such change in Europe, where no sharper decline in manufacturing occurred.

Why did the panic of 2008 spread abroad?

Why did the Great Recession spread outside the United States? In particular, why did almost all Western industrial countries enter a deep and pronounced recession together? The failure of Lehman Brothers sent ripples throughout international financial markets, plus European banks were heavily involved in the US subprime mortgage market. Yet, financial and goods markets are not perfectly integrated and this should not have lead to such perfectly coordinated business cycles.

Philippe Bacchetta and Eric van Wincoop show that you do not need complete market integration to get there, only partial. All you need is that market integration be sufficiently high. In addition, tight credit, very low interest rates and inactive fiscal policy "help" tremendously with creating a panic, and we certainly were in such a situation at the time. And this panic is what makes it different from "normal" recessions, where synchronization is not perfect. The model hinges on the fact that there are possibly multiple equilibria and a global panic is the optimal coordination on a bad one. Crucial to the model are a couple of rather strange assumptions, though: prices are preset while wages are fully flexible, I would have thought wages to be less flexible than prices; and there are two periods in the model, meaning that the panic state must be permanent. As a consequence, am not quite sure what to make of this paper.

China is doing is right with managing its exchange rate

China has been heavily criticized by western politicians and policy-makers for its exchange rate policy that favors its export industry. Some have tried to explain to Chinese authorities that it is not in their best interest to follow a quasi-fixed exchange rate with the US dollar. Indeed, we know from past experience that fixed-exchange rates can be very expensive to maintain, especially in the context of large external imbalances. But is China different? After all, it financial development is
clearly less advanced than Western economies, and the Chinese economy is growing much faster.

Philippe Bacchetta, Kenza Benhima and Yannick Kalantzis look at the optimal exchange-rate policy of a growing economy where domestic households do not have access to international markets, that is, China. They find that the optimal path for the exchange rate is first a real depreciation during a growth spurt, and then a real appreciation in the long-run. This is pretty much what China has been applying. In other words, China did everything right given its situation, and this is because the growth spurt generates a glut of savings that have nowhere to go. The real depreciation allows to take care of this current account imbalance having the central bank serve as intermediary and converting foreign assets to domestic ones for the desperate households. In some sense, we could even argue that the Bank of China has not done enough of that given the real estate bubble, which is also a consequence of this savings glut.

Containerization and world trade

The introduction of containers has dramatically simplified international trade but has been resisted in some ports with even more dramatic consequences. Before containers, the unloading of ships was a process that would drag on for days, if not weeks, involved a lot of manual labor. With containers, a ship can unloaded or loaded in hours. Unions resisted the containerization of port facilities, and where this was successful port became rapidly obsolete and underused. The prime example was Liverpool, which is still reeling from this major negative shock to its most important economic sector. The ports that quickly adopted container thrived though, and mostly still do. While there are undoubtedly distributional consequences, what has been the overall impact of the introduction of containers?

Daniel Bernhofen, Zouheir El-Sahli and Richard Kneller exploit the different timing of the adoption of containers across ports to tease out how much more international trade containers have brought. For trade among developed economies, they find that containers multiplied exchanges by about eight over a twenty year period. That is huge. The much celebrated impact of the GATT is about half that, still huge though. This shows that any study about the growth of trade around 1960-90 needs to take containerization into account.

Travel time and the border effect

The border effect describes a striking feature of the data on trade volumes. Volumes typically decrease with distance traveled, with a jump down when a border has to be crossed. The size of this effect is mostly estimated with distance data taken from straight lines between trading areas, and often by simply taking the center of those regions. With considerable work, one can do better.

Henrik Braconier and Mauro Pisu determine the distance along roads as well as travel time for within-Europe trade, and this for almost 50,000 city pairs. While this neglects cargo train traffic, which has a substantial share of international traffic in Europe, this is as precise as it can get, I suppose. The interesting bit is that once a border is involved, travel distance and time are about 10% longer for town pairs that are equidistant when measured as a straight line. That means that literature has over-estimated the border effect by about as much. One could, however, also argue that the border effect is precisely stemming from the fact that it leads to travel time losses, at least in part, and that there is therefore no over-estimation. It depends what you really mean by border effect.

