Chapter 1 Introduction This volume brings together a series of selected papers, all previously published elsewhere, that apply general equilibrium theory in order to obtain policy relevant insights on topical issues of international trade and migration. Part I focuses on European integration, applying dynamic numerical general equilibrium methods to quantify the effects of geographic extension of the European Union, focusing in particular on the effects of eastern enlargement of the EU on incumbent western member countries. Part II asks whether the history of world trade after World War II suggests that WTO membership has promoted bilateral trade volumes, as perhaps expected. Part III addresses the distributional effects of offshoring using suitably modified models of comparative advantage. Part IV focuses on immigration, offering a rigorous theoretical analysis of the so-called immigration surplus as well as an econometric estimation of the gains and pain that Germany may have experienced by initially restricting immigration from new EU member countries after the EU s eastern enlargement in 2004. In this introductory chapter, these parts are put into a broader perspective against the backdrop of economic globalization. 1. Economic Globalization 2.0 During the past couple of decades we have witnessed what might be called Economic Globalization 2.0, or the second big wave of economic globalization in history. The first wave has predated the second by almost exactly 100 years, ending more or less abruptly with the outbreak of the Great War in 1914, and followed by almost 50 years of international conflict and inward-oriented as well as non-cooperative economic policies in almost all parts of the world. It was not until the end of the 20 th century that the world has returned to a degree of economic integration that the developed world had already reached, and by some measures even surpassed, at the 1
2 1. Introduction end of the 19 th century. Of course, looking merely at the cost of transport and communication, the world has now become a much smaller place than it was a hundred years ago. However, globalization is not something that can meaningfully be measured along this scale alone. Focusing on the real (as opposed to the monetary side) of the phenomenon, closer inspection reveals several characteristics that set present-day globalization apart from its 19 th 20 th century precursor. Perhaps the most important characteristic of present-day globalization that sets it apart from the first wave a hundred years ago is that it is more rule-based through multinational institutions. In the present context, the most important of these institutions is the World Trade Organization (WTO), put in place in 1995, which grew out of the General Agreement on Tariffs and Trade (GATT) of 1947, and which now features a membership that spans almost the entire globe. Among other things, the WTO rules feature multilateral negotiations on trade liberalization, based on reciprocity as well as most-favored nation treatment. Eight successive rounds of negotiations among GATT member countries have brought down post World War II tariffs to historically low levels. Not only are present tariffs low on average, they also vary less across goods than they did in the early days of the GATT. 1 Perhaps more importantly, under WTO rules tariffs are legally bound, which implies that they are removed from the arsenal of instruments that governments may use at discretion and in a non-cooperative manner, in order to pursue their own policy goals. Moreover, advances in negotiations, particularly in the Uruguay Round (1986 1994), have extended these cornerstones of the world trading system to non-tariff barriers as well as services. Hence, globalization on markets for goods and services now seems more solidly guarded against protection-induced backlashes than was the case in the late 19 th century. 2 It seems fair to conclude that we would now see a world much more fragmented by harmful protection of segmented national markets, particularly given the world recession that was caused by 1 To give just a few numbers, average tariffs for major European countries have come down from levels of well above 30 percent in the inter-war years to around 5 percent in 2007. For the US, they have come down from 35 percent in the 30s to 3.5 percent in 2007; see Bown (2000). 2 It is worth pointing out that, contrary to widespread perception, the first wave of globalization did not abruptly come to a halt at the outbreak of the Great War, but had come under attack from increased protection much earlier, mainly from perceived distributional consequences; see Hatton and Williamson (2005).
1. Introduction 3 the financial crisis of 2007/2008, if it were not for the success of the GATT in past rounds of trade liberalization and for the disciplinary force of WTO membership. Yet, there are shadows. Arguably, world trade at the present is more prone to distortions than was the case in the late 19 th century. There are two reasons for this. The first is a proliferation of regional trading blocs that cause regional discrimination. The second is that, somewhat paradoxically, the WTO features what might be called an institutionalization of distortions through administered protection, most notably in the form of safeguard and anti-dumping duties. 1.1. Regional trading blocs As to regional discrimination, from its inception the GATT has featured an exemption from the most favored nation (MFN) principle in its Article XXIV, which allows member countries to form discriminatory regional trading arrangements. 3 This exemption was invoked very early on after World War II, the most prominent example, of course, being the formation of a customs union as the first step towards the European Economic Community (EEC), based on the treaty of Rome in 1957. The EEC has since turned into the European Union (EU) which now forms the world s most important regional trading bloc, with economic integration that goes far beyond preferential trade liberalization. Looking only at the Single Market, and ignoring the problems that it is presently facing with its approach to monetary integration, most observers would agree that the EEC (EU) is a success story. Indeed, as regards abolition of tariff and technical barriers to trade in goods and services, it has served as a role model for further regional trading arrangements that have emerged over time. Thus, a further distinguishing feature of the present wave of globalization is the proliferation of regional trading blocs. 4 Increasingly, these trading blocs are perceived as a preferred alternative to multilateral trade liberalization. This is perhaps best witnessed by the momentum that negotiations on both, a Transpacific Partnership and the Transatlantic Trade 3 A similar provision is contained in Article V of the General Agreement on Trade in Services (GATS). 4 The WTO presently lists 363 Regional Trade Agreements. Of these, more than 200 have been registered after the formation of the WTO in 1995. See http://rtais.wto.org/ui/publicsummarytable.aspx (accessed March 21, 2013).
