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II – B FLEXIBILITY IN TRADE AGREEMENTS B FLEXIBILITY IN TRADE AGREEMENTS The aim of this section is to: (a) clarify what Economists have identified several rationales for justifies the inclusion of contingency measures in the existence of trade agreements, such as those trade agreements; (b) provide an account of all embodied in the WTO, and its antecedent, the circumstances when a suspension of commitments General Agreement on Tariffs and Trade (GATT). may make economic sense; and (c) identify the Two main approaches can be distinguished.1 The flexibility measures built into WTO agreements. first states that in the absence of a trade agreement, The section provides a framework for the discussion a country may be tempted to manipulate the of specific contingency measures in the subsequent terms-of-trade (i.e. the price of its exports relative sections of the Report. to its imports) in order to increase its national income at the expense of its trading partners. The 1. ECONOMIC THEORIES OF second approach stresses the economic and political TRADE AGREEMENTS AND THE difficulties that governments face in setting trade policy. As discussed below, trade agreements allow ROLE OF FLEXIBILITIES governments to escape terms-of-trade conflicts and/ or to resist pressures from the private sector and Trade agreements aim to strike a balance between special-interest groups urging the government to flexibility and commitments. If there is too deviate from a liberal trade policy. much flexibility, the value of the commitment is undermined. If there is too little flexibility, countries i) The traditional approach to trade agreements may refuse to make deep commitments or may easily renege on such commitments. This section explores The main logic of the terms-of-trade (or traditional) how this trade-off works. It reviews the economic approach is that countries that have market power rationale for international trade cooperation and (i.e. that can influence their terms-of-trade) cannot explains the reason for the inclusion of flexibilities resist the temptation to act in their own interests. in a trade agreement. It is important to highlight Johnson (1954) analyzes a situation where each the distinction between the initial motivations for country sets trade policy in an attempt to improve introducing flexibilities and the consequences of its terms-of-trade and increase national income. The using such flexibilities. This section focuses on the resulting “non-cooperative equilibrium” (known as reasons for including flexibilities while the effects Nash equilibrium) is inefficient as the unilateral of specific measures are examined in Sections C actions of countries cancel out one another. More and D. restrictive trade policies by all countries have little (a) The economic rationale for trade net effect on the terms-of-trade, but lead to a agreements contraction of trade volumes which reduces overall welfare (see Box 1). There has long been a solid argument in favour of free trade based on economic efficiency. Based on this premise, there is no need for trade agreements since governments intent on maximizing national welfare would consider any deviation from free trade as a self-defeating choice. Notwithstanding this well-known argument, unilateral trade policies that inefficiently restrict trade flows do occur and trade agreements that aim to limit such unilateral actions are in place. 21 WORLD TRADE REPORT 2009 Box 1 Terms-of-trade and the international cost-shifting problem This box examines why countries may be Importantly, however, terms-of-trade manipulation tempted to exploit terms-of-trade effects and why is a “beggar-thy-neighbour” type of policy. The such unilateral behaviour leads to an inefficient benefit to Country A comes at the expense outcome, i.e. a reduction in global welfare. of welfare in Country B. This is because the Consider two large trading partners, Country A tariff can be seen as a tax partly paid by foreign and Country B. Each government can choose free producers who cannot fully pass it on to domestic trade or impose a tariff on imported goods. What consumers and, therefore, end up bearing part of will be the welfare effect if Country A imposes a the burden. As the government in Country A does tariff on imports from Country B? How will the nothing to offset the negative effect that the tariff tariff affect the welfare of Country B? imposes on foreign producers, it has adopted a policy which is inefficient from the point of view When the government of a large country imposes of global welfare. This is the beggar-thy-neighbour a tariff on an imported good, it reduces the that the terms-of-trade theory identifies. demand for that good in the international market as domestic residents will buy less of it at the The last step is to understand what would be higher domestic price. Because the consumers the optimal trade policy in Country B given the in Country A represent such a large proportion strategy of the government