The Great Trade Collapse: What Caused It and What Does It Mean

The nifty batch analyse What caused it and what does it mean? Richard Baldwin 27 November 2009 public job experient a jerky, severe, and synchronised tip in late 2008 the sharpest in recorded history and deepest since WWII. This ebook written for the grounds patronage ministers gathering for the WTOs Trade Ministerial in Geneva presents the frugals professions received wisdom on the dis think up. dickens dozen chapters, written by leading economists from across the globe, summarise the latest research on the causes of the collapse as advantageously as its consequences and the prospects for recoin truth.According to the emerging consensus, the collapse was caused by the sudden, severe and worldwidely synchronised hold of purchases, especially of durable consumer and investment goods (and their parts and components). The impact was amplified by compositional and synchronicity launchs in which outside(a) bring home the bacon chains tacticed a central role. The gr eat handle collapse occurred mingled with the third quarter of 2008 and the second quarter of 2009. Signs are that it has ended and reco genuinely has begun, but it was huge the steepest decrease of mankind allot in recorded history and the deepest fall since the huge Depression.The can was sudden, severe, and synchronised. A hardly a(prenominal) facts justify the label The spectacular Trade Collapse. It was severe and sudden orbicular mess has dropped onwards three times since WWII but this is by further the gargantuanst. As prefigure 1 shows, globose change flatten for at least three quarters during three of the conceptionwide quoins that guard occurred since 1965 the oil- knock recession of 1974-75, the inflation-defeating recession of 1982-83, and the Tech-Wreck recession of 2001-02.Specifically The 1982 and 2001 drops were comparatively mild, with growth from the previous years quarter reaching -5% at the near. The 1970s font was twice that size, w ith growth stumbling to -11%. Today collapse is much worse for two quarters in a row, world concern flows have been 15% below their previous year levels. The OECD has monthly selective information on its members real dish out for the past 533 months the 7 big(p)gest month-on-month drops among the 533 all occurred since November 2008 ( teach the chapter by Sonia Araujo and Joaquim Oliveira).Figure 1 The great trade collapses in historical thought, 1965 2009 Source OECD Quarterly real trade data. The great trade collapse is non as large as that of the Great Depression, but it is much steeper. It took 24 months in the Great Depression for world trade to fall as far as it degene assess in the 9 months from November 2008 (Figure 2). The latest data in the figure (still somewhat preliminary) suggests a recovery is downstairsway. Figure 2 The great trade collapses vs. the Great Depression Source Eichengreen and ORourke (2009), based on CPB online data for latest.It was synchronis ed All 104 nations on which the WTO reports data experienced a drop in both imports and exports during the second half of 2008 and the first half of 2009. Figure 3 shows how imports and exports collapsed for the EU27 and 10 early(a)wise nations that together account for three-quarters of world trade each of these trade flows dropped by more than 20% from 2008Q2 to 2009Q2 many fell 30% or more. Figure 3 The great trade collapse, 2008 Q2 to 2009 Q2 Sources WTO online database.Figure 4 shows that world trade in well-nigh all product categories were positive in 2008Q2, or so all were negative in 2008Q4, and all where negative in 2009Q1. The categories most marked by supranational return chains (Mechanical and electrical machinery, Precision instruments, and Vehicles) saw some of the biggest drops, and detailed empirics in the chapter by Bems, Johnson and Yi holds that supply chains were hit harder controlling for other factors. The chart, however, shows that the falls were by no m eans extraordinary large in these sectors.Figure 4 All types of goods trade collapsed simultaneously Source Comtrade database. Manufactures and commodities Trade collapsed across the board, but it is principal(prenominal) to distinguish between commodities and manufactures. The collapse in minerals and oil trade started from a boom time and fell faster than total trade (Figure 5). The reason was prices. Food, materials and especially oil experienced a steep put out up in price in early 2008 the boom ended in mid 2008 well before the kinfolk 2008 Lehmans debacle. The price of manufactures, by contrast, was rather steady in this period (Figure 6).Figure 5 The great trade collapse and values Food, oil, and