On 5 October, 12 nations signed an agreement that, if ratified, will form the largest trade bloc in the world, accounting for roughly 40% of global income. The Trans-Pacific Partnership (TPP) brings together the US, Canada, Japan and nine other Pacific Rim economies—although, notably, neither China nor India are involved at the moment. The TPP is a prime example of what economists call a preferential trade agreement (PTA).
With the Doha round of multilateral trade negotiations under the World Trade Organization (WTO) all but dead, attention has shifted to PTAs as an avenue to jumpstart global trade. Yet, PTAs—as distinct from multilateral trade liberalization under the WTO—raise a host of distinct analytical questions. There is by now a lot of literature in economics that analyzes both the economics and the political economy of preferential—as opposed to multilateral—trade liberalization.
In a
2012 research paper, economist Pravin Krishna, a professor at Johns Hopkins University, provides a comprehensive overview of the debates around PTAs. I draw on this paper, and works cited in it, in what follows.
While PTAs are sometimes misleadingly referred to as “free trade areas”—a case in point being the North American Free Trade Agreement (NAFTA)—the reality is that they are a very different beast from free trade. A fundamental proposition of international trade theory asserts that in the absence of market failures, a movement towards freer trade—by, say, cutting tariffs and quotas that restrict imports—will be generally efficiency-enhancing for an economy.
And for a “small” economy—one that does not influence the prices of goods and services it trades in the global economy—the best policy will be a move to completely unfettered, fully free trade—again, in the absence of market failures.
This presumption—that freer trade is generally better—does not carry over to the case of PTAs. The reason is that when a country preferentially reduces trade barriers with its partners in a PTA, it is simultaneously keeping in place—or perhaps even raising—trade barriers against countries that are not members of the agreement.
A PTA is thus intrinsically two-faced—it frees trade with partners, while maintaining barriers against others. As a matter of economics, this takes us into the realm of the “second best”, a potentially dystopian world in which seemingly common sense presumptions about economic gain and loss may be turned on their head.
In 1950, Canada-born trade economist Jacob Viner published a classic book, The Customs Union Issue, which remains the foundation for how economists think about PTAs and why they are fundamentally different from genuine free trade. Viner coined the terms “trade creation” and “trade diversion” to capture the positive and negative impacts, respectively, if a PTA is formed.
Thus, if NAFTA created new trade between, say, the US and Canada, it would be trade creating, and this would be economically gainful. But if NAFTA diverted trade away from a more efficient outside supplier, say Peru, to a member of the agreement, say Mexico, this would be trade-diverting and would be economically harmful.
Empirical research, cited in the Krishna paper, confirms that the possibility of welfare-worsening trade diversion is not just a theoretical curiosity—NAFTA, in particular, probably diverted trade away from outside countries as much as it created new trade among US, Canada and Mexico.
While half a century of subsequent research has refined and modified Viner’s conclusions, the vital distinction between trade creation and trade diversion remains highly salient in policy-relevant discussions of actual PTAs, such as the newly formed TPP.
If the economics of PTAs creates ambiguity as to whether they are good or bad for global or even national economic welfare, the political economy is equally fraught. Proponents of PTAs, such as Fred Bergsten of the Peterson Institute for International Economics, a Washington DC think tank, argue that they are a surer route towards eventual global free trade than the multilateral trade liberalization process of the WTO.
On the other side, my own great guru, India-born trade economist Jagdish Bhagwati, argues that, on the contrary, a proliferation of PTAs will represent a “stumbling block” rather than a “building block” towards eventual multilateral trade liberalization. Bhagwati further contends that the criss-crossing tariff preferences and complex rules of origin within PTAs create a veritable “spaghetti bowl” of preferential arrangements, which are ultimately destructive of the goal of global free trade, which one might think of as a congealed and uniform lasagna.
Again, as with trade creation versus trade diversion, empirical studies of the stumbling block versus building block hypotheses, as documented by Krishna, come to mixed conclusions as to whether PTAs, in practice, inhibit the path towards global free trade. But the reality is that the Doha round of the WTO is all but dead, while PTAs proliferate—what is not clear is which is cause and which is effect, or if both emerge from some underlying political dynamic.
In recent times, it has become commonplace to argue that trade liberalization is not what really motivates the creation of PTAs, but rather that the real impetus is the drive towards “deep integration” on “beyond the border” economic issues such as labour and environmental standards, intellectual property protection (IPP), regulation of state-owned enterprises, and even broader social issues such as human rights, gender parity and so forth.
As a matter of economics, the problem with such arguments in favour of deep integration via PTAs is that they are attempting to marry two very different creatures. The freeing of trade should, in theory, be mutually gainful (making allowance for the second best issues discussed earlier). Yet, the harmonization of one country’s regulatory standards in labour, environment or something else to another country’s likely will not involve mutual gain but may even be costly for the country that is forced to harmonize.
Thus,
as I have argued recently in
Mint, by foisting US-style stringent IPP rules onto TPP, ostensibly a trade agreement, there will be a loss for India if we were ever to join—for this would gut our generic pharmaceuticals industry.
This is to say nothing of TPP impinging on how India runs its public sector units, sets labour or environmental regulations, and a slew of other non-trade related policy fields in which we would be surrendering our policy sovereignty to the US without the realistic prospect of economic gain in return.
Far from being mutually gainful, an enforced harmonization to US standards would involve a transfer of resources from India to the US, and would hardly be in India’s national interest—although it would certainly serve American interests, especially those of US corporations.
Having said all of this, would it make sense for India to consider joining TPP at some point in the future?
As noted above, I have argued that it would not be in India’s national interest to sign up to a US-dominated PTA of which the TPP is a prime example. My conclusion is in stark contrast to a much publicized
September 2015 study by Bergsten, who claims to find that India stands to gain handsomely from joining TPP, but would be hurt if it stays out.
The difference is due, in large measure, to the fact that Bergsten calculates the gains (and losses) from trade in a very narrow manner. The costs of harmonization that will be borne by a country such as India is absent from his analysis.
Bergsten’s narrow approach simply cannot address the entirely legitimate concerns that India will be forced into a self-defeating and disastrous enforced harmonization of domestic regulatory policies with those of the US, the dominant partner and putative hegemon within theTPP.
But whether one likes it or not, mega trade agreements of the preferential sort, as exemplified by the TPP, are here to stay. One could argue that a principled stand India could take is to stay out of the PTA racket altogether and throw its weight behind the moribund multilateral process as represented by the WTO.
Yet, this poses its own pitfalls, as the US plays hardball everywhere, including in the multilateral sphere. If India cannot stitch together a coalition of like-minded countries, we could end up being isolated and thus gain little, if anything, as what is left of the emaciated Doha Development Round reaches its endgame. A
recent article in
Mint ahead of the deliberations at the WTO ministerial summit in Nairobi highlights the dangers for India.
Whether or not India chooses to engage with TPP or other PTAs in the future, we should do so mindful of the pitfalls inherent in the fact that a “free trade area” is not the same as free trade—something, as we have seen, Jacob Viner wisely taught us half a century ago.
Economics Express runs weekly, and features interesting reads from the world of economics and finance.
