The Doha Disappointment
The ninth major round of world trade negotiations began in 2001 with a ceremony in the
Persian Gulf city of Doha. Like previous rounds, this one was marked by difficult negotiation.
But as of the summer of 2010, it appeared that something new had happened: For the
first time since the creation of the GATT, a round of trade negotiations appeared to have
broken down with no agreement in sight.
It’s important to understand that the apparent failure of the Doha Round does not undo the
progress achieved in previous trade negotiations. Remember that the world trading system is
a combination of “levers”—international trade negotiations that push trade liberalization forward—
and “ratchets,” mainly the practice of binding tariffs, which prevent backsliding. The
levers seem to have failed in the latest trade round, but the ratchets are still in place: The
reductions in tariff rates that took place in the previous eight rounds remain in effect. As a
result, world trade remains much freer than at any previous point in modern history.
In fact, Doha’s apparent failure owes a lot to the success of previous trade negotiations.
Because previous negotiations had been so successful at reducing trade barriers, the remaining
barriers to trade are fairly low, so that the potential gains from further trade liberalization
are modest. Indeed, barriers to trade in most manufactured goods other than apparel
and textiles are now more or less trivial. Most of the potential gains from a move to freer
trade would come from reducing tariffs and export subsidies in agriculture—which has
been the last sector to be liberalized because it’s the most sensitive sector politically.
Table 10-4 illustrates this point. It shows a World Bank estimate of where the welfare
gains from “full liberalization”—that is, the elimination of all remaining barriers to trade
TABLE 10-4 Percentage Distribution of Potential Gains from Free Trade
Full Liberalization of:
Economy
Agriculture and
Food
Textiles and
Clothing
Other
Merchandise All Goods
Developed 46 6 3 55
Developing 17 8 20 45
All 63 14 23 100
Source: Kym Anderson and Will Martin, “Agricultural Trade Reform and the Doha Agenda,”
The World Economy 28 (September 2005), pp. 1301–1327.
244 PART TWO International Trade Policy
and export subsidies—would come from, and how they would be distributed across countries.
In the modern world, agricultural goods account for less than 10 percent of total
international trade. Nonetheless, according to the World Bank’s estimate, liberalizing agricultural
trade would produce 63 percent of the total world gains from free trade for the
world as a whole. And these gains are very hard to get at. As already described, farmers in
rich countries are highly effective at getting favors from the political process.
The proposals that came closest to actually getting accepted in the Doha Round in fact
fell far short of full liberalization. As a result, the likely gains even from a successful
round would have been fairly small. Table 10-5 shows World Bank estimates of the welfare
gains, as a percentage of income, under two scenarios of how Doha might have played
out: an “ambitious” scenario that would have been very difficult to achieve, and a “less
ambitious” scenario in which “sensitive” sectors would have been spared major liberalization.
The gains for the world as a whole even in the ambitious scenario would have been
only 0.18 percent of GDP; in the more plausible scenario, the gains would have been less
than a third as large. For middle- and lower-income countries, the gains would have been
even smaller. (Why would China have actually lost? Because, as explained in the box
above, it would have ended up paying higher prices for imported agricultural goods.)
TABLE 10-5 Percentage Gains in Income under Two Doha Scenarios
Ambitious Less Ambitious
High-income 0.20 0.05
Middle-income 0.10 0.00
China -0.02 -0.05
Low-income 0.05 0.01
World 0.18 0.04
Source: See Table 10-4.
Do Agricultural Subsidies Hurt the Third World?
One of the major complaints of developing countries
during the Doha negotiations was the continuing
existence of large agricultural export and production
subsidies in rich countries. The U.S. cotton subsidy,
which depresses world cotton prices and therefore
hurts cotton growers in West Africa, is the most
commonly cited example.
But we learned in Chapter 9 that an export subsidy
normally raises the welfare of the importing
country, which gets to buy goods more cheaply. So
shouldn’t export subsidies by rich countries actually
help poorer countries?
The answer is that in many cases they do. The
estimates shown in Table 10-5 indicate that a successful
Doha Round would actually have hurt
China. Why? Because China, which exports manufactured
goods and imports food and other agricultural
products, would be hurt by the removal of agricultural
subsidies.
And it’s not just China that may actually benefit
from rich-country export subsidies. Some third
world farmers are hurt by low prices of subsidized
food exports from Europe and the United States—
but urban residents in the third world benefit, and
so do those farmers producing goods, such as
coffee, that don’t compete with the subsidized
products.
Africa is a case in point. A survey of estimates of
the likely effects of the Doha Round on low-income
African nations found that, in most cases, African
countries would actually be made worse off, because
the negative effects of higher food prices
would more than offset the gains from higher prices
for crops such as cotton.
