Toward an Index of Relative Economic Integration for North America: Conceptual Paper

Toward an Index of Relative Economic Integration for North America: Conceptual Paper Christopher Sands Canada Project, Americas Program Center for Strategic and International Studies Washington, D.C. June 27, 2002

Contents 1 Summary 2 2 Purpose 2 3 Definitions 2 4 Key Variables 4 Trade data 5 Capital data 6 Labor data 6 Other data 6 5 Context 7 6 Data Limitations 8 7 Invitation to Comment 8 8 References 9 1

1. Summary Researchers at the Center for Strategic and International Studies (CSIS), the U.S. International Trade Commission (USITC), and Industry Canada are working together to develop an index to measure relative degrees of economic integration among sub-national jurisdictions (e.g. states, provinces, municipal regions, etc.) in North America. The index will incorporate data on such variables as relative prices and flow volumes for trade in goods and services, and capital and labor movement to generate an index number on a scale that will represent the degree of economic integration between regions; by comparing index scores for particular jurisdiction-pairs over time, the extent of economic integration will be measurable. A number of other variables will be tested for their significance in determining or reflecting specific levels of economic integration. This conceptual paper is intended to outline the objective for developing such an index. A prototype index will be developed, using sample weightings for selected measures, and this will be presented for further comment. 2. Purpose This conceptual paper is the first step in a collaborative effort by researchers at the Center for Strategic and International Studies (CSIS), the U.S. International Trade Commission (USITC), and Industry Canada to develop an index to measure relative degrees of economic integration among national and subnational jurisdictions (e.g. states, provinces, municipal regions, etc.) in North America. The Index of Relative Economic Integration for North America (IREINA) is intended to provide a tool in the public domain to enable scholars and policymakers to detect patterns in the progress of economic integration revealing where it is present and its intensity. By assigning an index number representing the degree of integration present between discrete jurisdictions, it will be possible to determine correlated phenomena at each level, and gain a greater understanding of how integration progresses, and what its measurable effects may be. 3. Definitions Economic integration refers to the combination of markets, specifically markets for goods and services through trade, as well as capital markets and labor markets due to the mobility of these factors once barriers are removed. Why integrate? The answer is usually that integration produces welfare gains by making available more choices of inputs for producers and more products and services for consumers, allowing each jurisdiction to specialize production in areas of comparative advantage. There are two aspects of the phenomenon of economic integration, which Balassa (1973) described as both a process and a condition. As a process, economic integration is dynamic and variable; as a condition, it may be studied in terms of its attributable effects. 2

Economic integration is a relatively recent concept. Based on a thorough review of economic literature, Machlup (1977) concluded that the term economic integration was first used by Viner (1950) to refer to countries (rather than firms). Viner s key insight was that the elimination of barriers to trade results in the potential for trade diversion (away from non-integrated markets to integrated ones) and trade creation (the growth of new trade as the opportunity cost of doing business across a particular border is lowered). Following Viner s example, the focus on trade patterns as a quantitative indicator of economic integration has been common to much of the literature. However, there are some problems with the use of trade data alone to measure economic integration. Jovanović (1992) illustrates the inherent difficulty of quantitative studies of economic integration based on trade data, dividing them into two categories: ex post and ex ante models. He argues that ex post models, which attempt to measure integration effects by comparing existing data with an econometric model of the same economy had certain barriers not been removed or added, are problematic because the counterfactual models used as a basis for comparison are in turn based on hypothetical assumptions whose validity is impossible to test. Ex ante models look forward, extrapolating trends with and without the change to trade barriers and then comparing the results. These models are based on the best guesses of researchers, since they project into the future about which no data is available. As such, they give substance to these guesses by assigning a value to forecast differences. Partially as a result, studies of economic integration have focused on associated phenomena in effect, assuming integration is taking place and studying its impact on other data. In reviewing studies of European economic integration, which make up the vast majority of the work done on the subject of economic integration to date, Tovias (1994) noted the predominance of work making this a priori assumption that seeks to contrast the conditions for those states inside the common market with those outside. Prior to the mid- 1960s, Tovias found most research concentrated on the rationale for joining or remaining outside a customs union, again building on the work of Viner, among others. Then, from the mid 1960s forward, four topics have preoccupied economists looking at European economic integration: (1) the impact of integration agreements on the term of trade; (2) how scale economies and imperfect competition affect gains from integration; (3) comparison of the costs and benefits of different types of integration agreements, including customs unions, bilateral free trade agreements, multilateral agreements, and unilateral tariff reduction; and (4) the effects of non-tariff barriers. The introduction of gravity models in the mid-1960s to describe patterns of trade among countries and regions was proposed by Tinbergen (1962), among others. Deardorff (1998) explained that gravity models have been used to demonstrate that trade volumes between two countries are positively related to income and negatively related to the distance between them; that is, that the wealthier either country is, the more trade will occur, and the farther apart the two countries are, the less trade will occur an explanation that Deardorff found to be consistent with neoclassical trade theories based on specific factor endowments and comparative advantage. But the work of Helliwell (1998), which indicated that Canadian provinces continue to trade more with one another than with neighboring U.S. states, 3

