Endogenous Protection, Trade Negotiations, and the GATT · Endogenous Protection, Trade...

Endogenous Protection, Trade Negotiations, and the GATT

Richard Sherman

Department of Political ScienceMaxwell School of Citizenship and Public Affairs

Syracuse UniversitySyracuse, NY 13244-1090

tel. 315-443-9119fax 315-443-9082

e-mail [email protected]

For helpful discussions and comments on an earlier draft I thank James Caporaso, SteveChan, Thomas A. Dunn, John Odell, Michael Taylor, and three anonymous reviewers.

Abstract

The best existing models of trade policy derive from endogenous protection theory,which explains the tariff as a function of domestic-level demands for protection and ofthe willingness of governments to supply it. Absent from the theory are the international-level processes and institutions that govern trade policy, particularly the GeneralAgreement on Tariffs and Trade. I argue that the GATT, by institutionalizing tradenegotiations, has transformed trade politics from a political market for protection into apolitical contest between exporters and import-competitors. This has severed the tarifffrom macroeconomic fluctuations and weakened the effects of partisanship on tradepolicy. Tariffs in the major trading states respond instead to the tariffs of their mainnegotiating partners. I test this hypothesis in an econometric analysis of tariffs in theUnited States, Japan, and the European Community in the period 1953-1994, findingstrong evidence of tariff interaction and virtually no evidence to support standardendogenous-protection hypotheses.

1

Trade policy in democracies is the result of a competitive political process involving

voters, parties, and organized interest groups. This simple proposition motivates some of

the most successful explanatory models of trade policy to have emerged over the past two

decades, known collectively as endogenous protection theory. Standard models in this

tradition hold that the level of protection is a function of macroeconomic and political

variables, which are construed respectively as indicators of the demand for protection and

of the propensity of governments to supply it.1 Equipped with well-articulated theoretical

foundations and with the support of repeated empirical tests, endogenous protection

theory has emerged as a standard for research on the political economy of trade policy.

Absent from endogenous protection theory's research program, though, is an

examination of the political processes and institutions that govern contemporary trade

policy at the international level––specifically, the institutional system embodied in the

General Agreement on Tariffs and Trade (GATT) and its inheritor, the World Trade

Organization (WTO). This absence is noteworthy in that the GATT was designed to

thwart some of the connections between trade policy and the demand for protection that

are central to endogenous protection theory. The GATT has sought to link together the

tariffs of the major trading states, to bind negotiated tariffs against increase, and to

intervene in domestic political competition by engaging the interests of exporters in an

ongoing process of negotiated liberalization. The GATT/WTO is, at its core, an

1 See, e.g., Baldwin 1985; Bohara and Kaempfer 1991a, 1991b, 1992; Das and Das 1994; Henriques andSadorsky 1994; Krol 1996; Lohmann and O'Halloran 1994; Magee, Brock and Young 1989; Mansfield andBusch 1995; O'Halloran 1994; Salvatore 1987; Takacs 1981.

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institutional effort to sever the connection between protectionist demands and trade

policy.

In this light, endogenous protection theory's success can be seen as a measure of the

GATT system's failure. Anecdotal evidence amply supports the hypothesis that the

GATT has facilitated trade liberalization, but systematic evidence on the determinants of

trade policy points in the other direction: the institution appears to be epiphenomal to the

domestic-level political process that causes variation in the tariff. Since endogenous

protection models have not been tested against an alternative theory that incorporates the

effects of the GATT/WTO on trade policy, it remains an open question whether the

institution has had a significant effect on commercial openness in the major trading

states.

This article examines the effects of international institutionalization on domestic-level

political competition over trade policy. The central argument is that the GATT has

transformed domestic-level trade politics from a simple political market for protection––

one in which protection is available to any group that expends sufficient resources on

lobbying––into a political contest in which exporters and protectionists compete for

influence, pursuing policies that are generally at odds with each other. As the

institutional background against which trade policy is contested, the GATT system has

had three principal effects. First, by linking home and foreign tariffs together through an

ongoing negotiation process, it has motivated organized interest groups in exporting

sectors to lobby for negotiated trade liberalization. Second, it has severed the connection

3

between trade policy and fluctuations in the business cycle, since both exporters and

import competitors respond to macroeconomic conditions by lobbying for favorable (but

opposite) policy changes. Third, due to institutionalized negotiation under GATT rules,

the contest between exporters and import competitors has become biased in favor of

exporters. This has weakened the effect of partisan control of government on trade

policy: regardless of party, the political benefits of protection are increasingly

outweighed by the political benefits available from catering to exporting interests.

The central empirical implication is that the average tariffs of the major trading states

respond to the tariffs of their main negotiating partners in the GATT/WTO, but not to

domestic-level political and economic variables commonly employed in endogenous

protection theory: inflation, unemployment, economic output, and partisan control of

government. I test this hypothesis in an econometric analysis of tariffs in the US, Japan,

and Germany in the period 1953-1994. The results support the hypothesis that the

multilateral system has transformed trade politics: each country's tariff responds

significantly to foreign tariffs, while virtually no connection is found between the tariff

and domestic political and economic conditions.

These results challenge both conventional wisdom and a considerable body of

empirical research on the political economy of trade policy. At the same time, they

address a central controversy in international relations research: the effect of

international institutions on state behavior. The core of the liberal/realist divide in

international relations theory, the controversy concerns the ability of institutions to

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enhance prospects for international cooperation. Despite the effort that has gone into

making the case for international institutions, the systematic evidence supporting claims

of institutional effectiveness is not compelling.2 Endogenous protection theory's

contribution to this controversy comes in the form of empirical results consistent with the

hypothesis that international institutions have no effect on state behavior.

The results reported here strengthen the case for international institutions, at least in

the area of trade policy. I find that the GATT/WTO has succeeded in linking the tariffs

of the major trading states through an ongoing negotiation process and in establishing a

domestic-level political contest that is biased in favor of the proponents of negotiated

liberalization. These effects have been achieved without appreciable surrender of

sovereignty to supranational institutions and without central or hegemonic enforcement

of the institution's rules.3 The global trade institution has not only influenced trade

policy; it has severed the connection between the tariff and the demand for protection.

In the next section, I develop the central argument of the article: that tariff levels in

the major trading states during the GATT/WTO era respond to each other, but not to

domestic-level political and macroeconomic conditions. In the third section, I report the

results of an econometric test of the argument using data on US, Japanese, and German

2 See Keohane and Martin 1995; Kupchan and Kupchan 1995; Mearsheimer 1994, 1995; Ruggie 1995.3 Yarbrough and Yarbrough (1992) offer the view that free trade under the GATT is enforced by ahegemonic state (the US), but their argument is mistaken. GATT agreements are enforced principallythrough self-help measures and multilateral dispute settlement procedures.