CHAPTER 10 The Political Economy of Trade Policy 245
The smallness of the numbers in Table 10-5 helps explain why the round failed. Poor
countries saw little in the proposals for them; they pressed for much bigger concessions
from rich countries. The governments of rich countries, in turn, refused to take the political
risk of crossing powerful interest groups, especially farmers, without something in
return—and poor countries were unwilling to offer the deep cuts in their remaining tariffs
that might have been sufficient.
There was a more or less desperate attempt to revive the Doha Round in June 2007
because of the U.S. political calendar. Normally, Congress gives U.S. presidents a special
privilege called trade promotion authority, also known informally as fast-track. When
trade promotion authority is in effect, the president can send Congress a trade agreement
and demand an up-or-down vote—members of Congress can’t introduce amendments that,
say, give special protection to industries in their home districts. Without this authority,
trade agreements tend to get warped beyond recognition.
But President Bush’s trade promotion authority was scheduled to expire at the end of
July 2007, and a Democratic Congress wasn’t going to give new authority to a lame-duck
Republican president. Everyone realized, then, that a failure to reach a deal in the summer
of 2007 would ensure no deal before well into the next president’s administration. So a
meeting was held in the German city of Potsdam between the four key players: the United
States, the European Union, Brazil, and India (China sat on the sidelines). The result was
an impasse. The United States and the European Union blamed Brazil and India for being
unwilling to open their markets to manufactured goods, while Brazil and India accused the
United States and the European Union of doing too little on agriculture.
There was one more attempt to revive the round, in July 2008. But talks collapsed after
only eight days, over disagreements on agricultural trade among the United States, India,
and China. At the time of writing, the whole round appeared to be in a state of suspension,
with nobody admitting failure but no active negotiations underway.
Preferential Trading Agreements
The international trade agreements that we have described so far all involved a “nondiscriminatory”
reduction in tariff rates. For example, when the United States agrees with
Germany to lower its tariff on imported machinery, the new tariff rate applies to machinery
from any nation rather than just imports from Germany. Such nondiscrimination is normal
in most tariffs. Indeed, the United States grants many countries a status known formally as
that of “most favored nation” (MFN), a guarantee that their exporters will pay tariffs
no higher than that of the nation that pays the lowest. All countries granted MFN status
thus pay the same rates. Tariff reductions under the GATT always—with one important
exception—are made on an MFN basis.
There are some important cases, however, in which nations establish preferential trading
agreements under which the tariffs they apply to each other’s products are lower than
the rates on the same goods coming from other countries. The GATT in general prohibits
such agreements but makes a rather strange exception: It is against the rules for country A
to have lower tariffs on imports from country B than on those from country C, but it is
acceptable if countries B and C agree to have zero tariffs on each other’s products. That is,
the GATT forbids preferential trading agreements in general, as a violation of the MFN
principle, but allows them if they lead to free trade between the agreeing countries.7
7The logic here seems to be legal rather than economic. Nations are allowed to have free trade within their
boundaries: Nobody insists that California wine pay the same tariff as French wine when it is shipped to New
York. That is, the MFN principle does not apply within political units. But what is a political unit? The GATT
sidesteps that potentially thorny question by allowing any group of economies to do what countries do, and
establish free trade within some defined boundary.
246 PART TWO International Trade Policy
In general, two or more countries agreeing to establish free trade can do so in one of
two ways. They can establish a free trade area in which each country’s goods can be
shipped to the other without tariffs, but in which the countries set tariffs against the outside
world independently. Or they can establish a customs union in which the countries must
agree on tariff rates. The North American Free Trade Agreement, which establishes free
trade among Canada, the United States, and Mexico, creates a free trade area: There is no
requirement in the agreement that, for example, Canada and Mexico have the same tariff
rate on textiles from China. The European Union, on the other hand, is a full customs
union. All of the countries must agree to charge the same tariff rate on each imported
good. Each system has both advantages and disadvantages; these are discussed in the
accompanying box.
Subject to the qualifications mentioned earlier in this chapter, tariff reduction is a good
thing that raises economic efficiency. At first it might seem that preferential tariff reductions
are also good, if not as good as reducing tariffs all around. After all, isn’t half a loaf
better than none?
Perhaps surprisingly, this conclusion is too optimistic. It is possible for a country to
make itself worse off by joining a customs union. The reason may be illustrated by a
hypothetical example using Britain, France, and the United States. The United States is a
low-cost producer of wheat ($4 per bushel), France a medium-cost producer ($6 per
bushel), and Britain a high-cost producer ($8 per bushel). Both Britain and France maintain
tariffs against all wheat imports. If Britain forms a customs union with France, the tariff
against French, but not U.S., wheat will be abolished. Is this good or bad for Britain? To
answer this, consider two cases.
First, suppose that Britain’s initial tariff was high enough to exclude wheat imports
from either France or the United States. For example, with a tariff of $5 per bushel, it
Free Trade Area versus Customs Union
The difference between a free trade area and a customs
union is, in brief, that the first is politically
straightforward but an administrative headache,
while the second is just the opposite.
