is broad agreement between economists and trade negotiators that
the multilateral approach to reducing trade barriers--one that is
as inclusive as possible--is the best approach. This is somewhat
intuitive, in that solutions to problems should be more effective
the more broadly they are applied. Thus, the best way to solve
world hunger would be with a program that involved every affected
country. The same would hold true for illiteracy.
also holds true for trade, yet there seems to be much disagreement
between economists and trade negotiators regarding the potential
benefits of regional or bilateral free trade agreements (FTAs).
Many economists hold that FTAs can be harmful to the process of
liberalization and even result in an economic loss. "[The] present
bilateral approach to trade policy is gradually undermining the
open multilateral trading system," warns Dr. Anne Krueger, former
President of the American Economic Association.
Criticism of FTAs strikes many trade
negotiators and government leaders as a paradox, almost akin to
arguing that although a global anti-hunger or anti-illiteracy
campaign would be a step forward, the very same campaign adopted by
only two countries or a region could represent a step back. Half a
loaf, in other words, is worse than none. How can this be so?
essay will examine the arguments concerning FTAs and conclude that
despite the theoretical possibility of economic hardship, FTAs are
generally an economic good, although care must be taken as to how
they are constructed. Thus, the United
States should be open to free trade agreements outside of the World
Trade Organization (WTO), be they regional, bilateral, sectoral, or
unilateral. The meeting of the WTO in Seattle last November is a
step forward for U.S. and global trade interests, but that should
not preclude the United States from taking other steps as well.
TRADE CREATION AND TRADE DIVERSION
Economist Jacob Viner first explored the
potentially contradictory impact of trade in the 1950s by noting
that trade liberalization could result in either "trade creation"
or "trade diversion." Trade creation is
the benefit accrued when a country lowers its trade barriers, such
as a tariff, with the most efficient producer of a product as
happened, for example when the North American Free Trade Agreement
(NAFTA) allowed tomatoes from Mexico to enter the U.S. market.
Thus, the most efficient producer of a product would now sell more
to the liberalizing country and would do so at lower prices. The
consumers of the importing country would enjoy greater quantities
of the product at lower prices, and the producers would enjoy
what happens under trade diversion, which is what occurs when trade
barriers are lowered with an inefficient producer of a product? For
example, NAFTA allows sugar from Mexico to enter the U.S. market. Here, the economic results are
ambiguous. True, U.S. sugar consumers enjoy the benefits of lower
costs and will tend to import more of the product, and Mexican
producers enjoy the benefits of greater sales. But the most
efficient producer of sugar--Australia, for example--will have been
displaced in the U.S. market. Theoretically Australia's loss could
be greater than the others' gains. If so, trade has been diverted,
and the result is a global economic loss, with the harm to
Australia outweighing the gain to the U.S. and Mexico. The
Regional "free-trade areas" need not make
trade freer. By liberalizing trade only with their neighbors,
countries are by definition discriminating against those not lucky
enough to be in the local club. Some goods will be imported from
other members of the free-trade area at the expense of producers
elsewhere; and members will begin to specialize in industries in
which they lack comparative advantage.
WHEN DOES TRADE DIVERSION HOLD?
Viner's thesis was an important
contribution to international trade theory, but explaining that a
phenomenon could exist is quite different from explaining its
frequency, magnitude, or consequences.
major defect of the analysis is that it is static. Over time, a new
exporting country's productive efficiencies can improve as skills
are gained and volumes attained. So the theory of trade diversion
would see a problem with NAFTA's allowing the U.S. to import autos
from a less efficient producer (Canada) at the expense of the more
efficient producer (Japan). But after several years of NAFTA
experience, Canadian auto plants can frequently produce at Japanese
levels of productivity.
is not necessarily an intrinsic reason why one country is a more
efficient producer to begin with, so to accept the trade diversion
argument is to believe that current producers of a product will
retain their current competitive advantage in perpetuity. Yet we
know from history that competitive advantage can change over
Second, the theory as frequently stated
misrepresents the effects of trade diversion. The actual losses of
the supplanted exporter (its forgone "producer's surplus") are
smaller than it would appear, because that country will go on to
produce something else, a second-best alternative. Similarly, the
new exporting country must forsake the production of something, so
it does not gain all of the new producer's surplus.
other words, the actual shift in fortunes is less than the argument
contends because now that Mexico is exporting sugar, it must forgo
the production of a different item; now that Australia is no longer
exporting sugar, it will produce more of a different item.
