Large-scale changes in relative economic size necessarily involve heightened political tension and realignments, write Benny Kleinman, Ernest Liu and Stephen Reddin

Kleinman, Benny

Liu, Ernest

Redding, Stephen

English

LSE Research Online

Productivity	growth	in	one	country	affects	the	relativeincome	and	welfare	of	its	trade	partnersOne	of	the	most	dramatic	changes	in	the	world	economy	over	the	past	half	century	has	been	the	emergence	ofChina	as	a	major	force	in	world	trade.	A	central	question	in	international	economics	is	the	implications	of	sucheconomic	growth	for	the	income	and	welfare	of	trade	partners.	A	related	question	in	political	economy	is	the	extentto	which	these	large-scale	changes	in	relative	economic	size	necessarily	involve	heightened	political	tension	andrealignments	in	the	international	balance	of	power.	(See	here	and	here)In	Kleinman,	Liu	and	Redding	(2020),	we	provide	new	theory	and	evidence	on	both	of	these	questions	bydeveloping	bilateral	“friends”	and	“enemies”	measures	of	countries’	income	and	welfare	exposure	to	foreignproductivity	shocks	that	can	be	computed	using	only	observed	trade	data.	We	show	that	these	measures	are	exactfor	small	productivity	shocks	in	the	leading	class	of	international	trade	models	characterised	by	a	constant	tradeelasticity.	For	large	productivity	shocks,	we	characterise	the	quality	of	the	approximation	in	terms	of	the	propertiesof	the	observed	trade	data,	and	show	that	for	the	magnitude	of	the	productivity	shocks	implied	by	the	observeddata,	our	exposure	measures	are	almost	visibly	indistinguishable	from	the	predictions	of	the	full	non-linear	solutionof	the	model.	Our	approach	admits	a	large	number	of	extensions	and	generalisations,	including	multiple	sectors,input-output	linkages	and	economic	geography	(factor	mobility).Our	research	contributes	to	the	recent	revolution	in	international	trade	of	the	development	of	quantitative	trademodels	following	Eaton	and	Kortum	(2002)	and	Arkolakis,	Costinot	and	Rodriguez-Clare	(2012).	An	importantadvantage	of	these	quantitative	models	is	that	they	are	rich	enough	to	capture	first-order	features	of	the	data,	suchas	a	gravity	equation	for	bilateral	trade,	and	yet	remain	sufficiently	tractable	as	to	be	amenable	to	counterfactualanalysis,	with	a	small	number	of	structural	parameters.	A	major	challenge	is	that	these	models	are	highly	non-linear,	which	can	make	it	difficult	to	understand	the	economic	explanations	for	quantitative	findings	for	particularcountries	or	industries.	A	key	contribution	of	our	bilateral	friends-and-enemies	measures	is	to	allow	researchers	toconnect	quantitative	results	to	the	central	underlying	economic	mechanisms	in	the	model:	the	cross-substitutioneffect,	where	an	increase	in	the	competitiveness	of	a	foreign	country	leads	consumers	in	all	markets	to	substituteaway	from	all	other	nations;	a	market-size	effect,	where	an	increase	in	income	in	foreign	markets	raises	demand	forall	nations’	goods;	and	a	cost-of-living	effect,	where	an	increase	in	the	competitiveness	of	a	country’s	goodsreduces	the	cost	of	living	in	all	countries.	As	our	linearisation	uses	standard	matrix	inversion	techniques,	we	findthat	it	is	around	70,000	faster	than	solving	the	full	non-linear	solution	of	the	model.	Therefore,	our	methods	are	wellsuited	to	applications	where	large	numbers	of	counterfactuals	are	required,	and	facilitate	comparisons	of	thesecounterfactuals	across	alternative	quantitative	frameworks,	such	as	our	single-sector,	multi-sector	and	input-outputmodels.LSE Business Review: Productivity growth in one country affects the relative income and welfare of its trade partners Page 1 of 5		Date originally posted: 2020-09-15Permalink: https://blogs.lse.ac.uk/businessreview/2020/09/15/productivity-growth-in-one-country-affects-the-relative-income-and-welfare-of-its-trade-partners/Blog homepage: https://blogs.lse.ac.uk/businessreview/Our	main	empirical	contribution	is	to	use	our	friends-and-enemies	exposure	measures	to	examine	the	globalincidence	of	productivity	growth	in	each	country	on	income	and	welfare	in	more	than	140	countries	over	more	thanforty	years	from	1970-2012.	