The economic benefit of becoming a US state

After the Mexican-American War (1846-1848), a large chunk of northern Mexico was ceded to the United States in the so-called Mexican Cession (as a result of the Treaty of Guadalupe Hidalgo). This included the modern-day states of California, Nevada, and Utah, most of Arizona, and parts of New Mexico, Colorado, and Wyoming. We could also include the state of Texas, the annexation of which laid the seeds for the war.

This raises some obvious questions. Texas obviously thought they were better off as a state of the US. Is that actually what happened? What about the other states that joined the US as part of the Mexican Cession? And what about other territories that could easily have become states, such as Cuba or Puerto Rico?

Those are the questions that this recent working paper by Robbert Maseland (University of Groningen) and Rok Spruk (University of Ljubljana) sought to address. They use state-level and country-level data on GDP per capita, and attempt to estimate the economic growth impact of a state joining the US. This paper is interesting for several reasons, which is why we discussed it in the Economics Discussion Group at Waikato this week.

First, the paper illustrates the importance of the counterfactual - what would have happened if history had been different. In this particular case, what would economic growth have been in the Mexican Cession states, if they had remained part of Mexico? We don't know for sure of course, because we are only able to observe what happened after they became states, and we don't observe what would have happened if they didn't. Similarly, for the territories that didn't become US states that Maseland and Spruk look at, we don't observe what would have happened if they did become states, only what happened when they didn't.

Maseland and Spruk address the counterfactual problem by using the synthetic control method. Essentially, they create a model of each Mexican Cession state's observed variables (including GDP per capita) up to the time before the Mexican Cession, based on the observed variables of other countries. This creates, for each state, a synthetic version of the state that is made up of proportions of the data from other countries. For example, they find that:

...the growth pattern of prestatehood California is best reproduced by growth and development covariate values of Canada (49%), South Africa (19%), New Zealand (15%), Egypt (10%), Norway (5%), and United Kingdom (3%), respectively. On the other hand, the synthetic control group for Arizona consists of Egypt (70%), Jamaica (18%), United Kingdom (11%), and Greece (1%), respectively.

As an interesting aside, New Zealand was part of the synthetic versions of California (15%), Colorado (11%), Nevada (58%!), and New Mexico (1%).

The second interesting aspect of the paper is the results themselves. Maseland and Spruk compare the actual economic growth performance of each state with the growth performance of the synthetic version of itself. They find that there are:

...strong and pervasive effects of the admission on long-run growth. The underlying post-admission gap coefficients are both large, positive and statistically significant at 1%, respectively, and readily suggest that the effect of joining the US appears to be specific to the treated states.

For example, here's a graph of the economic growth path for actual and synthetic California:

The solid line is the actual trajectory for California, while the dashed line is the synthetic control. It is clear that they deviate from each other around 1850, and the synthetic control does much worse. This demonstrates how much better off California was after statehood.

Maseland and Spruk then go on to show that the opposite is true of Mexican states that did not join the US, finding that there are:

...large gains from the hypothetical admission of Mexican states to the United States although the variation in the long-run growth effect is notable... the states next to the US border appear to be most adversely affected by not joining the United States.

Maseland and Spruk then look at the hypothetical case of several territories joining the US, including Cuba, Puerto Rico, and the Philippines, (all of which were occupied by the US after the Spanish-American War in 1898), and Greenland (which was granted home rule by Denmark in 1979, and could hypothetically have joined the US as a state then). They find that:

By 2015, the synthetic Cuba as a hypothetical US states would be seven times richer than its real counterpart... By 2015, the difference between the synthetic Philippines as a US state, and the real Philippines is about a factor [of] 10.

...synthetic Puerto Rico as a US state would be 51 percent richer than the real non-state Puerto Rico... In terms of magnitude, the gap between synthetic Greenland as a US state and its real version as a Danish territory is 32 percent, respectively.

Finally, they look into the reasons for these substantial differences. Does statehood allow easy access to a larger domestic market and therefore drive economic growth, or does statehood lead to the adoption of better institutions? Maseland and Spruk find evidence in favour of the role of institutions:

On balance, our estimates indicate that the joint temporal and spatial variation in the level of electoral democracy can explain up to 41 percent of the statehood-induced growth premium. The corresponding variation in the level of liberal democracy accounts for up to 56 percent of the long-run growth benefits stemming from improved institutional quality upon the admission to the United States. The institutional quality bonus received by joining the US apparently drives a large part of the performance boost. This lends support to the second leg of the American Exceptionalism thesis, which is that it is America's political institutions that gave the US its unique advantage.

So, institutional quality was key to the improved economic growth performance of the Mexican Cession states after they joined the US.

There is a third reason why this paper is interesting. The original Constitution of Australia provided an opportunity for New Zealand to become a state of Australia. We chose not to. On the other hand, Western Australia became a state at that time following a referendum, when instead they could have become independent. An interesting exercise for an enterprising honours student might be to look at these two cases (data permitting) and follow the process outlined by Maseland and Spruk to construct the relevant counterfactuals for New Zealand and Western Australia. Was New Zealand better off going it alone?

[HT: Marginal Revolution]