The world is not flat. Distance is not dead. In short, borders matter. A large body of empirical work – stretching back to the John McCallum 1995 article “National Borders Matter: Canada-US Regional Trade Patterns” – shows that international borders reduce trade flows to an astounding degree. Recent studies have estimated this so-called “border effect” to have a negative impact on trade that is equivalent to a tariff of 50% or more.
Why does the border effect matter for economic policy? First, nations – even European nations – are breaking up. Czechoslovakia split, Yugoslavia split and there is talk of breaking up several other European nations. Second, it is important to know how to calibrate the meaning of free trade. To gauge the importance of remaining barriers, one needs to know what trade flows would be if all the visible trade barriers were removed. Third, if the goal of European integration is a truly integrated market, then it is important to study the lack of integration among EU members. Social and business networks, especially those related to language patterns rank highly among the factors that may account for the border effect.
A natural experiment on borders
Estimation of the border effect was always plagued by a question of reverse causality. Is it the border that is reducing commercial transactions between particular groups of producers and consumers, or is it the natural affinity among the group that is causing both the border and the reduced trade? After all, national boundaries are endogenous in the long-run and commercial ties are almost surely important.
One way to shed light on this is to look back at the wealth of Europe’s historical experience. As we argue in Schulze and Wolf (2007), the former Habsburg Empire prior to the First World War had some striking features that can help in gaining a better understanding on the role of borders and on European integration today.
To start with, the Habsburg Empire was a large and diverse legal and economic union. It comprised about 13% of Europe’s pre-First World War population and produced one-tenth of Europe’s GDP. It covered the territories of today’s Austria, Czech Republic, Croatia, Hungary, Slovakia and parts of Italy, Poland, Romania, the Ukraine and the former Yugoslavia into one single customs and monetary union. The empire was characterised by an unusually high degree of ethnic and linguistic diversity – not only across its territory as a whole but also within its major regions and cities. The final element that is critical concerns transportation costs. The late 19th century witnessed a sharp decline in transport costs due to a massive extension of the railway network.
Did borders matter within that empire prior to World War I? With hindsight, we know that the Habsburg domains were split up during and after the war among a number of successor states. This created international borders where none had been previously. It is exactly this aspect of the Habsburg case that make it such a useful natural experiment. It offers an almost unique opportunity to explore the possible imposition of economic borders, not of political, legal or administrative trade barriers.
To be specific, we analyse the dynamics of grain markets in the late 19th century Habsburg Empire at the level of its 20 largest cities as a natural experiment. The comparatively simple nature of these product markets allows us to put aside more complex explanations of border effects (such as firm heterogeneity or input-output linkages).
As many other studies, our work builds on the idea that in an economically perfectly integrated area without any frictions, the price of the same good at two different places must be the same: the “law of one price”. Hence, systematic deviations from this rule can be taken as indicators of trade frictions. We explore those trade frictions, and especially, whether the future borders along which the empire was split after 1914 can be identified as causing trade frictions already during the 19th century.
The key hypothesis concerns the importance of ethno-linguistic networks for trade. If ethno-linguistic networks were an important factor, then the intensification of networks among members of the same ethno-linguistic group, and the simultaneous decline of transportation costs, should have produced a border effect inside the Empire. That is, all else equal, two cities with little or no ethno-linguistic differences will tend to trade more with each other than cities with larger differences.
Our empirical strategy involves several steps. First, we ask whether there is any evidence for the emergence of borders within the Empire over the course of the late 19th century. Next, we explore possible economic reasons for this finding other than those related to ethno-linguistic differences. And finally, we test whether and to what extent the pattern of ethno-linguistic differences across the Habsburg monarchy can explain the estimated potential border effects. The analysis relies on three new data sets: annual wholesale prices for five types of grain in 20 major cities of the empire; a reconstruction of the shortest railway connections over time and between all 190 city-pairs, and detailed information on the composition of the 20 cities’ population by language.