Consider first the case of a customs union. Once
such a union is established, tariff administration is
relatively easy: Goods must pay tariffs when they
cross the border of the union, but from then on can
be shipped freely between countries. A cargo that is
unloaded at Marseilles or Rotterdam must pay duties
there, but will not face any additional charges if it
then goes by truck to Munich. To make this simple
system work, however, the countries must agree on
tariff rates: The duty must be the same whether the
cargo is unloaded at Marseilles, Rotterdam, or, for
that matter, Hamburg, because otherwise, importers
would choose the point of entry that minimizes their
fees. So a customs union requires that Germany,
France, the Netherlands, and all the other countries
agree to charge the same tariffs. This is not easily
done: Countries are, in effect, ceding part of their
sovereignty to a supranational entity, the European
Union.
This has been possible in Europe for a variety of
reasons, including the belief that economic unity
would help cement the postwar political alliance between
European democracies. (One of the founders
of the European Union once joked that it should
erect a statue of Joseph Stalin, without whose menace
the Union might never have been created.) But
elsewhere these conditions are lacking. The three
nations that formed NAFTA would find it very difficult
to cede control over tariffs to any supranational
body; if nothing else, it would be hard to devise any
CHAPTER 10 The Political Economy of Trade Policy 247
would cost $9 to import U.S. wheat and $11 to import French wheat, so British consumers
would buy $8 British wheat instead. When the tariff on French wheat is eliminated, imports
from France will replace British production. From Britain’s point of view, this is a
gain, because it costs $8 to produce a bushel of wheat domestically, while Britain needs to
produce only $6 worth of export goods to pay for a bushel of French wheat.
On the other hand, suppose the tariff was lower, for example, $3 per bushel, so that before
joining the customs union, Britain bought its wheat from the United States (at a cost
to consumers of $7 per bushel) rather than producing its own wheat. When the customs
union is formed, consumers will buy French wheat at $6 rather than U.S. wheat at $7. So
imports of wheat from the United States will cease. However, U.S. wheat is really cheaper
than French wheat; the $3 tax that British consumers must pay on U.S. wheat returns to
Britain in the form of government revenue and is therefore not a net cost to the British
economy. Britain will have to devote more resources to exports to pay for its wheat imports
and will be worse off rather than better off.
This possibility of a loss is another example of the theory of the second best. Think of
Britain as initially having two policies that distort incentives: a tariff against U.S. wheat
and a tariff against French wheat. Although the tariff against French wheat may seem to
distort incentives, it may actually help to offset the distortion of incentives resulting from
the tariff against the United States by encouraging consumption of the cheaper U.S. wheat.
Thus, removing the tariff on French wheat can actually reduce welfare.
Returning to our two cases, notice that Britain gains if the formation of a customs
union leads to new trade—French wheat replacing domestic production—while it loses
if the trade within the customs union simply replaces trade with countries outside the
union. In the analysis of preferential trading arrangements, the first case is referred to
as trade creation, while the second is trade diversion. Whether a customs union is
desirable or undesirable depends on whether it mainly leads to trade creation or trade
diversion.
arrangement that would give due weight to U.S.
interests without effectively allowing the United
States to dictate trade policy to Canada and Mexico.
NAFTA, therefore, while it permits Mexican goods
to enter the United States without tariffs and vice
versa, does not require that Mexico and the United
States adopt a common external tariff on goods they
import from other countries.
This, however, raises a different problem. Under
NAFTA, a shirt made by Mexican workers can be
brought into the United States freely. But suppose
that the United States wants to maintain high tariffs
on shirts imported from other countries, while
Mexico does not impose similar tariffs. What is to
prevent someone from shipping a shirt from, say,
Bangladesh to Mexico, then putting it on a truck
bound for Chicago?
The answer is that even though the United States
and Mexico may have free trade, goods shipped
from Mexico to the United States must still pass
through a customs inspection. And they can
enter the United States without duty only if they
have documents proving that they are in fact
Mexican goods, not transshipped imports from
third countries.
But what is a Mexican shirt? If a shirt comes
from Bangladesh, but Mexicans sew on the buttons,
does that make it Mexican? Probably not. But if
everything except the buttons were made in Mexico,
it probably should be considered Mexican. The
point is that administering a free trade area that is
not a customs union requires not only that the countries
continue to check goods at the border, but that
they specify an elaborate set of “rules of origin” that
determine whether a good is eligible to cross the
border without paying a tariff.
As a result, free trade agreements like NAFTA
impose a large burden of paperwork, which may be
a significant obstacle to trade even when such trade
is in principle free.
248 PART TWO International Trade Policy
Do Trade Preferences Have Appeal?
