The Relationship between Trade Openness and Economic Growth

Critically Review the Empirical Evidence on the Relationship between Trade Openness and Economic Growth

In 2008, the world as a whole produced goods and services worth an estimated $50trillion at current prices. Of that total, more than 30 percent was sold across national borders (Krugman, Obstfeld and Melitz, 2012, p.40). That statistic alone highlights that international trade is a fundamental factor in economic growth globally as no one country has the ability of production to produce every good that country requires. There are two basic reasons countries trade, the first is, a countries can benefit from their differences with one another and the second is countries trade in order to achieve economies of scale in production; that is where a country need only produce a limited range of goods at a larger scale and hence, more efficiently. The hypothesis for this essay is that the relationship between trade openness and economic growth is often over stated by academics. This essay through analysing empirical evidence in the region of Latin America seeks to establish how strong the relationship between trade openness and economic growth is. Having come from a financial debt crisis in 1982 due in part to closed economies and dictatorships, Latin America is a remarkable region that has shown resilience in the face of economic debt and through various policies has created economic growth and it is for this reason that the empirical evidence for this essay will be based on the region. The region of Latin America also has a population of 500 million people and a GDP of an estimated $3trillion (Chen and Emile, 2013, p.110) making it an attractive region for both developing and developed countries to establish trading links. The format of the essay will be a description of the theories which attempt to explain trade openness followed by an analysis of the empirical evidence of the relationship between trade openness and economic growth in Latin America. A focus will be placed on the long run prospects of economic growth in relation to trade openness.
The theory surrounding trade openness and economic growth can be complex and ambiguous regarding the relationship between the two. There are a number of theories based on trade that are relevant to the relationship between trade openness and economic growth, including comparative advantage, Hecksher-Ohlin theory, factor price equalisation, endogenous growth theory and gravity models. However, due to the constraints of the essay, only comparative advantage, Hecksher-Ohlin and factor price equalisation theories will be discussed in detail and analysed against the empirical evidence.
Comparative Advantage:
The theory of comparative advantage in its’ simplest form states that international trade leads to a country using it’s resources more efficiently through the import of goods and services that would otherwise prove too costly to produce and would lead to inefficiencies in the production of goods the country is better at producing (Yanikkaya, 2003, p.61). The notion of opportunity cost can be described to describe goods produced from resources that would have been used to produce other products had those products not been imported through trade. A country has a comparative advantage in producing a good if the opportunity cost of producing that good in terms of other goods is lower in that country than it is in other countries (Krugman, Obstfeld and Melitz, 2012, p.56). From this it can be assumed that imports and exports hold equal importance to the trade of a country as they complement each other. Trade can be of benefit to both countries if each country exports the goods it has a comparative advantage in according to Krugman, Obstfeld and Melitz (2012, p.67). It must be noted that the theory of comparative advantage does not require a country to have an absolute advantage in the production of a good for it to benefit from trade. The Ricardian model of trade is a useful model to explain comparative advantage. The model predicts that countries should export goods in which their productivity is relatively high compared to the production of those goods in the country buying the imports. However, the model does present a number of flaws. Firstly, it assumes a far-reaching degree of specialisation, it assumes away effects of international trade on the income distribution within a country, thus making the presumption that countries as a whole always benefit from trade, thirdly the model fails to provide a role for differences in resources among countries as a cause of trade, which may be viewed as a fundamental flaw as it can be argued, is one of the most important reasons for trading, and finally the model acknowledges the role of economies of scale as a cause of trade, hence failing to provide an explanation as to why large amounts of trade flows between apparently similar states (Krugman, Obstfeld and Melitz, 2012, p.75). The concept of comparative advantage and the Ricardian model together predict that trade will generate economic growth.