Do clean-car subsidies disguise protectionism?

The US has complained for decades that Japan is making it difficult for American companies to export cars there. The complaints were about regulation, prices, and subsidies. Japan has had a rather easy time dismissing these complaints with the mere fact that US car companies are very reluctant to build right-hand driven cars, which are required for driving on the left side of the road in Japan. The latest US complaint is about subsidies for clean cars, which again are supposed to favor Japanese cars. I would answer that the US could maybe build cleaner cars, but let us have another look at the issue.

Taiju Kitano studies the current Japanese subsidies and the American proposal on how the subsidies should be structured. The subsidy is for scrapping old cars for replacement by fuel-efficient ones. At issue is the method for determining which fuel-efficient cars qualify. Japan has its own method for setting fuel efficiency, but this is not calculated for cars with low production or imports, like US models. That disqualifies them for the subsidy. Later, foreign ratings have been accepted for qualification, but the US complained that its city-driving standard is used, while a city/highway combination were more appropriate. Japan claims its standard is close to the city standard in the US.

The use is not solely about calculation of fuel-efficiency standards, it also about potential market shares. Kitano thus estimates an oligopolistic model to determine demands in each market and thus demanded quantities under different policies. If the goal is to improve overall fuel efficiency, both policies score equivalently. The US one would be, however, much cheaper because new cars become eligible and they substitute for cars that command larger subsidies. The US is thus mainly helping Japan reduce its expenses, while having no impact on pollution or even a positive one on profits of Japanese car makers.

Why is living in poor countries so cheap?

Theory tells us the law of one price should hold: the same good should have the same price throughout the world after taking into account exchange rates (and transportation costs). Yet, there is plenty of empirical evidence that this is not true. And anecdotal evidence, too, think of how it is noticeably less expensive to live in developing countries. Why?

Daniel Murphy offers a new and simple explanation: complementarity between tradable and non-tradable goods. In a rich country, more non-tradable goods are available as complements, thus providers of tradable goods can charge higher prices if competition is not perfect. This conjecture is supported by empirical evidence showing that where more complements are used the prices of tradables are also higher. But given that the extend of complementarity seems to change from one country to the other, it seems to me that we are not really talking about the same good. We may measure it as the same good, but people seem to perceive it as a different good. It is just a measurement issue.

Bargaining power and international pricing

In international trade, how is the currency of invoicing determined? This is a big deal as it determines how is carrying the exchange rate risk. Even though this can be hedged, this still has a cost. And in this context, why is there quite frequently billing in a third currency? With such a "vehicle currency," bot exporter and importer face exchange rate risk. That does not seem right.

Linda Goldberg and Cédric Tille draw a theory of bargaining over price and exchange rate exposure between exporters and importers. An important element in this theory is the market structure. To gain a larger effective bargaining weight, you need to be larger and more risk tolerant, so surprise here. Then you also bear more exchange risk. Also, the size heterogeneity of firm on a market matters as well: the smaller firms then inherit the bargaining characteristics of the dominating ones. It would be interesting to see a test of this theory.

Too much legalese at the WTO

The World Trade Organization exists to foster free trade and to resolve disputes about unfair trade practices. It is thus an organization that treats with legal issues over an eminently economic matter. How much is Economics used in the process? Or has the WTO been captured by lawyers.

Thomas Prusa looks at three recent decisions in the dispute process. While it is not possible to see what happened inside the WTO, it seems pretty clear from the decisions that the Economics in them is lacking. It just looks like a situation where economists have been bypassed and the decision may make legal sense, but certainly not economic sense. Prusa argues that lawyers should not have been afraid of complex, abstract economics in the cases he looks at, as simple Masters' or even undergraduate level economics would have helped reach a better decision. While there is no doubt the cases have a strong legal aspect. at least some economics would have been good.

Is an imperfect monetary union leading to more volatility?

The theory of optimal currency areas initiated by Robert Mundell states that a monetary union should be beneficial between regions that have labor and capital mobility, fiscal transfer mechanisms and synchronized business cycles, or at least something approaching these conditions. In the case of Europe, this is clearly not met, but I guess the hope was that these conditions would eventually be met. The literature has been been rather superficial on what it means to not quite meet these criteria and what the consequences are. Yet, we have now techniques to model this better and test policies that could improve outcomes.