The European Union has slipped repeatedly into
bunches of trouble over the question of trade preferences
for bananas.
Most of the world’s banana exports come from
several small Central American nations—the original
“banana republics.” Several European nations,
however, have traditionally bought their bananas
instead from their past or present West Indian
colonies in the Caribbean. To protect the island producers,
France and the United Kingdom have historically
imposed import quotas against the “dollar
bananas” of Central America, which are typically
about 40 percent cheaper than the West Indian
product. Germany, however, which has never had
West Indian colonies, allowed free entry to dollar
bananas.
With the integration of European markets after
1992, the existing banana regime became impossible
to maintain because it was easy to import the
cheaper dollar bananas into Germany and then ship
them elsewhere in Europe. To prevent this outcome,
the European Commission announced plans in
1993 to impose a new common European import
quota against dollar bananas. Germany angrily
protested the move and even denied its legality:
The Germans pointed out that the Treaty of Rome,
which established the European Community, contains
an explicit guarantee (the “banana protocol”)
that Germany would be able to import bananas
freely.
Why did the Germans go ape about bananas?
During the years of communist rule in East
Germany, bananas were a rare luxury. The sudden
availability of inexpensive bananas after the fall of
the Berlin Wall made them a symbol of freedom. So
the German government was very unwilling to introduce
a policy that would sharply increase banana
prices.
In the end, the Germans grudgingly went along
with a new, unified system of European trade preferences
on bananas. But that did not end the controversy:
In 1995 the United States entered the fray,
claiming that by monkeying around with the existing
system of preferences, the Europeans were hurting
the interests not only of Central American
nations but also those of a powerful U.S. corporation,
the Chiquita Banana Company, whose CEO
had donated large sums to both Democratic and
Republican politicians.
In 1997 the World Trade Organization found that
Europe’s banana import regime violated international
trade rules. Europe then imposed a somewhat
revised regime, but this halfhearted attempt to resolve
the banana split proved fruitless. The dispute
with the United States escalated, with the United
States eventually retaliating by imposing high tariffs
on a variety of European goods, including designer
handbags and pecorino cheese.
In 2001, Europe and the United States agreed
on a plan to phase out the banana import quotas
over time. The plan created much distress and
alarm in Caribbean nations, which feared dire
consequences from their loss of privileged access
to the European market. But even then the story
wasn’t over. In January 2005, the European Union
announced that it would eliminate import quotas
on bananas, but that it would triple the tariff on
bananas that did not come from the so-called ACP
countries (Africa, Caribbean, and Pacific—essentially,
former European colonies). Latin American
countries immediately moved to challenge the new
tariff, and in December 2007 the WTO ruled that
Europe’s latest banana regime, like its predecessor,
was illegal. (Chiquita’s stock price jumped with
the news.)
Finally, in December 2009, the European Union
reached an agreement with Latin American banana
producers. It wouldn’t completely eliminate trade
preferences, but it would cut tariffs on bananas by a
third over a seven-year period.
CHAPTER 10 The Political Economy of Trade Policy 249
Case Study
Trade Diversion in South America
In 1991, four South American nations, Argentina, Brazil, Paraguay, and Uruguay,
formed a free trade area known as Mercosur. The pact had an immediate and dramatic
effect on trade: Within four years, the value of trade among the nations tripled. Leaders
in the region proudly claimed Mercosur as a major success, part of a broader package
of economic reform.
But while Mercosur clearly was successful in increasing intraregional trade, the theory
of preferential trading areas tells us that this need not be a good thing: If the new
trade came at the expense of trade that would otherwise have taken place with the rest
of the world—that is, if the pact diverted trade instead of created it—it might actually
have reduced welfare. And sure enough, in 1996 a study prepared by the World Bank’s
chief trade economist concluded that despite Mercosur’s success in increasing regional
trade—or rather, because that success came at the expense of other trade—the net
effects on the economies involved were probably negative.
In essence, the report argued that as a result of Mercosur, consumers in the member
countries were being induced to buy expensively produced manufactured goods from
their neighbors rather than cheaper but heavily tariffed goods from other countries. In
particular, because of Mercosur, Brazil’s highly protected and somewhat inefficient
auto industry had in effect acquired a captive market in Argentina, thus displacing
imports from elsewhere, just like our text example in which French wheat displaces
American wheat in the British market. “These findings,” concluded the initial draft of
the report, “appear to constitute the most convincing, and disturbing, evidence produced
thus far concerning the potential adverse effects of regional trade arrangements.”
But that is not what the final, published report said. The initial draft was leaked to
the press and generated a firestorm of protest from Mercosur governments, Brazil in
particular. Under pressure, the World Bank first delayed publication, then eventually
released a version that included a number of caveats. Still, even in its published version,
the report made a fairly strong case that Mercosur, if not entirely counterproductive,
nonetheless has produced a considerable amount of trade diversion.
