What has driven trade booms and trade busts over the past century and a half? Dennis Novy and colleagues use a new measure of the costs of international trade to estimate the contribution of falling costs to the first wave of globalisation around the turn of the twentieth century as well as the modern phenomenon of globalisation.
Most countries trade more on international markets today than ever before – both in absolute terms and as a proportion of their national output. How can we explain the phenomenal increase in international trade over the past few decades?
History provides a natural comparison. Starting around the mid-nineteenth century, the world saw a remarkable rise in international trade that came to a grinding halt during World War I and then in the Great Depression. This first wave of globalisation – from about 1870 until 1913 – led to a degree of international integration (measured by trade-to-output ratios) that many countries only achieved again in the mid-1990s.
Our research compares the first wave of globalisation with the current wave, which began after World War II. We also examine the retreat of world trade during the interwar period from 1921 to 1939. We are interested in the driving forces behind these trade booms and trade busts: was it changes in global output or changes in trade costs that explain the evolution of international trade?
Trade costs fell more rapidly and were a more important driver of trade growth before World War I than after World War II
To answer that question, we set up a "gravity" model of international trade. This borrows Isaac Newton’s insight that the gravitational force between two planets in space diminishes as the distance between them increases. Instead of planets, we consider countries whose "gravitational force" is the amount of their bilateral exports and imports. And instead of physical distance, this bilateral trade is impeded by trade costs such as transportation costs, tariffs and language barriers.
The innovation of our approach is to model these trade costs in a micro-founded way and to obtain an analytical solution for them based on our gravity model. We then take the model to the data, inferring trade costs from observed output and trade data for France, the UK, the US and 18 of their trading partners for the period 1870-2000.
Perhaps surprisingly, our results show that trade costs dropped much faster during the first wave of globalisation up to World War I than during the second wave after World War II. The average level of trade costs for the countries in our sample fell by 23% in the 40 years before World War I; but from 1950 to 2000, average trade costs only fell by 16%. For the same countries, average trade costs increased by 10% in the 20 years from the end of World War I to the beginning of World War II.
What are the factors underlying these trade costs? Our evidence suggests that the ones that matter most are geographical distance (a rough proxy for transportation costs), trade policy and tariffs, adherence to fixed exchange rate regimes and membership of the British Empire or Commonwealth. In particular, the technological breakthrough and spread of the steamship in the course of the nineteenth century is associated with increased trade, as is the spread of container shipping from the 1960s.
Unless there is a backlash in the form of protectionism, world trade has the potential to keep growing strongly over the coming decades
On the surface, the percentage growth in trade volumes is roughly comparable in both waves of globalisation (400% and 471%, respectively). But since trade costs dropped faster during the first wave, they are also more important in explaining the growth of trade in that period. From 1870 to 1913, falling trade costs account for over half of the growth in international trade, while the rest is explained by secular increases in output. But from 1950 to 2000, falling trade costs account for only a third of trade growth.
In explaining the trade bust of the 1930s, the role of trade costs is dominant. Based on output growth alone, we would have expected trade volumes to increase by nearly 90%. The fact that they declined by 13% highlights the critical role of the general tariff hike during the Great Depression and the collapse of the system of fixed exchange rates known as the gold standard.
What does our research say about the future of world trade? Compared with historical patterns, the level of bilateral trade costs is still high for many pairs of countries, especially for pairs that are far away from each other. This means that there is scope for costs to fall much further. Unless there is a backlash in the form of protectionism, world trade has the potential to keep growing strongly over the coming decades.
- "Trade Costs, 1870-2000," by David Jacks, Christopher Meissner and Dennis Novy, is published in the American Economic Review: Papers & Proceedings 98(2), Papers & Proceedings, May 2008, pp. 529-534.