The analysis of trade, trade policy and trade politics is relatively straightforward. Standard economic theory suggests that free trade is welfare maximizing (under a standard set of assumptions) and that changes to a country’s trade policies have distributional and, by implication, political effects. Countries are better off if they liberalise foreign trade. But there are exceptions. Relaxing some of the standard assumptions and allowing for increasing returns to scale, oligopolistic market structures, network effects and so on, new trade theory demonstrates how trade protectionism can be welfare-enhancing. This the exception that proves the proverbial rule. The general point stands, though, that free trade improves countries’ welfare in aggregate. This then raises a number of interesting questions.
Why should country A care if country B subsidises its exports or sells them at discounted prices? At first sight, this seems to imply a loss to country B and a gain for country A. At second sight, if the subsidies drive the import-competing companies/ sectors in country A out of business and country B then becomes a monopolistic producer, country A may yet suffer economic losses over the longer term. After all, markets are not always competitive and they are not always not frictionless (that is, when a company/ sector goes out of business, the reallocation of the factors of productions leads to a friction-related adjustment costs). It so happens that US concerns over technological leadership are to a significant degree concerned with competition in ‘winner-take-all’ (in addition to dual use technology) technologies.
Another potential effect of underpricing exports is that it allows the exporting country to build up productive capacity and accelerate economic development. This can and does have important international political consequences. This effect is roughly equivalent to the subsidy provided by an ‘undervalued’ currency (so-called Bretton Woods II). To the extent that trade policy becomes strategic in the sense of the government pursuing broader economic and non-economic goals and doing so by using non-market practices to price out/ out-compete actual and potential rivals, free trade is not necessarily the best policy response. Incidentally, this why the EU legalistic and rules-based approach to international trade (and investment) is ill-equipped to deal with more strategic national-security and economic-development-strategy-driven policy of its peers, the United States and China. This is one of the reasons why the EU has equipped itself with trade defense instruments (European Commission 2020). This supplements that EU’s toolkit, in addition to WTO-compliant instruments like countervailing and anti-dumping tariffs, safeguards and national security exceptions.
Standard political economy models predict that producers will face greater incentives to mobilise for or against free trade than consumers. The domestic politics of trade policy helps understand why tariff bindings have a two-fold purpose. Not only do they commit countries to (1) predictable (maximum) levels of import duties. But they also help (2) insulate a country’s trade policy from domestic political pressure, especially demand for protection. Safeguards need to be understood as escape clauses helping to balance international commitments with domestic political support for and sustainability of trade. Understandably, these escape clauses often prove contentious and none more so than the national security exception. All international trade creates sensitivity and vulnerability (Keohane & Nye 1977). In principle, almost any good goods be considered essential to national security. The scope to invoke a national security is significant, perhaps too significant. It is also worth noting that restricting trade is not a panacea. In addition to economic efficiency losses, protecting certain sectors and relying exclusively on domestic production may ironically increase risk due to diminishing diversification of supply, at least relative to a situation where a country sources a particularly good from a number of foreign suppliers and countries.
Reciprocity in international trade negotiations is crucial, for it allows the negotiating governments to mobilise domestic free-trade-oriented export interests to offset the domestic political pressure from import-competing, protectionist interests. Incidentally, this is why the 1934 Reciprocal Trade Agreement Act (RTAA) did (amongst other things). Rather than let Congress, beholden to import-competing, protectionist societal interests, set external tariffs, the RTAA enabled the executive to negotiate reciprocal tariff reductions, thereby brining pro-liberalisation domestic interests into the domestic political game. In a similar vein, the creation of the Office of the US Trade Representative (as an executive agency) wrested trade negotiations from the State Department in an attempt to force US trade negotiators more narrowly on trade rather than broader foreign policy goals and thereby pay greater attention to economic as opposed to broader political goals of trade agreements. Today, the relative greater importance of behind-the-border trade barriers and related regulatory issues mean that Congress almost invariably needs to get involved, even if it delegates trade negotiations to the executive through Trade Promotion Authority (TPA).
The modern history of international trade began with the famous Cobden-Chevalier Treaty in 1860. It was the first treaty to introduce the most favoured nation principle. This principle combined with a host of subsequent bilateral trade agreements effectively created a multilateral free trade system through bilateral agreements. The post-WWII General Agreement on Tariff and Trade (GATT) regime, which was supposed to be replaced by the International Trade Organization (ITO) but was not, was based on three fundamental principles: reciprocity, MFN (non-discrimination) and national treatment. This differed from the pre-WWI international trade regime. Crucially, as mentioned above, GATT allowed for exceptions. A subset to GATT members could form free trade area and therey disregard MFN. Scholars and historians continue to disagree what led the US, having initially insisted on exceptionless multilateralism, to accept this exception (e.g. US-Canada, future European integration and hence trade discrimination, British system of imperial preferences), in spite of the Britain’s commitment to the Atlantic Charta.
It is not surprising that multilateral trade liberalisation has effectively come to a halt. Given the large number of WTO members, their increased heterogeneity and the societally and politically more controversial issues related to trade liberalisation (not so much tariffs, but rather behind-the-border issues, including environmental, labour, investment protection issues etc.). No wonder regional trade agreements or issue-specific plurilateral agreements have gained greater importance. Low overall levels of tariffs, especially in advanced economies, also helps explain why the notion of level playing field is important these days.
