Handbook of International Economics(Vol. IV) —A means to better our understanding of global economy

It has almost been two decades since the Handbook of International Economics, Vol. III, came into libraries enlightening the professional researchers and senior students of economics about the progress of research on trade theory, international finance and macroeconomics of the open economy.

Since then, the global economy has witnessed incredible transformations: one, aided by sweeping technological innovations and the steady opening up of goods and capital markets, the world has witnessed deeper and wider trade and financial integration; two, emerging market economies grew at about 7% per annum on average and within it Asia grew much faster at close to 8% per annum; three, the share of emerging economies in world exports of goods and services doubled between 1990 and 2006; four, powerful economic giants have emerged; five, global economic imbalances reached threatening levels—external asset position of China, Japan and Germany rose to alarming levels, while the external liability of the US ($3.5 tn in 2008) rose to almost 25% of its GDP; six, sovereign debt booms and the resulting debt repayment crisis almost threatened the Euro zone; and, seven, globalization, having put all the countries into one boat, threatened global economic and financial stability via contagion risk—the wounds of Asian crisis of 1997 and the US subprime crisis of 2008 being fresh in mind. Above it, all these changes are cumulatively demanding systematic changes in the policy framework.

As the global economy is passing through these traumatic transformations, researchers in the field of international economics have simultaneously made tremendous “intellectual progress.” Drawing together all these research findings and lucidly presenting the resulting theoretical insights, the Handbook of International Economics – Vol.  IV has been brought out by Elsevier under the editorship of Gita Gopinath, Elhanan Helpman and Kenneth Rogoff. This volume presents multiple perspectives to better our understanding of the core areas of global economy by allocating six chapters to discuss international trade and another six chapters to discuss international macroeconomics—all written by eminent scholars from the respective fields.

In the opening chapter—“Heterogeneous Firms and Trade”—its authors, Marc J Melitz and Stephen J Redding, reviewing the empirical data that has emerged since the 1990s, introduce a general theoretical framework for the ‘firm-heterogeneity’—a new approach as against the ‘sectoral approach’ adopted by neoclassical analysts earlier—in differentiated product markets and through it explain a variety of features exhibited by the data such as performance differences and the differences in the payment of wages between exporters and non-exporters, patterns of within-industry reallocation of resources following trade liberalization, and patterns of trade participation across firms and destination markets. They move on to examine endogenous firm-specific productivity levels. They opine that there is a complementarity between exports and investments in productivity-enhancing avenues, for the payoff from such investments is found to be higher for the exporting firms. Finally, reviewing the recent literature on the impact of trade on wage inequity, the authors conclude that residual wage inequality, which is believed to be a product of the firm heterogeneity, has become the main culprit in generating inequality in earnings.

Moving on to the next chapter—“Multinational Firms and the Structure of International Trade”—we have Pol Antràs and Stephen R Yeaple who, reviewing the current literature on the role of multinational firms in the global trading system, attempt to answer questions such as: “Why do some firms become multinational? How do they select a country to locate their production center? Why do they prefer foreign affiliates?” It is observed that the most productive firms become multinationals operating primarily in capital-intensive and R&D-intensive sectors—preferably parents specialize in R&D while affiliates tend to sell goods in the host countries—while the least productive firms serve the domestic market. It is the differences in factor prices and firm heterogeneity that are found to primarily decide FDI. The chapter offering a detailed discussion about theories of the boundaries of firms and their impact on multinationals draws certain generalizations from the literature: high-productive firms have concentrated more on offshoring, while the most productive among them have gone for FDI. To explain the theoretical contributions of literature on these issues, the authors have also developed focal models, and to facilitate easy identification of similarities and the differences among these models, they have used the same tools and notations across models. They have also re-estimated the econometric models proposed in some of the influential papers with new datasets, perhaps, to provide updated empirical results. 

This is followed by an important chapter—“Gravity Equations: Workhorse, Toolkit, and Cookbook”— that exclusively focuses on the estimation and interpretation of gravity equations solely based on the theoretical foundations for bilateral trade. Beginning with a historical review of the fundamental equation and offering three related definitions, Keith Head and Thierry Mayer proceed to describe a series of theoretical models—representing demand conditions, supply conditions; perfect competition/monopolistic competition; symmetric firms/heterogeneous firms—that yield gravity equations. This is followed by a very useful discussion on the advantages and limitations of alternative methods, including Monte Carlo study of alternative estimators. They also discuss the prominent use of gravity equations in assessing the impact of trade policies such as free trade agreements and currency areas on trade flows duly pointing out the partial and general equilibrium effects. While foreseeing “a great deal of interesting work ahead”, the authors caution the reader not to rely solely on any one method, instead “advocate a tool-kit approach” to establish robustness.