4 1. Introduction and Investment Partnership between the EU and the US have gained just at the time when the Doha Round of multilateral trade negotiations has practically fallen off the cliff. Economists almost habitually criticize the popularity of trading blocs among policy makers by pointing out the distortionary costs that derive from regional discrimination between different sources of supply. However, for several reasons a complete removal of all distortions in a single huge step appears infeasible. If we bring in political economy forces to trace out what is feasible and what is not, then the verdict on the rising trend of regionalism in trade liberalization becomes less clear cut. The relevant question then is whether embarking on regionalism is a less costly route to the first-best situation of distortion-free trade between all countries, than is a strict adherence to MFN. The answer may well be yes, depending on the number and detailed nature of trading blocs as well as on the political economy environment. Some authors have voiced fundamental concerns about viewing trading blocs as stepping stones to a first-best world of distortion-free trade, while others are somewhat more sanguine. 5 More recently, some authors have argued that the changing nature of world trade, particularly the above mentioned increase in vertical specialization, combined with certain political economy mechanisms, might lead to a multilateralization of regionalism, particularly if member countries engage in race to the bottom unilateralism. 6 Moving from the grand systemic question to the more mundane task of evaluating the immediate consequences of specific trading blocs for their member countries, the relevant question is whether or not the resulting trade diversion reduces the benefits of trade creation. This is an empirical issue that can only be judged through case by case quantitative economic analysis, looking at the specifics of the agreement as well as the structural features of the economies involved in a theory-guided manner. The first part of this volume presents two papers of this sort looking at the most recent expansion of the EU towards eastern European countries that took place in 2004 and 2007, respectively. They do so on the basis of a calibrated dynamic general equilibrium model, which encompasses several policy instruments that go beyond just trade liberalization. The chapters take the perspective 5 For a fundamental criticism of regionalism that argues towards the stumbling bloc view, see Bhagwati et al. (1998). Ethier (1998) lists certain characteristics of a trading blocs that may make it act more like a stepping stone ; see also Ethier (2004). 6 See Baldwin (2006) and Baldwin and Low (2009).
1. Introduction 5 of an incumbent EU member, and they focus in particular on overall welfare effects, as well as, somewhat less common for this type of CGE models, on unemployment effects. 1.2. GATT/WTO: Trade promotion or institutionalization of protection? Doubts about an interpretation of the postwar world economy as a success story of the GATT/WTO also appear justified from countries increasing willingness to make use of WTO provisions for safeguard and anti-dumping protection. These provisions are an integral part of a complex trade disputesettlement mechanism. One might argue that, given a trade dispute, offering a settlement mechanism should be trade promoting. But the trade dispute is hardly exogenous to the settlement mechanism, hence the trade-promoting effect of the WTO regulation relating to safeguard and anti-dumping and similar provisions does seem in doubt. 7 Unlike regional trade agreements, the welfare cost of such distortions is largely unquestioned. In addition, there are direct resource costs from administration as well as rent-seeking, which is typically associated with this kind of protection. These types of cost often arise even if, in the end, the distortion as such can be avoided. Adding the trade-barrier effects of such administered protection to those of regional discrimination, one is lead to question the trade-promoting role of the WTO as a narrative of 20 th century globalization. Indeed, for all the improvement in transport and communication, one might argue that 21 st century globalization features more policy-induced trade distortions than did its precursor of the 19 th century, at least if one includes agricultural trade. Against the backdrop of these reservations, one might ask what seems like a simple question: Given all the characteristics of countries and commodities that form the basis of trade, and given all the natural as well as policy-induced barriers to trade, did WTO membership make a difference towards significantly promoting bilateral trade volumes? A theoryguided, detailed look at the entire history of world trade after World War II up to the present should allow us to provide at least a tentative answer. 7 The WTO gives a total number of 4,125 anti-dumping initiations filed over the period 1995 to 2012; see http://www.wto.org/english/tratop e/adp e/ad InitiationsBy ExpCty.xls. The corresponding number for safeguard measures is 234; see http://www. wto.org/english/tratop e/safeg e/sg-initiations By Reporting Member.xls.
