Worried About a Recession? Don’t Blame Free Trade

This article appeared in World Trade Magazine on June 3, 2008.

Speculation is growing that the U.S. economy may have already slipped into recession. If the past is any guide, politicians on the campaign trail will be tempted to blame trade and globalization for the passing pain of the business cycle. But an analysis of previous recessions and expansions shows that international trade and investment are not to blame for downturns in the economy and may, in fact, be moderating the business cycle.

In recent decades, as foreign trade and investment have been rising as a share of the U.S. economy, recessions have actually become milder and less frequent. The softening of the business cycle has become so striking that economists now refer to it as "The Great Moderation." The more benign trend appears to date from the mid-1980s.

The Great Moderation means that Americans are spending more of their time earning a living in a growing economy and less in a contracting economy. Our economy has been in recession a total of 16 months in the past 25 years, or 5.3 percent of the time. In comparison, between 1945 and 1983, the nation suffered through nine recessions totaling 96 months, or 21.1 percent of that time period.

America's recent experience of a more globalized and less volatile economy has not been unique in the world. Other countries that have opened themselves to global markets have been less vulnerable to financial and economic shocks. Countries that put all their economic eggs in the domestic basket lack the diversification that a more globally integrated economy can fall back on to weather a slowdown. A country that increases trade as a share of its gross domestic product by 10 percentage points is actually about one-third less likely to suffer sudden economic slowdowns or other crises than if it were less open to trade. As the authors of this study concluded:

Some may find this counterintuitive: trade protectionism does not "shield" countries from the volatility of world markets as proponents might hope. On the contrary...economies that trade less with other countries are more prone to sudden stops and to currency crises.

Globalization is not the only possible cause behind the moderation of the business cycle. Improved monetary policy, fewer external shocks (what some economists call "good luck"), and other structural changes in the economy may have all played a role. For example, the decline in unionization and the resulting increase in labor-market flexibility have allowed wages and employment patterns to adjust more readily to changing market conditions, mitigating spikes in unemployment. Better inventory management through just-in-time delivery has reduced the cyclical overhangs that can disrupt production.

Combined with those other factors, expanding trade and globalization have helped to moderate swings in national output by blessing us with a more diversified and flexible economy. Exports can take up slack when domestic demand sags, and imports can satisfy demand when domestic productive capacity is reaching its short-term limits. Access to foreign capital markets can allow domestic producers and consumers alike to more easily borrow to tide themselves over during difficult times.

A weakening dollar has helped to boost exports and earnings abroad, but the main driver of success overseas has been strong growth and lower trade barriers outside the United States. American companies have been earning a larger and larger share of their profits overseas for decades now. According to economist Ed Yardeni, the share of profits that U.S. companies earn abroad has increased steadily from about 5 percent in the 1960s to about a quarter of all profits today.

If the U.S. economy does tip into recession this year, free trade and globalization will be among the likely scapegoats. The pain of recession will be real for millions of American households, but raising barriers to foreign trade and investment will provide no relief for most affected workers. In fact, reverting to protectionism would only reduce the capacity of our economy to regain its footing and resume its long-term pattern of growth.