Moving forward, as the very name of the subsequent chapter—“Trade Theory with Numbers: Quantifying the Consequences of Globalization”—indicates, we have Arnaud Costinot and Andrés Rodríguez-Clare showing us how structural gravity equations can be used to quantify the effect of globalization on trade flows. Based on the knowledge gained from reviewing a variety of models that yield gravity equations, the authors conclude that many of them shared the same formulae—proportional decline of the share of spending on a country’s own goods and the elasticity of trade with respect to variable trade costs being the ingredients—for estimating the gains from trade. They have shown the usage of structural gravity models to estimate the impact of trade policies, such as tariffs, via counterfactual analysis. They also discuss how economic factors such as market structure, firm-level heterogeneity, multiple sectors, intermediate goods and multiple factors of production influence the outcome of trade liberalization. They finally wind up the chapter with a discussion on alternative approaches for quantifying the gains from globalization.

In appreciation of the rapidly growing volume of research on the effects of domestic institutions—acting as creators of comparative advantage—on international trade, the Editors have rightly introduced a new chapter, “Domestic Institutions as a Source of Comparative Advantage.” Nathan Nunn and Daniel Trefler did a good job by beginning the chapter with a discussion on how differences in the quality of legal system between two countries with similar technologies and factor prices can result in differing unit costs. Reviewing the accumulated research on the comparative advantages offered by the legal system of a country, the authors conclude that countries with better legal system tend to export relatively more, particularly in contract-intensive sectors. Simultaneously, they bring out clearly the significant methodological issues involved in the analysis. They have also traced the impact of institutions, such as associated with product market, financial market and labor market on comparative advantage. Finally, they have reviewed the literature on the effect of international trade on domestic institutions. Incidentally, the improvements that the Indian capital market witnessed since liberalization of the economy is a good example for the reverse causation emanating from international trade improving domestic institutions.

The final chapter under trade-related matters—“International Trade Agreements”—by Giovanni Maggi begins with a discussion on what essentially motivates a country to go for trade agreement—terms-of-trade theory-based motive, commitments-driven motive, and motive meant for taking advantage of trade policies that impact firm-entry and exit and reallocation of profits across firms and countries—using simple models that mostly factored in political and economic considerations. This is followed by a discussion on designing trade agreements, particularly, in the light of costs such as contracting frictions arising out of contract incompleteness and imperfect enforcement. Maggi also discusses dispute settlement mechanism under WTO. Finally, he addresses the issue of mushrooming of RTAs, tracing the economic and political reasons behind such a proliferation. He then discusses the impact of RTAs on multilateral trade negotiations under WTO. However, the chapter has no straight answer to many challenging questions such as: Why RTAs, though known to be discriminatory in nature vis-a-vis multilateral trade negotiations and are harmful to worldwide efficiency of resource allocation, are being entertained even by the US and Euro zone? Why Doha Round failed? How to eliminate bargain frictions under the demand for agricultural export subsidies, enforcing labor and environmental standards, etc.?

Moving to the next section of the book, International Macroeconomics, we have Ariel Burstein and Gita Gopinath, who, starting their chapter—“International Prices and Exchange Rates”—with a survey on the empirical theoretical developments on the relation between exchange rates and prices under five heads, present a framework to interpret the current empirical evidence. They examine the partial equilibrium problem of a firm and then the impact of exchange rate movements on the pricing of the firm at the boarder and at the consumer level, followed by an analysis of flexible prices and sticky prices. This is followed by aggregation of these prices and examining the implications for aggregate price indices. The focus then shifts to the current research that endogenizes variable markups and pricing to market—including factoring of details such as firm heterogeneity, consumer search and matching, distribution costs and inventories in alternative models, which are supposed to enhance our understanding of the link between exchange rates and prices. Finally, they present a general equilibrium model in which exchange rates and wages are determined by monetary shocks and also evaluate its utility.

The next chapter—“Exchange Rates and Interest Parity”—surveying the current literature since 1995, traces the theoretical and empirical contributions that facilitate determination of nominal exchange rates. Its author, Charles Engel, examines the traditional monetary models where Uncovered Interest Parity (UIP) and rational expectations hold good looked through the lens of the dynamic and stochastic New Keynesian perspective. He then describes the recent empirical tests that can explain and forecast exchange rates both in and out of sample. Moving to the recent developments on the residual term that captures deviations from the UIP, the author attempts to explain it out citing the recent finance-based models of foreign exchange risk premia, heterogeneous private information, deviation from strict rational expectations and other imperfections in capital markets. He then offers an easily learnable framework for several of these models. Interestingly, he concludes his chapter with suggestions for further research by raising provocative but right questions, of which this one stares straight in your face: Where is the convincing explanation for the actual movements in currency values [that we witnessed during 2008-2012]? This incidentally reminds me of an anecdotal theory often heard in dealing rooms: “Dealers never know why prices are moving because they are too busy moving prices.”

