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Week 4 Is regionalism a route towards global free trade? Regionalism is defined in the Dictionary of Trade Policy Terms as actions by governments to liberalize or facilitate trade on a regional basis.1 Across the world, regionalism can be observed through the formation of regional trading agreements which create free trade within particular groups of countries through reducing forms of discrimination (tariffs, import quotas, etc.) on trade among member nations. Regionalism can pave the way for the eventual achievement of free trade on a global scale through three main channels - Firstly, regional trading agreements can incentivise lower external tariffs in order to reduce the trade diversion caused by these agreements. Secondly, the political economy argument asserts that regionalism can reduce internal opposition in countries to further trade liberalisation. Thirdly, regionalism can serve as a building block for global free trade through lowering the barriers and negotiation costs associated with multilateral trade agreements. However, at the same time, regionalism may pose challenges to global free trade through creating interest groups that oppose further trade liberalization and through detracting policy-makers from multilateral negotiations aimed at promoting global free trade. Regionalism can be observed through the formation of Regional Trading Agreements (RTAs), defined as reciprocal trade agreements between two or more partners. As of 31 January 2014, the WTO records 377 RTAs as being in force, including notable ones such as the EU and the North American Free Trade Agreement (NAFTA). Around the world, the two most common forms of regional trading agreements are free-trade areas (FTAs) and custom unions (CUs). A FTA is a regional trading agreement formed by removing tariffs amongst member countries while allowing them to set tariffs against non-member countries independently. A CU takes a FTA one step further by applying a common tariff structure to trade with non-members.2 On a fundamental level, regionalism can pave the way for global free trade through the impact of RTAs on resource allocation within countries in the RTA. In particular, the welfare-reducing trade diversion caused by the formation of a RTA will prompt countermeasures that include reducing tariff barriers towards non-member countries.
Price, P
PM +Original Tariff PNM +Tariff Price of high-cost member, PM Price of low-cost non-member, PNM 1 2

Supply, Shome

3 5

Demand, Dhome
Q1 Q2 Q3 Q4

Quantity, Q

Figure 1: Effects of a Preferential Trading Arrangement

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Goode, Walter (2007), Dictionary of Trade Policy Terms, World Trade Organization. Baldwin, R. and A.J. Venables, (1995) Regional Economic Integration, in Handbook of International Economics, vol 3, ed. G. Grossman and K. Rogoff, North Holland 1995.

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First, it is necessary to explain how trade diversion could come about due to regionalism. As a result of increased regionalism, manifested in the formation of FTAs, removal of tariffs for goods from member nations could lead to the replacement of low-cost imports from outside the FTA with higher-cost goods from member nations. 3 As shown in Figure 1 above, the home countrys original consumption of a particular good was supplied by a low-cost nonmember country at a price of PNM + tariff. However, the formation of a RTA made it possible for a member country with a higher cost of production to undercut the non-member country by not paying a tariff. While the removal of tariffs for the member country would lead to an increase in the home countrys consumer surplus (Areas 1 + 2 + 3 + 4), it would lead to a fall in producer surplus (Area 1) and the fall in total tariff revenue formerly collected on imports (Areas 3 + 5). Accounting for these various effects, the positive trade creation effect due to the lowered restrictions on imports from member countries is represented by Areas 2 and 4 while the negative effect of trade diversion is represented by Area 5. As a result of trade diversion, both members and non-members of a RTA will have the incentive to push towards global free trade with overall lower tariffs.4 Under the assumption that governments set tariffs to maximise national welfare, members of a RTA will be encouraged to reduce tariff barriers towards non-member countries, in order to reduce the costly effects of trade diversion on welfare. The welfare-reducing effects of trade diversion could also encourage other non-member nations to press for greater tariff reductions and further liberalization in world trade. Theoretically, RTAs need not have adverse effects on multilateral tariff reductions as predicted by the Kemp-Wan theorem, which states that a piecemeal enlargement of a regional trading bloc will raise bloc members welfare.5 This implies that the highest possible welfare will be reached when all nations are part of the bloc. Nevertheless, this theoretical result rests on a critical assumption that lump-sum transfers between members are possible to ensure that they all gain from the RTA. In the absence of this assumption, there could be resistance within existing members of RTAs against an enlargement of the RTA. Empirically, nonmembers of a RTA could be spurred on by the positive effects of trade creation to join the RTA, as shown by the accession of Austria, Finland, and Sweden to the EU in 1995. From a political economy perspective, regionalism can contribute to global free trade through reducing internal opposition in countries that are part of RTAs to further trade liberalisation.6 Domestic firms experience tougher competition from other firms based in RTA member countries and as a result, unproductive companies that resist trade liberalisation will be weeded out. Even among surviving firms, the market share of the domestic industry would be lowered because of the free access to the domestic market enjoyed by exporters in partner countries. Hence, any price increase generated by higher tariffs is of lower value for the domestic industry as a whole.7 It is possible that this might weaken the domestic stance on protectionism and contribute to greater trade liberalisation. Regionalism can serve as a building block for global free trade through lowering the barriers and negotiation costs associated with global trade liberalisation through multilateral trade
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Krugman, P. and Obstfeld, M. (2006), International Economics: Theory and Policy. Pomfret, Richard (2001), "The Economics of Regional Trading Arrangements", OUP Catalogue. 5 World Trade Organization (2011), E. The multilateral trading system and PTAs, World Trade Report 2011. 6 Pomfret (2001) 7 Freund, C. and Ornelas E. (2010), Regional trade agreements: blessing or burden?, CenterPiece Summer 2010: 16-19.

