Multilateralizing Regionalism - Discussing Trade Forms in Europe

Table of Content

List of Figures

List of Appendix

List of Abbreviations

1. Introduction

2. Market Liberalization
2.1. Forms of Trade Agreements
2.2. Ongoing: Regionalism vs. Multilateralism
2.3. Reasons and Outcomes of Trade Liberalization
2.3.1. Unilateral Case
2.3.2. Multilateral Trade Negotiations and the Juggernaut Effect
2.3.3. Dominos & Preferential Trade Agreements (Regionalism Case)

3. Effects of Trade Liberalization
3.1. Historical Narrative of the 3 Main Effects in Europe
3.2. Europe’s Outcome: A Tangle of Diverse TAs
3.2.1. Europe’s Spaghetti Bowl
3.2.2. Comparing Europe’s with Asian Tangle
3.2.3. Taming the tangle - How to finally reach free trade?

4. Conclusion

Appendix

List of Literature

List of Figures

Figure 1: Own example for trade diversion

Figure 2: Juggernaut approach

Figure 3: Reciprocal trade take down tariffs

Figure 4: Dominos start the Juggernaut effect

List of Appendix

Appendix 1: 1990s situation of trade in Europe

Appendix 2: Euro Med trade bloc

Appendix 3: An example of global production unbundling in an IT good

Appendix 4: Unilateral Case of tariff cutting

Appendix 5: Domino effect II after Britain signed FTA with EEC

Appendix 6: Spaghetti bowl

Appendix 7: European Spaghetti bowl 1995

Appendix 8: Asian noodle bowl

Appendix 9: List of Regional Trade Agreements

List of Abbreviations

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1. Introduction

Outsourcing, off shoring and slicing up the value added chain is nowadays a necessity to survive for companies facing international competition. Manufacturing a car f. ex. means using local expertise/cost advantages and though creating a competition advantage. For instance, the German car manufacturer Volkswagen. The car Golf VI consists of intl. parts¹:

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Figure 1: Own example for trade diversion

Prerequesition was the possibility for VW to trade unfinished products among different countries without losing the price advantage through high tariffs. So the first assumption for slicing up the value added chain is the necessity of free trade. And this is the starting point. The countries in my example are all located in Europe. Europe, as a customs union, seems to be tariff free by now and at first glance as one big trading bloc. But this view deceives. The EU as a driver of regionalism, (Baldwin 2008) consists of several uni-, bi- (=regional) and multilateral trade agreements (TAs) among the countries inside and outside of the EU. (See appendix 9) The high num- ber of agreements is known as the spaghetti bowl effect and leads towards the first question: Too many TAs cause inefficiencies for the user so it can be cost efficient to pay a tariff instead of fulfilling the rules in the TA. Is this problem caused by the vast number of regional trade agreements (RTAs) or is this effect occuring regardless the form of TAs? The second question will answer, which kind of economic/political effects the different trade agree- ments (Uni-, bi-, and multilateral) cause. In context to European trade his- tory: How are they connected and are they substitutes respective comple- mentary to each other? Finally this paper will list what the WTO can do to aid the way to global free trade. Answering these questions makes it necessary to give a brief overview over market liberalization and used forms of TAs, the European trade situation and the problem of bilateralism vs. multilateralism in a broad view. Subsequently, the technical effects of TAs as well as their relations are presented. The outcome of the diverse TAs and the solution to this problem will also be presented, while the conclusion will summarize the answers to the above noted questions and note critical points. We start with an overview over the market liberalization.

2. Market Liberalization

To understand to which extent market liberalization affects international trade, this point distincts different forms of TAs and points out their effects.

2.1. Forms of Trade Agreements

To protect import competing industries countries use tariffs. This increases the price of imported goods and though protects local produced goods from a price competition. When it comes to market liberalization, governments cut off those trade barriers. This can happen unilateral, bilateral or multila- teral. To make clear, if Europe’s emphasis on regionalism is more effective than relying on the multilateralised WTO, definitions are given now:

Preferential trade areas

A Preferential trade area/agreement (PTA) gives preferred access to a given number of countries to a certain range of products. Preferred in this context means reduced and not completely eliminated tariffs. Usually established within a trade pact, it is the first step of economic integration aiming to create a free trade area. One basis principle is reciprocity, which means that the tariff among participating countries remain constant. (See appendix 9)

Unilateral Trade Agreements

One country reduces its import restrictions without a formal agreement on its own. This agreement is reciprocity free and will be done, regardless of the trading partners actions. Unilateral liberalization was usually set-in when Asia’s tiger states wanted to participate from the arising outsourcing wave and by that gain a certain amount of know-how through technology transfer. (Baldwin 2006, p.24f.)