manufactures Source ITC online database. Since food, fuels, and raw materials make up about a quarter of world(a) trade, these price movements had a big impact on aggregate trade figures. Countries myrmecophilous on commodity exports, in limited oil exporters, were among those that experienced the greatest drop in exports (see the chapters Africa by Peter Draper and Gilberto Biacuana, and by Leonce Ndikumana and Tonia Kandiero, and on India by Rajiv Kumar and Dony Alex).The drop in manufactures trade was also massive, but it voluminous mostly quantity reductions. Exporters specialising in durable goods manufactures saw a particularly sharp decline in their exports (see chapters on lacquer by Ruyhei Wakasugi and by Kiyoyasu Tanaka). Mexico, which is both an oil exporter and a participant in the USs manufacturing supply chain, experienced one of the worlds most severe trade slumps (see chapter by Ray Robertson). Figure 6 The great trade collapse and prices Commodity vs. manufactures Source CPB online database. CausesThe great trade collapse was triggered by and helped turn out the spherical economic slump that has come to be called The Great Recession. 1 As the left panel of Figure 7 shows, the OECD nations slipped into recession in this period, with the largest importing markets the US, EU and Japan (the G3) seeing their GDP growth plummet more or less in synch. The US and europium saw negative GDP growth rates of 3 to 4% Japan was hit far worse. Figure 7 The current recession, OECD nations and G3, 2007Q1 2009Q2 Note G3 is US, EU and Japan. Source OECD online data base. wherefore did trade fall so much more than GDP? Given the global recession, a drop in global trade is unsurprising. The question is Why was it so big? The chapter by Caroline Freund shows that during the four large, plazawar recessions (1975, 1982, 1991, and 2001) world trade dropped 4. 8 times more than GDP (also see Freund 2009). This time the drop was far, far larger. From a historical perspective (Figure 8), the drop is astonishing. The figure shows the trade-to-GDP ratio rising steeply in the late 1990s, before stagnating in the new century right up to the great trade collapse in 2008.The rise in the 1990s is explained by a look of factors including t rade liberalisation. A key driver, however, was the establishment of worldwide supply chains (manufacturing was geographically unbundled with various slices of the value-added process being injectd in nearby nations). This unbundling meant that the same value-added cover b secerns several times. In a simple international supply chain, imported parts would be change into exported components which were in turn assembled into final goods and exported again, so the trade figures counted the final value added several times.As we shall see, the presences of these senior highly integrated and tightly synchronised production networks plays an important role in the nature of the great trade collapse (see chapters by Rudolfs Bems, Robert Johnson, and Kei-Mu Yi, and by Andrei Levchenko, Logan Lewis, and Linda Tesar). Figure 8 World trade to world GDP ratio, 1980Q1 to 2009Q2 Source World imports from OECD online data base World GDP based on IMF data. Emerging consensus on the causes Econo mists around the world have been working hard to understand the causes of this unusually large and abrupt shut down of international trade.The dozen chapters in Part II of this book summarise all the key research most of it done by the authors themselves. They do not all agree on all points, but a consensus is emerging. When sales drop sharply and the great trade collapse was a gigantic drop in international sales economists look for demand wounds and/or supply piques. The emerging consensus is that the great trade collapse was mostly a demand shock although supply side factors played some role. The demand shock operated through two distinct but mutually reinforcing channels Commodity prices which tumbled when the rice bubble fall apart in mid 2008 continued to follow world demand in its downward spiral. The price movements and modest demand sent the value and volume of commodities trade diving. The production and exports of manufacturing collapsed as the Lehmans-induced s hock-and-awe caused consumers and firms to wait and see snobby demand for all manner of postpone-able consumption crashed. This second point was greatly amplified by the very particular nature of the demand shock that hit the worlds saving in September 2008. Why so big? This consensus view, however, is incomplete.It raises the question If the trade drop was demand driven, why was the trade drop so much larger than the GDP drop? The answer provided by the emerging