Philipp Engler and Simon Voigts do this with a DSGE model where they explicit the market structure, following the situation in the current European Monetary Union: no labor mobility, imperfect goods market integration, incomplete financial markets, no fiscal transfers at business cycle frequency, and asymmetric shocks. They find that adding a monetary union to the mix increases the volatility of consumption and employment significantly, essentially because country-specific monetary policy cannot be enacted. What can be done then? Engler and Voigts show that area-wide fiscal policy can do a lot of good, and much more than isolated fiscal policy would. And this is exactly what is missing in Europe. Absent this, one could imagine increasing labor mobility, but the trend in Europe right now seems to go the other way, with several countries thinking about restricting immigration from member countries. European integration is hard.

Can IKEA replace the BigMac or the Ipod?

When a good is exported and exchange rates fluctuate, how much of the exchange rate change is reflected in local pricing? Establishing the extend of this pass-through has been the subject of an extensive literature over the past years as international price datasets have been made available. A major difficulty is with the coding of the goods, and one is not always sure that goods in different countries are comparable.

Anthony Landry and Marianne Baxter fix this issue by looking at the IKEA catalog in six countries over seven years. Part of the IKEA catalog is marketed in several countries, and these goods are identical and produced in the same country. The prices are valid for a full year, though, so the prices also reflect how the company thinks the exchange rates will move over the next year (How does IKEA do in high inflation countries?). Pass-through is estimated to be about 14-30%, which is low but may reflect the fact that the forecasts made by IKEA end up being smoother than actual exchange rate movements.

There is one aspect that I find very exciting in this data. Could the IKEA be a replacement for the Big Mac index that the Economist has popularized? The latter measured whether currencies are over- or under-valued by looking at exchange rates and local prices of a supposedly uniform good. As I argued before (I, II), the Big Mac is, however, not uniform, and meat or other components are sometimes local and of different quality, especially because there may be some local regulations for food products. In addition, a Big Mac contains a service component that is priced in as well, and MacDonald restaurants are definitively not comparable across countries. I better indicator was the iPod index, as this is a uniform good across all countries, unfortunately it looks like the iPod is going to go the way of the dodo within a few years. Could the IKEA catalog be the a good candidate? I think so, as it contains many goods that are available in several countries, and thus we have ways to take into account when a good is dropped from distribution. The drawbacks are the limited number of countries (IKEA is present in 40) and the annual frequency. And the fact that IKEA is making bets over future exchange rates with its pricing.

European tourism and the Euro

If you have traveled across Europe before the introduction of the Euro, you have certainly been annoyed by the frequent changing of currencies. Not only did you need to worry about getting cash at the border, you also had tp learn about new denominations, rethink the prices you see, and end up with unused loose change (ignoring the exchange risk one faces as well). With the introduction of the Euro, all this has been greatly simplified, even if not all countries joined. Beyond the convenience for the tourist, has this spurred additional tourism.

María Santana Gallego, Jorge Vicente Pérez Rodríguez and Francisco Jos&e;eacut Ledesma Rodríguez ask this question and find that, yes, it had a positive impact, to the tune of 20 to 40% for EMU country tourist arrivals, and mostly so after 2002 (when Euro coins and notes were introduced) in contrast to 1999 (when the exchange rates were fixed). In addition, there is evidence of tourism diversion: The stated increases occurred to the detriment of non-EMU countries. In other words, tourists substituted away from countries that are not carrying the Euro.

PS: Things seem to be looking a bit better for Greece right now. But if it were still to be dropped from the Euro-zone, consider a substantial negative impact on its vital tourism industry.

Voluntary pollution restrictions do not work

The literature on international environmental agreements has established that when such agreement are only of the self-enforcing kind (not imposed by a supranational entity), they cannot exceed three participants. That is certainly disappointing, as we would need much more than that to get significant impact. This literature, however, looked at these countries in a vacuum, in particular the only interaction they would have is through pollution. Now it turns out that in reality they also trade with each other, and trade policy is also available as an instrument.

