From theory to policy with gravitas: A solution to the mystery of the excess trade balances

Bilateral trade balances often play a controversial role in the international trade policy debate. They may reflect hidden and asymmetric (i.e., unfair) trade barriers and/or aggregate trade imbalances due to macroeconomic factors. Several studies give credence to the former argument and argue that standard gravity forces fail to explain observed bilateral trade balances, dubbing this “The Mystery of the Excess Trade Balances”. We solve the mystery and show that the gravity model explains bilateral trade balances well. Our analysis suggests that, on average, there is little room for trade cost asymmetries to lead to bilateral trade imbalances except in certain sectors (e.g., Mining and Services), where the modeling of the direct bilateral trade costs in the gravity model can be improved. We also uncover a new property of the structural multilateral resistances as asymmetric trade costs. This is exactly what solves the mystery.