Trade Openness and Its Effect on Economic Growth

By: Jacob Jasperson

I. Introduction There has been much discussion as of late to the nature of globalization; what it does, who it affects, how we can use it to our advantage. Economists have debated this topic for years, swaying back and forth, trying to decide whether openness increases growth or doesnt. But the question still remains; does trade openness lead to increased economic growth, both in developed and developing countries? The topic has been studying so much that one would think a consensus should have been reached. However, that is not the case. Many economists (Grossman and Helpman (1991), Rivera-Btiz and Romer (1991), Devereux Lapham (1994), Edwards (1998), Wacziarg (2001) and Greenway et. al (2002)) have found that increased levels of trade openness lead to increased levels of economic growth. Still others (Redding (2002), Rodriguez and Rodrik (1999), Clemens and Williamson (2002) and Vamakidis (2002)) have questioned those findings, wondering if the connection between growth and openness is really as strong as some say it is. This question has never been more relevant than it is today. With lawmakers wondering how to protect domestic businesses from the threat of competition, II. Theoretical Review As was stated earlier, economists have long debated the issue of openness and economic growth at the empirical level. Much of the contention is that authors cant agree on appropriate definitions for the major terms (measures of growth, trade openness, etc). Baldwin (2003) argues that this is one of the primary differences between investigators of this topic. His

paper on the subject notes that while some authors are interested in the casual relationship, most are interested in the effects of the policies that governments are imposing. Another difficulty and source of contention that Baldwin points out is the lack of good data on the subject. Since there has only been about 30-40 years of good data, researchers often have to resort to case studies, which Baldwin argues has a greater tendency to introduce the authors biases. Baldwin focuses on several theoretical aspects of study or points where countries began shifting from protectionist to outward oriented. He brings up the import substitution policies of the 30s and 40s, talking about the infant industry argument. He then shifts focus to 1982, with the debt crises, and claims this is where most countries began to shift their economic policies to outward. It was at this point, Baldwin contends, that academics began to shift their focus regarding the measure of protection. Little, Tibor, Scitovsky, and Scott (1970) presented a new concept of effective rate of protection. This concept looks at the value added and assigns a level of protection based on that. Baldwin then moves into the new growth theory, pointing out the models of Grossman and Helpman (1991). This looks at how trade policy can affect growth rates. Although Grossman and Helpman made many simplifying arguments (a point that will be contested later in the literature review), they still found that there is no definite answer to whether protection increases or decreases the growth rate; it depends on the patter of imports and exports. Nonetheless, Baldwin finds that almost all the studies examined find some evidence of a positive relationship between growth and outward looking policies. Baldwin does mention the

study done by Rodriguez and Rodrik (2001), which will be discussed later in this paper, in which they expressed skepticism that there is a strong relationship between openness and economic growth. Baldwin concludes by reiterating that the differences among researchers appear to be based on the differences in the definition of openness. Baldwin makes the point that all the authors mentioned not only favor the reduction of tariff barriers; they also call for other policies aimed at eliminating large debts, improving education, reducing government corruption, etc. These authors are studying much more than just the effects of trade policies. The other issues Baldwin points out is the high multicolinearity among the determinants of openness. It is for this reason that economists often try and combine them into one term labeled openness. Finally, the finding that increases in exports and increases in growth are generally positively related faces the problem of causation; export increase may be the result of trade policy changes, or vice versa. Another empirical study done was that of Kneller et. al (2008). The authors here also started out by bringing to light the varying opinions and positions held regarding openness and growth. Grossman and Helpman (1991), Rivera-Btiz and Romer (1991), Devereux Lapham (1994), Edwards (1998), Wacziarg (2001) and Greenway et. al (2002) all found based on their models that trade openness and economic growth had a positive relationship. On the contrary, Redding (2002), Rodriguez and Rodrik (1999), Clemens and Williamson (2002) and Vamakidis (2002) all found models that did not unequivocally support a positive relationship. Kneller argued that when testing a model of this nature, you need to test the influence of both measurements of trade liberalization as well as the conditionality. Kneller as points out that, despite the fact there appears to be a strong positive relationship between liberalization and