6 1. Introduction The second part of this volume presents two chapters dealing with certain methodological problems that we face when searching for an answer through employing the gravity model of bilateral trade. As opposed to the structural approach followed in order to evaluate the specific case of eastern EU enlargement, these chapters follow a reduced-form approach, meaning that they abstain from a structural model that traces out the effects of specified trade barriers for a well-defined policy scenario. More specifically, the chapters contribute to the literature by focusing at the first time formation of trading relationships between countries, the so-called extensive margin of trade. 1.3. High resolution globalization A further characteristic of modern trade that sets it apart from trade in the first era of economic globalization relates to the nature of trade. Two features stick out. The first is the role of product differentiation coupled with increasing returns to scale. While economies of large scale production no doubt were important also in shaping trade patterns of the 19 th century, the prevalence of intra-industry trade based on product differentiation that we have been witnessing during 20 th century globalization is unparalleled in history. It has shaped modern thinking about the nature of trade, most notably through adding variety effects to the traditional gains from trade that derive from comparative advantage. 8 The aforementioned chapters presented in this volume, looking at EU enlargement and the trade-promoting effect of WTO membership, place due emphasis on these modern features of trade. The second feature of modern trade relates to the level of resolution at which the division of labor takes place among trading economies. More specifically, revolutionary improvements in the technology of transport and communication over the past couple of decades have facilitated a progressive fragmentation of production processes in many industries. By this, I mean a slicing up of production into multiple stages, with the principle of cross-country arbitrage on cost differences commanding relevance for ever smaller slices of the value added chain. The outcome is what is now referred to as offshoring, meaning the selective offshore provision of single tasks out 8 The pioneering contributions here are Krugman (1979) and Krugman (1980). The revolution in thinking about gains from trade towards emphasizing variety gains is nicely documented in Feenstra (2010) and Arkolakis et al. (2012).
1. Introduction 7 of complex production processes. As a result of such high-resolution globalization, workers now feel exposed to international competition for single tasks from far away low wage countries. Oftentimes, this is competition even from within firm boundaries. Thus, it contrasts markedly from old times when workers have perceived shelter against direct competition by virtue of being tied to the fate of their firms. Increasingly, the relevant criterion for such within-firm competition from foreign labor no longer is the level of education and skills achieved by the worker. What matters, instead, is whether modern technology of communications permits the specific type of a task performed by a worker to be separated from other parts of the production process, thus also permitting dislocation from the domestic economy. Tasks that are mostly routine in nature and do not require face to face contact will typically be more exposed to such offshoring than tasks of a non-routine nature. For policy makers and the general public, this perception of enhanced low wage foreign competition on a part of the workforce, including the highly skilled, has led to a new form of anxiety about, and resistance to, economic globalization. To economists, these developments have meant a challenge in terms of developing models that would adequately describe the transition from low-resolution globalization to high-resolution globalization that has emerged in the form of task trade. This process might also be described as an unbundling of comparative advantage. Again, this phenomenon is unparalleled in history and was absent in 19 th century globalization. The outcome is a new type of models that have come to be known as models of offshoring, or models of task trade, as opposed to models of trade in final goods. In addition, economists are facing the challenge of adding aspects of contractual imperfections that often come along with trade in highly specified varieties of inputs. As a result, modern trade theory also features models that explain the organizational form of trade, in addition to the disparate locations of production and use of goods or inputs. 9 As a consequence of this literature, it has now become customary to distinguish between offshoring which means obtaining inputs or tasks 9 The most prominent examples for models that focus on high resolution trade are the models of task trade developed by Gene Grossman and Esteban Rossi-Hansberg. In Grossman and Rossi-Hansberg (2008), they present a task trade model with a comparative advantage flavor, whereas in Grossman and Rossi-Hansberg (2012) they present a model of task trade based on Marshallian scale economics, assuming complete absence of comparative advantage. The most prominent example for models that focus on the role of contractual imperfections in determining the organizational form of trade is the
8 1. Introduction from abroad, and outsourcing which indicates using an arms-length relationship for input provision, irrespective of where the input is produced, or where the task is performed. The set of papers collected in Part III of this volume deal with theoretical aspects of international fragmentation and offshoring. They take what might be called a comparative advantage approach: Offshoring is analyzed in the spirit of general equilibrium models of comparative advantage. The new phenomenon thus emerges within a more or less conventional framework, where international trade reflects arbitraging on cross country differences in factor cost. Offshoring thus appears as a vehicle to unbundle comparative advantage. Where comparative advantage initially relates to bundles of activities tied together by the need to be performed jointly at a single location, each activity has now become a separate tradable entity of its own. One expects additional gains from trade, but also a whole new pattern of trade, associated with a new pattern of income distribution within countries. 10 The chapters in this volume mainly focus on the tension between additional gains from offshoring on the one hand and potentially unwelcome redistribution effects on the other. 1.4. The missing element: International labor market A final distinguishing characteristic of modern globalization relates to migration. Nineteenth century migration was largely perceived as emigration to frontier countries in the New World where it met few, if any, policy restrictions. In contrast, migration in the second wave of globalization, at least towards the end of the 20 th century, has been discussed, first and foremost, from an immigration country perspective, and migration countries have mostly taken a selectively restrictive policy stance. Indeed, the structure of 20 th century international migration has mainly been governed by restrictive immigration policies. 11 There appears to be a widespread hold-up model of trade in intermediates developed by Antràs and Helpman (2004). For a recent survey of this literature, see Feenstra (2009). 10 In pursuing the analysis of offshoring within refined comparative advantage models, the papers collected in this volume have been inspired by the early papers on fragmentation by Feenstra and Hanson (1997), Deardorff (2001a), Jones (2000) and Jones and Kierzkowski (2001). The term unbundling is due to Baldwin (2006); see also Baldwin (2011). 11 For a very instructive account of migration in the two waves of economic globalization, see O Rourke and Williamson (1999), Hatton and Williamson (2005). On the restrictive policy stance, see Legrain (2007). For a recent survey, see Felbermayr et al. (2012).
