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05/13/2009

Where are the largest gains from trade liberalization?

Gordon Hanson has set up a Shadow Committee on U.S. Trade Policy, and has asked several economists to respond to specific questions.  Here is the one I was charged with:

Rightly or wrongly, some have interpreted Krugman’s recent Nobel address, which has gotten considerable play in Washington, as implying ambivalence about the benefits of trade for the U.S. What does trade theory tell us about the initiatives the US should make a priority in its trade policy agenda?

And my answer:

A society's gains from trade liberalization in different sectors depend on a lot of things, but as a rule of thumb, it is useful to focus on three things. (Here I will look at only U.S. policies, leaving aside the question of which initiatives should be pursued abroad.) 

First, how large is the trade restriction (or subsidy) in question?  Economic theory tells us that the gains from removing a tax or subsidy rise with the square of the wedge. So sectors where there are large policy interventions are particularly ripe for liberalization, everything else held constant.

Second, what is the likelihood that the liberalization will aggravate a pre-existing market imperfection?  In the case of the U.S., the main imperfection I would worry about is technological externalities.  These spillovers are likely to be associated with activities that employ lots of highly-skilled workers.  My rule of thumb here would be that liberalization that results in the contraction of sectors that employ such workers is unlikely to generate much gains, and may even be harmful.

Third, is the liberalization likely to worsen income distribution at home?  Many economists disregard distributional concerns (either because they do not think these are important, or else because they assume other policy instruments are available to deal with equity).  But I do not find this a tenable position.  So I would argue that any potential efficiency gains have to be traded off against potentially adverse movements in income distribution.  

How do these considerations inform the question at hand, namely the nature of the initiatives the US should make a priority in its trade policy agenda?

Consider some obvious initiatives.  On narrow economic efficiency grounds, the reform that would generate the biggest bang for the buck by far is the relaxation of visa restrictions that prevent unskilled workers from poor nations from being employed in the U.S.  This is because the magnitude of the barrier in question here (measured by the wedge between earnings of otherwise similar low skill workers here and in poor countries) is bigger than in any other area of international commerce.  But the trouble is that the likely distributional impact is also very adverse.  So we can generate the efficiency gains only at the expense of making domestic unskilled workers worse off.  Considerations 1 and 3 clash.

How about further trade liberalization in the conventional areas of manufactures?  The problem here is that the barriers are already extremely low (in the low single digits), and the efficiency gains to be had are correspondingly small.

How about outsourcing?  Outsourcing of low-skilled labor is on the whole bad for income distribution, while out-sourcing of high-skilled labor may run against consideration 2, the need to keep sectors that are the likely depositories of technological externalities at home. 

So where does this leave us?  I can think of two areas of liberalization where existing barriers are high and do not face the objections that I have considered so far.

First, agriculture.  Subsidies and other trade-distorting measures are rampant in agriculture, especially in crops like cotton and sugar.  It is hard to argue that these activities generate externalities or that their contraction would be bad for income distribution as a whole.  So this is clearly an area of priority.  (Note that I am not considering the impacts on other countries, which is not my focus here.  The positive impacts abroad are typically vastly exaggerated, but the domestic benefits are not in question.)

Second, visa restrictions on highly-skilled foreign workers.  The barriers here are large, since we know the visa quotas bind severely.  Allowing more foreign scientists and engineers in will reduce incentives to outsource technologically-advanced operations abroad, and will help expand sectors that are likely to generate positive spillovers.  The distributional effects are unlikely to be adverse, as it is the top of the labor market that will be affected.

So the trade policy initiatives that deserve priority in the U.S. are: liberalize agricultural trade, and expand visa quotas for highly skilled foreign workers. 

Note that the U.S. can do both of these on its own, and does not need Doha or action on the part of the rest of the world to reap the gains from these reforms.          


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