Regional (bilateral) Trade Agreements²

A regional trade agreement (RTA), also called bilateral trade agreement, is a feature of the multilateral trading system and is also known as trade pact. The agreement can include guarantees for investments, covers tax, tariff and trade topics and is also known as PTA. Objectives are to reduce tariffs, quotas and trade restrictions. By 15th May 2011, 489 RTAs, counting goods and services notifications separately, have been notified to the GATT/WTO. The appendix lists 380 physical RTAs (counting goods and services together), of which 202 are currently in force. (WTO 2011a)

Multilateral Trade Agreements (MTAs)

MTAs between GATT members aim to reduce tariffs and nontariff trade barriers. Outcome of negotiations, such as the GAT and WTO rounds, are exemplary the Asia-Pacific Trade Agreement (1976), Economic Cooperation Organization (ECO) (1992), Generalized System of Preferences Global System of Trade Preferences among Developing Countries (GSTP) (1989) and the Melanesian Spearhead Group (MSG) (1994)

Differences between the Trade Agreements

While a unilateral agreement is completely free of reciprocity and is set-up by a single country, a RTA is negotiated between two countries and bases on the principle of reciprocity to avoid disadvantages. A MTA, such as the GATT, set-up rules for all participating countries. While MTAs are popular for the US, the EU consists mainly on RTAs. Chapter 3 will analyze, if regionalism is the better way to global free trade, or if MTAs are more useful. To give complete answers, a briefly overview about the trade liberalization in a historical manner have to follow then.

2.2. Ongoing: Regionalism vs. Multilateralism

Decomposed trade barriers around the world are a result of liberalization in trade. Beginning from the post-war period, Europe was far away from a well prospering and liberal, tariff free trading zone. While having an average European tariff rate of 30.4 % in 1931, the situation changed significantly after the 2nd world war. In 1950 the average tariff was 17.8 % and declined continuously towards 4% till now. (EU 2011) (Baldwin 2006, p.4 f) Bald- win (2006, p.6) pointed out six facts about post-war tariff liberalization: The liberalization process started, as we saw above, with high tariffs. Rich na- tions - under the leadership of the US - liberalized more intensive than poor- er ones, because outsourcing became sooner a topic in those countries. Be- cause of the bad experiences with two world wars, industrial goods were in focus of trade. Agricultural goods had been part of protection mechanism for a long time to secure the survivability of a nation in case of a war. Until now, the liberalization process took 50 years.

An approach to multilateralise trading with one MTA was the Doha devel- opment round. Objective was to intense the trade with developing nations. Unfortunately until now and four rounds no agreement had been closed. The missing multilateral agreement gave the starting point for RTAs which causes a tangle. Breuss (2008, p. 573) saw hereby a multilateralism vs. re- gionalism problem, which is not the focus of this work. It focuses more on multilateral tariff cutting which went hand in hand with regional trade agreements - and in case of Asia - with unilateral tariff cutting. The expla- nation why this is the case will be given in the chapter following, when it comes to Juggernaut, Domino & Race-to-the-Buttom effects.

2.3. Reasons and Outcomes of Trade Liberalization

Three main effects in the story of uni- and regional TAs versus multilateral TAs matter: The Juggernaut, Domino and Race-to-the-Buttom unilateralism. Now the effects will be described briefly while relying them on the Euro- pean case latter. One question that has to be asked is, why countries decided to liberalize markets they former found to be protect worthy by high tariffs. Baldwin developed a political economy framework (2006, p. 7) which in short words sais that companies from import competing industries support tariffs until they see greater probability success in generating net profit from exports than they expect losses from imports.

2.3.1. Unilateral Case

Tariff cutting and reducing trade barriers on a country’s own will seems to be destructive at first glance. Trading partners are not committed to reduce trade barriers too. The reason why in the unilateral case is also formulated in two short figures that are attached in Appendix 4.³ While seeing more chances in gaining a net profit from exporting goods in other countries compared to the potential losses of import competing companies, the de- mand for protection on the supply side is declining. Hence, tariffs and trade barriers are reduced unilaterally. A new equilibrium will be formed. Latter, we see this in Asia due to the potential benefit of outsourced European labor intensive workload. (Baldwin 2006, p.7)

If the protection level is heading towards zero barriers, it is called Race-to-the-bottom unilateralism. It will occur if there is no import competing industry. They do not fear competition and hence open their market. For instance, the tiger states opened their markets to attract foreign direct investments through overtaking fragments from the value added chain by being a beneficiary of the outsourcing trend. (See also Ch. 3)