1. Introduction 9 consensus that it is the natural right of any country to protect its labor market from uncontrolled immigration, but nowhere near a comparable consensusexistsforgoodsandcapitalmarkets. 12 One might argue that high resolution globalization on goods and service markets renders the case for international migration less convincing. After all, offshoring seems like a way to draw on foreign labor markets, without any need for workers to migrate. However, it would seem very far fetched to argue on a grand scale that trade in labor tasks substitutes for migration. 13 Overall, huge cross border migration flows also in the second wave of economic globalization notwithstanding, it seems warranted to regard a truly international labor market as the big missing element in the second wave of economic globalization. This holds true particularly if one considers the immigration restrictions that are still in place, or threatened to be introduced when policy makers see immigration as a scapegoat for national labor markets being under strain. The single most important exception to the labor market as a missing element in globalization is the EU s Single Market Program that provides for free movement of people within its member countries. But here as well, abolishing migration barriers has proved much more difficult than for goods and capital markets, leading to the (in)famous transitional agreements that have allowed incumbent countries, in blunt violation of the Single Market, to maintain albeit temporarily their immigration restrictions for new members subsequent to eastern enlargement of the EU in 2004. Ireland, the UK and Sweden were the only countries abstaining from such transitional agreements and have, indeed, seen a significant surge in immigration from new member countries subsequent to 2004. The final set of papers collected in Part IV of this volume address three important reasons for why it proves so difficult to abolish migration barriers. The first is that it seems difficult to understand why immigration is potentially gainful for the entire group of natives in the immigration countries, and the exact conditions under which this is true. The second is that, even if it is true, an attempt to address the distributional effects within different factor owners within the group of natives seems much more challenging than with distributional effects of trade. The reason is any mechanism of compensating losers through taxing winners begs the question of how to treat 12 This point is forcefully made by Freeman (2006). 13 Looking at the history of international migration, the hypothesis of substitutability between trade and migration seems generally questionably; see Felbermayr et al. (2012).
10 1. Introduction migrants as a new type of domestic residents. And the third issue is that the wage effects that derive from immigration seem utterly straightforward from common sense, but are very hard to demonstrate empirically. 2. Contents of the volume 2.1. Modeling eastern enlargement of the EU The selection of papers presented in this volume deal with special aspects of Globalization 2.0 as described in the previous section. To put the papers in Part I that deal with eastern enlargement of the EU into a somewhat broader perspective, I start off by briefly reviewing a set of papers that are not included in this volume and which in some sense set the stage for the two papers that are included. Subsequently, I turn to a brief review of the papers contained in the volume, which are grouped in four chapters. European economic integration started out with six countries founding the European Coal and Steel Community (ECDS) in 1952 and the European Economic Community (EEC) in 1958. In 2013, the European Union (EU) expects to welcome Croatia as its 28 th member country. The block has seen 5 enlargements, whereby the eastern enlargement, taking place in two consecutive steps in 2004 and 2007, was by far the largest and perhaps the most controversial. All formerly socialist countries in eastern Europe had received an invitation to apply for EU membership through the Maastricht Treaty of 1992. Ten of them have promptly applied, but negotiations about fulfilment of the so-called Copenhagen entry criteria took almost 10 years, until they could finally enter in 2004 and 2007. 14 During the negotiation process, it appeared that all of the applicant countries from eastern Europe were eager to join as quickly as possible, while some of the incumbent countries, particularly those bordering to the former Iron Curtain, were quite skeptical about unwelcome consequences of eastern enlargement. In particular, incoming member countries were expected to draw transfer payments through the EU s Common Agricultural Policy (CAP) as well as its Structural and Regional Policy that would far outweigh their contribution payments. Moreover, they were expected to send large numbers of migrants under the Single Market provision of free movement of people, potentially 14 The Czech Republic, the Slovak Republic, Poland, Hungary, and the three Baltic states Estonia, Latvia, Lithuania were able to join in 2005, alongside Cyprus and Malta, while Bulgaria and Romania were able to do so in 2007.