growth, there are many exceptions and several countries make significant departures from this relationship. The problem with openness, Kneller contends, is that it is multidimensional, and therefore cannot be captured by a single measure. We need to combine information regarding the timing of trade liberalization, as well as trade policy variables and volume measures of openness. As for the conditionality aspect, we need to take a look at the effects of human capital, natural barriers, and institutional quality. Kneller also looks at the Rodriguez and Rodrik study, as well as the Edwards paper. Kneller then turns his attention to the different strands of cross-country literature; the with-without and the before-after strands. The with-without strand of cross-country study focuses the attention on different countries across the same time frame, with some countries being designated as open and others being designated as closed. Some examples given are the World Bank (1990) and Mosley et. al (1991). The before-after approach (which is the approach Kneller takes) focuses on the same country across time, looking at the changes that occur after a trade reform. Kneller finds that, while the effect of trade openness is significantly positive, it varies quite a bit the further and further you get from the mean. He also finds that the growth outcomes are more positive over the longer term. Another interesting finding of this study is the sensitivity it has to the choice of countries. Kneller demonstrates, using small changes in observations, that the significance and impact of trade openness varies a great deal depending on the countries chosen. One thing that limited his study greatly was the countries that were

found to be successful post-liberalization were also found to be relatively successful preliberalization. Due to this, Kneller suggests that a case-by-case method for finding the true impact of trade on a particular country would be more appropriate. Perhaps one of the most influential and most cited papers regarding this topic is Rodriguez and Rodrik (1999) Trade Policy and Economic Growth: A Skeptics Guide to the CrossNational Evidence. Rodriguez and Rodrik take four important papers in the area of openness and growth and critique them, saying that issue of openness and growth remains an open question; far from being settled in empirical terms. The central question they want to examine is whether countries with lower policy-induced barriers to trade grow faster (ceterius paribus). Again, we are looking at the implications in terms of trade polices action statements if you will. The general answer for whether trade will promote innovation in a small open economy depends on comparative advantage. The authors first look at Dollar (1992), with their main critique on the variable VARIABILITY (index of real exchange rate variability). They found that VARIABILITY, in fact, measured economic instability overall. They contested whether this was an indicator of trade orientation. They add regional dummies , succession initial income, and initial schooling to the regression; VARIABILITY remained robust but the variable DISTORTION (index of real exchange rate distortion) did not. Rodriguez and Rodrik then turn their attentions to Sachs-Warner, another very popular paper on this topic. The Sachs-Warner dummy (which has been used in many subsequent papers to address trade openness) is high and robust when inserted in growth regressions. The

dummy address the issue of openness using five indicators; average tariff rate, non-tariff barriers, economic system (socialist or not), state of monopoly on major exports, and black market premiums. The authors question it, wondering which individual components of the dummy are most responsible for the strength of the variable. They found that the strength came mainly from the black market premiums and state monopoly of exports. Because of this, Rodriguez and Rodrik then ask what these two variables measure? Should they be included in a measure of openness? They find that the state monopoly of exports variable is not a good measure of trade openness, as it very closely resembles a geographic dummy (Sub-Saharan African dummy). They also find that, while there is not enough evidence to say that higher black market activity is not related to economic growth, it is undistinguishable from many other independent but unrelated variables. Therefore, the inclusion of it as a measure of trade policy is unwarranted. Another prominent study in the debate of openness critiqued by Rodriguez and Rodrik is Edwards (1998). Edwards takes the approach of analyzing the robustness of openness-growth relationship using different indicators. The authors argue that the robustness Edwards shows with his model is largely the artifact of weighting; in fact when you take Edwards results and apply conventional techniques, only 3 out of the 19 specifications originally significant remain. Rodriquez and Rodrik conclude by saying that although the data seems to consistently report positive relationships between growth and openness, the issues would not have generated so much attention had economists not felt that something wasnt fitting. They also make clear that there is no credible evidence for suggesting trade barriers lead to higher

growth; they simply want to clear up the overstatement of evidence in favor of trade openness that currently exists in the literature today. III. Empirical Model We wanted in this paper to make generalizations across the board regarding trade openness and GDP growth, and so therefore decided to not go with the before-after approach (since it was mentioned in the literature that the before-after approach raised some concern with making generalizations to other countries). We also wanted to move away from using dummy variables to measure trade openness, as the many shortcomings to that approach have already been discussed. The model we arrived at was:

Where: GDPgrowth is the annual growth rate for a countrys GDP Govexpend is the general government final consumption expenditure, as a percentage of GDP Inflation is the countrys inflation rate Trade is the countrys exports plus imports, as a percentage of GDP Primaryeduc is the average duration of primary education, in years Secondaryeduc is the average duration of secondary education, in years Democracy is a dummy=1 if the country is a democracy Eastasia is a geographic dummy=1 if the country is located in Eastern Asia

Europe is a geographic dummy=1 if the country is located in Europe or Central Asia Latinamerica is a geographic dummy=1 if the country is located in Latin America or the Caribbean Middleeastern is a geographic dummy=1 if the country is in the Middle East Southasia is a geographic dummy=1 if the country is in South Asia Subsaharan is a geographic dummy=1 if the country is in Sub-saharan Africa. The reasons for choosing the model we did are numerous, mostly based off of the previous work that has been completed on this topic. We will now discuss more in depth why we selected each variable, as well as the theoretical expectations we have for them. The first variable we will discuss is govexpend. This variable measures the final government consumption expenditures as a percentage of GDP

