6 Trade: Preferential Agreements

Overview

Preferential Trade Agreements (PTAs) are a major cornerstone of international trade policies in the 21^st century. PTAs are agreements between two or more countries that grant preferential treatment to each other’s goods and services by reducing tariffs and other barriers to trade. With the introduction of the World Trade Organization (WTO), PTAs were initially regarded as a thing of the past, but PTAs are more prevalent now than ever. More than two-fifths of world trade takes place within PTAs (Bagwell 2011, 7). There are currently 796 trade agreements on file, of which 557 are active, and 354 are in force at this time. As shown in Figure 1, this number has jumped significantly after the end of the Cold War and the 1994 General Agreements on Tariffs and Trade (GATT) Uruguay Round.

In this chapter, we argue that the current world order of Preferential Trade Agreements (PTAs) prevalence and necessity is based on the Hegemonic Stability Theory (HST). HST posits that a stable global economic system requires the presence or necessity of a dominant economic power, or hegemon, that can enforce the rules and norms of the system.

From the perspective of Hegemonic Stability Theory, PTAs can be seen as a threat to the stability of the global trading system. If countries begin to focus on regional trade agreements, they may start to neglect the broader global economic system, leading to the fragmentation of the framework of the current system. This could ultimately challenge the existing hegemon’s control and threaten the stability of the global economic system.

Therefore, it is important to consider the implications of PTAs in terms of their impact on the global economic order. While PTAs may provide benefits to the involved countries, they should not be seen as a substitute for the existing global trade system. Instead, they should be seen as a supplement to the global system and a way to further strengthen it. Organizations like the WTO provide a useful, global, framework for trade, but preferential trade agreements allow

In the following sections we look at past examples, namely, The Council for Mutual Economic Assistance (CMEA) aka COMECON, which was the Soviet Union’s trade agreement amongst eastern bloc and communist friendly states. We also look at the European Union, its predecessors, and the goals for which they were created. We delve into the political and economic ramifications of both the past through case studies in addition to the current reality facing us now. namely with the Trans-Pacific Partnership and the outlook it entails for the near-term future of trade.

Global Hegemon Theory

The current “American Empire” is in a downward trajectory- despite the best efforts of many actors, no successor has fully filled this void. There is not currently a single sphere of influence, thus explaining the reemergence and importance of PTAs today. Arguably the peak of current American order was in the 1990s when the Soviet Union dissolved. The competing spheres of influence dissipated allowing the commencement of the 1994 GATT Uruguay round to shape how trade will function in this new world. After the September 11^th attacks in 2001 the absolute supremacy of the United States was shown. This has not been a swift affair and American willingness to act on the foreign stage has waned significantly. The tax on resources and morale of the citizenry has triggered somewhat of an isolationist desire to be self-sufficient and not interfere in the qualms of others.

In today’s world there are multiple overlapping spheres of influence, including the United States, China, the European Union, and India. This overlap is unique and unprecedented in the last few centuries. Before the Second World War, trade was limited to your own sphere and those around you. After the Second World War there were two global spheres of influence that states belonged to, the West, led by the United States, and what lay behind the “Iron Curtain”, centered around the Soviet Union. Now, there are two main transcontinental spheres: the receding American influence sphere, and the increasingly large Chinese sphere.The unique factor is the states which play both sides along with the new regional powers emerging. Though initially viewed as sharing similarities to The Non-Aligned Movement (NAM) of the Cold War, the realities are much more profound. Specifically, countries like Turkey and India are becoming a regional powerhouse with strong relationships with both Russia/China and the United States. They are effectively playing both sides to achieve the best possible outcome for themselves. Other emerging powers like Brazil, Mexico and Indonesia are gaining regional influence and the ability to set the course of their respective regions. Within these new dynamics between states, preferential trade agreements between those with common interests are emerging. For example, in 2009 Australia and New Zealand struck a deal with the 10 countries that make up the Association of Southeast Asian Nations (ASEAN) in a new agreement dubbed the ASEAN Australia-New Zealand Free Trade Area (AANZFTA) in order to decrease tariffs between all nations involved. Because of this agreement, trade creation between members has increased significantly and trade diversion to non-members has increased at a lesser rate (Gharleghi, 2020). With emerging powers bearing no loyalty to a hegemon, the current landscape is one of PTAs continuing to flourish.

