FRBSF Economic Letter

1999-35 | November 19, 1999

Are We Globalized Yet?

Charles Engel


The buzzword in popular international economics in the 1990s is “globalization.” And there’s no doubt that financial markets have become increasingly integrated internationally. The Mexican crisis of 1994 and the Asian crisis of 1997-98 demonstrate the importance of global capital markets in nations’ economies.

Goods and services markets also appear to have become more integrated in the 1990s, as regional trade arrangements and international trade agreements have reduced trade restrictions. But if goods and services markets were truly integrated, then prices would tend to be the same from country to country. And casual observation suggests that this is not the case at all. For example, travel to Europe was cheap in the mid-1980s, and millions of Americans flocked there for their first trips abroad. By 1990, the situation appears to have been reversed: America had become the inexpensive travel destination. Stories were told of Japanese tourists buying Japanese-made electronic consumer products in the U.S. at much lower prices than they would pay in Japan. Now, at the end of the 1990s, American prices are no longer bargains, but good buys can be found in Canada.

This Economic Letter examines why goods prices are different from country to country, with a special focus on the U.S. and Canada, two of the most integrated economies in the world.

Integration of markets and goods prices

One might expect goods prices to be equalized across countries if markets were truly integrated. If prices were higher in one country, entrepreneurs might find it profitable to export goods from cheaper countries to the higher-price country and make a profit. Then, as the supply of goods increases to the high-price country, prices there would fall into line with the other countries.

Globalization has not meant that the prices consumers pay for goods and services have equalized across the world. That should not be surprising for a couple of reasons. First, many products simply are not traded internationally. Globalization has not made it any easier for a Parisian to have a view of Mt. Rainier from his salon, or for a Seattleite to take a stroll to the Left Bank to enjoy a good tarte tatin. The “price” of a house with a view of Mt. Rainier is very much higher for a Parisian than for a Seattleite. Many services–of which housing services are but one example–are not easily traded. To be sure, economic theory maintains that market forces still would tend to narrow the gap in prices of services internationally as markets become globalized. For example, international trade tends to raise wages in low-wage countries. Since a large component of the cost of services is wages, there ought to be some tendency toward equalization of prices of services even if the services themselves are not internationally traded.

But even easily tradable goods have different prices in different locations, as our everyday experience reveals. A quart of milk is more expensive at the corner convenience store than at the large discount grocery store. Yet more expensive is the small downtown market. It is easy to understand this price differential in economic terms. Rents for the space to market milk and other costs for the retailer vary widely even within a single urban area. Sometimes the consumer is willing to pay the higher price at the neighborhood convenience store or the downtown market. The cost in terms of the shopper’s time and travel expenses is often too great to justify a trip to the discount grocery.

But these explanations do not account for the large differences across countries in consumer prices. The problem is illustrated in Figure 1. The thin line plots the real exchange rate between U.S. and Canadian dollars. This provides a measure of the overall consumer price level in the U.S. relative to Canada as measured in a common currency–in this case, the U.S. dollar. When that line rises above 1.0 on the right-hand-side vertical scale, overall consumer prices are higher in Canada. As the graph shows, Canadians paid higher prices in the late 1980s and early 1990s. During that period many shopping centers sprang up just south of the border near large Canadian cities, allowing some Canadians to take advantage of low U.S. prices. Then for most of the 1990s the situation reversed. Canadian consumer prices dipped below U.S. prices in 1993 and have stayed below ever since. In 1999, overall Canadian consumer prices are only about 75% of U.S. consumer prices.

Prices in the U.S. and Canada

It is surprising to see such large swings in relative prices between the U.S. and Canada. Surely these are two of the most integrated economies in the world. If the term “globalization” applies anywhere, it is to these two economies. They have a free trade agreement. Travel between them is virtually unrestricted. The people speak a common language, levels of education are similar, and even geographically the countries are quite alike. Why should there be such large swings in prices?

The relative price of consumer products in different countries is closely tied to exchange rates–the price of one currency in terms of another. As the U.S. dollar price of a Canadian dollar rises, Canadian goods become more expensive compared to U.S. goods. It may seem obvious that this should happen. The Canadian department store sets prices in Canadian dollars and the U.S. department store sets prices in U.S. dollars. The exchange rate fluctuates substantially from day to day and month to month, but most prices in the department stores change infrequently. A numerical example shows how a change in the exchange rate can affect the relative price. Suppose a particular model of television sells for 800 Canadian dollars in Vancouver, and 500 U.S. dollars in San Francisco. If the exchange rate is 0.61 U.S. dollars per Canadian dollar, the U.S. dollar equivalent price of the television sold in Vancouver is $488 (equal to 800 times 0.61). Televisions are cheaper in Vancouver. If the Canadian dollar rises in value to 0.65 U.S. dollars, the U.S. dollar price of the television sold in Vancouver is $520. Now, televisions are cheaper in San Francisco.

