Trade liberalization and per capita income convergence: a difference-in-differences analysis

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1 Journl of Interntionl Economics 55 (2001) locte/ econbse Trde liberliztion nd per cpit income convergence: difference-in-differences nlysis Mtthew J. Slughter* Drtmouth College nd NBER, Drtmouth College, 309 Rockefeller Hll, Hnover, NH 03755, USA Received 9 November 1998; received in revised form 30 December 1999; ccepted 16 Februry 2000 Abstrct In this rticle I nlyze whether trde liberliztion contributes to per cpit income convergence cross countries. The nlysis focuses on four post-1945 multilterl trde liberliztions. To identify trde s effect on income dispersion, in ech cse I use difference in differences pproch which compres the convergence pttern mong the liberlizing countries before nd fter liberliztion with the convergence pttern mong control countries, chosen using vriety of methods, before nd fter liberliztion. My min empiricl result is I find no strong, systemtic link between trde liberliztion nd convergence. In fct, much evidence suggests trde liberliztion diverges incomes mong liberlizers Elsevier Science B.V. All rights reserved. Keywords: Trde liberliztion; Income convergence JEL clssifiction: F1; F4 1. Introduction Does trde liberliztion cuse per cpit income convergence cross countries? Trde theory offers n mbiguous nswer: trde cn either converge or diverge incomes. In this rticle I offer new empiricl evidence on this question bsed on four importnt post-1945 trde liberliztions. *Tel.: ; fx: E-mil ddress: slughter@drtmouth.edu (M.J. Slughter) / 01/ $ see front mtter 2001 Elsevier Science B.V. All rights reserved. PII: S (00)

2 204 M.J. Slughter / Journl of Interntionl Economics 55 (2001) To identify trde s effect on income dispersion, in ech of the four cses I use difference in differences methodology which compres the convergence pttern mong the liberlizing countries before nd fter liberliztion with the convergence pttern mong control countries before nd fter liberliztion. In ech cse I identify trde liberliztion s role s the estimted difference in differences of convergence rtes pre- nd post-liberliztion between the two groups of countries. As will be discussed, there is no obvious wy to select control countries. So to guge the robustness of results I try three different selection methods: using brod informtion on geogrphy nd/ or income; using ctul country-by-country dt on income nd trde flows; nd simply picking countries rndomly. The centrl contribution of this rticle is its difference-in-differences methodology. The few existing empiricl studies focusing on trde nd income convergence ttempt to identify trde s effect minly through single comprison (t most) of two groups of countries. All these studies rgue tht their single comprisons support the hypothesis tht trde converges incomes. However, s I discuss below these single comprisons cn ctully be consistent with either convergence or divergence. The difference-in-differences pproch is explicitly designed to overcome the potentil mbiguities of the single-difference studies. As such, this pproch tries to build on these importnt erlier studies. It is not without problems itself, but on blnce it ims to shrpen the nlysis of erlier work. My min empiricl result is I find no strong, systemtic link between trde liberliztion nd convergence. This result comes from initil single-difference estimtes nd the core difference-in-difference estimtes using two different convergence mesures nd wide rnge of control groups. In fct, much of the evidence suggests tht trde liberliztion diverges incomes mong liberlizers. This rticle hs five dditionl sections. Section 2 briefly summrizes some theory of trde nd convergence. Section 3 reviews relted empiricl work nd highlights some potentil methodologicl limittions which this pper tries to improve upon. Section 4 outlines the difference-in-differences empiricl strtegy nd discusses how I modify it to the current reserch question. Section 5 presents the dt nd empiricl results. Section 6 summrizes the results nd concludes with discussion of my strtegy in the broder context of future reserch ides. 2. Trde nd per cpit income cross countries: theory Consider country s per cpit income (pcgdp) distributed to two fctors of production, lbor nd cpitl. Ntionl Income w 3 L 1 r 3 K K pcgdp 5]]]]] 5]]]] 5w 1 r 3] L L L Here, L nd K re the country s endowments of lbor nd cpitl nd w nd r re the respective ntionl rel fctor prices for lbor nd cpitl. This set-up ssumes

3 M.J. Slughter / Journl of Interntionl Economics 55 (2001) tht the totl vlue of gross domestic output ccrues to L nd K nd tht for ech fctor there is one ntionl mrket. How cn interntionl trde ffect convergence? Trde liberliztion cn influence ech of the three bsic determinnts of ntionl income s just written: 1 fctor prices, fctor quntities, nd production technology. First, consider the fctor prices w nd r. The fctor-price-equliztion (FPE) theorem is usully defined s the set of endowment points mong countries for which, given certin ssumptions bout technology nd tstes, free trde entils not only equl goods prices cross countries but lso equl prices for nontrdble fctors s well. As sttement bout free-trde equilibri, however, the FPE theorem does not hve cler dynmic predictions for the process of trde liberliztion. Mny studies hve exmined whether liberliztion tends to bring fctor prices closer together. The generl nswer is mybe : s with the FPE theorem, whether fctor prices converge depends on cross-country tstes, technology, nd endowments. Smuelson (1971) demonstrtes tht in the stndrd specific-fctors frmework freer trde very likely genertes convergence. In contrst, Stiglitz (1970) finds the opposite when two countries hve different rtes of time preferences: freer trde tends to diverge fctor prices. And Derdorff (1986) presents two-country, two-fctor, four-good Heckscher Ohlin model in which freer trde converges product prices but ctully diverges fctor prices. Slughter (1995) provides n empiricl exmple: the construction of cnls nd rilrods in ntebellum United Sttes converged interregionl commodity prices but not interregionl wges. Lemer nd Levinsohn s (1996) survey distinguishes the outcome of FPE from the process of wge convergence, nd notes tht lower trde brriers do not necessrily converge fctor prices. Next, consider endowments of L nd K. There is long history of extending sttic Heckscher Ohlin models to llow fctor ccumultion over time (see, for exmple, Findly s, 1984 survey). The bsic result here is tht trde liberliztion hs n mbiguous net effect on endowments cross countries. In some wys liberliztion converges them but in other wys it diverges them. One importnt wy tht liberliztion cn converge endowments is by reducing perceived investment risk in poorer countries. Lne (1997) formlizes model in which trde greements signl reduced investment riskiness in countries pr- 1 This discussion expnds upon shorter discussion in Slughter (1997). Mny ppers on convergence cnnot nlyze the role of interntionl trde becuse they ssume Solow world in which countries producing single ggregte good exist independent of one nother (e.g., Brro nd Sl-i-Mrtin (1992)). By construction, interntionl linkges such s trde, fctor mobility, nd technology trnsfer don t ply ny role. Insted, convergence rises from per cpit cpitl stock convergence. Identicl production technologies nd time preferences cross countries ensure (ssuming no exogenous technologicl progress) tht ll countries tend towrds the sme (K/L) nd thus the sme w nd r s well. It immeditely follows tht ll countries rech the sme pcgdp level nd convergence is complete.

