How do we know that open trade helps economic growth?

The nature of globalization is certainly changing, but it is not clear that the overall level is decreasing. It seems true that the level of goods moving across international boundaries is increasing much more slowly or not at all. However, the level of services moving across international boundaries is increasing significantly, and the movement of information, data, and people is also increasing. But as countries around the world consider the possibility of decoupling from the global economy, it is useful to ask what the consequences of such a decision might be.

In particular, does greater openness to trade improve economic growth? What evidence can you provide to explain this point in some way? Douglas A. Irwin describes the types of research that have been used to address this question over the past two decades or so. “Does Trade Reform Promote Economic Growth? A Review of Recent Evidence” (World Bank Research Observer(Published online on April 25, 2024).

Irwin explains that until the late 1990s, the most prominent evidence for a link between open trade and growth was based on researchers choosing an outcome variable, such as GDP per capita, and then choosing a way to measure the openness of an economy (either an explicit barrier to trade, such as a tariff, or a more subtle trade barrier, such as a government-controlled exchange rate). They then computed whether there was a correlation between trade barriers and the outcome, per capita income. Of course, other possible explanatory variables could also be added and controlled for statistically.

There are some obvious problems with this approach. As every econometric course teaches, correlation is not causation. Countries that decide to open up their trade will have been systematically different from those that did not. In particular, countries that open up their trade will have recognized short-term gains from doing so and will have implemented a series of complementary reforms. Countries that do not open up their trade will not have recognized these gains and will have implemented potentially complementary reforms. When researchers look at alternative measures of trade openness and alternative ways of considering other possible factors, they often find that the results change as well. Moreover, when you consider all the factors that affect growth at some baseline level—human capital, physical capital, technology, rule of law, culture, infrastructure, natural resources, geography, and so on—it is not clear that governments will do much by simply changing their trade rules.

Irwin recognizes this problem and explains how researchers have tried different approaches. In particular, instead of comparing countries, these studies often look at growth within specific countries. For example, the “comprehensive control” approach looks at countries that implemented trade reform. It then looks for a group of countries that had very similar growth patterns prior to the trade reform (often geographically similar to the original country) but did not implement the trade reform. The hypothesis is that since these countries developed similarly in the past, they should have developed similarly in the future in the absence of the trade reform. If there is a break in the similarity at the time of the trade reform, that means something. Other studies look at firm-level data from countries. Do industries that are affected by greater openness to trade (particularly by additional foreign competition and increased ability to purchase inputs for production) perform better than other industries that are less affected? Finally, there are detailed case studies of countries that have implemented trade reform.

Economists tend not to trust a single measure of a phenomenon, but when multiple research methods using different data sources find similar results, we become more confident in the results. Looking at the combined results of these methods, Irwin summarizes:

But recent research has shown a surprising consistency: For developing countries that lag behind technologically and face significant import restrictions, there appears to be measurable economic returns from more liberal trade policies. … [A] A variety of studies using a variety of policy measures have found that countries that implemented trade reforms experienced economic growth rates of about 1.0 to 1.5 percentage points higher. These gains, according to several studies, accumulated to about 10 to 20 percent higher incomes over a decade. The effects vary across countries because the scope of reforms and the contexts in which they occurred differ. Further research is needed to understand this heterogeneity, which may be due to labor market rigidities, financial frictions, or inputs from the service sector. At the microeconomic level, the productivity gains from lower tariffs on imported intermediate goods are much clearer. This is repeated across countries.

In other words, these results on trade openness focus on “developing countries that are technologically backward and have significant import restrictions,” and thus have little relevance to countries like the United States, which are technologically backward in many sectors, have only modest import restrictions, and have a large internal market. But if you are concerned about the power of big U.S. companies and the resulting lack of competition, it seems a plausible response to pressure these companies to compete as much as possible with competitors from around the world.