No modern nation is or can be economically self-sustaining.1 Any country that tries to produce all the goods and services it needs will inevitably see less quality and variety. This is because all countries have different constraints on production, such as available resources and capital. Sometimes certain types of production are impossible altogether.
Crops, for instance, require arable land, water, and the right climate. If a country doesn’t meet these conditions, that country can’t grow enough of its own crops to sustain its population. Natural minerals are another example, as is mass production, which requires a certain level of accumulated knowledge and capital — those things aren’t distributed equally.
International trade, however, makes it possible for countries to leverage their own advantages and overcome these constraints. They can focus on what they do best and sell it to other countries in exchange for goods and services difficult or impossible to produce domestically. This theory has driven globalization for decades, but lately it has met with new criticism and challenges. Though world trade won’t collapse entirely, these trends could significantly slow and in some ways reverse what was once a seemingly unstoppable integration. Here we’ll look at what drives globalization, what drives the recent pushback, and where the trends might take us.
The law of comparative advantage
The theoretical basis of foreign trade derives from the two-hundred-year-old economic law of comparative advantage, which suggests things should be produced where opportunity cost is lower. Theoretically, then, trade and specialization benefits all partners — albeit in different ways — accelerating growth, creating jobs, and increasing income.
After World War II, economies used this model to open up free trade, which eventually led to globalization. No doubt, global trade is a powerful economic engine that has already contributed to lifting many out of poverty.2 However, it has always had its critics. In the 1950s, for example, economists in developing countries pointed to unequal global income distribution.3 More recently, though, developed countries have begun to criticize the system, blaming it for losses in output, jobs, and the size and wealth of their middle class.4
And indeed, economic data and foreign trade statistics indicate the second age of globalization — which started after the Second World War — is near exhaustion. Let’s analyze the factors that contribute to discrepancies between the world’s largest economies, and the trends that threaten the sustainability of global economic growth.
Major trends in world trade development over the last decades
We can isolate four trends: Rapid growth; the emergence of new leaders; changes in trade composition; and the growing international interconnectedness made possible by global supply chains.
Trade flows have increased dramatically over the last three decades. According to WTO trade statistics, the value of world merchandise exports rose from $2 trillion in 1980 to $18 trillion in 2017 — the equivalent of 6.1 percent growth per year, on average. Trade in commercial services grew even faster over the same period, from $367 billion in 1980 to $5 trillion in 2017 — or 7.5 percent per year.
Perhaps the most significant fact about world trade since 1980 is that for most of this period trade has grown much faster than output5 — nearly twice as fast in terms of volume (i.e., accounting for changes in prices and exchange rates). Between 1980 and 2017, merchandise trade by volume increased more than five-fold. Trade growth averaged 4.8 percent per year between 1985 and 2018, but in that same period global GDP growth averaged only 2.9 percent. That means trade grew about 1.7 times as fast as output. (It’s worth noting, however, that the data for 2012-2018 indicates this trend has changed: World merchandise exports since 2012 have grown only 1.1 times faster than output, which might suggest some fundamental changes in the global system.)
Why the differences in growth rates? We can point to the spread of supply chains, which are characterized by the unbundling of production processes across countries. This has had implications for conventional statistical measurements, which we discuss in more detail below.5
Perhaps the most important recent change in trade patterns has been the role of developing countries: They’ve taken on a larger share of world trade, which pairs with a corresponding decline for developed economies.5
In 1980, developing economies represented just 30 percent of world merchandise trade, but by 2017 that had increased to 49 percent — virtually half. Over the same time, the share for developed economies dropped just as sharply, from 70 percent to 51 percent. One striking difference: shifts in economic focus. For instance, in 1980 developing economies mostly focused on oil exports, but by 2017 developing Asian economies had stepped up. Imports display similar trends.
Data illustrates that Asian ascent. 1980 China had a one-percent share of world exports, making it the tenth-largest exporter among developing economies. By 2017, however, that share had risen to 13 percent, and China had taken its place as the largest developing exporter (and indeed the largest exporter in the world, if you count individual E.U. member states independently). Similarly, in 1980 the Republic of Korea, India, and Thailand weren’t in the top ten developing exporters, but 37 years later their shares in global trade had risen to three percent, two percent and one percent, respectively. It’s no surprise that over the same period developed economies such as the E.U., the U.S., and Japan all recorded declines.
Trade between developing nations has also grown faster than trade between developed nations (and faster than trade between developed and developing nations). This is because developing countries have struck more and more trade agreements over this time, which have reduced former barriers and allowed them to open their markets to each other.5
For many years, the share of manufactured goods in trade increased relentlessly: Between 1970 and 2017 the share rose from 59 percent to 71 percent. In contrast, shares of food products and agricultural raw materials fell — from 17 percent and 8 percent (respectively) in 1960 to 9 percent and 1 percent in 2017. The share of fuel and mining products — which rise and fall with oil prices — hasn’t exhibited a clear trend either way.
