What happened when two rich countries liberalized trade? Pain, and then gain

The New York Times, "Economic Scene" , January 27, 2005

Economists argue for free trade. They have two centuries of theory and experience to back them up. And they have recent empirical studies of how the liberalization of trade has increased productivity in less-developed countries like Chile and India. Lowering trade barriers, they maintain, not only cuts costs for consumers but aids economic growth and makes the general public better off.

Even so, free trade is a tough sell. "The truth of the matter is that we have one heck of a time explaining these benefits to the larger public, a public gripped by free trade fatigue," the economist Daniel Trefler wrote in an article last fall in The American Economic Review.

One problem, he argued, is that there is not enough research on how free trade affects industrialized countries like the United States and Canada. Another is that research tends to concentrate on either long-term benefits or on short-term costs, instead of looking at both.

"We talk a lot about the benefits of free trade agreements, but when it comes to academics studying it, we know next to nothing in terms of hard-core facts about what happens when two rich countries liberalize trade," Professor Trefler, of the Rotman School of Management at the University of Toronto, said in an interview.

His article, "The Long and Short of the Canada-U.S. Free Trade Agreement," uses detailed data on both Canadian industries and individual companies to address these gaps. (The paper is on his Web site here.) The study looks at the effect of tariff reductions, the simplest kind of liberalization.

Tariffs are usually not considered that significant in developed countries, where many major industries compete without such protection. But, Professor Trefler said, "they're not significant except where they matter."

Before the agreement went into effect in 1989, more than one in four Canadian industries were, in fact, protected by tariffs of more than 10 percent. Those industries included not only businesses known for their protectionism, notably apparel makers, but manufacturers of a wide range of products, from beer and pretzels to coffins, plastic pipes and paper bags.

Before the agreement, imports from the United States faced an average tariff of 8.1 percent and an effective tariff of 16 percent. The effective rate included import taxes on the final product and tariffs paid on raw materials. Someone importing a chair could face a direct tariff on furniture, for example, but could also pay indirect tariffs on wood and upholstery fabric.

Not surprisingly, the Canadian industries that had relied on tariffs to protect them "were hammered" when those barriers disappeared, Professor Trefler said. "They saw their employment fall by 12 percent," he said, meaning one in eight workers lost their jobs. In manufacturing as a whole, the trade agreement reduced employment by 5 percent.

"Employment losses of 5 percent translate into 100,000 lost jobs and strike me as large," he wrote, "not least because only a relatively small number of industries experienced deep tariff concessions."

No wonder free trade agreements touch off so much opposition.

As painful as those layoffs were, however, the job losses were a short-term effect. Over the long run, employment in Canada did not drop, and manufacturing employment remains more robust than in other industrialized countries.

"Within 10 years, the lost employment was made up by employment gains in other parts of manufacturing," Professor Trefler found.

While low-productivity plants shut down, high-productivity Canadian manufacturers not only expanded into the United States but further improved their operations. Along the way, they hired enough new workers to make up for losses elsewhere.

"The average effect of the U.S. tariff cuts on Canadian employment was thus a wash: the employment losses by less-productive firms offset the employment gains by more productive firms," Professor Trefler wrote in an e-mail message, citing further research.

Nor, contrary to predictions, did Canadian wages drop because of competition from less-educated, nonunionized workers in the southern United States. Quite the opposite: using payroll statistics, he found that "for all workers, the tariff concessions raised annual earnings" by about 3 percent over eight years.

Admittedly, that is not a lot. "A 3 percent rise in earnings spread over eight years will buy you more than a cup of coffee, but not at Starbucks," he wrote. "The important finding is not that earnings went up, but that earnings did not go down." In addition, he said, "there is absolutely no evidence" that the trade agreement worsened income inequality.

The big story is that lowering tariffs set off a productivity boom.

Formerly sheltered Canadian companies began to compete with and compare themselves with more-efficient American businesses. Some went under, but others significantly improved operations.

The productivity gains were huge. In the formerly sheltered industries most affected by the tariff cuts, labor productivity jumped 15 percent, at least half from closing inefficient plants. "This translates into an enormous compound annual growth rate of 1.9 percent," he wrote.

But closing plants is not the whole story, or even half of it. Among export-oriented industries, which expanded after the agreement, data from individual plants show an increase in labor productivity of 14 percent. Manufacturing productivity as a whole jumped 6 percent.

"The idea that a simple government policy could raise productivity so dramatically is to me truly remarkable," Professor Trefler said.

And the long-run increase in productivity did not result mostly from shutting down inefficient plants. It came from better operating practices.

"That's not coming from natural selection," he said. "That firm's actually doing business differently."

Thanks in part to the trade agreement, he sees a shift in attitudes among the younger generation of Canadian managers. They are less content to be the best in Canada's relatively small market.

"They're thinking the competition isn't here in Toronto," he said. "The competition is there in the U.S. To succeed in U.S. markets, you have to play like the Americans do, which is innovate and upgrade."