Do free trade agreements actually increase members' international trade?

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Abstract

For over 40 years, the gravity equation has been a workhorse for cross-country empirical analyses of international trade flows and — in particular — the effects of free trade agreements (FTAs) on trade flows. However, the gravity equation is subject to the same econometric critique as earlier cross-industry studies of U.S. tariff and nontariff barriers and U.S. multilateral imports: trade policy is not an exogenous variable. We address econometrically the endogeneity of FTAs. Although instrumental-variable and control-function approaches do not adjust for endogeneity well, a panel approach does. Accounting econometrically for the FTA variable's endogeneity yields striking empirical results: the effect of FTAs on trade flows is quintupled. We find that, on average, an FTA approximately doubles two members' bilateral trade after 10 years.

Introduction

The issue of exogeneity may also be an important problem when dummy variables are used (in a gravity equation) to estimate the effects of free trade areas (Lawrence, 1998, p. 59).

One might expect — having witnessed a virtual explosion in the number of free trade agreements (FTAs) among nations over the past decade and a half — that the answer to the question posed in this paper's title is unequivocal: yes! Surprisingly, international trade economists can actually claim little firm empirical support for reliable quantitative estimates of the average effect of an FTA on bilateral trade (all else constant).

Over the past 40 years, the “gravity equation” has emerged as the empirical workhorse in international trade to study the ex post effects of FTAs and customs unions on bilateral merchandise trade flows.1 The gravity equation is typically used to explain cross-sectional variation in country pairs' trade flows in terms of the countries' incomes, bilateral distance, and dummy variables for common languages, for common land borders, and for the presence or absence of an FTA. Nobel laureate Jan Tinbergen (1962) was the first to publish an econometric study using the gravity equation for international trade flows, which included evaluating the effect of FTA dummy variables on trade. His results suggested economically insignificant “average treatment effects” of FTAs on trade flows. Tinbergen found that membership in the British Commonwealth (Benelux FTA) was associated with only 5 (4) percent higher trade flows. Since then, results have been mixed, at best. For example, Aitken (1973), Abrams (1980), and Brada and Mendez (1985) found the European Community (EC) to have an economically and statistically significant effect on trade flows among members, whereas Bergstrand (1985) and Frankel, Stein and Wei (1995) found insignificant effects. Frankel (1997) found positive significant effects from Mersosur, insignificant effects from the Andean Pact, and significant negative effects from membership in the EC in certain years. He noted:

If the data from four years — 1970, 1980, 1990, 1992 — are pooled together, the estimated coefficient on the European Community is a smaller 0.15, implying a 16 percent effect” (p. 83).

Frankel (1997) concluded that several readers “have found surprising our result that intra-European trade can be mostly explained by various natural factors, with little role for the EC until the 1980s….” (p. 88). Other studies in international trade have had similar seemingly implausible results.2

The fragility of estimated FTA treatment effects is addressed directly in Ghosh and Yamarik (2004). These authors use extreme-bounds analysis to test the robustness of FTA dummy coefficient estimates. They find empirical evidence using cross-section data that the estimated average treatment effects of most FTAs are “fragile,” supporting our claims. Thus, there still are no reliable ex post estimates of the FTA average treatment effect. This paper is aimed at addressing this puzzle.

All these studies, however, typically assume an exogenous right-hand-side (RHS) dummy variable to represent the FTA treatment. In reality, FTA dummies are not exogenous random variables; rather, countries likely select endogenously into FTAs, perhaps for reasons unobservable to the econometrician and possibly correlated with the level of trade.3 This paper applies developments in the econometric analysis of treatment effects — some well-known and others more recent — to estimate the effects of FTAs on bilateral trade flows using a panel of cross-section time-series data at five-year intervals from 1960 to 2000 for 96 countries. The literature on treatment effects, developed in the context of numerous labor economics studies (cf., Wooldridge, 2002), provides rich tools that have not previously been used for analyzing the effects of bilateral trade policies on international trade flows.

This is not the first paper in empirical international trade to call attention to the potential endogeneity bias in estimating the effect of trade policies on trade volumes. For instance, Trefler (1993) addressed systematically the simultaneous determination of U.S. multilateral imports and U.S. multilateral nontariff barriers in a cross-industry analysis. Trefler found using instrumental variables that, after accounting for the endogeneity of trade policies, the effect of these policies on U.S. imports increased tenfold. Lee and Swagel (1997) also showed using instrumental variables that previous estimates of the impact of trade liberalization on imports had been considerably underestimated.