SUMMARY
The ninth major round of world trade negotiations began in 2001 with a ceremony in the
Persian Gulf city of Doha. Like previous rounds, this one was marked by difficult negotiation.
But as of the summer of 2010, it appeared that something new had happened: For the
first time since the creation of the GATT, a round of trade negotiations appeared to have
broken down with no agreement in sight.
It’s important to understand that the apparent failure of the Doha Round does not undo the
progress achieved in previous trade negotiations. Remember that the world trading system is
a combination of “levers”—international trade negotiations that push trade liberalization forward—
and “ratchets,” mainly the practice of binding tariffs, which prevent backsliding. The
levers seem to have failed in the latest trade round, but the ratchets are still in place: The
reductions in tariff rates that took place in the previous eight rounds remain in effect. As a
result, world trade remains much freer than at any previous point in modern history.
In fact, Doha’s apparent failure owes a lot to the success of previous trade negotiations.
Because previous negotiations had been so successful at reducing trade barriers, the remaining
barriers to trade are fairly low, so that the potential gains from further trade liberalization
are modest. Indeed, barriers to trade in most manufactured goods other than apparel
and textiles are now more or less trivial. Most of the potential gains from a move to freer
trade would come from reducing tariffs and export subsidies in agriculture—which has
been the last sector to be liberalized because it’s the most sensitive sector politically.
Table 10-4 illustrates this point. It shows a World Bank estimate of where the welfare
gains from “full liberalization”—that is, the elimination of all remaining barriers to trade
TABLE 10-4 Percentage Distribution of Potential Gains from Free Trade
Full Liberalization of:
Economy
Agriculture and
Food
Textiles and
Clothing
Other
Merchandise All Goods
Developed 46 6 3 55
Developing 17 8 20 45
All 63 14 23 100
Source: Kym Anderson and Will Martin, “Agricultural Trade Reform and the Doha Agenda,”
The World Economy 28 (September 2005), pp. 1301–1327.
244 PART TWO International Trade Policy
and export subsidies—would come from, and how they would be distributed across countries.
In the modern world, agricultural goods account for less than 10 percent of total
international trade. Nonetheless, according to the World Bank’s estimate, liberalizing agricultural
trade would produce 63 percent of the total world gains from free trade for the
world as a whole. And these gains are very hard to get at. As already described, farmers in
rich countries are highly effective at getting favors from the political process.
The proposals that came closest to actually getting accepted in the Doha Round in fact
fell far short of full liberalization. As a result, the likely gains even from a successful
round would have been fairly small. Table 10-5 shows World Bank estimates of the welfare
gains, as a percentage of income, under two scenarios of how Doha might have played
out: an “ambitious” scenario that would have been very difficult to achieve, and a “less
ambitious” scenario in which “sensitive” sectors would have been spared major liberalization.
The gains for the world as a whole even in the ambitious scenario would have been
only 0.18 percent of GDP; in the more plausible scenario, the gains would have been less
than a third as large. For middle- and lower-income countries, the gains would have been
even smaller. (Why would China have actually lost? Because, as explained in the box
above, it would have ended up paying higher prices for imported agricultural goods.)
TABLE 10-5 Percentage Gains in Income under Two Doha Scenarios
Ambitious Less Ambitious
High-income 0.20 0.05
Middle-income 0.10 0.00
China -0.02 -0.05
Low-income 0.05 0.01
World 0.18 0.04
Source: See Table 10-4.
Do Agricultural Subsidies Hurt the Third World?
One of the major complaints of developing countries
during the Doha negotiations was the continuing
existence of large agricultural export and production
subsidies in rich countries. The U.S. cotton subsidy,
which depresses world cotton prices and therefore
hurts cotton growers in West Africa, is the most
commonly cited example.
But we learned in Chapter 9 that an export subsidy
normally raises the welfare of the importing
country, which gets to buy goods more cheaply. So
shouldn’t export subsidies by rich countries actually
help poorer countries?
The answer is that in many cases they do. The
estimates shown in Table 10-5 indicate that a successful
Doha Round would actually have hurt
China. Why? Because China, which exports manufactured
goods and imports food and other agricultural
products, would be hurt by the removal of agricultural
subsidies.
And it’s not just China that may actually benefit
from rich-country export subsidies. Some third
world farmers are hurt by low prices of subsidized
food exports from Europe and the United States—
but urban residents in the third world benefit, and
so do those farmers producing goods, such as
coffee, that don’t compete with the subsidized
products.
Africa is a case in point. A survey of estimates of
the likely effects of the Doha Round on low-income
African nations found that, in most cases, African
countries would actually be made worse off, because
the negative effects of higher food prices
would more than offset the gains from higher prices
for crops such as cotton.
