Link between trade liberalisation and economic growth

Contents

List of figures

List of tables

1. Introduction

2. Methodology

3. Evolution of restrictions and GDP

4. Percentiles of the restriction variable

5. Correlation between level of restriction and GDP in the continents

6. Independent sample T-test (Hypothesis test)

7. Caveat in the analysis

8. Conclusion

Reference list

Bibliography

Appendix A: Variables and weights of the restriction index

Appendix B: Correlations between index of restriction and GDP in the six continents

Appendix C: Countries with negative correlation between index of restriction and GDP

Appendix D: Independent sample T-tests

Appendix E: Evolution of the index of restriction and the GDP in countries with negative correlations, 1970 - 2007

List of figures

Figure 1: Evolution of the index of restriction

Figure 2: Evolution of the GDP

Figure 3: Relation between restriction and GDP in Oceania

Figure 4: Relation between restriction and GDP in Dem. Rep. Congo

Figure 5: Relation between restriction and GDP in China

List of tables

Table 1: Evolution of restriction and GDP, 1970 - 2007

Table 2: Percentiles of the restriction variable

Table 3: Group Statistics Dem. Rep. Congo

Table 4: Independent Samples Test Dem. Rep. Congo

1. Introduction

One of the great economic debates of all times is whether trade liberalisation or rather protectionism promotes economic growth (Case, Fair and Oster, 2009, p. 710). Ricardo (1955) claims with his theory of comparative advantage that specialisation and free trade benefits all participants. The producers and consumers ostensibly gain access to a wider range of products at lower prices and higher quality, the resources are used more efficiently, and the manufacturers may expand their products and facilities in foreign markets. However, in all times some politicians and market participants have been arguing against free trade and in favour of protection. Trade liberalisation would destroy jobs in non-competitve sectors, infant industries may have no chance to develop and the domestic economy depends to strong on foreign markets. The aim of this report is to discuss the link beween trade liberalisation and economic growth based on data and statistical outcomes.

2. Methodology

Before discussing whether trade liberalisation is effective in promoting economic growth, it is important to define what trade liberalisation actually is, and to justify what methods are used to do this. Without this it is not possible to judge whether it is effective or not. This report uses the index of restriction to trade and investment of the KOF Index of Globalization (Eidgenössische Technische Hochschule Zürich, 2011) to measure the level of trade liberalisation. The larger the value of this index the more liberalised the country is. Appendix A shows on which indices and variables this index is based as well as their weights and definitions. Economic growth is measured by the evolution of the GDP (Gross Domestic Product). Both variables, the index of restriction and the GDP, are available from 136 countries and six continents (Africa, Asia, Europe, North and South America, and Oceania) from 1970 to 2007. These data are analysed with the statistical programme SPSS to calculate several statistical outcomes (evolution, percentiles, correlation, and hypothesis test) in order to support the different arguments for and against trade liberalisation.

3. Evolution of restrictions and GDP

Figure 1 shows the evolution of the index of restriction to trade and investment in the six continents from 1970 to 2007. In all continents the restriction index increased over the 37 years, in particular since 1990. America, Asia and Oceania have currently nearly the same level of liberalisation. However, the restriction index of North and South America increased with on average 75.7% much faster than those of Asia and Oceania. Asia grew by 37.9% and Oceania only by 29.4%. Africa has the lowest level of liberalisation although it rose by 62.9%. Europe has, in contrast, the highest index but it increased only by 30.5%.

Figure 1: Evolution of the index of restriction

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Figure 2 indicates the evolution of the GDP in billions of dollar. The GDP increased as well as the index of restriction in all continents. However, the distribution is much wider. South America had the highest increase with 245.4% while Europe had the lowest with only 54.5%. The GDP of the other continents grew all between 192.4 and 224.9% (see table 1). The highest level of GDP has currently North America followed by Asia and Europe. Asia overtook Europe in 1990. Oceania and South America are in the middle and Africa has the lowest level of GDP although it grew by 224.9%.

Figure 2: Evolution of the GDP

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If both graphs are compared a clear relationship between the level of liberalisation and the growth of GDP can be seen. Those continents with the highest increase of liberalisation (North America, South America, and Africa) had the highest growth of GDP. In contrast, those continents with the lowest increase of liberalisation (Europe, Oceania, and Asia) had the lowest growth of GDP. Table 1 illustrates this positive relationship. However, this does not conclude that trade liberalisation supports economic growth. For example, despite the high level of liberalisation in Europe, the growth is at a low level, and the significant increase of liberalisation in South America in the 1990s did not lead to an equivalent growth in GDP.

Table 1: Evolution of restriction and GDP, 1970 - 2007

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4. Percentiles of the restriction variable

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Table 2: Percentiles of the restriction variable

The table above shows the percentiles of the variable of restriction to trade and investment in the six continents from 1970 to 2007. A percentile is a value of a variable that indicates the percent of a distribution that is equal or below to it (Darby and Goldfinch, 2007, pp 11-12). For example, the 10th percentile is the value equal or below which 10% of the observations may be found. The 50th percentile is the median which indicates the middle value in a data set. 50% of the observations will be above this point and 50% will be below this value (ibid., p. 11).

