Free Trade, Growth, and Convergence

...the removal of trade barriers by the EEC countries during the postwar period coincided with movement to new, higher and steeper, growth paths by each country.

In Free Trade, Growth, and Convergence (NBER Working Paper No. 6095), Faculty Research Fellow Dan Ben-David and Michael Loewy ask how free trade affects output levels and steady-state growth rates. Emphasizing the role of trade in the dissemination of knowledge, they show that increased trade can lead to income convergence among nations and increased growth rates for all.

The debate over free trade has heightened during the past decade with the enlargement of NAFTA and the creation of the World Trade Organization. Critical to this debate is the question of whether freer trade reduces income disparity among trading partners and, to the extent that the income gap is reduced, whether this reduction comes at the expense of the wealthier trade partners.

In this study, the authors cite evidence of widespread slowdowns in growth during the postwar years which occurred in conjunction with the increasing trend towards liberalization of trade. They ask whether this apparently negative relationship between trade and growth is the correct way to view the evidence. They suggest that the longer-run perspective might present a more accurate account of the link between the two.

For example, both World Wars I and II were accompanied by sharp drops in output levels that were followed by initially high growth, as countries rebounded to their respective pre-war growth paths. These high growth rates were bound to fall eventually. But in contrast with the aftermath of World War I, the period following World War II saw a host of important changes, not the least of which was movement towards free trade. The result was that while most post-WWI countries returned to their old growth paths, the majority of post-WWII countries moved to new long-run paths characterized by higher income levels and faster growth.

The analysis in this paper is based upon the premise that free trade spurs the dissemination of knowledge. Specifically, per capita growth depends on the accumulation of knowledge by each country, which in turn depends on the domestic and foreign stocks of knowledge. The extent to which domestic goods are exposed to foreign trade affects the extent of knowledge spillovers across countries. The authors examine the impact of tariff reductions by one or more countries within the context of this model. They are able to simulate not only long-run or "steady-state" behavior, but also the behavior of countries during the transition from one steady state to the next as a result of changes in commercial policy.

Ben-David and Loewy find that: 1) countries with similar technologies will grow at the same rates in the steady state, although not necessarily at the same levels; 2) a unilateral reduction of tariffs by one country is enough to raise the steady-state growth rates of all countries -- although more widespread reductions have even stronger growth effects; 3) unilateral trade liberalization may enable the reforming country to overtake and surpass wealthier countries.

They then compare their predictions with evidence on five of the six original founding countries of the European Economic Community (EEC). While these countries showed no tendencies towards income convergence or divergence between 1870 and WWII, the post-WWII period was characterized by both extensive trade liberalization by the EEC and a marked reduction in income disparity among member countries. As Ben-David and Loewy show, the reduction in the income gap was not a result of faster growth by the relatively poorer countries coming at the expense of slower growth by the Community's relatively wealthy countries. In fact, the removal of trade barriers by the EEC countries during the postwar period coincided with movement to new, higher and steeper, growth paths by each country. Export-GDP ratios in each of the countries were substantially higher as well.

Finally, the authors argue that less developed countries tend to erect protective trade barriers, which are counterproductive, since they serve to restrict the flow of knowledge through the trade pipeline. They caution that it will be difficult to reduce the income gaps between these countries and developed nations as long as barriers on their trade remain in place.