From the WTO this week in Geneva:
Are preferential trade deals out of control?

posted on September 10, 2007
by Greg Rushford

The view of Lake Geneva from the offices of the World Trade Organization's headquarters along the Rue de Lausanne is, especially on calm days in late-summer, one of placid beauty. But as this Fall approaches, the international civil servants who are entrusted by the WTO's 151 member governments with administering the rules of the world's international trading system look out over increasingly disturbed economic and political waters. As if the stalled Doha Round of trade liberalizing negotiations weren't worry enough, there is a growing sense of unease that that the multilateral global trading system is being marginalized. More than half of world trade flows through some 400-plus preferential bilateral and regional trading routes. The core principle of the WTO's multilateral rules -- a pledge by member countries that they will treat each of their trading partners equally -- is thus now officially a minority view. The essence of the rapidly proliferating preferential trade deals is to confer economic privileges upon those who are included, while discriminating against trading partners who are left out.

This morning in Geneva, Director-General Pascal Lamy and the WTO secretariat have assembled a group of trade luminaries -- not all of whom see eye to eye -- to thrash out their views over the next two and a half days on what should be done about preferential trade. The "Multilateralising Regionalism" conference will publish papers that will highlight the sharp differences between mainstream economists, who tend to condemn preferential trade, and policymakers and advocates who defend it.

I've had an advance peek at two of the most dramatically opposed presentations that illustrate the two sides of the preferential trade debate. Renowned economic theorist Jagdish Bhagwati, the foremost critic of preferential trade, will give a keynote speech at a high-level reception tomorrow evening. In his remarks, Bhagwati will preview arguments he will elaborate upon in a forthcoming book, Termites in the Trading System. The book will draw upon economic and political history to make the case that the "pandemic" of preferential trade agreements are "a pox on the world's trading system." The opposing view will come from two of Washington, D.C.'s leading advocates for preferential trade, Gary Hufbauer and Jeffrey Schott, who are associated with Fred Bergsten's Peterson Institute for International Economics. The two think-tank experts will present a 45-page paper that includes an econometric "gravity model" to make their case that the so-called Free Trade Agreements actually expand world trade more than they distort trade flows. For anyone who wants to understand this very important international economic debate, both Bhagwati's Termites and the Peterson Institute paper will be must reading.

Bringing economic pooh-bahs to Geneva

The WTO conference has been co-organized by the Geneva-based Graduate Institute of International Studies, and also the Centre for Economic Policy Research, which is based in London. The key man to see in both outfits is Richard Baldwin, who is a professor of international economics at the graduate institute and also CEPR's policy director. Other prominent speakers will include the WTO's Pascal Lamy, economist Joe Francois of the Johannes Kepler University Linz, in Linz, Austria; Masahiro Kawai of the Asian Development Bank, and Claude Barfield from the American Enterprise Institute in Washington, D.C. World Bank official Carsten Fink will also participate, as will Brazilian trade diplomat Vera Thorstensen, who chairs the WTO's committee on rules of origin. On Wednesday morning, Lamy will chair a roundtable debate featuring academics Bhagwati and Baldwin, and also WTO ambassadors from China, Chile, Norway, and Uganda.

Defending preferential trade

For preferential trade skeptics who want to test their views, perhaps the most interesting presentation is in the paper by the Peterson Institute's Gary Hufbauer and Jeffrey Schott. Fitting Asia-Pacific Agreements into the WTO System was funded by the Swiss government's secretariat for economic affairs. Last year, SECO funded a study by Hufbauer and Richard Baldwin that touted the benefits of a Swiss-U.S. bilateral trade deal.

The Hufbauer-Schott study doesn't deny that preferential trade deals - and particularly, discriminatory rules of origin -- distort trade flows. "The more complex and industry-specific the origin requirements, the more the rules will have a chilling effect on trade, in large part by raising the cost of compliance," the authors note. "Indeed, in the US-Canada context, some firms have decided that the additional transactions costs would be higher than the MFN tariff and thus have not applied for the FTA preferences."