1. Introduction 11 disrupting incumbent countries labor markets. To some extent it was also expected that eastern European firms who were enjoying cheap domestic labor would threaten incumbent countries firms through import penetration on goods markets. At the same time, however, eastern European countries were expected to become attractive places for incumbent countries capital, particularly through foreign direct investment (FDI) by their multinational firms. Quite clearly, eastern enlargement of the EU looked like a massively complex scenario that seemed much more ambiguous from an overall welfare perspective for incumbent countries than for new entrants. How would different incumbent countries of the EU be affected by having ten additional countries appearing on both sides of the EU budget as well as participating in its Single Market? As negotiations were in full swing towards the end of the 1990s, there was high demand for an answer to this question. Yet, providing a disciplined answer based on economic theory constituted a formidable challenge. It required a model that captures the general equilibrium mechanisms, including distributional as well as aggregate welfare effects, of extending the Single Market with its four freedoms (movement of goods, services, capital and people) to a well-defined set of new countries, each with its idiosyncratic characteristics. Moreover, a suitable model would need to include an accurate representation of the fiscal consequences of EU membership, and to capture fiscal implications for an incumbent country of extending EU membership to a group of newcomers. Ideally, such a model would be empirically implemented separately for any one incumbent country of interest. A model that aims to meet these requirements was presented in Kohler and Keuschnigg (2000). In Kohler and Keuschnigg (2001) and Keuschnigg and Kohler (2002) this model was calibrated to the Austrian economy as an incumbent country of special interest, due to its geographic proximity to eastern Europe. The calibrated model was employed to calculate the distributional and aggregate welfare consequences of enlarging the EU to those countries that have eventually joined the EU in 2004 and 2007. Keuschnigg et al. (2001) does the same for Germany as the incumbent country of interest, looking at a subgroup of eastern countries that have joined in the first round of enlargement in 2004. The scenario that these papers are looking at pretty much includes all of the elements alluded to above, including in particular the trade as well as fiscal implications from the CAP.
12 1. Introduction The model used in these papers is a dynamic general equilibrium model featuring several sectors with varying degrees of product differentiation under monopolistic competition. It thus incorporates the modern view of trade mentioned above. Moreover, assuming two types of labor, skilled and unskilled, the model is also able to address distributional effects of enlargement. Two further important aspects of the model relate to macroeconomic closure. The first is economic growth through forwardlooking investment in physical capital, whereby the capital stock is composed of differentiated goods, as in Romer-type endogenous growth models. Growth is subject to a variety externality in that firms fail to internalize the positive effect of investment on the degree of product differentiation. However, the model assumes that this effect is not strong enough to support endogenous long-run growth in income per capita. But it does address growth effects of enlargement, although given a stationary long run equilibrium these are pure level effects. A second aspect, somewhat unconventional in trade models of this sort, is that the household sector is composed of overlapping generations who are engaged in forward-looking decision making on consumption expenditure versus savings. Accumulation of physical capital and financial wealth is subject to a given world real interest rate. This model structure generates a rich pattern of adjustment to the scenario of eastern enlargement of the EU. In addition to sectoral reallocation and distributional effects for skilled and unskilled labor, enlargement potentially increases the long-run capital stock of the economy which is associated with short-run revaluation of firm values. Since existing firms are always owned by old generations of the present who own financial wealth, such revaluation generates windfall gains for these generations, at the expense of younger generations with less financial wealth as well as those entering economic activity in early periods of adjustment. The model traces out a characteristic pattern of intergenerational incidence of the welfare effects, in addition to redistribution across skilled and unskilled labor. At the same time, it proposes a rigorous metric for an aggregate welfare effect from EU enlargement. Through an elaborate representation of the expenditure as well as the revenue side of the government budget, the model is able to address fiscal implications of a country being a member of the EU and, therefore, also of the fiscal consequences that this country must expect from EU enlargement through both market integration vis àvisnew member countries as well as through the EU financial framework having to accommodate these new
1. Introduction 13 member countries. Importantly, the aforementioned welfare effects incorporate these fiscal consequences of EU enlargement. Putting this model to use for a detailed analysis of the Austrian and the German case, the above mentioned papers came up with the bottom line of positive overall welfare effects of enlargement. The effect was calculatedtobeabout0.6percentofgdpforaustria,whereasforgermany,the calculated welfare gain was in the vicinity of 0.3 percent. 15 The numbers are to be understood as measures of an equivalent income variation, i.e., annual gains that would accrue forever. However, the numbers exclude the benefits from immigration. For the Austrian case, including expected immigration flows boosts the expected gains to 1.8 percent of GDP. But as it would later turn out, Austria as well as Germany were among the countries opting for the above mentioned transitional agreements, allowing them to maintain their immigration restrictions vis à vis new member countries of the EU. Hence, for the time being, such additional migration gains could not be expected to materialize. The first round of applying this model to Austria and Germany had left two issues unresolved. The first was that the model assumes full employment, which is a worrying simplification. The second was that Germany and Austria are certainly special cases. Both have close historic ties to eastern Europe and are bordering on the former Iron Curtain. Therefore, they are particularly exposed to eastern enlargement of the EU. Other countries, say Spain, Portugal or Ireland, would arguably be much less exposed, in addition to being different in positions regarding the fiscal implications of EU enlargement. Part one of this volume presents two papers that attempt to improve on these shortcomings. Chapter 2 of this volume, entitled Eastern Enlargement of the EU: Jobs, Investment and Welfare in Present Member Countries, does away with the assumption of full employment by introducing labor market frictions, maintaining all of the specific model features mentioned above, and applying this enriched model to the case of Germany. 16 Labor market frictions are of the search and matching type, including unemployment benefits 15 Based on a somewhat less detailed, static model Baldwin et al. (1997) had calculated a welfare gain of about 0.2 percent of GDP for incumbent countries and 1.5 percent for eastern newcomers. 16 The paper is an abridged version of a paper with the same title, published in Berger, H and T Moutos (eds.), Managing European Union Enlargement, pp. 173 210, coauthored by Christian Keuschnigg and Ben Heijdra.