5

tariffs from 1953-1994.4 The fourth section discusses issues not taken up in the empirical

analysis (including non-tariff barriers), and it concludes. The appendix provides data

sources and additional details of the econometric analysis.

Political markets, political contests, and negotiated trade policy

The best economic argument against trade protection is that it benefits special

interests at the expense of the economy at large. Alas for the economy, this is also the

best political explanation for why protection exists. The costs of protection are

distributed widely (among consumers and owners of the abundant factor of production),

while its benefits accrue to smaller groups that are more readily organized (firms,

industries, and owners of the scarce factor of production). The collective action problem

facing advocates of trade liberalization is therefore greater than the problem facing

protectionists. Due to the bias in political representation favoring organized groups over

unorganized ones, trade policy––when determined entirely as a domestic matter––tends

to favor protectionists over free traders.

Trade policy in the purely domestic setting resembles a political market: protection is

available at a price (measured in lobbying expenses, campaign contributions, or bribes),

and groups willing to pay the price can expect to receive it. The price of protection and

4The German tariff is used here as a proxy for the European Community's external tariff. See the appendixfor details on data sources.

6

the value of pursuing it are related to political and economic conditions that may be taken

as exogenous: partisan control of government, unemployment, inflation, economic

growth, and other economic indicators. Variation in these exogenous conditions in the

political economy is therefore taken as a likely predictor of the aggregate level of

protection.

While the concept of a political market is intriguing, it is misleading as a metaphor

for contemporary trade politics in the major trading states. On offer on the political

market is not only domestic protection but also its opposite, foreign trade liberalization.

The two are "opposite" in that each comes at the cost of the other: substantial gains in

access to foreign markets require corresponding reductions in domestic trade barriers, and

a rise in domestic protection is likely to be met with a retaliatory response abroad. The

political market for trade policy is thus not a market but a contest, with spoils transferred

from losers to winners.

The market metaphor worked well for trade politics before the GATT because the

losers, being principally unorganized, did not take part in the contest. In his analysis of

the politics of the Smoot-Hawley Tariff Act of 1930, Schattschneider wrote that "the

pressures supporting the tariff [were] made overwhelming by the fact that the opposition

[was] negligible."5 Such was the scale of the protectionist bias in interest-group activity

and influence, argued Schattschneider, that the legislation would have been little different

5 Schattschneider 1935: 285.

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had there been no opposition to it at all.6 The Smoot-Hawley tariff was the result of a

formally democratic process to which only protectionists had effective access.

Some sixty years after Schattschneider's analysis, Congress's actions on the Uruguay

Round agreement indicate that a substantial shift in US trade politics had taken place. In

hearings before the Senate Finance Committee, public witnesses favoring the new GATT

agreement outnumbered the agreement's opponents by more than two to one. Of the

written communications received by the committee, eleven were in favor of the

agreement and only three opposed.7 Not only the traditional beneficiaries of trade

liberalization (importers and import-dependent industries) lined up on the side of the

Uruguay Round agreement. Along with them were industry coalitions such as the US

Chamber of Commerce, the Intellectual Property Committee, and the Alliance for GATT

Now. Eight months after the hearings, substantial majorities of both parties in both

houses of Congress voted to implement the agreement.8

The transformation of the trade policy landscape can be attributed to two institutional

changes. First, the Reciprocal Trade Agreements Act (RTAA) of 1934 delegated

considerable tariff authority from Congress to the President,9 allowing the President to

proclaim negotiated tariff reductions into law without Congressional action (or later,

under fast-track authority, requiring a yes-or-no vote by Congress with no amendments).

Second, the 1947 General Agreement on Tariffs and Trade established an institutional

6 Schattschneider 1935: 109.7 Committee on Finance, US Senate 1994: 66-78, 82-105, 108-30.8 Preeg 1995: 181-183.

8

framework for international negotiations on trade policy. As a result, the tariffs of the

major trading states were linked together: they would rise together as a result of

retaliatory withdrawals of concessions or fall together in consequence of negotiated

reductions. The GATT, including among its members most of the world's industrial

democracies, provided an institutional context in which multilateral negotiations became

routine.

Since domestic protection could be traded away for access to foreign markets, the

benefits of lobbying against protection were no longer spread as thinly as in earlier eras.

Organized interest groups in export sectors could reap concentrated benefits by

advocating negotiated liberalization, and protectionists would have not only to gain

political access but to defeat exporters in a political contest in order to succeed. The

GATT did not extinguish pressure for protection, nor did it abolish the special-interest

politics of trade in favor of a political calculus based on general interests. Instead, it

motivated special interests in exporting sectors to organize and lobby for trade

liberalization.

Gilligan emphasizes the role played by the RTAA in the transformation of US trade

politics.10 While this Depression-era legislation was crucial for American trade policy, it

had no direct effect on other countries' trade laws, nor did it establish an institutional

forum for multilateral negotiations. The RTAA's effects on policy are simple enough to

establish––the average US tariff fell by almost 50% in the decade following the act's

9 See Destler 1995; Gilligan 1997

9

passage––but it is less straightforward to identify independent effects of the RTAA on

interest-group competition. Depression and then war meant that the years between the

RTAA's passage and the origin of the GATT were extraordinary, combining an urgent

Keynesianism with a militarized foreign policy. Viewed through an American lens, the

RTAA marks the transformation of trade politics. From a cross-national perspective, the

creation of the GATT is the decisive moment.

Negotiated trade policy and macroeconomic conditions

The central insight of endogenous protection theory is that the pursuit of protection

by firms, industries, labor unions, and other lobbying groups may be systematically

related to economic and political variables. At the aggregate level, this implies that

macroeconomic conditions have predictable effects on the level of protection.11 Crucial

to these effects is that each independent variable influences the tariff in a single direction

on average. For example, inflation is said to give rise to demands for reductions in tariffs

as a means of taking pressure off prices.12 For the inflation-protection link to survive,

10 Gilligan 1997.11 A variety of endogenous protection theory not considered here deals with the structure of protection.Models of the structure of protection explore the relationship between industry characteristics and industry-level trade barriers in order to assess the relative political influence of sectoral interest groups. See, e.g.,Hansen 1990; Lavergne 1983; Trefler 1993.12 Bohara and Kaempfer 1991a; Lohmann and O'Halloran 1994: 621; Magee, Brock and Young 1989: 188.This argument is problematic, as it requires voters to subscribe to a perverse macroeconomic theory inwhich tax cuts lead to reductions in inflation.

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inflation must influence trade policy in a single direction––in the standard treatment, the

effect must be to reduce protection on average.