In terms of volume, we estimate that between 1980 and 2017 the volume of trade in manufactured goods increased more than seven times in size, while over the same period agricultural products, fuels, and mining products increased less than four times.
Trade in manufactured goods has outpaced growth because production has grown increasingly fragmented: Components often move many times from country to country before they’re assembled into a final product and sold. Each time a component moves from one nation to another, that same component gets counted, which inflates volume counts. In contrast, because exports such as fuel and food products are mostly consumed in the first country they arrive, they only get counted once.
Fragmentation has also integrated economies. Countries become increasingly dependent on supplies from their trade partners — and from the suppliers of their suppliers, etc. This increased interconnectedness cuts the other way, too: Today, the effects of trade disputes between any two big economies can spread beyond their borders and threaten the global economy.
What shapes global trade system
As mentioned earlier, we can explain the rise of foreign trade via the theory of comparative advantage, first proposed in 1817 by English political economist David Ricardo in his book “On the Principles of Political Economy and Taxation.” In the first half of the 20th century, Swedish economists Eli Heckscher and Bertil Ohlin extended this theory to account for relative access to factors of production, such as land, labor, and capital. Accordingly, countries specialize in goods and services for which these conditions are most favorable.
Another group of factors explains the remarkable expansion of trade: overall growth of the world economy; reduced trade barriers and transportation costs; monetary policy; institutional reforms; higher standards of living in developing countries; and increases in commodity prices in the early 2000s. Let’s take these one by one.
Economists widely agree that reductions in trade barriers have been the main driver of world trade. This includes drops in import and export duties, the elimination of non-tariff restrictions, lower transportation costs, advances in aviation and sea freight transportation, and investments in ports.
Unfortunately, comprehensive statistics on historical prices for international freight services don’t exist. Estimates based on available data (mainly for the U.S.) suggest international costs have about halved between the mid-1970s and mid-2000s.6
Additionally, developing countries have cut tariffs significantly. For example, average weighted import tariffs in India, China, and Brazil decreased from between 27-77 percent in 1990 to between 4-9 percent in 2017. Import tariffs in developed countries according to UNCTAD on average were not higher than 2% of imported goods’ value in 2017.
Monetary policies of the largest emission centers also influence trade dynamics. Soft monetary policies increase liquidity, and over the last 25-30 years, developed countries have by and large employed relatively soft policies. For example, the effective Federal Funds Rate at the end of 1980 was 19 percent; it’s now 2.4 percent.
Those policies overlapped with developments in trading platforms and technological progress in telecom and financial services. This incentivized foreign direct investment in developing economies, the most familiar example being offshoring. The increases were especially acute during periods of localized currency depreciation.
As developing countries began to see increases in household income, demand for imports increased in step. Demand for meat and dairy products went up, for example, as did demand for durable goods.
Commodity prices also went up. Higher prices increased the value of exports and attracted investments in fossil fuels and raw materials. This in turn kicked up trade in related equipment and components.
World Trade and Global Value Chains
We can also connect the above factors to fragmentation. Lower tariffs and rapid technological advancements — along with relatively low wages in developing countries — incentivized trade in parts and tasks, as opposed to trade in final goods.7
Clearly, fragmentation isn’t new — countries have always imported intermediate inputs. But the process accelerated in the last 30 years. Firms and countries are increasingly integrated into global production and distribution networks, called global value chains (GVCs). Parts and tasks that move through GVCs often cross borders multiple times before they’re assembled into a final product.7
We can trace the trend to the boom in trade since the early 1990s.7 A second measure would be the demonstrable growth in re-exported intermediate imports as a share of total imports.
GVC case study: The iPhone
One classic study of GVCs is the drop in the factory production costs for Apple’s iPhone.
Though China produces iPhones, almost none of the components — such as touch screen display, memory chips, and microprocessors — are manufactured there. Apple buys the components from a mix of U.S., Japanese, Korean, and Taiwanese companies (e.g., Intel, Sony, Samsung, and Foxconn) and has them shipped to China; then they leave China inside an iPhone.8
As a result, factory costs decompose. For instance, the cost of a 32 GB iPhone 7 shipped from China to the U.S. is $237.50 — but only $8.46 of that cost actually goes to China.8
This demonstrates two problems with GVCs: unequal income distribution, and the warping of conventional trade stats.
Even though China is the final iPhone exporter, it receives a tiny part of the total factory cost. Most of the cost goes to the countries that make the components, with the largest share going to U.S. producers. And the difference between China and the U.S. is even greater when we account for the total $649 sales price of the iPhone 7 at its debut.
This illustrates how countries that specialize in low-skill stages of production don’t gain as much from international trade as do countries that specialize in high-skill stages — such as technological development, R&D, and design — and have the final sales market.
We can also see how foreign trade measurements can mislead us, disguising the real contribution that each trading partner makes to the final price of a product. According to customs foreign trade statistics, the U.S. iPhone trade deficit with China is $237.50 per phone. But as we just saw, China’s real contribution to that deficit is only $8.46, mostly for assembling.
