Tear Down This Wall

I feel something is keeping us apart

German reunification will mark its 20th anniversary this year. Last November, the country celebrated 20 years since the Berlin Wall came down. Time enough for it to be just a bad memory, it would seem. Nowadays, you really have to know where to look if you want to see a trace of the old border.

But, as CESifo researchers Volker Nitsch and Nikolaus Wolf show in a very interesting paper released around the time of the Berlin Wall two-decade anniversary, the wall is still alive and well. At least, as regards its impact on trade. And this is not the only “deactivated” political border where its effects on trade are still felt.

This is indeed odd. If the EU has largely erased borders for travel, labour, study and intra-EU migration, why should an invisible, but nonetheless effective, domestic barrier to trade still persist in Germany?

Messrs Nitsch and Wolf take advantage of the fact that Germany’s reunification in 1990 provides a unique natural experiment for examining the effect of political borders on trade. When the Berlin Wall came down, followed quickly by political and economic union, the impervious administrative barrier to trade between both parts of Germany was effectively removed within a very short period of time.

Thus, the evolution of intra-German trade over the two subsequent decades can provide unequalled insights into globalisation and border effects on trade patterns.

There is undoubtedly evidence of an easing of trade across the old political border, but the question is, how long does it take for its impact on trade in to disappear completely?

A large body of empirical literature has established that national borders reduce trade by about 50 percent or more. However, there is no consensus regarding why this should be so. Three kinds of explanations are put forth: the “political barriers” approach, the “fundamentals” approach, and the “artefact” approach.

The political barriers approach states that borders continue to affect trade mainly because of the existence of non-tariff barriers that diminish trade even after the removal of tariff barriers, or even after the establishment of a currency union. In other words, the establishment of a free-trade area or a currency union removes only some political barriers, but anything short of political unification will still leave plenty to hinder trade. For example, trade across the US-Canadian border or the Franco-German border may still be affected by differences in taxation or dissimilar legal frameworks.

The fundamental approach, in turn, asserts that border effects stem from some source of heterogeneity between regions that exists independently of the political border and often predates it. Usually, culture, language, social and business networks, as well as geography, can play a role in this: a mountain range can pose a significant barrier to trade, while a river or sea can ease it.

The artefact approach claims that border effects are at least to some extent a statistical artefact that arises from the difficulties of separating the impact of border-related trade barriers from the impact of geographical distance and from the non-directional multilateral barriers to trade.

The contribution of Messrs Nitsch and Wolf’s paper is to use variation in the cross-section and over time on the former intra-German border to distinguish between the three above approaches.

The authors use two new data sets on German domestic trade flows from the period from 1995 to 2004 to analyse the pattern of trade within Germany after reunification had removed all administrative barriers to trade. Crucially, the two data sets allowed them to identify the effect of the former East-West border after controlling for the effect of administrative borders between the 16 German federal states (such as Bavaria and Hesse) on trade. If border effects arise from “fundamentals”, such a slow adjustment of social and business networks in East and West Germany or the permanence of purely geographical barriers, their effects would be expected to decline only gradually.

Furthermore, if estimates of border effects are indeed a statistical artefact, resulting from aggregation bias, for instance, it would be reasonable to expect no lingering impact of the former East-West border on intra-German trade patterns, once the data is controlled for all the factors concerned.

After a detailed statistical analysis, the authors find little evidence that political integration is necessarily followed by rapid economic integration. The impact of the former East-West border on trade is declining steadily, but very slowly.

This particular pattern of change over time strongly suggests that border effects are neither statistical artefacts nor mainly driven by administrative or “red tape” barriers, but instead arise from more fundamental factors. After all, over the period in question, 1995-2004, no administrative barriers to trade continued to exist along the former Iron Curtain in addition to barriers along federal state borders. The authors estimate that it will take from 33 to as many as 40 years to remove completely the impact of the old political border on trade.

In sum, borders indeed matter and it is hard to change them, because they are related to underlying economic fundamentals. South Korea, watch out. An eventual political union with your prickly northern neighbor might turn out to be the easy bit after all.

Volker Nitsch, Nikolaus Wolf: Tear Down this Wall: On the Persistence of Borders in Trade, CESifo Working Paper No. 2847

• Other CESifo Working Papers by Volker Nitsch
• Other CESifo Working Papers by Nikolaus Wolf
• Other CESifo Working Papers dealing with trade
• Other CESifo Working Papers dealing with integration
• Other CESifo Working Papers dealing with home bias
• CESifo Working Papers published in the past three months