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Jourdd INTEiBtAMMlAL ECOWOMICS ELSEVIER Journal of International Economics 38 (1995) l-24 Trade blocs, currency blocs and the reorientation Barry Eichengreen”, Douglas A. Irwinb’* aDepartment of Economics, University of California, Berkeley, CA 94720, USA bGraduate School of Business, University of Chicago, IL 60637, USA revised version received July 1994 Abstract We analyze the impact of commercial and financial policies on the reorientation of trade in the 1930s. We report evidence that commercial Key words: Trade blocs; Currency blocs; Regional Trade Arrangements JEL classification: F13; N70 ‘We may characterize the change that occurred as a disintegration of world trade: (Folke Hilgerdt, 1942, pp. 90-91).’ * Corresponding author. 0022-1996/95/$09.50 0 Elsevier Science B.V. All rights reserved SSDI 0022-1996(94)001350-O 2 B. Eichengreen, D.A. Irwin / Int. Econ. 38 (1995) l-24 1. Introduction The early 1930s witnessed an astonishing implosion of world trade. Between 1929 its value in current U.S. dollars fell by 50 percent. Though deflation contributed to the collapse, even ’ World primary B. Eichengreen, D.A. Irwin I J. Int. Econ. 38 (1995) l-24 3 rest of the world. Foreign currency that allowed countries to finance payments imbalances and collateralize borrowing from foreign banks could have further stimulated intra-bloc trade, insofar as these resources could be used ’ On exchange control and clearing arrangements, see Ellis (1941) and Neal (1979), respectively. Eichengreen (1992) discusses the exchange dumping duties of the gold bloc countries. 4 B. Eichengreen, D.A. Irwin I J. Znt. Econ. 38 (1995) l-24 implications for trade. Members of the sterling area traded unusually extensively among themselves, due to the trade-promoting effects of intra- bloc exchange rate stability, but also traded unusually extensively with the rest of the Economic Survey for 1932-33, shows the dollar value of world trade spiralling downward from 1929 through 1933. The contraction of trade far exceeded the contemporaneous decline 3 The difference on the import and export sides reflects the improvement in the terms of trade of the industrial countries. Figures in this paragraph are taken from Maddison (1989b, p. B. Eichengreen, D.A. Irwin I Fig. 1. The contracting spiral of world trade, month by month, European states (Bulgaria, Greece, Hungary, Romania, Turkey, 4 The figures in this 6 B. Eichengreen, D.A. Irwin I J. Int. Econ. 38 (1995) l-24 Commercial policies and exchange rate arrangements were the obvious sources of these adaptations. The Ottawa Agreements negotiated between Britain and the Dominions in 1932 aimed to stimulate Commonwealth trade by 5 How much market power Germany possessed is disputed (see Milward, 1981; Kitson, 1992). B. Eichengreen, D.A. Irwin I J. Int. Econ. 38 (199.5) l-24 7 Although the Smoot-Hawley tariff was largely nondiscriminatory, it was rolled back not by a general reduction in import duties but by bilateral agreements reached under the provisions of the Reciprocal Trade Agree- ments Act of 1934. bThe countries were Canada, Guatemala, El Salvador, Honduras, Nicaragua, Costa Rica, Cuba, Haiti, Colombia, Brazil, France, Belgium/Luxembourg, the Netherlands, Sweden, Finland, and Switzerland. 7The agreement 8 B. Eichengreen, D.A. Irwin 1 .I. Int. Econ. 38 (1995) 1-24 tariffs, extending quota rights differentially to foreign suppliers as a way of securing market access for their exports. A third group of countries in Central and Southeastern Europe also maintained 9 Anderson (1979) and Bergstrand (1985) have shown that the gravity equation can be derived as a reduced form of a broad class of structural models. In applications to contempor- ary data, such equations have proven useful in predicting the pattern of trade and assessing the effects of commercial policies. B. Eichengreen, D.A. Irwin I Int. Con. 38 (1995) l-24 9 One solution is to forgo the double-log specification for a semi-log form in which the dependent variable (bilateral trade) is expressed in levels, and independent variables in logs. While this allows us to + TRADE), where