suggests that the relation of trade to geographic proximity inherent in gravity models may not be adequate to explain trade flows, in North America at least. However, increased trade in goods and services alone is not a satisfactory indicator of economic integration. Robson (1980) is critical of the focus most researchers have placed on trade flows between jurisdictions as a measure of economic integration to the near exclusion of other quantitative possibilities: Trade ratios are useful in providing broad indicators of the actual level of economic interdependence among the member countries of a grouping, but as an indicator of the degree or progress of integration they are of limited value. In the first place, the degree of integration is a relative concept that refers implicitly to the extent to which the potential for profitable integration is actually exploited ( ) Furthermore, trade ratios throw little light on the progress of integration, because they do not reveal the degree to which the trade flows have been affected by the integration arrangements rather than reflect an interdependence that would exist anyway. (Robson, 1980:189-90). Twenty years later, Harris (2001) observed that several additional measures of economic integration are now being used to compensate for the limitations of over-reliance on trade flows, including: foreign direct investment (FDI) flows and stocks; corporate merger and acquisition activity; cross-border labor movements; tourism and business travel; transportation flows (such as the number of times a border is crossed); and telecommunications traffic, measured in email messages, Internet access, web site visits, cross-border electronic commerce sales, and so forth. But Harris also notes, Other than traditional trade, investment, and migration data, our knowledge about most of these other forms of interactions is weak at best and further research and data collection in these areas is needed. (Harris, 2001:3). 4. Key Variables Two types of measurement are important for all three kinds of variables: price and mobility (or quantity). For integrated markets, the relative prices of goods and services, capital and labor should tend to converge in all regions of the market, allowing in some cases for transportation cost differences. And the volume of flows between different areas can measure the mobility of these specific factors within integrated markets. Using Balassa s dichotomy, price measures can show the degree to which the condition of integration is present, and flow volumes can be used to measure the process of integration at work. An index number is calculated to show how the price of a bundle of items has changed over a period of time. The calculation is based on a formula that assigns different weights to each item based on the proportion of total expenditure that each item represents. Named for the economists who developed them, Paasche indexes are those that use the current year figures, and Laspeyres indexes involve using the data of a particular year as a base year, and comparing current year data with the base year. 4

