On the Endogeneity of International Trade Flows and Free Trade Agreements

For 40 years, the gravity equation has been a workhorse for cross-country empirical analyses of international trade flows and – in particular – the effects of free trade agreements (FTAs) on trade flows. However, the gravity equation is subject to the same econometric critique as early cross-industry studies of U.S. tariff and nontariff barriers and U.S. multilateral imports: trade policy is not exogenous. The potential endogeneity of FTA binary right-hand-side variables motivates developing a theory of FTA determination compatible with the theory of international trade flows. Allowing econometrically for the FTA variable’s potential endogeneity yields striking empirical results: the effect of FTAs on trade flows is quadrupled. Moreover, in the context of our estimation framework which accounts for selection bias, the results suggest that countries that select into FTAs have “chosen well.