¶ Understanding Trade Deals and Uncertainty
Hello, you are listening to an episode of Trade Talks, a podcast about the economics of trade policy. I am Samaya Keynes, economics and trade correspondent for The Economist in London. And I'm Chad Bowne, a senior fellow at the Peterson Institute for International Economics in Washington. In this episode, we have a special treat planned. Our first guest.
Nuno Lemau, economics professor at the University of Maryland, will join us to talk about his research, including some that is part of Chad's new book, Economics and Policy in the Age of Trump. But first, a fun fact. I am a pretty keen choral singer. And after my last rehearsal, I asked other members of my choir what they thought trade deals were all about. I think trade deals are about two countries agreeing the same rules.
securing new opportunities to sell your product abroad? I mean I guess probably like tariffs is mainly what I kind of think about when I think of trade deals. People think trade deals are about cutting tariffs or harmonizing rules, but they are so much more than that. Crucially, they create certainty, and that certainty supports trade.
In choir, I only start singing when I know the others are going to start too. I do not like unexpected solos. My music is kind of like a trade deal. If I didn't have it, my musical output would suffer. This matters now for real trade deals because there are two... Big examples of huge uncertainty being injected into trade arrangements. Trump is the obvious first example. He's threatened to withdraw from various trade deals in Mexico, Canada, South Korea.
But there's another big one much closer to my home, which is Brexit. When the UK voted to leave the European Union, that injected huge uncertainty into its relationship with the European Union. Take a car manufacturer like Nissan.
It used to be confident that it would have easy access to the EU from Britain. Low tariffs, not much hassle when it was crossing the border. But with Brexit... this huge injection of uncertainty it just can't be so sure what if britain crashes out and faces tariffs of ten per cent what if they're accused at the border all of a sudden investing in the uk is not looking so hot
Last year, when Nissan was choosing where to build its new SUV factory, Theresa May, the British Prime Minister, had to pledge that they wouldn't lose out from Brexit. It worked that time, they are planning this factory, but... She can't do that for every company. That's why you have a trade deal. And with that introduction, on to the evidence. First, Chad and I will ask Nuno about two examples he's worked on.
when portugal joined the european economic community and when china joined the world trade organization how much of the impact of these deals was down to tariffs and how much was because of the extra certainty that they created Then we'll discuss what the evidence means for policymakers. Could it be that the Trump administration might learn some lessons from this research? All will be revealed.
¶ The Role of Certainty in Agreements
So we're extremely happy to be joined today by Professor Nuno Lamau from the University of Maryland. Thank you for having me, Chad. So first question, do... trade deals actually lower uncertainty what kind of uncertainty are they supposed to help with well there are different kinds of uncertainty that trade deals might potentially help with so one specific one is if you're a firm and trying to make some kind of investment in order to sell into foreign markets. And this is something that is a...
very large investments, then you might be worried about whether in five years or 10 years, this investment will pay off. And you might be worried that, for example, you'll face higher tariffs or some form of other kinds of regulations. Trade agreements can help basically set up certain kinds of rules and expectations for these firms so that they feel more certain about making certain kinds of investments.
But this is one of the stated objectives, right? This is what trade deal makers are thinking about when they're crafting these deals. Yes, that's right. In fact, it's one of the... key stated objectives that they have. And although a lot of the focus is typically on...
and discussion is about how these agreements actually reduce barriers when they negotiate it, when they talk about it. And you see this in the current NAFTA renegotiations. A lot of it is actually about just ensuring a predictable environment for things like business.
planning, investments, and so on. Great. So if I had to think of a massive, massive trade deal, I guess I would think of the general agreement on tariffs and trade, which was the big one in 1947 after the Second World War. Did that big trade... agreement lower uncertainty for businesses? Yeah, so that's a good example. So it came right after the Second World War, as you said, but also after the trade wars in the 1930s. And one of its sort of specific objectives was to try to prevent...
