Old ideas about foreign trade are being retired

Noah Smith

Most academic models of international trade are pretty simplistic. Some of these models are surprisingly effective for making certain types of predictions — for example, economists are very good at predicting how much different countries will trade with each other. But they’re not so good at predicting what kind of things the countries will specialize in, which country will have a trade deficit or surplus, how trade will affect growth, or which workers and businesses will benefit from trade.

It might be that in order to get at these questions, economists will have to abandon their simple models and think about the complexity of international trade. Economic theorists have long realized that the linkages between different products, both within and between countries, might be crucially important to those nations’ prosperity. But until recently, the data and statistical methods didn’t allow a detailed mapping of the structure of economic specialization around the world. Now, a number of economists are working on new empirical approaches that take into account the huge variety and complicated connections between the products and services that get traded across international borders.

Two such economists are Ricardo Hausmann of Harvard’s Kennedy School and Cesar Hidalgo of Massachusetts Institute of Technology. They and their research team have a theory that the more different products a country makes, the better positioned it is to grow. This idea runs counter to the conventional wisdom — and the predictions of many standard models — that different countries hyperspecialize in only a few goods and services. According to Hausmann and Hidalgo, countries are better off when they can make a multitude of things. Countries such as Saudi Arabia that rely on a single product will perform worse, all else equal, than countries such as Japan that can make almost anything they want.

The economists claim that their so-called economic complexity index is much better at predicting long-term economic growth than other forecasting methods based on things like the level of regulation or the amount of investment in education. They recently put out a report predicting that China’s growth will slow over the next decade, while India’s will remain rapid. Here are some of Hausmann and Hidalgo’s predictions for country growth rates from 2016 to 2025:

Obviously, more than just economic complexity matters here — population growth is also important, as is a country’s initial level of income (richer countries have less room to grow). But if Hausmann and Hidalgo are right, investors should be looking at India, Indonesia and Vietnam.

Another group of researchers from the World Bank, World Trade Organization and elsewhere, led by David Dollar, have taken a different approach. This group has mapped out global value chains — the sequences of trade where raw materials are turned into components, then into finished products and finally into retail sales.

Dollar’s team has identified something they call the smile curve. This is the tendency of countries in the middle of the production chain to get a smaller share of a product’s final value. The countries and companies that make the complex components in a phone or a computer tend to earn high profits, as do those that handle the research, design, marketing and retailing. But the countries in the middle, that assemble components into finished products and then ship them off to be sold, tend to get a thinner slice of the pie. Dollar et al. find that despite its huge dominance in manufacturing industries, China is located precisely at the most unfavorable middle part of the curve. In other words, China is stuck doing low-value assembly instead of the more lucrative component manufacturing, research, design, marketing and sales.

That’s actually good news for Chinese manufacturing employment, since China tends to do the things that require large numbers of hands and eyes. But it’s less good for the profits of Chinese companies, which is why China would probably like to start building more globally recognized brands. Unless China moves into higher value-added activities, its robust economic growth may slow — just as Hausmann and Hidalgo also predict.

The development of these new models is good news for the economics profession. It means that mainstream economists are diversifying their approaches, supplementing their old simple models with new ones that recognize the fantastic complexity of the real-world economy. That should help defuse some of the criticism that has been leveled against the field for underestimating the damage wrought by overselling of policies like financial deregulation and free trade with China.

And it might help policy makers devise better strategies toward trade and development. If Hidalgo and Hausmann are right, countries should focus on creating highly diversified economies. If Dollar et al. are right, countries should focus on trying to escape the trap of assembling other countries’ products. Old development strategies based on simple approaches like deregulation and free trade might turn out not to be enough.

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion. © 2017, Bloomberg View.

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