This is how Thomas Eichner and Rüdiger Pethig expand the extant literature. The addition of trade allows more countries to participate in a self-enforcing agreement. But this comes at the cost of an agreement with significantly less bite. These are interesting results, but I have a hard time finding intuition for this, and the authors are not of much help. Consider this to be an appeal for clarification.

On the benefits of multinational firms

Multinational companies are the scorn of the anti-globalization movement, and some of it is well deserved. Often, their size allows them to push governments around, especially poorer ones, and they can exploit tax loopholes in ways domestic firms cannot. But multinational firms can also bring benefits to economies. After all, they are just one manifestation of largely free trade, which is in general welfare-enhancing. The benefit mentioned the most often is that multinationals enhance the transfer of new technology between countries. A second benefit is that they shake up local competition and thus encourage Schumpeterian creative destruction. Of course, the fact that inefficient firms get hurt is not Pareto dominant, hence the grief from protectionists.

Using a big panel of firms across 60 countries (over a million firms!), Laura Alfaro and Maggie Chen find that the second impact of multinationals is significant. They are in particular interested in the domestic distribution of productivity and revenue. In theory, knowledge transfer shifts both distributions to the right. Market reallocation, though, shifts the distribution of revenue to the left and truncates the left of the productivity distribution. Looking at the data, it is not clear which effect dominates. The experience differs from country to country, with developing ones benefiting more from knowledge transfer and developed ones from increased competition. And about two-thirds of the average productivity increase can be attributed to knowledge transfer.

Exchange rates and scapegoats

It is notoriously difficult to understand exchange rate fluctuations, especially in the shorter term. Predicting them is even worse, to the point that a random walk has consistently been shown to be the best predictor (with isolated exceptions). Consistently beating the random walk is seen as the holy grail in international finance.

Philippe Bacchetta and Eric Van Wincoop came up with an intriguing theory: there is no point in trying to relate exchange rate movements to observable fundamentals. Market participants react to rate changes by rationalizing them with some observed fundamental even when the true reason may be unobservable. And market participants keep changing the variables they look at. Everyone has made fun of press reports that explain that the dollar went up because of some event, and then the same event explains why the dollar went down the next day. This is what Bacchetta and Van Wincoop call scapegoating.

This is pretty much all theory. Marcel Fratzscher, Lucio Sarno and Gabriele Zinna have now found a way to test empirically this theory of scapegoats. The reason it took so long is that you need the right data: first a monthly survey of market participants on what they think is driving exchange rate movements, second the order flow data of a major market participant. The data supports remarkably well the scapegoat theory. When there is a large volume of orders, which are not public information and should thus be treated as unobservables that influence market outcomes, and one of the fundamentals moves more than usual in one way or the other, markets participants often link the latter to exchange movements. This is purely after the fact rationalizing, or as used in other contexts, superstition. How this is going to help us in forecasting exchange rate movements is not clear, though.

Avoiding sovereign debt dilution with debt seniority

There is a natural tendency for firms to borrow too much. This is known as the debt dilution problem. It occurs because the borrower does not factor in the impact on old debt of borrowing more. Indeed, it makes old more risky, and hence increases borrowing costs. The market response to this problem was to introduce debt seniority, wherein some debt classes have priority over others in liquidation. For example, primary mortgages have priority over secondary mortgages, and the latter carry higher interest rates. The fact that one has a secondary mortgage has then no bearing on the riskiness and cost of the primary mortgage.

Satyajit Chatterjee and Burcu Eyigungor point out that there is not such concept in sovereign debt, but it should. Indeed, debt dilution happens at a massive scale in sovereign debt, and the market response when debt dilution happens such as now in many countries is to have shorter terms. This increases costs significantly, as Southern European countries have recently witnessed. Chatterjee and Eyigungor show that if sovereign debt also had a seniority structure, the frequency of default would be significantly reduced, by 40% taking the example of Argentina. It also reduces the volatility of spreads by two thirds. That seems very interesting.