As a first step, a prototype formula for the IREINA will be developed that incorporates relative prices of tradable goods and services, capital, and labor. To capture changes in the degree of economic integration over time, it is likely that the IREINA will be a Laspeyres index, with a base year to be determined according to data availability and other considerations. Harris is certainly correct that additional data collection and study is necessary, but as Robson suggests, it is possible to improve on the measurement of integration through the use of existing data on trade and capital flows by adding people flows (using migration data). Certain issues emerge with each type of data that should be noted at this stage. Trade Data The collection of tariffs gave national governments a reason to track import data, with the result that this data remains some of the best available on trade. But since sub-national governments in North America do not have the power to impose tariffs, the data is less complete for states, provinces and metropolitan areas. Export data can be derived from another jurisdiction s import data, but is similarly qualified. The value of service trade can be difficult to quantify, since nothing physical may cross the border to be counted. Educational service trade can be a student crossing the border for university, or kids heading to summer camp. Architectural and design services, or call centers providing product support, can be provided to foreign customers electronically. The point is not to overstate the degree of difficulty in quantifying certain trade, since in such cases; satisfactory data can be gathered or estimated. Yet it may require some effort to improve on trade data currently available. The presence of intra-industry is an important indicator of integration that can be estimated. Trade between firms in the same sector can indicate specialization, which is one anticipated consequence of economic integration. In addition, such trade will foster price convergence in both jurisdictions (given that customers and suppliers are the same). Greenaway and Milner (1986) note that estimates of intra-industry trade have been made to determine the costs and benefits of protectionism and trade liberalization, and to consider the gains from specialization of production, using a variety of models; but no single model has become standard. They conclude: With the emergence of an orthodox theory of intra-industry trade, comparable to the Heckscher-Ohlin-Samuelson model of inter-industry trade (and one in which factor proportions, scale economies, scales and types of product differentiation, and market structure might interact to determine volumes and patterns of trade) we might be able to establish model-specific, testable hypotheses. Until such time we are restricted to considering to what extent documentary evidence is suggestive of support for specific models. (Greenaway and Milner, 1986:123) The significance of intra-industry trade, however, warrants the effort to incorporate a reliable, even if non-standard, estimate of its prevalence into the IREINA. 5

Capital Data Data on capital flows is mainly data on investment, of which there are two important types. Foreign Direct Investment, or FDI, is made by private firms and individuals (government aid is not normally included in this term) in fixed assets such as property, plants and equipment. Portfolio investment is private capital purchases of shares in companies, bonds and other government securities. As noted earlier, the term integration was originally used to refer to the operations of companies, and both FDI and portfolio investment take on additional importance for the measurement of integration when they are investments by firms in subsidiary or allied operations, since these tend to reflect stable capital relationships that may lead to trade and labor exchanges that further promote economic integration between jurisdictions. Where possible, it is valuable to identify these types of structural relationships in investment data. One method may be in considering corporate merger and acquisition activity, as Harris suggests. On a microeconomic level, it would be interesting to consider the frequency and value of bank automated teller machine withdrawals, credit card transactions, and even check cashing by persons in one jurisdiction accessing accounts in another. In the tourism sector, the degree to which retailers accept a foreign currency at a posted exchange rate could also be used to indicate economic integration. Labor Data Labor migration can be short-term or long-term, and can include a variety of compensation levels, from farm workers to senior executives. In adjacent jurisdictions, there may be daily commuters who cross border to work, a strong indication that the two labor markets are being at least partly integrated. When one worker changes location, family members may follow, leading to indirect labor market integration (for example, when the worker s child takes on a paper route). Capturing these ripple effects of single worker relocation would be highly desirable. Similarly, when a student crosses a border for his or her education, friendships made can result in future integrative activity, such as business partnerships and tourism. This suggests that where possible labor data should be augmented with data on the flows of people for non-employment purposes, such as tourism and education. Convergence in median incomes (not simply wages, but total compensation including benefits) are useful to consider as an indicator of economic integration, but these should be considered in light of local cost of living measurements, and the connection between incomes and labor productivity. Other Data While concentrating on the most readily available data concerning trade, capital and labor data, it will be important to test relationships between other types of data and the prototype index. Harris suggests several candidates for such consideration, and there are others such as 6

