Contrary to widely held views, trade can decrease GDP volatility through sectoral specialisation and country-wide diversification

An important question at the crossroads of macro-development and international economics is whether and how openness to trade affects macroeconomic volatility. A widely held view in academic and policy discussions, which can be traced back at least to Newbery and Stiglitz (1984), is that openness to international trade leads to higher GDP volatility. The origins of this view are rooted in a large class of theories of international trade predicting that openness to trade increases specialisation.

Because specialisation (or lack of diversification) in production tends to an increase a country's exposure to shocks specific to the sectors (or range of products) in which the country specialises, it is generally inferred that trade increases macro volatility. This view seems present in policy circles, where trade openness is often perceived as posing a trade-off between the first and second moments (i.e. trade causes higher productivity at the cost of higher volatility).

New research tests these views

In a recent paper (Caselli et al. 2017), my co-authors and I revisit this common wisdom on two grounds.

  • First, we point out that the existing wisdom is strongly predicated on the assumption that sector-specific shocks (i.e. shocks that hit a particular sector) are the dominant source of GDP volatility.

The evidence, however, does not support this assumption. Indeed, country-specific shocks – shocks common to all sectors in a given country – are at least as important as sector-specific shocks in shaping countries' volatility patterns (e.g. Koren and Tenreyro 2007).

Our first contribution is to show that when country-specific shocks are an important source of volatility, openness to international trade can lower GDP volatility. In particular, openness reduces a country's exposure to domestic shocks, and allows it to diversify its sources of demand and supply, leading to potentially lower overall volatility. This is true as long as the volatility of shocks affecting trading partners is not too big, or the covariance of shocks across countries is not too large. In other words, we show that the sign and size of the effect of openness on volatility depends on the variances and covariances of shocks across countries.

  • Second, we question the mechanical assumption that higher sectoral specialisation per se leads to higher volatility.

Indeed, whether GDP volatility increases or decreases with specialisation depends on the intrinsic volatility of the sectors in which the economy specialises in, as well as on the covariance among sectoral shocks and between sectoral and country-wide shocks.

Simulation results: Trade, specialisation and volatility

We make these points in the context of a quantitative model of trade and GDP determination. We use the model in conjunction with sector-level production and bilateral trade data for a diverse group of countries to quantitatively assess how changes in trading costs since the early 1970s have affected GDP volatility. 

We find that the decline in trade costs since the 1970s has caused sizeable reductions in GDP volatility in 80% of the countries in our sample, while it led to modest increases in volatility in the other third. The range of changes in volatility varies significantly across countries, with the largest declines in volatility due to trade in excess of 60%, and the largest increases in volatility due to trade of around 6-8%. On average trade reduced volatility by around 20%.

The general decline in volatility due to trade is the net result of the two different mechanisms discussed above: sectoral specialisation and country-wide diversification. The country-wide diversification mechanism contributed to lower volatility again in 80% of the countries in our sample, suggesting that there is scope for diversification through trade.

Equally interesting, and against conventional wisdom, is the finding that higher sectoral specialisation does not always lead to higher volatility. For about one-third of countries, the sectoral specialisation channel contributed to lower volatility. As with the overall net effect of trade on volatility, the relative importance of the two mechanisms we highlight varies across countries, though the effect of the specialisation mechanism is on average one-third of the effect of the diversification mechanism.

Concluding remarks

To summarise, our study challenges the standard view that trade increases volatility. It highlights a new mechanism – country diversification – whereby trade can lower volatility. It also shows that the standard mechanism of sectoral specialisation, usually deemed to increase volatility, can in certain circumstances lead to lower volatility. The analysis indicates that diversification of country-specific shocks has generally led to lower volatility during the period we analyse, and has been quantitatively more important than the specialisation mechanism.

As the model and quantitative results illustrate, openness to trade does not always cause an unambiguous effect on volatility. The sign and size of the effect varies across countries. This result might partly explain why direct empirical evidence on the effect of openness on volatility has yielded mixed results. Some studies find that trade decreases volatility (e.g. Cavallo 2008, Haddad et al. 2010, Strotmann et al. 2006, Burgess and Donaldson 2015, Parinduri 2011), while others find that trade increases it (e.g. Rodrik 1998, Easterly et al. 2000, Kose et al. 2003, di Giovanni and Levchenko 2009). The model-based analysis can circumvent the problem of causal identification faced by many empirical studies, allowing for counterfactual exercises that isolate the effect of trade costs on volatility. Moreover, it can cope with highly heterogeneous trade effects across countries.

References

Burgess, R and D Donaldson (2012), "Railroads and the demise of famine in colonial India", MIT, manuscript.

Caselli, F, M Koren, M Lisicky, S Tenreyro (2017), “Diversification through trade”, CEPR, Discussion paper No. 10775.

Cavallo, E (2008), "Output volatility and openess to trade: a reassessment", Journal of LACEA Economia, Latin America and Caribbean Economic Association.

di Giovanni, J and A Levchenko (2009), "Trade openness and volatility", The Review of Economics and Statistics, 91(3): 558-585.

Donaldson, D (2015), "Railroads of the Raj: Estimating the impact of transportation infrastructure", American Economic Review, forthcoming.

Easterly, W, R Islam and J Stiglitz (2001), "Shaken and stirred: Explaining growth volatility", Annual World Bank Conference on Development Economics: 191-212, World Bank.

Haddad, M, J Lim and C Saborowski (2010), "Trade openness reduces growth volatility when countries are well diversified", World Bank, Working paper S5222.

Koren, M and S Tenreyro (2007), "Volatility and development", Quarterly Journal of Economics 122(1): 243–287.

Kose, A, E Prasad and M Terrones (2003), "Financial integration and macroeconomic volatility", IMF Staff Papers, 50(SI): 119-142.

Newbery, D and J Stiglitz, (1984), "Pareto inferior trade", Review of Economic Studies 51(1): 1-12.

Parinduri, R (2011), "Growth volatility and trade: Evidence from the 1967-1975 closure of the Suez Canal", University of Nottingham, manuscript.

Rodrik, D (1998), "Why do more open economies have bigger governments?", Journal of Political Economy 106(5): 997-1032.

Strotmann, H, J Döpke and C Buch (2006), "Does trade openness increase firm-level volatility?", Deutsche Bundesbank, Research Centre, Discussion Paper Series 1: Economic Studies 2006,40.

Trade openness Volatility Specialisation International trade Shock transmission Diversification