4 206 M.J. Slughter / Journl of Interntionl Economics 55 (2001) ticulrly in poorer countries which tend to be more risky initilly. Post-liberliztion cpitl ccumultes more rpidly in now-less-risky poorer countries, nd ll else equl this tends to converge income cross countries by rising (K/L) towrd richer-country levels. In contrst, there re t lest two importnt wys for trde liberliztion to work in the opposite direction. One is through Stolper Smuelson effects on cpitl rentls. Bldwin (1992) formlizes how liberliztion cn generte dynmic gins from trde for country reltively well endowed with cpitl by rising its r (through the usul Stolper Smuelson effect) nd thus ccelerting investment. For country reltively poorly endowed with cpitl, dynmic losses from trde cn result s liberliztion lowers r nd thus slows investment. The cross-country impliction of these dynmic djustments is divergence of reltive endowments: cpitl-rich countries invest more while cpitl-poor countries invest less. Another wy freer trde cn diverge cross-country endowments is by inhibiting the onset of diminishing mrginl returns to investment. In closed economy cpitl ccumultion slows becuse of investment s diminishing mrginl physicl productivity. But with free trde, FPE implies tht country fces constnt mrginl returns to investment. In n open economy investment chnges the ntionl output mix s predicted by the Rybczynski theorem insted of reducing r. Trde dmpens the usul closed-economy convergence mechnism. This mens tht richer countries do not lose their incentive to invest s soon s they would in utrky. As result, endowments cross countries need not converge. Ventur (1997) rgues tht this process explins South Kore s ongoing growth despite its prolonged high rtes of investment. Finlly, consider technology. If countries hve different levels of technology which cn somehow trnsfer cross countries, trde might be n importnt medium through which technology ctully flows. This might hppen s countries reverse engineer their imports or through the interpersonl contcts tht ccompny trde. Trde liberliztion cn thus boost technology flows. Whtever the exct mechnism, trde-medited technology flows chnge countries rel fctor prices nd thus per cpit income. Given country s endowment of inputs, improved technology implies higher mrginl physicl productivities for fctors nd thus higher rel prices for these fctors (ssuming fixed world product prices). To the extent tht technology flows from dvnced to less-dvnced countries, trde liberliztion helps rise fctor prices in lessdvnced countries up towrds the fctor prices in dvnced countries. Krugmn (1979) presents generl-equilibrium model of this equlizing flow of technology. If technology does not flow from dvnced to less-dvnced countries, however, then freer trde need not converge incomes cross countries. Mtsuym (1996) formlizes model in which freer trde lters interntionl technology flows to generte divergence cross countries. Here freer trde leds poorer countries to specilize in technologiclly-stgnnt products becuse they lck the resources necessry to relize gglomertion economies of high-technology products.

5 M.J. Slughter / Journl of Interntionl Economics 55 (2001) Menwhile, richer countries grow even richer becuse they focus more on the high-technology products. In summry, trde liberliztion s mny effects on cross-country levels of fctor prices, fctor quntities, nd production technology hve n uncler net effect on cross-country income levels. 3. Trde nd per cpit income cross countries: empiricl evidence The existing evidence on trde nd interntionl income differences is mixed. There is some evidence tht trde cuses divergence nd other evidence tht it cuses convergence. Moreover, the evidence on convergence my be mbiguous 2 due to reserch design. Bernrd nd Jones (1996) provide some evidence tht freer trde diverges income cross countries. They document tht cross-country productivity levels (mesured s either lbor or totl-fctor productivity) for individul mnufcturing industries since 1970 hve been either not converging or even diverging. In contrst, since 1970 cross-country productivity levels in services hve been converging. To reconcile these fcts Bernrd nd Jones hypothesize tht interntionl trde might be cusing the divergence: in the trdble-goods sectors, comprtive dvntge leds to speciliztion, nd to the extent tht countries re producing different goods, there is no priori reson to expect the technologies of production to be the sme or to converge over time (p. 1237). In contrst with these results, Ben-Dvid (1993, 1996) nd Schs nd Wrner (1995) present evidence linking trde to income convergence. These studies document historicl episodes of income convergence cross group of countries tht were reltively open to ech other (Schs nd Wrner, 1995), tht liberlized trde policy mong ech other (Ben-Dvid, 1993), or tht trde lot with ech other (Ben-Dvid, 1996). The common conclusion of these ppers is tht interntionl trde cuses convergence. These ppers contribute to the convergence literture by explicitly considering role for trde. But their reserch design leves their evidence somewht open to interprettion. Using severl criteri ddressing trde nd finnce policies nd outcomes, Schs nd Wrner clssify ech country in 1970 s either open or closed. From 1970 to 1989 only in the group of open countries did the poorer countries in 1970 tend to grow fster over the next 19 yers. They conclude tht the open economies disply strong tendency towrds economic convergence... We suggest tht the most prsimonious reding of the evidence is tht... the convergence club is the club of economies linked together by interntionl trde (p. 41). A potentil limittion of Schs nd Wrner s methodology is they compre 2 For detiled survey of recent empiricl studies on trde policy nd growth, see Rodriguez nd Rodrik (1999).

