Industrial specialization and the asymmetry of shocks across regions

Economic integration, through greater capital market integration, will induce higher regional specialization in production, rendering regional shocks less symmetric. To support this claim empirically, we develop a utility based measure of shock asymmetry and calculate it for each U.S. state. We regress it (using both ordinary least squares and instrumental variables) on a state-by-state 1-digit industrial specialization index and a 2-digit manufacturing specialization index, controlling for relevant economic and demographic variables. The main empirical result is that both specialization indices are positively and significantly correlated with the degree of shock asymmetry in both ordinary least squares and instrumental variables regressions. ; This finding, combined with the causal relation running from inter-regional capital market integration to regional specialization in production found in Kalemli-Ozcan, Sorensen, and Yosha (1999), points to the following chain of events: Economic integration fosters the development of institutions that facilitate inter-regional risk sharing. Equipped with better insurance against asymmetric shocks, regions can afford to increase their specialization in production which, in turn, renders shocks more asymmetric. This mechanism counter-balances the effect suggested by Frankel and Rose (1998)--that economic integration among regions (or countries) will induce more trade among them rendering regional shocks more symmetric. Which effect will dominate is an open empirical question.