[An updated version of this article can be found at International Trade Agreements in the 2nd edition.]
Ever since Adam Smith published The Wealth of Nations in 1776, the vast majority of economists have accepted the proposition that free trade among nations improves overall economic welfare. Free trade, usually defined as the absence of tariffs, quotas, or other governmental impediments to international trade, allows each country to specialize in the goods that it can produce cheaply and efficiently relative to other countries. Such specialization enables all countries to achieve higher real incomes.
Although free trade provides overall benefits, it hurts some people, most particularly the shareholders and employees of industries who lose money and jobs because they lose sales to imported goods. Some of the groups that are hurt by foreign competition wield enough political power to obtain protection against imports. Consequently, barriers to trade continue to exist despite their sizable economic costs. Although it has been estimated that the U.S. gain from removing trade restrictions on textile and apparel would have been over $12 billion for 1986 alone, for example, domestic textile producers have been able to persuade Congress to keep tariffs and quotas on imports.
While virtually all economists think free trade is desirable, they differ on how best to make the transition from tariffs and quotas to free trade. The three basic approaches to trade reform are unilateral, multilateral, and bilateral.
Some countries, such as Britain in the nineteenth century and Chile and South Korea in recent decades, have undertaken unilateral tariff reductions—reductions made independently and without reciprocal action by other countries. The advantage of unilateral free trade is that a country can reap the benefits of free trade immediately. Countries that lower trade barriers by themselves do not have to postpone reform while they try to persuade other nations to lower their trade barriers. The gains from such trade liberalization are substantial: a major study by the World Bank shows that income grows more rapidly in countries open to international trade than in those more closed to trade.
However, multilateral and bilateral approaches—dismantling trade barriers in concert with other countries—have two advantages over unilateral approaches. First, the economic gains from international trade are reinforced and enhanced when many countries or regions agree to a mutual reduction in trade barriers. By broadening markets, concerted liberalization of trade increases competition and specialization among countries, thus giving a bigger boost to efficiency and consumer incomes. Britain reaped additional benefits from unilaterally lowering its tariffs in the nineteenth century because its success with free trade prompted other countries to lower their barriers as well.
Second, multilateral reductions in trade barriers may reduce political opposition to free trade in each of the countries involved. That is because groups that otherwise would be opposed or indifferent to trade reform might join the campaign for free trade if they see opportunities for exporting to the other countries in the trade agreement. Consequently, free trade agreements between countries or regions are a useful strategy for liberalizing world trade.
The best possible outcome of trade negotiations is a multilateral agreement that includes all major trading countries. Then free trade is widened to allow many participants to achieve the greatest possible gains from trade. The General Agreement on Tariffs and Trade (GATT), which the United States helped found after World War II, is an excellent example of a multilateral trade arrangement. [Editor's note: since this was written the GATT has been transformed into the World Trade Organization (WTO) in 1995.] The major countries of the world set up GATT in reaction to the waves of protectionism that crippled world trade during the Great Depression. With over 100 member countries, GATT is both an international agreement that sets the rules for world trade and an international institution that provides a forum for members to negotiate reductions in trade barriers.
As a multilateral trade agreement GATT requires its members to extend most-favored-nation (MFN) status to other trading partners participating in GATT. MFN status means that each member of GATT receives the same tariff treatment for its goods in foreign markets as that extended to the "most-favored" country competing in the same market, thereby ruling out preferences for, or discrimination against, any member country. Since GATT began, average tariffs set by member countries have fallen from about 40 percent shortly after World War II to about 5 percent today. These tariff reductions helped stimulate the large expansion of world trade after World War II and the concomitant rise in real per capita incomes among developed and developing nations alike. The gain from removal of tariff and nontariff barriers to trade as a result of the Tokyo Round (1973 to 1979) of GATT negotiations has been put at over 3 percent of world GNP.
