What Drives Trade Flows? Mostly Demand, Not Prices

I just participated (for the last time, thank god) in the UMass-New School economics graduate student conference, which left me feeling pretty good about the next generation of heterodox economists. [1] A bunch of good stuff was presented, but for my money, the best and most important work was Enno Schröder’s: “Aggregate Demand (Not Competitiveness) Caused the German Trade Surplus and the U.S. Deficit.” Unfortunately, the paper is not yet online — I’ll link to it the moment it is — but here are his slides.

The starting point of his analysis is that, as a matter of accounting, we can write the ratio of a county’s exports to imports as :

X/M = (m*/m) (D*/D)

where X and M are export and import volumes, m* is the fraction of foreign expenditure spent on the home country’s goods, m is the fraction of the home expenditure spent on foreign goods, and D* and D are total foreign and home expenditure.

This is true by definition. But the advantage of thinking of trade flows this way, is that it allows us to separate the changes in trade attributable to expenditure switching (including, of course, the effect of relative price changes) and the changes attributable to different growth rates of expenditure. In other words, it lets us distinguish the changes in trade flows that are due to changes in how each dollar is spent in a given country, from changes in trade flows that are due to changes in the distribution of dollars across countries.

(These look similar to price and income elasticities, but they are not the same. Elasticities are estimated, while this is an accounting decomposition. And changes in m and m*, in this framework, capture all factors that lead to a shift in the import share of expenditure, not just relative prices.)

The heart of the paper is an exercise in historical accounting, decomposing changes in trade ratios into m*/m and D*/D. We can think of these as counterfactual exercises: How would trade look if growth rates were all equal, and each county’s distribution of spending across countries evolved as it did historically; and how would trade look if each country had had a constant distribution of spending across countries, and growth rates were what they were historically? The second question is roughly equivalent to: How much of the change in trade flows could we predict if we knew expenditure growth rates for each country and nothing else?

The key results are in the figure below. Look particularly at Germany,  in the middle right of the first panel:

The dotted line is the actual ratio of exports to imports. Since Germany has recently had a trade surplus, the line lies above one — over the past decade, German exports have exceed German imports by about 10 percent. The dark black line is the counterfactual ratio if the division of each county’s expenditures among various countries’ goods had remained fixed at their average level over the whole period. When the dark black line is falling, that indicates a country growing more rapidly than the countries it exports to; with the share of expenditure on imports fixed, higher income means more imports and a trade balance moving toward deficit. Similarly, when the black line is rising, that indicates a country’s total expenditure growing more slowly than expenditure its export markets, as was the case for Germany from the early 1990s until 2008. The light gray line is the other counterfactual — the path trade would have followed if all countries had grown at an equal rate, so that trade depended only on changes in competitiveness. When the dotted line and the heavy black line move more or less together, we can say that shifts in trade are mostly a matter of aggregate demand; when the dotted line and the gray line move together, mostly a matter of competitiveness (which, again, includes all factors that cause people to shift expenditure between different countries’ goods, including but not limited to exchange rates.)
The point here is that if you only knew the growth of income in Germany and its trade partners, and nothing at all about German wages or productivity, you could fully explain the German trade surplus of the past decade. In fact, based on income growth alone you would predict an even larger surplus; the fraction of the world’s dollars falling on German goods actually fell. Or as Enno puts it: During the period of the German export boom, Germany became less, not more, competitive. [2] The cases of Spain, Portugal and Greece (tho not Italy) are symmetrical: Despite the supposed loss of price competitiveness they experienced under the euro, the share of expenditure falling on these countries’ goods and services actually rose during the periods when their trade balances worsened; their growing deficits were entirely a product of income growth more rapid than their trade partners’.
These are tremendously important results. In my opinion, they are fatal to the claim (advanced by Krugman among others) that the root of the European crisis is the inability to adjust exchange rates, and that a devaluation in the periphery would be sufficient to restore balanced trade. (It is important to remember, in this context, that southern Europe was running trade deficits for many years before the establishment of the euro.) They also imply a strong criticism of free trade. If trade flows depend mostly or entirely on relative income, and if large trade imbalances are unsustainable for most countries, then relative growth rates are going to be constrained by import shares, which means that most countries are going to grow below their potential. (This is similar to the old balance-of-payments constrained growth argument.) But the key point, as Enno stresses, is that both the “left” argument about low German wage growth and the “right” argument about high German productivity growth are irrelevant to the historical development of German export surpluses. Slower income growth in Germany than its trade partners explains the whole story.
I really like the substantive argument of this paper. But I love the methodology. There is an econometrics section, which is interesting (among other things, he finds that the Marshall-Lerner condition is not satisfied for Germany, another blow to the relative-prices story of the euro crisis.) But the main conclusions of the paper don’t depend in any way on it. In fact, the thing can be seen as an example of an alternative methodology to econometrics for empirical economics, historical accounting or decomposition analysis. This is the same basic approach that Arjun Jayadev and I take in our paper on household debt, and which has long been used to analyze the historical evolution of public debt. Another interesting application of this kind of historical accounting: the decomposition of changes in the profit rate into the effects of the profit share, the utilization rate, and the technologically-determined capital-output ratio, an approach pioneered by Thomas Weisskopf, and developed by others, including Ed WolffErdogan Bakir, and my teacher David Kotz.
People often say that these accounting exercises can’t be used to establish claims about causality. And strictly speaking this is true, though they certainly can be used to reject certain causal stories. But that’s true of econometrics too. It’s worth taking a step back and remembering that no matter how fancy our econometrics, all we are ever doing with those techniques is describing the characteristics of a matrix. We have the observations we have, and all we can do is try to summarize the relationships between them in some useful way. When we make causal claims using econometrics, it’s by treating the matrix as if it were drawn from some stable underlying probability distribution function (pdf). One of the great things about these decomposition exercises — or about other empirical techniques, like principal component analysis — is that they limit themselves to describing the actual data. In many cases — lots of labor economics, for instance — the fiction of a stable underlying pdf is perfectly reasonable. But in other cases — including, I think, almost all interesting questions in macroeconomics — the conventional econometrics approach is a bit like asking, If a whale were the top of an island, what would the underlying geology look like? It’s certainly possible to come up with a answer to that question. But it is probably not the simplest way of describing the shape of the whale.
[1] A perennial question at these things is whether we should continue identifying ourselves as “heterodox,” or just say we’re doing economics. Personally, I’ll be happy to give up the distinct heterodox identity just as soon as economists are willing to give up their distinct identity and dissolve into the larger population of social scientists, or of guys with opinions.
[2] The results for the US are symmetrical with those for Germany: the growing US trade deficit since 1990 is fully explained by more rapid US income growth relative to its trade partners. But it’s worth noting that China is not: Knowing only China’s relative income growth, which has been of course very high, you would predict that China would be moving toward trade deficits, when in fact it has ben moving toward surplus. This is consistent with a story that explains China’s trade surpluses by an undervalued currency, tho it is consistent with other stories as well.

23 thoughts on “What Drives Trade Flows? Mostly Demand, Not Prices”

  1. Great piece. Big fan of accounting decompositions to drive new insights. I'm disappointed that more has not been made of a Keynesian cross on savings propensities like the one below:

    http://neweconomicperspectives.org/2011/06/sector-financial-balances-model-of.html

    Elementary question – is the counterfactual claim about Germany that, based on the trends in income _in the sense of GDP_ alone, Germany 'should' have run a larger surplus?

    If so, this seems an odd conclusion on the basis that running a trade surplus should constitute an injection to GDP?