consensus is that the nature of the demand shock interacted with compositional and synchronicity rigs to greatly exaggerate the movement of the trade-to-GDP ratio. Compositional effect The compositional effect turns on the peculiar nature of the demand shock. The demand shock was very large, but also focused on a narrow range of domestic value-added activities the production of postponeable goods, consumer durables and investment goods.This demand drop immediately, reducing demand for all related intermediate inputs (p arts and components, chemicals, steel, etc). The compositional-effect argument is founded on the fact that postponeables make up a narrow slice of world GDP, but a very large slice of the world trade (Figure 9). In a nutshell, the common cause of the GDP and trade collapse a sudden drop in the demand for postponeables operated with full push up on trade but diminished force on GDP due to the compositional difference.The large demand shock applied to the near-totality of trade spell only applying to a thin portion of GDP. Here is a simple example. 2 Suppose exports consisted of 90% postponeable (consumer and investment electronics, transport equipment, machinery and their parts and components). GDP, however, consists most of non-tradeables (services, etc). Taking postponeables share in US GDP to be 20%, the pre-crisis situation is When the sales of postponeables slumps by, say, half, the numerator falls much more than the denominator.Assuming that other continues growth in trade and GDP by 2%, the post-crisis trade to GDP ratio is Exports have fallen 44. 8% in this example, while GDP has fallen only 8. 4%. In short, the different composition of trade and GDP, taken together with the specific nature of the demand shock, has resulted in trade falling more than 5 times as fast as GDP. See the chapter by Andrei Levchenko, Logan Lewis, and Linda Tesar for a careful investigation of this logic utilise detailed US production and trade data they find that the compositional effect accounts for most of the US trade drop.The chapter by Joseph Francois and Julia Woerz uses US and Chinese data to argue that the compositional effect is key to apprehension the trade collapse. 3 Figure 9 Composition of world goods trade Source WTO online database for 2007. Synchronicity effect The synchronicity effect helps explain why the great trade collapse was so great in an even more direct manner almost every nations imports and exports fell at the same time. There was no(prenomi nal) of the averaging out that occurred in the three other postwar trade drops. besides why was it so synchronised?There are two leading historys for the remarkable synchronicity. The first concerns international supply chains, the second concerns the ultimate cause of the Great Recession. The profound internationalisation of the supply chain that has occurred since the mid-eighties specifically, the just-in-time nature of these vertically integrated production networks served to coordinate, i. e. rapidly transmit, demand shocks. Even a decade ago, a drop in consumer sales in the US or Europe took months to be transmitted covering to the factories and even longer to reach the suppliers of those factories.Today, Factory Asia is online. Hesitation by US and European consumers is transmitted almost instantly to the entire supply chain, which reacts almost instantly by producing and buying less trade drops in synch, both imports and exports. For example, during the 2001 trade coll apse, monthly data for 52 nations shows that 39% of the month-nation pairs had negative growth for both imports and exports. In the 2008 crisis the figure is 83%. For details on this point, see Di Giovanni, Julian and Andrei Levchenko (2009), Yi (2009), and the chapters by Rudolfs Bems, Robert Johnson, and Kei-Mu Yi, and by Kiyoyasu Tanaka.The second explanation awaits a bit of background and a bit of conjecture (macroeconomists have not arrived at a consensus on the causes of the Great Recession). To understand the global shock to the demand for traded goods, we need a thumbnail sketch of the global crisis. How the subprime crisis became the global crisis The Subprime Crisis broke out in August 2007. For 13 months, the world viewed this as a financial crisis that was mainly restricted to the G7 nations who had mismanaged their monetary and regulatory policy especially the US and the UK.Figure 3 shows that world trade continued growing agait in 2007 and early 2008. The crisis met astasised from the Subprime Crisis to the global crisis in September 2008. The defining routine came when the US Treasury allowed the investment bevel Lehman Brothers to go bankrupt. This shocked the global