TRADE is the value of bilateral exports and imports. For large values of TRADE, ln(1 + TRADE) = ln(TRADE) and the constant elasticity relationship is preserved; for small values, ln(1 + TRADE) = TRADE, approximating the semi-log Tobit relationship. The equation can be estimated by scaled OLS (or an analogous TRADE does not equal zero.” We adopt a specification similar to used by Frankel et al. (1994): ln(1 + TRADE,,) = PO + PI ln(GNP, . GNPj) + & ln([GNP,IPOP,] . [GNPjIPOPj]) + &DZST,, + &CONT where TRADE, is the nominal value of bilateral trade between countries i and j, GNP,. GNPi is the product of the two countries’ nominal national incomes, [GNP,IPOP,] . [GNPjIPOPj] is the product of the two countries’ per capita national incomes (also in nominal terms), DZST, is the distance between the economic centers of CONT is a dummy variable for whether the two countries are contiguous. A problem with this specification is that the disturbance may be correlated I” One can solve for the local elasticity around the mean by dividing the coefficients by the mean value of the dependent variable, 10 B. Eichengreen, D.A. Irwin I J. Int. Econ. 38 (1995) l-24 with one of the regressors, thereby biasing the estimates. If a large ujj is drawn, for instance, trade is higher and, by accounting identity, GNP is The Network of World Trade. The sum of a country’s exports and imports with another country is expressed in Network. We assembled data for 34 4. Econometric results and interpretation Table 1 presents estimates of the basic model using various estimation techniques for purposes of comparison. Together, the independent variables explain 50-60 percent of I* This follows Linneman (1966). We are indebted to Lant Pritchett for making this data available to us. Table 1 Determinants of trade in the interwar period. exclusive of trade and currency blocs 1928 193s Scaled Double- Tobit Scaled Double- Tobit OLS IV-OLS IV-SUK log IV OLS IV-OLS IV-SUR log (6.W (7.64) -5.31 (6.49) 0.97 (17.00) 0.91 (20.37) 1.03 (14.45) -0.51 (4.31) 1.14 (3.30) 561 0.42 (1.51) 561 -0.57 (9.07) 0.38 (1.42) 561 0.29 0.59 3.201 0.57 1.062 -6.24 -10.79 (8.53) 0.86 (19.73) 0.73 (16.59) -0.37 (6.79) 0.30 (1.37) 12 B. Eichengreen, D.A. Irwin I Int. Econ. 38 (1995) l-24 estimator used, consistent with the fact that trade, after falling along with output and employment during the Depression, failed to rebound fully with the recovery of incomes. This pattern is consistent with the arguments of Woytinsky and Woytinsky 2 I3 The cross-equation correlation of disturbances is as follows: r&,, = 0.79, r&,, = 0.71, r35,38 = 0.71. The likelihood ratio test (x’ distribution) of whether the off-diagonal elements of the variance-covariance matrix are zero (indicating no correlation across years) is 1270.016, decisively rejecting that hypothesis (see Greene, 1993, p. 454). B. Eichengreen, D.A. Irwin I lnt. Econ. 38 (199.7) 1-24 13 from 1980 1990, Frankel et al. (1994) find that a double-log specification yields uniformly lower coefficients on all of the independent variables than our double-log estimation, although our instrumental variables approach accounts 4.1, Trade blocs Table 2, reporting only scaled OLS and scaled SUR results, introduces variables representing the principal regional arrangements of the I4 This is consistent with Lewis’s (1949) description of pre-World War I and interwar trade as primarily an exchange of manufactured goods and raw materials between industrial and tropical countries. I5 Exchange controls and clearing arrangements resemble financial restrictions in some respect but commercial Annual Report on Exchange Controls and Exchange Restrictions) treats exchange controls separately from trade policies. We follow this convention and discuss exchange controls and clearing arrangements as a form of currency policy. Whether countries adopting them are properly regarded as a bloc are from the data to determine. 14 B. Eichengreen, D.A. Irwin Table 2 Determinants of trade in the interwar period: Effect of overlapping trade G-4) (3.05) 0.09 -0.31 (0.55) 0.04 -0.17 0.24 (0.20) B. Eichengreen, D.A. Irwin I J. Int. Econ. 38 (lW.5) 1-24 Table 2 (continued) 15 Variable 1928 Scaled SUR IV Scaled SUR IV Scaled SUR IV Exchange control member -0.41 n 561 H’ 0.67 S.E. Notes: See Table 1. 