Level playing field is a bit of an opaque concept. It broadly refers to fairness. Fairness itself is fairly complex even under the best or simplest of circumstances. Generally, level playing field refers to issues and policies such labour, state aid, taxation & competition, subsidies and environmental standards. With tariffs at very low levels, differences in regulation are seen as giving one country or the other an unfair advantage. Precisely this issue is currently rearing its head in the context of the Brexit negotiations, especially given the objective of zero-tariff/ zero-quota access. Speaking of which …. Britain’s greaer dependence on the EU market than vice versa means that Britain has more to lose in the event of more restriced market access. The EU will also suffer welfare losses, but relatively less so. Relatedly, if the UK leaves the EU without an FTA in place, it will not be able to only reduce its tariffs on EU imports only. MFN means it is not allowed to discriminate in favour of EU imports. It can of course lower all its WTO tariffs to zero. But this means it will have nothing to offer in terms of tariff reduction in future trade negotiations with the EU or any other WTO member. It would continue to be able to offer concessions related to non-tariff barriers, of course.
Upon leaving the EU, the UK faced a choice between a customs union, a free trade agreement and WTO rules. A customs union provides Britain with zero tariffs access to the EU and imposes common external tariffs on industrial goods. A free trade area provides it with zero tariffs on trade with the EU but allows it to retain the ability to set own external tariffs vis-à-vis third countries. A default to WTO rules/ MFN terms would provide Britain with more limited access to the EU, but greater flexibility in terms of international trade policy. (International trade lawyers have raised the possibility that the UK could invoke a derogation to the MFN principle and temporarily maintain preferences (vis-à-vis the EU) until a new trade agreement is in place, similar to the continued existence of ‘imperial preferences’ post-WWII.) It is worth nothing though that a customs union typically applies to (industrial) goods only. Staying in the customs union would therefore have allowed Britain to strike services trade agreement with non-EU countries. A drawback of staying in the customs union, however, is that Britain would have adjust its tariffs in response to the EU signing trade deals with third parties, while the third party, signing an agreement with the EU (and not the customs union) is not obligated to extend preferences to the UK. In other words, a customs union severely constrains UK trade policy, at least as far goods trade is concerned. Moreover, moving from a single market (with by and large mutual recognition) to a less integrated customs union is a vexed issue because of regulation and, by extension, customs procedures and checks. Even if bilateral trade is based on zero-tariff, zero-quota access, goods crossing the border encounter friction and this leads to increased costs (time and money). Given just-in-time delivery and intricate supply chains, this may even put at risk entire supply chains and sectors, not to mention the issues related to inversion, intermediate vs finished inputs, rules of origin and cumulation (whether bilateral, diagonal or full) in case of a free trade area.
The creation of free trade areas raises the issues of trade creation, trade diversion and trade deflection. Trade diversion occurs when, due to regional trade liberalisation like FTAs, a switch occurs from a more efficient to a less efficient producer. This translates into welfare losses. Trade creation, on the other hand, occurs when trade liberalisation (free trade area or customs union) leads to a switch to a more efficient producers (welfare gain). A similarly sounding but originally unrelated concept is trade deflection, which describes a situation where the imposition of tariffs on a country’s export (e.g. China) leads the country to divert its export to third countries (e.g. China exporting steel to Europe and Japan after the imposition of US tariffs). Closely related is the question of fungibility. If, for example, China retaliates against US tariffs by imposing tariffs on (or stops buying) soy beans from the US and switches to Brazil as a supplier, and assuming soy beans are a fungible commodity, two things should happen: Brazil can presumably charge higher prices to China (sort of monopsonistic effect) and US exporters may have to accept lower prices if they manage to divert their exports to the markets that Brazil serviced previously. The picture becomes more complicated if the seasonality of production, transport costs, elasticities and the duration of existing supply contracts are taken into account. Clearly, non-fungible exports are vulnerable and sensitive to import restrictions (e.g. gas transported through pipelines) giving the importer potentially more leverage.
The existence of international supply chains has made the volume of gross exports an inadequate measure of trade sensitivity. Strictly speaking, the economic effect of trade measures can be derived from calculating the value-added embedded in exports. If a country imports all of the components of a good that it then exports, the domestic value-added will be much smaller than if all the components had been produced locally. Neither gross nor net exports are the right way to measure the impact on economic growth, even though net exports comes a little closer.
Last but not least, the distinction between protectionism and domestic regulation can be difficult to make and it is bound to be politically contentious in practice. Regulations may translate into market access restrictions and/ or they can raise price of a good. Exporters negatively affected by domestic regulations will regard them as protectionist measures (even though principle of national treatment applies). Moreover, if Europe exports no digital services to the US, then a European digital tax will look like protectionism from the US point of view. Reciprocity may or may not help solve that sort of issue. Similarly, EU regulation may also of protectionism, but may simply be a reflection of societal or political preferences (e.g. data protection). In other words, it can be difficult, even impossible to distinguish between protectionism and regulation. And some sort of reciprocity or compensation will likely be required for the injured party not to take retaliatory action (e.g. French digital tax and tariffs on French wine).