Hecksher-Ohlin Theorem
The theory of Hecksher-Ohlin goes further than the theory of comparative advantage and seeks to establish how a country can gain comparative advantage by producing products that utilise factors that are abundant in that country. The theory therefore, takes into account the production factors that utilise factors that are abundant in that country in relation to the production factors available to a country; land, labour and capital. The theory also determines that the cost of any factor or resource is a function of supply and demand, hence, factors that are in abundant supply relative to demand will be cheaper and factors that are in great demand relative to supply would be more expensive (Krugman, Obstfeld and Melitz, 2012, p. 110.) The theory states that countries will produce and export goods that require factors that are in great supply and would import goods that required factors that are in short supply but high demand. The Hecksher-Ohlin theorem of trade therefore predicts that trade will result in economic growth for a country.
Factor Price Equalisation
The theory of factor price equalisation has four propositions and is based on a two-region, two-commodity, two-factor example, according to Samuelson (1948, p.169):
1. Free international trade will equalise factor prices, relatively and absolutely so long as there is partial specialisation with each country producing some of both goods.
2. ‘Unless initial factor endowments are too unequal, commodity mobility will always be a perfect substitute for factor mobility’ (Samuelson 1948, p.169).
3. Irrespective of initial endowment even if factors were manoeuvrable, at worst they would relocate only up to a certain proportion, after which commodity mobility would be sufficient for full price equalisation.
4. To the range that product movements are effective substitutes for factor transfers, world productivity is, in one sense optimal; but at the same time the imputed real returns of labour in one country and of land in the other will necessarily be lower, not only relatively but also absolutely, than under autarky.
Factor-price equalisation contains three assumptions that in the real-world are untrue. The first is that both countries produce the same goods, the second is that both countries have access to the same technology and finally that trade equalises the prices of goods in both countries (Krugman, Obstfeld and Meltiz, 2012, p.128). These three assumptions imply that the factor-price equalisation occurs only if the two countries are similar in their relative factor endowments, hence factor price equalisation may not occur between countries that have vastly different ratios of capital to labour or of skilled to unskilled labour (Krugman, Obstfeld and Melitz, 2012, p.128). If countries have different technologies of production factor-price equalisation will not occur as the country with the superior technology will have a higher wage rate and a higher rental rate than the country with inferior technology (Krugman, Obstfeld and Melitz, 2012, p,128). Factor price equalisation does not take into account the cost of transport and barriers to trade such as tariffs or other restrictions to trade that prevent complete factor-price equalisation (Krugman, Obstfeld and Melitz, 2012, p.128).
The theories of comparative advantage and Hecksher-Ohlin and factor-price equalisation all assume that free and open markets will lead countries to determine which goods they could produce more efficiently than a country they have a trading relationship with and that prices of goods along with other variables such as wages will change in accordance to the prices in the trading country. Theories by their very nature of prediction are often contradicted by real-world events and it is necessary to analyse empirical evidence to establish whether the predictions and assumptions made by the theories mentioned above are reliable in reality.
Empirical Evidence:
As mentioned in the introduction, Latin America will be the sole region reviewed in the empirical evidence, from the years directly prior to the debt crisis suffered in the region in 1982 to recent years, along with a general view of the evidence globally. Again due to the constraints of this essay only the basic measure for trade openness, simple trade shares, which is exports plus imports divided by GDP will be used as the measure for trade (Yanikkaya, 2003, p.60). Economic growth will simply be measured by GDP. and only the long-run effects on growth will be reviewed. Academic research has found that countries with higher population densities tend to have more open economies and interact on a greater level also tend to have faster growing economies which would suggest there is a positive correlation between trade openness and economic growth. Yanikayya found that population densities positively affect growth by increasing trade volumes (2003, p.84) which, confirms that an inference may be drawn that it is appropriate to use the measure of population densities as a variable when measuring the trade openness of an economy.
From studying the trade theories it is expected that the empirical evidence will confirm that trade openness causes economic growth in a region. The empirical evidence supporting this prediction can be seen in the results of academic papers by Harrison, Lee et al, Nannicini and Billmeier (1996, p.443; 2004, p.468; 2011) where is was found that openness has a positive correlation with GDP growth in the long run. However, it must be noted that Harrison (1996,p.443) questioned the use of trade shares as a variable as it is one of the least robust measures of openness.
