Olli's follies and the Pros and Cons of TAFTA

The recent letter of EU commissioner Olli Rehn to EU finance ministers which, against overwhelming empirical evidence that austerity has failed (see graphs below), continues to support the economic equivalence of the Ptolemaic theory, just leaves me speechless in the face of so much arrogance and Besserwisserei (there is really no adequate english translation for this word, pedantery only comes close).

      Austerity and Changes in Debt-to-GDP ratios in the Eurozone 

Source: Paul de Grauwe; data source: Financial Times and datastream

    Austerity and Economic Growth in the Eurozone 

Source: Paul de Grauwe 

Since a number of other observers have already competently commented on this issue, please allow me to refer you to selected comments by Paul Krugman: "Euro Delusions", Karl Whelan, economics professor and former economist at the Federal Reserve: "Is Debate about Fiscal Multipliers unhelpful ?", Paul de Grauwe, professor of International Economics at the London School of Economics: "Panic-Driven Austerity in the Eurozone and its Implications", and an independent economic blogger in Brussels: "Die Kosten des Sparwahns."

I will instead comment upon another issue, proposed at the last EU summit: a trans-atlantic free trade agreement (TAFTA). This idea is not new. Already in 1995, European officials put forward a proposal for the creation of a US-EU free trade agreement, provoking me to write a paper about it while I spent a sabbatical at Harvard's Kennedy School of Government. The paper is rather wonkish, but might contain a few useful insights ---> see some extracts below:

EXTRACTS of a 1995 paper on the Pros and Cons of TAFTA
prepared for Harvard University, John F. Kennedy School of Government

(copyright held by the author of this blog)

Net Trade Gains from TAFTA

International trade theory is concerned with the efficiency of global resource allocation and the maximization of global welfare. The theory holds that global welfare rises if the formation of a free trade area (FTA) results in greater opportunities for specialization and trade. Conversely, global welfare suffers a decline if the FTA diverts trade from more to less efficient producers. Hence, according to traditional trade theory a free trade area improves global welfare if and only if its trade-creating effects outweigh its trade-diverting effects.1 In the next sections I will examine whether this might be the case with the creation of TAFTA.

Trade Creation2

According to Lawrence (1995) trade creation will be largest among FTA member countries with high initial levels of protection suppressing their trade.3 With the exception of agricultural trade, this is clearly not the case in the US or in Europe. Tariffs are already very low so that further tariff reductions under TAFTA are unlikely to result in large additional trade flows. However, TAFTA is likely to strengthen the competitive pressure on ‘outsiders’ to either join the group or create another free trade area (either complementary to or competing with TAFTA), thus spreading the process of liberalization and trade creation among other nations (domino effect).4

It is further argued that the mere increase in market size leads to economies of scale and scope and enhances the opportunities for specialization and trade. This effect is said to be strongest among countries that produce similar goods.5 On this point, the statistical evidence in favor of TAFTA is most convincing. With a common US-European market of 750 million people, a common GDP of $15 trillion,6 and an expected enlargement of the European Union to include Central and Eastern Europe in the not too distant future, the trade creation potential from TAFTA is enormous.

Recent experience also suggests that intra-industry trade and foreign direct investments (FDI) flourish particularly well among countries at similar stages of development. Borne out by statistical evidence of trade and investment flows among OECD countries during the past decade,7 TAFTA is likely to strengthen the already existing intra-industry trade and FDI-creating effects. Furthermore, the spill-overs from innovations induced by FDI will benefit TAFTA members as well as external producers, and is likely to create additional trade inside and outside of the free trade zone. 

Trade Diversion

One of the most salient arguments advanced in opposition of FTAs centers around the allocative efficiency implications of trade diversion from more to less efficient producers. This argument refers to the effects of discriminatory rules of origin or other barriers against producers outside of the FTA region. Even if trade creation is enhanced inside the FTA, trade diversion will occur, and global welfare will be impaired, if more efficient producers outside the free trade zone are prevented from competing with ‘inside’ producers. Bhagwati puts it bluntly: “[FTAs] are two-faced, bringing free trade to members, but amounting to implied protection against non-members.”8

This argument would indeed weigh heavily if TAFTA led to trade diversion as a result of discriminatory trade practices or other negative effects on outside producers9. Hence, to avoid any reduction in global welfare care should be taken to prevent and/or offset the potential trade-diversionary impact of TAFTA by lowering external tariffs as well as internal ones, by maintaining a non-discriminatory rules and regulations, and by keeping the group open for membership to all interested countries.10

A related view holds that even if the FTA is not discriminatory against outsiders it impedes efforts toward free global trade by diverting scarce resources away from multilateral trading initiatives and by providing an attractive alternative instead.11 The evidence from a recent WTO report suggests, however, that FTAs promote liberalization trends and thereby reinforce the global trading system. Rather than alternatives to free global trade, FTAs seem to be complements and stepping stones toward it.12

Yet, some economists warn that the global effects of TAFTA, especially when combined with APEC, may be extremely harmful to the multilateral trading system. TAFTA and APEC together cover 80% of world trade and encompass the most significant players and issues, leaving little room and scope for negotiation under the WTO umbrella.13 In view of the mounting international opposition to the formation of a ‘rich-country club’, it is advisable to avoid this exclusive image of TAFTA and keep it open to other regional and non-regional members, both rich and poor.14

Institutional Aspects of TAFTA15

While traditional trade theory focuses on the creation of trade flows and the minimization of trade diversion to optimize the global welfare impact of an FTA, non-traditional trade analysis takes a broader view of global welfare. It takes into account the effects of ‘deeper integration’ measures and addresses economic governance issues that affect the sovereignty of the nation state.16 In my view, a thorough assessment of the net gains from TAFTA also requires the weighing of the expected costs and benefits from the institutional changes under discussion.