The effect of economic aggregates on the demand for protection derives from

variation in the value of lobbying relative to directly productive economic activity. As

the economic return to the directly productive activity of an industry or labor union falls,

the relative value of lobbying for policy rises.13 Since some of this political activity may

be directed toward trade policy, adverse economic conditions can be expected to lead to

demands for changes in the level of protection.

Under negotiated trade policy, though, this logic cuts both ways: just as import

competitors respond to adverse economic conditions by demanding protection, so do

exporters respond by demanding negotiated liberalization in order to gain expanded

access to foreign markets. While the two groups lobby for opposite changes in policy,

aggregate economic conditions have identical effects on their incentives to lobby. To

clarify this point, I briefly consider five variables often employed in endogenous

protection models: the trade balance, inflation, unemployment, exchange rates, and GDP

growth.

The trade balance nicely illustrates the problematic link between macroeconomic

variables and negotiated trade policy. The trade balance simply subtracts imports from

exports, thus indicating in one figure the performance of export industries and of import-

competing industries. In endogenous protection models, a decline in the trade balance is

13 Magee, Brock and Young 1989: 185-186.

11

generally expected to result in a rise in protectionist pressure;14 this follows from the

premise that the trade balance measures the economic fortunes of import competitors.

What it misses is that the trade balance also measures the fortunes of export industries,

which are expected to respond to a declining trade balance by pressing for negotiated

liberalization. By combining exports and imports in one figure, the trade balance also

combines the expected effects on lobbying by protectionist and antiprotectionist groups.

Since the groups lobby for opposite policy changes, the combined effect does not

theoretically influence the tariff in a single direction.

Inflation, unless it is exactly compensated by changes in the exchange rate, harms

producers in both export and import-competing industries. Inflation raises the price of

domestically produced goods––both those produced for export and those produced for the

domestic market––relative to the world price of competing goods. If inflation gives

either group an incentive to lobby for changes in trade policy, then it gives the same

incentive to both groups: import competitors are expected to seek higher tariffs, while

exporters are expected to pursue lower foreign tariffs (and thus, through negotiation,

lower domestic tariffs).

Unemployment, a symptom rather than a cause of industry-level economic woes, has

similar cross-cutting political effects. Either due to its direct effects on workers or as an

indicator of surplus capacity, unemployment reflects poor performance in the economy as

14 Bohara and Kaempfer 1991a; Coughlin, Teerza and Khalifah 1989; Das and Das 1994; Feigenbaum,Ortiz, and Willett 1985; Henriques and Sadorsky 1994; Krol 1996; Magee, Brock and Young 1989: 189-194; Salvatore 1987; Takacs 1981.

12

a whole. If this aggregate economic condition were specific to one group (import

competitors or exporters), it could be expected to exert a unidirectional effect on trade-

policy lobbying. Since this is not generally true, unemployment resembles inflation in its

effects on trade lobbying: if unemployment gives one group an incentive to lobby for

changes in trade policy, then it gives the same incentive to the opposing group.

Exchange rates have been singled out in some recent research as prime motivators of

protectionist political activity.15 This may be true, since an increase in the value of the

home currency causes imports to fall in price relative to domestic substitutes. A highly

valued currency, though, is as harmful to exporters as to import competitors, since it

raises the price of exportable goods relative to the world price of competing products.

Both groups benefit from a cheap currency and are harmed by an expensive one; the

lobbying incentives given to each group by exchange-rate changes are therefore identical.

Endogenous protection models commonly assert that GDP growth exerts a negative

effect on protection.16 This hypothesis suffers from the same defect as the hypothesis

linking protection to the trade balance: slow economic growth harms both import

competitors and exporters, who are expected to lobby for opposite policy changes. By

claiming that governments respond to slow economic growth with tax increases, it also

implies that governments subscribe systematically to a perverse macroeconomic policy.

Still, a psychological model of behavior by voters and politicians may be at work in the

15 Mansfield and Busch 1995; Dornbusch and Frankel 1987.16 Bohara and Kaempfer 1991a, 1991b; Henriques and Sadorsky 1994; Salvatore 1987; Takacs 1981.

13

hypothesis linking GDP growth to the trade balance, and historically it is hardly unheard

of for governments to raise tariffs in response to economic downturns. A simple

bivariate regression of the differenced tariff on the current differenced GDP growth rate

in the United States, Japan, and Germany over the period 1953-1994 yields mixed results.

In the United States, GDP growth exerts a significant positive effect on the tariff; in

Germany, it exerts a significant negative effect; and in Japan, there is no significant

relationship between the two variables.17 Similar regressions using lagged differenced

GDP growth indicate no significant effect on the tariff in any of the three countries.

From a cross-national perspective, GDP growth does not appear to have a systematic,

unidirectional effect on the tariff.

Partisan control of government and the GATT/WTO system

It is sensible to expect that partisan control of government influences trade policy,

since political parties frequently (if decreasingly) take different rhetorical positions on

trade. Unlike macroeconomic effects, partisan effects on the tariff are still theoretically

present under negotiated trade policy; however, they are expected to be weaker than in a

strictly domestic-level trade policy regime. The simplest reason for this is that the

17 In the United States, the coefficient on GDP growth is 0.04 with a White standard error of 0.02,significant at the 0.05 level. In Japan, the coefficient is 0.003 with a standard error of 0.07, (in)significantat the 0.94 level. In Germany, the coefficient is -0.06 with a standard error of 0.02, significant at the 0.05level. The equations for the US and Japan are estimated as AR(1) processes in order to compensate forserial correlation.

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GATT/WTO represents a deliberate effort to bring about negotiated reductions in trade

barriers. Parties in power thus find themselves in an institutional context of trade

diplomacy predisposed toward liberalization. Protectionist and free-trading governments

alike inherit negotiations begun by their predecessors in office, tariffs bound by previous

negotiations, and international rules limiting the protectionist impulse.

Stripped to its essentials, the GATT is a prohibition on three things: the

discriminatory application of trade barriers, the use of most quantitative restrictions, and

the raising of tariffs bound by previous negotiations. Like all systems of international

law, the GATT is imperfect, and its rules are occasionally violated; still, adherence is the

norm rather than the exception for trade in most nonagricultural goods. For an analysis

of partisan effects on the tariff, the binding of tariffs is of central importance: a state can

raise bound tariffs only at the expense of withdrawals of concessions by foreign states.

The cost of such a protectionist move is thus borne directly by the country's export

industries. By the conclusion of the Tokyo Round, industrialized countries had bound

94% of their nonagricultural tariff classifications on average.18 The practical

consequence is a rather extreme restriction on the ability of protectionist parties to raise

tariffs.