6 208 M.J. Slughter / Journl of Interntionl Economics 55 (2001) closed nd open economies only during the period in which the countries re clssified s closed or open. They do not exmine whether the behvior of ech group might be chnged over time becuse of being closed or open. Suppose tht from 1950 through 1969 the subsequently open group hd been converging even more rpidly thn it did fter 1970, while the subsequently closed group hd been diverging even more rpidly thn it did fter Then one might conclude tht 3 openness slowed convergence, not ccelerted it. Ben-Dvid (1996) finds tht from 1960 to 1989, groups of reltively welthy countries which trded significntly mong ech other tended to disply significnt per cpit income convergence reltive to the convergence ptterns of rndomly grouped countries. He concludes tht These findings would pper to corroborte the intuition of Heckscher nd Ohlin tht trde does indeed ply n equlizing role (p. 294). By seprting countries solely bsed on trde flows, Ben-Dvid is more likely thn Schs nd Wrner to identify trde s role in income convergence. But like Schs nd Wrner, he compres two groups of countries (trding prtners nd rndom prtners) only during the period in which the trding groups ctully trde extensively. There is no effort to control for the groups convergence ptterns during some erlier period. Agin, ignoring this period might miss importnt informtion. Finlly, Ben-Dvid (1993) nlyzes five episodes of post-1945 trde liberliztion, nd finds tht per cpit income dispersion mong liberlizing countries generlly shrnk fter liberliztion strted. He writes tht This pper provides evidence tht movement towrd free trde my ctully... [be] leding to reduction in income disprity cross countries... The [FPE] theorem provides frmework for relting trde s impct on income convergence (p. 653). Ben-Dvid s primry evidence tht liberliztion cuses convergence is tht during liberliztions, countries converged. He does mke some comprisons of post-liberliztion convergence either to the pre-liberliztion experience of liberlizers or to set of control countries. But these comprisons give only limited informtion. In Tble 1 (p. 667) nd Tble 3 (p. 674), for vrious time periods nd vrious country groups he reports estimted rtes of income convergence. But he never explicitly mtches groups during similr time periods nd/ or similr number of members. And he never formlly tests for ny differences mong convergence rtes, either within time periods cross groups or within 3 A second issue regrding Schs nd Wrner is their mesurement of openness. They clssify country s either closed or open using five different criteri: non-triff brrier coverge; triff rtes; blck-mrket premi on exchnge rtes; overll economic system-socilist or cpitlist; nd the extent of government intervention in the export sector. A country is closed if it fils ny one of these five criteri. Becuse their openness mesure combines mny criteri it is difficult to interpret their results in terms of trde-relted fctors only. Rodriguez nd Rodrik (1999) exmine this issue in close detil.

7 M.J. Slughter / Journl of Interntionl Economics 55 (2001) group cross time periods. The lck of structurl comprisons mkes the results somewht difficult to interpret. In summry, Schs nd Wrner nd Ben-Dvid hve been mong the first to test crefully for trde s effect on income convergence. As such, these studies re importnt contributions. However, these studies identify trde s effect minly through single comprison (t most) of two groups of countries. This use of just single difference leves the evidence somewht open to interprettion. In wht follows I im to build on these studies by identifying trde liberliztion s effect 5 on convergence by using difference-in-differences estimtion strtegy. 4. Empiricl strtegy: difference-in-differences estimtion 4.1. The generl difference-in-differences methodology The bsic intuition of the difference-in-differences pproch is tht to study the impct of some tretment, one compres the performnce of the tretment group pre- nd post-tretment reltive to the performnce of some control group pre- nd post-tretment. In principle, the control group shows wht would hve hppened to the tretment group in the bsence of ny tretment. Applied to the issue of trde liberliztion s effect on income convergence, this pproch suggests tht one compre the convergence pttern mong liberlizing countries pre- nd postliberliztion with the convergence pttern mong control countries pre- nd post-liberliztion. Trde liberliztion s role is identified s the estimted difference in differences of convergence rtes pre- nd post-liberliztion between the two groups of countries. If liberliztion cuses convergence (divergence), then the movement to freer trde should ccelerte convergence (divergence) reltive to wht the rte would be bsent liberliztion. To develop this empiricl strtegy I first present the typicl difference-in- 4 In the text discussing Tbles 1 nd 3 Ben-Dvid does report whether ech estimted convergence rte is significntly different from zero. But this informtion lone is not sufficient to determine whether difference between two estimted convergence rtes is sttisticlly different from zero-or whether difference-in-differences mong four estimted convergence rtes is sttisticlly different from zero. For exmple, in Tble 1 EEC convergence ws not sttisticlly different from zero but ws sttisticlly different from zero during liberliztion. But it does not follow from this tht the two convergence rtes differ from ech other: if the convergence rte is estimted sufficiently imprecisely then one cnnot reject the hypothesis tht this rte is the sme s the liberliztion rte. 5 Some relted studies include Mokhtri nd Rssekh (1989) nd Dvis (1992), who test for link between wge convergence cross OECD countries nd trde flows. Also, Eton nd Kortum (1995) find tht growth in mny OECD countries is ccounted for by ides generted in foreign countries while Coe nd Helpmn (1995) nd Coe et l. (1997) present evidence tht trde medites the flow of these ides nd their impct on totl fctor productivity. However, none of these studies focuses directly on trde nd income convergence s do the ppers discussed in this section.