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agreements. Negotiating RTAs allows government officials to gain the expertise and experience needed to enforce trade agreements at the global level, which will be useful in subsequent multilateral trade negotiations. 8 The decrease in independent participants resulting from the formation of regional trading blocs could also possibly facilitate negotiation during multilateral trade negotiations. RTAs also serve as opportunities for experimentation of trade liberalisation on a smaller scale, allowing regulatory competition to select the best trade codes and principles to be used in promoting global free trade.9 Empirically, in examining the effect of regionalism on unilateral trade liberalisation on ten Latin American countries, Estevadeordal et al. (2008) found that preferential tariff reduction in a given sector, as a result of regionalism, did induce a faster decline in external tariffs in free trade areas. Having obtained statistically significant results in the case of the Latin American countries, the authors conclude that free trade areas are likely to be building blocs to external trade liberalisation, exemplifying the notion that regionalism can be a route to global free trade.10 However, the authors of the empirical study mentioned above do admit that their findings contrast with those of similar studies done on the US and the EU11. Those studies found that the US and the EU liberalised less during the WTOs Uruguay Round in sectors which had preferential trading arrangements. They highlighted that a key reason for this discrepancy could be the high existing levels of tariffs present in the Latin American countries that create a huge trade diversion effect that can be mitigated through lower tariffs.12 At this point, it is therefore pertinent to consider counter-arguments that highlight how regionalism, in the form of RTAs, could be an impediment to the global liberalisation of trade. From a political economy perspective, regionalism could lead to the increased presence of interest groups or producers that would oppose further trade liberalization. Grossman and Helpman (1995) show that in countries where producers are able to form lobbies to influence policymakers, the RTAs most likely to arise are with partner countries which have relatively higher costs of production in particular sectors, thus allowing for export rents. 13 The preferential access to partners market as a result of a RTA will create rents to some firms or interest groups, which may consequently resist the lowering of external tariffs to non-member nations. If these groups are powerful enough, free trade could become politically infeasible.14 Regional arrangements could also detract policy-makers from focusing on multilateral negotiations which promote global free trade. The positive effects from trade creation resulting from RTAs would reduce the ex-post gains from multilateral free trade, lowering the incentives of member nations to pursue trade liberalization with non-member countries. Further, considering the limitations on government resources, it is possible that resources that
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Freund and Ornelas (2010) Pomfret (2001) 10 Estevadeordal A. et al. (2008) Does Regionalism Affect Trade Liberalization towards Non-members?, Quarterly Journal of Economics 123: 1531-75. 11 Limao, Nuno, Preferential Trade Agreements as Stumbling Blocks for Multilateral Trade Liberalization: Evidence for the U.S., American Economic Review, 96 (2006), 896914. 12 Estevadeordal et al. (2008) 13 Grossman, Gene M. and Helpman, Elhanan. "The Politics of Free-Trade Agreements." American Economic Review, 1995, 85(4), pp. 667-90. 14 Freund, C. and Ornelas E. (2009), Regional Trade Agreements, CEP Discussion Paper No. 961.

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could have been used to promote global free trade are diverted into promoting regional trading arrangements.15 In conclusion, I would argue that regionalism can be a potential route to global free trade because of its positive impact in incentivising countries to further liberalise their trade policies as a result of trade diversion, decreased domestic opposition and lowered barriers to negotiations. Nevertheless, despite the growing trends in regionalism, global free trade still remains a work in progress because of the inherent challenges associated with it and the further challenges posed by regionalism, such as the increased presence of interest groups opposing further trade liberalisation. Regionalism will only lead to global free trade if challenges like these can be overcome by the momentum of policy-makers who make global free trade a priority.

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Freund and Ornelas (2009)