financial community since they had untrue no major(ip) financial institution would be allowed to go under. Many of the remaining financial institutions were fundamentally bankrupt in an accounting sense, so no one knew who might be next. Bankers stopped modify to each other and credit markets froze.The Lehman bankruptcy, however, was just one of a half dozen impossible events that occurred at this time. Here is a short list of others4 All big investment banks disappeared. The US supply lent $85 billion to an insurance company (AIG), borrowing money from the US Treasury to cover the loan. A US money market fund lost so much that it could not reelect its depositors detonator. US Treasury Secretary Paulson asked the US Congress for three-quarters of a trillion dollars based o n a 3-page proposal he had difficulties in answering direct questions about how the money would fix the problem. The hereto individuation US Securities and Exchange Commission banned short selling of bank stocks to slow the drop in financial institutions stock prices. It didnt work. Daniel Gros and Stephano Micossi (2009) pointed out that European banks were too big to fail and too big to save (their assets were often multiples of the their home nations GDPs) Congress said no to Paulsons ill-explained plan, promising its own version. As commonwealth around the world watched this unsteady and ill-explained behaviour of the US government, a massive feeling of hazard formed.Extensive research in behavioural economics shows that people tend to act in extremely jeopardy averse ways when gripped by hero-worshipfulnesss of the unk right offn (as opposed to when they are faced with risk, as in a game of cards, where all outcomes can be enumerated and assigned a probability). Fall 2008 was a time when people really had no idea what might happen. This is Ricardo Caballeros hypothesis of Knightian Uncertainty (i. e. the fear of the unknown) which has been endorsed by the IMFs chief economist Olivier Blanchard. Consumers, firms, and investors around the world decided to wait and see to hold off on postponeable purchases and investments until they could determine how bad things would get. The delaying of purchases and investments, the redressing of balance sheets and the switching of wealth to the safest assets caused what Caballero has called sudden financial arrest (a conscious credit entry to the usually fatal medical condition sudden cardiac arrest). The fear factor spread across the globe at internet speed. Consumers, firms and investors all feared that theyd find out what capitalism without the capital would be like.They independently, but simultaneously decided to shelf plans for buying durable consumer and investment goods and indeed anything that could be postponed, including expensive holiold age and leisure travel. In previous episodes of declining world trade, there was no Lehman-like event to synchronise the wait-and-see positioning on a global scale. The key points as concerns the trade and GDP collapse As the fear factor was propagating via the electronic press the transmission was global and instantaneous. The demand shock to GDP and the demand shock to trade occurred simultaneously. Postponeable sector production and trade were hit first and hardest. There are a number of indications that this is the right story. First, global trade in services did not, in general, collapse (see the chapter by Aditya Mattoo and Ingo Borchert). Interestingly, one of the hardly a(prenominal) categories of services trade that did collapse was tourism the ultimate postponeable. Second, macroeconomists investigations into the transmission mechanisms operating in this crisis show that none of the usual transmission vectors trade in goods, inter national capital flows, and financial crisis contagion were esponsible for the synchronisation of the global income drop (Rose and Spiegel 2009). Supply-side effects The Lehman-link sudden financial arrest froze global credit markets and spilled over on the specialized financial instruments that help grease the gears of international trade letters of credit and the like. From the earliest days of the great trade collapse, analysts suspected that a lack of trade-credit financing was a contributing factor (Auboin 2009). As the chapter by Jesse Mora and William Powers argues, such supply-side shocks have been important in the past.Careful research on the 1997 Asian crisis (Amiti and Weinstein 2009) and historical bank crises (see the chapter by Leonardo Iacovone and Veronika Zavacka) provide convincing evidence that credit conditions can affect trade flows. The Mora and Powers chapter, however, finds that declines in global trade finance