International trade ; Free trade ; Canada ; European Economic Community

Hang-Sheng Cheng

English

Research Papers in Economics

FRBSF WEEKLY LETTER
August 5, 1988
Toward Trade Blocs?
The European Community's decision to achieve
full economic integration by 1992 and the pend-
ingU.s.-Canada Free Trade Agreement have
raised important questions about the future
shape of world trade and the appropriate direc-
tion of u.s. foreign trade policy. The debate that
has been sparked by these two developments
centers on the pros and cons of trade regionalism
versus trade multilateralism. Most analysts favor a
multilateral approach to trade issues, but they are
divided regarding the advisability of regional
trade blocs. Some fear that regionalism may lead
to a "Fortress Europe" mentality and the aban-
donment of multilateral approaches. Others, in
contrast, find the formation of regional blocs po-
tentially beneficial and argue that the u.S. ought
to widen the u.S.-Canada agreement to encom-
pass nations in the Pacific Basin region.
This Letter discusses the recent trend toward the
formation of regional trade blocs and examines
the pros and cons of trade regionalism. Although
trade blocs have the potential to diminish trade
with non-member nations, this need not be the
case. In fact, over the last forty years, regional
economic integration coupled with multilateral
reductions of trade barriers has aided in the rapid
expansion of world trade and world output. Both
as a practical matter and as a guiding principle,
the United States should continue to pursue mul-
tilateral reductions of barriers to world trade, and
yet not close the door to any nation that might
seek to enter into a free-trade agreement with the
United States.
Regional trade blocs
Regional trade blocs are by no means a new phe-
nomenon. A number of regional trade blocs have
been in existence for some time: the Committee
on Mutual Economic Assistance (COMECON) for
the Soviet bloc nations; the European Free Trade
Association for northern European nations; the
Lome Convention by which the European Com-
munity provides special treatment to imports
from 63 African, Caribbean, and Pacific nations;
the Latin American Free Trade Association and
the Andean Group for South American countries;
the Central American Cornmon Market; the Ca-
ribbean Community; the free-trade agreement
between the United States and Israel; the Asso"
ciation of South East Asia Nations (ASEAN) that
seeks freer trade among the six nations of that re-
gion; and the recently concluded free-trade
agreement between Australia and New Zealand.
However, two recent developments in particular
give rise to a widely shared perception that trade
regionalism is growing, perhaps at the expense of
multilateralism. The first is the recent decision by
the twelve nations of the European Community
(Ee) to achieve full economic integration, by the
end of 1992. This agreement requires the mem-
ber nations to remove all border controls on the
intra-community movement of goods and people,
adopt common standards for industrial products,
harmonize rates ofvalue-added tax, abolish
control over capital movement within the com-
munity, open up public contracts for community-
wide bidding, and enable businesses to operate
under a common set of rules and regulations
throughout the community. In short, the aim is to
form a single market for the community's 320
million people-compared to the 250 million
people in the United States and the 122 million
in Japan.
The second recent development is the U.s.-Can-
ada free trade agreement, which was signed by
President Reagan and Prime Minister Mulroney
in January 1988 and is now awaiting ratification
by the two countries' legislatures. Ratification
would set in motion, beginning January 1, 1989, a
ten-year process that would eliminate all tariffs
between the two countries, remove import
quotas and licensing requirements on agricul-
tural products, abolish restrictions on energy
trade, allow free entry and grant national treat-
ment to banks and other types of financial
institutions, open biddings on government pro-
curement contracts, and set up a mechanism for
subjecting trade disputes to compulsory arbitra-
tion. The agreement would achieve considerably
less economic integration than that envisioned in
the European Community's plan. Nevertheless,FRBSF
the U.S.-Canada agreement would be a major
step towards eliminating both tariff and non-tariff
trade barriers between these two neighbors.
A multilateral approach
Since the early 1940s the United States has been
at the forefront of trade negotiations, advocating
multilateral, non-discriminatory removal of trade
restrictions. The u.s. leadership was instrumental
in the signing of the first General Agreement on
Tariffs and Trade (GATT) in 1947 and the estab-
lishment of a Secretariat to promote free trade on
a worldwide basis. Since then, seven rounds of
multilateral negotiations have been conducted
under GATT auspices, resulting in substantial
reductions in tariff and non-tariff barriers to inter-
national trade. Recently, an eighth round, the
Uruguay Round, started, with a view toward ex-
panding the negotiations to cover agricultural
trade and trade in services-both hitherto ex-
cluded-as well as protection of patents and
copyrights.
this multilateral approach to trade policy was
adopted after the disastrous experiences of the
1930s, when high national trade barriers contrib-
uted to both the sharp contraction in world trade
and to the severity and longevity of the Great
Depression. Bilateral negotiations for tariff reduc-
tions, initiated by the United States in the 1930s,
proved to be both time-consuming and self-
defeating, since bilateral negotiations with subse-
quent countries frequently diminished or negated
the benefits from previously negotiated reduc-
tions in trade barriers with other countries. In
contrast, multilateral reductions of trade barriers
negotiated under GATT rules have ensured that
the benefits are shared by all the participating
members.
Regionalism versus multilateralism
Under the GATT's Article 24, member nations are
allowed to enter into regional trade agreements
that accord more favorable trade treatment to
members than to non-members only if such
agreements do not result in higher average trade
barriers against non-members than beforethe
agreement. Of course, there is a risk that the
lower barriers within the trade bloc will encour-
age substitution of imports from members for
imports from non-members; however, these
agreements have been allowed on the premise
that the reduced trade barriers within the region
)
would increase member nations' incomes,
which, in turn, would increase the trade bloc's
