Accounting for Model Uncertainty and Natural Trading Partner Effects

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Accounting for Model Uncertainty and Natural
Trading Partner Effects
Trade Creation and Diversion Revisited
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Road Map

• Reexamine PTAs impacts on trade flows
• Introduce New Methodology
• Address Model Uncertainty
• Allow for Natural Trading Partners
• Generate New Results
• Identify PTAs tangible benefits
• Identify individual PTAs trade
  creation/diversion
• Highlight relevance of comprehensive approach

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A Brief History of Trade Flow Determinants

• Ricardo (Technology)
• Heckscher / Ohlin (Factor Endowments)
• Brander / Spencer / Krugman (IRS, Market
  Structure)
• Rivera Batiz / Romer / Young (Endogenous Growth)
  
• Melitz/Antras (Intra-Industry Cost Heterogeneity)

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Trade Flows and Trade Restrictions

• Trail Blazers Static Models
• Kruger (1972), Findlay Wellisz (1982), Hillman
  (1982)
• Second Generation Endogenous Protection Models
• Grossman Helpman (1995) etc.
• Preferential Trade Agreements (PTAs)

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Trade Flows and Trade Restrictions

• Preferential Trade Agreements (PTAs)
• Viner (1950) (Static Trade Creation/Diversion)
• Stepping Stones vs. Stumbling Blocks Krugman
  (1991, 1993)
• PTAs cannot be trade creating in the absence of
  intercontinental transport costs.
• Prohibitive transport costs gt PTA trade creation
  dominates
• Finite transport costs gt PTA trade diversion
  dominates
• Frankel, Stein and Wei (1995, 6, 8) model
  continuum of transport costs.
• The more remote trading partners are from the
  rest of the world, the more likely they are to
  form RTAs due to less potential trade diversion.
• The more natural trading partners are, the more
  likely an FTA will be formed by the countries
  governments due to more potential trade creation.

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Trade Flows and Trade Restrictions

• Stumbling Blocks
• Lobbies as stumbling blocks, b/c common external
  tariff (Panagranya Findlay 1996)
• Diverting PTAs are politically more likely (GH
  1995)
• Larger PTAs have monopoly power (Deardorff and
  Stern 1994)
• Given differences in factor endowments, trade
  with a few countries is sufficient to maximize
  gains from trade. Deardorff and Stern and Haveman
  (1994)
• PTAs inhibit further multilateral tariff
  reduction, (Krishna 1998)

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Trade Flows and Trade Restrictions

• Stepping Stones (complementary effect of pref.
  tariffs Bagwell Staiger 1998)
• preferential tariff induces trade diversion,
  which is costly, so external tariffs declines to
  compensate and shift imports back to their
  original source)
• PTAs allow lower external tariff b/c (tariff
  revenue competition, PTA free trade benefits
  allow for lower tariff revenues, so external
  tariff falls. RTA may promote external
  liberalization, Richardson 1993)
• Baldwin (1993, 1995, 1997) Levy (1996)
• Non-member exporters lobby forces joining if
  diversion is large
• Larger PTAs shifts more power to the export lobby
• Larger PTA even more attractive to join (more
  trade creation)
• PTA induced harmonization, allows new revenues
  that overcome trade fixed costs Freund (2000)

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PTA Effects Can Have Many Sources That Are
Difficult to Disentangle

• Possible Scenarios
• Among members Trade Creation / Trade Diversion
• Between members Trade Diversion / Open Block
• Between Non Members Trade Diversion /Open Block
• Which Theory is Empirically Relevant?
• Which Effect(s) Dominate?
• How do we sift through the many models for
  evidence??

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PTA Effects Can Have Many Sources That Are
Difficult to Disentangle

• Possible Scenarios
• Among members Trade Creation / Trade Diversion
• Between members Trade Diversion / Open Block
• Between non members Trade Diversion /Open Block
• Which Theory is Empirically Relevant?
• Which effect(s) dominate?
• How do we sift through the many models for
  evidence??
• This is the DEFINITION of Models Uncertainty

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Model Uncertainty Why do we care?