8 210 M.J. Slughter / Journl of Interntionl Economics 55 (2001) differences pproch, following the detiled discussion in Meyer (1994). I then discuss how I modify this typicl pproch to cses of trde liberliztion, with prticulr focus on the issues of defining tretment nd determining control groups. Suppose group of economic gents hs some tretment pplied t single point in time, nd suppose further tht some outcome for these gents cn be observed both before nd fter tretment ppliction. Then one could try to estimte the tretment effect with the following regression: y 5 1 bd 1 e, (1) it t it where yit is the outcome for gent i (i51,...,n) t time t (t50 or1),dt is dichotomous vrible equl to one if t51 nd zero if t50, nd eit is n error term (whose vrince vries by t). b identifies the cusl effect of tretment under the identifying ssumption tht E[eitud t] 5 0, i.e., tht without tretment ll gents would be comprble over time (such tht without tretment b 50). b cn be determined by estimting Eq. (1) or simply by clculting the single difference of the chnge in men outcomes before nd fter tretment (i.e., the verge outcome t t50 minus the verge outcome t t51). For exmple, in Crd nd Krueger (1994) the tretment ws n increse in New Jersey s sttutory minimum wge on April 1, The outcome of interest ws employment in New Jersey fst-food resturnts, so to implement (1) one might mesure employment for smple of N New Jersey fst-food resturnts t t50 (Februry 1992 in this study) nd then gin t t51 (November 1992). If the identifying ssumption were vlid, then from (1) b would identify the employment effect of the minimum-wge chnge. A problem with this single-difference pproch is potentil violtion of the identifying ssumption. Between t 5 0 nd t 5 1 mny forces other thn tretment might ffect the outcome of interest. For exmple, New Jersey fst-food employment might chnge becuse of the business cycle or shifts in consumer tstes. The essence of the difference-in-differences pproch is to try to ccount for these other forces by lso exmining the outcomes for control group tht does not receive the tretment but tht presumbly is ffected by these other forces. This suggests j 1 j j j y 5 1 d 1 d 1 bd 1 e, (2) it 1 t t it where now j indexes the two groups with j51 for the tretment group nd j50 for j the control group; d is dichotomous vrible equl to one if j 5 1 nd zero if j j 5 0; nd d t is dichotomous vrible equl to one if both j 5 1 nd t 5 1, nd zero otherwise. b is gin the key coefficient which identifies the cusl effect of tretment. It is obtined by estimting (2) or simply by clculting the difference in differences equl to the chnge in men outcomes for the tretment group minus the chnge in men outcomes for the control group. The prmeter 1 cptures how both groups re ffected over time by ny non-tretment forces,

9 M.J. Slughter / Journl of Interntionl Economics 55 (2001) while the prmeter cptures ny time-invrint difference in outcomes between the tretment nd control groups. Similr to in (1), the key identifying j j ssumption in Eq. (2) is tht E[e itud t] 5 0, i.e., tht b 50 in the bsence of tretment. This ssumption is most plusible when the untreted comprison group is very similr to the tretment group (Meyer, p. 18). Crd nd Krueger use fst-food resturnts in estern Pennsylvni s the control group to ccount for non-tretment forces such s sesonlity: since sesonl ptterns of employment re similr in New Jersey nd estern Pennsylvni... our comprtive meth- 6 odology effectively differences out ny sesonl employment effects (p. 773) The difference-in-differences methodology pplied to trde liberliztion The tsk now is how to pply the difference-in-differences pproch to the issue of trde liberliztion nd per cpit income convergence. A first issue to consider is the tretment. In typicl difference-in-differences studies in economics (mostly public finnce nd lbor economics) the tretment is one-time chnge in government policy pplied eqully to ll members of the tretment group. The equl ppliction llows identifiction of the tretment nd control groups. And the one-time nture of the chnge mkes it esy to select specific pre- nd posttretment points in time, where by the ltter it is ssumed tht the full tretment effect hs been relized. Rel-world trde liberliztion tends to differ from the typicl tretment in three importnt wys. First, lots of trde liberliztion (or restriction) is undertken unilterlly or multilterlly but to different extents cross countries. This suggests tht difference-in-difference nlysis of trde liberliztion requires cses where ll trding prtners liberlized to the sme extent following the sme timetble. Second, s discussed in Section 2, mny convergence effects of liberliztion re likely to pper t the sme time s brrier reduction. For exmple, s brriers fll product prices chnge, which in turn my trigger responses including FPC nd ltered investment. This suggests tht the post-tretment period should be defined s the entire time period of liberliztion. Third, historicl trde liberliztions usully hve not been one-time events but rther hve been implemented grdully over multiple yers. In these cses the tretment effect, convergence posttretment, should be looked for t multiple points in time rther thn just t single point. In light of these issues, for this study I define the tretment to be sizble trde liberliztion implemented eqully by ll prticipnts with cler strting nd stopping dtes. The cler dtes identify the spn of the post-tretment period during which effects will be looked for. I require sizble liberliztions ssuming they re more likely to ffect income convergence thn minor liberliztions. For 6 Implementing (2), Crd nd Krueger find, somewht surprisingly, tht reltive to chnges in Pennsylvni, New Jersey fst-food employment rose, not fell, fter the minimum-wge increse.