    1. Some points about Germany:

      1. Germany had (despite the opportunities in East Germany!) a low increase of productivity compared with the EU
      2. Manufacturing wages are, contrary to quite some other EU countries, higher than average wages.
      3. Which, in an European perspective, means that manufacturing wages are relatively high
      4. And wage restraint has been especially prevalent in the state sector (i.e. education).
      5. Domestic demand, as exemplified by retail sales, have been extra-ordinarlily flat during the last 15 years or so, contrary to almost all other EU countries (even today, it still is)
      6. Job growth is surprising and considerable during about the last 4 years, before this period job growth was dismal
      7. The current account surplus vis a vis the EU has declined with about 40 billion Euro during the last two or three years, the surplus with the rest of the world has however increased with about this amount. Which shows that Germany is at the moment exporting its demand restraint policies

      This is all consistent with the views voiced above. An increasing trade surplus is not a boost to the economy when it's caused by lower imports. In that case, it's the consequence of a 'bust' of the economy (which does mitigate the decline in domestic demand caused by lower final expenditure)

      Merijn Knibbe

    2. Elementary question – is the counterfactual claim about Germany that, based on the trends in income _in the sense of GDP_ alone, Germany 'should' have run a larger surplus? If so, this seems an odd conclusion on the basis that running a trade surplus should constitute an injection to GDP?

      The demand measure is expenditure, not GDP, altho I'm pretty sure the results would be the same if you used GDP. And yes, that is the counterfactual — that Germany's low relative growth "should" have meant an even higher surplus, if competitiveness had been unchanged.

      It is true that higher net exports –> higher GDP. But it's also true that higher GDP –> higher imports, i.e. lower net exports. The first relationship is what matters when we are trying to account for GDP growth; the second matters when we are trying to account for changes in trade flows.

  2. Hmmm. I’m starting to hate the visual display of quantitative information.

    So when the dotted line roughly parallels the black line, then changes in trade imbalances are due to demand. And when the dotted line parallels the gray line, then changes in trade imbalances are due to competitiveness (i. e., changing relative wages, productivity, etc).

    But what if the dotted line parallels both the black and the gray? And what if black and gray diverge sharply and dotted just stays flat between them—does that mean that demand and competitiveness are contributing equally, or cancelling out, or that there’s some other factor driving things, or do we just not need to explain flat dotted lines since the trade imbalances aren’t changing?

    Because to me the German dotted line doesn’t look like it strongly moves with either the black or the gray lines, although you could give a small edge to black. Especially in the period after about 2003; the black line rises sharply and the gray line plunges sharply, while the dotted line just stays flat, even when black and gray go through symmetrical jags from 2008.

    The US graph is inconsistent. From 1990 to 1998 dotted parallels both black and gray; from 1998 to 2005 dotted strongly parallels gray; from 2005 to 2008 it strongly parallels black; then back to gray in 2008-10. So the US shows clear competitiveness effects more often than clear demand effects.

    Eyeballing all the graphs on whether they show demand effects or competitiveness effects:
    Canada, clearly demand;
    China, indeterminate;
    France, clearly competitiveness;
    Britain, clearly demand;
    Germany, indeterminate;
    Italy, clearly competitiveness;
    Japan, indeterminate, edge to competitiveness;
    US, all over the map;
    Austria, clearly demand;
    Belgium, indeterminate;
    Spain, clearly demand;
    Finland, clearly competitiveness;
    Greece, clearly competitiveness until 2009;
    Ireland, indeterminate;
    Netherlands, indeterminate;
    Portugal, mainly demand.

    So by my subjective reading, five countries show unambiguous demand dependence, four show unambiguous competitiveness effects, six show a mix or are indeterminate.

    The graphs clearly show that competitiveness sometimes does not drive changes in trade imbalances, and that demand sometimes does; I guess those are important results.

    But the graphs also show that competitiveness is sometimes the dominant factor, and that demand does not explain everything—especially not in the US, where there are major competitiveness effects; or in Greece, where competitiveness effects dominate until 2009; or in Germany, which is a muddle.

    Or am I missing something again? Does the paper present any evidence that doesn’t require eyeballing squiggly lines?