Along with tariffs used in administered protection (such as countervailing duties),

unbound tariffs remain available for governments intent on restricting imports. These

instruments, though, contribute only marginally to a country's average tariff, the

18 Preeg 1995: 191

15

dependent variable in most empirical studies of endogenous protection. The strongest

effect that protectionist parties are likely to have on the average tariff comes simply from

doing nothing; that is, stalling in negotiations, withholding concessions, or refusing to

negotiate at all.

This they do. Yet, in a context of negotiated trade policy, these behaviors are not

distinct from what would be expected of a government inclined toward free trade. As

long as there is a political payoff to protection, governments of either free-trading or

protectionist persuasions stand to gain by extracting maximally valuable concessions

from foreign states in exchange for minimally painful domestic concessions. No

negotiator could expect to achieve this objective without playing the role of a hard

bargainer; i.e., without signaling, falsely or otherwise, that her government has

protectionist preferences. For free-trading and protectionist governments alike, giving

the impression of reluctance is part of the process of negotiation. Indeed, analytical

narratives of GATT negotiations give evidence of far less enthusiasm for trade

liberalization than might naively be expected among states convened for exactly that

purpose.19

This does not imply that the negotiating strategies of protectionist and free-trading

governments will exactly converge. It does imply that negotiated outcomes are dyadic

rather than monadic in nature, reflecting the interaction of several states' preferences

rather than the preferences of a single state. A free-trading government may well fail to

19 Dam 1970: 56-78; Grieco 1990; Jackson 1989; Preeg 1970, 1995.

16

negotiate large tariff cuts if its negotiating partners are protectionists; similarly, a

protectionist government may negotiate larger-than-expected tariff cuts if it faces free-

trading states across the negotiating table. Due to the dyadic nature of bargaining

outcomes, negotiated trade policy tends to weaken the relationship between partisan

control of government and the tariff.

Institutionalized negotiations under the GATT have also made trade liberalization less

politically costly (and protection more so) than in the institution's absence. A norm of

reciprocity, in which the major trading states make roughly equivalent cuts in trade

barriers, has governed GATT negotiations since the early 1960s at latest.20 The effect of

reciprocity is to minimize the severity of distributive conflict in trade negotiations, so that

states can expect not to cede more market access than they gain. Table 1 provides

evidence that reciprocity has been at work in trade policy interactions among the United

States, Japan, and Germany during the period 1953-1994. The table gives summary

statistics of the annual difference between the states' differenced tariffs across all three

pairs (US-Japan, US-Germany, and Japan-Germany), along with one-sample t-tests of the

hypothesis that the mean difference in each pair is not equal to zero. In all cases, the null

hypothesis of equal mean tariff changes is clearly accepted.21

20 Dam 1970: 58-78.21 The null hypothesis of equal means is accepted under both directional and directionless forms of the ttests.

17

Table 1. Tests of equality of differenced tariffs across pairs of states, 1953-1994

Variable Mean 95% conf. interval t (H0:mean=0) prob > |t|

∆US tarifft – ∆Japanese tarifft -.072 -.230 .087 -.91 .37

∆US tarifft – ∆German tarifft .043 -.128 .213 .51 .62

∆Japanese tarifft – ∆German tarifft .114 -.108 .336 1.04 .30

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In the absence of the reciprocity restriction, governments in less powerful states

might expect to lose political support through negotiations, having to open their markets

more widely than their stronger negotiating partners. Reciprocity allows weaker states to

gain from negotiations despite their unpromising bargaining positions. For both weak and

strong states, the norm of reciprocity tips the scales of domestic political competition

moderately in favor of exporters: even if reciprocity means that exporters' gains are

exactly offset by import competitors' losses, consumers still gain from tariff reductions.

These arguments suggest that partisan effects on the tariff are weakened, and

macroeconomic effects possibly eliminated, by the GATT/WTO's system of negotiated

trade policy. Each country's tariff responds instead to the tariffs of its main negotiating

partners. Empirically, it is of course possible that macroeconomic conditions, while

stimulating both protectionist and antiprotectionist lobbying, work more strongly in one

direction than the other on average. It is also possible that the GATT/WTO, while

seeking to bias trade policy in a liberalizing direction, has failed to weaken the

connection between partisan preferences and trade policy. These questions can be

resolved only through empirical analysis, the subject of the next section.

An empirical analysis of international and domestic effects on the tariff

An empirical assessment of the hypothesis that a country's tariff responds to the

tariffs of its negotiating partners must confront two related issues. First, the causal

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relationship between the tariffs of, say, Japan and the United States operates in both

directions: the Japanese tariff influences the US tariff because the US tariff influences

the Japanese tariff. Estimating the US tariff as a function of the Japanese tariff thus

raises the econometric problem of endogeneity in the explanatory variables, which is

typically handled by means of instrumental-variables techniques such as two-stage least-

squares (2SLS). The technique requires selection of a set of instrumental variables to

predict the endogenous explanatory variable (in this example, the Japanese tariff) in a

first-stage regression; the predicted values from the first-stage regression are then used as

proxies for the observed values of the endogenous explanatory variable in a second-stage

regression.

The second problem is related to the first and to the theoretical argument presented

above. To generate an appropriate set of instrumental variables for, say, the Japanese

tariff, one must construct a model of the Japanese tariff that fits the data reasonably well.

The difficulty raised by this procedure is that the best existing models of variation in the

tariff are those based on endogenous protection theory, and even those models often fail

to provide a good fit to the data. One of the variables commonly included in

endogenous-protection models––the inflation rate––is included among the instrumental

variables used in the 2SLS estimations I report here, along with other variables that

improve the fit of the first-stage regressions. What makes this procedure reasonable is

that the first-stage regressions in 2SLS estimation are intended only to provide a good fit

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to the data, not to explore or establish the statistical significance of the covariates used to

predict the endogenous explanatory variables.

The data used for the analysis cover three countries (the United States, Japan, and

Germany) and 42 years (1953-94). The data for the main equations include the tariff rate

(measured as 100 × customs revenues divided by imports), producer-price inflation, the

unemployment rate, the real GDP growth rate, political variables, and foreign tariffs. For

Germany and Japan, the political variables are the seat shares (respectively) of the

Christian Democratic Union/Christian Social Union in the Bundestag and of the Liberal

Democratic Party in the Japanese House of Representatives. For the United States, the

political variables are dummies representing the party of the President (1=Republican,

0=Democrat), the majority party in Congress (1=both houses Republican, 0 otherwise),

and split control of Congress (1 if the majority party in the House is not the same as the

majority party in the Senate, 0 otherwise).