that type of event from actually occurring. So by one measure, we've had no trade war since then. I guess it's been successful. And this kind of possibility of a trade war was very much a real one. in 2008 during the Great Recession. Do we have any more rigorous evidence that uncertainty went down? Here are a couple of examples. So one of them is, you know, you could just look at volatility of tariffs before and after countries going to the GATT. And I did that in...
some work with Professor Giovanni Maggi at Yale and find that that's in fact the case. Another more specific one is some research by a co-author of mine, Kyle Hanley, at the University of Michigan, where he looks specifically at the GATT. tariff binding. So these are things that countries...
agreed to, and they're basically maximum tariffs that they'll say that they'll set on other countries. And he basically finds that if these are lowered, this tends to increase trade, even though, or even if... those tariffs aren't actually being charged. It's just the possibility, the threat that they are charged, when that gets lowered, that tends to increase trade. So that's one specific example.
Wow. So even when the letter of the law changes, but the government policy of the tariff levels doesn't change, that still seems to affect firm behavior. That's exactly right.
¶ Case Studies: Portugal and China
OK, so let's let's talk about another example, because I know you've looked at many in your research. What about when Portugal joined the European Economic Community? That was a case where a trade deal got signed and it was supposed to. lower uncertainty. What uncertainty did they face before joining this deal?
I think that that's a really interesting case, personally, because that's actually one of the reasons why I became a trade economist. I'm Portuguese, and Portugal joined D.C., and Portugal saw lots and lots of changes at that point. One of them, when it went into D.C., is that it could now export goods into those markets knowing that it would receive no tariffs or basically have free trade.
But the interesting thing was that it could actually already do that before 1986 in a lot of manufacturers. So what really changed in terms of tariff treatment was that before... the agreement, the Portuguese exporters were not really sure that that preferential treatment was going to remain in place. Whereas after the agreement, being part of the European market, they were much more...
sure that that would be the case. Okay, so there's this deal. It gives firms certainty that they won't face suddenly higher tariffs. What happens after Portugal joins? Essentially, when Portugal joins its exports to the sea and also to Spain, joined at the same time, increased dramatically. And a big part of it was new firms and new products being exported.
And one, I think, interesting contrast there is that if you look at what happened to Portugal's exports to these markets when they signed the initial... agreement, the one where just the tariffs were lowered but not secured, you see that there's a very small effect then and a very large effect. when you have this different agreement where we have this securing of preferences. Okay. Sometimes we economists get into trouble because we find results that are statistically significant, but...
They're not always economically important. So can you tell us, you know, how big are these effects? You know, what are the size of the certainty gains, the reduction in uncertainty that we're talking about? To give you kind of a headline number, so Portugal exports to the EC in Spain. 1987 were about 15% of its GDP. And so by taking these estimates that we had, we basically find that if uncertainty had not changed, if it had remained as it was before, that would have basically been about...
12% of GDP instead. So these are... really large effect as far as trade policy effects go. Basically what you're doing there, you're effectively finding that the uncertainty is counting for a three percentage point difference in trade as a share of GDP. In this setting, yes, that's right. Amazing. Now, I want to move us to a different example that you talk about. You have this paper in the American Economic Review in which you look at China and its entry into the World Trade Organization.
So first of all, let's describe the uncertainty that China faced before it entered the WTO. So again, that was another really interesting case. So when in the 1990s, China essentially... when exporting to the U.S., faced what were called the MFN tariffs. So these are the same tariffs that other members of the WTO actually faced. Now, China was not a member of the WTO, and so one key difference between itself and the other countries was...
that yearly the U.S. Congress would vote on whether or not to revoke this MFN tariff. And the reason why that was important is that it did actually, the House actually passed that three times. It got vetoed by the president. But if it had actually been implemented, China would face tariff increases of about 30 percent.
