Insider-Outsider Distortions and Trading Blocs

I think Martin Wolf has this right. What appears on the surface to be a series of free trade agreements betweent the U.S. and other countries is really a system of insider-outsider trade with all the distortions such preferential treatment brings about:

A Korean-American strand enters trade’s spaghetti bowl, by Martin Wolf, Commentary, Financial Times: ...This month marks the 60th anniversary of the General Agreement on Tariffs and Trade... It also sees the announcement of a “free trade agreement” between [the U.S.] and South Korea. The core of the Gatt was non-discrimination. The core of the new agreement is its opposite. ...

At a first glance, the new FTA does deliver a substantial opening between the world’s largest economy and its 11th largest: nearly 95 per cent of bilateral trade in consumer and industrial products is to become duty free within three years, with most remaining tariffs abolished within 10...

Why do I object? Is such trade liberalisation not precisely what most economists interested in trade believe in? The answer to this question is “yes and no”: yes, because liberal trade is desirable, but no, because this form of liberalisation is not necessarily a move towards liberal trade. As Jagdish Bhagwati of Columbia University has argued, “free trade agreements” should, instead, be called “preferential trade agreements”. I would prefer “discriminatory trade agreements”.

In this case, the US and South Korea agree to discriminate in favour of exporters or investors based in each other’s territory. The obvious potential economic cost of such an agreement is what Jacob Viner, the great inter-war trade economist, called “trade diversion”. In other words, the partners might shift from more competitive to less competitive suppliers. In this case, however, trade diversion may be modest, since these two countries are among the world’s most competitive suppliers of a wide range of goods and services.

A more significant economic cost, however, is systemic. The number of preferential trade agreements has exploded upwards in recent years... Other countries will be desperate to avoid the adverse effects upon them. This makes probable yet another jump in the prevalence of such agreements.

That will have at least two further economic consequences. First, an increasing proportion of the world’s trade is sure to be governed by the diverse rules of origins and special procedures of a host of discriminatory bilateral and plurilateral agreements. That guarantees an explosion in administrative complexity. Second, every further bilateral agreement will alter the degree of preference enjoyed by existing suppliers. That guarantees an explosion of business uncertainty. ...

The political consequences of this development are, however, at least as important. First, a company’s market access will depend increasingly on the power of its own government to lever open other markets rather than its competitiveness. Second, big powers will compete with one another to wrest more favourable terms for their own producers. The emergence of such power-driven trading blocs is a world away from the hopes of the founding fathers of the Gatt system. ... If the US, as the dominant economic player, makes discrimination a central principle of its own policy, how can it fail to become a global model, with predictable and disturbing results? ...

I am a long-run optimist on this. As the number of agreements explodes upwards some wise policymaker will surely ask why his or her country conducts trade policy through a hundred or more bilateral agreements. Why, he will ask, do we not have a single multilateral agreement, instead? He may even want a name for this new agreement. I know. Why not call it the “World Trade Organisation”?

Paul Krugman talked about this in 1992:

A Global Economy Is Not the Wave of the Future, by Paul Krugman, 1992: Where is our global economy headed...? The most fashionable script says that we are moving into an age of unprecedented international economic integration, that market technology, telecommunications, and faster transportation have shrunk the world, that borders are dissolving, and that We are about to see a globalization of business.

I'm reminded of an old South American joke that says Brazil is the country of the future, and always will be. ... What I would argue is that we're heading for regionalization, a breaking up of the world economy into blocs. ... [W]hile technology can integrate the world, whether it does so depends on politics. ... Political obstacles to economic integration beat technology every time. ...

Why are the political reasons for an integrated world economy so much weaker than the technological reasons? In an ideal world, most economists would agree, the free movement of goods, of services, of capital, of multinational enterprises, and probably of people is in the best interests of both the world economy and individual countries. But there is usually little connection between actual trade policy and what's good for a country. Trade policy is made in the real world of politics. And in that world, national welfare doesn't vote. Only interest groups vote.

Thus, well-organized interest groups, like producers, have more influence than disorganized groups like consumers. One example is our import quota on sugar. For the 250 million Americans who eat it, sugar is hidden in a variety of processed foods. Only the producers understand the importance of the quota. ...

So what will the next few years bring? I don't visualize a great trade war, nothing that dramatic. But I do see ... an inward turning of the world into trading blocs. They already exist in North America and the European Community, and, more obscurely, in the investment ties between Japan and some Pacific Rim countries.

Members of these trading blocs will claim that what they have done is not at the expense of their relations with the outside world. The Europeans say they are not creating Fortress Europe. We say that the North American Free Trade Area will not turn into Fortress NAFTA. Nor will the Japanese concede any emerging trade bloc.

But all that is nonsense. For the next 10 to 15 years, those on the inside of these blocs are going to have a stronger voice than those on the outside. ... It is inevitable that we will become more restrictive against trade from the outside. In fact, just by providing preferences for our neighbors, we will divert world trade from trade between blocs to trade inside blocs... 

One saving grace is we're not talking of a balkanization of the world. These trading blocs will be huge entities. The importance of free trade and the evils of protectionism are both usually overstated. Protectionism, for example, did not cause the Great Depression of the 1930s. And so we should not be swept up by the romance of mega trends, thinking that integration of the world's economy is inevitable. It isn't. A world without borders is a possibility, yes, but it is a possibility that depends on politics. ...

Update: See Ben Muse for quite a bit more on potential trade diversion and third party impacts arising from the trade agreement between the U.S. and Korea.