GATT, Integration, and Sovereignty

PTAs formed before 1995 were primarily concerned with trade in goods and took the form of free-trade areas (FTAs) or, more rarely, customs unions (CUs), involving mainly tariff liberalization. The General Agreement on Tariffs and Trade (GATT) was created after the second World War as a framework on trading in the new post-war era and has since been built upon numerous times. Most worthy of note in relation to PTAs is the framework laid out for trade relations between states outside of normal GATT rules. Specifically, Article XXVI of the 1994 Uruguay round which includes a developing country exception agreed to in 1979. Article XXVI provides the parameters under which FTAs and CUs can be created. FTAs are permitted “provided that trade barriers between members are eliminated on substantially all trade”. The Enabling Clause “permits developing countries to grant each other whatever preferences to which they may agree.” In addition, the Generalized System of Preferences “allows developed countries to grant preferential access to developing countries” (Krishna 11-12).

There are various levels of integration countries can achieve in PTAs. The most intertwined and complex of these is a customs union (CU). In such trade agreements the parties have a unified policy for trade with non-members of the agreement. This at its essence surrendering some aspects of its sovereignty to another body. This may eventually lead to even further integration through common institutions such as with the European Union (EU). The surrender of sovereignty is a hard pill to swallow, thus leading to the current gridlock in the further integration of Europe.

The European Union is the most prominent example of a customs union today. It was originally conceived as the European Coal and Steel Community (ECSC) at the end of the Second World War. One of the initial ideas behind its formation was that if two countries, like France and Germany had integrated economies, it would be very difficult for them to go to war with each other again. To add further pressure to this, coal and steel were two of the most important industries affecting the economies of the war and its immediate aftermath. It was initially targeted as it only conceded a very specific and limited amount of autonomy while furthering the goal of European peace.

In 1957, the members of the ECSC met in Rome and signed The Treaty of Rome. This created the European Economic Community (EEC). The treaty laid out the main principles of the EU today, one of which is the common market. To achieve a common market required the implementation of a customs union. The six countries were surrendering an unprecedented amount of sovereignty and intertwining their fates in a way few countries have done while maintaining independence.

Many other European countries at this time were either unable or unwilling to join the EEC. A huge factor for many was the amount of sovereignty being surrendered in a customs union. Seven of these other European states met in Stockholm in 1960 signing the Stockholm Convention creating the European Free Trade Association (EFTA). The EFTA removed many trade barriers within member states but did not create a common market or impose a customs union. This left the sovereignty of its members’ foreign policies intact. Most EFTA members left the association to join the EEC and other European community treaties with time. There are still four members today who have chosen not to join the EU: Iceland, Liechtenstein, Norway, and Switzerland. These countries operate independently of the EU and have decided their sovereignty is more important than the potential benefits of joining the EU.

The EEC evolved with the creation of other European Community treaties leading to the creation of the European Union in 1993. The market has been further integrated through the use of a common currency, the Euro. This is managed by the European Central Bank, and constricted members’ abilities to use currency to help exports. There are numerous institutions in place now as well which make the trade decisions for the whole of the block. Since the inclusion of treaties like the Schengen agreement of 1985 which eliminated law enforcement controls at the borders between members of the treaty, countries’ trade policies are largely now decided in Brussels.

PTAs can open the door to further integration between members which can diminish sovereignty. However, this is rarely the initial intent and many countries remain fiercely independent and resist. In the next section we look at The Council for Mutual Economic Assistance (CMEA) and the ill-fated TransPacific Partnership (TPP) and the role hegemony and sovereignty played in their creation and implementation.

Case studies of CMEA and TPP

The first major PTA created in the post-war order was surprisingly on the eastern side of the iron curtain: The Council for Mutual Economic Assistance (CMEA) aka COMECON (acronym bears no relation to communism). This was created by the Soviet Union as a reaction to the plans laid out by the 1947 Committee of European Economic Cooperation (CEEC). This committee ultimately laid preparations for the implementation of The Marshall Plan to rebuild Western Europe. The sudden prospect of an integrated Europe cooperating and acting in unison caused the Soviet Union to get ahead of the curve of the anticipated Marshall Plan. Thus, the CMEA was initially created in 1948 as a customs union between its satellite states in Eastern Europe. What is most notable about the CMEA is that it preceded the Warsaw Pact defensive alliance. The purpose of these two agreements was to provide the legal means for the Soviet Union to reduce the sovereignty of the nations of the eastern bloc so they could more easily impose power in Eastern Europe.