total demand for imports from outside the bloc.
Whether the positive trade-creating income
effect would indeed outweigh the negative trade-
diverting substitution effect depends critically
on the extent to which the trade bloc's external
trade barriers after the agreement are on average
higher or lower than before. The more a regional
agreement is coupled with a lowering of the
trade bloc's external trade barriers, the more
likely is the agreement to enhance welfare for the
non-member nations as well as for member na-
tions. In this sense, the seven rounds of GATT
trade-barrier reductions have helped to ensure
that the income effects of the creation of trade
blocs outweigh the substitution effects. Trade re-
gionalism thus can be compatible with trade
muItilateralism.
Although the u.S.-Canada free-trade agreement
eliminates many trade barriers between the two
nations and leaves their respective trade barriers
against others unchanged, the leaders of both
governments have pledged to work toward multi-
lateral reductions oftrade barriers in the Uruguay
Round. The agreement, therefore, should be
viewed as a step toward freer trade in the spirit of
GATT, and not as a step toward greater fragmen-
tation. Similarly, further European economic
integration need not be a move away from trade
multilateralism if the European Community's
trade barriers with non-members are lowered af-
ter 1992.
Pacific free-trade area?
Supporters of the U.s.-Canada free-trade agree-
ment see substantial gains for both countries in
terms of job creation and greater output growth,
without significant adverse effects on third na-
tions. The logic of this claim suggests that the
free trade area should be enlarged to include
other countries with which the two nations al-
ready have close trade relations. The prime
candidates would seem to be nations in the Pa-
cific Basin region.
Attractive as this idea may seem, a Pacific free-
trade area is unlikely in the foreseeable future.
Negotiations to create free-trade areas tend to be
time consuming and politically difficult even
among neighboring countries with strong eco-nomic and cultural ties, as the experiences of the
EC nations and the United States and Canada
suggest. Pacific Basin nations, moreover, differ
widely in their cultural traditions and stages of
economic development. Bilateral trade negotia-
tions between the u.s. and these countries in
recent years do not seem encouraging to the idea
of a Pacific free-trade area.
In any event, Pacific trade has grown rapidly
without regionwide free-trade agreements. For in-
stance, U.S. trade with Asia-Pacific countries
grew from 22 percent of total U.S. trade in 1976
to 35 percent in 1986. To varying degrees, intra-
regional trade also increased as a share of indi-
vidual Asia Pacific countries' total trade during
the same period. In 1986, intra-regional trade ac-
counted for more than 60 percent ofthe total
trade of all Asia-Pacific countries, a high propor-
tion of which was in every case trade with the
United States. Thus, it appears that market forces
already have accomplished much of what exten-
sive trade negotiations would be intended to
achieve. Further increases in Pacific trade may
best be pursued in the context of the Uruguay
Round of multilateral GATT negotiations.
Policy concerns
Trade multilateralism has been the guiding prin-
ciple of u.s. trade policy and the GATT negotia-
tions over the past forty years. Recently, however,
public opinion seems to be inclining toward a
view that rejects multilateralism as outdated and
out of touch with the real world. Articles in the
popular press and even in some prestigious busi-
ness journals now argue that this kind of idealis-
tic thinking has bound the United States to hold
its market wide open for foreign imports, even
though foreign countries discriminate against
U.s. exports. They suggest thatthe United States
should abandon the multilateral doctrine and in-
stead adopt a "fair trade" or "tailored trade"
approach that would require reciprocity from its
trade partners; the u.s. market would be open
only to those that open their markets to U.S.
goods.
Since the proponents of this view typically re-
gard foreign markets as less open than the U.S.
market, adoption of this approach would neces-
sarily mean either a general rise in U.s. trade
barriers or the formation of trade blocs with se-
lected trade partners and an increase in trade
barriers against all others. In either case, calls for
reciprocity often are no more than thinly dis-
guised calls for trade protection-a policy that in
the past has stifled the world economy.
As a tactic, threats of higher trade barriers may
succeed in getting concessions in isolated cases
in the short run. However, such a strategy for the
long run risks being called bluff. Failure to raise
barriers then destroys the credibility of such a
policy, while a decision to raise barriers invites
retaliation and inflicts injuries on all.
In short, regional free-trade arrangements cou-
pled with reductions in external trade barriers
continue to be a sound policy approach for the
United States and the world economy. Although
trade blocs in themselves are not necessarily
harmful to national welfare, their formation takes
protracted and often arduous negotiations, with
uncertain outcome. Given the scarcity of experi-
enced trade negotiators in all countries, both the
United States and the world community would
be well advised in the next several years to con-
centrateon insuring the success of the Uruguay
Round of GATT negotiations, rather than attempt-
ing to form any new trade blocs or enlarging the
existing ones.
Hang-Sheng Cheng
Vice President
International Studies
Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Barbara Bennett) or to the author.... Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco 94120. Phone (415) 974-2246.u()~6U!4S0m 4o~n U060JO OpOfl0U
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MONETARY POLICY OBJECTIVES FOR 1988
On July 13, Federal Reserve Board Chairman Alan Greenspan presented a mid-year report to
the Congress on the Federal Reserve's monetary policy objectives for the remainder of 1988. The
report reviews economic and financial developments in 1988 and presents the economic out-
look heading into 1989. For single or multiple copies of the report, write to the Public
Information Department, Federal Reserve Bank of San Franci.sco, P.O. Box 7702, San Francisco,
CA 94120, or phone (415) 974-2246.
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Toward trade blocs?

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Toward trade blocs?

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