The path to global free trade: Spaghetti bowls as building blocs

1. The path to global free trade:Spaghetti bowls as building blocs Richard E. Baldwin Professor of International Economics Graduate Institute of International Studies, Geneva World Economy Annual Lecture Nottingham 22 June 2006

2. Introduction & Plan • Topic: Final steps to global free trade. • Bhagwati’s paths. • Define: global free trade. • Bold prediction & caveats. • Outline • Political economy of liberalisation. • Structured historical narrative. • Staging post 2010. • The final 2 steps. • WTO’s job.

3. 6 stylised facts • The GATT process started when tariffs were very high worldwide; • Rich nations liberalised much more than poor nations, in both the GATT process (i.e. bound rates) and RTAs; • The liberalisation focused on industrial goods in which two-way trade in similar goods is prevalent; • The process took 40 years; • Some sectors were excluded entirely and others experienced much less tariff cutting; • Regional tariff cutting went hand-in-hand with multilateral liberalisation.

4. Political Economy • Status quo tariff. • Tariff balances supply & demand for protection. • Supply = marginal cost curve (marginal welfare damage). • Demand = marginal utility curve (marginal benefit to special interests).

5. Protection demand euros S D quantity euros Protection demand P’ a P P’ a P T T’ Pw T T T’

6. Protection supply euros S euros b d P’ c Naïve opt’l tariff a Protection Supply P T’ e f Pw g Pw’ D T quantity T’

7. Juggernaut: demi-cycle 1 Political equilibrium tariff balances S & D for protection. Reciprocal trade talks re-align political economy forces inside each participating nation. Protection supply shifts up. Exporters become anti-protectionists. euros Protection Supply (recip.) Protection Supply (unil.) Protection demand T T T’

8. Juggernaut: demi-cycle 2 Politically optimal tariff depends of size of import competing sector. Walrasian entry, n. Number of import competing firms rise with tariff. FE curve. Same for export sector, but can’t plot. Tariff,T FE To n no

9. Juggernaut effect Fold supply & demand into GFOC. Solution to govt first order condition. GFOC rises with n since politically optimal T rises with n. More to protect on margin. Tariff,T FE Eo To GFOC (unil) n no

10. Juggernaut effect Start: unilaterally politically optimal tariff, To. Reciprocal trade talks shift GFOC down. Lower opt’l T for any given n (exporters are now in the game). Juggernaut rolls forward to E’ Tariff,T FE GFOC (unil) Eo To A GFOC (recip) T1 B T’ E’ n

11. Juggernaut effect If all exports covered by the reciprocity, politically optimal tariff is zero. Could take decades crush the anti-trade forces (import competing firms) & build pro-trade forces (export firms). Tariff,T FE GFOC (unil) Eo To GFOC (MTN) n Efinal

12. Domino effect Demi-cycle I: Idiosyncratic formation or deepening of a trade bloc re-aligns the political economy forces inside non-member nations. Pro-membership political economy forces: Non-member exporters: Trade diversion (fresh loses) & Trade Creation (lost opportunity). Anti-membership political economy forces: If deeper, may resist more. If export sectors are politically larger than import competing sectors. Demi-cycle II: if a new member joins, “forces for inclusion” get stronger in non-member nations.

13. RTB unilateralism Competition for out-sourcing jobs and investment drive nations to unilaterally cut tariffs. Re-aligns political economy forces in DCs. Unbundling of manufacturing process (i.e. fragmentation, vertical differentiation, slicing up value added chain) is key. Destroys import substitution (scale, competition) Makes export-led industrialisation more successful (foreign technology from MNC/buyers, ready market). Finer division of labour may mean no import competing industry. MNC role may imply imports mostly re-exported. Importers are also exporters => no political economy conflict.

14. Ancillary effects Intra-sectoral special interest politics. Melitz model & reciprocal liberalisation: big firms win, small firms lose. Add Mancur Olsen’s Asymmetry on political organisation & juggernaut effect works well on intra-industry trade. Losers lobby harder. Home market magnification effect. Industry becomes more footloose, not less, as trade barriers fall. Competition for industry becomes more fierce as tariffs fall globally. (Small preference margins can matter a lot).

15. Historical Narrative 3 key effects: Jugger (MTNs), Domino (RTAs), RTB (unilateralism). “Empirical evidence” intended to “demonstrate” usefulness of the 3 key effects. Line sketch. Can’t pretend to explain everything.