The CMEA is a fantastic case study since it’s the only major PTA which ceased force and was not replaced by a true successor in the modern era. As the eastern bloc satellites were liberated from communism their status as Soviet tributaries ended. This left the CMEA without a common binding force and thus ceased effect on June 28, 1991. The principles of economic cooperation between the former members had an attempted revival in the planned Organization of International Economic Cooperation Transition. However, due to the collapse of the Soviet Union into 13 republics, the process terminated. The closest successor to the CMEA would be the Commonwealth of Independent States (CIS) however this agreement was a last-ditch attempt to preserve the trade links between the new republics of the Former Soviet Union (FSU), not the eastern bloc and communist allies of the past.

The most notable example of a brand-new PTA created in the last twenty years is the ill-fated TransPacific Partnership (TPP). This agreement was spearheaded by the United States to single handedly cutoff China from its region, in hopes of igniting a decline and decimation of their growing sphere of influence. Arguably, the CMEA was used as a framework for the anti-China measures in the agreement. As stated above the United States’ ability to steward this continued world order is currently hampered by domestic distractions and calls for isolation. Thus, in an ironic twist of fate, the United States pulled out of the very agreement it had written and lobbied other nations to join. The remaining members went ahead and signed the agreement, ratifying it as the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP).

The American void in agreement has left an opportunity for China to join, although they would still be subject to the restrictions placed by the U.S. However, they would have gained access to countries that are highly unlikely to ever sign bilateral or Chinese-led multilateral agreements. Japan, with some assistance from Australia, has ensured the opportunity for the United States to return remains available, however they will not be able to do so indefinitely.

Political Rationale

Most of the political rationale for the creation of Preferential Trade Agreements are defensive in nature. Whether that be to protect and maintain established trade linkages or divert existing ones to politically advantageous locations. Sometimes the trade agreements are offensively minded with the intention of gaining influence or creating new supply chains within politically advantageous locations. Whether offensively or defensively minded the overall idea remains the same: enrich your friends while impoverishing your enemies.

Many of the PTAs that were made were created with the intention of directing trade to a more politically advantageous location. There are two ways in which trade agreements can be crafted in order to achieve this. A trade agreement can protect established industries within the PTAs member nations or seek to divert trade from nations outside of the PTA to nations in the PTA. Nations that seek to protect trade invoke a Rules of Origin clause.Typically, Rules of Origin dictate what goods-producing countries are eligible for preferential treatment within an FTA. NAFTA, for example, has an origin clause that dictates that a certain percentage of production must occur within North America for the good to trade freely. Overall, PTAs seek to create and promote trade with relatively few limits among member countries.

PTAs that seek to divert trade often will raise the cost to trade with nations outside of the PTA and lower the costs of trade within the PTA. When geopolitics are factored in, a country might choose to negotiate a PTA with a country or countries with the primary goal of exercising influence or gaining favor. A modern example of the U.S. negotiating a PTA with the goal of exercising influence would be the Trans-Pacific Partnership, or TPP. Created in 2016, “The TPP could help to address these grievances by diverting trade away from China and directing trade toward other countries, such as Australia, that enjoy more friendly relations with the U.S” (Chow). The trade agreement was made with the containment and exclusion of the People’s Republic of China as its chief motive. While it is very hard to create a trade agreement that creates trade when previously non-existent, if certain circumstances are met trade can be created rather than diverted. However, these are mostly when PTAs follow free trade principles and rarely occur by design.

Many PTAs were also made with alliance structures in mind. Given the omnipresence of geopolitics, many nations use economics to leverage allies and enemies alike. As stated by Mansfield, “the gains from trade accrue to states with common security goals. Allies therefore have little reason to view as threatening increases in the power of members that are generated by trade. In fact, the gains in efficiency that are fostered by the expansion of trade among allies should increase the aggregate income of the alliance partners and hence, their collective military power.” (Anderson and Blackhurst 208). States tend to economically support political allies with preferential trade, rather than political adversaries. Nations are more comfortable with other powers making gains from trade if the partner powers have the same policy goals; however, hesitancy would be present when hostile powers benefit from trade. If two powers with the same policy goals mutually benefit from trade, then the two nations would use their surplus resources in cooperation. However, should two hostile nations mutually benefit from trade, then they would use their surplus resources in competition. This can be seen in Stalin’s creation of COMECON. Stalin created the organization not to promote trade, he wanted to prevent trade. “Following what he perceived to be an American drive for control of the whole of Europe, outside the Soviet Union, particularly through the establishment of the Marshall Plan in 1947, he clearly wanted to establish a distinct and defensible Soviet-East European economic system.” (Wallace and Clarke 1). Stalin saw American influence in Europe increase, and wanted to carve his satellite states far out of America’s reach.