In contrast with this prediction the evidence shows that in the long run there is no positive relationship between trade shares and growth during the period 1961-2002 , irrespective of whether the countries were highly trade dependent or not, or whether they were developed or not (Sarker, 2008, p. 772; Astorga, 2010, p.239 ;Lutz, 2010,p.447; Cuadros et al 2004, p.183). The evidence present by Winters and Masters (2013, p.1069) claims that low-income countries do not benefit from trade liberalisation where, as high-income countries do benefit from having open economies, the use and exchange of technology which would be better exploited by higher-income countries may be a reason for this difference. This is further reinforced by Edwards (2008, p.2) who stated that long-term income per capita in Latin America had only grew an a mere average of one percent per year between 1970 and 2006 with only the region of sub-Saharan Africa, with a rate of economic expansion that averaged 0.9 percent, doing worse with Edwards arguing that this is of a result of Latin America adopting a more liberal trade policy and suffered poorer economic growth as a result of introducing more open trade policies, however, it was also found that countries more open to international trade suffered less from the effects of external crisis. This finding would promote trade openness as a preventative measure to suffering adverse affects to external crisis which is still a major issue in Latin America economic policy as the debt crisis of 1982 still lives long in the memory of the region. This is in line with the prediction of factor-price equalisation in relation to Latin American countries trading with countries of similar factors of production. The growth experienced in Latin America in the years directly preceding to the debt crisis of 1982 although being in contrast to trade theories however, it is now believed that the economic growth experienced in the region was brought about through an inflation in the value of domestic currencies and inefficient systems (Edwards, 2008, p.126). This if interpreted another way could be said to be in line with the predictions of the theories as the closed economies of Latin America collapsed due to the oil shocks of 1973 which confirms that trade openness leaves countries less open to effects of external crisis.
The empirical results show a negative relationship between tariff rates and growth (Yanikkaya, 2003, p.63; Edwards, 2008, p.136) which, would imply that the theories of comparative advantage and Hecksher-Ohlin are good predictions of economic growth. Many of the empirical studies researched for this essay failed to take into account the effects of non-trade barriers on trade ignore the fact that there has been an increase in the use of non-trade barriers to restrict trade. However, it must be noted that an empirical study by Edwards (1993) found there to be no significant relationship between non-trade barriers and growth (Yanikkaya, 2003, p.66). Yanikkaya believes that no single measure of trade openness is superior to another which suggests that irrespective what variable is used to measure trade openness throughout all the academic papers the empirical tests should still provide the same results (2003, p. 66) It may be important to note which countries the region of Latin America trades with such as OECD countries or non-OECD countries as it may be assumed that OECD countries have higher technological advances than non-OECD countries and this may lead to greater transfers of technology to Latin America resulting in greater economic growth for the region. Trade between the region of Latin America and countries that have higher technological advancement would fall under the theory of Hecksher-Ohlin. The empirical evidence shows the above statement to be false and it is irrelevant whether trade occurs between developing and developed countries or developing and developing countries (Dorwick and Golley, 2004, p.53). However, Yanikayya found evidence to the contrary as empirical evidence of the estimated coefficients for trading with OECD countries is slightly smaller than the coefficient of non-OECD countries (2003,p.72). The empirical evidence also suggests that, barriers to trade are in fact ineffective to reducing trade, however, it may be concluded that trade barriers may result in negative repercussions on growth as they reduce the size of the external sector of a country (Yanikayya, 2003, p.84). In what can be described as going against the grain of the theories of trade the empirical evidence found that barriers to trade do not necessarily result in lower economic growth especially for developing countries (Yanikkaya, 2003, p.84). Even with all the conflicting results in the empirical evidence the real-world recovery of Latin America from its’ debt crisis by following a policy of trade openness known as the ‘Washington Consensus’ given significant weight to the argument that there is a strong relationship between trade liberalisation and economic growth with GDP growth in Argentina, Chile and Peru exceeding six per cent per annum (Edwards, 2008, p.128). Chen and Emile (2013, p.120) found that all long-run effects of imports and export with China, through trade openness have resulted in positive economic growth for Latin America. However, it was from following the policies of trade openness that Latin America suffered another crisis in the early 2000s with the average rate of per capita growth at 0.75 per cent between 1998 and 2004 (Edwards, 2008, p.130) which, obviously contrasts with the empirical evidence on Latin America from its’ recovery from the debt crisis of 1982. These statements are in direct conflict with the predictions of the trade theories.