Figure 1 - Tests of Normality: Skewness, Kurtosis, and Jarque-Bera

60

50

Series: Standardized Residuals Sample 1998 2007 Observations 310 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability
-10 -5 0 5 10 15 20

40

30

20

2.35e-15 0.056788 21.13614 -13.57476 3.237011 0.269052 11.24020 880.7940 0.000000

10

Figure 2 Scatter plot of Residuals

500

400

RESID^2

300

200

100

0 -20 -10 0 10 20 30

GDPGROWTH

Figure 3 Graph of Residuals

25 20 15 10 5 0 -5 -10 -15 50 100 150 200 250 300

GDPGROWTH Residuals

Durbin Watson stat upper bound=1.89449, lower bound=1.73389

Table 1 Estimation Output of Original Regression

Dependent Variable: GDPGROWTH Method: Panel Least Squares Date: 11/25/08 Time: 01:20 Sample: 1998 2007 Periods included: 10 Cross-sections included: 31 Total panel (balanced) observations: 310 Variable C DEMOCRACY EASTASIA EUROPE GOVEXPEND INFLATION LATINAMERICA MIDDLEEASTERN PRIMARYEDUC SECONDARYEDUC SOUTHASIA SUBSAHARAN TRADE R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood F-statistic Prob(F-statistic) Coefficient 9.743276 -4.054648 -1.854481 0.349023 -0.116117 -0.033972 0.365513 0.034181 -0.175138 -0.070790 2.285422 2.881720 0.015538 0.229159 0.198014 3.301758 3237.776 -803.5118 7.357803 0.000000 Std. Error 2.839551 0.647311 1.247568 1.128509 0.047347 0.009450 1.352064 1.261517 0.304494 0.364830 1.317059 1.216326 0.003940 t-Statistic 3.431273 -6.263833 -1.486477 0.309278 -2.452446 -3.594902 0.270337 0.027095 -0.575178 -0.194036 1.735246 2.369201 3.944060 Prob. 0.0007 0.0000 0.1382 0.7573 0.0148 0.0004 0.7871 0.9784 0.5656 0.8463 0.0837 0.0185 0.0001 4.464860 3.686904 5.267818 5.424513 5.330458 1.119129

Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion Hannan-Quinn criter. Durbin-Watson stat

Table 2 Hausman test

Correlated Random Effects - Hausman Test Equation: ORIGINAL Test cross-section random effects Chi-Sq. Statistic 8.260838

Test Summary Cross-section random

Chi-Sq. d.f. 5

Prob. 0.1424

Cross-section random effects test comparisons: Variable GOVEXPEND INFLATION TRADE PRIMARYEDUC SECONDARYEDUC Fixed 0.013654 -0.039366 0.035868 2.534081 -0.865922 Random -0.109331 -0.035159 0.016119 -0.052144 -0.069406 Var(Diff.) 0.014126 0.000011 0.000167 1.490858 0.918919 Prob. 0.3008 0.1966 0.1266 0.0342 0.4060

Cross-section random effects test equation: Dependent Variable: GDPGROWTH Method: Panel Least Squares Date: 11/25/08 Time: 12:29 Sample: 1998 2007 Periods included: 10 Cross-sections included: 31 Total panel (balanced) observations: 310 WARNING: estimated coefficient covariance matrix is of reduced rank Variable C GOVEXPEND INFLATION TRADE PRIMARYEDUC DEMOCRACY EASTASIA EUROPE LATINAMERICA MIDDLEEASTERN SECONDARYEDUC SOUTHASIA SUBSAHARAN Coefficient -9.019581 0.013654 -0.039366 0.035868 2.534081 NA NA NA NA NA -0.865922 NA NA Std. Error 8.631214 0.138873 0.010209 0.014344 1.306561 NA NA NA NA NA 1.103362 NA NA t-Statistic -1.044996 0.098323 -3.855964 2.500552 1.939505 NA NA NA NA NA -0.784803 NA NA Prob. 0.2970 0.9217 0.0001 0.0130 0.0535 NA NA NA NA NA 0.4333 NA NA

Effects Specification Cross-section fixed (dummy variables) Period fixed (dummy variables) R-squared Adjusted R-squared S.E. of regression Sum squared resid 0.450548 0.359318 2.951094 2307.873 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion 4.464860 3.686904 5.135709 5.678114

Log likelihood F-statistic Prob(F-statistic)