Although GATT embodies the principle of nondiscrimination in international trade, Article 24 of GATT permits the formation of "customs unions" among GATT members. A customs union is a group of countries that eliminate all tariffs on trade among themselves but maintain a common external tariff on trade with countries outside the union (thus technically violating MFN). This exception was designed in part to accommodate the formation of the European Economic Community (EC) in 1958. The EC, which has grown from six to a dozen participating countries, has gone beyond reducing barriers to trade among member states. It also coordinates and harmonizes each country's tax, industrial, and agricultural policies. The EC aims at even greater economic integration than in a customs union by moving toward a common market—an arrangement that eliminates impediments to the mobility of factors of production, such as capital and labor, between participating countries.
GATT also permits free trade areas (FTAs), such as the European Free Trade Area, which is composed primarily of Scandinavian countries. Members of FTAs eliminate tariffs on trade with each other but retain autonomy in determining their tariffs with nonmembers.
Unfortunately, GATT has encountered difficulties in maintaining and extending the liberal world trading system in recent years. Discussions on trade liberalization often move slowly, and the requirement for consensus among GATT's many participants limits how far agreements on trade reform can go. While GATT successfully reduced tariffs on industrial goods, it has had much less success in liberalizing trade in agriculture, services, and other areas of international commerce. Moreover, slower growth of the world's economies in the seventies and eighties increased protectionist pressures worldwide. These pressures caused a proliferation of new trade barriers—such as voluntary limits on exports of steel and cars to the United States—not strictly covered by GATT regulations. Recent negotiations, such as the Uruguay Round of trade talks that began in 1986, aimed to extend GATT rules to new areas of trade. These negotiations, however, have run into problems, and their ultimate success is uncertain.
As a result many countries have turned away from GATT toward bilateral or regional trade agreements. One such agreement is the U.S.-Canada Free Trade Agreement (USCFTA), which went into effect in January 1989. The USCFTA eliminated all tariffs on U.S.-Canada merchandise trade and reduced restrictions on trade in services and foreign investment, categories not covered by GATT. Economists have estimated that the USCFTA will increase Canada's national income by anywhere from 0 to 8 percent, the particular estimate depending on the assumptions underlying the analysis. The total U.S. gain is roughly equivalent to the Canadian gain, but the percentage gains in U.S. income are much smaller because the U.S. economy is about ten times the size of Canada's. The United States also has a free trade agreement with Israel and is, together with Canada, negotiating to bring Mexico into a North American Free Trade Agreement (NAFTA), and it has contemplated bilateral or regional trade agreements with other countries in Latin America, Asia, and the Pacific. Free trade zones have recently been established in parts of South America as well.
The advantage of such bilateral or regional arrangements is that they promote greater trade among the parties to the agreement. They may also hasten global trade liberalization if multilateral negotiations run into difficulties. Recalcitrant countries excluded from bilateral agreements, and hence not sharing in the increased trade they bring, may then be induced to join and reduce their own barriers to trade. But these advantages must be offset against a disadvantage: by excluding certain countries these agreements may shift the composition of trade from low-cost countries that are not party to the agreement to high-cost countries that are.
Suppose, for example, that Japan sells bicycles for $50, Mexico sells them for $60, and both face a $20 U.S. tariff. If tariffs are eliminated on Mexican goods, U.S. consumers will shift their purchases from Japanese to Mexican bicycles. The result is that Americans will purchase from a higher-cost source, and the U.S. government receives no tariff revenue. Consumers save $10 per bicycle, but the government loses $20. If a country enters such a "trade-diverting" customs union, economists have shown that the cost of this trade diversion may exceed the benefits of increased trade with the other members of the customs union. The net result is that the customs union could make the country worse off.
Another concern is that greater reliance on a bilateral or regional approach to trade liberalization may undermine and supplant, instead of support and complement, the multilateral GATT approach. Hence, the long-term result of bilateralism could be a deterioration of the world trading system into competing, discriminatory regional trading blocs, thereby stifling world trade. Just such a disastrous experience in the thirties prompted the creation of the current multilateral trading system and makes its repair and refurbishment today an urgent task.
Douglas A. Irwin is a professor of economics at Dartmouth College. He has formerly served on the staff of the President's Council of Economic Advisers and the Federal Reserve board.
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