Costs

If TAFTA remains limited to a cooperative trade and investment agreement with an à la carte menu of policy measures, the costs in terms of sovereignty loss will be minimal to zero. Since the US, however, envisions a number of ‘deeper integration’ measures such as the standardization of product tests and the harmonization of regulatory policies, there will be some adaptation costs to conform with common standards as well as some loss in independence in policy making. I expect that most of the costs from deregulation will be borne by European countries due to their much higher level of regulations and the extent of industrial policies applied in the region. 

Benefits

The potential trade- and investment benefits from institutional changes envisioned under TAFTA are sizeable. Regulatory harmonization and the mutual recognition of each other’s product standards and certification procedures will facilitate market access and reduce production and distribution costs. Further, the security of market access and the guarantee of FDI property rights will diminish investor uncertainty and is bound to stimulate two-way trade and investment flows as well as job creation on both sides of the Atlantic. Moreover, the benefits from institutional harmonization accrue to both internal and external producers.

Other Considerations

US public opinion on TAFTA seems to be divided. Its enthusiastic reception by multinational corporations comes as no surprise. Unexpectedly, however, TAFTA also enjoys strong support among labor unions and the democratic minority in Congress who view the agreement as their “last chance” to introduce Europe’s labor and welfare standards in the US.18 Given the maturity of the economies involved there is little concern about US workers’ pay being “undercut by the pitiful wages in poor countries.”19

Employer groups, on the other hand, are apprehensive about TAFTA’s expected upward pressure on US labor and welfare costs, and the potentially damaging effect on US competitiveness.20 Other groups argue that, as an exclusive rich-country club, TAFTA will be internationally divisive and result in the extension of Europe’s protective ‘tariff walls’ to the US.21

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1/Compare Lawrence (1995): “Regionalism, Multilateralism and Deeper Integration”, pp. 21-25.
2/Consistent with the new General Agreement on Trade in Services (GATS), foreign direct investments and other factor and non-factor service trade is included under the broad heading ‘trade’.
3/Ibid., p. 25.
4/Baldwin (1993: “A Domino Theory of Regionalism”) points out the “domino effect” of the proliferation of FTAs (cited in Lawrence,1995, p. 39).
5/Lawrence (1995), p. 26.
6/See the Economist of May 27, 1995: “In need of fastening”.
7/Recent trading patterns among OECD countries reflect growing intra-industry trade flows. Parallel to this trend, two-way FDI flows among OECD countries have tripled from 1982-92, growing several times faster than global trade and output (see Brooks-Senftleben, 1993: “Private Capital Flows .......: Overview of Recent Trends and Some Thoughts on Sustainability and Future Prospects”, Ibero-America Institute for Economic Research, Discussion Paper No. 62, p. 9).
8/Compare the arguments advanced by Bhagwati in the Financial Times of May 31, 1995: “Personal View - the High Cost of Free Trade Areas”.
9/Compare Lawrence (1995), pp. 26-27. He points out that outsiders may be hurt by a decline in their terms of trade due to lower demand for their imports from FTA members. However, Lawrence also argues that the negative terms of trade effect could be offset by income- and import-stimulating economies of scale effects inside the FTA.
10/A recent WTO report suggests that the trade-diverting impact of existing FTAs has been minimal to non-existent even though discriminatory rules of origin are widely applied (see the summary of key WTO findings in the Financial Times of July 12, 1995: “FT Exporter”).
11/Compare the comments by Mr. Ruggiero, head of the WTO, in the Financial Times of April 28, 1995: “Priorities in World Trade.”
12/Compare the Financial Times of July 12, 1995: “FT Exporter”.
13/The economists referred to are Anne Krueger and Jagdish Bhagwati (compare the Financial Times, of April 28, 1995: “Priorities in World Trade”.
14/Yi (1994) argues that FTAs that are open to outsiders will eventually lead to full multilateral free trade (see Yi, Sang-Seung: “Stable Structures of Trading Blocs and Welfare”, mimeo, Dartmouth College, cited in Lawrence, 1995, p. 42).
15/Compare Lawrence (1995) for an introduction to non-traditional trade analysis based on institutional effects.
16/For example subsidies or other industrial or trade policy measures (compare Lawrence, 1995, pp. 28-34.
17/TAFTA was first proposed by Mr. Kinkel, Foreign Minister of Germany. The European trade commission strongly favors the initiative (compare the Financial Times of April 20, 1995, and the Economist of May 27, 1995).
18/See the International Herald Tribune of June 8, 1995: “Europe’s Search for Security......”
19/Quoted from the Wall Street Journal of June 5, 1995: “US Backs More Liberal Trade Effort with Europe.....”
20/Compare the EIU Crossborder Monitor of June 21, 1995: “More Market Access: Trade Partners Wary of Bold Initiatives Globally.”
21/Ibid. and Financial Times, April 28, 1995: “Priorities in World Trade”.