14 1. Introduction as well as wage taxation as government policies that directly affect the labor market. The chapter includes a detailed model description that also serves for a better understanding of the subsequent chapter. The application to Germany also features a somewhat refined empirical treatment of possible labor migration that would follow subsequent to termination of the transitional agreement. In terms of the bottom line, this refined application of an enriched model reconfirms the overall welfare gain of enlargement for the German economy reported in the earlier papers. Indeed, the calculated gain is even larger, almost 0.5 percent of GDP if we combine the (negative) fiscal consequences and integration on goods markets alone, and increased by a further 0.7 percentage points of GDP by the beneficial effects of labor inflows. As regards unemployment, the outcome depends on how unemployment benefits are defined, but the thrust of the numerical application is a reduction of unemployment for skilled labor, whereas unskilled labor is predicted to suffer from additional unemployment. However, the magnitude of these unemployment effects is very small in either case, well below half a percentage point in most of the scenarios considered. Chapter 3, entitled Eastern Enlargement of the EU: A Comprehensive Welfare Assessment, takes a much less detailed perspective, but offers two advantages. 17 First, it provides a very general analytical approach to understanding enlargement effects on incumbent countries. And secondly, it offers an approach towards learning from the German results what eastern enlargement might hold for all of the other incumbent member countries of the EU, without the effort of calibrating a full CGE model for any one of them. The analytical approach draws on duality theory, and it highlights three principal channels through which EU enlargement is likely to affect an incumbent country: the trade effects, the product differentiation and growth effects, and the immigration effects. The empirical approach proposed in order to translate the German magnitudes into enlargement effects for other incumbents is based on the notion of separate welfare elasticities for: i) trade integration, ii) migration, and iii) the budgetary consequences of enlargement. The results obtained for Germany for any one of these scenario components are first expressed in terms of welfare elasticities, and in a second step these elasticities are then combined with country-specific representations of the enlargement scenarios for each of the other member countries. The outcome is a diverse picture of heterogeneity 17 The chapter has originally been published under the same title in the Journal of Policy Modeling, 26, 65 888 (2004).
1. Introduction 15 across incumbent countries in terms of welfare effects to be expected from EU enlargement. The heterogeneity is substantial, with Austria sticking out as by far the largest winner (about 2 percent of GDP, including the benefits from immigration), to be followed by Germany (about 1 percent). At the other end of the scale, we find countries like Spain, Ireland and Portugal who would suffer a loss. Portugal is trailing the list with a loss of about 1.3 percent of GDP. 2.2. The role of distance and WTO membership for trade A notable feature of empirical research on the trade patterns that have evolved in the era of Globalization 2.0 is the enormous popularity of the so-called gravity model of trade which explains bilateral trade between any two countries as reflecting their economic size and the geographic distance between them. The popularity is partly based on empirical success, but empirical success of the gravity model is older, dating back as early as the 1950s, than its present popularity. What made the model so popular over the past 2 decades or so is its enhanced theoretical foundation. In one way or another, this foundation has to do with the introduction of geography as a determinants of trade. This reflects the simple acknowledgment that trade is costly and that, other things equal, the cost of trade depends on geographic distance between trading partners. Part II of this volume turns to empirical gravity analysis of trade. The gravity equation for bilateral trade follows from any model that predicts perfect specialization, meaning that any one good is produced in equilibrium only by one country, combined with homothetic preferences that feature positive consumption of all goods in all countries. 18 Presently, there are two lines of theoretical reasoning that lead to trading equilibria of this kind. The first, and most popular, is found in the above mentioned monopolistic competition model of trade, mainly a reaction to intra-industry trade which is an empirical hallmark of Globalization 2.0 ; see above. The theoretical foundation of the gravity model along these lines is due to Anderson (2079), with a significant refinement in Anderson and van Wincoop (2003). 19 More recently, a new foundation for the gravity equation was proposed by Eaton and Kortum (2002) who combine geography with a stochastic view of Ricardian comparative advantage. 18 This was first pointed out by Deardorff (2001b). 19 For convenient surveys see Feenstra (2003) and Anderson (2011).
