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Defining North American Economic Integration North American Agrifood Market Integration: Current Situation and Perspectives Cancun, Mexico May, 2004 Raymond Robertson Defining North American Economic Integration Raymond Robertson Department of Economics Macalester College 1600 Grand Ave. St. Paul, MN 55105 [email protected] Preliminary Draft prepared for the 2004 NAAMIC conference April 13, 2004 Abstract: Economic integration has important implications for growth, producers, and consumers, but definitions and measures of economic integration are numerous and varied. This paper defines economic integration, discusses why integration is important, and evaluates four prominent measures of integration for North America before and after NAFTA. I thank Steven Zahniser and Ron Knutson for very helpful comments and assume all responsibility for any remaining errors. I. Overview "Economic integration" is a term that is often used but rarely defined. In popular contexts, to "integrate" means to "make whole" or to "unite." In the economic context, however, the practical meaning of economic integration is the removal of barriers to commercial exchange. This concept applies to all forms of commercial exchange: goods and services (e.g. buying and selling final goods and services), production (buying, selling, and combining inputs such as materials and capital), and employment. Barriers to commercial exchange can be natural (e.g. mountains, oceans, and distance), cultural (e.g. information, language, and preferences), and political (e.g. borders, tariffs, quotas, and administrative standards). Since human economic activity is synonymous with commercial exchange, falling barriers to exchange define economic integration. Understanding the idea of economic integration may be straightforward, but measuring it is not. The academic literature has identified a wide range of measures that capture various aspects of integration. Of these, the four most frequently used measures are product-level prices, factor markets, trade volumes, and product availability. All four are valuable measures that effectively capture different aspects of economic integration. The differences between the measures suggest that some might be more useful in certain contexts than in others. A comparison between the different measures suggests that the last two might generate the most meaningful insights into North American economic integration because conditions in Mexico, a developing country, are quite different than in Canada and the United States. To motivate the different measures of economic integration, the next section of the paper briefly discusses why economic integration is important. As defined above, 1 economic integration is clearly important for growth, which ultimately determines each country's standard of living. Integration also drives change, which often is difficult and is therefore resisted. These changes directly affect producers and consumers, and therefore it is important to be able to identify the results of measures designed to foster economic integration, like trade agreements. The sections that follow therefore discuss each different measure of integration and what they tell us about integration in North America. II. Introduction: Why integration is important in the Americas Fifty years ago, Latin America and other developing regions were at the peak of Import Substitution Industrialization. Having rejected the open markets and free trade that characterized the world fifty years before, the conventional wisdom suggested that the path to growth and prosperity was to focus inward and rely on government to generate the big push that would lead to development. Exhaustion of the ISI model, the relative success of the export-oriented East Asian countries, and the debt crisis triggered a reconsideration of the closed economy approach. In the mid 1980s and early 1990s Latin America dismantled barriers to trade and enacted sweeping reforms. The goal of these reforms was to integrate the previously closed countries into the world economy. Economic integration is important for total national well-being because it affects aggregate growth. Growth ultimately determines each nation's standard of living. On the macro level, Frankel and Romer (1999) showed that countries that trade more internationally have higher incomes. The World Bank's 1993 report The East Asian Miracle suggested that export promotion strategies explained much of the rapid and sustained growth of the Asian Tigers. European incomes converged as the European 2 countries reduced barriers to trade (Ben-David 1993). These are just three examples of many studies that find a positive link between economic integration and growth.1 Economic integration is also important to individual producers. Exposure to foreign markets is associated with higher rates of innovation within establishments (Alvarez and Robertson, 2004). Bernard and Jensen (1999) find a positive link between firm-level productivity and exposure to foreign markets.2 Integration with world markets increases access to intermediate inputs and ideas that can enhance productivity. Economic integration also increases actual and potential competition, which can be challenging in both positive and negative ways. Firms under competition from more efficient foreign producers often shrink and lay off workers, while others are able to respond aggressively and increase productivity. Growth, innovation, and productivity are not the only potential benefits of trade. Most trade models suggest that the gains from trade are largest for consumers because consumers are able to buy goods more cheaply through imports. The potential size of the gains to consumers is quite large. Bradford and Lawrence (2004), for example, estimate that if markets were integrated, and prices were equalized, then developing countries could experience gains over US$103 billion and developed countries could experience gains over US$450 billion. Lured by the promise of these gains, but frustrated by the stalled Uruguay round, countries pursued regional trade agreements. Europe advanced towards a single currency. In the Americas, several regional trade agreements emerged. Brazil, 1 Of course, these studies have not escaped criticism. There is an ongoing debate about the specific policies that might contribute to growth through economic integration and the importance of other factors, such as institutions, that also affect growth. We discuss this debate later in the paper. 2 Neither of these studies conclusively shows that the causality runs from exporting to higher productivity, and therefore may suggest that more productive firms are the ones that export. 