• Individual researchers typically emphasize a
  single model as they seek support for a
  particular regressor
• (the alternative is Null Hypothesis, or no
  effect)
• Inferences procedures based on a single model
  overstate the precision of the inferences
• ? procedures do not account for the additional
  uncertainty surrounding the validity of model.
• standard errors understate uncertainty

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Previous Approach To Model Uncertainty In Trade
Flow Empirics

• Ghosh and Yamarik (2004, JIE)
• First (and to date only) attempt to account for
  model uncertainty in trade flow / PTA estimation
• Use Extreme Bounds Analysis (EBA)
• (Leamer 1978, 1983, 1985)

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Previous Approach To Model Uncertainty In Trade
Flow Theory

• Ghosh and Yamarik (2004, JIE)
• First (and to date only) attempt to account for
  model uncertainty in trade flow / PTA estimation
• Use Extreme Bounds Analysis (EBA)
• (Leamer 1978, 1983, 1985)
• Conclusion No evidence of trade creation or
  diversion for any PTA! Relaxed extreme bounds
  pick up only trade diverting PTAs!!

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Extreme Bound Analysis-- Assessment --

• Lack of Statistical Theory Backbone
• Reduce model space artificially to avoid running
  all regressions. (Why?)
• Why has each model (no matter how terrible) equal
  weight?
• What is the robustness criterion? (see growth
  theory)
• How relevant is the analysis if the model space
  holds billions of models and the researcher
  searches only over less than 0.0000001 of the
  model space?
• Severe omitted variable bias
• Could be (and has been) considered data mining

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Bayesian Model Averaging (BMA)

• BMA Intuition
• Model Selection estimating the performance of
  different models in order to choose the best one.
• Model Averaging average predictions from
  different models to achieve improved performance
• Posterior Estimate weighted average over all
  models, where weights are given by model quality.
• BMA is a) theory based, b) based on objective
  criteria, and c) proof exists that BMA delivers
  best predictive performance (Raftery 1995)

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Bayesian Model AveragingQuick details for the
math hungry

• posterior probability for model Mk (the
  weight) is

• is the integrated likelihood (over
  all regressors)

• Posterior Mean

• D is the data,
• Mk is a model in some model space M, K is number
  of models,
• is a quantity of interest
• Nice priors largely wash out with 15000
  observations

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Econometric Framework

• Basic Building Block Gravity Equation
• Can be derived from a variety of trade models
  Deardorff (1998)
• Successful in explaining implied trade flows
  (Frankel Romer 1999)

Zijt proxies for trade costs / trade theory
covariates
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Definition of PTA Dummies

• Trade Creation dummies (PTAij)
• 1 only if both trade partners are members of a
  respective PTA
• 0 otherwise
• Trade Diversion/Open Block Dummies (PTAi)
• 1 if one and only one trade partner is a member
  of a respective PTA
• 0 otherwise

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Trade Theory Covariates (Zijt)

• Geography
• Border, Remoteness, Landlocked, Island, Area
• Historical Ties
• Language, Common Colonizer, Colony
• Exchange Rate / Trade Policy
• Sachs dummy, Currency Union, Floating FX rate, FX
  volatility
• Factor Endowments / Development
• GDP p.c.
• Log Differences in
• GDP p.c.
• Education
• Population Density

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Data

• Identical to no effect data of Ghosh and
  Yamarik (2004)
• Avg Bilateral Trade Flows, 186 countries, 14,522
  observations, 3,420 bilateral trade pairs,
  five-year intervals (1970-1995)
• 12 major PTAs
• Europe EU, EFTA, EEA
• Pacific Rim APEC, ASEAN, NAFTA, ANZCERTA
• Latin America CACM, CARICOM, LAIA, AP (Andean
  Pact), MERCOSUR

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European PTA Members
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Results Europe
Clear, strong open Block Effects.
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Pacific Rim PTA members
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Results Pacific Rim
Now significant trade creation and diversion and
open block PTAs matter a lot! Puzzling high
APEC Large Trade Diversion for Nafta!
?
?
?
?
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Latin American PTA Membership
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Results Latin America
Orthodox results of Strong trade creation And
trade diversion In Latin America
?
?
?
?
?
?
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Summary part I

• Using
• identical data
• statistically sound approach to model uncertainty
• considers all possible models (including best
  model)
• Derive quality-weighted averaged estimates
• We overturn the bleak PTAs dont matter results
  and show that several have trade creating, trade
  diverting and open block effects.