have not had a major impact on trade flows. Wh ile global credit markets in general did freeze up, trade finance declined only clean in most cases. If anything, US cross-border bank financing bounced back earlier than bank financing from other sources.In short, trade financing had at most a moderate role in reducing global trade. Internationalised supply chains are a second potential source of supply shocks. One could sound off that a big drop in demand combined with deteriorating credit conditions might produce general bankruptcies among trading firms. Since the supply chain is a chain, bankruptcy of even a few links could get over trade along the whole chain. The chapters by Peter Schott (on US data), by Lionel Fontagne and Guillaume Gaulier (on French data), and by Ruyhei Wakasugi (on Japanese data) present evidence that such disruptions did not occur this time.They do this by looking at very disaggregated data (firm-level data in the Fontagne-Gaulier chapter) and distinguishing between the so-called intensive and extensi ve margins of trade. These margins decompose changes in trade flows into changes in sales across existing trade traffic (intensive) and changes in the number of such relations (extensive). If the supply-chain-disruption story were an important part of the great trade collapse, these authors should have found that the extensive margin was important.The authors, however, find that the great trade collapse has been primarily driven by the intensive margin by changes in pre-existing trade relationships. Trade fell because firms sold less of products that they were already selling there was very little destruction of trade relationships as would be the case if the extensive margin had been found to be important. This findings may be due to the notion of hysteresis in trade (Baldwin 1988), namely, that large and sunk market-entry costs criminate that firms are reluctant to exit markets in the face of temporary shocks.Instead of exiting, they merely scale back their operations, time la g for better times. Protectionism is the final supply shock commonly broached as a cause of the great trade collapse. The chapter by Simon Evenett documents the rise in crisis-linked protectionist measures. While many measures have been put in place on average, one G20 government has broken its no-protection pledge every other day since November 2008 they do not yet cover a substantial fraction of world trade. Protection, in short, has not been a major cause of the trade collapse so far.Prospects The suddenness of the 2008 trade drop holds out the hope of an as sudden recovery. If the fear-factor-demand-drop was the driver of the great trade collapse, a confidence-factor-demand-revival could equally drive a rapid return of trade to robust growth. If it was all a demand problem, after all, little long-lasting damage leave alone have been done. See the chapter by Ruyhei Wakasugi on this. There are give signs that trade is recovering, and it is absolutely clear that the drop has halted. Will the trade revival continue?No one can know the next path of global economic recovery and this is the key to the trade recovery. It is useful nonetheless to think of the global economic crisis as consisting of two very different crises a banking-and-balance-sheet crisis in the over-indebted advanced nations (especially the US and UK), on one hand, and an expectations-crisis in most of the rest of the world on the other hand. In the US, UK and some other G7 nations, the damage done by the bursting subprime bubble is still being felt.Their financial systems are still under severe strain. Bank lending is sluggish and corporate-debt issuances are problematic. Extraordinary direct interventions by central banks in the capital markets are underpinning the economic recovery. For these nations, the crisis specifically the Subprime Crisis has caused lasting damage. Banks, firms and individuals who over-leveraged during what they thought was the great moderation are now holdin g back on consumption and investment in an attempt to redress their balance sheets (Bean 2009).This could play itself out like the lost decade Japan experienced in the 1990s (Leijonhufvud 2009, Kobayashi 2008) also see the chapter by Michael Ferrantino and Aimee Larsen. For most nations in the world, however, this is not a financial crisis it is a trade crisis. Many have reacted by instituting fiscal stimuli of historic proportions, but their banks and consumers are in relatively good shape, having avoided the overleveraging in the post tech-wreck period (2001-2007) that afflicted many of the G7 economies.The critical question is whether the damage to the G7s financial systems