What factors determine the size of trade flows between countries? Trade theory suggests that comparative advantage and resource endowments explain why countries trade and what they trade, but these models have less to say about how other factors influence the total volume of trade between countries. To measure bilateral trade flows, policy analysts often employ “gravity models,” which suggest that “mass” (usually proxied by GDP) ought to increase trade flows while distance ought to decrease them. Additional economic and geographic variables are usually included to account for specific characteristics of countries that also may influence trade flows. More recently, researchers have augmented the basic gravity model with political and institutional variables in order to better understand how factors such as currency unions, tariffs, wars, and exchange-rate regimes affect trade flows between countries.
Studies examining the effects of currency unions on trade, and more specifically the effects of the Eurozone on trade among its members, are leading examples of the new emphasis on understanding how institutions affect trade. Advocates of the euro suggest that a single currency boosts trade among members of the Eurozone by reducing uncertainty over exchange-rate movements, by lowering transactions costs, and by spurring competition. While noting that there are costs to adopting the euro (such as the freedom to deviate from the ECB’s interest-rate path), policymakers who favour the new monetary arrangement point to the growth in trade among constituent members as one reason why it ought to be maintained. To date, there is little agreement on the precise impact of the Euro on trade, but recent estimates suggest that it may have boosted average trade by roughly 5 to 10 percent within the Eurozone (Baldwin, 2006).
Other types of political relationships also have the potential to influence trade flows. For example, many of the studies that report on the salutary effects of currency unions also provide evidence that a country’s prior colonial status exerts a large and statistically significant positive effect on current bilateral trade. This finding raises several interesting questions, including whether extant empires boost contemporaneous trade, and if so, how they operate to influence trade. Although formal empires declined during the twentieth century, the changing geopolitics of the 21st century and the continued underperformance of sub-Saharan African countries have reignited interest in understanding how earlier empires and colonial relationships affect economic outcomes (Ferguson 2004; Lal 2001, 2004; Acemoglu, Johnson, and Robinson, 2001).
The Age of High Imperialism
Examining the Age of High Imperialism (1870-1913) helps to shed light on how political relationships can come to dominate trade flows. The late nineteenth and early twentieth centuries are often referred to as the first era of globalization, and provide a nice benchmark for comparison with the modern period since the earlier period was also characterized by durable monetary arrangements (the gold standard) and currency unions (the Latin and Scandinavian Monetary Unions). But the dominant political feature that dictated both trade and financial flows during the earlier period of globalization was empire.
Even though the British Empire, which spanned five continents, was still unrivalled during the 19th century, continental European countries began to more actively challenge Britain’s role on the world stage in the latter half of the century. New imperial powers sought overseas territories to complement their growing economies, which had been stimulated by the industrial revolution. Colonial acquisitions during this phase of expansion included Britain extending its holdings in Burma, Malaysia, and Africa, France consolidating its Indo-Chinese Empire and its foothold in Madagascar, and Germany carving out an empire in Africa. The Age of High Imperialism also included the United States, which had acquired the Philippines and Hawaii after its war with Spain.
The notion that trade and empire are linked is certainly not new. Scholarly debate reaches back over a century, but few studies have attempted to measure the effects. Recent research based on a large, new database of over 21,000 bilateral trade pairs from the Age of High Imperialism finds that, on average, being in an empire more than doubled trade, even after controlling for a variety of standard economic and geographic influences (Mitchener and Weidenmier, 2007). The study also suggests that the contemporaneous effects of empire on trade were larger than the effects of either non-empire currency unions or the gold standard – the largest currency arrangement in history – and significant enough in size to overcome the tyranny of distance.
Although there are many possible ways in which a particular colony’s trade was affected by being in a nineteenth or early-twentieth century empire, trade policies and lower transactions costs appear to be important in explaining why being in an empire boosted trade. Like tariffs and regional free trade agreements today, imperial trade policies of a century ago strongly influenced trade flows. In particular, preferential trade agreements (which were designed by colonies and metropoles to set higher rates on non-empire goods and were used by the Portuguese, American, Spanish Empires and British Dominions), as well as customs unions within empires (employed by France and many of its colonies) significantly boosted the flow of trade within empires.
Empires also lowered transactions costs and payments frictions by promoting a common language among merchants (a lingua franca), creating familiarity with local customs and culture, and encouraging the development of distribution and marketing channels and the formation of social networks. As with the euro today, the role of “vehicle currencies” and currency unions was central to lowering the transaction costs associated with trade. In the empires of last century, transactions costs declined significantly due to the widespread propagation and use of colonial currencies. The United States introduced the dollar in its dependencies after acquiring many of its colonies in the Spanish-American War of 1898. British and German colonies joined the sterling and mark blocks or formed currency unions with other colonies in the region. British colonies in East Africa, for example, formed a silver rupee union with India that also included some areas in East Africa that were members of the German Empire. The large increase in trade flows due to empire-based currency unions may have been especially pronounced during the first era of globalization since many colonies, especially in Africa, had largely conducted trade through barter. When the economies became monetized as a result of colonization and the introduction of colonial currencies, trade rose in response to the benefits that accrued from having a standard unit of account and medium of exchange.
Tariffs, currency unions, free trade areas, and empires hinge on the commitments of rulers and policymakers to maintain their existence. Even after these commitments are abandoned, such institutions can continue to exert influence over economic outcomes. The research on trade points to the complexities in understanding the legacies of institutions. Research suggests that prior colonial status still boosts bilateral trade today. In the classical economics tradition, some researchers view these larger trade flows as welfare enhancing, while others point to the potential pitfalls of “locking” ex-colonies into long-run trade patterns that are sub-optimal and potentially counterproductive for economic development. Other researchers focus on the relationship between institutions, trade, and economic development. Some suggest that settler colonies, in particular, may have benefitted from the trade and openness that the British Empire promoted; trade may have left institutions that fostered greater economic development and growth as a result. On the other hand, European empires may have undermined long-run productivity and growth in other colonies by leaving extractive institutions that did not introduce protections for private property or restrain governments from expropriation (Acemoglu, Johnson, and Robinson, 2001). While empires appear to have increased trade flows then and now, in creating the machinery for trade, empires also imparted institutions that had ambiguous effects on economic growth and development.
Acemoglu, Daron, Simon Johnson, and James Robinson. (2001). “The Colonial Origins of Comparative Development: An Empirical Investigation.” American Economic Review 91(5):1369-1401.
Baldwin, Richard. (2006). “The Euro’s Trade Effects” European Central Bank Working Paper 594 (March).
Ferguson, Niall. (2004). Colossus: The Price of American Empire. New York: Penguin Press.
Lal, Deepak. (2004). In Praise of Empires: Globalization and Order. New York: Palgrave Macmillan.
Mitchener, Kris James and Marc Weidenmier. “Trade and Empire.” Economic Journal (Forthcoming) and NBER Working Paper 13765.