Trade effects when formation of trade agreements is endogenous

Wolfgang Keller, Carol H Shiue, 19 December 2013

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In the summer of 2013, the EU began negotiations with the US for a preferential trade agreement. Negotiations with Canada are ongoing since 2009 and now in their final leg. The EU has preferential trade agreements with more than 40 countries, some formed in the early 1970s (e.g. with Switzerland since 1973) and others only very recently (e.g. with South Korea since 2011). It is fairly typical to observe early joiners and late joiners to trade agreements. What will these trade agreements do to volume traded and the integration of markets? And what explains this sequence of trade agreement formation?

It turns out that the two questions cannot be independently answered. For the EU-Canada free trade agreement, the EU expects that the value of bilateral trade will increase by around 42%, from around €62 to €88 billion. That increase is a lot higher than the effect of trade agreements on trade estimated by an early paper by Rose (2004) — which was zero. Other research revisiting this result has found that trade agreements do in fact increase trade. Yet a potentially crucial missing component from most of the analyses is the endogenous formation of trade agreements.1

One reasonable hypothesis is that trade agreements with higher returns in terms of the trade they produce are created before agreements with lower returns. If that were the case, a naïve regression approach that pools all these agreements would overstate the true trade agreement effect. However, it is not clear that the return to Nicaragua, for example, which had an agreement with the EU in 2013, was lower than Chile’s return, which had an agreement with the EU ten years earlier. We thus study an environment in which the differences in when and how specific countries decide to join can be identified. This allows us to show that they play an important part for estimating the impact of a trade agreement on trade (Keller and Shiue 2013).

Evidence from the Zollverein

We demonstrate these properties by looking at the evolution of trade agreements in 19th century Europe. The German Zollverein of 1834 was arguably the most important regional free trade agreement of the 19th century. It was the first time that politically independent states removed trade barriers between themselves and delegated tariff-setting authority to a higher body.1

The Zollverein shares with modern day trade agreements and economic unions the feature that membership gradually expanded. Although the year 1834 is the official date of the beginning of the German Zollverein, the actual process occurred over the course of most of the 19th century. In particular, as the membership of the Zollverein under the leadership of Prussia increased in numbers, some German states feared that remaining outside the Zollverein would severely reduce their access to the Northern German sea coast and thus to a large chunk of international trade (Keller and Shiue 2008, Ploeckl 2010). The external border of the Zollverein imposed higher costs on the states in Germany's south than on those in the north, because the latter did not have to cross the Zollverein customs border in order to trade internationally from Germany's coast.

In our analysis of the case of 19th century Germany we capture the motives for joining a specific trade agreement - the Zollverein - at a level of detail that is not only unprecedented, but is also targeted to the specific historical context of the agreement.

We compare two estimates:

  • A naïve estimate in which we examine the amount of price convergence after entry into the Zollverein customs union.
  • An estimate in which the Zollverein customs union membership is instrumented by the geographic location of German states relative to their distance to the Northern German sea coast, in accordance with the historical context.

Findings

We find that the latter estimation procedure – which takes into account the endogeneity between price convergence and the timing of when members join – gives an estimate of the impact of the trade agreement that is several times larger than the naïve estimate. The reason for the large difference is that the naïve estimate does not take into account the fact that states that joined the customs union early on were likely to be different from states that would join later, and the differences could systematically change the amount of price convergence.

The example of the Zollverein shows that it is important to examine countries’ characteristics and the sequence of membership. The case of the Zollverein shows that taking into account the particulars of a trade agreement changes significantly the conclusions about the causal effects of a customs union on trade and prices.

As Viner (1950) noted, 'generalisations about the origin, nature, and consequences of unification of tariffs tend to be based mainly or wholly on the German [i.e. Zollverein] experience'. We now know that beyond its significance as a trade agreement, the Zollverein era provides lessons on the impact of economic policy harmonisation on the political cohesion between states that are at the core of today's policy debate, not only in Europe but also at a global level.

References

Baier, S and J Bergstrand (2007), “Do Free Trade Agreements Actually Increase Members.International Trade?”, Journal of International Economics.

Egger, P, M Larch, K E Staub and R Winkelmann (2011), "The Trade Effects of Endogenous Preferential Trade Agreements", American Economic Journal: Economic Policy 3 pp. 113-143.

Keller, W and C H Shiue (2013), “Endogenous Formation of Free Trade Agreements: Evidence from the Zollverein’s Impact on Market Integration”, revised version of CEPR Discussion Paper No. 9387, March.

Keller, W and C H Shiue (2008), "Tariffs, Trains, and Trade: The Role of Institutions versus Technology in the Expansion of Markets", NBER working paper No. 13913.

Ploeckl, F (2010), "The Zollverein and the Formation of a Customs Union", ESH working paper No. 84, Oxford University.

Rose, A (2004), “Do We Really Know that the WTO Increases Trade?”, American Economic Review.

Viner, J (1950), The Customs Unions Issue, New York: Carnegie Endowment for International Peace.


 1 Baier and Bergstrand (2007) and Egger et al. (2011) aim at accounting for the endogenous formation of trade agreements, however they rely mostly on generic country characteristics such as income.

Topics: International trade
Tags: FTAs, trade agreements, Zollverein

Director of the McGuire Center for International Economics and Professor at the University of Colorado-Boulder

Carol H Shiue

Associate Professor, Department of Economics, University of Colorado at Boulder

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