Looking solely at production costs has
another shortcoming: It ignores the indirect business costs. To
take our example, even if tomatoes from China were found to be
cheaper than those from Mexico, there are a range of reasons why a
U.S. vegetable importer might well prefer to continue doing
business with Mexico: less expensive transportation costs,
freshness of produce, rapidity of delivery, ease of Spanish-English
coordination, ease of same time zone coordination, breadth of
dollar-peso instruments, and so on. In other words, the indirect
costs of doing business with a seemingly less expensive supplier
might in fact be greater.
extent that trade diversion does occur, the importing nation has a
strong incentive to remedy the matter. If the United States has
displaced the most efficient producer of sugar by signing NAFTA,
then the United States has a strong incentive to remedy that by
allowing Australian sugar to come in tariff-free, at which point
U.S. sugar prices would be cheaper still. Why would the U.S.
government penalize U.S. consumers just to support inefficient
significantly, the diversion argument also ignores the aggregate
effects of liberalization: An FTA might result in some trade
creation and some trade diversion, but the former is likely to
substantially outweigh the latter. As FTAs are a relatively recent
phenomenon, there is not much in the way of scholarly studies to
show that trade diversion has exceeded trade creation. Mexican
sugar has supplanted Australian sugar, but other aspects of
U.S.-Mexican trade could well reflect trade creation.
Bank economist Alan Winters states the paucity of analysis even
are no satisfactory ex post estimates of regional integration on
excluded countries' welfare.... We have virtually no hard evidence
on how regional integration affects economic welfare in the rest of
world.... [We] have largely failed to measure the effects that
theory shows to matter and...much of what we have measured hardly
matters at all.
only can we not conclude that trade diversion exceeds trade
creation, but we cannot conclude what effects, if any, FTAs have
had on the non-participating countries.
TWO OTHER ARGUMENTS
economic arguments recede in the debate, two other arguments are
advanced against FTAs: tidiness and distraction. The tidiness
argument is that it is too messy to have a series of FTAs involving
different countries on different issues with different timetables.
Trade specialist Claude Barfield states:
trading world dotted with separate bilateral and multilateral FTAs,
each with different interim timetables, tariff levels, and
nontariff barrier liberalization rules, would become enormously
inefficient.... A multinational corporation such as IBM, Siemens,
or Samsung would face a daunting task in sorting out trade rules
that governed their simultaneous operations in APEC, NAFTA,
MERCOSUR, the European Economic Area--not to mention individual
countries such as Chile or Turkey, which had separate arrangements
with regional groupings and individual nations.
distraction argument, on the other hand, is not that FTAs are too
messy, but that they are too bothersome, absorbing efforts for
small gains when those efforts could be used more effectively
elsewhere, such as in multilateral negotiations. "Given limited
resources in the office of the USTR and in other federal agencies
responsible for formulating and implementing trade policy, it was
inevitable that NAFTA would result in some diversion of attention
from the multilateral system," states Krueger.
tidiness premise is that a multinational corporation would be
distraught if one country offered a 10 percent reduction in its
tariffs and another country offered a 20 percent reduction, because
this would complicate planning. But multinationals successfully
accommodate national distinctions in such non-trivial matters as
currencies, taxes, labor, health and packaging regulations, and
consumer preferences, so why not in trade barriers? A sales manager
who complained about an uneven reduction in a tariff because it was
too complicated, instead of viewing this as an opportunity to
improve sales, is a manager who will soon be leaving his
amount of information to be managed under a plethora of trade
regimes would be far less complicated than, say, the amount of
information required to assign a special numerical code to every
individual. In other words, it would be less complicated than using
a phone book. Indeed, there are several Internet sites that offer
free calculations of duties once simple data are entered.
the main rebuttal to the tidiness argument is the matter of
practicality. The reason that there are so many peculiar trade
initiatives is not because trade negotiators have a penchant for
the untidy, or because they enjoy confounding economists; it is
because the particular set of trade agreements in place are the
ones that are feasible. There is no reason that trade policy
formulation and implementation should be any less prone to the slow
pace of government, the bureaucratic interplay, and the role of
special-interest groups than other aspects of public policy. It
should not be surprising that trade policy proceeds unevenly,
perhaps even untidily.
why not take whatever incremental steps one can toward
liberalization when it is possible to take them? It is simply
easier to get two countries to agree on an initiative than to get
the 134 members of the WTO to agree. Why should trade
liberalization be a convoy, forced to move only at the speed of the
slowest ship? The advantages of the FTA approach are that countries
can move at a pace they determine to be the best for themselves;
countries can experiment with different arrangements and
timetables; and countries are not constrained by the
lowest-common-denominator policies of the WTO, in which the need
for unanimity allows parochial interest to slow down the entire
are more politically feasible than a multilateral agreement because
they involve fewer participants and can be more precisely
customized to meet their needs. Sensitive issues can be broached on
a smaller scale, which can make the change more politically
palatable. Americans can accept the idea of textile imports from
Mexico more readily than the idea of textile imports from China.