in Country A. If the of the market, this fall in demand for the good government in Country B chooses free trade, produced in Country B depresses its price in it is hurt by the tariff imposed by its trading the international market, which in turn implies partner. If, on the other hand, the government that Country A obtains its imports at a lower in Country B imposes its own tariff on goods international price than before. This positive effect produced in Country A, it will also benefit from of a tariff on the country’s welfare is the terms- an improvement in its terms-of-trade. This is why of-trade effect.2 Country A will set this benefit unilateral policy setting leads trading partners to against the costs of trade restrictions, which arise retaliate against each other. Both governments because of the expansion of inefficient domestic impose trade restrictions, creating a situation often production and the reduction in consumer choice called “trade war”. In this situation, the benefits that the tariff introduces. of the terms-of-trade are generally cancelled out (with neither country gaining from it) while the imposition of the tariffs reduces global welfare. This situation, which is often referred to as a It is important to note that an agreement facilitates “Prisoners’ Dilemma” driven by terms-of-trade, trade cooperation, but does not eliminate the can be avoided through a trade agreement between signatories’ beggar-thy-neighbour temptations. In countries allowing them to cooperate rather than act the absence of external punishment mechanisms, unilaterally.3 By cooperating in binding agreements a trade agreement needs to be “self-enforcing”: to reduce their trade restrictions, countries overcome signatories will abide as long as respecting the this inefficiency (Mayer, 1981). Interestingly, the agreement is in their own interest. This implies purpose of a trade agreement in this situation is that the short-term gains from deviating from the not tied to the assumption that governments choose commitment must be balanced by the long-term trade policy to maximize national income. Even loss from retaliation. when governments are concerned about the political consequences of their tariff choices, Bagwell and ii) The commitment approach to trade Staiger (1999; 2002) show that the two main agreements features of the GATT/WTO system, the principles of reciprocity and non-discrimination, are simple While the traditional approach to trade agreements rules that allow countries to escape the terms-of- emphasizes an international source of inefficiency trade driven Prisoners’ Dilemma.4 in trade policy (i.e. the temptation of countries to act in a non-cooperative manner), commitment 22 II – B FLEXIBILITY IN TRADE AGREEMENTS theory focuses on a domestic source of inefficiency. through which time-inconsistent trade policy may When setting trade policy, a government may be lead to inefficiencies (a partial list includes Staiger unable to make credible economic and/or political and Tabellini, 1987; Matsuyama, 1990 and Amin, commitments to the private sector or the parliament. 2003). In these models, the government wishes to use discretionary trade policy to increase social The lack of economic commitment leads to a welfare (for example, in response to unexpected so-called time-inconsistency problem. This is a events, or to allow temporary protection to an situation where the decision of the government to infant industry, etc.). However, the use of trade implement a certain policy at some future time policy changes the behaviour of participants in the is not optimal when the future period arrives. economy. If agents anticipate the policy that the Therefore, the statement that the policy will be government will implement, they can react to it in a implemented in the future is not credible (see Box way that will reduce the impact that it has on them. 2). The notion of time inconsistency has been This implies that the government will not be able to applied to trade policy in a large number of studies use discretionary trade policy as intended, and this which highlight several different mechanisms results in a socially inefficient trade policy. Box 2 Time-inconsistency The following example illustrates the time- In both situations, the problem becomes one inconsistency problem. A teacher informs her of finding a means of credibly committing to class that there will be an algebra test next week. carrying out the originally stated action – that This is the “optimal” action – the threat of the is, to hold the exam or maintain low inflationary test encourages the students to work hard which policies. For example, the teacher might promise is good for both the teacher and the students. to report the students’ results to a higher body, However, when next week arrives, the teacher and the government might delegate responsibility has the opportunity to rethink whether or not to for monetary policy to a Central Bank which is actually hold the test.

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