So the actual, there was a political fight going on in the United States each year when they were doing these votes. And there might have been that China might have actually faced those higher tariffs. So it wasn't just a fait accompli every year. When China did enter the WTO, everyone thinks that when it entered tariffs just...
crash down to almost nothing. But really what its entry did is to essentially give it more certainty and to remove this political process from the fact that it had these low tariffs. If you do look at the actual...
tariffs that China faced after it entered into the WTO in the U.S., those don't really change very much at all. And so what we do is basically we look at between 2000 and 2005, whether industries that faced very high threat tariffs, whether those industries had particularly high export growth, and we find that they do, and also find that those are the industries where they're the biggest... decreases in prices of Chinese goods coming into the US market.
Wow, so uncertainty is doing a lot of the work there. So we basically find that it's about, it accounts for about a third of the observed import growth in that period and, you know, this impact on prices. was about 15%, so a 15% decline in real prices of Chinese goods coming into the U.S. And I think that's really important in the context of the recent debate on the China impact. This is something that sometimes gets lost when we just focus on the negative.
employment and wage effects. Let's pause and kind of talk about that point for a moment, because certainly over the last year in the public debate in the United States, there's been a lot of discussion about China, the impact. Imports coming in from China, lost jobs, plants shutting down. But what you're finding here is it's a bigger story. And that in addition to that kind of stuff, you had a complementary story. You had some actual benefits.
coming into the United States because of this in the form of lower prices for U.S. consumers, Chinese companies making investments, providing new products. If you had to... quantify the effects, kind of put them into the size that trade economists are used to thinking about, so the tariff equivalent. What do you come up with in this exercise? In terms of these impacts, we...
find that it's equivalent to having had about a 13 percentage points tariff. So that was sort of how much uncertainty was kind of hindering the prices before it went into the WTO. How much do you know about the mechanisms involved here? We focused...
Basically, I'm trying to understand and identify whether the uncertainty component was at work. And it could be at work through a number of different ways. One key way in which it worked, if firms have to make large upfront investments in either new products or technology. or setting up distribution networks and so on. And if these are market-specific investments that take a while for firms to recoup, then they're going to be very worried about possible future tariffs.
We have some evidence that's consistent with this mechanism. Basically, we find that these impacts only work in industries where these costs of investments are very high and that they tend to be market specific. So it wasn't that China was also exporting. more in those industries to the EU or other markets after its entry into the WHO. So that suggested something about investing in supplying the U.S. in the U.S. market.
And the other thing we find is that there's new product entry because of this. And there's other more recent work that uses firm-level data and finds that there was also increases in firm. terms exporting to the U.S. using a similar approach to ours. Okay, so uncertainty really is stopping trade and certainty is making the world go round. That's the kind of slogan you'll get on this.
¶ Current Trade Policies and Implications
on this podcast. Okay, so this research is great, very interesting, but let's talk about today. There's this concern that the President Donald Trump is about to start this hot trade war, but you've spoken about him starting a cold trade war. Cold War. What do you mean by that? So basically in this article what we're doing is we're describing
the administration's plans to address what they call unfair foreign trade practices. And they've proposed to do it through things like unilateral policies, renegotiation or withdrawal from agreements, and just generally having... different kinds of threats of airport protection. So this is what we call Trump policies.
Still hoping for that to stay. Temporary, reversible, uncertain MFN and preferential policy. So there's an acronym. A new acronym for us. Excellent. Yeah. I mean, good luck with that one. Good effort. But good luck. And what we argue is that all of this amounts to a trade cold war, which essentially we define as a higher probability of kind of abandoning or renegotiating agreements.