These three countries are chosen due to the predominant role played by the US,

Japan, and the European Community in GATT negotiations. Representing large markets

and large shares of world trade, these three have acted as agenda-setters for GATT

negotiating rounds, and the negotiations themselves have centered mainly on issues of

interest to these three actors. The German tariff is used as a proxy for the EC common

external tariff after 1965––that is, the tariff is calculated as 100 × customs revenues

divided by all German imports before 1965; beginning in 1965, imports only from non-

EC member countries are used in calculating the German tariff. The choice of the year

21

1965 is made mainly on statistical grounds. The EC's common market was phased in

over the decade following the 1957 signing of the Treaty of Rome; selecting any given

year as the initial year of the common market is thus somewhat arbitrary.22 Treating

years other than 1965 as the initial year of the common market results in a large jump in

the series in and immediately after the initial year. The size of the apparent one-year

jump in the tariff is minimized when 1965 is chosen as the initial year of the common

market.

Since all three of the tariff series exhibit unit roots, they are differenced once in order

to induce stationarity. The independent variables are also differenced, with one

exception: the US political dummies are kept level, since in differenced form they

measure not partisan control but merely changes from one party to another. The

macroeconomic and political explanatory variables are lagged one period in order to take

account of the delay between demands for policy changes and policy changes themselves.

In the generic equation to be estimated for the three countries, the differenced

domestic tariff is the dependent variable; explanatory variables include the

macroeconomic and political variables discussed above and, in separate equations, each

of the other two countries' current differenced tariffs. The foreign tariffs are not lagged

since the hypothesis linking them to domestic tariffs through GATT negotiations suggests

that they influence each other simultaneously: rather than being determined through

22 Hayes 1993.

22

tacit, tit-for-tat style cooperation, the tariffs are explicitly linked via timetables for

implementation of negotiated reductions.

The first step in the analysis is to generate a set of instrumental variables to estimate

the foreign tariffs in each equation. The instrumental variables are the lagged tariff,

producer-price inflation, and imports in local currency at current prices, all in first

differences. To clarify this with an example: in equations in which the differenced

Japanese tariff appears as an explanatory variable, the instrumental variables include

differenced Japanese inflation, differenced Japanese imports, and the previous year's

differenced Japanese tariff. These instrumental variables were selected through a process

that began with a complete list of standard endogenous-protection variables (inflation,

unemployment, GDP growth, lagged tariffs, and partisan control of government) and then

eliminated variables that failed to contribute substantially to the fit of the first-stage

regressions. Imports were added to the instrument list in order to improve the fit of these

first-stage estimates.

The second step in the analysis is to insure that the domestic tariff is exogenous to the

instrumental variables. To accomplish this, I estimate models in which the domestic

tariff is predicted as a function of domestic political and economic variables, foreign

tariffs, and the instrumental variables. Wald tests are conducted against the null

hypothesis that the coefficients on the instrumental variables are all equal to zero.

Rejection of the null is evidence of failure of exogeneity of the instrumental variables. If

the Wald test indicates a failure of exogeneity, instrumental variables are lagged until the

23

test yields an insignificant statistic (the visible result is that the German inflation rate is

lagged in the first-stage regression of the model predicting the Japanese tariff as a

function of the German tariff). Details of the procedures, along with instrument lists for

each of the 2SLS equations, are provided in the appendix.

In addition to the 2SLS results, I also report results of ordinary-least-squares (OLS)

regressions for each of the six equations. The reason is that the endogeneity problem in

these equations is, with one exception, not severe enough to conclude that 2SLS

estimators are superior to OLS estimators. Tests of the appropriateness of the two

estimators, reported in the appendix, fail in all but one case to reject the joint null

hypothesis that the OLS specification is appropriate and that the instrumental variables

are specified correctly. The exception is the model predicting the US tariff as a function

of the German tariff, where the 2SLS estimator is clearly superior.

Here, the theory implies that one of the explanatory variables (the foreign tariff) is

endogenous to the dependent variable (domestic tariffs). However, from the standpoint

of estimation, the endogeneity problem is in all but one case rather trivial. This is

important because 2SLS estimates can be better or worse than OLS estimates, even in the

presence of theoretical endogeneity in the explanatory variables. The reason is that 2SLS

estimators suffer from finite-sample bias, which becomes worse as the number of

instrumental variables grows larger or as the fit of the instrumental variables to the

endogenous explanatory variable grows poorer.23 Both the OLS and 2SLS estimates

23 Davidson and MacKinnon 1993: 209-42.

24

should therefore be interpreted together as tests of the hypothesis on international vs.

domestic effects on the tariff.

The results are reported in tables 2 through 4. Table 2 reports results for models of

the US tariff using both 2SLS and OLS specifications and including both Japanese and

German tariffs among the explanatory variables. The results demonstrate that both the

Japanese tariff and the German tariff are significant predictors of the US tariff, with

positive coefficients as expected. None of the remaining variables is significant, and

there are no marginal cases of almost-significant predictors among the standard

endogenous-protection variables. These results are common across 2SLS and OLS

regressions. Since equations 2 and 4 exhibit heteroskedasticity, White heteroskedasticity-

consistent standard errors are reported for these equations.

Table 3 reports results of models of the Japanese tariff. The US tariff is highly

significant, with a positive coefficient, in both 2SLS and OLS models. The effect of the

German tariff is not significant in the 2SLS equation but is significant at the 0.06 level in

the OLS regression. All but one of the endogenous-protection variables are insignificant

in all equations; the exception is inflation, which is significant in one of the OLS models

(equation 7). Equations 6 and 8 exhibit heteroskedasticity; White standard errors are

reported for these equations.

In models of the German tariff, a dummy variable is included for the year 1964. This

is done in order to take account of the jump in the tariff series (discussed above) that

25

Table 2. Dependent variable= ∆US tarifft 1953-1994

2SLS Estimates OLS Estimates

(coefficients inboldface type aresignificant at the0.05 level)

Equation 1coefficient(standard error)prob > |t|

Equation 2**coefficient(standard error)prob > |t|



Constant -0.048(0.072)0.51

0.053 (0.145)0.72

-0.042(0.070)0.55

0.013(0.085)0.88

∆Inflationt-1 0.021(0.014)0.14

0.012(0.029)0.67

0.016(0.012)0.21

-0.009(0.019)0.63

∆Unemploymentt-1 0.014(0.049)0.78

0.114(0.084)0.19

0.024(0.047)0.61

0.098(0.059)0.11

∆GDP growth ratet-1 -0.007(0.015)0.65

0.028(0.198)0.71

-0.004(0.015)0.79

0.020(0.018)0.27

President t-1 -0.057(0.096)0.55

0.015(0.198)0.71

-0.066(0.094)0.49

-0.107(0.132)0.42

Congress t-1 0.233(0.199)0.25

0.320(0.274)0.25

0.224(0.195)0.26

0.207(0.250)0.41

Split Congress t-1 0.097(0.127)0.45

0.015(0.162)0.92

0.093(0.125)0.46

0.054(0.644)0.64

∆Japanese tariff t-1 0.496(0.097)<0.0001

0.431(0.063)<0.0001

∆German tariff t-1 0.804(0.318)0.02

0.231(0.115)0.05

adjusted R2 * * 0.56 0.073

F 5.43<0.001

0.980.46

8.50<0.0001

1.460.21

Durbin-Watson 1.94 2.05 1.92 1.66

* R2 is not interpretable in 2SLS models ** White heteroskedasticity-consistent standard errors

