The economic consequences of geopolitical fragmentation: Evidence from the Cold War

As the world grapples with signs of increasing geopolitical fragmentation, it is important to reflect on the lessons of the past. This column studies the economic impact of the Cold War, focusing on how the severity of trade barriers varied over time. While the Iron Curtain represented a tariff equivalent of 48% at its height in 1951, trade between East and West gradually became easier until the fall of the Berlin Wall in 1989. The Iron Curtain roughly halved East-West trade flows and caused substantial welfare losses in Eastern bloc countries that persisted until the end of the Cold War.

As the world grapples with signs of increasing geopolitical fragmentation (Goes and Bekkers 2022, Aiyar and Ilyina 2023, Campos et al. 2023, Balteanu et al. 2024, Bosone et al. 2024, Gopinath et al. 2024), it is important to reflect on the lessons of the past. Understanding the impact of trade barriers during the Cold War, and in particular on countries separated by the Iron Curtain, can provide insight into the potential consequences of future fragmentation.

Throughout the Cold War, Europe was divided by political, military, and cultural barriers between the Soviet-dominated East and the capitalist democracies of the West. The Iron Curtain encompassed both a physical border, of which the Berlin Wall was the most famous representation, and also a complex system of policies that restricted the flow of goods and services. While the physical border did not move, the politically motivated restrictions on trade did. Contrary to popular perceptions of the Cold War as a period of absolute isolation between East and West, trade policies towards each other varied considerably over time, and little is known about the extent to which these changes affected effective trade barriers.

In a recent paper (Campos et al. 2024a), we quantify the evolution of a tariff-equivalent measure of the Iron Curtain using previously unavailable data that include bilateral trade flows for East Germany and the USSR. We also analyse how the Iron Curtain generated trade integration within Eastern and Western Europe and how trade barriers with non-aligned or neutral countries evolved over time.

New data for Eastern European countries

A major challenge in conducting this analysis is the lack of complete historical data on bilateral trade flows for key Eastern bloc countries. For example, the IMF’s DOTS database, which is one of the main sources of bilateral trade data in the postwar period, does not include trade flows involving East Germany and the USSR, either as exporters or importers, for many years. To overcome this problem, we collect information from several editions of the statistical yearbooks of East Germany and the statistical reviews of foreign trade of the Soviet Union. We use exactly the same methodology used by the IMF for creating the original DOTS database, to incorporate these additional observations. Where the database contains data for specific years, we verify that our approach closely matches the existing information.

With this completed dataset, we use a structural gravity equation to estimate the effect of the Iron Curtain on bilateral international trade flows. Trade barriers associated with the Iron Curtain are identified by the difference between international trade flows that cross the Iron Curtain (i.e. from a country in Eastern Europe to a country in Western Europe and vice versa) and international trade flows that do not. For ease of interpretation, we convert estimates of trade barriers to a tariff equivalent measure. In a second step, we feed these estimates into a quantitative trade model to simulate the trade and welfare effects of a counterfactual world without the Iron Curtain.

Estimates of the trade costs of the Iron Curtain and their evolution over time

Our estimates suggest a progressive easing of trade barriers over the course of the Cold War. While there were intermittent fluctuations in the difficulty of trading across the Iron Curtain, the overall pattern shows a gradual easing of trade restrictions over time. Using a tariff-equivalent measure, we find that, at its height, the Iron Curtain had an effect similar to a 48% ad valorem tariff. The tariff-equivalent measure declined sharply in the second half of the 1950s and throughout the 1960s, settling at around 25% in the 1970s and 1980s (see Figure 1).

To put the ad valorem tariff into perspective, it is useful to compare it with estimates derived using similar models for other changes in trade policy. Head and Mayer (2021) show that the reduction in trade barriers caused by the deepening of the European Single Market after the Maastricht Treaty in 1992 was equivalent to an ad valorem tariff reduction of between 20% and 30% for trade in goods and between 10% and 20% for trade in services, whereas Felbermayr et al. (2024) indicate that GATT or WTO membership is equivalent to an ad valorem tariff reduction of between 6% and 13%. The estimated ad valorem tariff equivalents of major trade policy changes (such as entry into the GATT, the WTO, or the European Union) are therefore substantially lower than those that can be attributed to the Iron Curtain during the Cold War. In fact, the estimated trade barriers for the Iron Curtain during the height of the Cold War are similar to those that arise between opposing factions during actual wars, which Glick and Taylor (2010) estimate to be about 40% in tariff-equivalent terms.

In our paper, we also examine how trade barriers developed between European countries that were closer to the West (e.g. Switzerland, Ireland, and Sweden), neutral market economies (e.g. Austria and Finland), and non-aligned communist economies (e.g. Yugoslavia), and the two blocs on either side of the Iron Curtain. Western-leaning countries such as Switzerland, Ireland, and Sweden faced increasing trade barriers with the East, as did neutral countries such as Austria and Finland, at least until the early 1970s. Yugoslavia, on the other hand, experienced relatively high trade costs with both blocs. As a result, the Eastern bloc countries were the most disconnected from the rest of the world, as they experienced high trade costs not only with the West, but also with non-aligned or neutral countries.

Figure 1 Estimated tariff equivalent of the Iron Curtain

Notes: The figure shows the estimated tariff equivalent of the Iron Curtain’s borders measured in percentage points. The estimation uses a state-of-the-art structural gravity model. The tariff equivalent is calculated using a value for trade elasticity of 5.03, resulting from a meta-analysis and widely used in the literature (Head and Mayer 2014). The 95% confidence interval is calculated using the delta method.

A quantification of the missing trade and welfare losses due to the Iron Curtain

Using a state-of-the-art quantitative trade model that belongs to the class of universal gravity models described by Allen et al. (2020), we show that despite the gradual easing of trade restrictions over time, the Iron Curtain had an economically significant impact on trade flows and welfare throughout the Cold War period, especially for countries in Eastern Europe. We simulate general equilibrium results using the new Stata command described by Campos et al. (2024b) that allows us to simulate any general equilibrium model in the class of universal gravity models.

Figure 2 Trade flows between Eastern and Western Europe

Note: The figure shows the results of a simulation in which the trade barriers of the Iron Curtain are removed. The solid line shows the actual trade volume between Eastern and Western Europe. The dashed line shows the counterfactual trade volume if the trade barriers of the Iron Curtain were removed.

For our preferred calibration of the model, we find that the Iron Curtain roughly halved East-West trade flows (see Figure 2). Welfare losses in the median Eastern country increased from less than 1% of per capita consumption per year at the start of the Cold War to about 2% at the end, reflecting and increasing burden of the Eastern bloc’s economic isolation from the rest of the world prior to the end of the Cold War. This increase in welfare costs suggests that the lack of international trade may have been behind the push to liberalise Eastern bloc economies at the end of the Cold War, with initiatives such as perestroika launched by Gorbachev in the Soviet Union.

source : Voxeu.org