10 212 M.J. Slughter / Journl of Interntionl Economics 55 (2001) symmetry, I define the pre-tretment period to be s long s the liberliztion period, dt permitting. As discussed below, in two of the four cses the dt do not permit longer pre-tretment periods; in ll cses, the bsic results re robust to shortening or (when possible) lengthening the pre-tretment period by one or two yers. The outcome of interest is some mesure of per cpit income dispersion. For ech cse I mesure per cpit income dispersion mong the tretment group nd mong the control group two different wys, both of which hve re commonly used (e.g., Ben-Dvid, 1993, 1996). The first is the stndrd devition of the 7 nturl log of per cpit income mong group of countries. For this dispersion mesure, the nlog of Eq. (1) which I estimte is given by Eq. (3): s 5 1 (d ) 1 b (t) 1 b (t)(d ) 1 e, (3) rt 1 2 r 1 2 r rt where t indexes time in yers running from t 5 1 until t 5 T; r indexes the two equl-length regimes of interest: r50 for the pre-liberliztion regime running from t51 until t 5 (T/2) nd r51 for the post-liberliztion regime running from t 5 (1 1 T/2) until t 5 T; dr is dichotomous vrible equl to one if r51 nd zero if r50, nd e is n error term (whose vrince vries by r). The regressnd rt srt is the stndrd devition of the nturl log of per cpit income mong the liberlizing countries for regime r t time t. Eq. (3) is bsiclly spline regression where both regimes re llowed to hve different intercepts nd prmeters on time. The rte of chnge in income dispersion pre-liberliztion is given by b, 1 nd post-liberliztion it is given by (b11 b 2). In both regimes income convergence (divergence) is indicted by negtive (positive) slope coefficients. The single difference b2 indictes whether post-liberliztion convergence differs from tht pre-liberliztion. This single-difference coefficient is nlogous to the coefficient b in Eq. (1). For the difference-in-differences specifiction, let the superscript j indicte country group, with j51 the liberlizing group nd j50 some control group. Then the nlog to Eq. (2) which I estimte is given by Eq. (4), j j j j s rt (d r) 1 3(d ) 1 4(d r) 1 b 1(t) 1 b 2(t)(d r) 1 b 3(t)(d ) j j 1 b (t)(d ) 1 e, (4) 4 r rt j where the dichotomous vrible d indictes country group; the dichotomous j j vrible d r equls one if both j51 nd r51 nd zero otherwise; nd e rt is n error term (whose vrince vries by both j nd r). For ech of the four country-group/ 7 A common test for convergence is to regress cross-section of countries nnulized income growth rtes on their initil income levels: negtive coefficient indictes convergence. In theory this mesure nd tht in the text need not imply ech other even though in relity they often seem to coincide. In the terminology of Brro nd Sl-i-Mrtin, the mesure just described is bet convergence while tht in the text sigm convergence.

11 M.J. Slughter / Journl of Interntionl Economics 55 (2001) regimes, Eq. (4) estimtes seprte intercept term nd convergence rte for income dispersion. Country-group/ regime Intercept Convergence rte Liberlizing group pre-liberliztion b 1 1 Liberlizing group post-liberliztion 1 b 1 b Control group pre-liberliztion 1 b 1 b Control group post-liberliztion b 1 b 1 b 1 b The effect of trde liberliztion on income convergence cn be obtined by clculting the difference in differences of the estimted rtes. The difference in convergence rtes within the liberlizing group pre- nd post-liberliztion is given by b. The similr difference in convergence rtes within the control group is 2 given by (b 1 b ). Thus the difference in differences is given by (b 1 b ) (b ) 5 b. Assuming tht the only tretment pre- nd post-liberliztion between 2 4 the two groups is liberliztion, b identifies its effect. If trde liberliztion tends 4 to converge (diverge) incomes mong the liberlizing countries then b is positive 4 (negtive). Any cross-regime time effect on convergence common to both groups of countries is cptured by b 2, nd ny time-invrint differences in convergence 8 between groups is cptured by b. 3 My second mesure of income dispersion cptures how quickly ech country s income level is converging to the verge income level of tht country s group. Following Ben-Dvid (1993), let ( y 2 y br ) 5 g( y 2 y br ), (5) it11 t11 it t where yit is country i s log rel income per worker in yer t, y brt is the rithmetic verge of y, nd g is prmeter relting the verge income gp it from one yer to the next. Then define z 5 ( y 2 y br ) nd Dz 5 (z 2 z ), it it t it11 it11 it nd Eq. (5) cn be mnipulted to obtin the following eqution for estimtion: Dz 5 d(z ) 1 u, (6) it11 it it where d,0 represents the rte of convergence of y it to y br (with g 2 d 51). The t 8 For exmple, suppose tht pre-liberliztion neither group hd ny trend in income dispersion but tht fter liberliztion the liberlizing group converged t rte of 20.1 while the control group diverged t rte of 0.1. Then the difference within the liberlizing group equls (20.1)2(0) Similrly, the difference within the control group equls (0.1)2(0)50.1. Then the difference in differences is given by (0.1)2(20.1) Trde liberliztion leding to convergence is cptured by positive b. There is lterntive wy to clculte the difference in differences. First clculte the 4 pre-liberliztion difference in convergence rtes between the two groups, b. Then clculte the 3 post-liberliztion difference in convergence rtes between the two groups, (b 1b ). Then the 3 4 difference in differences is (b 1 b ) 2 (b ) 5 b

12 214 M.J. Slughter / Journl of Interntionl Economics 55 (2001) lrger (in bsolute vlue) is d, the fster is the convergence. For the initil single-difference nlysis, (6) becomes Dz 5 d (z ) 1 d (z )(d ) 1 u, (7) rit11 1 rit 2 rit r rit where r gin indexes regime, dr is defined s before, nd urit is n error term (whose vrince vries by r). Now the single difference d2 indictes whether post-liberliztion convergence differs from tht pre-liberliztion. Like b2 in Eq. (3), this single-difference coefficient is nlogous to the coefficient b in Eq. (1). For the difference-in-differences specifiction, gin let the superscript j indicte country group. This gives j j j j j j j j Dz 5 d (z ) 1 d (z )(d ) 1 d (z )(d ) 1 d (z )(d ) 1 u, (8) rit11 1 rit 2 rit r 3 rit 4 rit r rit where ll vribles re defined s before nd u is n error term (whose vrince vries by both j nd r). As in (4), the effect of trde liberliztion on income convergence cn be obtined by clculting the difference in differences of the estimted rtes, equl to d4 here. If liberliztion tends to converge (diverge) incomes mong the liberlizing countries then d4 is positive (negtive). Any cross-regime time effect on convergence common to both groups of countries is cptured by d 2, nd ny time-invrint differences in convergence between groups 9 is cptured by d. 3 In both Eqs. (4) nd (8), the key identifying ssumption is tht the only difference pre- nd post-liberliztion between the two groups is trde liberliztion. This is equivlent to sying tht b or d would be zero in the bsence of 4 4 liberliztion. This identifying ssumption mens tht ll the unobservbles not included in Eq. (4) hve specil time-series structure in which there is no shock tht ffects the reltive outcome of the two groups t the sme time s the trde-liberliztion shock. But for trde liberliztion, there cn be no shock ffecting the reltive outcome of the two groups pre- nd post-liberliztion. This leds nturlly to the question of how to select control groups. To nswer this, Tble 1 first lists the four liberliztion groups nlyzed in this pper: formtion of the Europen Economic Community (EEC); formtion of the Europen Free-Trde Are (EFTA); liberliztion between the EEC nd EFTA; nd the Kennedy round of the Generl Agreement on Triffs nd Trde (GATT). The informtion on prticipting countries nd both dtes nd depth of liberliztion comes from Ben-Dvid (1993) nd United Ntions (1968). I selected these cses becuse they ll involved substntil brrier cuts nd becuse the cuts were mde eqully by ll members in well-specified timetble. For ech cse I include ll countries which ctully implemented the stted brrier cuts in the stted j rit 9 As in Ben-Dvid (1996), one could extend Eqs. (7) nd (8) by using longer lgs of z s dditionl regressors. I do not do this becuse, s shown below, two of my four cses (EEC nd EFTA cses) do not hve erly enough dt to clculte longer lgs in the pre-liberliztion regime.