3 Argentina, Paraguay, and Uruguay formed MERCOSUR. The United States, Canada, and Mexico successfully negotiated the North American Free Trade Agreement. Trade agreements soon formed what is now called the "spaghetti bowl" of trade agreements in the Americas (IADB 2002, Estevadeordal and Robertson 2004). The goal of these agreements was to foster integration by lowering various political barriers to commercial exchange. Tariffs and quotas drive wedges between prices. As these barriers fall, holding all other factors constant, prices converge. The agreements also strive to harmonize standards and eliminate other "non tariff" barriers. Lowering these political barriers may also reduce natural barriers as well, such as distance. While obviously not being able to change physical distance, trade agreements that increase the volume of trade can result in falling transportation costs because the average cost of transportation falls as the volume of trade increases (transportation exhibits economies of scale, as Hummels (2004) describes). Therefore, trade agreements could contribute to price convergence over and above the effect of reducing political barriers to trade. These arguments suggest that an obvious metric for measuring integration would be to directly measure transportation costs between two countries. Surprisingly, very few studies directly incorporate transportation costs. Barrett and Li (2002) are one exception, and even they acknowledge that one can never observe all possible transactions costs that contribute to driving a wedge between international prices.3 In the North American case, although about 70% of trade is transported by truck, different goods have different transportation costs related to weight. If one is interested in a particular good, changes in 3 See also Beghin and Fang (2002). 4 transportation costs might be a good way to measure changes in integration, but, at the aggregate level, these comparisons are less straightforward. Even with the added benefit of falling average transportation costs, regional agreements may or may not sufficiently reduce barriers to integration. Nearly 20 years after reforms began, the Inter American Development Bank now reports that Latin Americans are frustrated with the lack of growth and are losing their enthusiasm for reforms. At least two possible explanations could reconcile the lack of success with the findings that trade and growth are linked. First, trade liberalization may be a necessary, but not sufficient, condition for growth. Rodrik and Subramanian (2002) argue that "institutions rule:" protections of property rights, lack of corruption, healthy financial markets, infrastructure, and education may also be necessary conditions for growth. This may be particularly true for Mexico's NAFTA experience (Tornell, Westerman, and Martnez 2004). Another reason is that reforms may not have been completely carried out (Fontaine 2002). In the case of international economic integration, the implication is that agreements that reduce tariffs may not be enough to actually facilitate integration if other, less transparent, barriers take the place of tariffs, quotas, and licenses. Therefore, it makes sense to take a multifaceted approach to understanding, measuring, and evaluating integration. While the academic literature contains several different measures of economic integration,4 I present the measures that have received the most attention - price convergence, factor markets, trade volumes, and product availability 5 – in the next four sections. Schiff and Winters (2003) offer an excellent 4 Studies that discuss how political and legal integration relate to economic integration include Eichengreen (1996) and Echandi (2001). 5 There are several other measures that appear in the literature that are not discussed. Krueger, Salin, and Gray (2002), for example, apply a probabilistic measure that draws on the industrial organization literature that is closely related to the price measures discussed in section III. 5 overview of how regional agreements contribute to these measures. In each section, I discuss the applicability of each measure for measuring integration in North America before and after NAFTA. The final section offers concluding thoughts. II. Price Convergence When trading, buyers and sellers must agree on a price. Therefore, the fundamental mechanism underlying international economic integration is price equalization. Since different countries often use different currencies, economists use the term purchasing power parity (PPP) to discuss comparisons of prices in different currencies. If PPP holds, then currency-adjusted prices are equal across countries. There are three ways to use prices as a metric for integration. The first is a convergence in absolute price levels. After accounting for natural, cultural, and political barriers to trade, price levels of identical products should be equal. The second is to follow price movements over time: prices of similar products should move in similar ways over time in integrated markets, regardless of whether or not the levels of the prices are equal. The third is to examine the range of variation of prices. This approach is based on the idea that prices in integrated markets should exhibit less variation than prices in segmented markets because arbitrage reduces the range in which prices can vary. A growing number of studies use price levels of similar goods in different countries. The focus of these studies ranges from very specific products, such as pesticides in the United States and Canada (Carlson et al. 1999), to a wide range of products over many countries (Bradford and Lawrence 2004). Carlson et al. (1999) find pesticide and herbicide prices differ between North Dakota and Manitoba and attribute these differences to differences in patents, market size, and number of available 6 substitutes. Bradford and Lawrence (2004) also find that price differences in the European Union seem to be large and persistent. Producer prices exhibit differences as large as 20% in adjacent countries and reach 30%-50% between continents. The second approach follows prices over time. There are several variations of this theme. Some papers measure the speed at which prices converge back to some differential. Froot, Kim, and Rogoff (1995) examine deviations from PPP over 700 years and find that deviations are quite persistent. Others suggest that goods in integrated markets should change prices in comparable ways, such as in the same direction and approximately the same time (Xu 2003). Other authors use similar approaches, such as Betts and Kehoe (1991), 6 but the findings are often mixed. Engel and Rogers (1996) employ a third approach. They posit bands that define the range of price movements that do not elicit arbitrage. Price movements out of these bands would invite arbitrage and bring prices back within the bands. Transportation costs increase the range in which prices can fluctuate without attracting competition. Therefore, they suggest that a measure of market integration is the variance of goods between cities. Close cities should have narrow bands because transportation costs are lower, and therefore the overall variance of prices should be a function of distance and market barriers. As market barriers fall, the variance of price movements should also fall to reflect increasing integration.7 6 For readers interested in econometrics, these studies include Granger causality, error-correction models, cointegration tests (e.g. Ghosh 2003, Mohanty, Peterson, and Smith 1996, Mohanty and Langley 2003, Moodley, Kerr, and Gordon 2000, Paul, Miljkovic, and Ipe 2001), and vector autoregression (VAR) models (e.g. Dawson and Dey 2002). Baulch (1997) criticizes these studies, noting that transfer costs are significant and introduces a technique to incorporate transfer costs into the analysis. The problem with this approach, however, is that it requires some data on transfer costs which are often very difficult to find. 7 Berkowitz and deJong (2003) employ this approach when examining Russian integration. 7