We	find	a	substantial	and	statistically	significant	increase	in	both	the	mean	anddispersion	of	welfare	exposure	to	foreign	productivity	shocks	over	our	sample	period,	consistent	with	increasingglobalisation	enhancing	countries’	economic	dependence	on	one	another.	We	find	that	productivity	growth	in	mostcountries	raises	their	own	income	compared	to	world	GDP	and	reduces	the	income	of	most	(but	not	all)	othercountries	compared	to	world	GDP.	Even	compared	to	a	weighted	average	of	OECD	countries,	we	find	that	Chineseproductivity	growth	has	an	increasingly	large	negative	effect	on	US	relative	income.	Nevertheless,	once	changes	inthe	cost	of	living	are	taken	into	account,	this	Chinese	productivity	growth	has	an	increasingly	large	positive	effect	onaggregate	US	welfare.More	generally,	we	find	large-scale	changes	in	bilateral	patterns	of	welfare	exposure	to	foreign	productivity	growthover	time.	We	illustrate	these	changes	in	Figure	1	using	a	network	graph,	where	the	nodes	are	countries	and	theedges	capture	bilateral	welfare	exposure.	For	legibility,	we	display	the	50	largest	countries	in	terms	of	GDP	and	the200	edges	with	the	largest	absolute	values	of	bilateral	welfare	exposure.	The	size	of	each	node	captures	theimportance	of	each	country	as	a	source	of	productivity	shocks	(as	a	source	of	welfare	exposure	for	other	countries);the	arrow	for	each	edge	shows	the	direction	of	bilateral	welfare	exposure	(from	the	source	of	the	productivity	shockto	the	exposed	country);	and	the	thickness	of	each	edge	shows	the	absolute	magnitude	of	the	bilateral	welfareexposure.	Countries	are	grouped	to	maximise	modularity	(the	fraction	of	edges	within	the	groups	minus	theexpected	fraction	if	the	edges	were	distributed	at	random).At	the	beginning	of	our	sample	period	in	1970,	the	global	network	of	welfare	exposure	is	dominated	by	the	U.S.,Germany	and	other	western	industrialised	countries	(top-left	panel).	Moving	forward	to	1985,	we	see	theemergence	of	Japan	and	a	cluster	of	newly	industrialised	countries	(NICs)	in	Asia,	and	we	observe	western	Europeincreasingly	emerging	as	a	separate	cluster	of	interdependent	nations.	By	the	time	we	reach	2000,	the	separateclusters	of	countries	in	Asia	and	Western	Europe	become	even	more	apparent,	with	China	beginning	to	displaceJapan	at	the	centre	of	the	Asian	cluster.	By	the	end	of	our	sample	period	in	2012,	China	replaces	the	U.S.	at	thecentre	of	the	global	network	of	welfare	exposure,	with	the	US	more	tightly	connected	to	China	and	other	Asiancountries	than	to	the	cluster	of	western	European	countries.Figure	1.	The	bilateral	network	of	welfare	exposure	for	the	50	largest	countries	by	gross	domestic	product	(GDP),	1970-2012LSE Business Review: Productivity growth in one country affects the relative income and welfare of its trade partners Page 2 of 5		Date originally posted: 2020-09-15Permalink: https://blogs.lse.ac.uk/businessreview/2020/09/15/productivity-growth-in-one-country-affects-the-relative-income-and-welfare-of-its-trade-partners/Blog homepage: https://blogs.lse.ac.uk/businessreview/LSE Business Review: Productivity growth in one country affects the relative income and welfare of its trade partners Page 3 of 5		Date originally posted: 2020-09-15Permalink: https://blogs.lse.ac.uk/businessreview/2020/09/15/productivity-growth-in-one-country-affects-the-relative-income-and-welfare-of-its-trade-partners/Blog homepage: https://blogs.lse.ac.uk/businessreview/We	compare	our	friends-and-enemies	exposure	measures	in	our	baseline	model	with	a	single	sector	to	those	inmodels	with	multiple	sectors	and	input-output	linkages.	Although	there	is	a	strong	correlation	between	thepredictions	of	all	three	models,	we	find	that	introducing	both	sectoral	comparative	advantage	and	productionnetworks	has	quantitatively	relevant	effects	on	bilateral	income	and	welfare	exposure	for	individual	pairs	ofexporters	and	importers.	Additionally,	both	the	multiple-sector	and	input-output	models	yield	additionaldisaggregated	sector-level	predictions,	in	which	even	foreign	productivity	growth	that	is	common	across	sectors	canhave	heterogeneous	effects	across	individual	industries	in	trade	partners,	depending	on	the	extent	to	whichcountries	compete	with	one	another	in	sectoral	output	markets	versus	source	intermediate	inputs	from	one	another.Comparing	these	sector-level	predictions	for	the	impact	of	Chinese	productivity	growth,	we	find	some	markeddifferences	across	countries.	