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North Korea: Witness to Transformation

Gravity Reconsidered

by | July 10th, 2014 | 09:40 am

Last year I did a post on what North Korea’s trade might look like if it were a “normal” country, that is to say exhibited the international trade propensity of a typical country from around the world.  The bottom line was that South Korea is North Korea’s natural partner, and the lack of North-South trade imposes tremendous costs on the North Korean economy.

As I wrote in a subsequent post reviewing some work out of the Asan Institute, “the workhorse gravity model relates the decline in the volume of trade to distance (hence the ‘gravity’ moniker). It is a robust empirical regularities in economics to which theorists have devoted time to trying to justify in formal models…It’s not clear to what extent this empirical regularity is due to transport costs per se, and how much of the decline of trade volume with distance is due to other transactional costs such as cultural or linguistic dissimilarity.”

The model can be used not only to generate counterfactual trade patterns, it can be used to project trade volumes as well. And here the story gets interesting.

If one estimates a standard gravity model and applies it to North Korean trade, the overall volume of trade increases more than seven-fold, demonstrating that despite the run-up in trade volumes in recent years, North Korea still has a long way to go before its international trade behavior converges on the global norm.

Yet even this result may understate the case. Computable general equilibrium modeling work that Sherman Robinson and I did years ago, indicated that with fundamental reform both North Korean national income and its trade propensities would increase substantially, ultimately leading to a more than 20-fold increase in trade, albeit from a more autarkic base than is observed today.

But depending on the scenario, even this explosion in cross-border trade might constitute an underestimate.  Consider what might happen if North Korea became a fully-owned subsidiary of South Korea, as might occur in a German-style collapse and absorption scenario. South Korea “over-trades” according to the norm of our gravity model. In recent years, trade predicted on international norms between the US and South Korea is only 20 – 30 percent the size of real observed bilateral flows. In a collapse and absorption scenario, it is plausible that the South Korea chaebol, with their worldwide marketing and distribution networks, could be the primary agents of the rehabilitation of the North Korean economy. It would not be implausible to expect their North Korean operations to exhibit similar propensities to trade as their South Korean facilities currently do, and as a consequence, actual trade-at least in the manufacturing sector, mining is a different matter—might exceed any of the model-derived results.

I suppose the lesson in this is that models are useful but it is also important to map them to the scenario under consideration.  In this case, the results for “normal country,” “fundamental reform,” and “South Korean takeover,” differ markedly.