-751.0349 4.938611 0.000000

Hannan-Quinn criter. Durbin-Watson stat

5.352540 1.405614

Table 2 Estimation as a fixed effects model

Dependent Variable: GDPGROWTH Method: Panel EGLS (Cross-section random effects) Date: 11/25/08 Time: 12:27 Sample: 1998 2007 Periods included: 10 Cross-sections included: 31 Total panel (balanced) observations: 310 Swamy and Arora estimator of component variances Variable C GOVEXPEND INFLATION TRADE PRIMARYEDUC DEMOCRACY EASTASIA EUROPE LATINAMERICA MIDDLEEASTERN SECONDARYEDUC SOUTHASIA SUBSAHARAN Coefficient 9.040458 -0.109331 -0.035159 0.016119 -0.052144 -4.208946 -1.929318 0.393777 0.516644 0.023317 -0.069406 2.439945 2.880709 Std. Error 4.346997 0.071829 0.009675 0.006216 0.465019 1.072361 2.105847 1.923466 2.299734 2.144035 0.546341 2.248669 2.080341 t-Statistic 2.079702 -1.522110 -3.633909 2.593204 -0.112134 -3.924933 -0.916172 0.204722 0.224654 0.010875 -0.127038 1.085062 1.384729 Prob. 0.0384 0.1291 0.0003 0.0100 0.9108 0.0001 0.3603 0.8379 0.8224 0.9913 0.8990 0.2788 0.1672

Effects Specification S.D. Cross-section random Period fixed (dummy variables) Idiosyncratic random Weighted Statistics R-squared Adjusted R-squared S.E. of regression F-statistic Prob(F-statistic) 0.213148 0.155773 2.967753 3.715017 0.000000 Mean dependent var S.D. dependent var Sum squared resid Durbin-Watson stat 4.464860 3.229968 2536.577 1.285113 1.526524 2.951094 Rho 0.2111 0.7889

Unweighted Statistics R-squared Sum squared resid 0.285323 3001.873 Mean dependent var Durbin-Watson stat 4.464860 1.085918

Stata Output
Random-effects GLS regression Group variable: country R-sq: within = 0.1055 between = 0.4966 overall = 0.2226 Number of obs Number of groups = = 310 31 10 10.0 10 49.87 0.0000

Obs per group: min = avg = max = Wald chi2(12) Prob > chi2 z -0.26 -0.30 -4.29 -1.33 3.60 1.31 -1.27 0.06 0.19 -0.15 1.05 -4.17 2.19 P>|z| 0.798 0.766 0.000 0.183 0.000 0.192 0.205 0.952 0.853 0.880 0.293 0.000 0.028 = =

Random effects u_i ~ Gaussian corr(u_i, X) = 0 (assumed) gdpgrowth primaryeduc secondarye~c inflation govexpend trade subsaharan eastasia europe latinamerica middleeast~n southasia democracy _cons sigma_u sigma_e rho . Coef. -.1217668 -.1663423 -.0416432 -.097255 .022168 2.768035 -2.708863 .1174246 .4344483 -.3296363 2.407618 -4.53727 9.758558 1.5175427 2.9970573 .20406532 Std. Err. .4746648 .5585215 .0097139 .0729817 .0061622 2.119824 2.137708 1.959018 2.343372 2.182983 2.291463 1.088667 4.449074

[95% Conf. Interval] -1.052093 -1.261024 -.060682 -.2402964 .0100904 -1.386743 -6.898693 -3.722181 -4.158477 -4.608205 -2.083566 -6.671017 1.038533 .808559 .9283398 -.0226044 .0457865 .0342456 6.922813 1.480968 3.95703 5.027373 3.948932 6.898802 -2.403522 18.47858

(fraction of variance due to u_i)

Breusch-Pagan / Cook-Weisberg test for heteroskedasticity Ho: Constant variance Variables: primaryeduc secondaryeduc inflation govexpend trade subsaharan eastasia europe latinamerica middleeastern southasia democracy chi2(12) Prob > chi2 = = 102.68 0.0000

Variable europe eastasia middleeast~n subsaharan latinamerica southasia secondarye~c primaryeduc trade govexpend democracy inflation Mean VIF

VIF 8.82 7.74 3.96 3.68 3.14 2.98 2.66 2.53 1.75 1.62 1.61 1.22 3.47

1/VIF 0.113404 0.129245 0.252805 0.271940 0.318735 0.335903 0.376490 0.395467 0.572324 0.618665 0.620416 0.821047

Breusch and Pagan Lagrangian multiplier test for random effects gdpgrowth[country,t] = Xb + u[country] + e[country,t] Estimated results: Var gdpgrowth e u Test: Var(u) = 0 chi2(1) = Prob > chi2 = 14.95 0.0001 13.59326 8.982352 2.302936 sd = sqrt(Var) 3.686904 2.997057 1.517543