13 M.J. Slughter / Journl of Interntionl Economics 55 (2001) Tble 1 Cses of trde liberliztion Cse Liberlizing Pre-liberliztion Liberliztion Triff cuts [ of control nme countries period period within group countries EEC Benelux, Frnce, 1950 Jn % 54 Germny, Itly thru 1958 to July 1968 EFTA Austri, Denmrk, 1952 July % 54 Norwy, Sweden, thru 1959 to Jn Switz., UK EEC-EFTA EEC plus 1958 July % 60 EFTA thru 1967 to Jn Kennedy 37 1together 1963 Jn % 88 Round thru 1967 to Jn Argentin, Austrli, Austri, Belgium, Brzil, Cnd, Chile, Czechoslovki, Denmrk, Dominicn Republic, Finlnd, Frnce, Germny, Greece, Icelnd, Indi, Isrel, Itly, Jmic, Jpn, Kore, Luxemborg, Mlwi, Netherlnds, N. Zelnd, Norwy, Peru, Portugl, South Afric, Spin, Sweden, Switzerlnd, Trinidd nd Tobgo, Turkey, United Kingdom, United Sttes, Yugoslvi. Source: Ben-Dvid (1993). timetble. In ech cse, for defining the post-liberliztion period strting yers include the yer of first reductions if the dte ws June or erlier; ending yers re the clendr yer of the finl triff cut regrdless of its month. The preliberliztion period I then define s covering the sme number of yers (dt permitting, s the dt strt in 1950). For exmple, the EEC cse s postliberliztion period ws 1959 through 1968, so pre-liberliztion ws 1950 through Control countries should be very similr to the tretment group (Meyer, p. 18) but for the tretment. Wht this mens in prctice is not obvious. Accordingly, I select control countries three different wys. First, I define control groups by brod informtion on geogrphy nd/ or income. For exmple, GATT s 37 liberlizers spn wide rnge of developed nd developing countries ll over the world. So I construct its control group to be ll countries in the world not prt of the Kennedy round. For continuity, in ech of the other three cses I lso construct rest-of-the-world control group s ll countries other thn tht cse s liberlizers. These other three cses consist of Europen countries which were welthy reltive to most of the world. So for these three cses I lso use s control groups ll other Europen countries nd ll other originl Orgniztion of Economic Coopertion nd Development (OECD) countries. Thus, by this first selection method the first three cses hve three control groups ech nd the fourth cse one. Also, ll the EEC (EFTA) control groups lso exclude the EFTA (EEC) countries becuse both sets of countries hd very similr tretments t lmost exctly the sme time. Note tht different control groups hve different numbers of countries. Given the criterion of prticulr control group, the number of countries is constrined only by dt vilbility: for country to be in tht group there must be dt on per

14 216 M.J. Slughter / Journl of Interntionl Economics 55 (2001) cpit income for every yer of the pre- nd post-liberliztion periods. This prevents chnges in income dispersion due to countries entering nd exiting the smple. My second selection method uses ctul dt on per cpit income nd trde openness (exports plus imports s shre of GDP) to pick countries which look most similr to the liberlizing countries. Convergence ptterns my depend on per cpit income, e.g., convergence mechnisms my vry with overll development. And Ben-Dvid (1996) links trde flows nd convergence; perhps the role of trde-medited convergence mechnisms depends on the size of trde volumes. For ech cse, for ech liberlizing country during the pre-liberliztion period I clculte verge per cpit income nd verge trde openness. Next, I clculte similr verges for ll countries in ech of tht cse s first set of control groups. From ech of these control groups I then pick the one country which is most similr to the liberlizing country in question, where similrity is mesured s follows. First rnk countries bsed on smllest bsolute difference in per cpit incomes, then rnk them the sme wy bsed on smllest bsolute difference in trde openness, nd then sum the two rnks nd pick the one country with the closest overll rnk. In cses where two liberlizing countries shre the sme most-similr control country, I use second-closest control countries (nd beyond, when necessry) following the principle of mximizing overll closeness of the 10 liberlizers s group. Overll, this second selection method genertes the sme number of control groups per cse s the first method, but here ech control group hs the sme number of countries s tht cse s liberlizing group. My third selection method simply picks control countries rndomly from the rest of the world. Specificlly, for ech cse I select rndomly from ll other countries in the world for which there is dequte dt number of countries equl to the number of liberlizers. Becuse I hve no ide if ny prticulr rndom group is pproprite, I repet this exercise 1000 times for ech cse nd report verge estimtion results. Ech method for selecting control groups picks similr countries differently. The first uses brod informtion on geogrphy nd/or income; the second uses ctul country-by-country dt on income nd trde flows; nd the third simply picks countries rndomly. Which mechnism is best depends on how well one thinks dt on geogrphy, income, nd/ or trde flows find countries stisfying the difference-in-differences identifiction ssumption. It is true tht during ech cse mny other countries were lso liberlizing trde. But references on recent trde greements (e.g., Bhgwti nd Pngriy, 1996) do not revel ny country groups which were liberlizing the sme wy s ny of the tretment groups e.g., 10 For exmple, suppose tht liberlizer L1 is closest to potentil control C1 with n overll rnk of two nd then next closest to potentil control C2 with n overll rnk of four. Liberlizer L2 is lso closest to potentil control C1 with n overll rnk of two, but is next closest to potentil control C3 with n overll rnk of 20. I would then select C1 to be the control for L2 nd C2 to be the control for L1, becuse C2 is rnked much closer to L1 thn C3 is to L2.