Using unemployment insurance to compensate for losses from opening trade

It is quite obvious that the gains from trade are positive, but implementing a free trade agreement obviously also implies some losses, in particular for workers whose skills were locked into the industry that just opened up. The implementation of some free trade agreements includes some compensation for such workers, but it is not much used if available. Why? And why would we need such compensation schemes at all?

Indeed, Marco de Pinto points out that unemployment insurance fulfills this role remarkably well. Those who benefit the most from the free trade agreement, and work, contribute to it, while those who lost, and are unemployed, receive insurance benefits. And if the unemployment insurance is not actuarially fair, that is OK, as it corresponds to a side-payment to the losers (no pun intended). But of course, the necessary taxation is distorting to the point of destroying the gains from trade. In such a context, it appears to be better to finance the unemployment insurance with a wage tax, as it neutral on all markets, in particular because under unionized labor markets, after tax wages are unchanged in aggregate. A profit tax is worse, but better than a payroll tax because it does not reduce labor demand for low-skilled workers as much.

How integrated are Eastern and Western Europe now?

25 years ago, it was very rare to see a car with Eastern European plates in Western Europe. Now, they are all over the place, including trucks (why are there so many from Romania?). This is a clear indication, even if you ignore history, that the East-West integration is stronger than it has been for a long time. But there are more aspects to integration than the movement of cars.

Catherine and Klaus Prettner basically look whether the two regions are cointegrated. They build two national aggregates, one with 12 European Community countries (unfortunately no UK) and 5 Central European countries. Using a vector error-correction model with restrictions from a standard open-economy business-cycle model with cash-in-advance. Output shocks to one area spill over to the other, surprisingly in similar magnitudes in both directions. Interest rate shocks are expectedly asymmetric though: West impacts East, but East does not impact West. But given that all this has been in transition mode over the 1995-2009 sample, I really wonder how these impacts have changed over time. A framework with time varying coefficients would have been helpful here.

Are the Chinese capital controls optimal?

China is currently amassing large foreign reserves while imposing internally capital controls. Does this make sense? Wouldn't an economy that has the ability to create such surpluses want to participate more fully in world markets? One should not forget that these foreign reserves are accumulated thanks to a positive trade balance and a fixed exchange rate, not thanks to a particularly well functioning capital market in China. In fact, the financial sector in quite under-developed in China, and most households have access to nothing more than simple bank accounts.

Philippe Bacchetta, Kenza Benhima and Yannick Kalantzis build a model where the central bank has access to world market, but domestic households not. This enables the central bank to impose a different interest rate than the world interest rate, but it steady-state it is best to replicate an open economy: accumulate reserves and issue domestic debt at the world interest rate. If the economy grows rapidly, though, you want to have a higher interest rate domestically while imposing capital controls, that is, one needs to prevent arbitrage. But then, intertemporal substitution needs to happen through international reserves, as households cannot do it.

What is intriguing here is that we have a situation where open markets are welfare inferior to restricted ones with a reserve accumulation policy. Usually, we think that free markets would work best, especially as here there is no moral hazard, systemic risk, or other distortion. The reason is that borrowing constraints are binding as the economy converges towards steady state, and it cannot provide adequate intertemporal allocation in open markets. The central bank needs to help, and needs to differentiate interest rates to do so. That can only happen with capital controls.

An economist's foray into econophysics

I have described here some of the outlandish forays of physicists into Economics, where they try to use concepts from their discipline with disastrous results (last post here). But economists themselves may borrow concepts from physics. One that stuck was sunspots, from some chance correlation between sunspot activity and stock market performance, and made popular by David Cass and Karl Shell. But there were very little physics in this.

Martin Evans ventures deeper, using the concept of dark matter to understand exchange rate movements. It is well known that it is very difficult to understand what moves exchange rates. Dark matter is something that we cannot observe, but we see its impact. In this case, Evans builds a model where dark matter has an impact on nominal exchange rates, and then on other variables. This is based on the empirical observation that something like dark matter has an impact on expectations on long-run exchange rates, but not on recent and future interest rate differentials. This is achieved in the model by introducing shocks to household risk aversion. Why? Well, it is dark matter (or animal spirits). But all that matters is that it explains a large share of exchange rate fluctuations, in a rather consistent way for the other variables. Physicists would be happy with that. Economists would want to understand why.