26

Table 3. Dependent variable = ∆Japanese tarifft 1953-1994







Constant 0.130(0.088)0.15

0.022(0.151)0.88

0.07(0.070)0.26

0.056(0.100)0.58

∆Inflationt-1 -0.016(0.012)0.21

-0.038(0.026)0.16

-0.025(0.010)0.01

-0.033(0.020)0.10

∆Unemploymentt-1 0.227(0.278)0.42

0.216(0.248)0.39

0.207(0.222)0.36

0.266(0.209)0.21

∆GDP growth ratet-1 -0.0009(0.003)0.76

-0.002(0.003)0.52

-0.001(0.002)0.66

-0.004(0.003)0.20

∆LDP share t-1 -0.025(0.017)0.16

0.0008(0.017)0.96

-0.016(0.014)0.25

0.003(0.016)0.85

∆US tariff t-1 2.254(0.298)<0.0001

1.402(0.187)<0.0001

∆German tariff t-1 0.218(0.578)0.71

0.487(0.249)0.06

adjusted R2* * 0.64 0.21

F 14.35<0.0001

1.990.10

15.80<0.0001

3.220.02

Durbin-Watson 2.00 1.91 2.06 1.89

* R2 is not interpretable in 2SLS models** White heteroskedasticity-consistent standard errors

27

Table 4. Dependent variable = ∆German tarifft 1953-1994







Constant 0.047(0.097)0.63

0.016(0.069)0.82

-0.032(0.072)0.66

-0.066(0.072)0.37

∆Inflationt-1 -0.026(0.031)0.41

-0.014(0.029)0.63

-0.032(0.028)0.27

-0.020(0.021)0.36

∆Unemploymentt-1 -0.032(0.102)0.76

-0.066(0.095)0.50

-0.077(0.090)0.40

-0.075(0.082)0.37

∆GDP growth ratet-1 0.022(0.029)0.46

-0.005(0.024)0.85

0.008(0.026)0.76

0.003(0.024)0.91

∆CDU/CSU share t-1 -0.054(0.034)0.12

-0.016(0.022)0.48

-0.018(0.026)0.51

-0.011(0.022)0.61

1964 dummy -1.672(0.11)<0.0001

-5.167(3.955)0.20

-1.705(0.082)<0.0001

-1.662(0.46)<0.001

∆US tariff t-1 1.571(0.61)0.01

0.520(0.147)0.001

∆Japanese tariff t-1 0.337(0.103)<0.01

0.28(0.102)<0.01

adjusted R2* * 0.32 0.33

F 3.59<0.01

3.48<0.01

4.16<0.01

1.92<0.01

Durbin-Watson 1.97 1.81 2.18 2.07

* R2 is not interpretable in 2SLS models** White heteroskedasticity-consistent standard errors

28

results from selection of a given year (here, 1965) as the initial year of the European

Common Market. The results for the German tariff, reported in Table 4, resemble those

for the US tariff: both of the foreign tariffs have significant positive effects, while none

of the remaining variables is significant (save for the 1964 dummy). As in the US case,

these results are common across 2SLS and OLS regressions. Three of the equations

exhibit heteroskedasticity (equations 9, 10, and 11) and are reported using White standard

errors.

These results provide clear evidence of interaction among the tariffs of the United

States, Japan, and the European Community. Virtually no evidence is found to support

the claims of endogenous protection models linking domestic-level political and

economic variables to the tariff (the lone exception is in the case of Japan, where inflation

appears as a significant predictor of the tariff in one of the OLS equations). Still, in light

of the theory developed above, some care should be used in interpreting the results,

especially those regarding partisan effects. At the theoretical level, there is no reason to

expect that macroeconomic conditions exert systematic, unidirectional effects on the

demand for protection or on the willingness of governments to supply it. The empirical

tests reported in this section can be interpreted as largely rejecting the endogenous-

protection hypothesis relating macroeconomic conditions to the tariff.

Partisan effects, while weakened under negotiated trade policy, are not theoretically

extinguished by it. Partisan influences on the tariff may accumulate over time in a way

that is not perceptible in the systematic lag structure of a regression equation; thus, the

29

empirical results offer somewhat weaker evidence for the absence of partisan effects. For

purposes of the argument developed above, however, the evidence is fairly conclusive.

Endogenous-protection models of the tariff do not survive hypothesis tests against the

theory that the tariffs of the major trading states respond mainly to each other, through

the negotiation process of the GATT/WTO.

Conclusion: tariffs, institutions, and trade policy

The political pressures that influence the tariff have long been of interest in political

economy. Research on the subject has blossomed during the past two decades, due in no

small part to the systematic approach offered by endogenous protection theory. Most

endogenous-protection models, though, have been drawn against a political background

that no longer exists in the major trading states: a domestic-level market for protection

isolated from international politics. The omission of international-level influences has

led to misspecification of political models of tariff formation and to unwarranted

inferences about the effects of macroeconomic and political variables on trade policy.

Developing an accurate model of variation in the tariff is not in itself of fundamental

importance; there is no grave need for a technique that predicts variation in industrial-

country tariffs now standing at something less than 3% on average. Models of trade

policy are useful instead as a means of gaining insight into the political processes that

they represent. At issue in this article is the ability of an international institution to

30

intervene in domestic-level political processes that, left to themselves, yield reliably

deficient outcomes. The results reported here lend credence to the possibility of this type

of intervention. Negotiated trade policy under the GATT/WTO has transformed trade

politics by incorporating international influences and pro-liberalization interest groups

into domestic-level political competition. In doing so it has tied the tariffs of the major

trading states to each other and weakened their connection to traditional indicators of the

demand for protection.

A theory based on the effects of institutionalized negotiation is not the only account

that can be given of postwar trade liberalization. Other explanations focus on ideological

change24, resistance to protection by multinational corporations,25 security alliances

among trading partners,26 or, at further remove, hegemonic stability,27 class coalitions

and regime types,28 and the systemic distribution of capabilities.29 Indeed, Marx of The

Communist Manifesto would instantly recognize a period of trade liberalization––the

destruction of protectionist walls to institute "the one unconscionable freedom"––as an

imperative of capitalist reproduction.