A new measurement
The problem: Conventionally, trade flows are measured in gross. And again we can see that the value of products that cross borders several times is counted multiple times.9 This inflates both value and volume, and explains why global trade growth has outpaced global GDP growth. And it’s becoming more severe: Exports increasingly contain intermediate inputs sourced from abroad, which makes it tough to identify the real contribution a given export makes to an economy. This often also obscures which specific economic sectors generate value added.9
How to fix this? Some economists suggest we only count value added. This way, export value includes only the domestic value added that stays overseas. Imports calculated in value-added terms would include only foreign value added that stays at home.10
This system doesn’t change the ultimate measure of a country’s trade balance with the world, but it does affect balances with separate partners. For instance, when we apply the concept to trade between the U.S. and China, the deficit is about 35% lower than the conventional statistics show. (It revises the -$420 billion deficit in 2018 to -$273 billion.)
Free Trade, Trade Wars, and Military Power
The rise of GVCs has created unprecedented economic interdependence. This means disruptions between two major trade partners will affect all other economies. The most familiar example is the running trade war between the U.S. and China. To date they have imposed or hiked import tariffs on more than half their bilateral trade in goods. According to the IMF, the trade war between these two countries could significantly affect global GDP growth.11
It’s also revealing to look at causes and effects of the trade war in view of the theory of world trade.
As we mentioned above, countries specialize where they have a comparative advantage. Other factors increase the speed of specialization and unveil comparative advantages that trade barriers once blocked.
Comparative advantage isn’t static. Historically it shifts with stages of industrialization. In the first stage of industrialization, mechanized agriculture and mass production technologies created comparative advantage in such labor-intensive goods as textiles and apparels. This increase in both productivity and labor costs shifted comparative advantage to the production of goods such as machinery and transportation, which in turn incentivized labor-intensive firms and technologies to move abroad.12
In the third stage of industrialization, rising productivity and labor costs made labor- and capital-intensive production unprofitable. In response capital-intensive technologies have moved abroad, so developed nations now experience deindustrialization. We’ve since seen the rise of service-oriented welfare states and employment sectors built around advanced information technologies, such as vibrant health and financial industries.12
Specialization in a world of free trade increases the production potential of the global economy. The problem, though, is that the gains aren’t equally distributed — not only between countries, but within countries as well. When the U.S. moved labor-intensive production abroad, U.S. manufacturing started to hemorrhage jobs. Some began to blame U.S. trade deficits, especially with China, for these losses.
The manufacturing job losses in large part fueled the trade war with China. But the trade war can’t reverse losses driven mainly by rapid technological progress, such as automation. Instead, the war might have the opposite effect, significantly reducing U.S. consumer welfare and hurting the global economy.12
One could say that instead of trade wars, the U.S. might be better off if it aligns its trade policy with its comparative advantages (knowledge- and R&D-intensive production) and concentrates on promoting education and training programs that enable its citizens to adapt to a changing world.12
Though this strategy has a solid theoretical basis, we should note that manufacturing isn’t simply a way to create employment and wealth — it’s also key to military strength. And in a world of military conflicts both extant and budding, it’s unlikely that countries will follow principles of free trade and comparative advantage if it undermines their military power.
- Why Foreign Trade Is Important. World Affairs, vol. 97, no. 1, 1934, pp. 25–27. JSTOR. Link
- Making Globalization Sustainable. International Labour Organization and World Trade Organization, 2011. Link
- Patrice M. Franko, The Puzzle of Latin American Economic Development Rowman & Littlefield Publishers, 2003, pp. 51-74
- David H. Autor, David Dorn, and Gordon H. Hanson, 2013. The China Syndrome: Local Labor Market Effects of Import Competition in the United States. American Economic Review. Link
- World Trade Report 2013. Factors Shaping the Future of World Trade. WTO. Link
- Hummels David, Lugovskyy Volodymyr, Skiba Alexandre, May 2009. The trade reducing effects of market power in international shipping, Journal of Development Economics, Elsevier, vol. 89(1), pages 84-97. Link
- World Development Report 2020. The World Bank, January 11, 2019. Link
- Jason Dedrick, Greg Linden, Kenneth L. Kraemer, July 6, 2018. We estimate China only makes $8.46 from an iPhone – and that’s why Trump’s trade war is futile. The Conversation. Link
- Trade in Value-Added: Concepts, Methodologies and Challenges. Joint OECD-WTO note. Link
- John B. Benedetto, July 2012. Implications and Interpretations of Value-Added Trade Balances. United States International Trade Commission. Journal of International Commerce and Economics. Link
- World Economic Outlook, October 2018. IMF Link
- Brian Reinbold , Yi Wen, October 9, 2018. Understanding the Roots of the U.S. Trade Deficit. Federal Reserve Bank of St. Louis. Link