Ethno-linguistic networks and intra-Empire border effects
Our results confirm that overall integration was under way: average trade frictions across the Habsburg Empire were declining between the 1870s up to World War I. However, this process of integration was systematically biased along the future borders, and increasingly so. While there is no evidence of the post-war borders in Austria-Hungary’s grain markets for the early years in our sample, the borders become visible from the mid-1880s onwards. Their impact rises afterwards and stays high until the outbreak of World War I.
The emergence and persistence of this ‘border-before-a-border’ cannot be explained by changes in infrastructure, simple geographical features, asymmetric integration with neighbouring regions, or just random effects. What does account for the emerging border effect is the extent of ethno-linguistic heterogeneity across regions and cities as captured by differences in languages. While language heterogeneity apparently didn’t matter in the early years of the period studied, it increasingly shaped the process of economic integration in the later decades. And this was the outcome of two factors, in particular.
First, as markets became more closely integrated as a result of declining transport costs, the relative importance of other non-distance related barriers to inter-regional exchange, such as ethnic or linguistic differences, increased. Second, the absolute importance of these differences rose with increasingly ethnically-based forms of social and economic organisation such as the significant rise in trade co-operatives or many examples for boycott-movements against other ethno-linguistic groups. While the formation of ethno-linguistic networks entailed a lowering of information costs among members and helped diffuse common preferences, it also reduced the extent of exchange with non-network members. Thus, the rise of borders within the Habsburg Empire prior to 1914 was likely driven by both trade-creating and trade-diverting effects of networks. Our paper shows empirically that the presence and strength of ethno-linguistic networks between cities can indeed completely explain the emerging ‘border effect’.
What it means for today’s Europe
These findings do have implications. From an historical perspective, the re-drawing of the map may have had less of an adverse impact than we thought. Regional integration patterns along the lines of the post-war borders began to emerge before the war. Moreover, with respect to present-day issues of European integration, the results suggest that the persistence of ethno-linguistic networks within an environment of declining trade costs can be a powerful factor in shaping integration processes. If so, the future of European integration will increasingly require a clearer understanding of the economics of network formation at both the national and international levels. Not at least, the case of Habsburg suggests that language policy can be crucial for this.
There are currently 23 official languages in the European Union of 27, and the number of languages spoken is still somewhat higher. Thus, linguistic fragmentation is high and language statistics show that cross-border mobility is limited as most of those languages are spoken only within their native countries. Only English, French, German, Hungarian, Polish, Portuguese and Spanish have more than half a million native speakers outside their native countries, and only for English, French, German, and Spanish the number of people who speak these languages well is significantly larger than the number of native speakers. The legal status of the 23 official languages implies very significant costs in terms of efficiency and limits to innovation.
For example, Fidrmuc, Ginsburgh, and Shlomo (2007) point out that European multilingualism often implies the delay of the implementation of European law or large direct and indirect costs of patent applications filed with the European Patent Office. As implied by our work, linguistic networks add to those costs as they limit the scope for further European integration in a world with reduced technical barriers to trade and communication. Essentially, networks limit the size of the European market. There is of course no simple solution, because languages are deeply rooted in societies and because linguistic standardisation would imply significant costs in terms of language disenfranchisement, restricting the rights and opportunities of many linguistic groups. Nevertheless, the issue needs to be addressed, as the status quo with 23 official languages is certainly highly inefficient. A possible improvement would include a significant extension of secondary and tertiary language teaching in schools, dual qualification programs for language teachers, and renewed large-scale efforts to foster transnational mobility across Europe.
Borders matter in an integrating world as long as ethno-linguistic networks matter. Our work on the 19th century Habsburg Empire suggests that the European Union needs to find a new approach to language policy if it aims to achieve a truly common market.
Max-Stephan Schulze and Nikolaus Wolf, “On the Origins of Border Effects: Insights from the Habsburg Customs Union”, CEPR Discussion Paper No. 6327, June 2007.
Jan Fidrmuc, Victor Ginsburgh and Shlomo Weber, “Ever Closer Union or Babylonian Discord? The Official-Language Problem in the European Union”, CEPR Discussion Paper No. 6367, June 2007.