Many great powers also use trade agreements to influence smaller nations. The great powers use their leverage within the trade bloc to get whatever concessions they desire. One such example was within the COMECON, trade bloc. The Soviet Union would utilize its dominant position within the Socialist world to exert influence on other Socialist nations. As stated in COMECON, Trade and the West, “It is an interesting theory that most East European problems stem from the efforts of monocentric governments to control their pluralistic societies. The theory could be extended to the USSR and, in a doubly complex fashion, to the CMEA–the Soviet Party attempting to run all the other communist pirates, and each in turn trying to run its own country” (Wallace, W., V., & Clarke 64). The Soviet Union viewed COMECON as that mechanism of influence to promote whatever version of Socialism they envisioned. The United States also viewed PTAs as a mechanism to promote their influence. Unlike the Soviet Union, which used a multilateral trade deal to influence multiple nations, the United States instead exerts their influence using many bilateral deals. “For the United States, entering bilateral rather than multilateral agreements enhanced its influence over the other participating countries” (Mansfield, E. D., & Pevehouse, J. C. W. 594). This was because the United States sought to build multinational institutions using consensus and cooperation, while the Soviet Union used coercion and force.

Economics of PTAs

Now that we understand the political implications and the history of Preferential Trade Agreements, we can transition into the overall economic impacts of PTAs in terms of trade creation and trade diversion. What do we mean by trade creation and trade diversion? In basic terms “PTAs that create trade increase welfare; PTAs that divert trade may reduce welfare” (Krishna 18). PTAs create trade by removing obstacles of trade, such as tariffs, quotas, and nontariff barriers. Competition created by the PTA between foreign and domestic producers creates new opportunities to sell abroad and obtain cost savings from greater economies of scale. This demonstrates the perceived cause and effect of trade which encourages a more efficient allocation of resources in the economy raising the average productivity of businesses and industries in states. Through this increase in productivity, trade can boost the overall economic output and workers’ average real wage. Consumers and businesses profit because trade lowers prices for some goods and services as explained, increasing the variety of products available for purchase. These agreements can enable states to harmonize laws and regulations which, among other effects, make the costs of operating businesses in other countries similar to those costs in their own state. Easing regulations on foreign investment and providing improved legal protections for foreign investors facilitates greater investment by states. An example of this would be NAFTA which caused significant increase in trade and investment mostly stemming from the U.S.-Mexico trade totaling $481.5 billion in 2015, and U.S.-Canada trade, which totaled $518.2 billion. Trade between Mexico and Canada meanwhile was the fastest-growing channel of trade between 1993 and 2015 even though the overall total was much lower at $34.3 billion. The combination of these totals sum up to over a trillion dollars in trilateral trade which has increased by 258.5% in nominal terms and a real increase of 125.2% since 1993. In terms of GDP the United States’ increased by 39.3% to $51,638, Canada’s increased by 40.3% to $50,001, and Mexico’s increased by 24.1% to $9,511.