2.3.2. Multilateral Trade Negotiations and the Juggernaut Effect

This point is much more relevant to the relationship of Regionalism vs. Multilateralism. The so called Juggernaut effect shows, how MTAs affect the tariffs. Baldwin (2006, p.8) identified reciprocity as a key element of the Juggernaut approach. It means, that a nation receives better market access only for the price of lowered own trade barriers. As a result and first part of the Juggernaut⁴ logic, all participating countries are lowering their tariffs. The second part is the dynamic process of liberalization. According to Baldwin and Robert Nicoud (2006) and Baldwin (2006), the optimal tariff depends on the number of import-competing and exporting firms. If there are many import competing firms, then the marginal benefit is greater than in the unilateral case (p. 8). Vice versa, the profit will claim if there are many exporting firms with a possibility to get into new markets. The following figure shows the contribution:

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Figure 2: Juggernaut approach.

Source: Baldwin 2006, p. 9

Explanation:The more companies compete to importing companies (x-axis), themore optimal is a higher tariff (y-axis) to protect the industry. GFOC stands for the governmental first order condition. This is for the unilateral approach.

Interestingly, Baldwin (2006, p. 10) stated, that through reciprocal trade talks a lower equilibrium in tariffs is possible. This follows logic, while countries with lower information asymmetry are more likely to follow op- timal decisions. (Principal-Agent problem; see next Figure) The question now is, if the net profit for every country participating a MTA will rise or if the pie still remains the same size. The new trade theory ar- gues that additional net gains in export will just compensate losses in the import competing sector. (Baldwin 2006, p.10) This is true, to a certain amount. The pie doesn’t get bigger - but there are differences who will ben- efit, said the new new trade theory. (Melitz 2003, Eaton and Kortum 2002 cited by Baldwin 2006, p.10) Bigger companies can use the comparative cost advantage. That means the existing fix costs are split up to a greater amount of goods. Also variable costs are lower while using experience curve effects and optimized production methods. (Hill 1988, p.403f) So we see two effects: Companies that can use a comparative cost advantage can profit, while smaller companies in import competing industries will suffer and exit.

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(Source: Baldwin 2006, p.10)

Figure 3: Reciprocal trade take down tariffs

Explanation: The left figure shows declining tariffs while the FOC goes left towards a new equilibrium (GFOCrecip; E’). In the right Figure all goods aretraded and hence, step-by-step, the tariff finally reaches 0 (Efinal).

Also there is an economic loss of suddenly unemployed workforce that was employed in the smaller companies. This point is sadly not considered by Baldwin at all and part of the critic.

2.3.3. Dominos & Preferential Trade Agreements (Regionalism Case) Baldwin (2006, p.11) wrote, that the domino effect is a key element of Re- gionalism. It prerequisites that a country has positive effects approving the RTA. That means, potential profits from exporting goods will exceed losses from competition in the import competing sector. To a certain point the country is indifferent if it should join. The second stage then starts, if a non- member actually decides to join. This creates an insider-outsider issue where the outsider will increase suffering with every additional nation agreeing the PTA.

The sooner a country enters the PTA the earlier the industry fit the needs. Bigger is better in terms of cost advantages and using experience curve ef- fects. At the beginning of a PTA with just two members, the pressure to join is low and the failure rate is unknown. If the PTA would fail, sunk costs (Marketing for the other country, Training, product development) had been to carry. It would be best to join now and gain advantages against later join- ing countries but information asymmetry will stay until enough other coun- tries joined. Arising pressure then creates the wish to join - another domino stone fell down.

One question this paper answers is which relationship between regionalism and multilateralism exists. Baldwin (2006, p.13) connected both in a frame- work with the notice, that both occurred in a tandem which makes it useful to connect them.

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Source: Baldwin (2006, p.13)

Figure 4: Dominos start the Juggernaut effect

Explanation: FE FE’’Comparing the unilateral (left) with the multilateral situation (right), the more companies join the PTA (n), the higher thetariff for other nations (T) will be. FE FE’: The fewer companies approved a membership in the PTA (n), the lower the tariff and herewith thepressure against outstanding countries will be (to join). The first case marks the domino case. A final tariff of zero (Viner’s ambiguity) appears whenthere is no notable pressure against the non-members.

Interim conclusion: We saw by now that there are three major effects occur- ring in the trade liberalization: Juggernaut, Domino and race-to-the-bottom (RTB) unilateralism. Juggernaut explains why it can be optimal to reduce tariffs while the domino effect explains why countries join. The RTB ap- proach itself explains the tariff cutting in countries that not participate in trade agreements, nevertheless wants to profit from outsourced activities.

Now these major effects are applied to Europe’s history of trade liberalization. The objective hereby is to identify relations between multilateralism (Juggernaut) and regionalism (Domino).

