4086 Ann Harrison and Andrés Rodríguez-Clare

instrument for bilateral trade. In the first-stage regressions, Frankel and Romer regress
the log of country i’s trade with country j as a share of country i’s GDP on distance and
other variables:

lnðtij =GDP i Þ ¼ a0 X ij þ zij

The vector X includes the log of distance between country i and j, the log of popula-
tion and area in both countries, and dummy variables indicating whether the two
countries share a common border and whether they are landlocked. There are no sub-
scripts for time in this specification: this is a pure cross-section using data for 1985.
Frankel and Romer show that greater distance from a trading partner reduces bilateral
trade, and they are able to explain 36% of bilateral trade in the first stage. Using the first
stage estimates, Frankel and Romer then generate an OPENNESS variable by aggre-
gating predicted bilateral trade with all of country i’s trading partners. In the second
stage, Frankel and Romer regress log of income per capita in 1985 on the predicted
trade share, log of population and log of area. They show that OPENNESS positively
affects income per capita.
The beauty of this approach is that geographic proximity is without question exog-
enous with respect to income. There are several problems, however. Since distance
does not change over time, the authors cannot allow for country-specific fixed effects
ai in Eq. (1) and are restricted to pure cross section estimation. While one solution in
principle would be to control for factors that vary across countries but remain fixed
over time—such as cultural or institutional differences—it may be difficult to control
for all these omitted determinants of income. Another concern is that Frankel and
Romer’s original results are not very robust: the statistical significance on predicted
openness disappears once we add continent dummies, which is not surprising since
all the identification is from the cross section. Frankel and Romer also omit observa-
tions with zero bilateral trade in the first stage, which probably contributes to the poor
first-stage R-square and the resulting weak instrument problem. Rodriguez and Rodrik
(1999) are also critical of Frankel and Romer because they argue that greater openness
to trade generated through geographic proximity may have different effects from trade
generated through trade policy interventions. One further concern is that the instru-
mental variable estimates magnify the impact of trade on incomes, in contrast to what
one would expect if trade is a positive function of income. The explanation given by
Frankel and Romer is that the bias goes in the opposite direction because of measure-
ment error, but one is still left wondering whether or not the authors have successfully
addressed the endogeneity of trade to income.
Alcalá and Ciccone (2004) use the insights of Frankel and Romer to improve on
their initial specification. They use all bilateral trade data available in the first stage,
including those bilateral trade pairs with zero trade, which improves the first stage