    1. The point with Germany is the gray line falls, meaning that based on competitiveness alone, Germany's trade balance would have moved toward deficit. The black and dotted lines rise, meaning that based on relative income growth alone, the trade balance would have moved toward surplus, as in fact it did. You can see those qualitative results without worrying too much about the specific squiggles.

      The paper does have some results in tables; I'll try to put up an update to this post in the next day or so giving some numerical examples which will hopefully make the logic clearer.

    2. You're right that there is a lot of variation between countries in terms of the relative importance of demand and competitiveness. That's one of the interesting things about it! What's boring about so much of economics is the effort to prove some universal results, which just don't exist for any interesting questions in macroeconomics.

  3. I would be what you call a 'mainstream' economists, although I don't identify with the label. In fact most mainstream economists just call themselves economists. If you had to label mainstream economists then most are reg monkeys at heart who would be classified as utilitarians from a political perspective.

    The biggest difference between mainstreamers and heterodox/Austrians, is that H/A's demand the the world be a certain way. They really want their politics to be validated by economics. As if that is sufficient justification for the correctness of their political philosophy.

    1. Do you REALLY believe that 'mainstream' economists don't demand the world be seen a certain way? That their worldview isn't constricting and doesn't posit any values?

      That seems incredibly naive to me and is part of the problem w/ the economic mainstream – the lack of critical self-awareness.

  4. Fascinating argument that certainly appeals to my Post-Keynesian biases. Quick question though…

    You mention that its mostly demand, not prices driving trade flows. Do you think it's possible to reconcile the story here with a view that institutional factors (e.g. tax policy) prevent demand from having a larger impact on relative prices? In other words, demand's impact on trade flows is exacerbated by measures to reduce price fluctuations.

    1. It's mostly demand driving trade flows for Germany and for some other countries. Competitiveness clearly matters a lot for e.g. China.

      In terms of why competitiveness doesn't matter, there are two broad possible answers. one is that relative price doesn't change much (including, importantly, the case of limited passthrough or pricing to market); the other that demand is relatively inelastic. If the sum of trade elasticities is near 1, then relative price is not going to matter no matter how much it changes. I admit I'm fairly agnostic about the relative importance of these two possibilities; I suspect that both are important.

      Note that competitiveness is broader than price. For instance, I think the most important form of increasing competitiveness in China is a broadening of the range of goods it produces, rather than a reduction in price.

  5. Any hypothesis on why some countries' exports seem more dependent on competitiveness than others?
    The only explanation that I can think of is that some countries trade in stuff that can be easily substituted with internal products and/or exports of other countries, hence they are very sensitive to competitiveness, while other countries trade in stuff that cannot be substituted so easily so competitiveness is not an issue.

  6. JW

    Perhaps I'm being thick, but how is he controlling for the endogeneity & simultaneity here? As in, what about the competing hypothesis that it's the trade surplus that led to the differential growth rates in the first place?

    1. Ritwik. It is not ecoometrics. There is no need to control for anything. How much expenditure grew in each country, and how the distribution of expenditure shifted across countries, are just facts. So there is no need to worry about endogeneity, simultaneity,e tc.

      This is the point I am trying to make at the end — one of the reasons I think accounting decompositions are to be preferred to econometrics is that they do not involve any hypotheses about underlying functions, so issues like this don't come up.

    2. Ok, but then how accurate is it to make a statement like

      "slower income growth in Germany than its trade partners explains the whole story"

      Why not instead say, "the trade surplus fully explains the slower income growth of Germany"

    3. Because the latter statement would not be true.

      Let's imagine two countries, A and B. Initially, total expenditure of each country is 100, of which 80 falls on domestic goods and 20 on the other country's. So each country has balanced trade, with imports=exports=20. If both countries grow at the same rate, and the composition of spending in each country remains the same, trade will continue to be balanced.