technological linkages (measured by the cross-listing of patents, establishment of joint ventures and alliances for research and development); regulatory and standards harmonization (including mutual recognition agreements); and exchange rate relationships. Also, we would like to test for any connection between the pattern of economic integration and business cycles. At the outset, the intention is to include as many potentially significant variables as possible. 5. Context A working IREINA formula should be applicable to any pair of jurisdictions for which satisfactory, discrete data are available. To map the progress of integration within North America, the IREINA should be able to show integration levels between states and provinces, and even between metropolitan areas. The value of discriminating among such sub-national jurisdictions will be in correlating certain effects of integration with the degree of integration present. For example, if the IREINA produced a score on a scale from 1 to 10, with 10 indicating greater integration, then it would be possible to associate certain effects with, for instance, the transition from 4 to 5 on such a scale. If Iowa rated an IREINA score of 4 with Canada, and Minnesota rated a 5, Iowa might anticipate that when a Canadian firm opens a large plant in Des Moines, Iowa may need to increase direct air service to Canada to match Minnesota in order to smooth its transition to an IREINA score of 5. If states with IREINA scores with Canada greater than 3 also had retailers who accepted Canadian dollars at a posted exchange rate in their tourist areas, a state that hoped to attract more Canadian travelers would be able to anticipate demand for this facility and work with small businesses to help them to make this service available. Smoothing and minimizing the transition costs associated with deepening economic integration would be one use for the IREINA. Another might be accounting for the costs and benefits of greater integration. If Ontario found its IREINA score with Florida was higher than with British Columbia, this could help government officials to allocate their resources more effectively. British Columbia might discover that its IREINA score with California was higher than for neighboring Washington state, and as a result work to remove hidden barriers to closer ties between BC and Washington. Away from borders, the linkages established by economic integration are harder to detect, particularly for the general public. The governor of Kansas might use the state s IREINA score to show why it was emphasizing trade promotion with Quebec, or seeking investment from Alberta or might simply use IREINA scores as a measure of Kansas s success in such efforts. Prince Edward Island might use its IREINA scores to prioritize its efforts to attract visitors from Chicago and New York City, rather than Boston and Philadelphia. North America also includes Mexico, and the IREINA will be developed to work in Mexico as well. The initial emphasis on Canada and the United States is based mainly on the compatibility of Canadian and U.S. data gathering methodologies, which makes the incorporation of mixed source data easier to manage. Mexican statistical officials and experts will be approached to critique the prototype index and overall design. 7

6. Data Limitations Many specific areas where limited data is available have already been mentioned. It is a particular concern that data for the IREINA may not be currently available at the stateprovincial or metropolitan level. Data collection is costly, and must be justified. However, it is hoped is that the development of the IREINA will help to justify the collection of data related to integration at sub-national levels by the relevant agencies. 7. Invitation to Comment This conceptual paper is designed to provide an overview of the plan to develop the IREINA, and the potential applications for such a tool. Comments on the concept and approach outlined here are welcome from all interested parties, and should be directed to the author at csands@csis.org. 8

8. References Bela Balassa. The Theory of Economic Integration. London: George Allen & Unwin, 1973. Alan V. Deardorff. Determinants of Bilateral Trade: Does Gravity Work in a Neo-Classical World? in The Regionalization of the World Economy, edited by Jeffrey A. Frankel. A National Bureau of Economic Research Project Report. Chicago: University of Chicago Press, 1998. David Greenaway and Chris Milner. The Economics of Intra-Industry Trade. Oxford: Basil Blackwell, 1986. Richard Harris. North American Economic Integration: Issues and Research Agenda. Industry Canada Research Publications Program, Discussion Paper Number 10. Ottawa: Industry Canada, April 2001. John F. Helliwell. How Much Do National Borders Matter? Washington: Brookings Institution Press, 1998. Miroslav N. Jovanović. International Economic Integration. London: Routledge, 1992. Fritz Machlup. A History of Thought on Economic Integration. New York: Columbia University Press, 1977. Peter Robson. The Economics of International Integration. London, George Allen & Unwin, 1980. Jan Tinbergen. Shaping the World Economy: Suggestions for International Economic Policy. New York: Twentieth Century Fund, 1962. Alfred Tovias. A Survey of the Theory of Economic Integration in European Integration: Theories and Approaches edited by Hans J. Michelmann and Panayotis Soldatos. Lanham: University Press of America, 1994. Jacob C. Viner. The Customs Union Issue. New York:,1950 9