Natural disasters and the effect of trade on income: A new panel IV approach

Natural disasters affect bilateral trade. We use this fact to generalize the instrumental variables strategy of Frankel and Romer (1999) to a panel setup. This allows revisiting an old question: Does openness cause per capita GDP? We work with a modified gravity framework in which we interact foreign natural disasters with geography. Predicting the exogenous component of bilateral trade flows and aggregating over trade partners, we obtain a time-varying instrument for multilateral openness of a country. Controlling for constant determinants of income (history, geography) by means of fixed effects, we find a robust positive effect of trade on income. Averaging 0.74, the estimated elasticity is substantially smaller than the one obtained in the cross-section. Poor or non-OECD countries feature a larger elasticity.

► Foreign natural disasters interacted by geography predict bilateral trade changes. ► Aggregation yields a time-varying exogenous instrument for openness. ► The instrument works well in panel regressions explaining countries' income. ► Estimated income-elasticities are much smaller than in usual cross-section. ► The effect of trade on income is larger in poor or non-OECD countries.