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Results Control Variables
Strong effects from gravity and other country
specific Controls The only variables that do not
receive support are - FLOAT - ED DIFF - ISLAND
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The Importance of Fixed Effects(Natural Trading
Partners)

• Hummels and Levinsohn (1995)
• Trade is largely specific to country-pairs
• We may not know why, or cannot account for it
  with our covariates, no matter how many controls
  we include.
• We introduce country pair fixed effects
• Isolate whether countries trade a lot with each
  other because of PTAs or because they are
  natural trading partners
• Cheng and Wall, 1999 (EU, Nafta, Mercsur) Egger
  and Pfaffermayr, 2003 (gravity only)

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The Importance of Fixed Effects(Natural Trading
Partners)

• Introduce Country Pair Fixed Effects
• Example similarities in economic and social
  institutions, such as corruption or rule of law,
  or simple economic infrastructure such as
  telecommunications.
• A concrete example would be France-Germany, with
  excellent transport links (unobserved) and a PTA
  (observed), vs. Afghanistan-Kazakhstan, with bad
  transport links (unobserved) and no PTA
  (observed).

ij
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EuropeTrade Effects Purged of Natural Trading
Partner Effects
?
?

• Now EU is Trade Creating
• Strong Open Block Effect

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EuropePTA Flows Purged of Natural Trading
Partner Effects

• Only after controlling for natural trading pairs,
  the EU is Trade Creating
• EU countries naturally under-trade relative to
  the prediction of the standard gravity model.
  This missing trade is a standard feature of the
  basic gravity model, see e.g. Pollak (1996) or
  Rose (2004).
• EU Open Block Trade Creation does not survive but
  is simply due to similarities among trading
  partners

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Latin America PTA Flows Purged of Natural
Trading Partner Effects

• Counterintuitive Effects Disappear
• All Effects are Natural Trading Partner Effects

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Pacific Rim PTA Flows Purged of Natural Trading
Partner Effects
!
?
?
?
Counter Intuitive APEC Trade Creation
vanishes AFTA and APEC Trade Creation
confirmed NAFTA Trade Creation is maintained
but smaller
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Pacific Rim PTA Flows Purged of Natural Trading
Partner Effects

• NAFTA 26 trade diversion?

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Trade Creation/Diversion Importance of
Comprehensive Approach

• Most PTA Studies estimate Trade Creation for
  one/a few PTAs
• Marginal Effects (too diverse to average) vs
  Global Effects
• Most studies dont distinguish Trade
  Creation/Open Block
• Example1 Two countries are in two different
  PTAs what matters for trade flows is the Open
  Block effect / Trade Diversion of BOTH PTAs (70
  countries, most high income countries are in
  PTAs)
• Example2 All countries (PTA or not) get open
  block effects from all other PTAs. So pairwise
  trade diversion may turn into multilateral trade
  creation!

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Trade Creation/Diversion

• Most PTA interactions are Trade Creating
• EVEN NAFTA trade can be trade creating with Nafta
  non members

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Conclusions

• 1) Address Model Uncertainty
• obtain correct PTAs effects PTAs do matter (!)
• 2) Purge Natural Trading Partner contamination.
• Eliminate Counterintuitive Results (!)
• Isolate actual PTA effects (most PTA effects
  smaller)
• 3) Comprehensive Approach
• Identifies crucial interactions that can overcome
  false trade diversion (US / ASIA)
• Overwhelmingly, PTAs are stepping stones to freer
  trade