Notes on Chapter 8: Regional Trading Agreements

Chapter 8: Regional Trading Agreements

Regional Trading Arrangements

  • Since World War II, advanced nations have significantly lowered trade restrictions using two approaches:
    • Reciprocal reduction of trade barriers through the General Agreement on Tariffs and Trade (GATT)
    • Regional Trading Arrangements
    • Member nations agree to impose lower barriers to trade within the group than with nonmember nations.

Regional Integration versus Multilateralism

  • A major purpose of the World Trade Organization (WTO) is to promote trade liberalization through global agreements.
  • Achieving consensus among many countries is challenging.
  • By the early 2000s, WTO faced challenges and was seen as stumbling.
  • Countries began to increasingly look toward regional agreements as an alternative.
  • The number of regional agreements has risen from 70 in 1990 to 300 today, covering over 50% of international trade.
  • Regional trading blocs are characterized as discriminatory and may decrease the discretion of member nations in pursuing trade with outsiders.
  • Once regional benefits are received, there is little incentive for countries to sign multilateral WTO agreements that would undermine those benefits.
  • Regional agreements can foster global market openings and lead to deeper economic interdependence.
    • The establishment of a regional free trade area encourages the adjustment of workers from import-competing industries (where the country has a comparative disadvantage) into exporting industries (where the country has a comparative advantage).

Types of Regional Trading Arrangements

  • Economic Integration
    • Defined as the process of eliminating restrictions on global trade, payments, and factor mobility, uniting two or more national economies in a regional trading arrangement.
  • Types of Regional Trading Arrangements
    • Free Trade Area
    • All tariffs and non-tariffs are removed among member nations.
    • Customs Union
    • All tariff and non-tariff barriers are eliminated among members, and each member nation imposes identical trade restrictions against non-participants.
    • Example: Benelux (Belgium, Netherlands, Luxembourg)
    • Common Market
    • Permits free movement of goods and factors of production among members and applies common external trade restrictions against nonmembers.
    • Example: European Union
    • Economic Union
    • National, social, taxation, and fiscal policies are harmonized and administered by a supranational institution.
    • Monetary Union
    • Unification of national monetary policies and use of a common currency administered by a supranational monetary authority.
    • Example: United States.

Impetus for Regionalism

  • Motivations for forming regional trading arrangements include:
    • The prospect of enhanced economic growth.
    • Economies of large-scale production.
    • Increased specialization and learning-by-doing.
    • Increased foreign investment.
    • Variety of non-economic objectives:
    • Management of immigration flows.
    • Promotion of regional security.
    • Enhancement and solidification of domestic economic reforms.

Static Effects of Regional Agreements

  • Figure 8.1
    • Welfare-Increasing Trade Creation Effect (area “a + b”)
    • Occurs when domestic production of one member in a union is replaced by another member’s lower-cost imports.
    • Welfare-Decreasing Trade Diversion Effect (area “c”)
    • Happens when imports from a low-cost supplier outside the union are replaced by higher-cost suppliers within the union.

Dynamic Effects of Regional Agreements

  • Creation of Broader Markets
  • Dynamic Gains:
    • Economies of scale.
    • Greater competition.
    • Increased investment.
    • Accelerated pace of technical advances and increased productivity.

The European Union

  • In the 1950s, Western European nations removed tariffs and exchange restrictions, viewing them as counterproductive.
  • Pursuant to the Treaty of Rome (1957), the European Community transitioned to the European Union with the primary goal of trade liberalization.
  • Original members included Belgium, France, Italy, Luxembourg, the Netherlands, and West Germany.
  • The timeline of European integration:
    • 1957 – Trade liberalization begins.
    • 1968 – Establishment of a free-trade area.
    • 1970 – Formation of a customs union.
    • 1985 – Launch of the program to form a common market.
    • 1992 – Elimination of all non-tariff barriers to trade.
    • 2002 – Implementation of the European Monetary Union (EMU) and introduction of a single currency, the Euro, under the Maastricht Treaty (1992).
  • Convergence Criteria for EMU include:
    • Price stability.
    • Low long-term interest rates.
    • Stable exchange rates.
    • Sound public finances.
  • The Euro emerged in 2002 as the official currency for 18 of the 28 member nations (the Eurozone):
    • Countries include Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Portugal, Slovakia, Slovenia, and Spain.
    • The United Kingdom, Denmark, and Sweden maintain their own currencies.
  • The Euro is used worldwide.

Agricultural Policy of the EU

  • Common Agricultural Policy (CAP)
    • Abolished restrictions on agricultural products traded internally.
    • Provided support for prices received by farmers through:
    • Deficiency payments.
    • Output controls.
    • Direct income payments.
  • Variable Levies
    • Levy determined daily based on the difference between the lowest price in the world market and the support price, more restrictive than fixed tariffs.
    • Discourages foreign producers from undercutting prices to maintain export sales.