Vietnam will entertain the idea of free trade with its neighbors in
the Association of Southeast Asian Nations (ASEAN), but it will
take a while for it to be comfortable with the idea of free trade
with the largest Pacific economies, all former adversaries: China,
Japan, and the United States. Simply put, countries can be more
willing to augment their trading relations on an incremental basis
than they are to make a bold move through the WTO.
economist Jagdish Bhagwati, who has written elegantly and
persuasively on the benefits of trade liberalization, pejoratively
labels this uneven approach a "spaghetti bowl" approach to trade. If that is what
FTAs represent, perhaps more spaghetti is in order.
other weaknesses, the distraction argument is premised on a false
alternative: that a global round of liberalization or a regional
agreement are both equally likely. If so, a more encompassing
multilateral accord is surely the bigger prize. Yet what is the
basis for that assumption? The recently completed Uruguay Round
required 13 years to bring to a conclusion. The nascent Seattle
Round of WTO trade liberalization will involve several dozen more
countries and a range of new and potentially sticky issues from
genetically modified foods to Internet commerce, all of which
implies that this new round could well make the Uruguay Round look
speedy by comparison. The protracted contest for the position of
WTO Secretary General between former New Zealand Prime Minister
Mike Moore and Thailand Deputy Prime Minister Supachai Panitchpakdi
should give all onlookers pause for thought about placing all hopes
for liberalization on the WTO.
unstated premise of pure multilateralism is that the world trading
system is one of equal countries of equal economic weight, equally
disposed toward trade liberalization. If, on the other hand, most
of the world's trade is undertaken by a handful of countries or
groupings, could not more economic benefit be achieved more quickly
by working with this core group?
distraction argument is questionable for other reasons. Although it
is plausible that FTAs distract from multilateral agreements, it is
equally plausible that FTAs build support for such agreements. FTAs
demonstrate on a small scale that countries can withstand the
problems of dislocation and will benefit from expanded trade.
Remember: Even if there is trade diversion, trade liberalization
results in benefits for the importing and exporting country.
Whatever trade diversion might exist would be suffered by the third
country which is not participating in the agreement. The lesson
here is: Participate in agreements and you will not suffer losses.
Or if you cannot participate in this particular agreement, go and
initiate something of your own.
Similarly, FTAs could be viewed as an
exercise in constituency-building. They train the government
bureaucracies to recognize that liberalization is healthy. They
show the general public that increased trade is an economic good.
They allow the participating countries to develop the sinews of
international commerce, from port improvements to international
communication links to financial practices. These all create a
predisposition for further liberalization. It creates trade winners
to counter the naysayers who believe that trade only creates
distraction argument also suffers from a confusion of ends and
means. Is the goal of international trade to promote the
international trading system, or is the goal of the international
trading system to promote international trade? A free trade
agreement between NAFTA and the European Union (EU) would embody
over 50 percent of world gross domestic product (GDP) and could be
more important economically than the Uruguay Round. If the goal of the
WTO could be reached, albeit outside the WTO process, should we not
be equally grateful? Rather than FTAs distracting from the WTO, one
could better argue in this instance that the real problem with the
WTO is that it distracts from the ability to achieve FTAs.
experience of the United States as both the NAFTA and the Uruguay
Round negotiations drew to a close is instructive. The NAFTA
discussions were moving along more quickly, and the message to the
international community was clear: The United States is moving
ahead with trade liberalization, and you are free to stay on the
sidelines; but you will not have the ability to block those who
want to move ahead. Preserving the ability of the countries that
are liberalizing more quickly to operate outside of the WTO will
induce the more recalcitrant countries to make the WTO work.
Indeed, a committed protectionist country
would pursue two parallel goals in trade policy: First, attempt to
ensure that countries have no alternative to the multilateral
process. Second, frustrate and delay all multilateral
Conversely, FTAs cause the protectionist
country to pay a price for its policies. Not every country will
participate in every FTA, but the protectionist country will never
participate in any. As a result, it will never have the opportunity
to offset the trade diversion of one FTA with the trade creation of
end, the question of whether FTAs help or hinder the multilateral
process is unprovable because of the many variables that affect the
emergence of FTAs and the conclusion of multilateral rounds. There
is not a large body of scholarly analysis on this matter. It is worth noting,
however, that in other international agreements from the mundane
(international postal union and international civil aviation
agreements) to the acute (chemical weapons treaties, human rights
agreements), plurilateral accords are typically viewed as adding
to, not detracting from, multilateral agreements.
