In praise of trade frictions

Are restrictions on free trade a better idea than generally thought? I ask because, despite his lauding of it, it is reported that Johnson will impose customs checks upon goods imported from the EU. This lends credence to the estimate (pdf) by The UK in a Changing Europe that Johnson’s plan might eventually cut UK GDP by over six per cent.

But might this estimate miss an important mechanism and thus over-state the costs of us leaving the single market?

What follows cuts against all my instincts in favour of free trade and EU membership. My gut tells me to agree with Martin Wolf’s claim that Johnson’s proposals mean shooting ourselves in both feet. But we should always question our beliefs. And there is, I suspect, more to be said in favour of trade frictions than we have heard so far.

My story starts in a strange place, with the Feldstein-Horioka puzzle. This is the fact (pdf), pointed out in 1979, that net capital flows between countries are much smaller than you would imagine or, to put it another way, that current account imbalances are surprisingly small.

One reason for this is that financial markets, on their own, cannot achieve any net transfer of capital between countries This is simply because every seller needs a buyer: I can only dump my holdings of UK equities if somebody buys them. My effort to shift capital out of the UK is therefore offset by somebody else shifting it in. Instead, a net transfer of capital out of the UK requires that there be a trade surplus. This, by definition, entails an offsetting outflow of capital: if we are selling more goods and services to foreigners we are earning more than we are spending – ie saving, and these savings must be invested abroad.

So, what is it that limits trade imbalances and therefore current account imbalances? The answer, said Maurice Obstfeld and Kenneth Rogoff in a famous 2001 paper (pdf), are trade frictions. By these they mean not just tariffs but also non-tariff barriers such as the red tape of border checks, regulatory differences or simply customers’ preferences (pdf) for home-made goods. It’s difficult for a country to export or import a lot simply because trade costs (pdf) are high. Trade imbalances, therefore, tend to be small.

One Big Fact supports Obstfeld and Rogoff’s theory. It’s that the EU’s single market reduced trade costs - and this led to a rise in countries’ external imbalances. For example between 1980 and 1997 (when Schengen came into effect) Germany ran an annual average current account surplus of just 0.9% of GDP. Since then, though, it’s run an average surplus of 4.7% of GDP. And since 1997 the external deficits of Spain and Greece have been twice what they were in the previous 17 years.

Trade frictions, therefore, reduce current account imbalances.

Which can be a good thing. To see why, remember that a current account deficit means – by definition – that a country’s domestic investment exceeds its domestic saving. But think about what this means for its banking system. If investment exceeds savings, the growth in bank lending might well exceed the growth in deposits or the purchase of bank equity by domestic savers. Which means banks might well be becoming riskier – either because they are becoming more highly leveraged, or are more dependent upon wholesale funding to plug the growing gap between loans and deposits. It is for this reason that the NIESR (pdf) and Dallas Fed (pdf) have both found that big current account imbalances help predict financial crises.

The single market, therefore, might well have led to the euro crisis by fuelling greater external imbalances.

Was it really an accident that developed economies saw almost no banking crises during the Bretton Woods era, when current account imbalances were small, but saw plenty before and since?

In limiting current account deficits, then, trade frictions help preserve financial stability.

This is a great prize. Coen Teulings and Nick Zubanov have shown that financial crises lead to a huge and permanent loss of GDP. And this can be multiplied, because crises can lead to bad policy. Nick Crafts points out that the last one gave us austerity and hence Brexit. “The economic costs of the banking crisis are much larger than is usually supposed” he says. An important transmission mechanism here has been proven by Ben Friedman: economic stagnation, he has shown, leads to intolerance, xenophobia and anti-democratic sentiment.

Against all this is the fact that trade frictions create lots of deadweight losses. But even summed across countless goods, these can be small. So much, in fact, that Arnaud Costinot and Andres Rodriguez-Clare have estimated (pdf) that if the US were to shift to autarky it would only cost it 2-8% of GDP: for the UK, the cost would be around four times as much but for the EU much the same. As James Tobin used to say – rightly – “it takes a heap of Harberger triangles to fill an Okun gap.” And an Okun gap is what we get from a banking crisis.

Of course, Harberger triangles aren’t the only cost of trade frictions. There is also the fact that, in reducing competition, they retard productivity and innovation. But banking crises also do so. It’s a wash.

So, what can be said against this argument for trade frictions? I don’t think it’s sufficient to say that banks are sufficiently strong now that a crisis is unlikely. Even if this is true now, it might not remain the case in coming years. Over long enough periods, small probabilities become big ones.