CHAPTER 10 The Political Economy of Trade Policy 245
The smallness of the numbers in Table 10-5 helps explain why the round failed. Poor
countries saw little in the proposals for them; they pressed for much bigger concessions
from rich countries. The governments of rich countries, in turn, refused to take the political
risk of crossing powerful interest groups, especially farmers, without something in
return—and poor countries were unwilling to offer the deep cuts in their remaining tariffs
that might have been sufficient.
There was a more or less desperate attempt to revive the Doha Round in June 2007
because of the U.S. political calendar. Normally, Congress gives U.S. presidents a special
privilege called trade promotion authority, also known informally as fast-track. When
trade promotion authority is in effect, the president can send Congress a trade agreement
and demand an up-or-down vote—members of Congress can’t introduce amendments that,
say, give special protection to industries in their home districts. Without this authority,
trade agreements tend to get warped beyond recognition.
But President Bush’s trade promotion authority was scheduled to expire at the end of
July 2007, and a Democratic Congress wasn’t going to give new authority to a lame-duck
Republican president. Everyone realized, then, that a failure to reach a deal in the summer
of 2007 would ensure no deal before well into the next president’s administration. So a
meeting was held in the German city of Potsdam between the four key players: the United
States, the European Union, Brazil, and India (China sat on the sidelines). The result was
an impasse. The United States and the European Union blamed Brazil and India for being
unwilling to open their markets to manufactured goods, while Brazil and India accused the
United States and the European Union of doing too little on agriculture.
There was one more attempt to revive the round, in July 2008. But talks collapsed after
only eight days, over disagreements on agricultural trade among the United States, India,
and China. At the time of writing, the whole round appeared to be in a state of suspension,
with nobody admitting failure but no active negotiations underway.
Preferential Trading Agreements
The international trade agreements that we have described so far all involved a “nondiscriminatory”
reduction in tariff rates. For example, when the United States agrees with
Germany to lower its tariff on imported machinery, the new tariff rate applies to machinery
from any nation rather than just imports from Germany. Such nondiscrimination is normal
in most tariffs. Indeed, the United States grants many countries a status known formally as
that of “most favored nation” (MFN), a guarantee that their exporters will pay tariffs
no higher than that of the nation that pays the lowest. All countries granted MFN status
thus pay the same rates. Tariff reductions under the GATT always—with one important
exception—are made on an MFN basis.
There are some important cases, however, in which nations establish preferential trading
agreements under which the tariffs they apply to each other’s products are lower than
the rates on the same goods coming from other countries. The GATT in general prohibits
such agreements but makes a rather strange exception: It is against the rules for country A
to have lower tariffs on imports from country B than on those from country C, but it is
acceptable if countries B and C agree to have zero tariffs on each other’s products. That is,
the GATT forbids preferential trading agreements in general, as a violation of the MFN
principle, but allows them if they lead to free trade between the agreeing countries.7
7The logic here seems to be legal rather than economic. Nations are allowed to have free trade within their
boundaries: Nobody insists that California wine pay the same tariff as French wine when it is shipped to New
York. That is, the MFN principle does not apply within political units. But what is a political unit? The GATT
sidesteps that potentially thorny question by allowing any group of economies to do what countries do, and
establish free trade within some defined boundary.
246 PART TWO International Trade Policy
In general, two or more countries agreeing to establish free trade can do so in one of
two ways. They can establish a free trade area in which each country’s goods can be
shipped to the other without tariffs, but in which the countries set tariffs against the outside
world independently. Or they can establish a customs union in which the countries must
agree on tariff rates. The North American Free Trade Agreement, which establishes free
trade among Canada, the United States, and Mexico, creates a free trade area: There is no
requirement in the agreement that, for example, Canada and Mexico have the same tariff
rate on textiles from China. The European Union, on the other hand, is a full customs
union. All of the countries must agree to charge the same tariff rate on each imported
good. Each system has both advantages and disadvantages; these are discussed in the
accompanying box.
Subject to the qualifications mentioned earlier in this chapter, tariff reduction is a good
thing that raises economic efficiency. At first it might seem that preferential tariff reductions
are also good, if not as good as reducing tariffs all around. After all, isn’t half a loaf
better than none?
Perhaps surprisingly, this conclusion is too optimistic. It is possible for a country to
make itself worse off by joining a customs union. The reason may be illustrated by a
hypothetical example using Britain, France, and the United States. The United States is a
low-cost producer of wheat ($4 per bushel), France a medium-cost producer ($6 per
bushel), and Britain a high-cost producer ($8 per bushel). Both Britain and France maintain
tariffs against all wheat imports. If Britain forms a customs union with France, the tariff
against French, but not U.S., wheat will be abolished. Is this good or bad for Britain? To
answer this, consider two cases.
First, suppose that Britain’s initial tariff was high enough to exclude wheat imports
from either France or the United States. For example, with a tariff of $5 per bushel, it
Free Trade Area versus Customs Union
The difference between a free trade area and a customs
union is, in brief, that the first is politically
straightforward but an administrative headache,
while the second is just the opposite.
