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The Economics of Preferential Trade Agreements
Jagdish Bhagwati and Arvind Panagariya
American Enterprise Institute for Public Policy Research
January, 1997
The essays collected in this volume critically assess the claims advanced by proponents of free trade areas and analyze the two principal initiatives of recent U.S. trade policy: the North American Free Trade Agreement and the Asia-Pacific Economic Cooperation. Mr. Bhagwati is the Arthur Lehman Professor of Economics and professor of political science at Columbia University. Mr. Panagariya is professor of economics and codirector of the Center for International Economics at the University of Maryland.
Contrary to popular opinion, which equates free trade agreements (FTAs) with genuine free trade, FTAs are in fact preferential trading arrangements (PTAs). They are therefore two-faced: they offer free trade to members but (implicitly) protection against nonmembers. The economics of PTAs is therefore far more complex than that of genuinely nondiscriminatory free trade. Indeed, the economics of PTAs leaves them open to serious reservations, bringing into doubt the wisdom of recent U.S. trade policy.
Since the early 1980s, FTAs have rapidly proliferated, and U.S. trade policy now embraces them energetically. This is evident from the current administration's (and indeed the Bush administration's) desire to extend the North American Free Trade Agreement (NAFTA) to Chile and beyond, and from the occasional high-level expressions of interest in turning the Asia-Pacific Economic Cooperation (APEC) into yet another FTA.
In the introductory chapter, the editors synthesize and extend the theory of PTAs that has emerged since the publication of the seminal work on the subject by the economist Jacob Viner, who first warned against a facile embrace of PTAs in 1950. The editors critically evaluate the claims that have recently been made in favor of PTAs by U.S. policy makers in Congress and in the Clinton administration and by economists in think tanks and universities. The essay concludes that the U.S. policy of encouraging PTAs (instead of frowning on them in favor of multilateral nonpreferential trade liberalization) has been a serious mistake.
Popular Fallacies
The introductory essay analyzes and dismisses as unscientific the popular claims that:
PTAs between natural trading partners are desirable, the naturalness being defined as large initial volume shares among member countries or relatively small distances between them
regional PTAs, where members share common borders or an ocean, are necessarily beneficial
simply because the PTAs formed under Article XXIV of GATT are required to maintain the average external tariff against nonmembers, trade will not be diverted away from them to member countries
The "Spaghetti Bowl" Effect
By building trade liberalization on the foundation of discrimination, PTAs create a fundamental conflict with multilateralism. The ill effects of this key difference become manifest when one examines the recent proliferation of PTAs. This proliferation has led to a crisscrossing of trade preferences assigned to countries, hence the term "spaghetti bowl," where products in many important markets today enjoy access on varying terms depending on where they supposedly originate. Owing to the globalization of production, the ability to identify the country of origin for products is increasingly problematic.
In chapter 2, Paul Wonnacott argues for hybrid FTA-customs union agreements in the future, to avoid the worst trade-distorting aspects of preferential trade agreements, and he provides specific empirical evidence of the spaghetti bowl phenomenon afflicting the world trading system today.
The current system is replete with transaction costs and with opportunities both to distort trade flows by administrative reclassification and to facilitate corruption. It demonstrates the wisdom of an earlier generation in favor of most favored nation (MFN) classification and its principle of nondiscrimination. In fact, with the generally benign intention of freeing trade, we have ironically reproduced the chaotic system of trade preferences that resulted from protectionist impulses in the 1930s!
What to Do?
The analyses in this volume then lead to two natural questions:
Can the drift toward ever more PTAs be stopped by illuminating the critical distinctions between FTAs and free trade?
If it is not possible to dissuade most politicians from favoring PTAs, how can the PTAs be defanged so as to minimize the harm they cause?
The attempt to halt the drift to PTAs is not altogether a lost cause. Gary Saxonhouse, in chapter 3, clearly describes how APEC resisted pressures from the United States to turn it into an Article XXIV-style FTA, or at least into a non-MFN preferential trading area that would be granted a waiver from Article XXIV. In the end, the Asian members of APEC insisted on MFN trade liberalization, forcing the issue in favor of nonpreferential trade liberalization, in keeping with their traditional distaste for a preferential approach to the world's markets. Indeed, these Asian nations have clearly seen that the term "open regionalism" is deceptive, when all it means is that new members may apply and be accepted if approved by national legislatures, with all the "nontrade" conditions that are now attached to such membership. Truly open regionalism on the trade front is in fact MFN liberalization, which openly and freely extends the trade barrier reductions to all.
In chapter 4, Claude Barfield analyzes the factors behind the rise of regionalism in U.S. trade policy, as well as the unfortunate drift toward demands for ever stricter reciprocity in trade agreements. He argues that the debates over labor and environmental preconditions and over reciprocity (particularly in APEC) will increase in coming years, dividing proponents of a more liberal trade environment.
These factors have helped to deflate the PTA balloon somewhat. Nonetheless, the threat from PTAs remains serious, and ways of further defanging them must be devised and implemented. Two ways of doing this can be distinguished.
One approach, to which many international economists have recently contributed, is to seek ways to strengthen GATT's Article XXIV to ensure that discipline on member states is enhanced, that nonmembers are not harmed, and that trade diversion is minimized. The problem with this approach, even though it has attracted ingenious proposals, is that few countries are now altogether without some PTA membership. Asking them to vote on making their lives difficult is like asking criminals to decide on their own sentencing. One may therefore be cynical and expect little to come out of this approach.
The other approach is to consider the PTAs as, in effect, hard to shape and reshape; after all, it is of their very essence to discriminate. So, noting that the preferences they give to members are relative to the trade barriers that are in place against nonmembers, one can work to eliminate them by seeking worldwide free trade at the border--preferences relative to zero are zero! For this reason, among others, a number of economists have proposed recently that the World Trade Organization adopt a target date the way that PTAs have, such as 2025, for the completion of the worldwide freeing of trade.
The main contribution of the present volume is to alert the policy makers to the substantial shift that is occurring in scholarly circles with regard to the wisdom of pursuing PTAs, to demonstrate that most of the pro-PTA arguments in the public domain are shallow, and to suggest an agenda for world trade liberalization that returns it to its earlier focus on multilateral principles.
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