Clearly, the literature on bilateral trade flows and bilateral FTAs using the gravity equation is subject to the same critique that Trefler raised: the presence or absence of an FTA is not exogenous. The issue is important because – if FTAs are endogenous – previous cross-section empirical estimates of the effects of FTAs on trade flows may be biased, and the effects of FTAs on trade may be seriously over- or under-estimated, as the extreme-bounds evidence in Ghosh and Yamarik (2004) suggests. To date, only three papers have attempted to address the potential bias in cross-section gravity models caused by endogenous FTAs, Baier and Bergstrand, 2002, Baier and Bergstrand, 2004b and Magee (2003). However, all three papers — using instrumental variables with cross section data — provide at best mixed evidence of isolating the effect of FTAs on trade flows.

The empirical results in our paper suggest three important conclusions. First, several plausible reasons exist to suggest that the quantitative (long-run) effects of FTAs on trade flows using the standard cross-section gravity equation are biased; we argue that unobservable heterogeneity most likely biases estimates downward. Second, we find that, owing to this bias, traditional estimates of the effect of FTAs on bilateral trade flows have tended to be underestimated by as much as 75–85%. Third, we demonstrate that the most plausible estimates of the average effect of an FTA on a bilateral trade flow are obtained from a theoretically-motivated gravity equation using panel data with bilateral fixed and country-and-time effects or differenced panel data with country-and-time effects. Other methods to identify the impact, such as instrumental variables using cross-section data, are compromised by a lack of suitable instruments. We find that, on average, an FTA approximately doubles two members' bilateral trade after 10 years.

Section 2 presents a (traditional) atheoretical cross-section gravity equation and a (modern) theoretically-motivated cross-section gravity equation. Section 3 provides motivation for suspecting endogeneity of FTA dummy variables and suggests the likely direction of bias. Section 4 summarizes some instrumental-variable and control-function econometric studies that have tried to eliminate endogeneity bias using cross-section data. Section 5 addresses panel techniques and discusses the results from applying various fixed and time effects and first differencing to panel data. Section 6 concludes.

Section snippets

The gravity equation in international trade

The gravity equation in international trade most commonly estimated using cross-country data is:PXij=β0(GDPi)β1(GDPj)β2(DISTij)β3eβ4(LANGij)eβ5(ADJij)eβ6(FTAij)ϵijwhere PXij is the value of the merchandise trade flow from exporter i to importer j, GDPi (GDPj) is the level of nominal gross domestic product in country i (j), DISTij is the distance between the economic centers of countries i and j, LANGij is a binary variable assuming the value 1 if i and j share a common

Endogeneity bias

A standard problem in cross-section empirical work is the potential endogeneity of RHS variables. If any of the RHS variables in Eqs. (1), (2) are correlated with the error term, ϵij, that variable is considered econometrically “endogenous” and ordinary least squares (OLS) may yield biased and inconsistent coefficient estimates. Potential sources of endogeneity bias of RHS variables' coefficient estimates generally fall under three categories: omitted variables, simultaneity, and measurement

Treatment effects in cross-section models of trade flows and free trade agreements

We briefly address conventional cross-section instrumental-variables (IV) and control-function approaches to address the FTA endogeneity bias associated with omitted variables and selection. We then discuss some previous studies using these techniques and summarize their mixed findings.

FTA treatment effects using panel data

As most standard econometrics textbooks now suggest, a ready alternative to cross-section estimation of treatment effects in the presence of unobserved time-invariant heterogeneity is the use of panel data (cf., Wooldridge, 2000). Having constructed a panel (for every five years) from 1960–2000 of the bilateral trade flows, bilateral trade agreements, and standard gravity equation covariates among 96 potential trading partners, we now pursue this approach. Three main alternative techniques

Conclusions

The purpose of this paper was to answer the question posed in the title: Do free trade agreements actually increase members' international trade? A motivation for this paper was that — after forty years of gravity equation estimates of the (treatment) effect of FTAs on trade flows — there seems no clear and convincing empirical evidence using the workhorse for empirical international trade studies that the answer is “yes.” This seems surprising in light of the proliferation of FTAs in the last

Acknowledgements

The authors are grateful to Jonathan Eaton, Judith Dean, Rob Feenstra, Scott Kastner, Mika Saito, Curtis Simon, Jeff Wooldridge, Eduardo Zambrano, two anonymous referees and participants at presentations at the American Economic Association annual meetings, Midwest International Economics meetings, U.S. International Trade Commission, and ISNIE meetings for excellent comments on earlier drafts. We thank Doru Cojuc, Katie Martin, Kushlani Rajapakse, Duncan Stewart, Li Zhang and Mike Jaszkowiak

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