While these broad-gauged theories can account for the interests supporting trade

liberalization, they are several steps away from explaining the political process that

24 Goldstein 1993.25 Milner 1988.26 Gowa and Mansfield 1993.27 Gilpin 1975; Kindleberger 1986; Krasner 1976.28 Rogowski 1989; Verdier 1998.29 Mansfield 1994.

31

causes variation in the tariff. Interests alone do not bring about policy changes, and in

particular they do not resolve the domestic- and international-level collective action

problems that stand in the way of free trade. Broad-gauged theories identify permissive

conditions for trade liberalization without specifying the political mechanisms that bring

it into existence. Though perhaps a strength for the theories' own purposes, this is an

equally great weakness for analysis of the short-term political influences on trade policy.

The political mechanisms that make trade liberalization possible are worthy of

analysis for reasons beyond theory. Endogenous protection theory, responsible for the

best existing models of annual variation in the tariff, draws seemingly credible

connections between macroeconomic conditions and trade protection. In a nutshell, the

theory claims that good economic performance leads to trade liberalization and poor

economic performance to protection. This suggests that trade policy is chained to the

business cycle and that institutions such as the GATT/WTO can do little more than add

friction to the domestic-level causal processes that determine it. If, as I have argued,

institutionalized negotiations can intervene in these domestic-level processes, then the

potential for trade liberalization through international institutions is much greater:

institutions can unchain trade policy from the business cycle and bring about

liberalization despite periods of poor economic performance.

The analysis here has been confined to a single trade policy instrument (tariffs),

rather than to the full range of devices that can be used for protectionist purposes. The

main reason is that data on non-tariff barriers (NTBs) are not adequate for assessing the

32

relative effect of international and domestic effects on protection. The best data source

for NTBs, the United Nations Conference on Trade and Development's NTB inventory,

covers only a short time period and provides little more than a tally of the incidence of

NTBs across industries in a sample of countries.30 Mansfield and Busch put these data to

work in an interesting analysis of statist vs. societal influences on NTBs,31 but data

limitations allow them a sample size of only twenty-eight (a panel of fourteen states

observed in 1983 and 1986) in a model including twelve independent variables. While

such a sample may be appropriate for Mansfield and Busch's purposes, it is clearly

inadequate for the analysis of trade policy interaction across states over time.

The argument developed here suggests that a reconsideration of research on NTBs is

in order. Whether statist or societal in origin, NTBs are commonly depicted as the result

of demands for protection originating at the domestic level. In a narrow sense, this is

definitionally true, but it is misleading as a model of variation in non-tariff barriers to

trade. Industrial-country NTBs typically emerge not merely in response to general

demands for protection, but as measures designed to counteract foreign subsidies or other

export-promoting policies. Agricultural NTBs arose in a context of heavily subsidized

production worldwide.32 The various quota schemes on textiles and apparel culminating

in the Multi-Fiber Arrangement (MFA) were likewise responses to subsidization by new

30 United Nations Conference on Trade and Development 1993: 39-48.31 Mansfield and Busch 1995.32 Dam 1970: 258; General Agreement on Tariffs and Trade 1962: 135 ff.

33

entrants into export markets for these commodities.33 Voluntary export restraints (VERs)

on automobiles, quotas and price floors on steel, market-share arrangements on computer

chips, and most other major NTBs resulted not simply from domestic-level protectionist

pressure but in response to subsidization, state-sponsored dumping, and infant-industry

protection by exporting countries.34 Like tariffs, contemporary industrial-country NTBs

are determined in a political context that includes both domestic and international

influences.

Non-tariff barriers respond not only to policies in exporting countries, but also to each

other. The American voluntary export restraint (VER) on Japanese automobiles led

quickly to similar measures by Canada and the European Community.35 The Multi-Fiber

Arrangement began in 1957 as an American VER on Japanese cotton textiles; within five

years the US was joined by the EC and other European countries in a multi-party system

of import quotas.36 In the 1970s and 1980s, the United States and the EC devised NTBs

on steel that clearly took account of each other's import restrictions; Hufbauer, Berliner,

and Elliott refer to the US and European steel NTBs as a "nascent multi-steel

arrangement."37

More important for the thesis of this article is that NTBs respond to each other in the

trade-liberalizing direction as well as the protectionist one. The Tokyo Round of GATT

33 Hufbauer, Berliner and Elliott 1986; Yoffie 1983.34 Nivola 1993; Levine 1985: 1-25; Crandall 1981: 1-45; Hufbauer, Berliner, and Elliot 1986.35 Jones 1994.36 Yoffie 1983: 43-160.37 Hufbauer, Berliner, and Elliott 1986: 170.

34

negotiations addressed several categories of NTBs, resulting in optional side agreements

that are generally viewed as failures.38 The Uruguay Round negotiations, though,

revisited these issues and, with one major exception (antidumping), effectively resolved

them. The terms of the agreement include tariffication of agricultural NTBs and

elimination of the Multi-Fiber arrangement, along with strengthened rules governing

subsidies, technical barriers to trade, so-called safeguards (including VERs) and several

other types of non-tariff measures. Just as importantly, the negotiations produced much-

strengthened adjudication and enforcement procedures capable of ensuring compliance

with the NTB agreements.39

Trade barriers in any form are political devices designed to satisfy domestic-level

demands; to suggest otherwise would be plainly mistaken. Explaining contemporary

trade barriers without reference to the international politics of trade, though, is at odds

with both logic and evidence. Among the major trading states, trade policy is not

determined in a domestic-level vacuum. Connections between domestic and foreign

trade policy are predictable, explicit, and largely institutionalized. As a result, the

demand for protection is but one of the varieties of pressure brought to bear on states'

trade policies, and protectionist interests must face free-trading interests in a political

contest biased toward liberalization.

38 Grieco 1990; Preeg 1995: 24-27.39 See Organisation for Economic Cooperation and Development 1994; Preeg 1995.

35

The GATT, an institution based rather unabashedly on the self-interest of states, has

proved more successful than seemed likely at its inauguration. The GATT's success

appears to owe less to the specific legal structure that it has imposed on trade than to the

mere fact of its existence. By providing an international market for the exchange of trade

barriers, the institution has undermined domestic-level political markets for protection

and has motivated exporters to demand negotiated liberalization. Through this

mechanism, the institution has internationalized the politics of trade.

36

Appendix: data sources and econometric procedures

Data sources

Tariffs are measured as 100 × customs revenue divided by imports (f.o.b.) in local

currency at current prices. Through 1988, US customs data are taken from B. R.

