Is Trade Good or Bad for the Environment? Sorting Out the Causality Jeffrey Frankel and Andrew Rose Review of Economics and Statistics NBER Working Paper 9201 (2002)

Theoretical Precedents Environmental Kuznets Curve literature – Inverted-u shaped relationship between pollution and income Pollution Haven Hypothesis – strict regs in rich countries shift polluting industry to poor countries Factor Endowments Hypothesis – relatively capital-rich countries export pollution intensive goods Porter Hypothesis – strict environmental regulation promotes trade Politics and Environment – democracy promotes efficient regulation, openness, and income growth) – as F&R write: “ what if free-market policies are no more important to growth than free-market domestic policies, but tend to be correlated with them? (p.11)

Conclusion Income, openness, emissions are all endogenous

This paper’s goal Determine whether trade and income growth have positive or negative impact on environmental indicators controlling for endogeneity of each.

Equation to be estimated EnvDam - one of the seven measures of environmental damage, ln(y/pop) – log of 1990 real GDP per capita, [X+M]/Y – ratio of nominal X and M to GDP (openness) polity – how democratic is the structure of the government LandArea/pop – per capita land area e – residual representing other causes

Data Dependent variables: cross country data for 1990 for 7 different environmental indicators: – Concentrations in micrograms per cubic meter (averaged across a country’s measuring stations and cities) of SO2, PM, NO2; – industrial CO2 emissions per capita (in metric tons), – average annual percentage change in deforestation for , – energy depletion (=unit resource rents x physical quantities of fossil fuel energy extracted), – % of rural population with access to clean water

Independent Variables Direct measures: – X+M/Y (ratio of nominal exports + imports/GDP) – natural log of 1990 per capital gdp (real PPP- adjusted) – Polity IV Project indicators of autocratic/democratic nature of gov’t (ranges from -10 to +10 (-10=strongly autocratic, +10=strongly democratic) – ln(land area per capita)

Indirect Measures—Trade Intensity fitted [X+M/Y where fitted[X+M] are predicted by a gravity model. Gravity models regress actual pairwise trade on – log of distance, – log of partner country population, – log of area, – and dummy variables for common language, common land border, and landlocked status.

Source: Frankel and Romer, 1999, “Does Trade Cause Growth” AER p.384.

– “After estimating the gravity model for a large data set on pairwise trade, we aggregate the exponent of the fitted values across bilateral trading partners to arrive at a prediction of total trade for a given country. The correlation between actual trade shares and [the] generated instrument is.72.

(From their working paper:) Initial per capita income Investment Estimates of human capital investment based on primary and secondary schooling enrollment rates Growth rate of population Indirect Measures—Income “other controls”

Source: Frankel & Rose 2002 NBER working paper

Results for NO 2, SO 2, PM

standard errors are largest for PM (not stat sig), then NO2 (moderately stat sig), then SO2 (strongly stat sig).

Results for NO 2, SO 2, PM Openness has neg impact on each type of emissions.

Results for NO 2, SO 2, PM Polity: improved governance has a beneficial effect.

Results for NO 2, SO 2, PM Just in terms of signs, EKC does seem to be present; but, again, isn’t stat sig for PM, and only moderately so for NO2.

Results for NO 2, SO 2, PM IV results: similar to OLS results, with diminished significance levels in some cases.

3A. Results for other environmental measures OLS Beneficial effect of energy depletion and water access CO2: free-rider problem, global externality IV Detrimental effect of openness on CO2 loses significance Beneficial effect of energy depletion becomes significant at 10% level

To summarize The use of IV to correct for simultaneity can make an important difference to some results. Some evidence that openness reduces air pollution; Little evidence that openness causes significant environmental degradation; Exception: carbon dioxide; Supportive of the EKC hypothesis; Positive effect of democracy on environmental quality.

Extensions: Do some countries have a “comparative advantage” in pollution?

Version 1---income High income open countries farm out their polluting production to low income open countries. Test: include interaction term: openness x income. If the Income version of PHH holds, this interaction should have a negative fitted coefficient. Sample Results: (SO2 from Table 6, NBER Working Paper)

Note: sign on interaction term is positive for both IV and OLS! Similarly, they find pos. interaction term for PM, and don’t get stat sig results on interaction terms for the other environmental indicators.

Version 2: Countries endowed with a large supply of environmental quality become pollution havens, exporting dirty goods to more densely populated countries. Test by adding (openness × land area/capita) Result: coefficients are of mixed signs and are insignificant ---no evidence supporting the pollution haven hypothesis.

Version 3 (Factor Endowments Hypothesis): trade may lead to an increase in pollution among the capital- endowed countries and a decrease among the labor- endowed countries. Test by adding (openness × capital/labor) Result: coefficients are of mixed signs and are insignificant

Their conclusions “There is no evidence that poor, land-abundant, or capital-abundant countries use trade to exploit a “comparative advantage” in pollution.”

4. Conclusions This paper models the effect of trade on the environment, controlling for income and other relevant factors. Contribution: address the endogeneity fo income and especially trade (IV drawn from the gravity model) Summary of the results: Trade appears to have a beneficial effect on some measures of env. quality; Little evidence that trade has a detrimental effect overall; Reject the hypothesis of an international race to the bottom driven by trade; No evidence for the pollution haven hypothesis. Trade has an indirect effect on the environment through EKC. The major example where trade and growth may have the detrimental effects feared by environmentalists is CO2.

Caveats Cross-country vs. panel data – Unobserved heterogeneity Number of observations is small – As low as 35 for NO2 in IV estimation. Test of PHE vs FEH? – Income and K/L work in opposite direction, and are correlated If interact only one at a time with openness, may well find statistically insignificant results even if both (PHE and FEH) are acting simultaneously.