      Now, suppose expenditure in country A grows relative to country B, so that after some time expenditure in country A is equal to 150 while in B it is still 100. If the composition of expenditure is unchanged, A will now be spending 120 on domestic goods and 30 on goods from B, while B will still be spending 80 on its own goods and 20 on goods from A. Thus, B will now have a trade surplus of 10, while A will have a deficit of 10. This is what it means to talk about a change in trade balance that is fully explained by a change in income.

      If we observed those changes in income, but found that B had a surplus of only 5, we would say that it had a surplus despite becoming less competitive, i.e. each person is spending a smaller fraction of their income on goods from B, but B still develops a surplus because of the change in the distribution of income across countries.

      Does that make sense?

  7. "But the key point, as Enno stresses, is that both the "left" argument about low German wage growth and the "right" argument about high German productivity growth are irrelevant to the historical development of German export surpluses. Slower income growth in Germany than its trade partners explains the whole story."

    I hope this isn't a stupid question: But is 'low German wage growth' not a major factor in German 'slower income growth'?

    And then, isn't the 'left' argument therefore relevant, especially since raising German income is certainly (?) preferable to reducing others'? In which case, would Krugman's suggestion of inflation in Germany address the imbalance, even if his reasoning is wrong?

    I'm not trying to save Krugman.. just more wondering what the policy prescription of this insight would be.

    Thanks, and great blog!

    1. That's right. Low wages in Germany do contribute to its surplus. But they do so by reducing overall expenditure in Germany, not by making its exports more competitive.

  8. WAIT – don't relative prices play a huge role in relative income growth? It seems that separating expenditure growth from wage growth is mistaken – especially if Germany does not have a massive shortfall in funds for productive investment, which seems highly unlikely…

    If you favor raising expenditure while not increasing wages or making unproductive investment, then I'm unsure of where the expenditure comes from. Non-investment government spending? It is unclear that this would resolve the imbalances, which I think are the result of (household) underconsumption…

    As you say in the most recent comment – low wages in Germany caused a declining household share of GDP, and a declining consumption share of GDP. So by definition, savings rose. Investment rose too – but not by as much, which entails a trade surplus.

    For peripheral europe e.g. spain, you have the mirror process: a less competitive tradable goods sector, and incoming capital (from Germany). So, the choice is unemployment, or unproductive investment i.e. (unsustainable) rising debt and asset prices. Real estate prices soar, debt grows – and there you a have rising consumption and investment; the very overconsumption that is entailed by Germany's underconsumption/exporting of saving. The process is unsustainable.

    The wage story is most important, because it causes the under-expenditure /underconsumption/excess savings that erodes peripheral europe's tradable goods sector while also soaking it with capital to spend on unproductive investment. It is worth noting that the Euro makes it more difficult for Spain to fend of German capital exports.

    So the story of under-expenditure is more specifically underconsumption. (Though it can be good for some developing or 'backwards' countries (i.e. Gerschenk), but temporarily.)

    Where have I gone wrong?

    1. don't relative prices play a huge role in relative income growth?

      Not necessarily, no.

      It seems that separating expenditure growth from wage growth is mistaken

      The point is to separate expenditure growth from the production costs of tradable goods. Wages are an important component of both. The debate is not over whether faster wage growth in Germany would help move intra-European trade toward balance — it would. The debate is by what mechanism.

      If you favor raising expenditure while not increasing wages or making unproductive investment

      Here's the confusion. The position being criticized in this post is that faster wage growth in Germany is desirable because it would raise the relative cost of German goods. I agree that if Europe is going to combine reasonably high growth rates with reasonably balanced trade, German wages must rise. But relative costs are not the reason.

      For peripheral europe e.g. spain, you have the mirror process: a less competitive tradable goods sector

      Assumes facts not in evidence.

      The wage story is most important, because it causes the under-expenditure /underconsumption/excess savings that erodes peripheral europe's tradable goods sector while also soaking it with capital to spend on unproductive investment.

      Right. But this story, which I agree with, does not say anything about competitiveness or relative costs.

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