16 1. Introduction Against the backdrop of the world becoming an ever smaller place through ever cheaper transport of both goods as well as information, one would expect geographic distance to play an ever smaller role in explaining the pattern of bilateral trade between different countries. And the gravity model seems an ideal vehicle to demonstrate this effect. Surprisingly, however, empirical estimations of the gravity equation have often come up with the conclusion that the trade barrier effect of distance has been increasing, rather than falling, over time during Globalization 2.0. This seems to contradict the notion of an ever smaller world, and it has become known as the distance puzzle, see Disdier and Head (2008). Chapter 4 of this volume, entitled Exploring the Intensive and Extensive Margins of World Trade, addresses this puzzle from a novel perspective, focusing on what is often called the extensive margin of world trade. 20 The extensive margin of world trade is defined as the formation or termination of trading relationships between countries, as opposed to the intensive margin which involves variations in trading volumes for existing trading relationships. Until relatively recently, empirical estimations of the gravity equation have typically restricted the sample used to country pairs with positive trade, thus focusing on the intensive margin. If the declining role of distance as a barrier to trade fails to show up in gravity estimates at the intensive margin, might advances in the technology of transport and communication at least have eased the formation of trading relationships? How important was the extensive margin in the evolution of world trade since World War II? Can we extend the gravity approach to include both the extensive and intensive margins in a unified framework? Does the distance puzzle fall if we do? These are the questions addressed in chapter four of this volume. The chapter first develops a vintage accounting framework in order to trace out the empirical importance of the two margins of world trade, and applying this framework to world trade it concludes that the extensive margin has contributed significantly to the growth of world trade over the second half of the 20 th century. For instance, about 40 percent of world trade growth from 1950 to 1997 is attributable to the extensive margin. Thus, restricting data samples to country pairs with positive trade ignores an important part of the story. This generates a bit of a theoretical curiosity. 20 This paper has originally been published under the same title in the Review of World Economics, 142(4), 2006, pp. 642 674, coauthored by Gabriel Felbermayr.
1. Introduction 17 While country pairs with zero trade are perfectly consistent with the Eaton and Kortum (2002) foundation of the gravity equation, the standard version of the monopolistic competition model, which is usually invoked when estimating this equation, implies that all country pairs have positive trade. In other words, it has no extensive margin of trade. However, as the two papers in part two of this volume show, the model is readily extended to explain movements at the extensive margin of world trade. For instance, introducing fixed cost of taking up a trading relationship is enough to generate an extensive margin of trade. 21 But allowing for the extensive margin of world trade also forms an econometric challenge in that it implies a violation of the assumptions required for standard techniques to deliver consistent parameter estimates for the usual log-linear gravity equation. The underlying problems are heteroscedasticity (efficiency of estimation) and an omitted variable (consistency of estimation). There are three ways to deal with this problem. One is to take account of the nonlinearity which is implied by the extensive margin through estimating a non-linear model, as suggested by Santos Silva and Tenreyro (2006). The second is to stick to a log-linear equation but treat the extensive margin as a first step of estimation, separately from the intensive margin, through a so-called Heckman selection model. This approach has, for example, been followed in Helpman et al. (2008). The third approach, applied in Chapter 4, is to treat the extensive margin as a corner solution, and to use a Tobit approach to estimate the parameters at the extensive as well as the intensive margin of trade. The Heckman as well as the Tobit approach deliver separate estimates for the two margins, the difference being that the Heckman model assumes a explanatory variables for selection model that do not fully coincide with those for the intensive margin, whereas the Tobit model assumes that the two margins are driven by the same underlying variables. Before turning to an estimation of the full Tobit model of gravity, chapter four readdresses the distance puzzle with somewhat less refined techniques, such as estimating a time-varying distance coefficient and a Probit estimation of the extensive margin. While the time-varying coefficients indicate an increasing role of distance over time, the Probit estimation already indicates a negative time trend in the trade barrier effect of distance at the extensive margin. The Tobit estimation solidly substantiates this evidence. 21 In Helpman et al. (2008) this assumption is combined with firm heterogeneity.
18 1. Introduction The overall conclusion drawn from chapter four is that the distance puzzle disappears once the extensive margin of trade is included alongside the intensive margin. A further natural application of the gravity model lies in helping to identify special factors that influence trade volumes, other than those of gravity. Two of such special factors have received a lot of interest in the recent literature, one being membership in the GATT/WTO, the other being membership in a currency union. As indicated above, the mainstream narrative of postwar economic history holds that GATT/WTO membership should have exerted a trade-promoting influence. But again, it has proven surprisingly difficult to demonstrate this effect through empirical estimations of the gravity model of trade; see Rose (2004) and Rose (2010). 22 While first paper in Part II includes parenthetical evidence that a tradepromoting influence might have been present at the extensive margin of world trade. 23 In Felbermayr and Kohler (2010), this issue is taken up in more detail in chapter five, entitled WTO Membership and the Extensive Margin of World Trade: New Evidence. 24 The paper provides new evidence, trying to obtain something like a final answer to this question. It surveys the more recent literature, including estimation methods, and develops a detailed but simple theoretical model of the extensive margin of world trade based on the monopolistic competition foundation of gravity. In its empirical part, Chapter 5 relies on the Poisson pseudo maximum likelihood estimator for the nonlinear equation model, as suggested by Santos Silva and Tenreyro (2006). In addition, it estimates a Probit model for the extensive margin, distinguishing between four subperiods of postwar trade liberalization representing different episodes of trade negotiations under the multilateral world trading system that started out with the GATT: the pre-kennedy Round episode (1948 1967), the Kennedy Round episode (1968 1978), the Tokyo Uruguay Round episode (1979 1994) and the most recent episode of the WTO (1995 2008). We find that this way 22 In passing, it is perhaps worth mentioning that the expectation of a common currency boosting trade was more than born out by early gravity estimates, indicating a spectacular tripling of trade. However, subsequent studies have led to a substantial correction towards much lower magnitudes in the vicinity of 5 20 percent; see S Silva and Tenreyro (2010). 23 Similar evidence is also found in Helpman et al. (2008). 24 This paper has originally been published in The World Economy, 33(11), 2010, pp. 1430 1469, coauthored by Gabriel Felbermayr.