15 M.J. Slughter / Journl of Interntionl Economics 55 (2001) during the Kennedy Round the rest of the world ws not lso reducing triffs by 50%. This suggests there re meningful differences between tretment nd control groups. For completeness I report results using ll three mechnisms. To summrize, my empiricl pln is to estimte Eqs. (3), (4), (7), nd (8) on ech of the four cses listed in Tble 1, where for Eqs. (4) nd (8) ll control groups just described re used. All equtions re estimted using ordinry lest squres with robust stndrd errors to llow for generl heteroskedsticity in the error terms. Before reporting the estimtion results, it helps to relte this pln s key equtions to erlier work. Both Schs nd Wrner nd Ben-Dvid (1996) compre the convergence of group of lredy open (Schs nd Wrner) or lredy trding (Ben-Dvid) countries with control group of closed or rndomly selected countries. In terms of Eq. (4), these studies contrst (b 1 b 1 b 1 b ) with (b 1 b ). This single difference (b 1 b ) my suffer from not controlling for ny differences between the two groups tht my hve predted the influence of openness/ trde. In ddition, these two studies do not hve cler policy tretment. Schs nd Wrner mesure openness using both policies nd mrket outcomes; Ben-Dvid s country groupings re bsed on endogenously determined trde flows. Ben-Dvid (1993) is the study closest in method to this one. His nlysis of trde-liberliztion cses do hve cler tretments. But much of his nlysis looks t the performnce of liberlizing countries post-liberliztion, i.e., ( b 1 b ), or 1 2 (somewht informlly) t this performnce reltive to the pre-liberliztion performnce, b. These quntities need not ber ny systemtic reltionship to b Dt nd empiricl results 5.1. Dt All dt come from the Penn World Tbles of Summers nd Heston (1997). Both rel income per cpit nd per worker re in this dt set. I use income per worker becuse most convergence models ssume ll people work. Becuse there is very high smple correltion between lbor forces nd popultions, results re very similr using either mesure Single-difference estimtion results As wy to visulize the regression results for the single-difference estimtes, j Fig. 1 plots s rt over time for ech of the four cses listed in Tble 1. If trde liberliztion were converging incomes, then one might expect to see convergence ccelerte fter ech trde greement strted. But none of the four cses displys drmtic ccelertion. Indeed, in the EFTA nd EEC-EFTA cses convergence ppers to slow post-liberliztion. The GATT cse hs convergence post-liberliztion, but it mostly occurs in one yer. Also, the rnge of income dispersion is

16 Fig. 1. Per cpit income dispersion for the four cses, pre- nd post-liberliztion. In ll pnels the verticl xis mesures per cpit income dispersion mong the liberlizing countries, mesured s the stndrd devition of the nturl log of per cpit incomes. In ll pnels the verticl line mrks the onset of trde liberliztion. 218 M.J. Slughter / Journl of Interntionl Economics 55 (2001)

17 M.J. Slughter / Journl of Interntionl Economics 55 (2001) Tble 2 Differences in rtes of per cpit income convergence pre- vs. post-liberliztion for liberlizing countries Cse Pre-liberliztion Post-liberliztion Difference in Number nme convergence rte convergence rte convergence of for liberlizers for liberlizers rtes observtions EEC Liberliztion (22.888)** ( )*** (21.006) EFTA Liberliztion (29.626)*** (26.164)*** (4.620)*** EEC-EFTA Liberliztion ( )*** (29.194)*** (6.327)*** Kennedy Round Liberliztion (20.513) (22.224)* (21.254) These convergence rtes re prmeter estimtes of the difference-in-differences regression specified in Eq. (3). Reding cross, the columns report the following prmeters: b 1;(b11 b 2); b2. T-sttistics re reported in prentheses for robust stndrd errors. ***, **, nd * denote significnce t the 99%, 95%, nd 90% levels. much nrrower in this cse thn the other three, suggesting this cse might not be s informtive. Tble 2 presents the regression results for Eq. (3) for ll four cses. The key coefficient estimte is b 2, where negtive (positive) b2 indictes tht convergence ccelerted (decelerted) with the onset of liberliztion. In none of the four cses is convergence significntly fster fter liberliztion strts. In the EEC nd GATT cses convergence ccelerted, but not significntly. In the EFTA nd EEC-EFTA cses convergence decelerted significntly. Tble 3 presents the Tble 3 Differences in rtes of per cpit income convergence pre- vs. post-liberliztion for liberlizing countries Cse Pre-liberliztion Post-liberliztion Difference in Number nme convergence rte convergence rte convergence of for liberlizers for liberlizers rtes observtions EEC Liberliztion (22.448)** (23.807)*** (20.762) EFTA Liberliztion (22.770)*** (3.028)*** (0.021) BEC-EFTA Liberliztion (24.822)*** (22.509)** (1.138) Kennedy Round Liberliztion (20.761) (21.415) (20.394) These convergence rtes re prmeter estimtes of the difference-in-differences regression specified in Eq. (7). Reding cross, the columns report the following prmeters: d 1;(d11 d 2); d2 T-sttistics re reported in prentheses for robust stndrd errors. ***, **, nd * denote significnce t the 99%, 95%, nd 90% levels.