In the time from 1970 to 2007 Europe had the highest level of liberalisation. Its 90th percentile is 79.3. That means that only 10% of the values are above 79.3 and only 10% are under 62.9 as the 10th percentile is 62.9. The distribution is mainly equal. It ranges from 62 to 82.2. Africa had, in contrast, the lowest level of liberalisation over the 37 years. 40% of the values are under 28.9, only 10% are over 43.2, and the maximum is 46.1. Asia, North and South America and Oceania have nearly all a 90th percentile of 60. However, their distributions are different. Asia and Oceania has a relevant constant evolution. 10% of the restrictions levels are under 45.7 / 48.6 and over 60.2 / 58.4. In contrast the level of liberalisation in North and South America is very volatile. Their 10th percentiles are 35.3 and 35.5 whereas the 90th percentiles are 58.4 and 60. The standard deviations¹ confirm this. Oceania and Asia have a standard deviation of 3.7 and 5.6 while North and South America have one of 9.9 and 11.1.

The table also shows the minimum, maximum and mean of the variable of restriction from 1970 to 2007. They substantiate that Europe has the highest level of liberalisation as it has the highest mean as well as the highest minimum and maximum. Oceania has the second highest mean followed by Asia, South and North America. Africa has the lowest one. Nevertheless, the percentiles tell nothing about the relationship between liberalisation and economic growth. In order to analyse the link between liberalisation and economic growth the two variables have to set into correlation.

5. Correlation between level of restriction and GDP in the continents

In the tables in appendix B the correlation coefficient between the level of restriction and GDP for each of the six continents is indicated. In all continents the correlation between these two variables is very positive. The highest correlation has Oceania with 0.965. This means in 96.5% of the cases the GDP depends positively on the level of restriction. Figure 3 visualises the clear positive association in Oceania. The higher the level of liberalisation, the higher the GDP is. Europe has the lowest correlation with 0.79, however, still a clear positive relationship between liberalisation and GDP. All other continents have a very strong association of over 0.90.

Figure 3: Relation between restriction and GDP in Oceania

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The significance of a relationship is measured by the sig (2-tailed) correlation coefficient. When it is less than 0.05 there is a significant linear relationship (Darby and Goldfinch, 2007, pp. 86-89). In all continents a significant correlation between liberalisation and GDP appears as the sig value is 0.000.

These results confirm the assumption at the beginning that there is a positive link between trade liberalisation and economic growth. There are three main reasons which explain the positive relationship. First, the consumers gain access to a greater variety of products at lower prices and higher quality (Krueger, 1998; Gerber, 2005, p. 88-89). Relative expensive domestic products are replaced by cheaper products from countries which enjoy a comparative advantage² in the production of these products. Hence, the consumers have more money left to spend and to increase their welfare what is positive for the domestic economy. But also the trade partner benefits from free trade because its exports grow and it receives therefore more money.

Second, manufaturers could benefit from free trade because they gain as well as consumers access to cheaper and a wider range of inputs for their products (Thirlwall, 2000, p. 9). As a result, resources are used more efficiently as the move out of inefficient production (from industries with a comparative disadvantage) and into efficient production (to industries with a comparative advantage). Thus, the economy becomes more efficiently, i.e. it can produce more output for any given level of resources and technology. This greater efficiency increases eventually the rate of economic growth (Sawyer and Sprinkle, 2006, p. 48).

Third, domestic industries can expand their market and production into new countries (Thirlwall, 2000, p. 9; Gerber, 2005, p. 88-89). They might gain new customers around the wourld and could benefit from cheaper work forces from other countries. Thus, free trade has potential advantages for all market participants and all nations.

Nevertheless, an interesting question is why the correlation coefficient of Europe is so much lower than those of the other continents. The cause could be the convergence theory. The theory states that the growth rates of less developed countries will exceed the growth rates of developed countries due to the diminishing returns³ (Case, Fair and Oster, 2009, p. 665). The trade liberalisation in the developed countries is already at such a high level that an increase of it has not such a big influence to the growth of GDP than it would have in developing countries. The industrialised countries have already reached their steady state.

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¹ The standard deviation indicates how the data are clustered around the mean. A small standard deviation means data points are tightly bunched and a large standard deviation data points are spread apart. (Darby and Goldfinch, 2007, p. 10)

² Comparative advantage is “the advantage in the production of a good enjoyed by one country over another when that good can be produced at lower cost in terms of other goods than it could be in the other country” (Case, Fair and Oster, 2009, p. 699)

³ The law of diminishing returns states that after a certain point, when additional units of a variable input (e.g. trade liberalisation) are added to fixed inputs (e.g. land), the marginal product of the variable input declines (ibid., p. 173).