The Role of Trade in Cross-Country Income Differences
This 17-minute podcast was released July 19, 2019.
“When we think about investment, it involves tradeoffs,” explains B. Ravikumar, senior vice president and deputy director of research at the Federal Reserve Bank of St. Louis. He talks with Kristie Engemann, a coordinator at the St. Louis Fed, about the role international trade plays in cross-country income differences. He discusses the study of economic development, who wins and who loses in trade, barriers to trade and more.
Kristie Engemann: Welcome to the Timely Topics series from the St. Louis Fed. I’m Kristie Engemann, your host for this podcast. With me today is B. Ravikumar, a senior vice president and deputy director of Research at the St. Louis Fed.
He will be talking to us about his work on economic development and trade, particularly the role that international trade plays in cross-country income differences.
Ravi, thank you for being here today.
B. Ravikumar: Thank you.
Engemann: Could you start by explaining what the study of economic development entails? What does that mean?
Ravikumar: The study of economic development is about trying to explain the income differences across countries. We typically measure the income differences by GDP per capita or GDP per worker in one country relative to another country.
Now, this is actually a very old problem. I mean, if you recall, Adam Smith’s The Wealth of Nations in 1776 was about trying to explain the income gap between rich and poor countries. When he was trying to do that, the gap was a factor of two. The rich countries were twice as rich as the poor countries. Now, it has grown quite a bit, so the gap is more like a factor of 35 or 40. It’s a much bigger problem now.
Engemann: What factors cause some countries to be so rich and some countries to be so poor?
Ravikumar: There are a host of factors. You could think of poor countries being poor because they lack physical capital, such as equipment and structures, etc. Or you could think of poor countries being poorer because they lack human capital, like the knowledge embedded in workers, the amount of schooling, etc.
If you kind of take a purely accounting perspective, you could ask the question, “How much of the income differences between rich and poor countries is due to these input differences like physical capital and human capital?”
It turns out if you do this accounting, the inputs that we can measure, like physical capital in each of the countries and human capital in each of the countries, those input differences account for something like 50% of the income differences, which means the other 50% has to come from stuff that we don’t know.
Typically, this is called “total factor productivity.” It’s in some sense a measure of our ignorance, but it kind of describes how these inputs are used in order to produce the output. We can take the same amount of inputs, and if you use them very inefficiently, you’ll produce less output, whereas if you use them efficiently, you’ll produce a lot of output.
These differences are partly due to how efficiently these inputs are used across countries in addition to these input differences.
Engemann: Why might our listeners be interested in learning about economic development? Why is it important?
Ravikumar: I can think of two reasons. One is purely a broad humanity perspective. When you think about income differences of the factor of 35 or 40, it’s sort of like living on $1 a day versus living on $35 or $40 a day. You might be interested in how to make this poor person who lives on $1 a day be slightly richer, maybe live on $5 a day, or live on $10 a day, or $20 a day, so that’s purely from a humanity perspective.
The other perspective is a business perspective, and you can ask the question, “Well, at $1 a day, how much can this poor person buy of any of the goods that the United States is trying to sell?” Not much, but if this poor person’s income rises to $20 a day, maybe he’ll be able to afford lots of things that the U.S. is willing to sell. From that market perspective, we might be interested in having the poor economies get richer.
That’s two angles I can think of.
Engemann: Economic development and trade are two topics that you’ve written quite a bit about. Before we get into the specifics of your research, could you just explain how countries gain from trade?
Ravikumar: Countries gain from trade basically for two simple reasons. One, by trade, maybe you can acquire better inputs at a lower price, so better and cheaper inputs, and that might make you better off. You could gain because of that. You would be better off importing coffee from Brazil or Colombia, German or Belgian chocolates, or steel from Japan, at a lower price than what you can effectively produce them here. That’s one angle.
The other angle is the allocation of resources. If you could buy them, the better and cheaper goods from elsewhere, you can allocate those resources to things that you are better at, so specialization is the way you gain via trade. If you could import coffee from Brazil or Colombia, maybe you don’t have to allocate that many resources to the production of coffee in the U.S. And you could allocate them to the production of something else that we are good at. That’s the sense in which gains from trade occur for the economies.
It’s very similar to the way the households think about specialization and gains from trade. Imagine if you are engaged in the production of everything that you want to consume. Like vegetables and meat and grains, and materials needed for clothing—like wool and silk and cotton—and shelter, like brick and wood and cement.
If you want to produce all of these just to provide food, clothing and shelter for yourself, it would be a very inefficient allocation of resources. You’re much better off specializing, say, in the production of cotton and then trading for everything else.