18 220 M.J. Slughter / Journl of Interntionl Economics 55 (2001) nlogous regression results for Eq. (7). Here the key coefficient estimte is d, 2 with negtive (positive) d indicting tht convergence ccelerted (decelerted) 2 with the onset of liberliztion. The bsic conclusion is the sme s from Tble 2. In none of the four cses is convergence significntly fster fter liberliztion strts: in ll cses income levels were converging to group verges both before nd fter liberliztion, but with no significnt difference between the two regimes. On blnce, the single-difference estimtes from both convergence mesures suggest tht trde liberliztion did not foster ny significnt, systemtic 11 convergence Difference-in-difference estimtion results As discussed in Section 4, these single-difference results might be msking the true effect of trde liberliztion. For exmple, in ech cse perhps postliberliztion there ws rpid income divergence in the rest of the world. Then despite the single-difference evidence, liberliztion my hve fostered convergence mong the liberlizers reltive to the control group of the rest of the world. The difference-in-differences regressions in Eqs. (4) nd (8) llow for this possibility. Figs. 2 nd 3 provide visul preview of the difference-in-differences results using the EEC cse s n exmple (for brevity, figures for the other three cses re j omitted). Fig. 2 plots s rt over time for the EEC countries nd for three possible control groups: the rest of the world, the rest of the OECD, nd the rest of Europe. j rt Fig. 3 plots EEC s long with three idel control groups constructed from dt on both per cpit income nd trde openness: one group picked from the rest of the world, one from the OECD, nd one from Europe (see Section 4 for detils on the control groups). Recll from Fig. 1 nd Tble 1 tht mong the EEC countries convergence ccelerted bit post-libertion, but not significntly. Piring this EEC difference with the respective differences for the control groups visulizes the difference in differences to be estimted. In Fig. 2 no control group shows drmtic chnge in convergence post-eec liberliztion. In prticulr, none shows mrked shift towrds less convergence or greter divergence. This suggests tht difference-in-difference estimtes will not indicte tht EEC liberliztion cused convergence. In Fig. 3 both the OECD nd world control groups pper to hve shrp chnges towrds convergence post-eec 11 The results in Tbles 2 nd 3 re generlly robust to dropping yer from or (where dt permit) dding yer to the strt of the pre-liberliztion period nd/ or the end of the post-liberliztion period. The only sensitive endpoint yer ws 1950 in the EEC cse. As Fig. 1 shows, the EEC group converged substntilly between 1950 nd If this cse strts in 1951, then both the singledifference estimtes in Tbles 2 nd 3 become significnt t the 5% level. However, strting this cse in 1950 is preferble both becuse the dditionl yer mkes the pre-liberliztion period closer in durtion to the post-liberliztion period nd becuse there is no cler reson why the 1950 informtion should be ignored.

19 M.J. Slughter / Journl of Interntionl Economics 55 (2001) Fig. 2. Per cpit income dispersion for the EEC nd three possible control groups, pre- nd post-liberliztion. In ll pnels the verticl xis mesures per cpit income dispersion mong the liberlizing countries, mesured s the stndrd devition of the nturl log of per cpit incomes. The verticl line mrks the onset of EEC trde liberliztion. See the text for description of the construction of the control groups. liberliztion (initilly slow convergence sped up for the OECD, nd initilly rpid divergence stopped for the world), suggesting tht these difference-in-difference estimtes will indicte EEC liberliztion ctully cused divergence. These visul difference-in-differences lso highlight tht wht mtters for control group is its outcome chnge reltive to the tretment group s outcome chnge, not its overll outcome reltive to tht of the tretment group. For exmple, in Fig. 2 there is no worldwide income convergence during the overll period if nything 12 there is moderte divergence. But the relevnt comprison is not overll worldwide no convergence versus overll EEC convergence: it is the chnge in convergence ptterns cross the two groups. Indeed, by construction the difference-in-differences pproch ccounts for these overll, time-invrint differences in outcomes between the two groups (coefficient b in Eq. (4) nd d in Eq. 3 3 (8)). Tbles 4 7 present the difference-in-differences estimtion results using ll three selection methods for control groups, one cse per tble. Ech row of ech tble reports the difference-in-differences prmeter estimte from either Eq. (4) 12 This unconditionl divergence of worldwide incomes hs recently been noted in the growth literture s generl pttern of the 20th century (e.g., Pritchett, 1997).

20 222 M.J. Slughter / Journl of Interntionl Economics 55 (2001) Fig. 3. Per cpit income dispersion for the EEC nd three possible control groups, pre- nd post-liberliztion. In ll pnels the verticl xis mesures per cpit income dispersion mong the liberlizing countries, mesured s the stndrd devition of the nturl log of per cpit incomes. The verticl line mrks the onset of EEC trde liberliztion. See the text for description of the construction of the control groups. (coefficient b 4) or Eq. (8) (coefficient d 4). Ech row lso reports the control group used, the number of countries in tht control group, nd the number of observtions in the estimtion eqution. For the rndomly chosen control groups I report the verge prmeter estimte for ll 1000 trils nd for just the trils with significnt prmeter estimte. A positive (negtive) estimte of b4 or d4 indictes tht trde liberliztion converges (diverges) per cpit incomes mong the liberlizing countries. The overll messge of Tbles 4 7 is tht trde liberliztion does not generte ny significnt, systemtic convergence. For the EEC cse in Tble 4 the estimtes re somewht mixed. The ll-country nd rndomly chosen control groups indicte insignificnt convergence, while the idel dt-chosen control groups mostly indicte divergence significntly so in one cse. In ech of Tbles 5 nd 6, ll estimtes but one indicte divergence, significntly so in mny cses. The GATT estimtes in Tble 7 show convergence, but only one is mrginlly significnt. In evluting the evidence in these tbles there re few points of note. First, once in Tble 5 nd twice in Tble 6 dt-chosen control group duplictes n ll-country control group: this is becuse there simply weren t enough countries in the ll-country pools for the dt to choose from. Second, the strength of evidence for or ginst the liberliztion-convergence hypothesis vries somewht cross control-group type. The dt-chosen control groups offer the strongest evidence