In a follow-up to yesterday’s post, I asked Jesus Fernandez-Villaverde two follow-up questions.

My first question: “Suppose Spain had been in South America.  Would the same policies still have worked nearly as well?”

Jesus replied: “Yes if a free trade agreement with US and Canada had existed.”

I then inquired: “So the gravity model just isn’t that important here?  Opening your economy when you’re surrounded by rich neighbors seems a lot more fruitful than opening your economy when you’re surrounded by other poor neighbors…”

Jesus’ extensive and thoughtful response, reproduced with his permission, lies below.

My answer relies on how I interpret gravity equations, so let me start with that.

Of course, it makes sense for Spain, let’s say, to trade with Portugal more than with Chile. But, if you cannot trade with Portugal (i.e., a political barrier exists), how bad it is? I would argue that not too bad AS LONG as you have alternative markets.

Think about Japan: its natural market in the 1950s and 1960s would have been China, but China was closed to trade. Thus, Japan trades with the U.S. Somewhat less efficient (the Pacific is a big ocean and transportation costs are not trivial) but something you can handle.

Or think today of Australian trade with China. People naively think that Australia is close to China. But it is not! Maps of that part of the world are at a small scale to fit all the countries! It takes a good 10.5 hour flight to go from Shanghai to Melbourne, which is approximately the same time than from London to San Francisco on a mild headwinds day.

In other words, if you are Chile and your neighbors are screwed up, but as long as you can trade with the US and Canada, not a biggie.

Where distance matters is in the political-economy of the country. In 1960, Spaniards looked at France and asked themselves: “What has France done to be richer than us? We want the same.” You do not look at Denmark or Sweden! Too far away, geographically and culturally. But the French? Not very different from us: same looks, slightly different dialect from Latin (Spanish vs. French), same religious-cultural background. If France can be rich and democratic, obviously, we can be rich and democratic too. And this is not a theoretical idea: people from my parents’ generation would tell me, when I was a kid, how they went to Paris in 1965 or 1966 and got back to Madrid or Barcelona and become fervent defenders of economic and policy reform. Demonstration effect at its purest.

The desire to look like France or Germany was why the median voter, since 1977 (first democratic elections) until 2019 (most recent election) has always sided with pro-European, mildly pro-market parties, i.e., your slightly boring social democratic or moderate conservative party. And that is why I always argued, during the financial crisis, that Spain would never leave the euro and it would always service its debt: the median voter would always side with the government that would commit to not leaving any stone unturned in the defense of “being European.”

In other words: your neighbors matter a lot, but they matter because they determine the comparison group that your voters use to evaluate policies. If you are Peru, you look at Brazil or Argentina and since these countries have bad political-economic equilibria, you do not feel you need to get your house in order.