You’d trade with someone else for vegetables, trade with someone else for bricks and housing, and so on. It’s the same way the economy works. Specialization opens up possibilities.
Engemann: Are there any examples where specialization might not be good, or it might not be optimal for a country?
Ravikumar: People have made the argument that if you specialize too much, it might be bad for national security. They can target very specific industries. In the name of national security, they can put up barriers so that you don’t specialize away from it. So you want some of that production, even though you might be inefficient at it, to take place in your economy.
And some people have made the argument based on natural resources that you don’t want to trade away all your natural resources, even though you might be inefficient at extraction of this particular natural resource. You might want some of that industry to be domestic and not import some of that.
And other people have made the argument in the case of infant industry protection, that is you don’t want some of the industries to be completely destroyed by imports, and you want time for this industry to develop. Even though you are currently inefficient at it, you might want to let some of these industries continue production, in the hope that they may become productive in the future.
Those are the arguments some people have made.
Engemann: During your Dialogue with the Fed presentation on the economics of trade, you mentioned that a country as a whole could gain from trade, but that there could be winners and losers within that country. Could you talk about that a little bit?
Ravikumar: [A] country as a whole gains because trade is not a zero-sum game. Since each one of us as a result of trade moves in the direction of what we are good at, both of us will be gaining. That’s not a zero-sum game.
But there would be winners and losers, because anytime there’s a price change, there are going to be winners and losers.
Take steel, for example; there are workers of steel, and there are users of steel. The users of steel are the ones who are going to use steel to produce various equipment like washing machines, dryers, ovens, furnaces, whatever. And there are lots of steel workers who would benefit if that washing machine industry expands, the dryer industry expands, the oven industry expands, because they can get steel at a cheaper price and they can expand the quantities of all of these objects being produced.
On the other hand, the producers of steel are going to lose the job if we import the steel. But in general, the country as a whole gains because relative to the producers of steel, the users of steel are a lot more. The gain to the country comes as a result of lots and lots of users using steel at a cheaper price compared to few workers not producing steel at a higher price.
Engemann: What are some examples of barriers to trade?
Ravikumar: The barriers come in various forms. The most straightforward one is tariffs. Tariffs are taxes on imports. Countries slap a duty on anything that comes into the country, and that effectively increases the price of imports relative to its actual production cost. That’s one form of barrier.
The other form of barrier could be in terms of import quotas. You could say the country is allowed to import only so many German cars of a particular variety in a given year, so that imposes a quota on how many cars from Germany can come into that particular country.
The third form could be putting restrictions on the content of the imports. You could say, “Any import that’s coming into the U.S. has to contain so many percentage of objects that are made in the U.S, and only so much percentage of the objects coming from elsewhere.” That’s another form of barrier that restricts what sort of imports are allowed into the country.
Those are three examples of barriers I can think of.
Engemann: And overall, how do trade barriers impact international trade?
Ravikumar: The trade barriers have a way of making the allocation of resources inefficient. Going back to the household example, it’s sort of like we’ve erected barriers to trade; now, the household is engaged in the production of everything, all the materials for the food, all the materials for the clothing, all the materials for the shelter.
The same thing applies at the economy level. We are engaged in the production of coffees and chocolates and steel, and if we were to specialize, we would be much better off. The barriers have a way of forcing us to allocate resources to the production of all the goods, including the goods that we are not good at producing.
Engemann: Now, let’s turn to your paper, which is titled, “Capital Goods Trade, Relative Prices, and Economic Development.” What question were you trying to answer?
Ravikumar: The broad question that we were after was, “Can trade change the amount of investment that a country makes?” To kind of back up a little bit, if you think about physical capital in a country, that stock is a result of years and years of investment made by that particular country.
When we think about investment, it involves tradeoffs. Any investment that we undertake—suppose a farmer wants to buy a tractor. He has to imagine, “OK, out of the current income, how much do I want to devote to current consumption, like food and clothing and shopping, whatever?” And “How much can I devote towards paying off this purchase of this capital good or this investment called ‘tractor?’”
If any international trade can affect that particular tradeoff, it changes the quantity of investment and hence the quantity of capital and that, in turn, implies more output in the future. That’s the sense in which we were trying to understand if the trade helps investment in capital stock and output. That was the broad question.
Engemann: And what were the main findings in your paper?
Ravikumar: In our sample, we didn’t have access to all of the countries. In our sample, the gap between the rich and the poor countries was a factor of 20. If we reduce the capital goods trade barriers globally, that gap would reduce by 40%. It comes through kind of two channels.