And then moving into and entering a hot trade war, which means an actual imposition of certain kinds of duties and so on. Okay, so what are some examples of these policies? What exactly are you talking about? Specific examples are, you know, the threat and eventual sort of withdrawal from TPP, the start of the renegotiation of NAFTA. We're waking up one morning.
and finding out that if you're Korea, maybe you're going to be out of a preferential agreement. And just more generally, this idea that the U.S. is now going to identify... countries with whom it has bilateral trade deficits and basically just do something about this. So we constructed a trade policy uncertainty index. It just measures how often these kinds of issues are on the news. And between the nomination and the election,
two-year period that went up basically four times. That's one small measure. It also seems to be changing expectations. So if you look during the campaign, there's surveys of global CEOs worried about and saying that they might delay their investments until certainty about the presidency was resolved. And more recent surveys basically find that about 95% of global CFOs are concerned that the U.S. will start a trade war with China.
Okay, so obviously we haven't got a hot trade war yet, but if you were to be advising the Trump administration based on your earlier empirical research, what lessons would you say that that research had? for this strategy that they seem to be employing? That earlier work on China...
While we were doing it, of course, this was not really didn't seem like a possibility, but we just thought, well, why not try to calculate a counterfactual where the U.S. would treat all of its trade partners the way that it was treating China? So just. Let's keep all of the tariffs as they are now, but just sort of make everybody believe that.
well, maybe tomorrow you'll wake up and we'll take them away from you. And so we calculated this, and basically the effects are fairly large. So the effects, one... way to measure them is that the effect on U.S. consumers would be equivalent to about a third of the effect of just shutting down U.S. imports from the rest of the world. So that gives you sort of some dimension of what.
potential impact this could actually have. Wow, that is big. Let me ask you another question here. So when we're thinking about the implications of your research, How should we think about them in terms of the kinds of trade deals that countries should be negotiating, signing, etc.? What are the implications as we think about this for the future?
Yeah, so I think one important point to keep in mind is that not all agreements will actually reduce uncertainty, and they certainly will not reduce uncertainty for all countries. These effects we've been talking about are effects for the member countries. So you could be increasing uncertainty towards non-member countries, and that could be quite important. I think that's an important...
area to do more research on. In terms of what's currently happening, another set of agreements that... we have found basically seems to actually generate uncertainty rather than reduce them are agreements whereby countries give preferences that are just temporary and subject to renewal. That's one of the potential costs of what's currently happening with the U.S. renegotiating its agreements is that countries might just start to view these as basically temporary preferences and things that are.
So that's really interesting. Over the last couple of weeks, in the NAFTA negotiations context, it was rumored... that the Trump administration was thinking about introducing a sunset clause into the agreement where after five years, they were going to require all three countries to vote unanimously. to want to keep the deal. So what your results would suggest is implementing something like that into a trade agreement might not be the best way to reduce uncertainty.
Absolutely not. And here I'll defer. I think it was the Canadian ambassador who... We had a good analogy for this, which is basically something like if every marriage had a five-year sunset clause on it, then certainly the divorce rate would be way higher than it is now. Great. Well, a solid note to end on. Divorce. Nuno, thank you so much. This has been really great. Yeah, thanks, Nuno. This has been fantastic having you. Congratulations on the podcast. Keep up the good work.
That is all from Trade Talks. So once again, let's give a very big thanks to Professor Nuno Lamau from the University of Maryland for agreeing to come and join us here today. Two thanks from me. The first to my choir, the Laycock Scholars. That's us, you can hear singing. And the second to Alex Baleveld, who sent an amazingly detailed suggestion for an episode last week. Please do keep them coming.
Please leave us a review on iTunes. We'd really, really appreciate it. And tell your friends, your relatives, your pets, random people. Just spread the word. If you have any specific feedback... then do get in touch on Twitter. I'm at Samaya Keynes. And I'm at Chad Bowne. And we're on at trade underscore underscore talks. That's not one, but two underscores. At trade underscore underscore talks.
Because when it comes to increasing trade policy uncertainty, threatening to blow up one free trade agreement just wasn't enough. What? So there's not just TPP, but NAFTA and Chorus and... Yeah, no, I got the number thing. It just wasn't that funny.