will prohibit a rapid recovery of demand and a restoration of confidence that will re-start the investment engine. In absence of a crystal ball, the chapter by Baldwin and Taglioni undertakes simple simulations that assume trade this time recovers at the pace it did in the past three global trade contraction s (1974, 1982 and 2001). In those episodes, trade recovered to its pre-crisis path 2 to 4 quarters after the nadir.Assuming that 2009Q2 was the bottom of the great trade collapse again an assumption that would require a crystal ball to confirm this means trade would be back on scotch by mid 2010. Forecasts are never better than the assumptions on which they are built, so such calculations moldiness be viewed as what-if scenarios rather than serious forecasts. Implications What does the great trade collapse mean for the world economy? The authors of this Ebook present a remarkable consensus on this.Three points are repeatedly stressed Global trade imbalances are a problem that needs to be tackled. One group of authors (see the chapters by Fred Bergsten, by Anne Krueger, and by Jeff Frieden) sees them as one the root causes of the Subprime Crisis. They worry that allowing them to continue is setting up the world for another global economic crisis. Fred Bergsten in particular argues that the US must get its federal budget deficit in order to avoid laying the carpet for the next crisis.Another group points to the combination of Asian trade surpluses and persistent high unemployment in the US and Europe as a source of protectionist pressures (see the chapters by Caroline Freund, by Simon Evenett, and by Richard Baldwin and Daria Taglioni). The chapter by ORourke notes that avoiding a protectionist backlash will require that the slump ends soon, and that severe exchange rate misalignments at a time of rising unemployment are avoided. Governments should guard against compliancy in their vigil against protectionism.Most authors distinguish the point that while new protectionism to date has had a modest trade effect, things need not persevere that way. The chapter by Simon Evenett is particularly clear on this point. There is much work to be done before economists fully understand the great trade collapse, but the chapters in this Ebook constitute a first bill of exchange of the consensus that will undoubtedly emerge from the pages of scientific journals in two or three years time. Footnotes 1 See Di Giovanni and Levchenko (2009) for evidence on how the shock was transmitted via international production networks. This is drawn from Baldwin and Taglioni (2009). 3 Jon Eaton, surface-to-air missile Kortum, Brent Neiman and John Romalis make similar arguments with data from many nations in an unpublished manuscript go out October 2009. 4 See the excellent timeline of the crisis by the New York Fed. 5 Caballero (2009a, b) and Blanchard (2009). References Auboin, Marc (2009). The challenges of trade financing, VoxEU. org, 28 January 2009. Baldwin, Richard (1988). Hysteresis in Import Prices The Beachhead Effect, American Economic Review, 78, 4, pp 773-785, 1988.Baldwin, Richard and Daria Taglioni (2009). The illusion of improving global imbalances, VoxEU. org, 14 November 2009. Bean, Charles (2009). The Great Moderation, the Great Panic and the Great Contraction, Schumpeter Lecture, European Economic Association, Barcelona, 25 August 2009. Blanchard, Olivier (2009). (Nearly) nothing to fear but fear itself, Economics Focus column, The Economist print edition, 29 January 2009. Caballero, Ricardo (2009a). A global perspective on the great financial insurance run Causes, consequences, and solutions (Part 2), VoxEU. rg, 23 January 2009. Caballero, Ricardo (2009b). Sudden financial arrest, VoxEU. org, 17 November 2009. Di Giovanni, Julian and Andrei Levchenko (2009). International trade, vertical production linkages, and the transmission of shocks, VoxEU. org, 11 November 2009.Freund, Caroline (2009a). The Trade Response to Global Crises Historical Evidence, World Bank working paper. Gros, Daniel and Stefano Micossi (2009). The beginning of the end game, VoxEU. org, 20 September 2008. Kobayashi, Keiichiro (2008). Financial crisis management Lessons from Japans failure, VoxEU. org, 27 October 2008. Leijonhufvud, Axel (2009). No ordinary recession, VoxEU. org, 13 February 2009. Rose, Andrew and Mark Spiegel (2009). Searching for international contagion in the 2008 financial crisis, VoxEU. org, 3 October 2009. Yi, Kei-Mu (2009), The collapse of global trade The role of vertical specialisation, in Baldwin and Evenett (eds), The collapse of global trade, murky protectionism, and the crisis Recommendations for the G20, a VoxEU publication.