Bilateral Trade and Rational Expectations of Armed Domestic and Interstate Conflict.

In this paper, I examine the effects of interstate and domestic armed conflict on bilateral trade levels. Almost all current research on the relationship between trade and conflict examines only the direct influence of conflict on trade. I argue that this research underestimates the effects of armed conflict on trade and show how both conflict and the belief among economic actors that conflict is likely in the future should depress trade levels. Within a gravity model of bilateral trade, armed violence increases the costs of production and exchange to firms, which reduces the profits of traders. If one also assumes firms are strategic actors that maximize both current and future returns from trade and rational forecasters of future armed conflicts, rational expectations of domestic and interstate conflict will limit bilateral trade among states even in the absence of overt violence. Expectations of future conflicts by firms increase the transportation, transaction, and production costs of trade, reducing the supply of goods to foreign markets. Thus, I propose that contemporaneous trade levels will be negatively related to expectations about future domestic and interstate conflicts as well as existing armed conflict. Using bilateral trade data from 1950-2000, I conduct empirical tests of the hypotheses that domestic and interstate armed conflicts, and expectations of these conflicts, deter bilateral trade. The results provide support for my hypotheses; extant armed conflict and the expectation of future conflict have a statistically significant negative influence on trade levels. Therefore, this research advances our understanding of the trade-conflict relationship by demonstrating both theoretically and empirically how higher expectations about future conflicts can reduce bilateral trade levels. [ABSTRACT FROM AUTHOR]