Consider first the case of a customs union. Once
such a union is established, tariff administration is
relatively easy: Goods must pay tariffs when they
cross the border of the union, but from then on can
be shipped freely between countries. A cargo that is
unloaded at Marseilles or Rotterdam must pay duties
there, but will not face any additional charges if it
then goes by truck to Munich. To make this simple
system work, however, the countries must agree on
tariff rates: The duty must be the same whether the
cargo is unloaded at Marseilles, Rotterdam, or, for
that matter, Hamburg, because otherwise, importers
would choose the point of entry that minimizes their
fees. So a customs union requires that Germany,
France, the Netherlands, and all the other countries
agree to charge the same tariffs. This is not easily
done: Countries are, in effect, ceding part of their
sovereignty to a supranational entity, the European
Union.
This has been possible in Europe for a variety of
reasons, including the belief that economic unity
would help cement the postwar political alliance between
European democracies. (One of the founders
of the European Union once joked that it should
erect a statue of Joseph Stalin, without whose menace
the Union might never have been created.) But
elsewhere these conditions are lacking. The three
nations that formed NAFTA would find it very difficult
to cede control over tariffs to any supranational
body; if nothing else, it would be hard to devise any
CHAPTER 10 The Political Economy of Trade Policy 247
would cost $9 to import U.S. wheat and $11 to import French wheat, so British consumers
would buy $8 British wheat instead. When the tariff on French wheat is eliminated, imports
from France will replace British production. From Britain’s point of view, this is a
gain, because it costs $8 to produce a bushel of wheat domestically, while Britain needs to
produce only $6 worth of export goods to pay for a bushel of French wheat.
On the other hand, suppose the tariff was lower, for example, $3 per bushel, so that before
joining the customs union, Britain bought its wheat from the United States (at a cost
to consumers of $7 per bushel) rather than producing its own wheat. When the customs
union is formed, consumers will buy French wheat at $6 rather than U.S. wheat at $7. So
imports of wheat from the United States will cease. However, U.S. wheat is really cheaper
than French wheat; the $3 tax that British consumers must pay on U.S. wheat returns to
Britain in the form of government revenue and is therefore not a net cost to the British
economy. Britain will have to devote more resources to exports to pay for its wheat imports
and will be worse off rather than better off.
This possibility of a loss is another example of the theory of the second best. Think of
Britain as initially having two policies that distort incentives: a tariff against U.S. wheat
and a tariff against French wheat. Although the tariff against French wheat may seem to
distort incentives, it may actually help to offset the distortion of incentives resulting from
the tariff against the United States by encouraging consumption of the cheaper U.S. wheat.
Thus, removing the tariff on French wheat can actually reduce welfare.
Returning to our two cases, notice that Britain gains if the formation of a customs
union leads to new trade—French wheat replacing domestic production—while it loses
if the trade within the customs union simply replaces trade with countries outside the
union. In the analysis of preferential trading arrangements, the first case is referred to
as trade creation, while the second is trade diversion. Whether a customs union is
desirable or undesirable depends on whether it mainly leads to trade creation or trade
diversion.
arrangement that would give due weight to U.S.
interests without effectively allowing the United
States to dictate trade policy to Canada and Mexico.
NAFTA, therefore, while it permits Mexican goods
to enter the United States without tariffs and vice
versa, does not require that Mexico and the United
States adopt a common external tariff on goods they
import from other countries.
This, however, raises a different problem. Under
NAFTA, a shirt made by Mexican workers can be
brought into the United States freely. But suppose
that the United States wants to maintain high tariffs
on shirts imported from other countries, while
Mexico does not impose similar tariffs. What is to
prevent someone from shipping a shirt from, say,
Bangladesh to Mexico, then putting it on a truck
bound for Chicago?
The answer is that even though the United States
and Mexico may have free trade, goods shipped
from Mexico to the United States must still pass
through a customs inspection. And they can
enter the United States without duty only if they
have documents proving that they are in fact
Mexican goods, not transshipped imports from
third countries.
But what is a Mexican shirt? If a shirt comes
from Bangladesh, but Mexicans sew on the buttons,
does that make it Mexican? Probably not. But if
everything except the buttons were made in Mexico,
it probably should be considered Mexican. The
point is that administering a free trade area that is
not a customs union requires not only that the countries
continue to check goods at the border, but that
they specify an elaborate set of “rules of origin” that
determine whether a good is eligible to cross the
border without paying a tariff.
As a result, free trade agreements like NAFTA
impose a large burden of paperwork, which may be
a significant obstacle to trade even when such trade
is in principle free.
248 PART TWO International Trade Policy
Do Trade Preferences Have Appeal?
The European Union has slipped repeatedly into
bunches of trouble over the question of trade preferences
for bananas.