Trade diversion is an economic behavior separate from trade creation, which diverts trade from countries that produce goods efficiently to countries that produce the same goods relatively inefficiently. This, likewise, occurs through the formation of a PTA, and preferential treatment is given towards partners. An example of this would be the Tequila Crisis which occurred in 1994. During this crisis the Mexican government imposed tariffs on imports entering Mexico, except imports under NAFTA, which included a clause that eliminated this charge on imports from participating countries. In 1998, the government increased tariffs on imports after experiencing revenue loss when the worldwide price of oil plummeted. This discriminatory practice against non-NAFTA members caused trade diversion from those exporters to the benefit of NAFTA members (Kreuger 1999). Another example of this is how the European Union’s application of common agricultural policy leads to increasing tariff discrimination towards outsiders. This is shown by the rate of discrimination and extra area imports having a negative correlation. Other important footnotes regarding trade diversion in term of PTA’s are that “PTA membership lowers trade outside the bloc by 6 per cent” (Ghosh and Yamarik 2004) and “Intra-PTA trade diversion has been found in 3 out of 22 PTAs analyzed; 5 PTAs lower the extra-PTA exports from member to non-member countries as referenced by Acharya et al.2011. While trade diversion does have an impact as a consequence of a PTA it is not seen as a central outcome of an agreement. There is support on both sides if PTA’s do indeed create trade or divert trade exemplified by various studies into the matter with overall mixed conclusions looking at the net welfare of PTA’s overall. An example of this in favor of trade creation would be the Canada-United States free trade agreement (CUSFTA). A study conducted by Clausing (2001) found data “that the agreement increased US imports from Canada, but did not divert US imports away from other US trading partners. Similarly, the CUSFTA study by Trefler (2004) confirms the finding that trade creation outweighs the trade diversion effect” (pg. 105 WTO report). Conversely a study by Romalis in 2007 of NAFTA deduces that the PTA is trade diverting overall in comparison to trade creation. In this study “Romalis uses changes in EU trade over the period to capture the counterfactual (i.e., what would have happened in the absence of the agreement) but finds that the welfare costs of NAFTA are small” (WTO report pg. 105). Some other studies of importance that corroborate these findings would be Magee’s study in 2008 using gravity models and Carrere’s study in 2006 using the same model. Magee’s study used “panel data for 133 countries in the 1980-1998 period and includes several fixed effects to capture the counterfactual: what would happen to trade if there were no PTAs. He finds that the average impact of PTAs on trade flows is small – only 3 percent – and that, on average, trade creation exceeds trade diversion” (WTO report 105). In comparison Carrere’s study on PTAs found that “130 countries from 1962 to 1996 have generated a significant increase in trade between members, often at the expense of the rest of the world, suggesting evidence of trade diversion” (WTO report 105) displaying further the debate if PTA’s really do create trade or divert trade with their being no clear answer due to so many different findings in support of both arguments.

PTAs and the WTO

Now that we have an understanding of the concepts of trade creation and trade diversion in PTAs, we can move on to our next critical topic: the relationship of PTAs with the World Trade Organization. Preferential trade agreements are an exception to the bedrock principle MFN, a provision of the WTO which states that countries must treat all their trade partners equally, and one country should not be favored over another, in other words no country should give another preferential treatment in reards to their imports. The two main exceptions to this provision exist: aiding in poorer countries’ economic development and comprehensive trade agreements that foster economic integration (i.e., EU, NAFTA, PTAs in general). Significantly, all WTO members are parties to at least one PTA. PTAs are an innovation of the WTO, and the way in which they function makes them comparable to the WTO and may be considered to be “multiplied WTOs” in different parts of the world. Interest in creating PTAs has skyrocketed due to global economic crises with the purpose of preserving existing openness in spite of political pressure to reduce access. The WTO’s transparency mechanism should be used to develop “best practice” guidelines on various aspects, traditional and new, of PTAs (new including environmental protections, labor rights, intellectual property related preferences). This would place a non-binding pressure on WTO members to not deviate from the established guidelines and would much more effectively aid in achieving the goals of trade liberalization and development than the old binding obligations that do not keep up with the fast-paced evolution of PTAs.

Just as the role of PTAs is evolving, so is the role of the WTO. While the U.S. has been a member of the WTO since 1995, and its predecessor GATT since 1948, it has since taken a somewhat controversial stance that has negatively affected routine WTO functions. The WTO’s dispute settlement mechanism includes an appellate court, which decides how to implement a resolution. However, since 2011, the U.S. has blocked the appointments of appellate judges, rendering the WTO’s accountability measures useless (Hufbauer 2011). Without this functioning mechanism, it is clear that the role of the WTO is forever changed, and PTAs may become even more important.

Conclusion

In conclusion, PTAs are a powerful tool policymakers can use in order to craft trade policy in a way that is beneficial for their respective country. During the Bretton Woods era, the world was in a place where the United States was taking an active leadership position. Becoming one of two global hegemons, the United States didn’t need to rely on regional trade agreements, but looked at trade through a global lens. Trade was conducted within the confines of global institutions. Upon the collapse of the Soviet Union, the United States was also arguably no longer in the same active leadership role with preferential trade agreements becoming more commonplace. Without a singular global hegemon, some regional leaders have carved spheres of influence in which important trade relationships are fostered and PTAs and RTAs are formed. A PTA can serve as much more than an economic tool. A developed country may consider a PTA as a means to exercise influence over less-developed countries. The TPP, for example, was seen as an opportunity for the U.S. to establish itself as a leader in the Pacific, in hopes that member countries would not turn to China for economic support. Sometimes this creates trade if the partners operate as if they were operating under liberal trade terms with each other but more often than not these trade agreements take trade from distant or hostile nations, diverting them towards nearby or friendly nations.

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