Export Subsidies in the EU

  • Export Subsidies
    • Ensure that any surplus agricultural output from EU farmers is sold overseas.
    • Provides incentives for farmers to increase production and reduce domestic supply, thus eliminating the need for the government to purchase the excess.

Evaluating the EU as a Common Market

  • For decades, EU members have sought to establish a common market with uniform policies on product regulation, trade, and movement of factors of production.
  • Persistent regulatory differences adversely affected business expansion plans across Europe.

Brexit: Withdrawal from the European Union

  • Since the establishment of the EU in 1957, 28 countries have joined, and none have left until now.
  • The Brexit Referendum of 2016 resulted in a vote of 52% to 48% in favor of the UK leaving the EU.
  • The process of withdrawal raised several issues:
    • Concerns about excessive power held by Brussels.
    • Fears surrounding immigration.
  • Pros and Cons of Brexit:
    • Potential financial benefits, as the UK currently contributes more to the EU than it receives.
    • Concerns about weakened economy and security for Europe overall, along with a potential loss of foreign investment.

Economic Costs and Benefits of a Common Currency: The EMU

  • The formation of the European Monetary Union (EMU) in 1999 led to the establishment of a single currency (Euro).
  • Benefits of the Euro include:
    • Lowers costs of goods and services.
    • Facilitates price comparisons within the EU.
    • Promotes more uniform pricing across the member countries.
  • The European Central Bank, located in Frankfurt, Germany, controls the supply of Euros, sets short-term Euro interest rates, and maintains fixed exchange rates for member countries.

Negotiating the Withdrawal from the EU

  • A 2-year window for the UK to negotiate terms of their departure.
  • Questions raised include:
    • How will the UK trade with the EU as a separate entity?
    • How can the EU stabilize the Euro?
    • Will the EU impose punitive measures on the UK regarding trade and security?

Optimum Currency Area (OCA)

  • Defined as a region where it is economically more favorable to have one official currency rather than multiple currencies.
  • Benefits of OCA:
    • More uniform prices and lower transaction costs.
    • Increased certainty for investors and enhanced competition.
    • Greater price stability.
  • Costs of OCA:
    • Loss of independent monetary policy.
    • Reduced flexibility regarding exchange rates.
  • For a monetary union to be successful, the following conditions should be met:
    • Similar business cycles and economic structures.
    • A single monetary policy should uniformly impact all participating countries.
    • No legal, cultural, or linguistic barriers to labor mobility.
    • Wage flexibility is necessary.
    • A system of stabilizing transfers should be in place.

Advantages and Disadvantages of Adopting a Common Currency

  • Advantages:
    • Improves economic efficiency.
    • Reduces the transaction costs of exchanging currency.
    • Eliminates exchange-rate risk.
    • Increases competition and broadens/deepens Euro financial markets.
  • Disadvantages:
    • Member countries in the EU may no longer use monetary policy or exchange rates to address economic disturbances.
    • Must manage budget deficits carefully.

Eurozone’s Problems and Challenges

  • Problems:
    • Some member countries did not meet economic entry criteria.
    • Difficulties in integrating different economies without adjustments.
    • The challenge of reducing budget deficits remains significant.
  • Challenges:
    • The ability of the European Central Bank to maintain a focus on long-term price stability.
    • Operating monetary policy effectively amid diverse economic conditions.
    • The necessity for structural reforms to ameliorate economic disparities.

North American Free Trade Agreement (NAFTA)

  • Background: Established in 1994, involving Mexico, Canada, and the United States.
    • Purpose: To enable better access to each other's markets, technology, labor, and expertise.
  • Economies of Scale:
    • Winner and Loser scenarios exist within the U.S. as it engages in free trade with Mexico.
  • NAFTA’s Benefits & Costs:
    • Benefits to Mexico are substantially greater than for the U.S. & Canada due to the comparative scales of their economies.
    • Mexico experiences an increase in production in sectors where it holds a comparative advantage.
    • Costs to Mexico include devastation for producers in sectors such as rice, beef, pork, and poultry due to inability to compete with U.S. products.
    • For Canada, the primary concern pertains to integration with the U.S. economy, threatening its social welfare model, with benefits mostly in the form of safeguards, maintenance of trade status, and equal access to the Mexican market.
    • Benefits for the U.S. include expanding trade opportunities, reducing prices, increasing competition, and enhanced political stability in neighboring Mexico as it grows wealthier.
    • Costs to the U.S. involve industries such as citrus and sugar that rely on import barriers, and unskilled workers facing competition from lower-paid workers, leading to job losses, although fears of mass relocations to Mexico have not materialized, as U.S. productivity allows for competitive wages.

Economic Data Summary

  • Table 8.5: Gross Domestic Product (Purchasing Power Parity), Employment, and Labor Productivity, 2015
    • Employment = (1 - unemployment rate) × labor force
    • Labor productivity = GDP/number of persons employed
    • Note: Due to rounding, numbers may not be precise.