The collapse of global trade, murky protectionism, and the crisis:

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VOX Research-based policy analysis and commentary from leading economists The causes of the collapse must, of course, ultimately be centred on the financial crisis that hit the US and other countries. This column seeks to contribute to our understanding of the transmission mechanisms or channels from the crisis to the synchronised trade collapse. One often-cited financial mechanism, for example, has been the collapse in trade credit. More broadly, tighter lending conditions worldwide have led to constraints on global spending, including spending on imports. A real transmission mechanism: Vertical specialisation However, there is a plausible propagation mechanism coming from the nonfinancial or real side of these economies, namely, the increased presence of vertical specialisation in international trade. Vertical specialisation occurs when goods are made in two or more sequential stages, and when at least one stage of production relies on imported inputs, and some part of that production is exported. Hummels, Ishii, and Yi (2001) and others have documented that vertical specialisation – alternatively known as international fragmentation of production or international production sharing – has been increasing over time. For purposes of comparison, it is useful to first review the logic behind the standard international trade transmission mechanism. Suppose that the US is hit by a large negative financial shock that leads to a decline in its output. The decline in output is equivalent to a reduction in income for households and firms. They adjust to the lower income by reducing their spending. Some of this reduced spending is on imports. Hence, countries that export to the US suffer a reduction in exports. These countries are now experiencing a decline in their output. An adjustment similar to the adjustment in the US now occurs. The adjustment eventually leads these countries to reduce their spending on imports, implying that US exports decline. Hence, trade declines in both the US and its trading partners. 16 The mechanism described above hinges on the income channel. The speed of adjustment depends on how long it takes for: • the decline in US output to lead to reduced spending by US households and firms, • the reduced spending by the US to lead to lower output in its trading partners, • the lower output in the US's trading partners to lead to reduced spending by their households and firms, • the reduced spending in the US's trading partners to lead to lower exports by the US. Depending on how long it takes the income effects to be transmitted, the adjustment could take some time. Moreover, in a world in which all trade is value-added, the decline in trade is exactly equal to the decline in demand for final imported goods. The trade effects are not amplified. What is the adjustment in a world with vertical specialisation, in which goods are produced sequentially in stages across different countries? Suppose again that the US is hit by a large negative financial shock that leads to a decline in its output. Initially, the adjustment is the same as in the standard international trade transmission mech- 16 The transmission mechanism continues, as the decline US exports represents a further drop in US output, leading to a further drop in US incomes and spending. However, each "round" is smaller than the previous round. 46
The collapse of global trade, murky protectionism, and the crisis anism. Households and firms suffer a decline in their incomes and adjust by reducing their spending on imports. The point of departure from the standard mechanism is that some of this reduced import spending is on imported vertically specialised goods, say, personal computers (PCs). The lower demand for PCs immediately translates into reduced demand by foreign PC firms for the imported parts and components used to produce them. Some of these parts and components are made by US firms. Consequently, US firms suffer an immediate reduction in their exports. Because international trade in a world with vertical specialisation is directly linked to the production chain, the shock is transmitted more quickly across countries. International trade declines in a more synchronised manner than in the nonvertically specialised world. An additional channel comes from reduced spending on domestically produced goods. The US may reduce its spending on goods "made in the USA," but which consist of imported parts and components. If these imported parts and components themselves are made from parts produced by US exporting firms, there again will be a direct production chain transmission mechanism from US imports (i.e., foreign exports) to US exports. The example above also indicates that the decline in trade flows is a multiple of the decline in demand for final imported goods. This is because trade flows are measured as gross flows, not as value-added flows. Imported chips embodied in PCs that are then exported are counted twice in the trade statistics, once as an import and once as an export (as part of the PC). Supporting evidence The stories told above are quite stylised. An academic version of the vertical specialisation mechanism is found in Burstein, Kurz, and Tesar (2008). An explanation based on vertical specialisation in principle can account for some portion of the severity and synchronisation of the collapse in global trade. Is there any supporting evidence? There are at least two suggestive pieces of evidence. The first is that the collapse in merchandise trade has been particularly acute in manufacturing. This is true whether one compares manufacturing trade to nonmanufacturing trade within countries or whether one compares countries with intensive manufacturing trade to countries without intensive manufacturing trade. In addition, the collapse in manufacturing production across the globe has also been sudden, severe, and synchronised. Finally, manufacturing, in general, is much more vertically specialised than agriculture and commodities. Hence, the vertically specialised nature of manufacturing could be a contributing force to the larger collapse in manufacturing production and trade. 17 The second piece of evidence involves motor vehicle trade flows between the US and its NAFTA partners. In 2008Q4, (nominal) US imports from its NAFTA partners were down 23.2%, and imports from all other countries were down 19.6% from 2007Q4 levels. These two declines are fairly similar and consistent with a reduction in demand by US households and firms for all types of motor vehicles. Turning to the export data, US exports to all countries but NAFTA were 1.5% in 2008Q4 higher than in 2007Q4. However, exports to the US's NAFTA partners were down about 20.1%, very similar to the decline in US imports. What is the reason for the disparity in export performance? The composition of US 17 Another reason for the large role of manufacturing is that many manufacturing goods tend to be durable. Durability adds to volatility. See Engel and Wang (2008). 47
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