For	nearby	Southeast	Asian	countries,	the	sectors	that	benefit	most	include	theelectrical,	medical	and	office	sectors,	consistent	with	input-output	linkages	between	related	sectors	through	globalvalue	chains	in	‘Factory	Asia’	(see	the	top	panel	of	Figure	2).	However,	for	the	resource-rich	emerging	economies,the	sectors	that	benefit	most	include	the	mining,	agricultural	and	basic	metals	sectors,	consistent	with	a	form	of“Dutch	disease,”	in	which	the	growth	of	resource-intensive	sectors	propelled	by	Chinese	demand	competes	awayfactors	of	production	from	less	resource-intensive	sectors	(see	the	​​​bottom	panel	of	Figure	2).Figure	2.	Industry	sales	exposure	to	Chinese	productivity	growthWe	use	our	friends-and-enemies	exposure	measures	to	provide	new	evidence	on	a	political	economy	debate	aboutthe	extent	to	which	increased	economic	rivalry	between	nations	necessarily	involves	heightened	political	tension.	Anumber	of	scholars	have	drawn	parallels	between	the	current	China-US	tensions	and	earlier	historical	episodes,such	as	the	confrontation	between	Germany	and	Great	Britain	around	the	turn	of	the	twentieth	century,	and	the	riseof	Athens	that	instilled	fear	in	Sparta	that	itself	made	war	more	likely	(the	Thucydides	Trap).	On	the	one	hand,	thereare	good	reasons	to	be	skeptical	about	this	essentially	mercantilist	view	of	the	world,	because	a	key	insight	fromtrade	theory	is	that	trade	between	countries	is	not	zero-sum.	On	the	other	hand,	it	remains	possible	that	the	extentto	which	countries	have	shared	economic	interests	is	predictive	of	their	political	alignment.	Consistent	with	thisview,	we	find	that	as	countries	become	less	economically	friendly	in	terms	of	the	welfare	effects	of	their	productivitygrowth,	they	also	become	less	politically	friendly	in	terms	of	their	foreign	policy	stances,	as	measured	by	UnitedNations	voting	patterns	and	strategic	rivalries.♣♣♣Notes:This	blog	post	is	based	on	International	Friends	and	Enemies,	NBER	Working	Paper	No.	27587,	July	2020.The	post	expresses	the	views	of	its	author(s),	not	the	position	of	LSE	Business	Review	or	the	London	Schoolof	Economics.LSE Business Review: Productivity growth in one country affects the relative income and welfare of its trade partners Page 4 of 5		Date originally posted: 2020-09-15Permalink: https://blogs.lse.ac.uk/businessreview/2020/09/15/productivity-growth-in-one-country-affects-the-relative-income-and-welfare-of-its-trade-partners/Blog homepage: https://blogs.lse.ac.uk/businessreview/Featured	image	by	Alexander	Ramsey	on	UnsplashWhen	you	leave	a	comment,	you’re	agreeing	to	our	Comment	PolicyBenny	Kleinman	is	an	economics	PhD	candidate	at	Princeton	University.			Ernest	Liu	is	an	assistant	professor	at	the	Bendheim	Center	for	Finance	at	Princeton’s	departmentof	economics.	His	research	interests	are	in	finance,	trade,	growth,	and	macro-development.		Stephen	Redding	is	Harold	T.	Shapiro	’64	professor	in	economics	at	Princeton	University.	He	is	anassociate	in	the	trade	programme	at	LSE’s	CEP	and	director	of	NBER‘s	international	trade	andinvestment	programme,	and	is	affiliated	with	a	number	of	other	institutions.	His	research	interestsinclude	productivity	growth	at	the	firm	and	industry	level,	international	trade	and	economicgeography.	LSE Business Review: Productivity growth in one country affects the relative income and welfare of its trade partners Page 5 of 5		Date originally posted: 2020-09-15Permalink: https://blogs.lse.ac.uk/businessreview/2020/09/15/productivity-growth-in-one-country-affects-the-relative-income-and-welfare-of-its-trade-partners/Blog homepage: https://blogs.lse.ac.uk/businessreview/

Productivity growth in one country affects the relative income and welfare of its trade partners

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Productivity growth in one country affects the relative income and welfare of its trade partners

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