3. Effects of Trade Liberalization

3.1. Historical Narrative of the 3 Main Effects in Europe

The post war liberalization started in 1948 with the foundation of the Organ- ization for European Economic Cooperation (EEC) that lead towards a 25% declining in tariffs. As a result inner European trade doubled from 1950- 1958 what led to the application of UK for the EEC. Soon after Britain, DK, N and IRE applied for EEC membership. The first domino effect occurred. Multilateral trade talks within the 1962 Kennedy, Tokyo and Uruguay round lowered tariffs by 1/3rd. Notable is, that tariffs are cut in general and not item-by-item. The multilateral tariff declining burst regionalism and multila- teralism so that in 1968 the EEC removed all tariffs on intra EEC trade. EF- TA did the same on intra EFTA trade in industrial goods. We see the first Juggernaut und the second domino effect. (Baldwin 2006, p.18) Some smaller RAs (Canada - US Auto pact and New-Zealand - Australia FTA) brought tariffs to zero on a regional basis while in the mid 1960s developing countries cut down tariffs unilaterally. Regionalism and multilateralism went in tandem, so we see no signs of regionalism, unilateralism and multi- lateralism being substitutes.

While the intra EEC trade was free of tariffs by 1968, Britain soon wanted to join. French president C. de Gaulle revoked Britain’s membership but after he retired in1973, Britain joined. Soon the domino effect started and EFTA countries signed FTAs with EEC countries that they former found it politically optimal to have tariffs with. A comparison of the two situations (before/after) can be found in appendix 5. In 1973 the Tokyo round lead towards the next juggernaut cycle.

Lowered tariffs on a multilateral base and the renunciation of the reciprocity rule for the undeveloped countries, keeps them in the situation that they must not reduce tariffs when a developed countries does. Again, multilateral and regional trading seems to be complementary. Also the 1980’s show no sign of the multi-, regional- and unilateralism as being substitutes. After the recession Europe deepened their FTA through the single European act (SEA) which again caused a domino effect and let other countries follow. To support the findings in relation to Europe it should be noted that the US also triggered the domino effect. When Mexico entered in bilateral trade talks 1988, Canada asked to participate and the NAFTA was born. Chile, Brazil, Argentina, Uruguay, Paraguay soon joined FTAs with the US.

Back to European topic, the fall of the USSR emerged the spaghetti bowl. The opening of soviet markets (glasnost) and promarket reforms (perestroi- ka) created domino effect along central and eastern European countries. The 1995 Barcelona process was a reaction to this where 12 hub&spokes agree- ments (=bilateral FTAs) were established. Turkey joined the EU customs union and bilateral agreements, called Euro-Mediterranean (“Euro-Meds”), triggered the domino: ’95: Israel & Tunisia, ’96 Morocco, ‘97Jordae, PLO, ‘01Egypt, ’02 Algeria, Lebanon and 2004 Syria followed. Multipliers were the Arab Maghreb Union (Morocco, Algeria, Tunisia, Mauretania & Libya) as well as the Agadir Agreement (Morocco, Tunisia, Egypt and Jordan). The Pan European Cumulation System started (PECS) to tame this tangle and to creating clear structures the EU15, EFTA 4 and ten of the applicant nations decided to amend their FTAs. A common set of rules of origin (ROOs) were mandatory for all members and exclusions went to be eliminated.

To summarize the situation in Europe, some facts can be stated: 1. It all started with high tariffs. 2. The Domino effect reaches developing nation due to the renouncement of the reciprocity approach by developed nations.

3. Declining tariffs were slowed down by the reciprocity approach and necessary negotiations. 4. War experiences led agricultural goods be the most protected good. 5. Multilateralism and Regionalism went in a tandem position and did not hinder each other. More over the historical narrative showed evidence for the fact, that slicing up the value added chain creates the necessity to integrate in worldwide trade.

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¹ Information bases on a telephone interview with Mr. Günzelsau, VW worker in Wolfsburg, Germany at May, 25th 2011.

² Some bilateral trade agreements: European Union - ACP countries, formerly via the trade aspects of the Cotonou Agreement, later via Everything But Arms (EBA) agreements India - Afghanistan (2003) India - Mauritius India - Nepal (2009) India - Chile (2007)

³ Due to limited space the Regionalism vs. Multilateralism will be granted more space than the unilateral case.

⁴ The word ‘juggernaut’ stems from a British mispronunciation of Jagannath. A festival is held in Puri involving the ‘chariot of Jagannath’, an enormous and unwieldy construction that requires thousands of people to get it rolling. Once started, however, it rolls over any- thing in its path.