Mitchell, International Historical Statistics: The Americas 1750-1988 (New York:

Stockton Press, 1993), Japanese customs data from B. R. Mitchell, International

Historical Statistics: Africa, Asia, and Oceania 1750-1988 (New York: Stockton Press,

1995), and German customs data from B. R. Mitchell, International Historical Statistics:

Europe 1750-1988, 3rd edn. (New York, Stockton Press, 1992). After 1988, customs data

are taken from Organization for Economic Cooperation and Development, Revenue

Statistics 1965-1996 (Paris: OECD, 1997). Data on imports are taken from International

Monetary Fund, International Financial Statistics Yearbook (Washington, DC:

International Monetary Fund, 1979 and 1995). German tariff data require disaggregating

German imports into EC and non-EC imports. Data on German imports from EC

members are taken from International Monetary Fund, Direction of Trade Statistics

Yearbook (Washington, DC: International Monetary Fund, various years) and converted

to local currency using average annual exchange rates taken from International Monetary

Fund, International Financial Statistics Yearbook (Washington, DC: International

Monetary Fund, 1979 and 1995).

37

Inflation is calculated as the annual percentage change in the producer price index.

These data are taken from International Monetary Fund, International Financial Statistics

Yearbook (Washington, DC: International Monetary Fund, 1979 and 1995).

GDP is measured in local currency at 1990 prices. For Japan, GNP is used rather than

GDP due to data limitations. The data are taken from International Monetary Fund,

International Financial Statistics Yearbook (Washington, DC: International Monetary

Fund, 1979 and 1995).

Unemployment is measured as the civilian unemployment rate. Through 1959, US

unemployment data are taken from Economic Report of the President (Washington, DC:

US Government Printing Office), various years; Japanese unemployment data are taken

from Nihon Tokei Nenkan (Japan Statistical Yearbook) (Tokyo: Sorifu, Tokeikyoku,

various years), and German unemployment data from B. R. Mitchell, International

Historical Statistics: Europe 1750-1988, 3rd edn. (New York, Stockton Press, 1992).

After 1959, unemployment data are taken from Organisation for Economic Cooperation

and Development, Main Economic Indicators (OECD: Paris, various years).

Political variables differ across countries and are explained in the text. For the United

States, data are taken from US Department of Commerce, Historical Statistics of the

United States (Washington, DC: US Government Printing Office, 1975); Harold Stanley

and Richard Niemi, Vital Statistics on American Politics (Washington, DC:

Congressional Quarterly Press, 1988), and Arthur S. Banks et al. (eds), Political

Handbook of the World: 1995-1996 (Binghamton, NY: CSA Publications, 1996). For

38

Japan, data are taken from Jaap Woldendorp and Chris Cook, The Facts on File Asian

Political Almanac (New York: Facts on File, 1994) and Arthur S. Banks et al. (eds),

Political Handbook of the World: 1995-1996 (Binghamton, NY: CSA Publications,

1996). The seat shares of the Liberal and Democratic parties are combined prior to 1956

to form the LDP seat share figure. For Germany, data are taken from Jaap Woldendorp et

al., Handbook of Democratic Government: Party Government in 20 Democracies (1945-

1990) (Dordrecht: Kluwer Academic Publishers, 1993), and Arthur S. Banks et al. (eds),

Political Handbook of the World: 1995-1996 (Binghamton, NY: CSA Publications,

1996).

Econometric procedures

This section reports goodness-of-fit statistics for regressions of the endogenous

explanatory variables (foreign tariffs) on the instrumental variables, tests of the

exogeneity of the dependent variables to the instrumental variables, and tests of

overidentifying restrictions on the 2SLS models. For brevity I describe each test first and

then collect the results in a table.

For convenience, I refer to the dependent variables (domestic tariffs) as y, the

exogenous explanatory variables as x (with coefficient vectors βx), the endogenous

explanatory variables as z (with coefficients βz), and the instrumental variables as w (with

coefficient vectors βw). Instrumental variables w, listed by equation, are as follows:

39

Equation Instrumental variables

1 ∆Japanese tariff(t-1), ∆Japanese inflation, ∆Japanese imports

2 ∆German tariff(t-1), ∆German inflation, ∆German imports

5 ∆US tariff(t-1), ∆US inflation, ∆US imports

6 ∆German tariff(t-1), ∆German inflation(t-1), ∆German imports

9 ∆US tariff(t-1), ∆US inflation, ∆US imports

10 ∆Japanese tariff(t-1), ∆Japanese inflation, ∆Japanese imports

The goodness-of-fit statistics are unadjusted R2 statistics for regressions of the

endogenous explanatory variables on x and w. The purpose of these first-stage

regressions is to maximize R2 while not including too many instrumental variables and

while insuring the exogeneity of domestic tariffs to the instrumental variables.

The exogeneity tests are derived from the models y = β0 + βxx + βzz + βww + ε, where

β0 is the constant term. They are Wald tests of the hypothesis that all the elements of βw

are equal to zero. The test results include an F statistic and a chi-squared statistic.

Rejection of the null hypothesis indicates that the dependent variable is endogenous to

the instrumental variables.

The 2SLS models are overidentified, since there are more instrumental variables than

endogenous explanatory variables. The tests of overidentifying restrictions are tests of

the joint null hypothesis that the OLS specification is appropriate and that the

40

instrumental variables are specified correctly; more simply, they are tests of the

hypothesis that the equations can be estimated efficiently by OLS regression. The tests

are conducted as follows: first, z is regressed on x and w, yielding residuals u. Then, the

following model is estimated: y = β0 + βxx + βzz + γu + ε. The test of overidentifying

restrictions is a test of the hypothesis that γ = 0. If the test yields a significant statistic,

then the 2SLS specification is clearly preferred to the OLS specification. If not, the OLS

specification is admissible.

41

Table 5. Goodness-of-fit statistics, exogeneity tests, and tests of overidentifying restrictions in 2SLSequations

Equation

Goodness-of-fit statistics

(R2 of regressions of z on w)

Exogeneity tests (equations y=β0 + βxx + βzz + βww + ε;Η0: βw = 0)

F χ2

prob>F prob> χ2

Tests of overidentifyingrestrictions (estimates of γin equations y = β0 + βxx +βzz + γu + ε)

γ (standard error)prob > |t|

1 .59 2.12 6.360.12 0.10

-0.113 (0.127)0.38

2 .20 1.80 5.400.17 0.14

-0.653 (0.319)0.05

5 .24 0.38 1.140.77 0.77

-0.476 (0.478)0.33

6 .26 1.61 4.820.21 0.19

0.303 (0.652)0.65

9 .33 1.91 5.740.15 0.13

-0.374 (0.533)0.49

10 .50 1.46 4.390.24 0.22

0.102 (0.239)0.63

42

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