The free trade sickness

From a new NBER working paper we learn that free trade agreements are like a virus. Yes indeed, FTAs are "contagious" in that countries are more likely to "catch" the free trade bug if a nearby country is already ill. True story... sorta.

Abusing an already over-abused metaphor, the paper mentioned above seeks to explain why new waves of trade liberalization are usually clustered in particular geographic regions.

And you know what? No developing region of the world caught the bug quite as bad as Latin America.

[Developing regions: number of free trade agreements]

One thing to notice: the bug doesn't seem to have been very contagious before 1976. Why?

Well... you see, when the famous British virologist, Dr. Adam Smith, discovered the free-trade virus towards the end of the 18th century it simply wasn't very contagious. Yes indeed, discovered during a brief visit to a pin factory, the virus was seemingly benign and exhibited the potential to improve welfare around the world by causing the infected to divide their labor--but it was very difficult to become infected. Upon further experimentation by Smith's colleague, Dr. David Ricardo, it was discovered that the virus, if capable of infecting entire nations, would cause those infected to specialize in that which they had a comparative advantage in.

Unfortunately, after years of experimental trials, it was concluded that intense and prolonged ideological exposure was necessary for the virus to spread, relegating its existence to the deepest and darkest backwaters of the world economy.

But all of this began to change in the late 20th century when, due to an unknown event, the virus mutated into a highly contagious and extremely dangerous version. During this time countless developing countries fell ill, lowering their tariffs at alarming rates exhibiting a reckless disregard for their national health... and stuff.

Anyway, the moral of the story is that I read dumb academic shit so that you don't have to! Oh, and even frivolous scholarly articles that revolve around silly metaphors sometimes have a grain of interesting information.

The End.

Early warning crisis indicators: truth in orthodoxy?

With the main drama of the world financial crisis behind us policy makers have lent increased urgency to coming up with ways to anticipate and thus prevent future crises. In other words, governments from around the world are looking for improved "early warning indicators" to keep this mess from ever happening again. Because, of course, NO ONE saw this crisis coming, right?

Whatever. The National Bureau of Economic Research has a new working paper out this week taking a fresh look at the early warnings literature. Unlike most papers studying the issue, which focus on particular variables specific to each past crisis in question, this paper approaches the 2008-09 crisis as if it didn't know anything about it before hand--prioritizing the variables most often identified in the past.

The authors, Jeff Frankel and George Saravelos from the Harvard Kennedy School, essentially ask the question: without the benefit of hindsight, would the standard crisis indicators have been able to successfully predict the 2008-09 crisis?

The paper starts with a very thorough review of past empirical studies to identify what indicators have most often been found to be statistically significant crisis predictors. Reviewing over 80 studies, the authors come up with these numbers, presented here courtesy of Maladjusted Charts:

[Number of times found to be statistically significant]

As can be seen above, there's no real shockers in this list as most of the top variables are the usual suspects. Foreign reserves has been found to be statistically significant by 50 different studies, followed by the real exchange rate (48), GDP (25), credit (22) and, of course, the current account (22).

Now, quite naturally, this on its own says more about the state of the economic literature than it does about what variables actually predict crises more accurately. The more orthodox variables have probably been studied for longer and hence more papers have found them significant. Similarly, variables like debt composition and capital flows only began to receive attention in the wake of the Asian crisis and the literature surrounding their role in financial crises has really only picked up in recent years.

So given this conceptual issue, a thorough empirical investigation--using innovative measures of crisis severity and incidence--might give less importance to the orthodox indicators, no? After all, a pattern in recent studies is that traditional indicators like foreign reserves to GDP or real exchange rate overvaluation do not predict crises as powerfully as previously thought.

Well, not so fast the authors of this paper say. After crunching the numbers they find that, without the benefit of hindsight and ignoring the particulars of the 2008-09 crisis, the two variables that predicted it's impact the best were foreign reserves and real exchange rate overvaluation.

Truth in orthodoxy? I wonder... That's really too bad though. I was kinda rooting for debt composition and capital flows.