Most of the world’s banana exports come from
several small Central American nations—the original
“banana republics.” Several European nations,
however, have traditionally bought their bananas
instead from their past or present West Indian
colonies in the Caribbean. To protect the island producers,
France and the United Kingdom have historically
imposed import quotas against the “dollar
bananas” of Central America, which are typically
about 40 percent cheaper than the West Indian
product. Germany, however, which has never had
West Indian colonies, allowed free entry to dollar
bananas.
With the integration of European markets after
1992, the existing banana regime became impossible
to maintain because it was easy to import the
cheaper dollar bananas into Germany and then ship
them elsewhere in Europe. To prevent this outcome,
the European Commission announced plans in
1993 to impose a new common European import
quota against dollar bananas. Germany angrily
protested the move and even denied its legality:
The Germans pointed out that the Treaty of Rome,
which established the European Community, contains
an explicit guarantee (the “banana protocol”)
that Germany would be able to import bananas
freely.
Why did the Germans go ape about bananas?
During the years of communist rule in East
Germany, bananas were a rare luxury. The sudden
availability of inexpensive bananas after the fall of
the Berlin Wall made them a symbol of freedom. So
the German government was very unwilling to introduce
a policy that would sharply increase banana
prices.
In the end, the Germans grudgingly went along
with a new, unified system of European trade preferences
on bananas. But that did not end the controversy:
In 1995 the United States entered the fray,
claiming that by monkeying around with the existing
system of preferences, the Europeans were hurting
the interests not only of Central American
nations but also those of a powerful U.S. corporation,
the Chiquita Banana Company, whose CEO
had donated large sums to both Democratic and
Republican politicians.
In 1997 the World Trade Organization found that
Europe’s banana import regime violated international
trade rules. Europe then imposed a somewhat
revised regime, but this halfhearted attempt to resolve
the banana split proved fruitless. The dispute
with the United States escalated, with the United
States eventually retaliating by imposing high tariffs
on a variety of European goods, including designer
handbags and pecorino cheese.
In 2001, Europe and the United States agreed
on a plan to phase out the banana import quotas
over time. The plan created much distress and
alarm in Caribbean nations, which feared dire
consequences from their loss of privileged access
to the European market. But even then the story
wasn’t over. In January 2005, the European Union
announced that it would eliminate import quotas
on bananas, but that it would triple the tariff on
bananas that did not come from the so-called ACP
countries (Africa, Caribbean, and Pacific—essentially,
former European colonies). Latin American
countries immediately moved to challenge the new
tariff, and in December 2007 the WTO ruled that
Europe’s latest banana regime, like its predecessor,
was illegal. (Chiquita’s stock price jumped with
the news.)
Finally, in December 2009, the European Union
reached an agreement with Latin American banana
producers. It wouldn’t completely eliminate trade
preferences, but it would cut tariffs on bananas by a
third over a seven-year period.
CHAPTER 10 The Political Economy of Trade Policy 249
Case Study
Trade Diversion in South America
In 1991, four South American nations, Argentina, Brazil, Paraguay, and Uruguay,
formed a free trade area known as Mercosur. The pact had an immediate and dramatic
effect on trade: Within four years, the value of trade among the nations tripled. Leaders
in the region proudly claimed Mercosur as a major success, part of a broader package
of economic reform.
But while Mercosur clearly was successful in increasing intraregional trade, the theory
of preferential trading areas tells us that this need not be a good thing: If the new
trade came at the expense of trade that would otherwise have taken place with the rest
of the world—that is, if the pact diverted trade instead of created it—it might actually
have reduced welfare. And sure enough, in 1996 a study prepared by the World Bank’s
chief trade economist concluded that despite Mercosur’s success in increasing regional
trade—or rather, because that success came at the expense of other trade—the net
effects on the economies involved were probably negative.
In essence, the report argued that as a result of Mercosur, consumers in the member
countries were being induced to buy expensively produced manufactured goods from
their neighbors rather than cheaper but heavily tariffed goods from other countries. In
particular, because of Mercosur, Brazil’s highly protected and somewhat inefficient
auto industry had in effect acquired a captive market in Argentina, thus displacing
imports from elsewhere, just like our text example in which French wheat displaces
American wheat in the British market. “These findings,” concluded the initial draft of
the report, “appear to constitute the most convincing, and disturbing, evidence produced
thus far concerning the potential adverse effects of regional trade arrangements.”
But that is not what the final, published report said. The initial draft was leaked to
the press and generated a firestorm of protest from Mercosur governments, Brazil in
particular. Under pressure, the World Bank first delayed publication, then eventually
released a version that included a number of caveats. Still, even in its published version,
the report made a fairly strong case that Mercosur, if not entirely counterproductive,
nonetheless has produced a considerable amount of trade diversion.
SUMMARY
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