16. Historical Narrative • 1947-1958. • GATT starts. • Juggernaut works but stops in 1950s.

17. Dominos trigger juggernauts • 1958-1972. • EEC formation: • Europe domino effect phase I. • Kennedy Round. • RTAs: US Auto Pact & EEC, EFTA. • MTNs, RTAs & unilateralism proceed in tandem. • Liberalisation begets liberalisation.

18. 1973-1985 • EEC first enlargement and EEC-EFTA FTAs, create another incentive for an MTN (Tokyo Round, 73-79). • Stagflation postpones all forms of trade liberalisation. Tokyo

19. 1986-1990 • Juggernaut & domino re-engage. • Single European Act, 1986. • US-Canada FTA talks start, 1986. • Uruguay Round starts, 1986.

20. 1990-1994 • European spaghetti bowl forms. • USSR collapse. • North American spaghetti bowls forms. • US-Mexico FTA triggers massive domino effect. • NAFTA, Mercosur, dozens of spoke-spoke FTAs, long queue for US bilaterals.

21. 1994-2000 • European spaghetti bowl advances. • Euro-Meds, etc. • North American spaghetti bowls advances. • NAFTA crushes Mexican anti-trade forces. • Mexico ‘sells’ its politically optimal tariff cuts in over 40 bilaterals. • Japan, EU & US.

22. 1986-2000 • RTB unilateralism in East Asia (circa 1985). Reductions in applied MFN tariffs on Asian crisis

23. MTNs, RTAs & unilateralism • In 1990s, as in the 1960s & 1980s, all the ‘isms’ progress hand-in-hand. • No evidence that ‘isms’ are substitutes.

24. 2000-2006 • East Asian noodle bowl starts. • China’s approach to ASEAN for FTA triggers domino effect in East Asia. • ACFTA, AKFTA, AJFTA, many bilaterals. • No significant regionalism to date, but lots promised. • Western Hemisphere spaghetti bowl advances. • US opposition to FTAs crushed by NAFTA; US follows promiscuous FTA strategy. • European FTAs multiply, spokes start to proliferate FTAs.

25. Staging Post 2010 • Europe, North America and East Asia: ‘fuzzy’, ‘leaky’ trade blocs. • North America & Europe done deals; between & within near-duty-free status (major flows). • Many East Asian FTAs may have problems (typically south-south), but Japan-Malaysia, & 4 other big ASEANs very likely to be implemented. • Rest due to domino and RTB unilateralism. • Prediction: Applied tariffs will be near zero for world’s major trade flows around 2010.

26. Fractals • Definition: “A rough or fragmented geometric shape that can be subdivided in parts, each of which is (at least approximately) a reduced/size copy of the whole.” • World trade system made of 3 fuzzy, leaky trade blocs each of which is made up of fuzzy leaky sub-blocs. • The point: • Solution to one is the solution to all (roughly).

27. PECS • How PECS fixed the European spaghetti bowl and why. • Spaghetti bowl problems: • Multi ROOs (hard to do biz in spokes) • Bilateral cumulation (hinders efficient sourcing in spokes) • 1997, EU set up PECS: • imposed common set of ROOs on EU, EFTA & CEECs. • Imposed diagonal cumulation.

28. PECS • Spaghetti bowl is not by accident. • Pair-specific political economy forces => pair-specific policy; especially hub & spoke. • Unbundling & off-shoring • Former beneficiaries of complexity downsized and off-shored from EU. • Some EU firms set up in spokes and are now harmed by the complexity (“us” becomes “them”). • EU firms push EU to tame the tangle of FTAs. • “Spaghetti bowl as building blocs” • Complexity & unbundling create new politically economy force • Push system the short distance from near-free trade with matrix of bilaterals to free trade ‘lake.’ • Multilateralise the FTAs. • Domino effect in ROOs/Cumulation.

29. 2 final steps • Penultimate: • Multilateralise the spaghetti bowl FTAs in North America (when US firms become victims of the complexity). • NAFTA ROOs already popular. • Diagonal cumulation is next. • East Asia, much more difficult. • Might be RTB unilateralism makes ROOs/Cumulation irrelevant. • ASEAN ROOs already popular.

30. 2 final steps • Ultimate • As global unbundling continues, SBBB pressures will mount. • Impractical to do a PECS given PECS, NAFTA & ASEAN ROOs. • Alternative is ITA-like agreement with coverage of most industrial goods. • Zero-for-zero.

31. WTO’s role • Penultimate: not much, should study impact of PECS on non-members more closely. • The final step could be in WTO, but not like DDA. • ITA was much more like old-fashioned GATT Rounds. • Much less emphasis on S&D. • Principle supplier ideas. • RTB unilateral to bring newly industrialising nations along.

32. END Thanks for listening: www.hei.unige.ch/baldwin/