THE EFFECTS OF REGIONAL TRADE AGREEMENTS: Forecasts may be underestimating productivity benefits

Modern techniques for evaluating the impact of regional trade agreements like the proposed Transatlantic Trade and Investment Partnership (TTIP) between the European Union and the United States may be substantially underestimating the likely increase in trade and productivity. That is the conclusion of a study by Holger Breinlich and Alejandro Cuñat, published in the September 2016 issue of the Economic Journal.

The researchers compare what the so-called ''heterogeneous firm models'' predict for the Canada-US Free Trade Agreement (CUSFTA) of January 1989 with the actual outcomes. They find that a simple modification greatly improves the forecasting accuracy of these models. It is important to get this right, they conclude, or we may be led to abandon free trade initiatives that promise significant productivity benefits.

Current negotiations over TTIP and the proposed Trans-Pacific Partnership (TPP) between Pacific Rim countries have once more drawn attention to the continuing surge in regional trade agreements. Given the lack of progress in the Doha Round of multilateral trade talks, most countries have turned their attention to such regional trade liberalisation initiatives.

The hope behind this development is of course that regional trade agreements will be economically beneficial for the participating nations or trade blocs. Previous research has shown that this is indeed the case, at least for developed economies. For example, Daniel Trefler (2004) showed that CUSFTA led to dramatic increases in Canadian manufacturing productivity.

While knowing with hindsight that a particular regional trade agreement has been beneficial for a country is useful, ideally it would be possible to make predictions about future regional trade agreements as well, such as TTIP and TPP.

Traditionally, so-called computable general equilibrium (CGE) trade models have been used to make such forecasts. While their use for this purpose has unquestionably been beneficial, not everybody is happy. For example, Timothy Kehoe (2005) and Edward Balistreri and colleagues (2011) criticise the forecasting performance of CGE models and point out that they neglect the effects of trade on aggregate productivity and trade growth along the ''extensive margin'' – when trade increases because more firms are trading or because firms are trading more products.

These shortcomings could potentially be addressed by the new generation of quantitative heterogeneous firm models based on seminal work by Marc Melitz (2003). The new study uses CUSFTA to evaluate whether these models do indeed live up to their expectations and could be used to replace or at least complement traditional CGE models.

A quick look at the data suggests that CUSFTA was associated with substantial trade and productivity gains in Canada: average goods trade flows (Canadian exports plus imports to and from the United States) increased by 118% over the period from 1988 to 1996, while the increase in labour productivity in Canadian manufacturing was 30%. This compares with growth rates of only 44% (trade) and 17% (productivity) for the pre-liberalisation period from 1980 to 1988.

The goal of the new study is to see to what extent different heterogeneous firm models can quantitatively replicate these increases in trade and productivity, and would thus be potentially useful for forecasting purposes.

The basic finding is that while the existing models get the basic direction of effects right, they substantially underestimate the actual increase in trade and, in particular, productivity. This predictive failure is large enough to raise doubts about their suitability for forecasting purposes.

But the researchers also show that a simple modification to existing models – allowing for within-firm productivity gains – greatly improves forecasting accuracy. They conclude:

''Overall, our results suggest that if we want to use the current generation of heterogeneous firm models for the purpose of forecasting the effects of regional trade agreements, we need to allow for sources of within-firm productivity increases.''

''Otherwise, the models will tend to underestimate dramatically the effect of free trade on productivity and might consequently lead us to abandon promising free trade initiatives.''

''Tariffs, Trade and Productivity: A Quantitative Evaluation of Heterogeneous Firm Models'' by Holger Breinlich and Alejandro Cuñat is published in the September 2016 issue of the Economic Journal. Holger Breinlich is at the University of Nottingham. Alejandro Cuñat is at the University of Vienna.