But it is not easy to explain why these price differences persist and, in particular, why relative prices track exchange rates over fairly long periods of time. Following up on the numerical example, it might be that for many months or years, the U.S. dollar prices of televisions are lower in Vancouver than in San Francisco. Why does the television manufacturer allow such a price discrepancy to persist? What makes it profitable to charge different prices in the two cities? Perhaps the prices differ for the same reason that a quart of milk is cheaper at the large grocery store than at the downtown market. Maybe rents and other costs are higher for the department store in San Francisco than for its counterpart in Vancouver. But the available evidence undercuts that explanation. When the exchange rate makes a large swing, the price differences reverse. When the Canadian dollar gains in value, U.S. dollar prices of goods sold in Canada rise even though there is no change in costs for the department store. For long periods of time the original situation is reversed and San Francisco has the lower U.S. dollar prices. The puzzle, then, is that prices charged in the department store adjust so slowly when the exchange rate changes–economists refer to this phenomenon as low “pass through.”

Returning to Figure 1, the thick line graphs the nominal exchange rate, which is the U.S. dollar cost of Canadian dollars (left-hand vertical scale). Note how closely the real exchange rate, that is, the relative price of goods (thin line) tracks the nominal exchange rate. Apparently the drop in Canadian prices since the early 1990s is almost exclusively due to the depreciation of the Canadian dollar. The amount that a producer can earn by selling a product in Canada has dropped considerably relative to what that producer can get in the U.S.

A two-sided puzzle

This is really a two-sided puzzle. One side of the puzzle is why firms continue to market goods in Canada at such low prices. It appears that profit margins for goods sold in Canada must be much lower than for goods sold in the U.S. Economic theory tells us that under these conditions, firms should begin moving out of Canadian markets and into U.S. markets. Exports to Canada from the U.S. should fall, and exports from Canada to the U.S. should increase. As the supply of consumer products begins to dry up in Canada, their prices should rise. At the same time, prices in the U.S. should fall as supply increases. Figure 1, however, shows that the fall in Canadian prices relative to the U.S. was unabated for seven years–from mid-1991 to mid-1998. This may indicate that markets for goods are not so highly integrated.

The other side of the puzzle is the exchange rate. Why has the Canadian dollar depreciated so much since 1991? Foreign exchange markets buy and sell money, and they operate like other asset markets. In the short run, the price of foreign exchange is primarily determined by expectations. If investors expect the Canadian dollar to depreciate, they will sell Canadian dollars. And if many investors are selling Canadian dollars, then, indeed, it will depreciate. Like any other asset, Canadian dollars must ultimately have some fundamental value that anchors expectations. Economists believe that prices of goods represent that anchor. In the long run, the Canadian dollar will only depreciate against the U.S. dollar if Canada’s inflation rate is persistently higher than the U.S.’s.

The difference in inflation rates in Canada and in the U.S. cannot explain the 25% depreciation of the Canadian dollar in the 1990s. Sometimes there are “bubbles” in asset markets. A bubble occurs when expectations do not have an anchor. Expectations are self-fulfilling. Perhaps the prolonged rise of the U.S. dollar against the Canadian dollar in the 1990s, in defiance of any trend in prices, is an example of a bubble–the Canadian dollar depreciated simply because investors expected it to depreciate, but with no economic fundamentals justifying those expectations. Some have claimed there are other examples of bubbles in foreign exchange markets–the U.S. dollar relative to the German mark in the first half of the 1980s, or the Japanese yen relative to the U.S. dollar in early 1995 are other examples of bubbles.

If the depreciation of the Canadian dollar were a bubble, it could explain why producers have not abandoned Canadian markets. Bubbles eventually burst, and when they do there can be huge swings in asset prices. The Japanese yen depreciated over 80% in just over three years–from 80 yen to a dollar in May 1995 to 145 yen to a dollar in August 1998. It is entirely plausible that the Canadian dollar could appreciate 20% to 30% in a short time, leading to a similar swing in profit margins on sales in Canada relative to profit margins in the U.S. Those U.S. producers that have made inroads into the Canadian market might not be willing to abandon the market under current circumstances. They may have undertaken substantial research and investment to be able to provide their goods to Canadian markets. With the current weakness of the Canadian dollar, their profit margins are squeezed. But they will not abandon the market if they believe the foreign exchange market has a bubble that might burst dramatically. It will be better to ride out the current situation and wait until Canadian sales are again profitable than to abandon the market altogether. If they stop selling in Canada they will have lost the market share that was costly to obtain. When the Canadian dollar regains strength, it is better to be in the market already than to undertake once again the expense of gaining a toehold in the Canadian market.

Conclusion

The huge differences in consumer prices across countries are a challenge for economic theory to explain. These differences persist despite increasing integration of markets for goods around the world. Perhaps these differences really come about not because goods markets are poorly integrated, but because goods producers do not fully pass through the effects of exchange rate changes or because foreign exchange rates are sometimes subject to bubble behavior.

Charles Engel
Professor of Economics, University of Washington,
and Visiting Scholar, FRBSF

Reference

Engel, Charles, and John H. Rogers. 1996. “How Wide Is the Border?” American Economic Review 86 (December) pp. 1,112-1,125.

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