FTA GROUND RULES
Although the ancillary reasons against FTAs
are not any more compelling than the economic reasons, it is fair
to note three legitimate concerns about the proliferation of
FTAs should explicitly adopt a policy of broadening membership on
an open-ended basis. No country should be able to pull up the
ladder after it enters the clubhouse. In other words, FTAs should
be structured so that they represent the first step in
liberalization, not the last step.
reason to structure FTAs to embrace an ongoing augmentation of
membership is the sequencing issue. Some might argue that
sequencing is not important, that FTAs will naturally be extended
beyond the original membership, eventually linking up with other
FTAs and leading finally to worldwide free trade. But there could
be an inducement for some members not to expand. The least
efficient participating countries, having gained preferential
access to some markets, might oppose extending the membership of
the FTA. For instance, if Chile were to join NAFTA, it would
somewhat diminish the value of the preferences won by Mexico. Chile
would, to some minor extent, displace Mexico in the U.S. market.
second issue involving FTAs is the rules of origin. Because
participating countries in the FTA will continue to maintain
different external tariff levels, a loophole exists for third
parties. Importers from non-member nations could avoid higher
tariffs by transshipping through the FTA member with the lowest
external tariff. To close this loophole, FTA agreements contain
rules of origin clauses. But as more and more bilateral FTAs are
formed, "a mass of paperwork is created for customs officials as
they try to certify which shipment could benefit from which set of
countries should examine mechanisms to mitigate the rules of origin
issues, such as establishing low levels of value before a product
qualifies as locally produced or eliminating the greatest
discrepancies in the participating countries' external tariffs.
countries should not enter into free trade agreements that are
hub-and-spoke, which give one country structural privileges over
other members. Privileges should be transitive so that any new
member of an FTA immediately gains equal privileges with all other
members, which will allow the benefits of the FTA to be
Opposition to FTAs is led by those who
favor multilateral mechanisms for trade liberalization; but rather
than being called multilateralists, they might more aptly be termed
universalists, because by their own logic even the WTO is lacking.
Major trading economies like China, Russia, and Taiwan are not in
the WTO. A pure universalist would
disapprove of the Uruguay Round, which will undoubtedly lead, if
only in a small way, to some trade diversion.
that matter, if you are an all-or-nothing universalist, why should
countries have free markets internally? A universalist should be
even uncomfortable with the idea of domestic markets, because they
are merely miniature FTAs.
is an underlying irony in the position of the universalists: If the
premise of free trade is that competition works, shouldn't that
also be the premise of free trade bodies? Shouldn't countries be
able to "shop around" by considering joining NAFTA or the WTO, and
even special trade relations with regional groupings such as the
EU, AFTA (ASEAN Free Trade Area), Caribbean Common Market, and
other organs? Consumers in some countries will respond more readily
to the benefits of enhanced trade and should be allowed to move in
are a range of bilateral and regional trade initiatives under
discussion. The European Union is grappling with extending
membership to the nations of Central Europe. The United States has
been negotiating an FTA with Chile for a number of years, and Chile
has had similar discussions with New Zealand. Israel has held
discussions off and on with both Canada and Mexico, and an FTA with
either would make Israel a member of NAFTA, since it already enjoys
an FTA with the United States. Congress recently passed a welcome
African trade initiative that will extend unilateral privileges to
some of the poorest countries in the world.
of the more ambitious initiatives are found in Southeast Asia. At
the September 1999 Auckland summit of the Asia-Pacific Economic
Cooperation forum (APEC), New Zealand proposed a "P-5" initiative,
which would be an FTA among NAFTA, New Zealand, Australia, Chile,
and Singapore. Singapore has proposed an FTA among the ASEAN
nations and Australia and New Zealand.
other side of the globe, several political leaders have proposed a
"TAFTA"--a Trans-Atlantic Free Trade Area between NAFTA and the EU.
Former Republican presidential candidate Steve Forbes has proposed
a NAFTA-UK-Ireland FTA.
United States should welcome these initiatives, even the ones to
which it is not a party, because they increase prosperity and lay
the groundwork for follow-on trade agreements.
Viner first noted the potential economic damage that might be done
by an FTA, economics literature has at best viewed FTAs with
suspicion, and many leading trade economists treat FTAs with
outright hostility. But despite the warnings of the critics, there
is not a great deal of evidence that FTAs in the aggregate have
been harmful, and there are strong arguments that FTAs are not just
helpful in themselves, but also useful steps on a path to broader
Franklin L. Lavin has
served in the U.S. Department of Commerce and on the National
Security Council. He currently works for a venture capital firm in