Instead, you could argue that we are trading off a certain loss – all those Harberger triangles – for what is only a reduced probability of disaster. Your attitude to this trade-off will depend upon your taste for risk.

A stronger argument though is simply that there is a cheaper way than trade frictions of reducing the probability of a crisis – to impose higher capital requirements upon banks. But what if the power of the banking lobby prevents this?  

All this suggests there might be more to be said for trade frictions than supposed. Which poses the question: why have we not heard an argument along these lines, when we have heard so many much weaker ones?

Comments

[Patrick Kirk]

Perhaps ecomomists are just condtioned to always say "Free trade = good" ? This is the first time I have ever seen a coherent argument that trade frictions are not stupid and harmful.

[Staberinde]

Hmm. If trade frictions are so good, maybe we should have some between London and Manchester, Scotland and England, Kidderminster and Bishops Stortford?

Is there an optimal level for trade frictions, or are more better?

[Dipper]

why is it good for the EU to have restrictions on trading outside the EU, but not good for the UK to have similar restrictions?

[Almar]

I haven't got the numbers to hand, but how much of the increased German trade surplus and the Spanish deficits are with other EU countries (where the single market reduced trading costs) and how much with non-EU countries? You also need to look at relative inflation rates since the start of of the Eurozone.

[droog]

And whilst Johnson may be imposing custom checks at the moment (aka when cake meets reality), how would this argument for trade frictions sit with the open position of the Britannia Unchained crowd? Just this week Johnson was lecturing the USA on the perils of trade wars.

It's hard to see this duality going on indefinitely. On the one hand a hard no-deal Brexit will lead to controls on both sides of the UK-EU divide, whilst on the other the free-marketeering wing of the Tory party wants to drop barriers for any and all items coming from anywhere in the world.

One tiny difference I see between Johnson's move and Trump's current war with China is that the friction caused by custom checks is not the same as straight-up tariffs. I guess Johnson is introducing friction where the monetary costs are incidental to the divergence he seeks, whereas with Trump making costs punitive is the whole purpose of the exercise. Johnson's goal would then be to introduce as much divergence and friction for as little costs as possible, whilst Trump wants costs to increase as much as possible. Nonetheless, I still can't see how this approach towards the EU would leave room to be more permissive with other non-EU partners. In other words, just because you are doing things differently from Trump doesn't automatically mean you're making sense.

[Robert Mitchell]

"An important transmission mechanism here has been proven by Ben Friedman: economic stagnation, he has shown, leads to intolerance, xenophobia and anti-democratic sentiment."

Isn't this in contradiction with the Easterlin paradox?

"every seller needs a buyer: I can only dump my holdings of UK equities if somebody buys them. My effort to shift capital out of the UK is therefore offset by somebody else shifting it in."

Say a foreign investor borrows dollars with printed local currency, buys your UK equities, then they go up. Dollars flow to his account. "Every seller needs a buyer" ignores leverage: the buyer can borrow dollars to buy and never repay but someone keeps their balance sheet expanded indefinitely, thus turning credit into money.

[KG]

Your initial instinct was right: trade frictions are bad. If current account imbalances are "small" for big countries it is because product ranges (and investment prospects) for said countries are pretty similar. And the "Okun" costs of the GFC ignore the (unsustainable, but real) benefits of the above-trend growth that preceded it.

[georgesdelatour]

Thanks for considering this, Chris.

A number of economists, especially from Cambridge, have been Free Trade Sceptics (FTS). Recently they’ve gone a bit quiet. Wasn’t J.K Galbraith a FTS? Isn’t John Eatwell? The most famous FTS today is probably Ha-Joon Chang, in his book “Bad Samaritans: The Myth of Free Trade and the Secret History of Capitalism”.

There’s an argument which goes all the way back to Friedrich List, which says that pure free trade tends to entrench the dominance of the already successful economies. List thought Germany could only afford to have free trade with Britain after a long period of protectionism had allowed German industry to build up its domestic competitive strength. He said that, without protection, the German people would end up as “drawers of water and hewers of wood for Britain”.

America grew to be the world’s largest economy while it was heavily protected. Chang likes to quote President Ulysses Grant, who remarked that “within 200 years, when America has gotten out of protection all that it can offer, it too will adopt free trade”.

Intriguingly, it’s List’s Zollverein which is the direct inspiration for the EU, not the Manchester free-traders.

[Jonathan]

georgesdelatour
FTS at Cambridge goes back to Keynes.
Gudgin there has done Brexit work broadly in this tradition which does indicate negative consequences but also suggests these are likely to have been overstated:
https://www.cbr.cam.ac.uk/fileadmin/user_upload/centre-for-business-research/downloads/working-papers/wp483.pdf