One is the relative price channel. The price of a capital good relative to consumption good falls as a result of opening up to trade, which means they can afford to undertake more investment or the tradeoff between consumption and investment is affected in a positive way, they can undertake more investment.
The second, since they are importing more capital goods, they don’t have to allocate resources to the production of capital goods. Now, all of a sudden, they can invest in things or specialize in things that they are good at.
If they specialize in things they are good at, that means their total factor productivity or efficiency improves, and hence their income goes up. Both of them point to an increase in their income relative to the situation before the capital goods barrier.
Now, it turns out that the specialization channel is where the bulk of the action is. Almost 60% of the action is coming from an increase in specialization.
Engemann: So is it correct to say that increased trade from the reduction of trade barriers would benefit the rich countries as well? And if so, then how would it help close the income gap between rich and poor countries?
Ravikumar: As I said before, this is not a zero-sum game. Both rich countries and poor countries benefit. To go back to the coffee example, maybe one way the rich countries would benefit would be we can import coffee from Colombia and in return give them tractors. The way the trade would work is coffee for tractors. If the poor countries become richer, they can afford to buy the tractors from the U.S. That’s one.
And we gain as a result of not only there’s a new market now as a result of lower barriers to trading with Colombia, but we can devote our resources, instead of the production of coffee, we can devote it to better things that we are good at, like the production of tractors. That’s one way it improves.
The poor countries gain more relative to rich countries because, to start with, the inefficiencies are much larger in poorer countries than in richer countries. That’s what explained the initial accounting that I talked about, where the gap due to the total factor productivity or inefficiency was close to 50%, and the bulk of the action is kind of trying to bring up the efficiency level in the poor country closer to that of the rich country.
They gain a lot more as a result of reducing the barriers compared to rich countries, but both poor countries and rich countries gain.
Engemann: And are there potential unintended consequences from the removal of trade barriers? Do the parties involved behave the way that people are expecting?
Ravikumar: Yeah, there are certain rules of the game that have to be respected as a result of opening up the trade barriers. You don’t want the countries to be artificially subsidizing something whose production cost is actually high. That’s against the rules of the game.
You don’t want countries to be stealing your intellectual property. I buy a laptop and if I copy all the software for use other than what was intended, that’s not playing by the rules of the game.
It’s very similar to what we go through in daily life. Imagine driving on an interstate and the left lane is meant for passing. And if we don’t obey the rules of the game and I clog up the left lane by slowing below the speed limit, it’s going to cause chaos. For the system to work, everybody has to play by the rules of the game.
Engemann: I like that analogy. You looked at reducing trade barriers. But on the flip side, what might happen if many countries increased trade barriers? Can you say anything about that based on your results?
Ravikumar: In that case, the cross-country income gap is going to get worse. Again, this kind of goes back to, I no longer have access to the cheaper inputs that I would have had had the trade been open. I no longer have access to specialization had the trade been open, so now I am engaged in the production of everything I need for food, everything I need for shelter, everything I need for clothing, and that’s a very inefficient allocation of resources. So my level of efficiency goes down dramatically as a result of closing the borders and increasing the barriers.
Both of them are pointing in the direction of worsening the income gap between rich and poor countries, so closing the borders is very bad for economic development.
Engemann: What are the key takeaways from your paper that you want our listeners to know?
Ravikumar: The key takeaway that I want to emphasize is that reducing the capital goods barriers affects the tradeoff between this consumption and investment. Because the relative price of a unit of capital good is available to poorer countries cheaper now, they will be able to make more investments, so the tradeoff looks better for them.
On top of that, because they’re importing these capital goods at a cheaper price, they don’t have to allocate resources to the production of capital goods. They can allocate that to the production of things that they are good at, and that specialization would increase their income as well. That’s also good for poorer countries.
Both these go in the direction of closing the income gap between the rich and poor countries, and the problem of economic development looks that much solvable compared to what we started with.
Engemann: Well, thank you so much for joining us today, Ravi. For more of Ravi’s research on this topic, go to research.stlouisfed.org and select “Economists.”
He also talked about economic development in a couple of videos that were released in 2015. To find those videos and to hear more podcasts from the St. Louis Fed’s Timely Topics audio channel, visit stlouisfed.org/timely-topics.
Economists and other experts from the St. Louis Fed talk about their research, economics-related topics in the news and issues specifically related to the Fed. Views expressed are not necessarily those of the Federal Reserve Bank of St. Louis or of the Federal Reserve System.