1.044 I.006 as opposed to interdependencies already evident in the previous decade, we include the same variables in our equations for 1928. The findings reported above survive this extension: ” Hamilton and Winters (1992) similarly find a persistent influence of historical ties in data on U.K. trade with its former colonies and Dominions 16 B. Eichengreen, D.A. Irwin I J. Int. Econ. 38 (1995) 1-24 the associated p-level of 0.09. Thus, the Ottawa Agreements of 1932 appear to have reinforced the existing tendency toward intra-Commonwealth trade. The coefficient on ‘Commonwealth Member’, indicating bilateral flows between Commonwealth countries and the “According to scaled SUR, there was no trade diversion due to Commonwealth member- ship in that year. 18The x2 test statistic of 4.84 leads us to reject the hypothesis of equality. 19These results are available from the authors upon request. B. Eichengreen, D.A. Irwin I J. In!. Econ. 38 (1995) 1-24 17 wise suggest and without concomitant trade diversion. In contrast, the Brocchi-Rome Agreements between Austria, Hungary, and Italy signifi- cantly discouraged trade with the rest of the world, while failing to 18 B. Eichengreen, D.A. Irwin I J. Znt. Econ. 38 (199.5) 1-24 1936. Although the coefficients on ‘Gold Bloc Member’, the variable indicating bilateral flows between gold bloc and non-gold bloc countries, are already positive in 1928, indicating that these countries had disproportion- ate 4.3. Exchange rate variability Nurkse (1944) argued that exchange rate volatility following the break- down of the international gold standard increased the uncertainty *’ Formally, we cannot reject the equality of the coefficient in 1928 1935, although the x2 for the change between 1928 of 2.43 yields a p-value of 0.119, which is nearly significant at conventional levels. *’ Gaps in the availability of exchange rate B. Eichengreen, D.A. Irwin I Int. 19 Table 3 Bilateral trade and exchange rate variability Variable 1928 Scaled SUR Scaled 0.80 0.23 control 20 B. Eichengreen, D.A. Irwin / J. Int. Econ. 38 (199.5) l-24 Table 3 (continued) Variable 1928 Scaled SUR Scaled SUR Scaled SUR Exchange control member -0.51 n 377 R’ 0.72 S.E. 0.921 Mean value of exchange rate variability 0.066017 0.00454 markets and hedging instruments plausibly accounts for the continued negative effect of variability on trade. However, the impact of exchange rate R. Eichengreen, D.A. Irwin I J. Int. Econ. 38 (199.5) 1-24 21 exchange dumping duties that gold bloc countries levied against imports from countries with depreciated currencies. After controlling for exchange rate variability, the tendency for the Reichsmark bloc to be 5. Conclusions This paper has reassessed the role of commercial and financial policies in the reorientation of international trade in the 1930s. We report evidence that commercial policies attenuated prior linkages between 22 B. Eichengreen, D.A. Irwin / J. Int. Econ. 38 (1995) 1-24 trade and currency blocs of the 199Os? They suggest caution for those tempted to attribute to preferential trade and currency arrangements all deviations in trade B. Eichengreen, D.A. Irwin I J. Int. Econ. 38 (1995) l-24 23 Office, Washington, DC, 1975. Canada: M. C. Urquhart and K. A. H. Buckley, Historical Statstics of Canada, Macmillan Press, Toronto, 1965. Ireland and the United Kingdom: B.R. and Brazil: Wilke (1990). India and the Netherlands Indies: Maddison (1989a). Portugal: Valerio (1983). Ireland: of Agriculture Statistics, Rome, various years, p. xi. International Labour Office, Yearbook of Lubour Statistics, Geneva, 1939, p. References Anderson, J.E., 1979, A theoretical foundation for the 24 B. Eichengreen, D.A. Irwin I J. Int. Econ. 38 (1995) 1-24 Capie, F., 1983, Depression and protectionism (Allen & Unwin, London). Condliffe, J.B., 1940, The reconstruction of world trade (Norton, New York). de Menil, G. and M. de Maurel, 1993, Trading with neighbors in turbulent times: Lessons from the breakup of the Austro-Hungarian Empire in 1919, unpublished