Moreover, looking at the various bilateral trade deals that have sprung up across Asia -- the so-called "noodle bowl" -- Hufbauer and Schott agree with preferential trade critics that countries who are not included stand to be harmed. "The US-Korea FTA will likely cause significant trade diversion away from Taiwanese exports to both Korean and US exports," they declare. "Future agreements that Japan might reach with Korea and the United States will do the same."
Taiwan would be included in a regional-wide preferential trade accord called the Free Trade Area of the Asia Pacific, Hufbauer and Schott point out. The so-called FTAAP was touted by Fred Bergsten -- preferential trade's biggest champion in Washington -- at an APEC forum last November in Vietnam as "the best, or perhaps only, way to catalyze a substantially successful Doha Round." In their paper, Hufbauer and Schott note that an FTAAP "would cover about 60 percent of US two-way trade and roughly 30 percent of total US FDI [foreign direct investment] stocks." The deal would also cover "about 60 percent of Chinese two-way trade and about 75 percent of Chinese FDI stocks," according to the paper.

But not everyone would seem to stand to benefit from such an FTAAP across Asia and the Pacific. While the deal would cover all 21 member countries of the Asia Pacific Economic Forum, South Asian countries would be left out. " Consider India, which wants to join APEC. "From a geopolitical standpoint, China would find it hard to put out the welcome mat; from an economic standpoint, the United States is not enthusiastic about a new APEC member that maintains some of the highest trade barriers in the world," Hufbauer and Schott note. "Unless India dramatically changes its commercial policy, and reaches a geopolitical accommodation with China, India will not be invited to join APEC or the FTAAP," they add.

"If the last decade was an era of proliferation of FTAs within the Asia-Pacific region, the next decade could become an era of triangular consolidation of spheres of influence with competition between the three major powers, the United States, China, and Japan," Hufbauer and Schott write elsewhere in their paper.

It is a safe bet that few critics of preferential trade who agree with Bhagwati's concerns about a "pandemic" of competing trade blocs, would be persuaded to change their minds after reading what Hufbauer and Schott have to say.

Do 'gravity models' have gravitas?

But Hufbauer and Schott present another argument, in the form of an econometric study called a "gravity model analysis." The think-tank experts basically tried to measure how preferential trade flows within the Asia-Pacific region increase or decrease trade by relying upon high math. They ran the numbers of thousands of trade statistics through a computer. "Implementing the FTAAP, according to these results, would augment trade for most countries in the region by roughly 50 percent," Hufbauer and Schott conclude.

It is unlikely that the econometric study will persuade preferential trade critics who either don't understand high mathematics, are suspicious of all numbers games that advocates in Washington, D.C. tend to play, or who just have a gut feeling that prevents them from being persuaded. Perhaps that should be called an educated gut feeling, one that embraces what economists would call the historical "political economy" issues associated with the consequences of preferential trade (particularly recalling the pre-World War II era of competing trade blocs). What about India and all the others who would be left out of an FTAA? How would such an Asian-oriented deal help, say, Europeans, not to mention Latin Americans and Africans?

It appears that gravity models that attempt to explain trade flows through statistical relationships seem to be less-than-definitive econometric tools. "They generally show expanding trade," observes Douglas Irwin, a Dartmouth professor of economics and a leading free-trade advocate, Irwin, who has not read the Hufbauer-Schott analysis, explains how such models are generally regarded by economists. "If the U.S. Canada and Mexico trade with each other, you would expect more trade." Irwin observes. "What gravity models don't show is: is this more efficient trade? They explain the amount of trade between two countries, but you don't know the terms of trade and you can't say whether that trade is good for the country. The models are completely agnostic as to the consequences for the national welfare, diverted trade, and so forth."

In his remarks this week in Geneva, economist Bhagwati will cite some economic history that suggests there is ample reason to fear the consequences of discriminatory trade. In his forthcoming Termites in the Trading System, Bhagwati quotes this passage written by famed British economist John Maynard Keynes, who reviewed the history of the 1930s and came to agree with Franklin D. Roosevelt's secretary of state, Cordell Hull, on the key principle of non-discrimination.

Keynes concluded: "The separate blocs and all the friction and loss of friendship they must bring with them are expedients to which one may be driven in a hostile world where trade has ceased over wide areas to be cooperative and peaceful and where are forgotten the healthy rules of mutual advantage and equal treatment. But it is surely crazy to prefer that."
Crazy or not, preferential trade now seems to have more to do with an uncertain future than hard-learned lessons of the past.