Spaghetti bowls revisited

OKONOMOS

Economic theory, usually gripping in its intellectual vigour, can also be infuriatingly blind to real life. Nothing illustrates this more than the vitriol that is poured by traditional economists on regional trading arrangements (RTAs).

The campaign is led by some of the world's best-known trade economists, and one of them famously described the proliferation of RTAs and the resulting trading arrangements as a spaghetti bowl. The name has stuck.

Recently, to see if I could get him to reconsider his set-in-stone view, I narrated to him the incident from the book Catch-22. The hero, Yossarian, refuses to fly on any more bombing missions. The squadron chaplain is sent to persuade him. "What would happen my son," asks the chaplain, "if everyone thought the way you do?"

"Then I'd be a bloody fool, wouldn't I, Father, to think any other way?" replies Yossarian.

The logic is worth pondering. If so many countries were forming RTAs, there simply has to be something in it and would countries that don't join an RTA, be bloody fools a la the Yossarian logic? Dismissing the phenomenon as bad form isn't just churlish, it isn't useful, either.

Apart from whatever else RTAs may achieve, they have two main effects. The first is that they restrict competition to within the bloc (the well-known trade diversion phenomenon) and thus increase the profitability of firms within the bloc. I am willing to bet that eventually this trade diversion creates the strength that leads to trade creation.

The second, less well-known, fact is that they reduce the distance over which trade is carried out. There are many who would argue that distance doesn't matter much because transport costs form only a small (and falling) proportion of total costs.

That may well be so, but often enough, it forms the decisive part of the costs. It can be the proverbial straw on the camel's back. Happily, empirical evidence for this intuition is now available in a recent paper* by Celine Carrere and Maurice Schiff.

They examine the evolution of countries' distance of trade (DOT) between 1962 and 2000 and find "that the DOT falls over time for the average country in the world, and that the number of countries with declining DOT is close to double those with increasing DOT."

This means that contrary to the received wisdom that distance doesn't matter, it has actually "become more important over time for a majority of countries."

They also examine the impact on the DOT of changes "in production, customs and domestic transport costs; air relative to land and ocean transport costs; competition, exchange rate policy, regional integration, uneven growth, and counter-season trade; and just-in-time inventory management."

The result: "Though regional integration has a negative impact on the DOT, the countries forming trade blocs had a DOT that was growing faster or falling more slowly than that of excluded countries." In plain language, this means that the extra-regional trade of the countries within the bloc increases.

Why? My hunch is that RTAs increase the efficiency of the firms within the RTA, who are then able to trade more with firms outside the bloc. The trading pattern of the firms in the European Union and Association of South East Asian Nations in the past 20 years provides some proof of this.

And, of course, there is the US factor: as the most important trading partner of most countries, its distance skews DOT for most countries. What seems to be happening is that as firms within RTAs grow stronger, the region's trade with the US increases and this skews the DOT because the US is so far away.

How does economic growth affect things? The authors find that when growth is high, firms tend to trade relatively more with countries of the region and this lowers DOT. This is what happened in the East Asia-Pacific region. And it happened in North American Free Trade Agreement as well, though in the 1990s.

Moral: India should pursue RTAs aggressively, never mind what the purists of trade economics say.

*On the Geography of Trade: Distance is Alive and Well, World Bank Policy Research Working Paper 3206, February 2004, www.worldbank.org