The difficulties of reforming international institutions and practices at the global level provide increasingly powerful impetus for regional economic arrangements. Of these arrangements, the European Union (EU) is the one with the most far-reaching implications. Observers in other parts of the world thus have good reason to look to Europe in order to gauge the possible future evolution of their own regional arrangements. In discussion paper No 1294 Research Associate Tamim Bayoumi and Research Fellow Barry Eichengreen consider the impact of preferential arrangements in Europe since 1950's. They use the gravity model which has long been the workhorse for empirical studies of the pattern of trade. Attraction (trade) depends upon mass (the product of economic size) and distance (geographic or economic). Specifically, the volume of trade between two countries should increase with their real (the so-called gravity variable), since large countries should trade more than small ones, and with per capita incomes, since rich countries should trade more than poor ones. It should diminish with geographical distance because proximity reduces transportation and information costs. Investigators then add dummy variables for participation in various preferential arrangements.

The author's specification, while compatible with the basic theory, departs from the standard model in important ways. Using this approach, they find that the formation of the EEC and EFTA free trade areas had significant impacts on Europe's trade that cannot be attributed to the participating countries' observable economic characteristics or even to unobservable factors, such as histories of intimate trade relations or beneficial trade structures, whose effects remained constant over time. For the founding members, these trade effects were concentrated in the early years of existence of their arrangements. EFTA was heavily trade creating, but the EEC promoted intra-bloc trade through a combination of trade creation and trade diversion. This conclusion is reinforced by the results for the first two enlargements of the Community, for which they also find both trade-creation and trade-diversion effects.

Is Regionalism Simply a Diversion?
Evidence from the Evolution
of the EC and EFTA
Tamim Bayoumi and Barry Eichengreen

Discussion Paper No. 1294, November 1995 (IM)