1. Introduction 19 of slicing time is crucial for the results obtained. Moreover, Chapter 5 focuses on the distinction between developing and developed countries, and it distinguishes between formal and de facto membership in the GATT. As pointed out by Rose (2010), looking at sub-samples across time and countries is delicate in the present context since this strategy, if pursued far enough, is almost bound to at some stage detect sub-samples where GATT/WTO membership is found to promote trade. It is therefore important to maintain a general focus when trying to come up with a final verdict. The Probit results presented in Chapter 5 may be interpreted as evidence for WTO membership to raise the odds that countries trade with each other at all, but the effect is by no means robust across country groups and time. This holds true for both formal and de facto membership. Estimates of the nonlinear model, which effectively looks at the external and the internal margin in combination, generate somewhat bleaker picture for WTO membership. It is only for the final years of our sample, i.e., the WTO era subsequent to completion of the Uruguay Round in 1994, that these estimates indicate a trade-promoting effect of membership. Again, this holds true for both types of membership, and for developed as well as developing countries. Chapter 5 concludes that the extensive margin does not constitute a powerful line of defense for the mainstream narrative which holds that membership in the postwar multilateral trading system has constituted a trade-promoting factor. 2.3. Offshoring: A new form of trade, conventional mechanisms? Trade economists have always had a key interest in trade as a potential determinant of factor prices and domestic income distribution. This interest was reinvigorated in the 1990s when the policy debate in many countries had turned on trade, and globalization more generally, as a potential cause of two trends in wages: a marked increase in the premium of wages for high-skilled over those of low-skilled workers, and in some countries even a reduction of real wages for low-skilled workers. These trends were largely seen with apprehension, hence the debate was vital for political acceptance or opposition to further trade liberalization efforts, or even a rei-introduction of specific measures of protection. It is probably fair to say, in retrospect, that in this debate on trade and wages a consensus view has emerged according to which the significance of trade as an explanatory factor for wage inequality is rather limited. Changes in
20 1. Introduction technology are generally thought to have played a larger role than trade. One of the arguments was that conventional trade theory would suggest that enhanced north-south trade should exert opposite forces on wages in (lowskill abundant) developing and (high-skill abundant) developed countries, whereas the aforementioned empirical trends have been observed almost throughout the world. The empirical observation of rising input ratios of skilled-to-unskilled labor in the face of the above trends would similarly fly inthefaceofconventionaltradetheory. But perhaps the inability of conventional trade theory to explain wage trends should be interpreted as a blow to theory, and not as a blow to the empirical argument that enhanced trade is partly responsible for observed wage trends. And indeed, modern developments of theory open up new perspectives on the mechanisms through which globalization on goods markets might affect domestic income distribution between different types of factor owners; see Harrison et al. (2011). Among these new perspectives is the recognition that offshoring may play a role different from trade in final goods. Already in the 1990s, Feenstra and Hanson (1997) have shown that offshoring could explain the simultaneous increase in the skill premium in both the North and the South. If the North relocates the least skill-intensive element of its chain of production, then its value added activity as a whole clearly becomes more skill-intensive. But the same might be true in the South, where this same element of value added may well be the most skill intensive of all. It becomes clear from this simple argument that offshoring blurs the distinction between trade and technology as tow rival explanations for rising wage inequality: Offshoring at the extensive margin is a change in technology, a point made more generally in Feenstra and Hanson (1999) and Feenstra et al. (2003). 25 According to the present consensus, the relationship between offshoring, or trade in tasks, and inequality is potentially much different from the relationship between income distribution and trade in final goods as highlighted in conventional trade models. What is much less clear, however, is whether this relationship is such that our faith in the old suspicion of trade as a significant cause of the aforementioned wage trends should be restored. 25 I use modern terminology here whereby offshoring means a cross-country relocation of certain elements of value added, rather than simply an increase of trade in a given set of intermediate inputs (the intensive margin). In addition to the extensive margin of different inputs, recent literature also emphasizes the extensive firm margin, where firms with different productivity also use a differently skill-intensive technology; see Burstein and Vogel (2012).