ANN ARBOR--There’s been no shortage of trade talk since the Brexit vote and the election of Donald Trump, who wants to rework the North American Free Trade Agreement and has complained about aspects of trade with China.
Though major changes have yet to be made with NAFTA or China, University of Michigan researcher Kyle Handley says that even talk of changes in trade policy carries real economic consequences.
"Politicians can be unpredictable, but businesses need to plan and invest for future policy and demand conditions around the globe on a timeframe that rarely corresponds to the political news cycle," said Handley, assistant professor of business economics and public policy at Michigan’s Ross School of Business.
"To provide some insurance and constrain future policy, one feature of trade agreements like NAFTA are long-term commitments to eschew protectionism and formal channels for dispute resolution. That institutional framework can reduce uncertainty even if actual trade barriers like import tariffs see little change."
Handley and colleague Nuno Limão of the University of Maryland studied U.S. trade with China before and after its entry into the World Trade Organization. The pre-WTO period involved years where China’s status as a temporary most-favored nation trading partner with the U.S. was threatened by politicians for various reasons. Though it never happened, it would have resulted in massive tariff increases for Chinese goods.
That favored nation status uncertainty ended with China’s accession to the WTO in 2001, which was followed by an acceleration in China’s export growth to the U.S.
Handley and Limão built a model to measure and quantify the effects of this policy uncertainty. It captures the interaction between uncertainty and investments in entering new markets by modeling the latter as sunk costs.
They found that China’s ascension to the WTO reduced the threat of a trade war with the U.S. and accounted for more than a third of the export growth between 2000 and 2005. While this decreased U.S. manufacturing sales and employment by more than 1 percent, U.S. consumers saw gains in real income from lower prices and access to new varieties of goods.
The higher prices paid by consumers due to uncertainty were equivalent to a 13-percentage-point tariff increase.
The study’s results suggest that many Chinese companies held back on export investments until the environment was more certain.
Handley’s and Limão’s findings point to the broader role reducing trade uncertainty plays in overall prosperity. For example, if the U.S. unilaterally threatens to abandon or renegotiate all its trade agreements and raises the tariff threat to a level similar to what China faced, U.S. consumers would face considerable costs.
"Events such as Brexit and threats to renegotiate agreements can undermine their value even if they lead to no applied policy change," Handley said.
The study is published in the American Economic Review.
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