There is a vast amount of academic research conducted in the field of trade openness and economic growth however, this has only lead to an ambiguity of measurements, variables and results without finding any conclusive evidence in supporting or disproving a relationship between trade liberalisation and economic growth.
Trade is a necessary factor in the economic growth of developing countries in Latin America as it provides access to capital for investment and intermediate goods that are all-important to their development. Trade allows producers access to bigger markets which in turn encourages the development of research and development through innovation. It can be concluded from the arguments above that developing countries will have a stronger relationship between trade openness and economic growth if they have open economies that trade with developed economies as the inadvertent trading of technology with their trading partners will act as a catalyst for further economic growth in the future, something that will not be as prominent if developing countries in Latin America chose to trade with countries of similar or less technological advancement. However, there is also evidence to suggest that trading with non-OECD countries, which may be considered to be less technologically advanced, is more beneficial going against the previous statement. Reasons for this may be that access to new and improved goods and technology is is not as important as access to markets which may potentially result in the exploitation of scale of economies and comparative advantage. This implies that the countries of Latin America will gain some benefit from trading with other developing economies as they will from trading with developed economies. It may also suggest that the presumption that all OECD countries are more technological advanced than non-OECD countries is inappropriate and perhaps a different test should be carried out to measure technological advancement, such as the percentage of the population working in the tertiary sector of the economy.
Almost all of the academic papers make reference to the theory of comparative advantage, bringing it to the forefront of trade theory ahead of the theories of Hecksher-Ohlin and factor-price equalisation, which are only mentioned in some papers. This leads us to the conclusion that trade theories should not be used as predictive models for macroeconomics in relation to the relationship between trade openness and economic growth.
The variables used to measure trade openness and economic growth were basic measures and perhaps more sophisticated measures would produce results more in line with the predictions of the trade theories. The hypothesis that the relationship between trade openness and economic growth is often overstated has been both confirmed and contradicted following an analysis of the academic research papers specifically in relation to the two debt crisis suffered by Latin America, the first caused by closed economies and dictatorships, with trade openness leading to an economic recovery before eventually leading to another debt crisis in the region in the early 2000s therefore, it is impossible to confirm conclusively whether the hypothesis has been proven to be true. It is certainly not true in all cases.
On a final note, the tests and results of the academic papers all vary greatly which is possibly the reason for the ambiguity between the conclusions drawn in the papers. The papers all lack any real connection with the trade theories implying that trade theory is somewhat irrelevant to the real-world event of international trade.

Reference List.
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Chen, Y and Emile, E. 2013. Trade Openness and Finance: Effects of Foreign Trade with China and Latin American Financial Development. Emerging Markets Finance and Trade, 49(3), pp. 110-122.
Cuadros, A. Orts, V. and Alguacil, M. 2004. Openness and Growth: Re-Examining Foreign Direct Investment, Trade and Output Linkages in Latin America. The Journal of Development Studies, 40(4), pp. 167-192.
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Lutz, J. 2010. Growth of Industrialised Countries and Trade Openness. The International Trade Journal, 15(4), pp. 429-455.
Nannicini, T. and Billmeier, A. 2011. Economics in Transition: How important is Trade Openness for Growth? Oxford Bulletin of Economics and Statistics, 73(3), pp. 287-314.
Samuelson, P. 1948. International Trade and the Equalisation of Factor Prices. Royal Economic Society, 58, pp. 163-184.
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Yanikkaya, H. 2003. Trade Openness and Economic Growth: a Cross-Country Empirical Investigation. Journal of Development Economics, 72(1), pp. 57-89.

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