Moving on to the next chapter—“Assessing International Efficiency”—we encounter an interesting beginning that entices us stay glued to the articulation, for Jonathan Heathcote and Fabrizio Perri—authors of the chapter—raise challenging questions: “Is the observed allocation of resources across residents in different countries Pareto efficient? Or is it possible for a single government …to devise a mechanism … that improves the welfare of residents in all the countries? If observed allocations are inefficient, how large are the potential welfare gains from improving efficiency?” And that sets the tone for the articulation to follow: departing from the traditional approach to answer these questions, the authors offer a unified framework to assess international efficiency at business cycles frequencies and over long- run as well. In the process, the authors bring forth the interconnectedness between the so called puzzles: cross-country co-movements in consumption, in investment, and co-movement between consumption and the real exchange rate. Finally they conclude: one, over long-run, allocations appear to be inefficient; two, patterns of cross-country co-movement in macro aggregates are consistent with the efficiency; and three, it is difficult to reconcile observed exchange rate dynamics with efficiency, nor could they be reconciled with alternative decentralized asset market structures—a pointer to explicit limit on international risk sharing? The obvious question that the authors raise in the conclusion of their chapter is: Whether specific policy interventions increase efficiency? And in answering this question, they validate a commonsensical argument, of course, with empirical evidence: removal of frictions in international financial markets should increase efficiency.

The next chapter—“External Adjustment, Global Imbalances, Valuation Effects”—begins with Pierre-Olivier Gourinchas and Hélène Rey—its authors—highlighting a few important stylized facts of the new international financial landscape: global imbalances, allocation puzzle, increased cross-border gross flows and positions, their heterogeneity, and the importance of valuation effects to understand their implications for the international monetary and financial system. Their analysis shows that capital flows to countries that enjoy high autarky returns to the capital. And productivity growth is identified as the main determinant of autarky returns in the neoclassical growth model. Which is why the authors infer that capital flows from emerging to advanced economies—a paradox. The authors analyze the current literature on ‘valuation effects’—arising from capital gains/losses resulting from a country’s external portfolio including gains/losses arising out of exchange rate movements—to understand the changes in a country’s net foreign asset position and its quantitative importance for long-term solvency. They conclude by asserting the dangers of contagion inherent to large-scale cross-border holdings, besides highlighting the need for deeper analysis of the international financial landscape.

The next chapter—“Sovereign Debt”—is all about understanding the economics of and the new challenges posed by sovereign debt. Its authors, Mark Aguiar and Manuel Amador, start the chapter with an apt statement: “the defining feature of sovereign debt is the limited mechanism for enforcement”, followed by a summary of current research on sovereign debt, debt-default, debt overhang and debt crisis. Reviewing a set of models, they explain the role of reputations versus legal enforcement mechanisms; the impact of debt overhang on macroeconomic outcomes such as investment, growth, and volatility; the time taking process of graduation to non-frequent defaulter status and the resulting debt overhang and political economy frictions; the possibility of unverifiable shocks in limiting risk-sharing; the vulnerability of self-fulfilling debt crisis; the difficulties involved in timely renegotiating of the debt, and the ability of theoretical models to quantitatively match key empirical patterns.  They conclude stating that more progress is needed on mapping the theoretical models to the data.

Aptly, the editors end the book with a chapter—“International Financial Crises”—wherein its author, Guido Lorenzoni, surveying the recent research on international financial crises, offers theoretical explanations to better our understanding of the global crises. The author first examines the earlier models of currency crisis, highlighting the effect of inconsistent policies adopted by countries with fixed exchange regime on the capital outflows. This is followed by an explanation about speculative attack models of currency crisis. He then describes the crises arising out of shock to the current account emanating from sudden stoppage in capital inflows for exogenous reasons and traces its implication for the real economy as a function of the exchange rate regime. Unlike in the last volume, examining the financial crises— that have today become more an amalgamation of sudden stop in capital flows, banking crisis, and sovereign debt crisis accompanied by currency crisis—both from monetary and fiscal policy fronts, the author explains why countries become vulnerable to crisis such as current account deficit, overvalued exchange rate, and large sovereign debt. He also examines the scope for preventive policies.

As we thus come to the end of the book, a naïve reader like me might end up wondering: What solution do I have for the global financial crisis? Nevertheless, one thing is certain: his economic perception of the underlying reasons for the crisis having been sharpened, he is sure to raise right and piercing questions, and that obviously puts him on the path of answer. Thus, it is a must-have reference book for all those who are engaged in researching India’s economy that is today plagued by widening current account deficit, falling currency, high inflation, not-too-comfortable fiscal deficiencies and a slack in GDP growth for almost last five years. It is no exaggeration to say that this book is an accolade worth having by every front-end researcher, for it offers on a platter the current status of research in international economics. The book is, of course, priced pretty expensively at $150 but it should not deter University libraries to generously make it available that too in sufficient numbers to its aspiring readers. And anything short of it is a disservice to the academia and the economy as well.

Courtesy: IUP Journal of Applied Economics